Registration No. 333-15867
Rule 424(b)(4)
Prospectus
[LOGO] Quest Diagnostics Incorporated
$150,000,000
10-3/4% Senior Subordinated Notes due 2006
Interest payable June 15 and December 15
Issue Price: 100%
Interest on the Notes is payable on June 15 and December 15 of each year,
commencing June 15, 1997. The Notes are subject to redemption on or after
December 15, 2001, in whole or in part, at the option of the Company, at the
redemption prices set forth herein. As discussed below, the Notes are also
subject to redemption at a premium, at the option of the Company, in case the
Distributions do not occur prior to March 31, 1997. Upon a Change of Control (as
defined), holders of the Notes may require the Company to purchase all or a
portion of the Notes at a purchase price equal to 101% of the principal amount
thereof, plus accrued and unpaid interest (if any) to the date of purchase. In
addition, in the event of certain asset sales, the Company may be required to
make an offer to purchase Notes at a price equal to 100% of the principal amount
thereof, plus accrued and unpaid interest (if any) to the date of purchase, with
the net proceeds of such asset sales. See "Description of the Notes--Optional
Redemption" and "--Repurchase at the Option of Holders."
The Notes will be unsecured senior subordinated obligations of the Company and
will be fully and unconditionally guaranteed (the "Senior Subordinated
Guarantees") on a senior subordinated basis by all of the Restricted
Subsidiaries of the Company (collectively, "the Guarantors"). The Notes and the
Senior Subordinated Guarantees will be subordinated in right of payment to all
existing and future Senior Debt and Senior Guarantees of the Company and the
Guarantors, respectively, will rank pari passu in right of payment with all
unsecured senior subordinated indebtedness and all unsecured senior subordinated
guarantees of the Company and the Guarantors, respectively, and will rank senior
in right of payment to any future indebtedness and guarantees of the Company and
the Guarantors, respectively, that may be subordinated thereto. On a pro forma
basis, as of September 30, 1996, after giving effect to the Distributions, the
sale of the Notes and the application of the proceeds thereof and $350.0 million
of borrowings under the Credit Facility, there was $367 million of Senior Debt
of Quest Diagnostics outstanding. The Notes are effectively subordinated to all
existing and future indebtedness and other liabilities of the Company's
Subsidiaries that are Unrestricted Subsidiaries, and thus not Guarantors, and
would be so subordinated to all existing and future indebtedness of the
Guarantors if the Senior Subordinated Guarantees were avoided or subordinated in
favor of the Guarantors' other creditors.
The Notes will be issued only in registered form in denominations of $1,000
and integral multiples thereof. See "Description of the Notes."
The Notes are being offered in connection with the Distributions of the
Company's Common Stock and the Covance Common Stock to holders of Corning Common
Stock. The net proceeds of the Notes offering will be used to repay, prior to
the Distributions, certain indebtedness owed by the Company to Corning. The
closing of the offering of the Notes is anticipated to occur prior to the
Distributions.
If as a result of an event outside the control of Corning, the Company and
Covance, the Distributions do not occur prior to March 31 , 1997, the Notes will
be subject to redemption, as a whole and not in part, at the option of the
Company, prior to June 30, 1997, at a redemption price equal to 101% of the
principal amount of the Notes plus accrued and unpaid interest, if any, to the
date fixed for redemption. See "The Distributions" and "Description of the
Notes--Optional Redemption."
The Notes have been approved for listing on the New York Stock Exchange, subject
to official notice of issuance.
See "Risk Factors" beginning on page 15 for certain considerations relevant
to an investment in the Notes.
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES
AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY
IS A CRIMINAL OFFENSE.
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Underwriting
Discount and Proceeds to
Price to Public (1) Commissions (2) Company (1)(3)
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Per Note 100% 2.75% 97.25%
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Total $150,000,000 $4,125,000 $145,875,000
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(1) Plus accrued interest, if any, from December 16, 1996.
(2) The Company and Corning have agreed to indemnify the Underwriters against
certain liabilities, including liabilities under the Securities Act of 1933.
Corning has agreed to pay the Underwriters certain fees in connection with
the Offering and the Distributions. See "Underwriting."
(3) Before deducting expenses payable by the Company estimated at $800,000.
The Notes are being offered by the Underwriters, subject to prior sale, when,
as and if delivered to and accepted by the Underwriters. The Underwriters
withhold the right to withdraw, cancel or modify such offer and to reject
orders in whole or in part. It is expected that delivery of the Notes will be
made in New York, New York, against payment therefor in immediately available
funds on or about December 16, 1996.
J.P. Morgan & Co.
Goldman, Sachs & Co.
Lazard Freres & Co. LLC
December 11, 1996.
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Map of the United States and Mexico indicating the locations of Quest
Diagnostics Regional Labs, Headquarters, Branch labs and Esoteric lab.
Map heading - Quest Diagnostics' Geographic Coverage.
IN CONNECTION WITH THIS OFFERING, THE UNDERWRITERS MAY OVERALLOT OR EFFECT
TRANSACTIONS WHICH STABILIZE OR MAINTAIN THE MARKET PRICE OF THE NOTES AT A
LEVEL ABOVE THAT WHICH MIGHT OTHERWISE PREVAIL IN THE OPEN MARKET. SUCH
STABILIZING, IF COMMENCED, MAY BE DISCONTINUED AT ANY TIME.
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No person has been authorized to give any information or to make any
representation other than those contained in this Prospectus, and if given or
made, such information or representation must not be relied upon as having
been authorized by the Company or by any of the Underwriters. This Prospectus
does not constitute an offer to sell, or a solicitation of an offer to buy,
the Notes in any jurisdiction to any person to whom it is unlawful to make
such offer or solicitation. Neither the delivery of this Prospectus nor any
sale made hereunder shall, under any circumstances, create any implication
that there has been no change in the affairs of the Company since the date
hereof.
Table of Contents
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Page
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Available Information 4
Prospectus Summary 5
Risk Factors 15
The Distributions 21
Use of Proceeds 25
Capitalization 26
Selected Historical Financial Data 27
Pro Forma Financial Information 31
Management's Discussion and Analysis of Financial Condition and
Results of Operations 38
Business 46
Management 66
Security Ownership by Certain Beneficial Owners and Management 76
Description of the Credit Facility 77
Description of the Notes 79
Underwriting 99
Validity of the Notes and Guarantees 100
Experts 100
Index to Financial Statements F-1
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Until January 5, 1997 (25 days after the date of this Prospectus), all dealers
effecting transactions in the Notes, whether or not participating in this
distribution, may be required to deliver a Prospectus. This is in addition to
the obligations of dealers to deliver a Prospectus when acting as
underwriters and with respect to their unsold allotments or subscriptions.
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Available Information
The Company has filed a Registration Statement on Form 10 under the Securities
Exchange Act of 1934, as amended (the "Exchange Act"), registering its common
stock, and is subject to the informational requirements of the Exchange Act, and
in accordance therewith will file reports, proxy statements and other
information with the Securities and Exchange Commission (the "Commission").
Reports, proxy statements and other information filed by the Company with the
Commission can be inspected and copies made at the public reference facilities
of the Commission, 450 Fifth Street, N.W., Room 1024, Washington, D.C. 20549 and
at the Commission's Regional Offices: 7 World Trade Center, 13th Floor, New
York, New York 10048 and Citicorp Center, 500 West Madison Street, Suite 1400,
Chicago, Illinois 60611. Copies of such materials can be obtained from the
Public Reference Section of the Commission, 450 Fifth Street, N.W., Room 1024,
Washington, D.C. 20549 at the prescribed rates. In addition, the Commission
maintains a Web site that contains reports, proxy and information statements and
other information regarding registrants that file electronically, such as the
Company. The address of the Commission's Web site is http://www.sec.gov. The
Company's common stock has been accepted for listing on the New York Stock
Exchange ("NYSE") and, with such listing, such reports, proxy statements and
other information regarding the Company may also be inspected and copied at the
offices of the NYSE, 20 Broad Street, New York, New York 10005.
The Company and the Guarantors have filed with the Commission a joint
Registration Statement on Form S-1 (the "Registration Statement") under the
Securities Act of 1933, as amended (the "Securities Act"), with respect to
the Notes and the Guarantees offered hereby. This Prospectus omits
information contained in the Registration Statement in accordance with the
rules and regulations of the Commission. Reference is hereby made to the
Registration Statement and related exhibits for further information with
respect to the Company, the Guarantors, the Notes and the Guarantees offered
hereby. Statements contained herein concerning the provisions of any document
are not necessarily complete and, in each instance, reference is made to the
copy of such document filed as an exhibit to the Registration Statement or
otherwise filed with the Commission. Each such statement is qualified in its
entirety by such reference. Copies of the Registration Statement and the
exhibits thereto may be inspected, without charge, at the offices of the
Commission, or obtained at prescribed rates from the Public Reference Section
of the Commission, at the addresses set forth above.
The Company has agreed to furnish holders of Notes its annual reports
containing financial statements audited by independent auditors and quarterly
reports containing unaudited financial information for the first three
quarters of each year for as long as the Notes remain outstanding.
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Prospectus Summary
This Summary is qualified by the more detailed information (including the
financial statements and related notes) set forth elsewhere in this
Prospectus which should be read in its entirety. Unless the context
indicates, or it is specifically indicated otherwise, all references to (i)
"Corning" include Corning Incorporated, a New York corporation, and its
consolidated subsidiaries, (ii) "Quest Diagnostics" or the "Company" include
Corning Clinical Laboratories Inc. (to be renamed Quest Diagnostics
Incorporated prior to the Distributions), a Delaware corporation, and its
direct and indirect subsidiaries (other than Covance) and assume that the
Distributions have occurred, and (iii) "Covance" include Covance Inc.
(formerly Corning Pharmaceutical Services Inc.), a Delaware corporation, and
its direct and indirect subsidiaries and assume that the Distributions have
occurred. Capitalized terms used but not defined in this Summary are defined
elsewhere in this Prospectus.
The Company
Quest Diagnostics is one of the largest independent clinical laboratory
testing companies in the United States. Quest Diagnostics offers a broad
range of routine and specialty ("esoteric") testing services used by the
medical profession in the diagnosis, monitoring and treatment of disease and
other medical conditions. Quest Diagnostics' network, which processes
approximately 60 million requisitions for diagnostic tests annually, consists
of 17 regional laboratories across the United States and the Corning Nichols
Institute ("Nichols") esoteric testing laboratory in San Juan Capistrano,
California. In addition, Quest Diagnostics has 14 branch laboratories in the
United States as well as one branch laboratory in Mexico City (branch
laboratories are smaller than regional laboratories), approximately 200
"STAT" laboratories and approximately 850 patient service centers located
throughout the United States. For the year ended December 31, 1995 and the
nine months ended September 30, 1996, Quest Diagnostics had net revenues of
$1,629 million and $1,231 million, respectively, and Adjusted EBITDA (income
(loss) before income taxes plus net interest expense, depreciation and
amortization and restructuring and other special charges) of $177 million and
$135 million, respectively.
Quest Diagnostics operates 24 hours a day, 365 days a year, utilizing a fully
integrated collection and processing system. Quest Diagnostics generally
performs and reports most routine procedures within 24 hours, employing a
variety of sophisticated and computerized laboratory testing instruments.
Quest Diagnostics provides daily pickup of specimens from most customers
principally through an in-house courier system. The specimens are sent to one
of the Company's laboratories where one or more tests are performed.
Each patient specimen is accompanied by a test requisition form, which is
completed by the customer, that indicates the tests to be performed and
provides the necessary billing information. Each specimen and related
requisition form is checked for completeness and then given a unique
bar-coded identification number. Once the appropriate information is entered
into the computer system, the tests are performed and the results are
delivered to the doctor, primarily through computer interface or manually.
Corning entered the clinical laboratory business in 1982 with the acquisition
of MetPath Inc. ("MetPath"), which was founded in 1967 and was one of the
first laboratories to expand beyond a regional market. Since January 1993,
Quest Diagnostics has acquired over thirty laboratories, including Damon
Corporation ("Damon"), Bioran Medical Laboratory ("Bioran") and Maryland
Medical Laboratory, Inc. ("MML"). In 1994, Quest Diagnostics enhanced its
presence in the esoteric testing market through the acquisition of Nichols, a
preeminent clinical laboratory with a leading reputation for esoteric testing
and test innovations.
While Corning's ownership provided the Company with the capital to grow
through acquisitions and to become one of the nation's largest independent
clinical laboratory testing companies, the management of both Corning and
Quest Diagnostics believe that Quest Diagnostics will be more competitive and
operate more successfully in the future as an independent company, with a
strong, focused and experienced management team to concentrate on customer
needs. Independence will also enable Quest Diagnostics to motivate its
employees by offering equity-based incentives tied directly to the
performance of the Company and individual performance. Quest Diagnostics'
management team has implemented a new business strategy, which focuses the
business around three key strategic areas: clinical operations, customer
focus and technological leadership and excellence.
The Clinical Laboratory Testing Industry
Clinical testing is a critical component in the delivery of quality health
care service to patients. Currently, clinical laboratory testing is the first
step in determining how a significant amount of all health care dollars are
spent.
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Quest Diagnostics believes that in 1995 the entire United States clinical
laboratory industry had revenues exceeding $30 billion. The clinical laboratory
industry consists primarily of three types of providers: hospital-affiliated
laboratories, independent clinical laboratories, such as Quest Diagnostics, and
physician-office laboratories. The Company believes that in 1995 approximately
56% of the clinical testing revenues in the United States were attributable to
hospital-affiliated laboratories, approximately 36% were attributable to
independent clinical laboratories and approximately 8% were attributable to
physicians in their offices and laboratories.
Quest Diagnostics believes that consolidation will continue in the clinical
laboratory testing business. In addition, Quest Diagnostics believes that it and
the other large independent clinical laboratory testing companies may have the
opportunity to increase their share of the overall clinical laboratories testing
market due to a number of external factors, including cost efficiencies afforded
by large-scale automated testing, Medicare reimbursement reductions and the
growth of managed health care entities which require low-cost testing services
and large service networks. In addition, legal restrictions on physician
referrals and the ownership of laboratories as well as increased regulation of
laboratories are expected to contribute to the continuing consolidation of the
industry.
Quest Diagnostics believes that a number of factors are likely to positively
influence the volume of clinical laboratory testing performed in the United
States in the future, including (1) the general aging of the population in
the United States; (2) an expanded base of scientific knowledge which has led
to the development of more sophisticated specialized tests and an increase in
the awareness of physicians of the value of clinical laboratory testing as a
cost-effective means of early detection of disease and monitoring of
treatment; (3) an increase in the number and types of tests which are, due to
advances in technology and increased cost efficiencies, readily available on
a more affordable basis to physicians; (4) expanded substance-abuse testing
by corporations and governmental agencies; and (5) increased testing for
sexually transmitted diseases such as AIDS. The impact of these factors is
expected to be offset in part by increased controls over the utilization of
clinical laboratory tests by both Medicare and the private sector,
particularly managed care organizations.
Business Strategy
Quest Diagnostics' overall goal is to be recognized by its customers, employees
and competitors as the best provider of comprehensive and innovative clinical
testing, information and services. To achieve this, Quest Diagnostics'
management team has focused the business around three key strategic areas:
clinical operations, customer focus and technological leadership and excellence.
(bullet) Best Supplier. Quest Diagnostics seeks to be the best supplier of
the highest quality and the lowest-cost testing services. Health
care providers and patients expect accurate, timely and consistent
laboratory test results at a fair price.
(bullet) Lowest-cost provider. Quest Diagnostics' average cost per requisition
varies significantly among its regional laboratories; there is an
approximately $7.00 difference in cost per requisition between the most
efficient regional laboratory and the average, and an approximately
$13.00 difference in cost per requisition between the most and the
least efficient regional laboratories. In many cases, these variations
do not relate to testing volumes or mixes, space costs, service
requirements or regional labor cost differences. To reduce costs, Quest
Diagnostics has begun to replicate the best practices from each region
throughout its national network. Management expects to achieve
significant cost savings within the next three years as these programs
are fully implemented. *
(bullet) Highest Quality Provider. Quest Diagnostics is dedicated to providing
accurate and timely test results and to being viewed by its customers
as the highest quality provider of clinical testing services. Quest
Diagnostics believes that implementation of best practices already
developed in certain regions will permit the Company to be viewed by
its customers as the highest quality provider of clinical testing
services.
(bullet) Preferred Provider. Quest Diagnostics seeks to be the preferred
provider of laboratory testing services to existing and new health care
networks on a selective basis determined by profitability of accounts.
Quest Diagnostics believes that it will become the preferred provider
to these networks as (1) large networks typically prefer to utilize
large independent clinical laboratories that can service them on a
national or regional basis and (2) the Company continues to pursue its
primary strategy of becoming the highest quality, lowest-cost provider.
To achieve this, Quest Diagnostics will employ a rigorous national and
regional process to both select and pursue customers and allocate
resources to support these efforts.
*This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See "Business-
Important Factors Regarding Forward Looking Statements." In particular, see
factors (a), (d) and (j).
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(bullet) Account Profitability. Quest Diagnostics intends to refocus its sales
efforts on pursuing and keeping profitable accounts. Quest Diagnostics
is actively reviewing the profitability of its current accounts,
including those with managed care organizations, and will either
increase pricing or eliminate accounts that cannot be serviced
profitably.
(bullet) Regional Profitability. Quest Diagnostics presently believes that it
has the leading market share among independent clinical laboratories in
most routine testing markets of the northeast, mid-Atlantic and midwest
regions. Approximately 65% of Quest Diagnostics' revenues and almost
all of its EBITDA is generated from markets in which the Company
believes that it has the leading market share. In most of these
markets, Quest Diagnostics believes that it also is the lowest cost
provider. Quest Diagnostics is evaluating its strategic alternatives
relative to units whose profitability does not meet its internal goals.
These alternatives may include joint ventures, alliances, or
dispositions. Quest Diagnostics believes that, while the clinical
laboratory industry is becoming national in scope, the Company can
subcontract with other clinical laboratories to perform testing for
national accounts in any markets in which the Company chooses not to
compete.
(bullet) Leading Innovator. Quest Diagnostics intends to remain a leading
innovator in the clinical laboratory industry by continuing to
introduce new tests, technology and services. Through its
relationship with the academic community and pharmaceutical and
biotechnology firms and a research and development budget exceeding
$15 million per year, Quest Diagnostics believes it is one of the
leaders in transferring innovation from academic biotechnology
laboratories to the market.
Recent Developments
By a plea agreement and civil agreement and release dated October 9, 1996,
between the Department of Justice ("DOJ") and Damon, all federal criminal
matters within the scope of the various federal investigations against Damon,
and all claims including the civil qui tam cases underlying the civil
investigations were settled for an aggregate of $119 million, which sum was
reimbursed to Quest Diagnostics by Corning. The Damon settlement does not
exclude Quest Diagnostics from future participation in any federal health care
programs on account of Damon's practices.
Quest Diagnostics' aggregate reserve with respect to all governmental and
private claims was $215 million at September 30, 1996 and is estimated to be
reduced to $85 million as of the Distribution Date as a result of the payment of
settled claims, primarily the Damon settlement of $119 million. Based on
information available to management and Quest Diagnostics' experience with past
settlements (including the fact that the aggregate amount of the Damon
settlement was significantly in excess of established reserves) management has
reassessed its reserve levels and believes that its current level of reserves is
adequate. However, it is possible that additional information may become
available which may cause the final resolution of these matters to be in excess
of established reserves by an amount which could be material to Quest
Diagnostics' results of operations and, for non-indemnified claims, Quest
Diagnostics' cash flows in the period in which such claims are settled. While
none of the governmental or nongovernmental investigations or claims is covered
by insurance, Quest Diagnostics does not believe that these matters will have a
material adverse effect on Quest Diagnostics' overall financial condition.
Corning Indemnity
In connection with the Distributions, Corning has agreed to indemnify Quest
Diagnostics against all monetary penalties, fines or settlements arising out of
any governmental claims arising out of alleged violations of applicable federal
fraud and health care statutes and relating to billing practices of Quest
Diagnostics and its predecessors that have been settled or are pending on the
Distribution Date. Corning has also agreed to indemnify Quest Diagnostics for
50% of the aggregate of all judgment or settlement payments made by Quest
Diagnostics that are in excess of $42.0 million in respect of claims by private
parties (i.e., nongovernmental parties such as private insurers) that relate to
indemnified or previously settled governmental claims and that allege
overbillings by Quest Diagnostics or any existing subsidiaries of Quest
Diagnostics, for services provided prior to the Distribution Date; provided,
however, such indemnification for nongovernmental claims will not exceed $25.0
million in the aggregate and all amounts indemnified against by Corning for the
benefit of Quest Diagnostics will be calculated on a net after-tax basis. Such
indemnification will not cover (i) any governmental claims that arise after the
Distribution Date pursuant to service of subpoena or other notice of such
investigation after the Distribution Date, (ii) any nongovernmental claims
unrelated to the indemnified governmental claims or investigations, (iii) any
nongovernmental claims not settled prior to five years after the Distribution
Date, (iv) any consequential or incidental damages relating to the billing
claims, including losses of revenues and profits as a consequence of exclusion
for participation in federal or state health care programs or (v) the fees and
expenses of litigation.
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The Distributions
On May 13, 1996, the board of directors of Corning approved a plan to
distribute to Corning shareholders the clinical laboratory testing business
being conducted by Quest Diagnostics and the contract research business being
conducted by Quest Diagnostics' wholly owned subsidiary, Covance (together,
the "Distributions").
The Distributions will be effected by distributing all of the outstanding shares
of Quest Diagnostics common stock (the "Quest Diagnostics Common Stock") to
holders of Corning common stock (the "Corning Common Stock"), followed
immediately by the distribution of all of the common stock of Covance (the
"Covance Common Stock") to those same holders, as holders of Quest Diagnostics
Common Stock. It is expected that the Distributions will be made on December 31,
1996 (the date on which the Distributions are to be made, the "Distribution
Date").
Prior to the consummation of the offering of the Notes contemplated hereby (the
"Offering"), the Company entered into a $450 million senior, secured credit
facility (the "Credit Facility"), among the Company, the lenders listed therein,
NationsBank, N.A., as Issuing Bank, Wachovia Bank of Georgia, N.A., as Swingline
Bank, and Morgan Guaranty Trust Company of New York, as Administrative Agent.
The Credit Facility is comprised of a $300 million six-year amortizing term
loan ("Tranche A Loan"), a $50 million seven-year term loan ("Tranche B Loan"
and together with the Tranche A Loan, the "Term Loans") and a $100 million
six-year revolving working capital facility (the "Working Capital Facility").
Corning currently has approximately $1.2 billion of Quest Diagnostics
intercompany debt. Approximately $145 million of net proceeds from the
Offering, together with the $350 million of borrowings under the Term Loans,
will be paid to Corning in satisfaction of a portion of the outstanding
intercompany debt. Corning will contribute the remaining intercompany debt to
Quest Diagnostics' capital. Borrowings under the Working Capital Facility,
substantially all of which is expected to be available as of the Distribution
Date, will provide for future working capital needs and other general
corporate purposes.
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The Offering
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Securities Offered $150,000,000 aggregate principal amount of 10-3/4% Senior Subordinated
Notes due December 15, 2006 (the "Notes").
Maturity Date December 15, 2006.
Interest Payment Date June 15 and December 15, commencing June 15, 1997.
Optional Redemption by the Company The Notes will be redeemable, in whole or in part, at the option of the
Company at any time on or after December 15, 2001, at the redemption
prices set forth herein, plus accrued and unpaid interest, if any, to
but excluding the date fixed for redemption. In addition, if as a
result of an event outside the control of Corning, Quest Diagnostics
and Covance, the Distributions do not occur prior to March 31, 1997,
the Notes will be subject to redemption, as a whole and not in part, at
the option of Quest Diagnostics, prior to June 30, 1997, at a
redemption price equal to 101% of the principal amount of the Notes,
plus accrued and unpaid interest, if any, to but excluding the date
fixed for redemption. See "Description of the Notes--Optional
Redemption."
Change of Control Offer Upon a Change of Control, the Company has the obligation to offer to
purchase all the outstanding Notes at a price equal to 101% of the
principal amount thereof, plus accrued and unpaid interest, if any, to
but excluding the date of purchase. See "Description of the Notes--
Repurchase at the Option of Holders--Change of Control" for a
discussion of the circumstances in which the Company may not be
required to make an offer to purchase upon a Change of Control.
Offers to Purchase In the event of certain asset sales, the Company will be required to
offer to repurchase the Notes at 100% of their principal amount, plus
accrued and unpaid interest, if any, to but excluding the date of
purchase with the net proceeds of such asset sales.
Subordination The Notes will be general unsecured obligations of the Company and will
be subordinated in right of payment to all existing and future Senior
Debt of the Company, including all indebtedness of the Company under
the Credit Facility. The Notes will rank Pari Passu in right of payment
with any other senior subordinated indebtedness of the Company.
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Subsidiary Guarantees The Notes will be guaranteed, jointly and severally, and fully and
unconditionally, on a senior subordinated basis by the Guarantors (the
"Senior Subordinated Guarantees"). The obligations of any Guarantor
with respect to its Senior Subordinated Guarantee will be subordinated
in right of payment, to the same extent as the obligations of the
Company in respect of the Notes, to all existing and future Senior
Guarantees, which will include the guarantees of the Credit Facility.
The Senior Subordinated Guarantees would also be subordinated to all
existing and future indebtedness of the Guarantors if the Senior
Subordinated Guarantees were avoided or subordinated in favor of the
Guarantors' other creditors. See "Risk Factors--Fraudulent Conveyance."
The obligations of a Guarantor under its Senior Subordinated Guarantee
will be released in certain circumstances, including if the Guarantor
ceases to guarantee the Credit Facility. See "Description of the
Notes--Senior Subordinated Guarantees."
Principal Covenants The indenture under which the Notes are issued (the "Indenture") will
impose certain limitations on the ability of the Company and its
subsidiaries to, among other things, incur additional indebtedness, pay
dividends or make certain other restricted payments, consummate certain
asset sales, enter into certain transactions with affiliates, incur
indebtedness that is subordinate in right of payment to any Senior Debt
and senior in right of payment to the Notes, enter into leases, incur
liens, merge or consolidate with any other person, or sell, assign,
transfer, lease, convey or otherwise dispose of all or substantially
all of the assets of the Company.
Use of Proceeds The Company intends to use the proceeds from the sale of the Notes,
together with the proceeds of borrowings under the Credit Facility, to
repay certain intercompany indebtedness owed to Corning. See "Use of
Proceeds."
The Distributions The Notes are being offered in connection with the Distributions of the
Quest Diagnostics Common Stock and the Covance Common Stock to holders
of Corning Common Stock. The closing of the offering of the Notes is
anticipated to occur prior to the Distributions.
Listing The Notes have been approved for listing on the New York Stock Exchange,
subject to official notice of issuance.
Risk Factors See "Risk Factors" for a discussion of certain factors that should be
considered in connection with an investment in the Notes.
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Summary Financial Data
The following table summarizes certain historical and pro forma financial
data of Quest Diagnostics at the dates and for each of the periods indicated.
The selected financial data as of and for each of the years ended December
31, 1995, 1994 and 1993 have been derived from the audited combined financial
statements of (the "Audited Financial Statements") and the notes thereto
included elsewhere herein. The selected financial data as of and for the
three and nine months ended September 30, 1996 and 1995 have been derived
from the unaudited interim combined financial statements of Quest Diagnostics
(the "Interim Financial Statements" and, together with the Audited Financial
Statements, the "Financial Statements") and the notes thereto included
elsewhere herein. In the opinion of Quest Diagnostics management, the
unaudited interim combined financial statements include all adjustments,
consisting of only normal recurring adjustments, that are necessary for a
fair presentation of the financial position and results of operations for
these periods. The unaudited interim results of operations for the three and
nine months ended September 30, 1996 are not necessarily indicative of the
results for the entire year ending December 31, 1996.
The selected pro forma financial data have been derived from the unaudited
pro forma combined financial information of Quest Diagnostics for the year
ended December 31, 1995 and for the three and nine months ended September 30,
1996 (the "Pro Forma Financial Information") and the notes thereto included
elsewhere herein. The pro forma statement of operations data gives effect to
the Distributions and the Accounting Policy Change (as defined below) as if
they had occurred on January 1, 1995 and the pro forma balance sheet data
gives effect to the Distributions and the Accounting Policy Change as if they
had occurred on September 30, 1996. The pro forma financial data does not
purport to represent what Quest Diagnostics' results of operations would have
been if the Distributions and the Accounting Policy Change had in fact
occurred on such dates, nor does it purport to indicate the future financial
position or results of future operations of Quest Diagnostics. The pro forma
adjustments are based upon currently available information and certain
assumptions that Quest Diagnostics management believes to be reasonable. The
summary historical and pro forma financial data set forth below should be
read in conjunction with "Selected Historical Financial Data," "Management's
Discussion and Analysis of Financial Condition and Results of Operations,"
the Financial Statements and the notes thereto and the Pro Forma Financial
Information and the notes thereto.
11
<PAGE>
<TABLE>
<CAPTION>
Three Months Ended September 30, Nine Months Ended September 30,
------------------------------------------------------------------------------------------------
Pro Forma Historical Pro Forma Historical
------------------------------- -------------------------------
1996(a) 1996 1995 1996(a) 1996 1995
--------------- --------------- --------------- ---------------- ---------------- --------------
(in thousands, except share, per share and percentage data)
<S> <C> <C> <C> <C> <C> <C>
Statement of Operations
Data:
Net revenues $ 405,352 $ 405,352 $ 399,959 $ 1,231,290 $1,231,290 $1,239,474
Costs and expenses:
Cost of services 255,390 255,390 240,868 768,809 768,809 735,984
Selling, general and
administrative 125,190 125,190 181,346(c) 371,439 371,439 399,635(c)
Provision for
restructuring and other
special charges(d) 155,730 155,730 201,730 201,730 45,885
Interest expense, net 11,804 19,866 20,927 35,784 59,887 61,529
Amortization of
intangible assets 7,672 10,328 11,293 23,803 31,772 33,678
Other, net 1,837 1,837 1,930 (198) (198) 4,429
--------------- --------------- --------------- ---------------- ---------------- --------------
Total 557,623 568,341 456,364 1,401,367 1,433,439 1,281,140
--------------- --------------- --------------- ---------------- ---------------- --------------
Income (loss) before taxes (152,271) (162,989) (56,405) (170,077) (202,149) (41,666)
Income tax expense
(benefit) (40,369) (43,553) (17,810) (33,759) (43,280) (3,642)
--------------- --------------- --------------- ---------------- ---------------- --------------
Income (loss) before
cumulative effect of
change in accounting
principle (111,902) (119,436) (38,595) (136,318) (158,869) (38,024)
Cumulative effect of
change in accounting
principle
--------------- --------------- --------------- ---------------- ---------------- --------------
Net income (loss) $ (111,902) $ (119,436) $ (38,595) $ (136,318) $ (158,869) $ (38,024)
=============== =============== =============== ================ ================ ==============
Pro forma shares
outstanding(e) 28,901,735 28,901,735
Pro forma net loss per
share $ (3.87) $ (4.72)
Balance Sheet Data (at end
of period):
Cash $ 40,000 $ 48,319 $ 46,908 $ 40,000 $ 48,319 $ 46,908
Working capital 306,741 114,718 129,319 306,741 114,718 129,319
Total assets 1,623,384 1,886,378 1,896,058 1,623,384 1,886,378 1,896,058
Long-term debt 515,494 1,219,900 1,114,367 515,494 1,219,900 1,114,367
Total debt 517,379 1,231,785 1,226,211 517,379 1,231,785 1,226,211
Stockholder's equity 615,024 132,670 320,576 615,024 132,670 320,576
Ratio of earnings to fixed
charges -- (f) -- (f) -- (f) -- (f) -- (f) -- (f)
Supplemental Data:
Net cash provided by
operating activities $ 25,236 $ 25,236 $ 38,202 $ 41,937 $ 41,937 $ 53,789
Net cash used in investing
activities (7,904) (7,904) (17,044) (53,097) (53,097) (77,911)
Net cash provided by (used
in) financing activities (6,618) (6,618) (18,006) 23,033 23,033 32,311
Bad debt expense $ 30,539 $ 30,539 $ 85,831(c) $ 81,891 $ 81,891 $ 127,297(c)
Bad debt expense as a % of
net revenues 7.5% 7.5% 21.5% 6.7% 6.7% 10.3%
Rent expense $ 12,515 $ 12,515 $ 11,860 $ 37,315 $ 37,315 $ 35,060
Capital expenditures 11,912 11,912 16,441 58,802 58,802 56,062
Depreciation expense $ 14,672 $ 14,672 $ 14,275 $ 43,460 $ 43,460 $ 42,358
EBITDA(g) $ (118,123)(h) $ (118,123)(h) $ (9,910)(c) $ (67,030)(h) $ (67,030)(h) $ 95,899(c)
EBITDA as a % of net
revenues (29.1%) (29.1%) (2.5%) (5.4%) (5.4%) 7.7%
Adjusted EBITDA(i) $ 37,607 $ 37,607 $ (9,910)(c) $ 134,700 $ 134,700 $ 141,784(c)
Adjusted EBITDA as a % of
net revenues 9.3% 9.3% (2.5%) 10.9% 10.9% 11.4%
Supplemental Ratio Data:
Adjusted EBITDA/interest
expense, net 3.2x 3.8x
(Adjusted EBITDA-capital
expenditures)/interest
expense, net 2.2x 2.1x
(Total debt--cash)/annualized
adjusted EBITDA 3.2x 2.7x
</TABLE>
(Footnotes on page 14)
12
<PAGE>
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------------------------------------------
Pro Forma Historical
-------------------------------------------
1995(a) 1995 1994(b) 1993
--------------- --------------- ------------- -------------
(in thousands, except share, per share and percentage data)
<S> <C> <C> <C> <C>
Statement of Operations Data:
Net revenues $ 1,629,388 $1,629,388 $1,633,699 $1,416,338
Costs and expenses:
Cost of services 980,232 980,232 969,844 805,729
Selling, general and administrative 523,271(c) 523,271(c) 411,939 363,579
Provision for restructuring and other
special charges(d) 50,560 50,560 79,814 99,600
Interest expense, net 49,209 82,016 63,295 41,898
Amortization of intangible assets 34,031 44,656 42,588 28,421
Other, net 6,221 6,221 3,464 6,423
--------------- --------------- ------------- -------------
Total 1,643,524 1,686,956 1,570,944 1,345,650
--------------- --------------- ------------- -------------
Income (loss) before taxes (14,136) (57,568) 62,755 70,688
Income tax expense (benefit) 7,443 (5,516) 34,410 25,929
--------------- --------------- ------------- -------------
Income (loss) before cumulative effect of
change in accounting principle (21,579) (52,052) 28,345 44,759
Cumulative effect of change in accounting
principle (10,562)
--------------- --------------- ------------- -------------
Net income (loss) $ (21,579) $ (52,052) $ 28,345 $ 34,197
=============== =============== ============= =============
Pro forma shares outstanding(e) 28,901,735
Pro forma net loss per share $ (0.75)
Balance Sheet Data (at end of period):
Cash $ 36,446 $ 38,719 $ 39,410
Working capital 200,740 214,358 139,771
Total assets 1,853,385 1,882,663 1,861,162
Long-term debt 1,195,566 1,153,054 1,025,787
Total debt 1,207,714 1,165,626 1,123,307
Stockholder's equity 295,801 386,812 395,509
Ratio of earnings to fixed charges -- (f) -- (f) 1.77(f) 2.20(f)
Supplemental Data:
Net cash provided by operating activities $ 85,828 $ 85,828 $ 37,963 $ 99,614
Net cash used in investing activities (93,087) (93,087) (46,186) (473,687)
Net cash provided by (used in) financing
activities 4,986 4,986 7,532 392,956
Bad debt expense $ 152,590(c) $ 152,590(c) $ 59,480 $ 47,240
Bad debt expense as a % of net revenues 9.4% 9.4% 3.6% 3.3%
Rent expense $ 46,900 $ 46,900 $ 49,400 $ 46,900
Capital expenditures 74,045 74,045 93,354 65,317
Depreciation expense $ 56,857 $ 56,857 $ 46,929 $ 38,058
EBITDA(g) $ 125,961(c) $ 125,961(c) $ 215,567 $ 179,065
EBITDA as a % of net revenues 7.7% 7.7% 13.2% 12.6%
Adjusted EBITDA(i) $ 176,521(c) $ 176,521(c) $ 295,381 $ 278,665
Adjusted EBITDA as a % of net revenues 10.8% 10.8% 18.1% 19.7%
Supplemental Ratio Data:
Adjusted EBITDA/interest expense, net 3.6x
(Adjusted EBITDA-capital expenditures)/
interest expense, net 2.1x
</TABLE>
(Footnotes on page 14)
13
<PAGE>
(Footnotes for preceding pages)
(a) Adjusted to reflect the pro forma effects of the Distributions and the
Accounting Policy Change. See "Selected Historical Financial Data" and "Pro
Forma Financial Information."
(b) In August 1993, Quest Diagnostics acquired Damon, a national clinical
testing laboratory with approximately $280 million in annualized revenue,
excluding Damon's California-based laboratories which were sold in April
1994. In November 1993, Quest Diagnostics acquired certain clinical-testing
laboratories of Unilab Corporation ("Unilab"), with approximately $90
million in annualized revenue. The Damon and Unilab acquisitions were
accounted for as purchases. Quest Diagnostics acquired MML, Nichols
Institute and Bioran in June, August and October 1994, respectively, and
accounted for these acquisitions as poolings of interest. Results presented
include the results of Quest Diagnostics, MML, Nichols Institute and Bioran
on a pooled basis. The increase in 1994 net revenues compared to 1993 net
revenues was primarily due to the Damon and Unilab acquisitions.
(c) Includes a third quarter 1995 charge of $62.0 million to increase the
reserve for doubtful accounts and allowances resulting from billing systems
implementation and integration problems at certain laboratories and
increased regulatory requirements.
(d) Provision for restructuring and other special charges includes charges for
restructurings primarily for workforce reduction programs, the write-off of
fixed assets and the costs of exiting a number of leased facilities. Other
special charges is primarily comprised of settlement reserves for claims
related to billing practices. See Note 5 to the Audited Financial Statements
and Notes 2 and 3 to the Interim Financial Statements.
(e) Includes the issuance of approximately 28.0 million shares of Quest
Diagnostics Common Stock in the Quest Diagnostics Spin-Off Distribution and
the issuance of an estimated 900,000 shares into the Quest Diagnostics
employee stock ownership plan.
(f) For purposes of this calculation, earnings consist of pretax income from
continuing operations plus fixed charges. Fixed charges consist of interest
expense and one-third of rental expense, representing that portion of rental
expense deemed representative of the interest factor. Earnings were
insufficient to cover fixed charges by the following amounts (in thousands):
<TABLE>
<CAPTION>
Three Months Ended September 30, Nine Months Ended September 30, Year Ended December 31,
----------------------------------- --------------------------------- --------------------------
Pro Forma Historical Pro Forma Historical Pro Forma Historical
------------ -------------------- ---------- --------------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
1996 1996 1995 1996 1996 1995 1995 1995
$152,271 $162,989 $56,405 $170,077 $202,149 $41,666 $14,136 $57,568
</TABLE>
(g) EBITDA represents income (loss) before income taxes plus net interest
expense and depreciation and amortization. EBITDA is presented and discussed
because management believes that EBITDA is a useful adjunct to net income
and other measurements under generally accepted accounting principles since
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. EBITDA is not a measure of financial
performance under generally accepted accounting principles 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.
(h) 1996 EBITDA includes charges of $142 million and $188 million for the three
months and nine months ended September 30, 1996, respectively, related to
charges to establish additional reserves for the Damon and other related
claims. In October 1996, Corning contributed $119 million to Quest
Diagnostics' capital to fund the settlement of billing issues related to
Damon and has agreed to indemnify Quest Diagnostics against certain related
and similar claims pending at the Distribution Date.
(i) Adjusted EBITDA represents income (loss) before income taxes plus net
interest expense, depreciation and amortization and restructuring and other
special charges. EBITDA and Adjusted EBITDA include bad debt expense.
Adjusted EBITDA is presented and discussed because management believes that
Adjusted EBITDA is a useful adjunct to net income and other measurements
under generally accepted accounting principles since 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 generally accepted accounting principles 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.
14
<PAGE>
Risk Factors
Prospective purchasers of the Notes should consider carefully the following
factors, as well as the other information set forth or incorporated in this
Prospectus, in deciding whether to purchase the Notes.
Subordination; Ranking of the Notes as Unsecured Obligations. The Notes will be
unsecured senior subordinated obligations of Quest Diagnostics and will be
unconditionally guaranteed on a senior subordinated basis by all of the
Restricted Subsidiaries of Quest Diagnostics. The Notes and the Senior
Subordinated Guarantees will be subordinated in right of payment to all existing
and future Senior Debt (as defined under "Description of the Notes--Certain
Definitions") and Senior Guarantees (as defined under "Description of the
Notes--Certain Definitions"), respectively, of the Company and the Guarantors,
will rank Pari Passu (as defined under "Description of the Notes--Certain
Definitions") in right of payment with all unsecured senior subordinated
indebtedness and all unsecured senior subordinated guarantees of Quest
Diagnostics and the Guarantors, respectively, and will rank senior in right of
payment to any future indebtedness or guarantees of Quest Diagnostics and the
Guarantors, respectively, that may be subordinated thereto. Upon any payment or
distribution of assets of Quest Diagnostics to creditors upon any liquidation,
dissolution, winding up, reorganization, assignment for the benefit of
creditors, marshalling of assets and liabilities or any bankruptcy, insolvency
or similar proceedings of Quest Diagnostics, the holders of Senior Debt will be
entitled to receive payment in full of the principal of (and premium, if any)
and interest on such Senior Debt, including all amounts due or to become due on
all Senior Debt, or provision will be made for payment in cash or cash
equivalents or otherwise, before the Holders of Notes are entitled to receive
any payments, subject to certain exceptions. See "Description of the
Notes--Subordination."
The Notes and the Senior Subordinated Guarantees will be effectively
subordinated in right of payment to all existing and future secured
indebtedness of Quest Diagnostics and the Guarantors, respectively, to the
extent of the collateral securing such indebtedness.
On a pro forma basis, as of September 30, 1996, after giving effect to the
Distributions, the sale of the Notes and the application of the proceeds
thereof and $350.0 million of borrowings under the Term Loans, there was $367
million of Senior Debt of Quest Diagnostics outstanding. All of the
borrowings under the Credit Facility have been guaranteed by the Guarantors
on a senior basis. While the Indenture will limit, subject to the certain
financial tests, the amount of additional Debt that Quest Diagnostics and its
Restricted Subsidiaries can incur, there is no other limitation on the amount
of Senior Debt that may be incurred. In addition, Quest Diagnostics may from
time to time hereafter incur additional Debt constituting Senior Debt,
including $100.0 million under the Working Capital Facility, substantially
all of which is anticipated to be available at the Distribution Date.
Substantial Operations at Subsidiary Level; Structural Subordination. Quest
Diagnostics holds substantial assets and conducts substantial operations
through its Subsidiaries. Quest Diagnostics thus derives a substantial
portion of its operating income and cash flow from its Subsidiaries and must
rely substantially upon distributions from its Subsidiaries to generate the
funds necessary to meet its obligations, including the payment of principal
of and interest on the Notes. Although the Indenture generally prohibits
Quest Diagnostics from permitting its Restricted Subsidiaries to allow
restrictions on their ability to pay dividends and other amounts to Quest
Diagnostics, any such restrictions could materially and adversely affect
Quest Diagnostics' ability to service and repay its debts, including the
Notes.
The Notes are effectively subordinated to all existing and future indebtedness
and other liabilities of Quest Diagnostics' Subsidiaries (if any) that are
Unrestricted Subsidiaries, and thus not Guarantors, and would be so subordinated
to all existing and future indebtedness of the Guarantors if the Senior
Subordinated Guarantees were avoided or subordinated in favor of the Guarantors'
other creditors. See "--Fraudulent Conveyance." The aggregate net revenues and
net loss from the Unrestricted Subsidiaries for the year ended December 31, 1995
were $21.7 million and $0.5 million, respectively. The Unrestricted Subsidiaries
had an aggregate net book value of $0.1 million at December 31, 1995. The
aggregate net revenues and net income for the Unrestricted Subsidiaries was less
than 3% of the Company's net revenues and net income for the nine months ended
September 30, 1996. The Unrestricted Subsidiaries had an aggregate net book
value of less than 3% of the Company's net book value at September 30, 1996.
The obligation of a Guarantor under its Senior Subordinated Guarantee will be
released if (i) such Guarantor ceases to be a Restricted Subsidiary, (ii)
such Guarantor ceases to guarantee the Credit Facility, (iii) the Notes are
defeased and discharged or (iv) all or substantially all of the assets of
such Guarantor or all of the Capital Stock of such Guarantor is sold
(including by issuance, merger, consolidation or otherwise) by the Company or
any of its Subsidiaries in a transaction complying with the provisions
described under "Certain Covenants--Repurchase at the Option of
Holders--Asset Dispositions."
Fraudulent Conveyance. The Senior Subordinated Guarantees may be subject to
review under federal or state fraudulent transfer law. To the extent that a
court were to find that (x) the Senior Subordinated Guarantees were incurred
by any Guarantor
15
<PAGE>
with intent to hinder, delay or defraud any present or future creditor, or a
Guarantor contemplated insolvency with a design to prefer one or more creditors
to the exclusion in whole or in part of others, or (y) any Guarantor did not
receive fair consideration or reasonably equivalent value for issuing its Senior
Subordinated Guarantees and any Guarantor (i) was insolvent, (ii) was rendered
insolvent by reason of the issuance of the Senior Subordinated Guarantees, (iii)
was engaged or about to engage in a business or transaction for which the
remaining assets of a Guarantor constituted unreasonably small capital to carry
on its business or (iv) intended to incur, or believed that it would incur,
debts beyond its ability to pay such debts as they matured, a court could avoid
or subordinate the Senior Subordinated Guarantees in favor of a Guarantor's
creditors. If the Senior Subordinated Guarantees are subordinated, payments of
principal and interest on the Notes generally would be subject to the prior
payment in full of all indebtedness of the Guarantors. Among other things, a
legal challenge of the Senior Subordinated Guarantees on fraudulent conveyance
grounds may focus on the benefits, if any, realized by a Guarantor as a result
of the issuance by Quest Diagnostics of the Notes. The extent (if any) to which
a particular Guarantor may be deemed to have received such benefits may depend
on Quest Diagnostics' use of the Offering proceeds, including the extent (if
any) to which such proceeds or benefits therefrom benefit the Guarantor. None of
the proceeds from the Offering will be contributed to the Restricted
Subsidiaries. See "Use of Proceeds." The measure of insolvency for purposes of
the foregoing will vary depending on the law of the applicable jurisdiction.
Generally, however, an entity would be considered insolvent if the sum of its
debts (including contingent or unliquidated debts) is greater than all of its
property at a fair valuation or if the present fair saleable value of its assets
is less than the amount that will be required to pay its probable liability
under its existing debts as such debts become absolute and matured. Based upon
financial and other information currently available to it, Quest Diagnostics
presently believes that the Senior Subordinated Guarantees are being incurred
for proper purposes and in good faith, and that the Guarantors (i) are solvent
and will continue to be solvent after issuing the Senior Subordinated
Guarantees, (ii) will have sufficient capital for carrying on their business
after such issuance and (iii) will be able to pay their debts as they mature.
There can be no assurance, however, that a court would necessarily agree with
these conclusions, or determine that any particular Guarantor received fair
consideration or reasonably equivalent value for issuing its Senior Subordinated
Guarantee.
Financial Impact of the Distributions. While Quest Diagnostics has a
substantial operating history, it has not operated as an independent company
since 1982. As a Corning subsidiary, Quest Diagnostics' working capital
requirements have been financed by Corning and Quest Diagnostics' major
acquisitions have been financed through the issuance of Corning common stock
and borrowings from Corning. Subsequent to the Distributions, Quest
Diagnostics' activities will no longer be financed by Corning. In addition,
it is anticipated that the rating of Quest Diagnostics' long-term debt will
be non-investment grade. This may impact, among other things, Quest
Diagnostics' ability to raise capital, fund working capital requirements or
expand, through acquisitions or otherwise, and could thereby have an adverse
effect on Quest Diagnostics' operating earnings and cash flow.
Substantial Leverage and Debt Service Requirements. After the Distributions
and as a result of the incurrence of debt under the Credit Facility and the
issuance of Notes, Quest Diagnostics will have substantial debt. At September
30, 1996, after giving effect to the transactions and adjustments described
in "Pro Forma Financial Information," Quest Diagnostics would have had $517
million of total debt and total capitalization of $1,131 million, on a pro
forma basis, and Quest Diagnostics' total debt as a percentage of total
capitalization would have been approximately 46%. In addition to creating
significant debt service obligations for Quest Diagnostics, the terms of the
Credit Facility will contain customary affirmative and negative covenants
that will, among other things, require Quest Diagnostics to maintain certain
financial tests and ratios and will restrict Quest Diagnostics' ability to
make asset dispositions, incur additional indebtedness, make certain payments
and investments, transact with affiliates or enter into mergers or
consolidate. See "Description of the Credit Facility."
The degree to which Quest Diagnostics is leveraged could have important
consequences to holders of the Notes, including the following: (1) Quest
Diagnostics' ability to obtain additional financing in the future for working
capital, capital expenditures, product development, acquisitions, general
corporate purposes or other purposes may be impaired; (ii) a substantial
portion of Quest Diagnostics' and its subsidiaries' cash flow from operations
must be dedicated to the payment of the principal of and interest on its
indebtedness; (iii) the Credit Facility will contain certain restrictive
financial and operating covenants, including, among others, requirements that
Quest Diagnostics satisfy certain financial ratios; (iv) a significant
portion of borrowings will be at floating rates of interest, causing Quest
Diagnostics to be vulnerable to increases in interest rates; (v) Quest
Diagnostics' degree of leverage may make it more vulnerable in a downturn in
general economic conditions; and (vi) Quest Diagnostics' financial position
may limit its flexibility in responding to changing business and economic
conditions. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations--Liquidity and Capital Resources" and "Description
of the Credit Facility."
Recent Losses. Quest Diagnostics incurred net losses of $52 million for the
year ended December 31, 1995 and $158.9 million for the nine months ended
September 30, 1996. The 1995 net loss includes the provision of $33 million
for restructuring charges (primarily relating to workforce reduction programs
and the cost of exiting a number of leased facilities) and $17.6
16
<PAGE>
million of special charges related to settlements of governmental billing
claims. The net loss for the 1996 period reflects the provision of $188 million
for additional reserves primarily relating to the investigation of
pre-acquisition billing practices of Damon and Nichols and $13.7 million to
write off capitalized software as a result of its decision to abandon the
billing system which had been intended as a new company-wide billing system. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations." There can be no assurance that Quest Diagnostics' operations will
be profitable in the future.
Intense Competition. The independent clinical laboratory industry in the
United States is intensely competitive. Quest Diagnostics believes that in
1995 approximately 56% of the revenues of the clinical laboratory testing
industry was generated by hospital-affiliated laboratories, approximately 36%
by independent clinical laboratories and 8% by thousands of individual
physicians in their offices and laboratories. Independent clinical
laboratories fall into two separate categories: (1) smaller, generally local,
laboratories that generally offer fewer tests and services and have less
capital than the larger laboratories, and (2) larger laboratories such as
Quest Diagnostics that provide a broader range of tests and services. Quest
Diagnostics has two major competitors that operate in the national
market--SmithKline Beecham Clinical Laboratories, Inc. ("SmithKline") and
Laboratory Corporation of America Holdings, Inc. ("LabCorp"). Both SmithKline
and LabCorp are affiliated with larger corporations that have greater
financial resources than Quest Diagnostics. There are also many independent
clinical laboratories that operate regionally and that compete with Quest
Diagnostics in these regions. In addition, hospitals are in general both
competitors and customers of independent clinical laboratories. The
independent clinical laboratory testing industry has experienced intense
price competition over the past several years, which has negatively impacted
Quest Diagnostics' profitability. The following factors, among others, are
often used by health care providers in selecting a laboratory: (i) pricing of
the laboratory's testing services; (ii) accuracy, timeliness and consistency
in reporting test results; (iii) number and type of tests performed; (iv)
service capability and convenience offered by the laboratory; and (v) its
reputation in the medical community. See "Business--The Clinical Laboratory
Testing Industry" and "Business--Competition."
Role of Managed Care. Managed care organizations play a significant role in
the health care industry and their role is expected to increase over the next
several years. Managed care organizations typically negotiate capitated
payment contracts, whereby a clinical laboratory receives a fixed monthly fee
per covered individual, regardless of the number or cost of tests performed
during the month (excluding certain tests, such as esoteric tests and
anatomic pathology services). Laboratory services agreements with managed
care organizations have historically been priced aggressively due to
competitive pressure and the expectation that a laboratory would capture not
only the volume of testing to be covered under the contract, but also the
additional fee-for-service business from patients of participating physicians
who are not covered under the managed care plan. However, as the number of
patients covered under managed care plans continues to increase, there is
less such fee-for-service business and, accordingly, less high margin
business to offset the low margin (and often unprofitable) managed care
business. Furthermore, increasingly, physicians are affiliated with more than
one managed care organization and as a result may be required to refer
clinical laboratory tests to different clinical laboratories, depending on
the coverage of their patients. As a result, a clinical laboratory might not
receive any fee-for-service testing from such physicians. See
"Business--Customers and Payors" and "Business--Effect of the Growth of the
Managed Care Sector on the Clinical Laboratory Business." During the nine
months ended September 30, 1996, services to managed care organizations under
capitated rate agreements accounted for approximately 6% of Quest
Diagnostics' net revenues from clinical laboratory testing and approximately
15% of the tests performed by Quest Diagnostics. Quest Diagnostics is
currently reviewing its pricing structures for agreements with managed care
organizations and intends to insure that all of its future agreements with
managed care organizations are profitably priced. However, there can be no
assurance that Quest Diagnostics will be able to increase the prices charged
to managed care organizations or that Quest Diagnostics will not lose market
share in the managed care market to other clinical laboratories who continue
to aggressively price laboratory services agreements with managed care
organizations. Quest Diagnostics may experience declines in per-test revenue
as managed care organizations continue to increase their share of the health
care insurance market.
Reliance on Medicare/Medicaid Reimbursements. Approximately 23% and 22% of
Quest Diagnostics' net revenues for the year ended December 31, 1995 and the
nine months ended September 30, 1996, respectively, were attributable to
tests performed for Medicare and Medicaid beneficiaries. Quest Diagnostics'
business and financial results depend substantially on reimbursements paid to
Quest Diagnostics under these programs. Quest Diagnostics is legally required
to accept the government's reimbursement for most Medicare and Medicaid
testing as payment in full. Such reimbursements are generally made pursuant
to fee schedules, which are subject to certain limitations the levels of
which have declined steadily since late 1984. Congress enacted a phased-in
set of reductions in the reimbursement limitations as part of its 1993 budget
legislation that reduced the Medicare national limitations in 1994 to 84% of
the 1984 national median, in 1995 to 80% of the 1984 national median and in
1996 to 76% of the 1984 national median. In 1995, both houses of Congress
passed a bill (the Medicare Preservation Act) that would have reduced the fee
cap schedule from 75% to 65% of the 1984 national median, but the bill was
vetoed by the President. Effective January 1, 1996, the Health Care Financing
Administration ("HCFA") adopted a new policy on reimbursement for chemistry
panel tests. As of January 1, 1996, 22 automated tests (rather than 19 tests)
became reimbursable by Medicare as part of an automated chemistry profile. An
additional allowance of $0.50 per test is authorized when more
17
<PAGE>
than 19 tests are billed in a panel. HCFA retains the authority to expand in the
future the list of tests included in a panel. Effective as of March 1, 1996,
HCFA eliminated its prior policy of permitting payment for all tests contained
in an automated chemistry panel when at least one of the tests in the panel is
medically necessary. Under the new policy, Medicare payment will not exceed the
amount that would be payable if only the tests that are "medically necessary"
had been ordered. In addition, since 1995 most Medicare carriers have begun to
require clinical laboratories to submit documentation supporting the medical
necessity, as judged by ordering physicians, for many commonly ordered tests.
Quest Diagnostics expects to incur additional reimbursement reductions and
additional costs associated with the implementation of these requirements of
HCFA and Medicare carriers. The amount of the reductions in reimbursements and
additional costs cannot be determined at this time. These and other proposed
changes affecting the reimbursement policy of Medicare and Medicaid programs
could have a material adverse effect on the business, financial condition,
results of operations or prospects of Quest Diagnostics. See
"Business--Regulation and Reimbursement--Regulation of Reimbursement for
Clinical Laboratory Services." A failure of Quest Diagnostics to properly and
promptly process its bills to Medicare may result in an increase in Quest
Diagnostics' bad debt expense. See "Business--Billing" and "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Results of Operations."
Billing. Quest Diagnostics' billings have been hampered by both the
industry-wide phenomenon of frequently missing or incorrect billing
information and increasingly stringent payor requirements, as well as the
existence of multiple billing information systems which have resulted in
large part from Quest Diagnostics' growth through acquisitions. Quest
Diagnostics' standard billing system has been implemented in seven of its 22
billing sites, which seven sites account for 35% of the Company's net
revenues. Quest Diagnostics is beginning to convert the remaining
non-standard billing systems to the standard SYS system. See
"Business--Information Systems" and "--Billing." Standardizing its billing
systems presents conversion risk to Quest Diagnostics as key databases and
masterfiles are transferred to the SYS system and because the billing
workflow is interrupted during the conversion, which may cause backlogs.
Government Investigations and Related Claims. As discussed under
"Business--Government Investigations and Related Claims," Quest Diagnostics has
settled various government and private claims (i.e., nongovernmental claims such
as those by private insurers) totalling approximately $192 million relating
primarily to industry-wide billing and marketing practices that had been
substantially discontinued by early 1993. Specifically, Quest Diagnostics has
entered into, (i) for an aggregate of approximately $180 million, five
settlements with the Office of the Inspector General ("OIG") of the Department
of Health and Human Services ("HHS") and the DOJ and two settlements and one
tentative settlement with state governments with respect to Medicare and
Medicaid marketing and billing practices of Quest Diagnostics and certain
companies acquired by Quest Diagnostics prior to their acquisition and (ii)
twelve completed settlements and one tentative settlement relating to private
claims totalling approximately $12 million. In addition, there are pending
investigations by the OIG and DOJ into billing and marketing practices at three
regional laboratories operated by Nichols prior to its acquisition by Quest
Diagnostics. There are no other private claims presently pending other than
routine claims that are not material in the aggregate. By issuance of civil
subpoenas in August 1993, the government began a formal investigation of
Nichols. The investigation of Nichols remains open. Remedies available to the
government include exclusion from participation in the Medicare and Medicaid
programs, criminal fines, civil recoveries plus civil penalties and asset
forfeitures. Although application of such remedies and penalties could
materially and adversely affect Quest Diagnostics' business, financial
condition, results of operations and prospects, management believes that the
possibility of this happening is remote. Quest Diagnostics derived approximately
23% and 22% of its net revenues for the year ended December 31, 1995 and the
nine months ended September 30, 1996, respectively, from Medicare and Medicaid
programs.
In connection with the Distributions, Corning has agreed to indemnify Quest
Diagnostics against all monetary penalties, fines or settlements for any
governmental claims arising out of alleged violations of applicable federal
fraud and health care statutes and relating to billing practices of Quest
Diagnostics and its predecessors that have been settled or are pending on the
Distribution Date. Corning has also agreed to indemnify Quest Diagnostics for
50% of the aggregate of all judgment or settlement payments made by Quest
Diagnostics that are in excess of $42.0 million in respect of claims by
private parties (i.e., nongovernmental parties such as private insurers) that
relate to indemnified or previously settled governmental claims and that
allege overbillings by Quest Diagnostics or any existing subsidiaries of
Quest Diagnostics, for services provided prior to the Distribution Date;
provided, however, such indemnification will not exceed $25.0 million in the
aggregate and all amounts indemnified against by Corning for the benefit of
Quest Diagnostics will be calculated on a net after-tax basis. However, such
indemnification will not cover (i) any governmental claims that arise after
the Distribution Date, (ii) any nongovernmental claims unrelated to the
indemnified governmental claims or investigations, (iii) any nongovernmental
claims not settled prior to five years after the Distribution Date, (iv) any
consequential or incidental damages relating to the billing claims, including
losses of revenues and profits as a consequence of exclusion for
participation in federal or state health care programs or (v) the fees and
expenses of litigation. Quest Diagnostics will control the defense of any
governmental claim or investigation unless Corning elects to assume such
defense. However, in the case of all nongovernmental claims related to
indemnified governmental claims related to alleged over-
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billings, Quest Diagnostics will control the defense. All disputes under the
Transaction Agreement are subject to binding arbitration. See "The
Distributions--Transaction Agreement."
Quest Diagnostics' aggregate reserve with respect to all governmental and
private claims, including litigation costs of approximately $6.6 million, was
$215 million at September 30, 1996 and is estimated to be reduced to $85 million
as of the Distribution Date as a result of the payment of settled claims,
primarily the Damon settlement of $119 million. Based on information available
to management and Quest Diagnostics' experience with past settlements (including
the fact that the aggregate amount of the Damon settlement was significantly in
excess of established reserves) management has reassessed its reserve levels and
believes that its current level of reserves is adequate. However, 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 theories of wrongdoing) may become available which may cause the
final resolution of these matters to be in excess of established reserves by an
amount which could be material to Quest Diagnostics' results of operations and,
for non-indemnified claims, Quest Diagnostics' cash flows in the period in which
such claims are settled. While none of the governmental or nongovernmental
investigations or claims is covered by insurance Quest Diagnostics does not
believe that these matters will have a material adverse effect on the Company's
overall financial condition.
Government Regulation. The clinical laboratory industry is subject to
extensive governmental regulations at the federal, state and local levels.
See "Business--Regulation and Reimbursement."
At the federal level, Quest Diagnostics' laboratories are required to be
certified under the Clinical Laboratory Improvement Amendments of 1988
("CLIA") and approved to participate in the Medicare/Medicaid programs.
Currently, all clinical laboratories, including most physician-office
laboratories ("POLs"), are required to comply with CLIA. However, the
Medicare Preservation Act, passed in 1995 by both Houses of Congress, would
have largely exempted POLs from having to comply with CLIA (except with
respect to pap smear tests). Although this provision was not maintained by
the House-Senate conference and was not included in the subsequent
legislation, it could be reintroduced at any time. The exemption of POLs from
CLIA would significantly reduce their costs, making them more financially
viable and a greater competitive challenge to Quest Diagnostics and would
more likely encourage physicians to establish laboratories in their offices.
A wide array of Medicare/Medicaid fraud and abuse provisions apply to
clinical laboratories participating in such programs. Penalties for
violations of these federal laws include exclusion from participation in the
Medicare/Medicaid programs, asset forfeitures, civil and criminal penalties.
Civil penalties for a wide range of offenses may be up to $2,000 per item and
twice the amount claimed. These penalties will be increased effective January
1, 1997 to up to $10,000 per item plus three times the amount claimed. In the
case of certain offenses, exclusion from participation in Medicare and
Medicaid is a mandatory administrative penalty. The OIG interprets these
fraud and abuse administrative provisions liberally and enforces them
aggressively. Provisions in a bill enacted in August 1996 are likely to
expand the federal government's involvement in curtailing fraud and abuse due
to the establishment of (i) an anti-fraud and abuse trust fund funded through
the collection of penalties and fines for violations of such laws and (ii) a
health care anti-fraud and abuse task force. See "Business--Regulation and
Reimbursement."
Potential Liability under the Spin-Off Tax Indemnification Agreements. Quest
Diagnostics will enter into the Corning/Quest Diagnostics Spin-Off Tax
Indemnification Agreement (as defined under "The Distributions--Spin-Off Tax
Indemnification Agreements") that will prohibit Quest Diagnostics for a period
of two years after the Distribution Date from taking certain actions, including
a sale of 50% or more of the assets of Quest Diagnostics or engaging in certain
equity or financing transactions, that might jeopardize the favorable tax
treatment of the Distributions under section 355 of the Internal Revenue Code,
as amended (the "Code"), and will provide Corning with certain rights of
indemnification against Quest Diagnostics. Quest Diagnostics may also have
indemnification obligations under the Corning/Quest Diagnostics Spin-Off Tax
Indemnification Agreement in the case of the acquisition of, or tender or
purchase offer by another person for, 20% or more of the outstanding Quest
Diagnostics Common Stock. The Corning/Quest Diagnostics Spin-Off Tax
Indemnification Agreement will also require Quest Diagnostics to take such
actions as Corning may reasonably request to preserve the favorable tax
treatment provided for in any rulings obtained from the Internal Revenue Service
("IRS") in respect of the Distributions. Quest Diagnostics and Covance will
enter into the Covance/Quest Diagnostics Spin-Off Tax Indemnification Agreement
(as defined under "The Distributions--Spin-Off Tax Indemnification Agreements")
that will be essentially the same as the Corning/Quest Diagnostics Spin-Off Tax
Indemnification except that Quest Diagnostics will make representations to and
indemnify Covance as opposed to Corning. If obligations of Quest Diagnostics
under either agreement were breached and primarily as a result thereof the
Distributions do not receive favorable tax treatment under Code section 355,
Quest Diagnostics would be required to indemnify Corning or Covance, as the case
may be, for Taxes imposed and such indemnification obligations could exceed the
net asset value of Quest Diagnostics at such time. See "The
Distributions--Spin-Off Tax Indemnification Agreements."
Professional Liability Litigation. As a general matter, providers of
clinical laboratory testing services may be subject to lawsuits alleging
negligence or other similar legal claims, which suits could involve claims
for substantial damages. Damages assessed
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in connection with, and the costs of defending any such actions could be
substantial. Litigation could also have an adverse impact on Quest Diagnostics'
client base. Quest Diagnostics maintains liability insurance (subject to maximum
limits and self-insured retentions) for professional liability claims. This
insurance does not cover liability for any of the investigations described under
"--Government Investigations and Related Claims" and "Business--Government
Investigations and Related Claims." While there can be no assurance, Quest
Diagnostics management believes that the levels of coverage are adequate to
cover currently estimated exposures. Although Quest Diagnostics believes that it
will be able to obtain adequate insurance coverage in the future at acceptable
costs, there can be no assurance that Quest Diagnostics will be able to obtain
such coverage or will be able to do so at an acceptable cost or that Quest
Diagnostics will not incur significant liabilities in excess of policy limits.
Absence of a Prior Public Market. The Notes are a new issue of securities with
no established trading market. The Notes have been approved for listing on the
New York Stock Exchange, subject to official notice of issuance. While the
Underwriters have informed Quest Diagnostics that they intend to make a market
in the Notes, they are not obligated to do so and may discontinue such market
making at any time without notice. Accordingly, there can be no assurance as to
the liquidity of any markets that may develop for the Notes.
Dependence on Key Employees. Quest Diagnostics' affairs are managed by a
small number of key management personnel, the loss of any of whom could have
an adverse impact on Quest Diagnostics. There can be no assurance that Quest
Diagnostics can retain its key managerial and technical employees or that it
can attract, assimilate or retain other skilled technical personnel in the
future. See "Business--Recent Organizational Changes" and "Management."
Certain Antitakeover Effects. Quest Diagnostics' amended and restated
certificate of incorporation (the "Certificate") and by-laws (the "By-Laws"),
and the Delaware General Corporation Law ("DGCL"), contain several provisions
that could have the effect of delaying, deferring or preventing a change in
control of Quest Diagnostics in a transaction not approved by the board of
directors of Quest Diagnostics (the "Board"), or, in certain circumstances,
by the disinterested members of the Board. In addition, an acquisition of
certain securities or assets of Quest Diagnostics within two years after the
Distribution Date might jeopardize the tax treatment of the Distributions and
could result in Quest Diagnostics being required to indemnify Corning and
Covance. See "--Potential Liability under the Spin-Off Tax Indemnification
Agreements."
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The Distributions
Overview of and Reasons for the Distributions
The Notes are being offered prior to but in connection with the distributions to
holders of common stock with attached preferred share purchase rights (the
"Corning Common Stock") of Corning of all of the outstanding common stock with
attached preferred stock purchase rights, of (i) Quest Diagnostics, which is
and, at the time of such distributions, will be a direct wholly owned subsidiary
of Corning, and (ii) Covance, which currently is and, at the time of such
distributions, will be a direct wholly owned subsidiary of Quest Diagnostics.
The distribution (the "Quest Diagnostics Spin-Off Distribution") of all the
outstanding common stock with attached preferred stock purchase rights of Quest
Diagnostics (the "Quest Diagnostics Common Stock") to the holders of Corning
Common Stock will be immediately followed by the distribution (the "Covance
Spin-Off Distribution" and, together with the Quest Diagnostics Spin-Off
Distribution, the "Distributions") of all of the outstanding common stock with
attached preferred stock purchase rights of Covance (the "Covance Common Stock")
to the holders of Quest Diagnostics Common Stock. Since the Covance Spin-Off
Distribution will be immediately after (but on the same day as) the Quest
Diagnostics Spin-Off Distribution, each holder of Corning Common Stock will,
immediately after the Distributions, not only hold shares of Corning Common
Stock but also shares of Quest Diagnostics Common Stock and Covance Common
Stock. The Distributions will occur at 11:59 p.m. on December 31, 1996 (the
"Distribution Date"). The shares of Quest Diagnostics Common Stock and Covance
Common Stock have been accepted for listing on the New York Stock Exchange
("NYSE") under the symbols "DGX" and "CVD," respectively, subject to official
notice of the Distributions.
The Distributions are subject to the satisfaction of several conditions
including the receipt of a favorable IRS ruling (as defined below). Prior to
the closing of the Offering, Quest Diagnostics transferred to Corning
approximately $350 million of initial borrowings under the Credit Facility in
partial repayment of certain intercompany indebtedness owed by Quest
Diagnostics to Corning (the "Intercompany Debt"). On the closing date of the
Offering, Quest Diagnostics will transfer the approximately $145 million net
proceeds from the Offering to Corning in repayment of additional Intercompany
Debt. Corning will cancel the Intercompany Debt as a contribution to the
capital of Quest Diagnostics. See "Use of Proceeds."
Closing Document Escrow Arrangements
It is currently anticipated that the Offering will close prior to the
Distributions. At the time of the closing of the Offering, all of the conditions
to the consummation of the Distributions under the Transaction Agreement (as
described below under "--Transaction Agreement") will have been satisfied or
waived, and all of the operative agreements necessary to effect the
Distributions will have been executed and placed in escrow with The Bank of New
York, as Escrow Agent (the "Escrow Agent"), pursuant to the terms of an Escrow
Agreement, dated the closing date of the Offering (the "Escrow Agreement"),
among Quest Diagnostics, Corning, Covance and the Escrow Agent.
The Escrow Agreement will require the Escrow Agent to release the documents
placed in escrow on the Distribution Date. If as a result of an event outside
the control of Corning, Quest Diagnostics and Covance, the Distributions do not
occur prior to March 31, 1997, the Notes will be subject to redemption, as a
whole and not in part, at the option of Quest Diagnostics, prior to June 30,
1997, at a redemption price equal to 101% of the principal amount of the Notes
plus accrued and unpaid interest at the date fixed for redemption.
Transaction Agreement
Corning, Quest Diagnostics and Covance have entered into the Transaction
Agreement (the "Transaction Agreement") providing for, among other things,
certain conditions precedent to the Distributions, certain corporate
transactions required to effect the Distributions and other arrangements
between Corning, Quest Diagnostics and Covance subsequent to the
Distributions.
The Transaction Agreement provides for, among other things, assumptions
of liabilities and cross-indemnities designed to allocate generally,
effective as of the Distribution Date, financial responsibility for the
liabilities arising out of or in connection with (i) the clinical laboratory
business to Quest Diagnostics and its subsidiaries, (ii) the contract
research business to Covance and its subsidiaries and (iii) all other
business conducted by Corning prior to the Distribution Date to Corning and
its subsidiaries other than Quest Diagnostics and Covance.
The Transaction Agreement provides that Corning, Quest Diagnostics and Covance
will use their respective commercially reasonable efforts to achieve an
allocation of consolidated indebtedness of Corning and an agreed upon capital
structure after the Distributions of Corning, Quest Diagnostics and Covance. In
addition to the specific indemnity described below, Corning, Quest Diagnostics
and Covance are obligated under the Transaction Agreement to indemnify and hold
harmless each other in respect of Indemnifiable Losses (as defined therein)
arising out of or otherwise relating to the management or conduct of their
respective businesses or the breach of any provision of the Transaction
Agreement; provided, however, that Quest Diagnostics will have no
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obligation to indemnify or hold harmless Corning in respect of Indemnifiable
Losses arising out of any governmental claims or investigations described in the
next paragraph.
As discussed under "Business--Government Investigations and Related Claims,"
Quest Diagnostics is subject to several governmental investigations. Any amounts
paid by Quest Diagnostics to settle these investigations, or as a result of a
judgment relating to these investigations, will be indemnified by Corning under
the Transaction Agreement. Under the Transaction Agreement Corning has agreed to
indemnify Quest Diagnostics against all monetary penalties, fines or settlements
arising out of any governmental criminal, civil or administrative investigations
or claims that have been settled prior to or are pending as of the Distribution
Date, pursuant to service of subpoena or other notice of such investigation to
Quest Diagnostics, as well as any qui tam proceeding for which a complaint was
filed prior to the Distribution Date whether or not Quest Diagnostics has been
served with such complaint or otherwise been notified of the pendency of such
action, to the extent that such investigations or claims arise out of or are
related to alleged violations of federal fraud and health care statutes
identified in the Transaction Agreement by reason of Quest Diagnostics or any
company acquired by Quest Diagnostics billing any federal program or agency for
services rendered to beneficiaries of such program or agency. Corning has also
agreed to indemnify Quest Diagnostics for 50% of the aggregate of all judgment
or settlement payments made by Quest Diagnostics that are in excess of $42.0
million in respect of claims by private parties (i.e., nongovernmental parties
such as private insurers) that relate to indemnified or previously settled
governmental claims and that allege overbillings by Quest Diagnostics or any
existing subsidiaries of Quest Diagnostics for services provided prior to the
Distribution Date; provided, however, such indemnification for private claims
will terminate five years after the Distribution Date (whether or not settled)
and will not exceed $25.0 million in the aggregate (reduced by certain tax
benefits as described below). Quest Diagnostics' aggregate reserve with respect
to all governmental and private claims, including litigation costs, was $215
million at September 30, 1996 and is estimated to be reduced to $85 million at
the Distribution Date and as a result of the payment of settled claims,
primarily the Damon settlement of $119 million.
Corning will not indemnify Quest Diagnostics against any governmental claims
that arise after the Distribution Date, even though relating to events prior
to the Distribution Date, or to any private claims that do not relate to the
indemnified or previously settled governmental claims or investigations that
relate to post-Distribution Date billings. Corning will not indemnify Quest
Diagnostics against consequential or incidental damages relating to the
billing claims, including losses of revenues and profits as a consequence of
any exclusion from participation in federal or state health care programs or
the fees and expenses of the litigation, including attorneys' fees and
expenses. All amounts indemnified against by Corning for the benefit of Quest
Diagnostics will be calculated on a net after-tax basis by taking into
account any deductions and other tax benefits realized by Quest Diagnostics
(or a consolidated group of which Quest Diagnostics is a member after the
Distributions (the "Quest Diagnostics Group")) in respect of the underlying
settlement, judgment payment, or other loss (or portion thereof) indemnified
against by Corning generally at the time and to the extent such deductions or
tax benefits are deemed to reduce the tax liability of Quest Diagnostics or
the Quest Diagnostics Group under the Transaction Agreement.
The Transaction Agreement provides that, in the case of any claims for which
Corning, Quest Diagnostics or Covance are entitled to indemnification, the
indemnified party will control the defense of any claim unless the
indemnifying party elects to assume such defense. However, in the case of all
private claims related to indemnified governmental claims related to alleged
overbillings, Quest Diagnostics will control the defense. Disputes under the
Transaction Agreement are subject to binding arbitration.
The Transaction Agreement also provides that, except as otherwise set
forth therein or in any other agreement, all costs or expenses incurred on or
prior to the Distribution Date in connection with the Distributions will be
allocated among the parties. Except as set forth in the Transaction Agreement
or any related agreement, each party shall bear its own costs and expenses
incurred after the Distribution Date.
Spin-Off Tax Indemnification Agreements
Corning and Quest Diagnostics will enter into a tax indemnification agreement
(the "Corning/Quest Diagnostics Spin-Off Tax Indemnification Agreement")
pursuant to which (1) Quest Diagnostics will represent to Corning that, to
the best of its knowledge, the materials relating to Quest Diagnostics
submitted to the IRS in connection with the request for ruling submitted to
the IRS are complete and accurate in all material respects, (2) Quest
Diagnostics will represent that it has no present intention to undertake the
transactions described in part (3)(iii) hereafter or cease to engage in the
active conduct of providing clinical laboratory testing services, (3) Quest
Diagnostics will covenant and agree that for a period of two years following
the Distribution Date (the "Restricted Period"), (i) Quest Diagnostics will
continue to engage in the clinical laboratory testing business, (ii) Quest
Diagnostics will continue to manage and own at least 50% of the assets which
it owns directly and indirectly immediately after the Distribution Date and
(iii) neither Quest Diagnostics, nor any related corporation nor any of their
respective directors, officers or other representatives will undertake,
authorize, approve, recommend, permit, facilitate, or enter into any
contract, or consummate any transaction with respect to: (A) the issuance of
Quest Diagnostics Common Stock (including options and other
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instruments convertible into Quest Diagnostics Common Stock) which would exceed
fifty percent (50%) of the outstanding shares of Quest Diagnostics Common Stock
immediately after the Distribution Date; (B) the issuance of any other
instrument that would constitute equity for federal tax purposes ("Disqualified
Quest Diagnostics Stock"); (C) the issuance of options and other instruments
convertible into Disqualified Quest Diagnostics Stock; (D) any repurchases of
Quest Diagnostics Common Stock, unless such repurchases satisfy certain
requirements; (E) the dissolution, merger, or complete or partial liquidation of
Quest Diagnostics or any announcement of such action; or (F) the waiver,
amendment, termination or modification of any provision of the Quest Diagnostics
Rights Plan (as defined therein) in connection with, or in order to permit or
facilitate, any acquisition of Quest Diagnostics Common Stock or other equity
interest in Quest Diagnostics, and (4) Quest Diagnostics will agree to indemnify
Corning for Taxes (as defined below) arising from violations of (1), (2) or (3)
above and for Taxes arising as a result of (A) an acquisition of 20% or more of
the stock of Quest Diagnostics by a person or related persons during the
Restricted Period or (B) the commencement of a tender or purchase offer by a
third party for 20% or more of Quest Diagnostics stock. If obligations of Quest
Diagnostics under this agreement were breached and as a result thereof one or
both of the Distributions do not qualify for the treatment stated in the ruling
Corning requested from the IRS (the "IRS Ruling"), Quest Diagnostics would be
required to indemnify Corning for Taxes imposed and such indemnification
obligations could exceed the net asset value of Quest Diagnostics at such time.
Corning and Covance will enter into a tax indemnification agreement (the
"Corning/Covance Spin-Off Tax Indemnification Agreement") pursuant to which
(1) Covance will represent to Corning that to the best of its knowledge, the
materials relating to Covance submitted to the IRS in connection with the
request for ruling submitted to the IRS are complete and accurate in all
material respects, (2) Covance will represent that it has no present
intention to undertake the transactions described in part (3)(iii) hereafter
or to cease to engage in the active conduct of providing contract research
services, (3) Covance will covenant and agree that during the Restricted
Period, (i) Covance will continue to engage in the contract research
business, (ii) Covance will continue to manage and own at least 50% of the
assets which it owns directly and indirectly immediately after the
Distribution Date and (iii) neither Covance, nor any related corporations nor
any of their respective directors, officers or other representatives will
undertake, authorize, approve, recommend, permit, facilitate, or enter into
any contract, or consummate any transaction with respect to: (A) the issuance
of Covance Common Stock (including options and other instruments convertible
into Covance Common Stock) which would exceed fifty percent (50%) of the
outstanding shares of Covance Common Stock immediately after the Distribution
Date; (B) the issuance of any other instrument that would constitute equity
for federal tax purposes ("Disqualified Covance Stock"); (C) the issuance of
options and other instruments convertible into Disqualified Covance Stock;
(D) any repurchases of Covance Common Stock, unless such repurchases satisfy
certain requirements; (E) the dissolution, merger, or complete or partial
liquidation of Covance or any announcement of such action; or (F) the waiver,
amendment, termination or modification of any provision of the Covance Rights
Plan (as defined therein) in connection with, or in order to permit or
facilitate, any acquisition of Covance Common Stock or other equity interest
in Covance and (4) Covance will agree to indemnify Corning for Taxes arising
from violations of (1), (2) or (3) above and for Taxes arising as a result of
(A) an acquisition of 20% or more of the stock of Covance by a person or
related persons during the Restricted Period or (B) the commencement of a
tender or purchase offer by a third party for 20% or more of Quest
Diagnostics stock. If obligations of Covance under this agreement were
breached and as a result thereof one or both of the Distributions do not
qualify for the treatment stated in the IRS Ruling, Covance would be required
to indemnify Corning for Taxes imposed and such indemnification obligations
could exceed the net asset value of Covance at such time.
Quest Diagnostics and Covance will enter into a second tax indemnification
agreement (the "Covance/Quest Diagnostics Spin-Off Tax Indemnification
Agreement") which will be essentially the same as the Corning/Quest Diagnostics
Spin-Off Tax Indemnification Agreement except that Quest Diagnostics will make
representations to and indemnify Covance as opposed to Corning. If obligations
of Quest Diagnostics under this agreement were breached and as a result thereof
one or both of the Distributions do not qualify for the treatment stated in the
IRS Ruling, Quest Diagnostics would be required to indemnify Covance for Taxes
imposed and such indemnification obligations could exceed the net asset value of
Quest Diagnostics at such time. Quest Diagnostics and Covance will enter into a
tax indemnification agreement (the "Quest Diagnostics/Covance Spin-Off Tax
Indemnification Agreement") which will be essentially the same as the
Corning/Covance Spin-Off Tax Indemnification Agreement except that Covance will
make representations to and indemnify Quest Diagnostics as opposed to Corning.
If obligations of Covance under this agreement were breached and as a result
thereof one or both of the Distributions do not qualify for the treatment stated
in the IRS Ruling, Covance would be required to indemnify Quest Diagnostics for
Taxes imposed and such indemnification obligations could exceed the net asset
value of Covance at such time.
The Spin-Off Tax Indemnification Agreements will also require (i) Quest
Diagnostics to take such actions as Corning may reasonably request and (ii)
Covance to take such actions as Corning and Quest Diagnostics may reasonably
request to preserve the favorable tax treatment provided for in any rulings
obtained from the IRS in respect of the Distributions.
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Tax Sharing Agreement
Corning, Quest Diagnostics and Covance will enter into a tax sharing agreement
(the "Tax Sharing Agreement") which will allocate responsibility for federal
income and various other taxes ("Taxes") among the three companies. The Tax
Sharing Agreement provides that, except for Taxes arising as a result of the
failure of either or both of the Distributions to qualify for the treatment
stated in the IRS Ruling (which Taxes are allocated either pursuant to the
Spin-Off Tax Indemnification Agreements or as described below), Corning is
liable for and will pay the federal income taxes of the consolidated group that
includes Quest Diagnostics and Covance and their subsidiaries, provided,
however, that Quest Diagnostics and Covance are required to reimburse Corning
for taxes for periods beginning after December 31, 1995 in which they are
members of the Corning consolidated group and for which tax returns have not
been filed as of the Distribution Date. This reimbursement obligation is based
on the hypothetical separate federal tax liability of Quest Diagnostics and
Covance, including their respective subsidiaries, calculated on a separate
consolidated basis, subject to certain adjustments. Under the Tax Sharing
Agreement, in the case of adjustments by a taxing authority of a consolidated
federal income tax or certain other tax returns prepared by Corning which
includes Quest Diagnostics or Covance, then, subject to certain exceptions,
Corning is liable for and will pay any tax assessments, and is entitled to any
tax refunds, resulting from such audit.
The Tax Sharing Agreement further provides that, if either of the
Distributions fails to qualify for the tax treatment stated in the IRS Ruling
(for reasons other than those indemnified against under one or more of the
Spin-Off Tax Indemnification Agreements), Taxes imposed upon or incurred by
Corning, Quest Diagnostics or Covance as a result of such failure are to be
allocated among Corning, Quest Diagnostics and Covance in such a manner as
will take into account the extent to which the actions or inactions of each
may have contributed to such failure, and Corning, Quest Diagnostics and
Covance each will indemnify and hold harmless the other from and against the
taxes so allocated. If it is determined that none of the companies
contributed to the failure of such distribution to qualify for the tax
treatment stated in the IRS Ruling, the liability for taxes will be borne by
each in proportion to its relative average market capitalization as
determined by the average closing price for the common stock of each during
the 20 trading-day period immediately following the Distribution Date. In the
event that either of the Distributions fails to qualify for the tax treatment
stated in the IRS Ruling and the liability for taxes as a result of such
failure is allocated among Corning, Quest Diagnostics and Covance, the
liability so allocated to Quest Diagnostics or Covance could exceed the net
asset value of Quest Diagnostics or Covance, respectively.
24
<PAGE>
Use of Proceeds
The net proceeds to Quest Diagnostics from the Offering are estimated to be
approximately $145 million. The net proceeds from the Offering, together with
approximately $350 million of borrowings under the Term Loans of the Credit
Facility, will be used to repay approximately $495 million of Intercompany
Debt owed to Corning. Corning will contribute to the equity capital of Quest
Diagnostics any Intercompany Debt owed in excess of the approximately $495
million of Intercompany Debt being repaid. After completion of the foregoing
transactions, Quest Diagnostics will not owe any Intercompany Debt to
Corning. The Intercompany Debt currently bears interest at a weighted average
interest rate of approximately 7% per annum and matures at various dates
through 2024.
25
<PAGE>
Capitalization
The following table sets forth Quest Diagnostics' capitalization as of
September 30, 1996 giving effect to (i) the consummation of the Offering and
the estimated initial borrowings under the Credit Facility, (ii) the
Distributions and (iii) the Accounting Policy Change (as defined below), as
if such transactions occurred on such date. This table should be read in
conjunction with the Financial Statements and notes thereto and the Pro Forma
Financial Information (as defined below) and notes thereto included elsewhere
herein. Historical combined and pro forma combined financial information may
not be indicative of Quest Diagnostics' future capitalization as an
independent company. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and "Business."
<TABLE>
<CAPTION>
Pro Forma
Historical Adjustments Pro Forma
------------- --------------- --------------
(in thousands)
<S> <C> <C> <C>
Cash $ 48,319 $ (8,319)(a) $ 40,000
============= =============== ==============
Short-term Debt:
Current portion of long-term debt $ 11,885 $ (10,000)(b) $ 1,885(h)
Revolving credit facility (c)
------------- --------------- --------------
Total Short-term Debt $ 11,885 $ (10,000) $ 1,885
============= =============== ==============
Long-term Debt:
Term loans $ 15,494 $ 350,000 (b) $ 365,494(h)
Notes 150,000 (b) 150,000
Payable to Corning 1,204,406 (8,319)(a)
(442,744)(b)
(753,343)(d)
------------- --------------- --------------
Total Long-term Debt 1,219,900 (704,406) 515,494
------------- --------------- --------------
Stockholder's Equity:
Contributed capital 297,823 6,000 (b)
753,343 (d)
11,250 (e)
150,000 (f) 1,218,416
Accumulated deficit (163,158) (13,239)(e)
(425,000)(g) (601,397)
Cumulative translation adjustment 1,801 1,801
Market valuation adjustment (3,796) (3,796)
------------- --------------- --------------
Total Stockholder's Equity 132,670 482,354 615,024
------------- --------------- --------------
Total Capitalization $1,352,570 $ (222,052) $1,130,518
============= =============== ==============
</TABLE>
(a) Historically, Quest Diagnostics has participated in Corning's centralized
treasury and cash management processes. Cash received from operations was
generally transferred to Corning on a daily basis. Cash disbursements for
operations and investments were funded as needed from Corning. The cash
balance at the Distribution Date will range from $30 million to $40
million. The pro forma adjustment to cash and payable to Corning
represents the reduction to bring cash to the Distribution Date range.
(b) The pro forma adjustment to current portion of long-term debt, term loans,
Notes, payable to Corning and contributed capital reflects borrowings by
Quest Diagnostics, immediately prior to the Quest Diagnostics Spin-Off
Distribution, to repay Corning for certain income tax liabilities and
intercompany borrowings. The assumed interest rates on these borrowings are
7.50% and 10.75% for the Credit Facility and the Notes, respectively. $6
million of debt financing costs were paid by Corning and are reflected as a
capital contribution.
(c) The Credit Facility will include a revolving credit facility of $100 million
which can be used to fund working capital and investment activities. Quest
Diagnostics management believes that substantially all of the revolving
credit facility will be available at the Distribution Date.
(d) The pro forma adjustment to payable to Corning and contributed capital of
$753.3 million reflects Corning's capital contribution to Quest
Diagnostics of the estimated remaining intercompany borrowings.
(e) The pro forma adjustment to contributed capital and accumulated deficit
represents costs directly related to the Quest Diagnostics Spin-Off
Distribution that Quest Diagnostics expects to record coincident with the
Quest Diagnostics Spin-Off Distribution. These costs, which are estimated at
$20.2 million ($13.2 million after tax), include approximately $9.0 million
related to professional advisory fees and $11.2 million related to the
establishment of an employee stock ownership plan. This amount is subject to
change based on the market price of the Quest Diagnostics Common Stock on
the Distribution Date.
(f) The pro forma adjustment to contributed capital represents the estimated
capital contribution related to Corning's indemnification under the
Transaction Agreement. See "The Distributions--Transaction Agreement." As
a result of funding settled claims, primarily the Damon settlement of
$119 million, the receivable from Corning is estimated to approximate $25
million at the Distribution Date.
(g) Coincident with the Quest Diagnostics Spin-Off Distribution, Quest
Diagnostics will adopt a new accounting policy for evaluating and
measuring the recoverability of intangible assets based on a fair value
approach (the "Accounting Policy Change"). The pro forma adjustment to
accumulated deficit represents the estimated impact of the Accounting
Policy Change. Quest Diagnostics management estimates the charge to
reduce the carrying value of intangible assets to fair value will be in
the range of $400 million to $450 million. The midpoint of the range has
been utilized for the preparation of the Unaudited Pro Forma Combined
Balance Sheet.
(h) The current portion of long-term debt and the term loans, exclusive of
the pro forma adjustment, consists primarily of a mortgage note payable
and capital lease obligations.
26
<PAGE>
Selected Historical Financial Data
The following table presents selected historical financial data of Quest
Diagnostics at the dates and for each of the periods indicated. The selected
financial data as of and for each of the years ended December 31, 1995, 1994
and 1993 have been derived from the Audited Financial Statements and the
notes thereto included elsewhere herein. The selected financial data as of
and for the three and nine months ended September 30, 1996 and 1995 (the
"Interim Financial Statements" and, together with the Audited Financial
Statements, the "Financial Statements") and the years ended December 31, 1992
and 1991 have been derived from the unaudited combined financial statements
of Quest Diagnostics. In the opinion of management, the unaudited combined
financial statements include all adjustments, consisting only of normal
recurring adjustments, that are necessary for a fair presentation of the
financial position and results of operations for these periods. The unaudited
interim results of operations for the three and nine months ended September
30, 1996 are not necessarily indicative of the results for the entire year
ending December 31, 1996.
The selected financial data should be read in conjunction with the Financial
Statements and notes thereto, and the Pro Forma Financial Information and
notes thereto included elsewhere herein. Historical combined financial data
may not be indicative of Quest Diagnostics' future performance as an
independent company. See the Financial Statements and notes thereto and Pro
Forma Financial Information. See also "Management's Discussion and Analysis
of Financial Condition and Results of Operations" and "Business."
27
<PAGE>
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------- ------------------------------
1996 1995 1996 1995
---------------- -------------- --------------- --------------
(in thousands, except percentage data)
<S> <C> <C> <C> <C>
Statement of Operations Data:
Net revenues $ 405,352 $ 399,959 $1,231,290 $1,239,474
Costs and expenses:
Cost of services 255,390 240,868 768,809 735,984
Selling, general and administrative 125,190 181,346(b) 371,439 399,635 (b)
Provision for restructuring and other
special charges(c) 155,730 201,730 45,885
Interest expense, net 19,866 20,927 59,887 61,529
Amortization of intangible assets 10,328 11,293 31,772 33,678
Other, net 1,837 1,930 (198) 4,429
---------------- -------------- --------------- --------------
Total 568,341 456,364 1,433,439 1,281,140
---------------- -------------- --------------- --------------
Income (loss) before taxes (162,989) (56,405) (202,149) (41,666)
Income tax expense (benefit) (43,553) (17,810) (43,280) (3,642)
---------------- -------------- --------------- --------------
Income (loss) before cumulative effect of
change in accounting principle (119,436) (38,595) (158,869) (38,024)
Cumulative effect of change in accounting
principle
---------------- -------------- --------------- --------------
Net income (loss) $ (119,436) $ (38,595) $ (158,869) $ (38,024)
================ ============== =============== ==============
Balance Sheet Data (at end of period):
Cash $ 48,319 $ 46,908 $ 48,319 $ 46,908
Working capital 114,718 129,319 114,718 129,319
Total assets 1,886,378 1,896,058 1,886,378 1,896,058
Long-term debt 1,219,900 1,114,367 1,219,900 1,114,367
Total debt 1,231,785 1,226,211 1,231,785 1,226,211
Stockholder's equity 132,670 320,576 132,670 320,576
Ratio of earnings to fixed charges -- (d) -- (d) -- (d) -- (d)
Supplemental Data:
Net cash provided by operating activities $ 25,236 $ 38,202 $ 41,937 $ 53,789
Net cash used in investing activities (7,904) (17,044) (53,097) (77,911)
Net cash provided by (used in) financing
activities (6,618) (18,006) 23,033 32,311
EBITDA(e) $ (118,123)(f) $ (9,910)(b) $ (67,030)(f) $ 95,899 (b)
EBITDA as a % of net revenues (29.1)% (2.5)% (5.4)% 7.7%
Adjusted EBITDA(g) $ 37,607 $ (9,910)(b) $ 134,700 $ 141,784 (b)
Adjusted EBITDA as a % of net revenues 9.3% (2.5)% 10.9% 11.4%
</TABLE>
(Footnotes on page 30)
28
<PAGE>
<TABLE>
<CAPTION>
Year Ended December 31,
--------------------------------------------------------------------
1995 1994(a) 1993 1992 1991
-------------- ------------- -------------------------- -----------
(in thousands, except percentage data)
<S> <C> <C> <C> <C> <C>
Statement of Operations Data:
Net revenues $1,629,388 $1,633,699 $1,416,338 $1,228,964 $941,116
Costs and expenses:
Cost of services 980,232 969,844 805,729 657,354 553,810
Selling, general and administrative 523,271(b) 411,939 363,579 334,665 193,934
Provision for restructuring and other
special charges(c) 50,560 79,814 99,600 13,000
Interest expense, net 82,016 63,295 41,898 31,775 14,205
Amortization of intangible assets 44,656 42,588 28,421 21,359 16,556
Other, net 6,221 3,464 6,423 16,300 6,636
-------------- ------------- -------------------------- -----------
Total 1,686,956 1,570,944 1,345,650 1,074,453 785,141
-------------- ------------- -------------------------- -----------
Income (loss) before taxes (57,568) 62,755 70,688 154,511 155,975
Income tax expense (benefit) (5,516) 34,410 25,929 52,115 52,128
-------------- ------------- -------------------------- -----------
Income (loss) before cumulative effect of
change in accounting principle (52,052) 28,345 44,759 102,396 103,847
Cumulative effect of change in accounting
principle (10,562)
-------------- ------------- -------------------------- -----------
Net income (loss) $ (52,052) $ 28,345 $ 34,197 $ 102,396 $103,847
============== ============= ========================== ===========
Balance Sheet Data (at end of period):
Cash $ 36,446 $ 38,719 $ 39,410 $ 20,528 $ 24,068
Working capital 200,740 214,358 139,771 161,759 126,406
Total assets 1,853,385 1,882,663 1,861,162 1,024,806 764,087
Long-term debt 1,195,566 1,153,054 1,025,787 431,624 270,682
Total debt 1,207,714 1,165,626 1,123,307 474,175 287,973
Stockholder's equity 295,801 386,812 395,509 408,149 291,973
Ratio of earnings to fixed charges --(d) 1.77(d) 2.20(d) 4.44(d) 5.83(d)
Supplemental Data:
Net cash provided by operating
activities $ 85,828 $ 37,963 $ 99,614 $ 101,077 $ -- (h)
Net cash used in investing activities (93,087) (46,186) (473,687) (203,884) -- (h)
Net cash provided by (used in) financing
activities 4,986 7,532 392,956 99,267 -- (h)
EBITDA(e) $ 125,961(b) $ 215,567 $ 179,065 $ 242,527 $213,593
EBITDA as a % of net revenues 7.7% 13.2% 12.6% 19.7% 22.7%
Adjusted EBITDA(g) $ 176,521(b) $ 295,381 $ 278,665 $ 255,527 $213,593
Adjusted EBITDA as a % of net revenues 10.8% 18.1% 19.7% 20.8% 22.7%
</TABLE>
(Footnotes on page 30)
29
<PAGE>
(Footnotes for preceding pages)
(a) In August 1993, Quest Diagnostics acquired Damon, a national
clinical-testing laboratory with approximately $280 million in annualized
revenues, excluding Damon's California-based laboratories, which were
sold in April 1994. In November 1993, Quest Diagnostics acquired certain
clinical-testing laboratories of Unilab, with approximately $90 million
in annualized revenues. The Damon and Unilab acquisitions were accounted
for as purchases. Quest Diagnostics acquired MML, Nichols and Bioran
Medical Laboratory ("Bioran") in June, August and October 1994,
respectively, and accounted for these acquisitions as poolings of
interest. Results presented include the results of Quest Diagnostics,
MML, Nichols and Bioran on a pooled basis. The increase in 1994 net
revenues compared to 1993 net revenues was primarily due to the Damon and
Unilab acquisitions.
(b) Includes a third quarter 1995 charge of $62.0 million to increase the
reserve for doubtful accounts and allowances resulting from billing
systems implementation and integration problems at certain laboratories
and increased regulatory requirements.
(c) Provision for restructuring and other special charges includes charges
for restructurings primarily for work force reduction programs, the
write-off of fixed assets and the costs of exiting a number of leased
facilities. Other special charges is primarily comprised of settlement
reserves for claims related to billing practices. See Note 5 to the
Audited Financial Statements and Notes 2 and 3 to the Interim Financial
Statements.
(d) For purposes of this calculation, earnings consist of pretax income from
continuing operations plus fixed charges. Fixed charges consist of
interest expense and one-third of rental expense, representing that
portion of rental expense deemed representative of the interest factor.
Earnings were insufficient to cover fixed charges by the following
amounts (in thousands):
<TABLE>
<CAPTION>
<S> <C> <C> <C>
Three months Ended September 30, Nine months Ended September 30, Year Ended December 31,
----------------------------------------------- ----------------------------------------------- -----------------------
1996 1995 1996 1995 1995
$162,989 $56,405 $202,149 $41,666 $57,568
</TABLE>
(e) EBITDA represents income (loss) before income taxes plus net interest
expense, depreciation and amortization. EBITDA is presented and discussed
because management believes that EBITDA is a useful adjunct to net income
and other measurements under generally accepted accounting principles since
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. EBITDA is not a measure of financial
performance under generally accepted accounting principles 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.
(f) 1996 EBITDA includes charges of $142 million and $188 million for the
three months and nine months ended September 30, 1996, respectively,
related to charges to establish additional reserves for settlement
issues. In October 1996, Corning contributed $119 million to Quest
Diagnostics' capital to fund the settlement of billing issues related to
Damon and has agreed to indemnify Quest Diagnostics against certain
related and similar claims pending at the Distribution Date.
(g) Adjusted EBITDA represents income (loss) before income taxes plus net
interest expense, depreciation and amortization and restructuring and other
special charges. EBITDA and Adjusted EBITDA include bad debt expense.
Adjusted EBITDA is presented and discussed because management believes that
Adjusted EBITDA is a useful adjunct to net income and other measurements
under generally accepted accounting principles since 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 generally accepted accounting principles 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.
(h) 1991 cash flow data, on a basis restated for poolings, is not available.
30
<PAGE>
Pro Forma Financial Information
The unaudited pro forma combined statements of operations for the three and
nine months ended September 30, 1996 and for the year ended December 31, 1995
present the results of operations of Quest Diagnostics assuming that the
Distributions and the Accounting Policy Change had been completed as of
January 1, 1995. The unaudited pro forma combined balance sheet as of
September 30, 1996 presents the combined financial position of Quest
Diagnostics assuming that the Distributions and the Accounting Policy Change
had been completed on that date. In the opinion of Quest Diagnostics
management, the unaudited pro forma combined financial information for the
year ended December 31, 1995 and the three and nine months ended September
30, 1996 (the "Pro Forma Financial Information") includes all material
adjustments necessary to restate Quest Diagnostics' historical results. The
adjustments required to reflect such assumptions are described in the Notes
to the Pro Forma Financial Information and are set forth in the "Pro Forma
Adjustments" column.
The Pro Forma Financial Information should be read in conjunction with the
Financial Statements and notes thereto included elsewhere herein. The Pro
Forma Financial Information presented is for informational purposes only and
may not necessarily reflect the future results of operations or financial
position or what the results of operations or financial position would have
been had the Distributions and the Accounting Policy Change occurred as
assumed herein, or had Quest Diagnostics been operated as an independent
company during the periods shown.
31
<PAGE>
Quest Diagnostics Incorporated
Unaudited Pro Forma Combined Statement of Operations
Three Months Ended September 30, 1996
<TABLE>
<CAPTION>
Pro Forma
Historical Adjustments Pro Forma
------------------- ------------------- -------------------
(in thousands, except share and per share data)
<S> <C> <C> <C>
Net revenues $ 405,352 $ $ 405,352
Costs and expenses
Cost of services 255,390 255,390
Selling, general and administrative 125,190 0 (a) 125,190
Provision for restructuring and other special charges 155,730 155,730
Interest expense, net 19,866 (8,062)(b) 11,804
Amortization of intangible assets 10,328 (2,656)(c) 7,672
Other, net 1,837 1,837
------------------- ------------------- -------------------
Loss before taxes (162,989) 10,718 (152,271)
Income tax (benefit) provision (43,553) 3,184 (d) (40,369)
------------------- ------------------- -------------------
Net loss $(119,436) $ 7,534 $ (111,902)
=================== =================== ===================
Pro forma shares outstanding 28,901,735 (e)
===================
Pro forma net loss per share $ (3.87)(f)
===================
</TABLE>
The accompanying notes to unaudited pro forma combined financial information
are an integral part hereof.
32
<PAGE>
Quest Diagnostics Incorporated
Unaudited Pro Forma Combined Statement of Operations
Nine Months Ended September 30, 1996
<TABLE>
<CAPTION>
Pro Forma
Historical Adjustments Pro Forma
------------------- ------------------- -------------------
(in thousands, except share and per share data)
<S> <C> <C> <C>
Net revenues $1,231,290 $ $ 1,231,290
Costs and expenses
Cost of services 768,809 768,809
Selling, general and administrative 371,439 0 (a) 371,439
Provision for restructuring and other special
charges 201,730 201,730
Interest expense, net 59,887 (24,103)(b) 35,784
Amortization of intangible assets 31,772 (7,969)(c) 23,803
Other, net (198) (198)
------------------- ------------------- -------------------
Loss before taxes (202,149) 32,072 (170,077)
Income tax (benefit) provision (43,280) 9,521 (d) (33,759)
------------------- ------------------- -------------------
Net loss $ (158,869) $ 22,551 $ (136,318)
=================== =================== ===================
Pro forma shares outstanding 28,901,735 (e)
===================
Pro forma net loss per share $ (4.72)(f)
===================
</TABLE>
The accompanying notes to unaudited pro forma combined financial information
are an integral part hereof.
33
<PAGE>
Quest Diagnostics Incorporated
Unaudited Pro Forma Combined Statement of Operations
Year Ended December 31, 1995
<TABLE>
<CAPTION>
Pro Forma
Historical Adjustments Pro Forma
--------------- -------------- ----------------
(in thousands, except share and per share data)
<S> <C> <C> <C>
Net revenues $1,629,388 $ $ 1,629,388
Costs and expenses
Cost of services 980,232 980,232
Selling, general and administrative 523,271 0 (a) 523,271
Provision for restructuring and other special
charges 50,560 50,560
Interest expense, net 82,016 (32,807)(b) 49,209
Amortization of intangible assets 44,656 (10,625)(c) 34,031
Other, net 6,221 6,221
--------------- -------------- ----------------
Loss before taxes (57,568) 43,432 (14,136)
Income tax (benefit) provision (5,516) 12,959 (d) 7,443
--------------- -------------- ----------------
Net loss $ (52,052) $ 30,473 $ (21,579)
=============== ============== ================
Pro forma shares outstanding 28,901,735 (e)
================
Pro forma net loss per share $ (0.75)(f)
================
</TABLE>
The accompanying notes to unaudited pro forma combined financial information
are an integral part hereof.
34
<PAGE>
Quest Diagnostics Incorporated
Unaudited Pro Forma Combined Balance Sheet
September 30, 1996
<TABLE>
<CAPTION>
Pro Forma
Historical Adjustments Pro Forma
------------- --------------- -------------
(in thousands)
<S> <C> <C> <C>
Assets
Current Assets:
Cash and cash equivalents $ 48,319 $ (8,319)(g) $ 40,000
Accounts receivable 323,171 323,171
Inventories 25,559 25,559
Deferred taxes on income 126,906 9,400 (h) 136,306
Due from Corning Incorporated 150,000 (i) 150,000
Prepaid expenses and other assets 25,217 25,217
------------- --------------- -------------
Total current assets 549,172 151,081 700,253
Property, plant and equipment, net 293,490 293,490
Intangible assets, net 1,001,500 (425,000)(j) 576,500
Other assets 42,216 10,925 (h) 53,141
------------- --------------- -------------
Total Assets $1,886,378 $ (262,994) $1,623,384
============= =============== =============
Liabilities and Stockholder's Equity
Current Liabilities:
Accounts payable and accrued expenses $ 374,058 $ 9,000 (k) $ 383,058
Current portion of long-term debt 11,885 (10,000)(h) 1,885
Income taxes payable 34,212 (18,632)(h)
(7,011)(k) 8,569
Due to Corning Incorporated and affiliates 14,299 (14,299)(h)
------------- --------------- -------------
Total current liabilities 434,454 (40,942) 393,512
Long-term debt, third-party 15,494 500,000 (h) 515,494
Payable to Corning 1,204,406 (8,319)(g)
(442,744)(h)
(753,343)(l)
Other liabilities 99,354 99,354
------------- --------------- -------------
Total liabilities 1,753,708 (745,348) 1,008,360
------------- --------------- -------------
Stockholder's Equity:
Contributed capital 297,823 6,000 (h)
150,000 (i)
11,250 (k)
753,343 (l) 1,218,416
Accumulated deficit (163,158) (425,000)(j)
(13,239)(k) (601,397)
Cumulative translation adjustment 1,801 1,801
Market valuation adjustment (3,796) (3,796)
------------- --------------- -------------
Total stockholder's equity 132,670 482,354 615,024
------------- --------------- -------------
Total Liabilities and Stockholder's Equity $1,886,378 $ (262,994) $1,623,384
============= =============== =============
</TABLE>
The accompanying notes to unaudited pro forma combined financial information
are an integral part hereof.
35
<PAGE>
Quest Diagnostics Incorporated
Notes to Unaudited Pro Forma Combined Financial Information
Statements of Operations
(a) The historical financial statements include substantially all of the costs
incurred by Corning on Quest Diagnostics' behalf and reflect all of its
costs of doing business. Quest Diagnostics management does not expect
administrative costs to increase as a result of being an independent, public
company.
(b) The pro forma adjustment to interest expense, net represents the difference
between historical intercompany interest expense and interest expense on the
third party debt to be incurred in connection with the Quest Diagnostics
Spin-Off Distribution. Quest Diagnostics will borrow, immediately prior to
the Quest Diagnostics Spin-Off Distribution, approximately $500 million in
long-term debt to repay Corning for certain intercompany borrowings. The
debt is assumed to consist of $350 million of borrowings under the Credit
Facility and $150 million of Notes. The assumed interest rates on these new
borrowings are 7.50% and 10.75% for the Credit Facility and the Notes,
respectively. If the interest rate on the Credit Facility fluctuates by
1/8%, interest expense fluctuates by approximately $440,000 annually.
(c) The pro forma adjustment to amortization of intangible assets represents the
estimated reduction of amortization expense due to the Accounting Policy
Change. Most of Quest Diagnostics' intangible assets resulted from business
combinations in 1993 accounted for as purchases. Significant changes in the
clinical laboratory and health care industries subsequent to 1993 have
caused the fair value of Quest Diagnostics' intangible assets to be
significantly less than their carrying value. Quest Diagnostics management
believes that a valuation of intangible assets based on the amount for which
each regional laboratory could be sold in an arm's-length transaction is
preferable to using projected undiscounted pre-tax cash flows. Quest
Diagnostics believes fair value is a better indicator of the extent to which
the intangible assets may be recoverable and therefore may be impaired.
Quest Diagnostics management estimates that the reduction of amortization
expense will approximate between $10.0 million and $11.3 million annually
and $2.5 million and $2.8 million quarterly. The midpoint of the range has
been utilized for the preparation of the Unaudited Pro Forma Combined
Statements of Operations.
(d) The pro forma adjustment to income tax (benefit) provision represents the
estimated income tax impact of the pro forma reduction in interest expense
at the incremental tax rate of 39.5%. The pro forma amortization expense
reduction will not impact income taxes as the amortization is not deductible
for tax purposes.
(e) The pro forma common shares outstanding represents Quest Diagnostics
management's current estimate of the number of shares to be outstanding
after the Quest Diagnostics Spin-Off Distribution. Management's estimate
includes (a) the issuance of approximately 28.0 million shares of Quest
Diagnostics Common Stock at an exchange ratio of one share of Quest
Diagnostics Common Stock issued for every eight shares of Corning Common
Stock outstanding at September 30, 1996 and (b) the issuance of an estimated
900,000 shares into the employee stock ownership plan. Quest Diagnostics
management's estimate of shares outstanding is subject to change as the
result of normal issuances and repurchases of Corning Common Stock prior to
the date of the Quest Diagnostics Spin-Off Distribution and finalization of
the proposed structure of the employee stock ownership plan.
(f) Pro forma net loss per share is computed by dividing net loss by the pro
forma shares outstanding during each period. Common stock equivalents are
not included in the loss per share computation because they do not result in
material dilution. Historical net loss per share data is not presented as
Quest Diagnostics' historical capital structure is not comparable to periods
subsequent to the Quest Diagnostics Spin-Off Distribution.
Balance Sheet
(g) Historically, Quest Diagnostics has participated in Corning's centralized
treasury and cash management processes. Cash received from operations was
generally transferred to Corning on a daily basis. Cash disbursements for
operations and investments were funded as needed from Corning. The cash
balance at the Distribution Date will range from $30 million to $40 million.
The pro forma adjustment to cash and payable to Corning represents the
reduction to bring cash to the Distribution Date range.
(h) The pro forma adjustment to deferred taxes on income, other assets, current
portion of long-term debt, income taxes payable, due to Corning Incorporated
and affiliates, long-term debt third party, payable to Corning and
contributed capital reflects borrowings, and related debt financing costs,
by Quest Diagnostics, immediately prior to the Quest Diagnostics Spin-Off
Distribution, to repay Corning for certain income tax liabilities and
intercompany borrowings. The debt is assumed to consist of $350 million of
bank borrowings under the Credit Facility and $150 million of Notes. $6
million of the debt financing costs were paid by Corning and are reflected
as a capital contribution.
(i) The pro forma adjustment to due from Corning Incorporated and contributed
capital represents the estimated receivable from Corning and capital
contribution related to Corning's indemnification obligations relating to
governmental claims under the Transaction Agreement. The receivable from
Corning is estimated to approximate $25 million at the Distribution Date.
The reduction from $150 million at September 30, 1996 to $25 million at the
Distribution Date is due to the fund-
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ing by Corning of indemnified claims, primarily the Damon settlement of $119
million, subsequent to September 30, 1996 and before the Distribution Date.
The remaining receivable will be paid by Corning upon the settlement of the
underlying, indemnified claims which is expected to occur within the next
twelve months.
(j) The pro forma adjustment to intangible assets, net and accumulated deficit
represents the estimated impact of the Accounting Policy Change. Quest
Diagnostics management estimates the charge to reduce the carrying value of
intangible assets to fair value will be in the range of $400 million to $450
million. The midpoint of the range has been utilized for the preparation of
the Unaudited Pro Forma Combined Balance Sheet. This charge has not been
reflected in the Unaudited Pro Forma Combined Statements of Operations
because it is non-recurring. See additional discussion on Quest Diagnostics'
planned change in accounting policy in note (c) above.
(k) The pro forma adjustment to accounts payable and accrued expenses, income
taxes payable, contributed capital and accumulated deficit represents costs
directly related to the Quest Diagnostics Spin-Off Distribution that Quest
Diagnostics expects to record coincident with the Quest Diagnostics Spin-Off
Distribution. These costs, which are estimated at $20.2 million ($13.2
million after tax), include approximately $9 million related to professional
advisory fees and $11.2 million related to the establishment of an employee
stock ownership plan. This amount is subject to change based on the market
price of the Quest Diagnostics Common Stock on the Distribution Date. This
charge has not been reflected in the Unaudited Pro Forma Statements of
Operations because it is nonrecurring.
(l) The pro forma adjustment to payable to Corning and contributed capital of
$753.3 million reflects Corning's capital contribution to Quest Diagnostics
of the estimated remaining intercompany borrowings.
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Management's Discussion and Analysis of
Financial Condition and Results of Operations
Overview
In the last several years, Quest Diagnostics' business has been affected by
significant government regulation, price competition and rapid change resulting
from payors' efforts to control cost, utilization and delivery of health care
services. As a result of these factors, Quest Diagnostics' profitability has
been impacted by changes in the volume of testing, the prices and costs of its
services, the mix of payors and the level of bad debt expense.
Payments for clinical laboratory services are made by government, managed care
organizations, insurance companies, physicians and patients. Increased
government regulation focusing on health care cost containment has reduced
prices and added costs for the clinical laboratory industry by increasing
complexity and adding new regulatory requirements. Also, in recent years there
has been a significant shift away from traditional fee-for-service health care
to managed health care, as employers and other payors of health care costs
aggressively move the populations they control into lower cost plans. Managed
care organizations typically negotiate capitated payment contracts whereby Quest
Diagnostics receives a fixed monthly fee per covered individual for all services
included under the contract. Capitated contract arrangements shift the risks of
additional routine testing beyond that covered by the capitated payment to the
clinical laboratory. The managed care industry is growing as well as undergoing
rapid consolidation which has created large managed care companies that control
the delivery of health care services for millions of people, and have
significant bargaining power in negotiating fees with providers, including
clinical laboratories. These market factors have had a significant adverse
impact on prices in the clinical laboratory industry, and are major contributors
to Quest Diagnostics' decline in profitability over the last two years. This
growth of managed care and use of capitated agreements are expected to continue
for the foreseeable future. See "Risk Factors--Role of Managed Care" and
"Business--Effect of the Growth of the Managed Care Sector on the Clinical
Laboratory Business."
A substantial portion of Quest Diagnostics' growth has come from acquisitions in
the last four years. The largest of these acquisitions were the purchases of
Damon and certain operations of Unilab in 1993 and the acquisitions of MML,
Nichols Institute and Bioran in 1994. As a result of these acquisitions, Quest
Diagnostics has recorded a number of special charges for restructuring and
integration costs since 1993. See Note 5 to the Audited Financial Statements and
Notes 2 and 3 to the Interim Financial Statements.
The MML, Nichols Institute and Bioran transactions were accounted for as
poolings of interests. The accompanying financial statements of Quest
Diagnostics have been restated to include the results of operations of these
pooled entities on a combined basis for all periods presented. The results of
operations for Damon and Unilab, as well as all other acquisitions accounted for
as purchases, have been included since their respective dates of acquisition.
Acquisitions accounted for as purchases have generated large amounts of goodwill
which are not deductible for tax purposes, giving rise to a high effective
income tax rate and increased sensitivity of the income tax rate to changes in
pre-tax income. See Note 4 to the Audited Financial Statements.
The clinical laboratory industry is subject to seasonal fluctuations in
operating results. Quest Diagnostics' cash flows are influenced by seasonal
factors. During the summer months, year-end holiday periods and other major
holidays, volume of testing declines, reducing net revenues and resulting cash
flows below annual averages during the third and fourth quarters of the year.
Winter months are also subject to declines in testing volume due to inclement
weather, which varies in severity from year to year.
The clinical laboratory industry is labor intensive. Approximately half of Quest
Diagnostics' total costs and expenses are associated with employee compensation
and benefits. Cost of services, which have approximated sixty percent of net
revenues over the past several years, consists principally of costs for
obtaining, transporting and testing specimens. Selling, general and
administrative expenses consist principally of the cost of the sales force,
billing operations (including bad debt expense), and general management and
administrative support.
Results of Operations
Three Months Ended September 30, 1996 Compared with Three Months Ended September
30, 1995. Earnings for the third quarter of 1996 were significantly below those
for the prior year due principally to the impact of special charges. Before
special charges, earnings were significantly above the prior year level, which
included a $62 million charge to operations to increase accounts receivable
reserves.
Net Revenues
Net revenues increased by $5.4 million, or 1.3%, over the three months ended
September 30, 1995 due to increased revenues from Quest Diagnostics' nonclinical
testing businesses. Volume of clinical testing increased by 1.8% but was offset
by average price declines of 1.7%. The majority of the price decline resulted
from changes in reimbursement policies of various third-party payors, shifts in
volume to lower-priced managed care business and intense price competition in
the industry. Also contributing to the price
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decline was a reduction in Medicare fee schedules effective January 1, 1996,
which accounted for approximately a 1% decrease in net revenues.
Costs and Expenses
Cost of services increased by $14.5 million from the prior period and as a
percentage of net revenues increased to 63.0% in 1996 from 60.2% in 1995.
These increases were due principally to the effects of declining prices and
increases in salaries and wages associated with improving customer service
levels, and wage adjustments.
Selling, general and administrative expense decreased by $56.2 million from the
prior period and as a percentage of revenues decreased to 30.9% in 1996 from
45.3% in 1995. These decreases were due principally to a reduction in bad debt
expense, which decreased by $55.3 million, from $85.8 million to $30.5 million,
and as a percentage of net revenues decreased from 21.5% to 7.5%. The reduction
in bad debt expense results primarily from the unusually high level of bad debt
expense in the prior year, which included a charge of $62.0 million to increase
receivables reserves. Quest Diagnostics has established, and maintains, rigorous
programs to improve the effectiveness of Quest Diagnostics' billing and
collection operations. The established programs include standard policies and
procedures, employee training programs and regular reporting and tracking of key
measures by senior management. The implementation of these programs during the
fourth quarter of 1995 has aided in reducing bad debt expense. However,
additional requirements to provide documentation of the "medical necessity" of
testing have added to the backlog of unbilled receivables and caused third
quarter 1996 bad debt expense as a percentage of revenues to increase above the
rate Quest Diagnostics had experienced during the first two quarters of 1996.
Additional efforts to collect medical necessity documentation are currently
being made and are expected to lower bad debt expense below the 1996 third
quarter rate during 1997.*
During the third quarter of 1996, Quest Diagnostics recorded a $142.0 million
charge to establish additional reserves associated with government and other
claims primarily related to billing practices at certain laboratories of Damon
and Nichols prior to their acquisition by Quest Diagnostics. Subsequent to the
third quarter, Quest Diagnostics entered into an agreement with the DOJ to pay
$119.0 million to settle all federal and Medicaid claims related to the billing
by Damon of certain blood test series for federally sponsored health care
programs. This payment was fully reserved as part of the third quarter charge.
Quest Diagnostics' aggregate reserve with respect to all governmental and
nongovernmental claims, including litigation costs, was $215 million at
September 30, 1996, and is estimated to be reduced to $85 million at the
Distribution Date as a result of the payment of settled claims, primarily the
Damon settlement of $119.0 million. Although management believes that
established reserves for both indemnified and non-indemnified claims are
sufficient, it is possible that the final resolution of these matters could be
in excess of established reserves by an amount which could be material to Quest
Diagnostics' results of operation and, for non-indemnified claims, Quest
Diagnostics' cash flows in the periods in which such claims are settled. Quest
Diagnostics does not believe that these matters will have a material adverse
effect on Quest Diagnostics' overall financial condition. See "Risk
Factors--Government Investigations and Related Claims" and "Business--Government
Investigations and Related Claims."
Additionally, in the third quarter Quest Diagnostics recorded a charge of $13.7
million to write off capitalized software as a result of its decision to abandon
the billing system which had been intended as its company-wide billing system.
Management now plans to standardize billing systems using a system already
implemented in seven of its sites. See "Risk Factors--Billing,"
"Business--Information Systems" and "Business--Billing" and Note 3 to the
Interim Financial Statements.
Net interest expense declined from the prior year's level due to lower average
borrowings during 1996. Amortization of intangible assets decreased below the
prior year's level due to certain intangible assets having been fully amortized.
Quest Diagnostics' effective tax rate is significantly impacted by goodwill
amortization which is not deductible for tax purposes and which had the
effect of decreasing the tax benefit rate for the third quarter of 1996.
Nine Months Ended September 30, 1996 Compared with Nine Months Ended September
30, 1995. Earnings were substantially below those for the prior year due
principally to special charges, price declines, increases in salaries and wages,
higher bad debt expense, and unusually severe winter weather experienced during
the first quarter of 1996.
Net Revenues
Net revenues decreased by $8.2 million, or .7%, from the prior period,
principally due to average price declines of approximately 3.4%, partially
offset by an increase in clinical testing of 1.2% and increased revenues from
Quest Diagnostics' nonclinical testing businesses. Adversely affecting the
volume growth was unusually severe winter weather in the northeastern and
central parts of the United States during the first quarter of 1996. The
majority of the price declines resulted from changes in reimbursement
policies of various third-party payors, shifts in volume to lower-priced
managed care business, and intense price competition in the industry. Also
contributing to the price declines was a reduction in Medicare fee schedules
effective January 1, 1996, which accounted for approximately a 1% decrease in
net revenues.
* This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See
"Business--Important Factors Regarding Forward Looking Statements." In
particular see factors (c), (d), (j) and (k).
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Costs and Expenses
Cost of services increased by $32.8 million from the prior period and as a
percentage of net revenues increased to 62.4% in 1996 from 59.4% in 1995. These
increases were due principally to the effects of declining prices and increases
in salaries and wages associated with improving customer service levels, and
wage adjustments.
Selling, general and administrative expense decreased by $28.2 million from the
prior period and as a percentage of net revenues decreased to 30.2% in 1996 from
32.2% in 1995. These decreases were due principally to a reduction in bad debt
expense, which decreased, by $45.4 million, from $127.3 million to $81.9
million, and as a percentage of net revenues decreased from 10.3% to 6.7%,
partially offset by costs associated with developing and implementing strategic
action plans and operating improvement plans. The reduction in bad debt expense
results primarily from the unusually high level of bad debt expense in the prior
year, which included a charge of $62.0 million to increase receivables reserves.
Quest Diagnostics has established, and maintains, rigorous programs to improve
the effectiveness of Quest Diagnostics' billing and collection operations. The
established programs include standard policies and procedures, employee training
programs and regular reporting and tracking of key measures by senior
management. The implementation of these programs during the fourth quarter of
1995 has aided in reducing bad debt expense. However, additional requirements to
provide documentation of the "medical necessity" of testing have added to the
backlog of unbilled receivables and caused third quarter 1996 bad debt expense
as a percentage of revenues to increase above the rate Quest Diagnostics had
experienced during the first two quarters of 1996. Additional efforts to collect
medical necessity documentation are currently being made and are expected to
lower bad debt expense below the 1996 third quarter rate during 1997.*
In the second quarter of 1996, as a consequence of an investigation begun in
1993, the DOJ notified Quest Diagnostics that it has taken issue with payments
related to certain tests received by Damon from federally funded health care
programs prior to the acquisition of Damon by Quest Diagnostics. Quest
Diagnostics management met with the DOJ several times to evaluate the substance
of the government's allegations. A special charge of $46.0 million was recorded
in the second quarter of 1996 to establish additional reserves equal to
management's estimate, at that time, of the low end of the range of potential
amounts which could be required to satisfy the government's claims. During the
third quarter of 1996 Quest Diagnostics recorded a $142.0 million charge to
establish additional reserves associated with government and other claims
primarily related to billing practices at certain laboratories of Damon and
Nichols prior to their acquisition by Quest Diagnostics. Subsequent to the third
quarter, Quest Diagnostics entered into an agreement with the DOJ to pay $119.0
million to settle all federal and Medicaid claims related to the billing by
Damon of certain blood test series for federally sponsored health care programs.
This payment was fully reserved as part of the third quarter charge. Quest
Diagnostics' aggregate reserve with respect to all governmental and
nongovernmental claims, including litigation costs, was $215 million at
September 30, 1996, and is estimated to be reduced to $85 million at the
Distribution Date as a result of the payment of settled claims, primarily the
Damon settlement of $119.0 million. Although management believes that
established reserves for both indemnified and non-indemnified claims are
sufficient, it is possible that the final resolution of these matters could be
in excess of established reserves by an amount which could be material to Quest
Diagnostics' results of operations and, for non-indemnified claims, Quest
Diagnostics' cash flows in the periods in which such claims are settled. Quest
Diagnostics does not believe that these matters will have a material adverse
effect on Quest Diagnostics' overall financial condition. See "Risk
Factors--Government Investigations and Related Claims" and "Business--Government
Investigations and Related Claims."
In the third quarter Quest Diagnostics recorded a charge of $13.7 million to
write off capitalized software as a result of its decision to abandon the
billing system which had been intended as its company-wide billing system.
Management now plans to standardize billing systems using a system already
implemented in seven of its sites. See "Risk Factors--Billing,"
"Business--Information Systems" and "Business--Billing" and Notes 3 to the
Interim Financial Statements.
In the second quarter of 1995, Quest Diagnostics recorded a provision for
restructuring totalling $33 million primarily for work force reduction programs
and the costs of exiting a number of leased facilities. Additionally, in the
first quarter of 1995 Quest Diagnostics recorded a special charge of $12.8
million for the settlement of claims related to the inadvertent billing errors
of certain laboratory tests that were not completely and/or successfully
performed or reported due to insufficient samples and/or invalid results.
Net interest expense remained relatively unchanged from the prior year level.
Amortization of intangible assets decreased below the prior year level due to
certain intangible assets having been fully amortized. A gain on the sale of
several small investments and the favorable settlement of a contractual
obligation, both of which occurred in 1996, accounted for the majority of the
change in "other, net" compared to the prior year.
* This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See
"Business--Important Factors Regarding Forward Looking Statements." In
particular see factors (c), (d), (j) and (k).
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Quest Diagnostics' effective tax rate is significantly impacted by goodwill
amortization which is not deductible for tax purposes. This had the effect of
reducing the tax benefit rate of Quest Diagnostics in both 1996 and 1995. The
effect of this non-deductibility is particularly apparent when amortization
increases in proportion to pre-tax earnings, as was the case in 1995.
Year Ended December 31, 1995 Compared with Year Ended December 31,
1994. Earnings for 1995 were significantly below those for the prior year as
a result of price declines, higher bad debt expense, and the impact of
restructuring and other special charges. The 1995 bad debt expense included a
$62.0 million charge to increase accounts receivable reserves in the third
quarter.
Net Revenues
Net revenues of $1.6 billion in fiscal 1995 remained essentially unchanged
from the prior year. Average price declines, estimated to be 3.7%, were
offset by estimated growth of approximately 4% in requisition volume. The
majority of the price declines resulted from changes in reimbursement
policies of various third-party payors, an accelerated shift in volume to
lower-priced managed care business, and intense price competition in the
industry. Also contributing to the price declines was a reduction in Medicare
fee schedules effective January 1, 1995 which accounted for approximately a
1% decrease in net revenues.
Costs and Expenses
Cost of services increased $10.4 million from 1994 and as a percentage of net
revenues increased to 60.2% in 1995 from 59.4% in 1994. These increases were
due principally to the impact of price declines and the added cost of doing
business in an increasingly complex environment. Partially offsetting these
factors were synergies associated with the elimination of duplicate
facilities, personnel and administrative functions of acquired entities,
including Damon, MML and Nichols.
Selling, general and administrative expense increased $111.3 million from
1994 and as a percentage of net revenues increased to 32.1% in 1995 from
25.2% in 1994. These increases resulted primarily from a higher level of bad
debt expense during 1995. Excluding bad debt expense, selling, general and
administrative expenses as a percentage of net revenues were approximately
22.7% as compared to 21.6% in 1994.
Bad debt expense increased to $152.6 million or 9.4% of net revenues in 1995
from $59.5 million or 3.6% of net revenues in 1994. This increase resulted
from an increase in ongoing bad debt expense of $31.1 million throughout 1995
and a $62.0 million charge to increase bad debt reserves in the third quarter
of 1995.
During 1995, ongoing bad debt expense increased from 4.4% of net revenues in the
first quarter to 6.5% of net revenues in the fourth quarter. This increase is
due principally to four developments that have complicated the billing process:
(1) increased complexity in the health care system; (2) increased requirements
in complying with fraud and abuse regulations; (3) deterioration in
reimbursement as the payor mix shifts; and (4) changes in Medicare reimbursement
policies. These four factors have placed additional requirements on the billing
process, including the need for specific test coding, additional research on
processing rejected claims that comply with prior practices, increased audits
for compliance, and management of a large number of contracts which have very
different information requirements for pricing and reimbursement.
In addition to the changes in the billing process, in mid-1995, Quest
Diagnostics experienced problems integrating billing operations from recent
acquisitions into existing billing operations and experienced significant
problems implementing a new billing system at its largest facility in Teterboro,
New Jersey. These factors, along with the significant changes in the billing
process discussed in the preceding paragraph, contributed to a significant
increase in the backlog of unbilled receivables and a significant deterioration
in the collection of receivables during the third quarter of 1995. As a result,
Quest Diagnostics recorded a charge of $62 million in the third quarter to
increase accounts receivable reserves. Quest Diagnostics has put in place a
rigorous program to improve the effectiveness of its billing and collection
operations and has stabilized the current billing system in Teterboro. See "Risk
Factors--Billing" and "Business--Information Systems" and "Business--Billing."
In the second quarter of 1995, Quest Diagnostics recorded a provision for
restructuring totalling $33.0 million, consisting primarily of costs for work
force reduction programs and exiting a number of leased facilities. In the first
quarter of 1995, Quest Diagnostics recorded a special charge of $12.8 million
for the settlement of claims related to inadvertent billing errors of certain
laboratory tests that were not completely and/or successfully performed or
reported due to insufficient samples and/or invalid results. In the third
quarter of 1994, Quest Diagnostics recorded a provision for restructuring and
other special charges totalling $79.8 million which included $48.2 million of
integration costs, $21.6 million of transaction expenses, and $10.0 million of
other reserves primarily related to the Nichols Institute, MML and Bioran
acquisitions. See Note 5 to the Audited Financial Statements.
Net interest expense increased by $18.7 million over the 1994 level due to an
increase in average debt levels, resulting principally from funding investing
activities and cash requirements associated with restructuring and other
special charges.
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Amortization expense increased principally due to additional intangible
assets arising from acquisitions completed in 1994 and 1995. Quest
Diagnostics' effective tax rate is significantly impacted by goodwill
amortization which is not deductible for tax purposes. This had the effect of
reducing the tax benefit rate to Quest Diagnostics in 1995 while increasing
the overall tax rate in 1994. See Note 4 to the Audited Financial Statements.
Year Ended December 31, 1994 Compared with Year Ended December 31,
1993. Earnings for 1994 were below those for the prior year due principally
to price declines, which outpaced the cost efficiencies realized from the
integration of acquisitions and other activities to reduce costs.
Net Revenues
Net revenues increased by $217.4 million, or 15.3%, over the prior year, due
principally to the net impact of acquisitions and dispositions which
increased net revenues by approximately $240 million. The net effect of
average price declines, estimated at 4%, offset by an increase in requisition
volume, estimated at 3%, accounted for the remaining change in net revenues.
The majority of the price declines resulted from a shift in volume to
lower-priced managed care business, changes in reimbursement policies of
various third-party payors, and intense price competition. Also contributing
to the price declines was a reduction in Medicare fee schedules effective
January 1, 1994 which accounted for approximately a 1% decrease in net
revenues.
Costs and Expenses
Cost of services increased $164.1 million over 1993 and as a percentage of
net revenues increased to 59.4% in 1994 from 56.9% in 1993. These increases
were due principally to the impact of price declines and the added cost of
doing business in an increasingly complex environment. Partially offsetting
these factors were synergies realized from integration of acquisitions.
Selling, general and administrative expense increased $48.4 million over 1993
and as a percentage of net revenues decreased slightly from 25.7% in the
prior year to 25.2%. Synergies associated with the elimination of duplicate
facilities, personnel and administrative functions of acquired entities,
primarily Damon, MML and Nichols, with those of Quest Diagnostics were
partially offset by an increase in bad debt expense, which increased by $12.3
million, from $47.2 million to $59.5 million, and increased from 3.3% of net
revenues in 1993 to 3.6% in 1994.
In the third quarter of 1994, Quest Diagnostics recorded a provision for
restructuring and other special charges totalling $79.8 million, which
included $48.2 million of integration costs, $21.6 million of transaction
expenses, and $10.0 million of other reserves primarily related to the
Nichols Institute, MML and Bioran acquisitions. Integration costs represented
the expected costs for closing clinical laboratories in certain markets where
duplicate Quest Diagnostics and Nichols Institute, MML or Bioran facilities
existed at the time of the acquisitions. In the third quarter of 1993, Quest
Diagnostics recorded a provision for restructuring costs and other special
charges totalling $99.6 million. The restructuring component of this special
charge aggregated $56.6 million related principally to the integration of
Quest Diagnostics' operations with those acquired in the Damon acquisition.
The special charge consisted primarily of a $36.5 million charge to reflect
the settlement and related legal expenses associated with a compromise
agreement with the DOJ to settle claims brought on behalf of the OIG. In
making the settlement, Quest Diagnostics did not admit any wrongdoing in
connection with its marketing or business practices. See "Risk
Factors--Government Investigations and Related Claims," "Business--Government
Investigations and Related Claims" and Note 5 to the Audited Financial
Statements.
Net interest expense increased by $21.4 million over the prior year, due
principally to increased borrowings associated with financing acquisitions
and, to a lesser degree, increased borrowing rates. Amortization of
intangibles increased due to additional intangible assets arising from
acquisitions completed in 1993 and 1994.
Quest Diagnostics' effective tax rate is significantly impacted by goodwill
amortization which is not deductible for tax purposes, and has the effect of
increasing the overall tax rate, particularly when amortization increases in
proportion to pre-tax earnings. This situation was the principal contributor
to the increase in the 1994 effective tax rate over the prior year. See Note
4 to the Audited Financial Statements.
Liquidity and Capital Resources
After the Distributions
Concurrently with the Quest Diagnostics Spin-Off Distribution, Quest
Diagnostics' debt will be restructured and equity recapitalized. Quest
Diagnostics plans to complete the Offering and incur approximately $350
million of borrowings under the Credit Facility. The proceeds from these
borrowings will be used to repay amounts owed to Corning. Amounts owed to
Corning in excess of the proceeds from these borrowings will be contributed
by Corning to Quest Diagnostics' capital. As a result of these
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actions, management estimates that Quest Diagnostics' long-term debt will be
reduced by approximately $704 million to approximately $515 million, and annual
interest expense will be reduced by approximately $33 million. The Credit
Facility will include a revolving credit facility of $100 million, substantially
all of which is expected to be available for borrowing at the time of the
Distributions.
Quest Diagnostics estimates that it will invest approximately $20 million during
the fourth quarter of 1996 for capital expenditures, principally related to
facility upgrades and investments in information technology. Capital
expenditures in 1997 are estimated to be approximately $95 million, of which
approximately $10 to $15 million relates to the conversion of billing and
laboratory systems to Quest Diagnostics' standard systems (see
"Business--Information Systems"). Quest Diagnostics expects to expand its
operations principally through internal growth and accelerated growth in
strategic markets and related lines of business. Quest Diagnostics expects such
activities will be funded from existing cash and cash equivalents, cash flow
from operations, and borrowings under the revolving credit facility. Quest
Diagnostics believes that the revolving credit facility will be sufficient to
meet both its short-term and its long-term financing needs. As a result, Quest
Diagnostics believes it has sufficient financial flexibility and sufficient
access to funds to meet seasonal working capital requirements, capital
expenditures and growth opportunities.
Quest Diagnostics does not anticipate paying dividends on the Quest Diagnostics
Common Stock in the foreseeable future. In addition, the Credit Facility
prohibits Quest Diagnostics from paying cash dividends on the Quest Diagnostics
Common Stock. Further, the Indenture under which the Notes will be issued will
restrict Quest Diagnostics' ability to pay cash dividends on the Quest
Diagnostics Common Stock based on a percentage of Quest Diagnostics' cash flow.
Coincident with the Distributions, Quest Diagnostics plans to record a
non-recurring charge of approximately $20 million associated with the
Distributions. The largest component of the charge will be the cost of
establishing an employee stock ownership plan. The remainder of the charge will
consist principally of the costs for advisors and other fees associated with
establishing Quest Diagnostics as a separate publicly traded entity. The amount
of the charge is subject to change based on the price of the Quest Diagnostics
Common Stock on the Distribution Date.
Although Quest Diagnostics has no present acquisition agreements or
arrangements, there may be acquisitions or other growth opportunities which will
require additional external financing, and Quest Diagnostics may from time to
time seek to obtain funds from public or private issuances of equity or debt
securities. There can be no assurance that such financing will be available on
terms acceptable to Quest Diagnostics. See "Risk Factors--Potential Liability
under the Spin-Off Tax Indemnification Agreements" and "The
Distributions--Spin-Off Tax Indemnification Agreements."
Quest Diagnostics management believes that the recapitalization of Quest
Diagnostics and the indemnification by Corning against monetary fines, penalties
or losses from outstanding government claims, together with the successful
implementation of its business strategy, will generate more predictable and
improved cash flows.* Additionally, Quest Diagnostics management believes that
these actions, together with Quest Diagnostics' leading market position or low
cost provider status in a number of geographic regions accounting for the
majority of its net revenues, will aid Quest Diagnostics in meeting the ongoing
challenges in the clinical laboratory industry brought on by growth in managed
care and increased regulatory complexity.*
Prior to the Distributions
Historically, Quest Diagnostics has financed its operations and growth with cash
flow from operations, borrowings from Corning, and stock issued by Corning to
finance certain acquisitions on behalf of Quest Diagnostics. Investing
activities have included business acquisitions and capital expenditures for
facility expansions and upgrades and information systems improvements.
Replacement of laboratory equipment has typically been financed through
operating leases.
Net cash provided by operating activities for the nine months ended September
30, 1996 was below the level for the comparable period of the prior year, as
a result of reduced earnings, partially offset by an improved collection rate
of accounts receivable and a reduction in restructuring spending. This
improvement in accounts receivable is a direct result of specific programs
initiated in the fourth quarter of 1995 to improve billing operations.
Although these programs are continuing, additional requirements of customers
to provide documentation of the "medical necessity" of testing are expected
to increase receivable levels in the future. The number of days sales
outstanding in accounts receivable ("DSOs") for the clinical testing business
is one measure used by Quest Diagnostics to monitor the effectiveness of its
billing operations. DSOs were 74 days at September 30, 1996 and December 31,
1995, 81 days at December 31, 1994, and 90 days at December 31, 1993.
* This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See
"Business--Important Factors Regarding Forward Looking Statements." In
particular see factors (a), (b), (c), (d), (e) and (j).
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Net cash provided by operating activities during 1995 increased above the prior
year despite reduced earnings, due primarily to changes in accounts payable and
accrued expenses and reduced spending for restructuring integration and other
special charges. Net cash provided by operating activities in 1994 declined from
the 1993 level principally due to larger increases in accounts receivables and
higher levels of spending for restructuring, integration and other special
charges during 1994.
Cash used for investing activities for the nine months ended September 30, 1996
was below the prior year level due to reduced acquisition activity and the sale
of several small investments during 1996. Investing activities during 1995, 1994
and 1993 were funded principally by cash flow from operations and borrowings
from Corning, and were principally for capital expenditures and acquisitions.
Cash used in investing activities in 1995 exceeded the prior year level due
principally to cash proceeds generated from the sale of certain California
operations in 1994. See Note 3 to the Audited Financial Statements.
Net cash provided by financing activities for the nine months ended September
30, 1996 was below the prior year level due primarily to reduced acquisition
activity during 1996. Financing activities in 1995, 1994 and 1993 consisted
principally of dividend payments to and net borrowing activities with Corning.
Adjusted EBITDA
Adjusted EBITDA represents income (loss) before income taxes plus net interest
expense, depreciation and amortization and restructuring and other special
charges. EBITDA and Adjusted EBITDA include bad debt expense. Adjusted EBITDA is
presented and discussed because management believes that Adjusted EBITDA is a
useful adjunct to net income and other measurements under generally accepted
accounting principles since 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 generally accepted accounting
principles 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.
Adjusted EBITDA for the third quarter of 1996 was $37.6 million, or 9.3% of net
revenues. Adjusted EBITDA in the prior year period was ($9.9) million. The
improvement in Adjusted EBITDA was principally due to a decrease in selling,
general and administrative expense (which decreased $56.2 million) and an
increase in net revenues of $5.4 million, partially offset by an increase in
cost of services (which increased $14.5 million).
Adjusted EBITDA for the nine months ended September 30, 1996 was $134.7 million,
or 10.9% of net revenues. Adjusted EBITDA in the prior year period was $141.8
million, or 11.4% of net revenues. The decline in Adjusted EBITDA was
principally due to a decrease in net revenues of $8.2 million and an increase in
cost of services (which increased $32.8 million), partially offset by a decrease
in selling, general and administrative expense (which decreased $28.2 million).
Adjusted EBITDA for 1995 was $176.5 million, or 10.8% of net revenues.
Adjusted EBITDA for the prior year period was $295.4 million, or 18.1% of net
revenues. The decline in Adjusted EBITDA was principally due to an increase
in cost of services (which increased $10.4 million) and an increase in
selling, general and administrative expense (which increased $111.3 million).
Adjusted EBITDA for 1994 was $295.4 million, or 18.1% of net revenues.
Adjusted EBITDA in the prior year period was $278.7 million, or 19.7% of net
revenues. The increase in Adjusted EBITDA was principally due to an increase
in revenues (which increased $217.4 million), partially offset by an increase
in cost of services (which increased $164.1 million) and an increase in
selling, general and administrative expenses (which increased $48.4 million).
Changes in Accounting Policies
Coincident with the Quest Diagnostics Spin-Off Distribution, Quest Diagnostics
management will adopt a new accounting policy for evaluating the recoverability
of intangible assets and measuring possible impairment under Statement of the
Accounting Principles Board No. 17. Most of Quest Diagnostics' intangible assets
resulted from purchase business combinations in 1993. Significant changes in the
clinical laboratory and health care industries subsequent to 1993, including
increased government regulation and movement from traditional fee-for-service
care to managed cost health care, have caused the fair value of Quest
Diagnostics' intangible assets to be significantly less than carrying value.
Quest Diagnostics management believes that a valuation of intangible assets
based on the amount for which each regional laboratory could be sold in an
arm's-length transaction is preferable to using projected undiscounted pre-tax
cash flows. Quest Diagnostics believes fair value is a better indicator of the
extent to which the intangible assets may be recoverable and therefore, may be
impaired. This change in method of evaluating the recoverability of intangible
assets will result in Quest Diagnostics recording a charge of between $400
million and $450 million coincident with the Quest Diagnostics Spin-Off
Distribution to reflect the impairment of intangible assets. This will result in
a reduction of amortization expense of approximately $10 million to $11.3
million annually and $2.5 million to $2.8 million quarterly.
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Upon adopting the new policy, management anticipates that the aggregate market
capitalization for Quest Diagnostics will be significantly less that its net
book value. While the market capitalization ascribes a value to Quest
Diagnostics as a whole, Quest Diagnostics' policy values individual laboratories
on a case by case basis, based on the estimated amount for which each regional
laboratory could be sold in an arm's-length transaction. Management believes
that the overall valuation of Quest Diagnostics represented by its market
capitalization ascribes a value to certain underperforming laboratories which is
lower than Quest Diagnostics used in assessing intangible asset recovery. The
higher value ascribed by Quest Diagnostics is principally associated with
management's assumption that a buyer within the industry will value these
businesses based on a multiple of revenues, versus a multiple of current cash
flows, due to the synergy opportunities which exist. While management believes
these estimation methods are reasonable and reflective of common valuation
practices, there can be no assurance that a sale to a buyer for the estimated
value ascribed to a regional laboratory could be completed. Additional factors
which management believes give rise to the difference between Quest Diagnostics'
anticipated market capitalization and net book value are market uncertainty
around the impact of increased government regulation and enforcement and growth
in managed care. These factors, as well as recent highly-publicized government
settlements, have created a negative sentiment in the market which management
believes is temporarily depressing the market value for publicly-traded clinical
laboratory companies. See Note 15 to the Audited Financial Statements.
In October 1995, the Financial Accounting Standards Board issued Statement
No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). This statement
defines a fair value-based method of accounting for employee stock options and
similar equity investments and encourages adoption of that method of accounting
for employee stock compensation plans. However, it also allows entities to
continue to measure compensation cost for employee stock compensation plans
using the intrinsic value-based method of accounting prescribed by APB Opinion
No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). Entities which
elect to continue accounting for stock compensation plans utilizing APB 25 are
required to disclose pro forma net income and earnings per share, as if the fair
value-based method of accounting under SFAS 123 had been applied. Quest
Diagnostics intends to account for stock compensation plans pursuant to APB 25
and, as such, will include the pro forma disclosures required by SFAS 123 in the
financial statements beginning in 1996.
Inflation
Quest Diagnostics believes that inflation generally does not have a material
adverse effect on its operations or financial condition because substantially
all of its contracts are short-term.
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Business
Overview
Quest Diagnostics is one of the largest clinical laboratory testing companies in
the United States, offering a broad range of routine and esoteric testing
services used by the medical profession in the diagnosis, monitoring and
treatment of disease and other medical conditions. Quest Diagnostics currently
processes approximately 60 million requisitions each year.
Quest Diagnostics is the successor by merger to MetPath, a New York corporation
organized in 1967. Corning acquired MetPath in 1982 and in 1992 merged MetPath
into Quest Diagnostics, which had been organized in 1990 as a holding company
for the clinical laboratory testing business and contract research business. In
1994, Quest Diagnostics expanded its presence in the esoteric testing market
through the acquisition of Nichols Institute, now known as Corning Nichols
Institute ("Nichols"), which is one of the leading esoteric clinical
laboratories in the world. Upon the consummation of the Distributions, Corning
Clinical Laboratories Inc. will adopt the name Quest Diagnostics Incorporated.
Since its founding in 1967, Quest Diagnostics' clinical laboratory testing
business has grown into a network of 17 regional laboratories across the United
States, the Nichols esoteric testing laboratory in San Juan Capistrano,
California and one branch laboratory in Mexico City. In addition, Quest
Diagnostics has 14 smaller branch laboratories, approximately 200 "STAT"
laboratories and approximately 850 patient service centers located throughout
the United States. A substantial portion of this growth has resulted from
acquisitions. See "--Acquisitions and Dispositions."
The principal executive offices of Quest Diagnostics are located at One Malcolm
Avenue, Teterboro, New Jersey 07608, telephone number: (201) 393-5000.
Recent Organizational Changes
Between 1990 and 1995, Corning tripled the size of its clinical laboratory
testing business, principally through acquisitions. Historically, prior
management pursued a strategy of growth through acquisitions, including
diversification outside of the clinical laboratory testing business. As a result
of difficult integrations and increased pricing pressures and regulatory
complexity in the clinical testing industry, a new strategy was needed. In May
1995, Corning responded by appointing Kenneth Freeman, then an Executive Vice
President of Corning, as President and Chief Executive Officer of Quest
Diagnostics, who was charged with the responsibility to formulate a new
strategy. Mr. Freeman has over 24 years of key financial and managerial
experiences at Corning, including serving as the general manager of Corning's
science products division and the President and Chief Executive Officer of
Corning Asahi Video Products Company. Under Mr. Freeman's leadership,
profitability of these operations increased.
Mr. Freeman immediately suspended Quest Diagnostics' acquisition program. Under
his direction, Quest Diagnostics began to refocus on its core clinical
laboratory testing business and reorganize its senior management team. As a
result, Quest Diagnostics is implementing the best practices in each region
throughout Quest Diagnostics; standardizing processes and systems; analyzing the
cost of serving various customers; intensifying efforts to correct persistent
billing errors to both enhance customer satisfaction and reduce the cost of
billing operations; enhancing its compliance program to audit and correct system
defaults and to better train employees in the laws and rules governing the
industry; and improving communications with employees by improving systems and
the kind and amount of current information available to employees.
Mr. Freeman revamped the senior management team by appointing four new senior
executives and changing the responsibilities of five other senior executives.
Additionally, approximately one-half of the existing laboratory facility
general managers were replaced.
Mr. Freeman also changed the management structure, appointing three of the
senior executives to newly created key positions--Douglas VanOort, who will
focus exclusively on laboratory operations, Don Hardison, who will focus on
commercial activities, and Dr. Gregory Critchfield, who will lead the efforts in
the science and medical areas and pursue innovations. All three report directly
to Mr. Freeman. See "Management--Executive Officers." Quest Diagnostics believes
that this new management structure will greatly enhance Quest Diagnostics'
ability to pursue its business strategy. Mr. VanOort and the regional and
facility operations leaders who report to him will focus their primary attention
on laboratory operations, efficiencies and standardization. Mr. Hardison and the
regional and local commercial leaders who report to him will develop and
coordinate national, regional and local sales and marketing efforts, and will
cultivate national and regional client relationships and provider alliances. Dr.
Critchfield will pursue scientific excellence in the laboratory as well as seek
out, develop and assimilate those new tests and technologies that will
differentiate Quest Diagnostics and propel its growth in the future.
This three-prong management structure is designed to implement Quest
Diagnostics' business strategy to make Quest Diagnostics the best supplier
(i.e., lowest-cost, highest quality) of quality testing services; the preferred
provider of fairly priced and useful health care services and information; and
the industry's leading innovator of new clinical tests, methodologies and
services.
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Business Strategy
Quest Diagnostics' overall goal is to be recognized by its customers, employees
and competitors as the best provider of comprehensive and innovative clinical
testing, information and services. To achieve this, Quest Diagnostics has set
several strategic goals and put in place organizational structures to implement
them.
Best Supplier. Quest Diagnostics seeks to be the best supplier of the highest
quality and the lowest-cost testing services. Health care providers and patients
expect accurate, timely and consistent laboratory test results at a fair price.
(bullet) Lowest Cost Provider. Currently, approximately 27% of Quest
Diagnostics' net revenues are from laboratories that Quest
Diagnostics believes are the lowest-cost providers in their
respective markets. Management believes that these laboratories are
the lowest cost providers in their respective markets based on its
knowledge of such markets and information obtained in acquiring
other laboratories. Quest Diagnostics currently receives
approximately 60 million requisitions for testing each year.
Currently, Quest Diagnostics' average cost per requisition varies
significantly among its regional laboratories: an approximately
$7.00 difference in cost per requisition between the most efficient
regional laboratory and the average and an approximately $13.00
difference in cost per requisition between the most and the least
efficient regional laboratories. In many cases, these variations do
not relate to testing volumes or mixes, space costs, service
requirements or regional labor cost differences. To reduce costs,
Quest Diagnostics has begun to replicate the best practices from
each region throughout its national network. Standardization of
equipment and supplies, as well as leveraging of Quest Diagnostics'
purchasing power, is also part of this strategy. While Quest
Diagnostics' overall program of standardization is in a preliminary
stage, Quest Diagnostics has already selected its standard clinical
instruments and has selected its national vendors for laboratory
supplies, temporary services and personal computers. Management
expects to achieve significant cost savings within the next three
years as these programs are fully implemented, the majority of which
are expected to be achieved by the end of 1998.*
(bullet) Highest Quality Provider. Quest Diagnostics is dedicated to
providing accurate and timely testing results and to being viewed by
its customers as the highest quality provider of clinical testing
services. Quest Diagnostics believes that implementation of best
practices already developed in certain regions will permit Quest
Diagnostics to be viewed by its customers as the highest quality
provider of clinical testing services. For example, as part of its
best practices policy, Quest Diagnostics is identifying the most
common service failures in each regional laboratory and establishing
procedures to substantially reduce these service failures.
Management believes that implementing these best practices will
increase the level of quality while lowering costs.** Historically,
Quest Diagnostics' experience has been that the regions with the
highest quality of services have also had the lowest costs.
Preferred Provider. Quest Diagnostics seeks to be the preferred provider of
laboratory testing services to existing and new health care networks on a
selective basis determined by profitability of accounts. Quest Diagnostics
believes that it will become the preferred provider to these networks as (1)
large networks typically prefer to utilize large independent clinical
laboratories that can service them on a national or regional basis and (2)
Quest Diagnostics continues to pursue its primary strategy of becoming the
highest quality, lowest cost provider. To achieve this, Quest Diagnostics
will employ a rigorous national and regional process to identify prospective
customers and to efficiently allocate resources to support these efforts.
Quest Diagnostics will also pursue innovative alliances and seek to assist
its partners in achieving their business objectives.
(bullet) Account Profitability. Quest Diagnostics intends to refocus its sales
efforts on pursuing and keeping profitable accounts. Quest Diagnostics
is engaging in an active program with current accounts, including those
with managed care organizations, to evaluate their profitability and
either increase pricing or eliminate accounts that cannot be serviced
profitably. Throughout the independent clinical laboratory industry,
there are substantial differences in pricing among, as well as the cost
of serving, various categories of payors and health care providers.
Quest Diagnostics is beginning to provide clear pricing guidelines to
its sales force and changing its commission structure so that
compensation is tied to the profitability of (rather than revenues
from) new business. Management expects to achieve significant benefits
from these programs within the next three years, the majority of which
are expected to be achieved by the end of 1998.***
* This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See "--Important
Factors Regarding Forward Looking Statements." In particular see factors
(c), (d), (g) and (j).
** This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See "--Important
Factors Regarding Forward Looking Statements." In particular see factors
(b), (c), (d), (f) and (j).
*** This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See "--Important
Factors Regarding Forward Looking Statements." In particular see factors
(a), (b), (c), (d), (f) and (i).
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(bullet) Regional Profitability. Quest Diagnostics presently believes that it
has the leading market share among independent clinical laboratories
in most routine testing markets of the northeast, mid-Atlantic and
midwest regions. Approximately 66% of Quest Diagnostics' revenues
and almost all of its EBITDA is generated from markets in which
Quest Diagnostics believes that it has the leading market share. In
most of these markets, Quest Diagnostics believes that it also is
the lowest cost provider. Quest Diagnostics is evaluating its
strategic alternatives relative to units whose profitability does
not meet its internal goals. These alternatives may include joint
ventures, alliances, or dispositions. Quest Diagnostics believes
that, while the clinical laboratory industry is becoming national in
scope, Quest Diagnostics can subcontract with other clinical
laboratories to perform testing for national accounts in any markets
in which Quest Diagnostics chooses not to compete. Quest Diagnostics
may also make selected local acquisitions where appropriate.
Leading Innovator. Quest Diagnostics intends to remain a leading innovator in
the clinical laboratory industry by continuing to introduce new tests,
technology and services. Through its relationship with the academic community
and pharmaceutical and biotechnology firms and a research and development budget
exceeding $15 million per year, Quest Diagnostics believes it is one of the
leaders in transferring innovation from academic biotechnology laboratories to
the market. For example, Quest Diagnostics (through its subsidiary Nichols) has
been informed by its licensors that it is currently the only independent
clinical laboratory that is using both molecular signal amplification (branched
DNA) and polymerase chain reaction (PCR) technologies for HIV testing. These
technologies permit the detection of lower levels of HIV than can be achieved
using other technologies, which in turn permits health care providers to better
tailor drug therapies for HIV-infected patients. Nichols continues to be one of
the leading esoteric testing laboratories in the world. Nichols serves
approximately 2,000 of the country's estimated 6,400 hospitals and counts among
its largest customers both LabCorp and SmithKline. Quest Diagnostics hopes to
leverage Nichols' existing relationships with hospitals into increased routine
testing to hospitals, which continue to perform over half of the clinical
laboratory testing in the United States.
The Clinical Laboratory Testing Industry
Clinical testing is a critical component in the delivery of quality health care
service to patients. Currently, clinical laboratory testing is the first step in
determining how a significant amount of all health care dollars are spent.
Laboratory tests and procedures are used generally by physicians and other
health care providers to assist in the diagnosis, evaluation, monitoring and
treatment of diseases and other medical conditions through the measurement and
analysis of chemical and cellular components in blood, tissues and other
specimens. Clinical laboratory testing is generally categorized as either
clinical testing, which is performed on body fluids such as blood and urine, or
anatomical pathology testing, which is performed on tissue and other samples,
including human cells. Clinical and anatomical pathology procedures are
frequently ordered as part of regular physician office visits and hospital
admissions. Most clinical laboratory tests ordered by health care providers are
considered "routine" and can be performed by most independent clinical
laboratories, while "esoteric" tests (which generally require more sophisticated
equipment, materials and personnel) are generally referred to laboratories, such
as the Nichols facility in San Juan Capistrano, that specialize in such tests.
Quest Diagnostics believes that in 1995 the entire United States clinical
laboratory industry had revenues exceeding $30 billion. The clinical laboratory
industry consists primarily of three types of providers: hospital-affiliated
laboratories, independent clinical laboratories, such as those owned by Quest
Diagnostics, and physician-office laboratories. Quest Diagnostics believes that
in 1995 approximately 56% of the clinical testing revenues in the United States
were attributable to hospital-affiliated laboratories, approximately 36% were
attributable to independent clinical laboratories and approximately 8% were
attributable to physicians in their offices and laboratories.
Quest Diagnostics believes that consolidation will continue in the clinical
laboratory testing business. In addition, Quest Diagnostics believes that it and
the other large independent clinical laboratory testing companies may have the
opportunity to increase their share of the overall clinical laboratories testing
market due to a number of external factors including cost efficiencies afforded
by large-scale automated testing, Medicare reimbursement reductions and the
growth of managed health care entities which require low-cost testing services
and large service networks. In addition, legal restrictions on physician
referrals and the ownership of laboratories as well as increased regulation of
laboratories are expected to contribute to the continuing consolidation of the
industry.
Quest Diagnostics believes that a number of factors are likely to positively
influence the volume of clinical laboratory testing performed in the United
States in the future, including (1) the general aging of the population in the
United States; (2) an expanded base of scientific knowledge which has led to the
development of more sophisticated specialized tests and an increase in the
awareness of physicians of the value of clinical laboratory testing as a
cost-effective means of early detection of disease and monitoring of treatment;
(3) an increase in the number and types of tests which are, due to advances in
technology and increased cost efficiencies, readily available on a more
affordable basis to physicians; (4) expanded substance-abuse testing by
corporations and governmental agencies; and (5) increased testing for sexually
transmitted diseases such as AIDS. The impact of these factors is expected to be
offset in part by increased controls over the utilization of clinical laboratory
tests by both Medicare and the private sector, particularly managed care
organizations.
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Quest Diagnostics believes that the clinical laboratory industry will continue
to be subject to pricing pressures as a result of (1) continued growth of the
managed care sector; (2) a shift toward capitated payment contracts within the
managed care sector; and (3) decreases in Medicare reimbursement rates. In
addition, increased regulatory requirements in the billing of Medicare are
expected to result in reimbursement reductions and additional costs to clinical
laboratory testing companies in the United States. Quest Diagnostics has
formulated strategies to address these challenges. See "--Business Strategy."
Services
Quest Diagnostics' laboratory business is comprised of routine testing, which
Quest Diagnostics management estimates currently generates approximately 88% of
Quest Diagnostics' net revenues; and esoteric testing, which is performed at the
Nichols facility in San Juan Capistrano and which Quest Diagnostics management
estimates generates approximately 10% of Quest Diagnostics' net revenues. The
balance of Quest Diagnostics' net revenues is derived principally from the
manufacture of clinical laboratory test kits.
Routine Testing Services and Operations. Routine tests, which are performed at
Quest Diagnostics' regional laboratories, include procedures in the area of
blood chemistry, hematology, urine chemistry, virology, tissue pathology and
cytology. Commonly ordered individual tests include red and white blood cell
counts, Pap smears, blood cholesterol level tests, AIDS-related tests,
urinalyses, pregnancy tests, and alcohol and other substance-abuse tests.
Routine test groups include tests to determine the function of the kidney,
heart, liver and thyroid, as well as other organs, and several health screens
that measure various important bodily health parameters.
Quest Diagnostics provides services through 17 regional laboratories located in
major metropolitan areas throughout the United States, as well as 14 branch
laboratories, approximately 200 STAT laboratories and 850 patient service
centers. Quest Diagnostics also operates a branch laboratory in Mexico. Regional
laboratories offer a full line of routine clinical testing procedures. "STAT"
laboratories are local laboratory facilities where Quest Diagnostics can quickly
perform and report results of certain routine tests for customers that require
such emergency testing services. "Branch laboratories" have a test menu that is
smaller than that of regional laboratories but larger than that of STAT
laboratories. A "patient service center" is a facility maintained by Quest
Diagnostics, typically in or near a medical professional building, to which
patients can be referred by physicians for specimen collection.
Quest Diagnostics operates 24 hours a day, 365 days a year, utilizing a fully
integrated collection and processing system. Quest Diagnostics generally
performs and reports most routine procedures within 24 hours, employing a
variety of sophisticated and computerized laboratory testing instruments. On an
average work day, Quest Diagnostics processes approximately 220,000
requisitions. Quest Diagnostics provides daily pickup of specimens from most
customers principally through an in-house courier system. The specimens are sent
to one of Quest Diagnostics' laboratories (generally a regional or branch
laboratory) where one or more tests are performed.
Each patient specimen is accompanied by a test requisition form, which is
completed by the customer, that indicates the tests to be performed and provides
the necessary billing information. Each specimen and related requisition form is
checked for completeness and then given a unique bar-coded identification
number. The unique identification number assigned to each specimen helps to
assure that the results are attributed to the correct patient. The requisition
form is sent to a data entry department where a file is established for each
patient and the necessary testing and billing information is entered. Once this
information is entered into the computer system, the tests are performed and the
results are entered, primarily through computer interface or manually, depending
upon the type of testing equipment involved. Most of Quest Diagnostics'
computerized testing equipment is directly linked with Quest Diagnostics'
information systems. Most routine testing is performed and completed during the
evening following receipt of the specimens to be tested, and test results are
readied for distribution the following morning either electronically or by
service representatives. Many customers have local printer capability enabling
laboratory medical reports to be printed in their offices. Customers who request
that they be called with a result are so notified in the morning. It is Quest
Diagnostics' policy to notify the customer immediately if a life-threatening
result is found at any point during the course of the testing process.
Esoteric Testing Services and Operations. Through Nichols, Quest Diagnostics
operates one of the leading esoteric clinical testing laboratories in the world.
Esoteric tests are performed in cases where the information provided by routine
tests is not specific enough or is inconclusive as to the existence or absence
of disease or when a physician requires more information. Typically, unlike
routine testing, only one test is performed per requisition. The logistics for
esoteric testing are similar to that for routine testing except that, due to the
complexity of the testing, approximately 60% of the tests are performed within
24 hours, with almost all of the rest being performed within one week. During
1995 Nichols performed approximately 3.9 million esoteric tests, of which 77%
were referred by sources other than Quest Diagnostics regional laboratories.
Esoteric tests generally require more sophisticated equipment and materials as
well as more highly skilled personnel to perform test procedures and analyze
results than what is required for routine testing. Consequently, esoteric tests
are generally priced substantially higher than routine tests. New medical
discoveries lead to the development of new esoteric tests. However, over time
esoteric tests may become routine tests as a result of improved technology or
increased volume. The volume of esoteric
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tests required by most health care providers, including hospitals, is relatively
low compared to the volume of routine tests. Because it is generally not cost
effective for such health care providers to perform the low volume of esoteric
tests in-house, a significant portion of esoteric tests are referred to clinical
laboratories like Nichols that specialize in such tests. Some examples of
esoteric testing procedures include capillary electrophoresis, cell culture
technology, chemiluminescent immunoassays, certain enzyme immunoassays, flow
cytometry, fluorescent in situ hybridization (FISH), inductively coupled plasma
mass spectroscopy (ICPMS), molecular tissue pathology, molecular signal
amplification (branched DNA), and polymerase chain reaction (PCR) technologies.
Nichols's laboratory is comprised of 18 individual laboratory departments, which
in the aggregate offer approximately 1,400 individual tests or "assays" in such
fields as endocrinology, genetics, immunology, microbiology, molecular biology,
oncology, serology, special chemistry and toxicology. Nichols believes that it
has been one of the leaders in transferring technological innovation from
academic biotechnology laboratories to the marketplace. Nichols was the first to
introduce a number of esoteric tests, including immunoassay methods for
measurement of circulating hormone levels and sensitive tests to predict breast
cancer prognosis. Among more recent developments have been tests to detect a
variety of tumor types, a common form of mental retardation, leukemia, cystic
fibrosis, osteoporosis, hepatitis and neurological disorder and to monitor
success of therapy in cancer and AIDS. The branched DNA and PCR technologies can
be applied to a variety of infectious agents and permit the detection of lower
levels of HIV than can be achieved under other technologies. The ability to
measure the amount of HIV permits health care providers to better tailor drug
therapies for HIV-infected patients. As part of its research and development
efforts, Nichols maintains a relationship with the academic community through
its Academic Associates program, under which approximately sixty scientists from
academia and biotechnology firms work directly with Nichols's staff scientists
to monitor and consult on existing test procedures and develop new esoteric test
methods. In addition, Nichols relies on internal resources for the development
of new tests as well as on license arrangements and co-development agreements
with biotechnology companies and academic medical centers.
Nichols also provides clinical laboratory testing in connection with
pre-marketing clinical trials of pharmaceutical drugs. This testing is
competitive with the testing performed by a subsidiary of Covance and is
expected to continue in the future. Quest Diagnostics management estimates that
net revenues from such testing accounted for less than 1% of Quest Diagnostics'
net revenues in 1995.
Diagnostics. Through its Nichols Institute Diagnostics ("NID") subsidiaries,
which were acquired as a result of the acquisition of Nichols Institute in
August 1994, Quest Diagnostics manufactures and markets clinical laboratory
kits primarily for esoteric testing. Test kits are sold principally to
hospital and clinical laboratories.
Customers and Payors
Quest Diagnostics provides testing services to a broad range of health care
providers. The primary types of customers served by Quest Diagnostics are as
follows:
Independent Physicians and Physician Groups. Physicians requesting testing
for their patients who are unaffiliated with a managed care plan remain the
principal source of Quest Diagnostics' clinical laboratory business. Fees for
clinical laboratory testing services rendered for these physicians are billed
either to the physician, to the patient, or to the patient's third-party
payor such as insurance companies, Medicare and Medicaid. In four states,
including New York and Michigan, Quest Diagnostics is required to bill
patients directly. The clinical laboratory industry is supporting legislative
efforts to expand direct patient billing. Billings are typically on a
fee-for-service basis. If the billings are to the physician, they are based
on the laboratory's wholesale or customer fee schedule and are typically
subject to negotiation. Otherwise, the billings are based on the laboratory's
retail or patient fee schedule, subject to limitations on fees imposed by
third parties and to negotiation by physicians on behalf of their patients.
Medicare and Medicaid billings are based on fee schedules set by governmental
authorities. See "--Regulation and Reimbursement."
HMOs and Other Managed Care Groups. HMOs and other managed care organizations
typically contract with a limited number of clinical laboratories and then
designate the laboratory or laboratories to be used for tests ordered by their
participating physicians. In an effort to control costs, the managed care groups
generally negotiate discounts to the fees usually charged by such laboratories.
Most testing for managed care organizations is being performed on a capitated
basis. Under a capitated payment contract, the clinical laboratory and the
managed care organization agree to a monthly payment per covered individual to
cover all laboratory tests during the month, regardless of the number or cost of
tests actually performed. Such contracts shift the risks of additional routine
testing beyond that covered by the capitated payment to the clinical laboratory.
In certain cases, however, the monthly payment may be subject to prospective or
retroactive adjustment if the number of tests performed exceeds (or is less
than) certain thresholds. The types of tests covered by capitated contracts are
negotiated for each contract, with esoteric tests and anatomic pathology
services generally not being covered under the capitation rate. Large regional
and national HMOs and preferred provider organization networks typically prefer
to utilize large independent clinical laboratories such as Quest Diagnostics
that can service the managed care groups on a national or regional basis. See
"--Effect of the Growth of the Managed Care Sector on the Clinical Laboratory
Business."
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Hospitals. Quest Diagnostics serves approximately 3,000 hospitals with services
that vary from providing esoteric testing to management contracts, where Quest
Diagnostics manages the hospital's laboratory for a fee. Hospitals generally
maintain an on-site laboratory to perform testing on patients receiving care and
refer less frequently needed procedures to outside laboratories. Hospitals are
typically charged for such tests a negotiated fee-for-service which is based on
the laboratory's customer fee schedule. Some hospitals actively encourage
community physicians to send their testing to the hospital's laboratory. In
addition, some hospitals have been purchasing physician practices and requiring
that the physicians/employees send their testing to the hospital's affiliated
laboratory. As a result, hospital-affiliated laboratories can be both a customer
and a competitor for independent clinical laboratories such as Quest
Diagnostics.
Other Institutions. Quest Diagnostics also serves other institutions,
including governmental agencies, such as the Department of Defense and prison
systems, large employers and independent clinical laboratories that do not
have the full range of Quest Diagnostics' testing capabilities. These
institutions are typically charged on a negotiated or bid fee-for-service
basis. Quest Diagnostics' services to employers principally involve the
provision of substance abuse testing services.
In 1995, no single customer or affiliated group of customers accounted for
more than 2% of Quest Diagnostics' net revenues. Quest Diagnostics believes
that the loss of any one of its customers would not have a material adverse
effect on Quest Diagnostics' results of operations or cash flows.
Payors. Most clinical laboratory testing is billed to a party other than the
"customer" that ordered the test. Tests performed for various patients of a
single physician may be billed to different payors besides the ordering
physician, including third-party payors (generally an insurance company or
managed care organization), Medicare, Medicaid or the patient.
The following table sets forth current estimates of the breakdown by payor of
Quest Diagnostics' total volume of requisitions and average approximate
revenues per requisition:
<TABLE>
<CAPTION>
Requisition Volume as
% of Total Revenue Per Requisition
--------------------- -------------------------
<S> <C> <C>
Patient 5%-10% $60-$80
Medicare & Medicaid 20%-25% $20-$25
Monthly Bill
(Physician, Hospital, Employer, Other) 35%-40% $15-$35
Third Party Fee-For-Service 15%-20% $30-$40
Managed Care--Capitated 15%-20% $ 5-$15
</TABLE>
For a discussion of the mix shift and the impact of the managed care sector
on volume and price trends, see "--Effect of the Growth of the Managed Care
Sector on the Clinical Laboratory Business."
Average Revenue per Requisition Trends. Since the fourth quarter of 1995,
declines in Quest Diagnostics' average revenue per requisition have moderated.
Average revenue per requisition for the quarter ended September 30, 1996 was
approximately 1.7% below the comparable period in 1995. This decline in revenue
per requisition was smaller than the approximate 4.8% and 3.6% decline
experienced in the first and second quarters of 1996, respectively. Since August
of 1995, the company-wide average revenue per requisition has remained
relatively stable and is effectively unchanged during the first three quarters
of 1996. This trend is illustrated by the following chart:
[REPRESENTATION OF A LINE CHART GRAPHIC]
Average Revenue per Requisition as a Percentage
of December 1994 Revenue per Requisition
Q1/95 98.6
Q2/95 97.6
Q3/95 95.8
Q4/95 95.1
Q1/96 93.9
Q2/96 94.1
Q3/96 94.2
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Sales and Marketing
Quest Diagnostics markets and services its customers through its direct sales
force of approximately 430 sales representatives, 300 account representatives
and 2,200 couriers.
Most sales representatives market the mainstream or traditional routine
laboratory services primarily to physicians, while others concentrate on
individual market segments, such as hospitals or managed care organizations, or
on testing niches, such as substance abuse testing. Quest Diagnostics' sales
representatives are compensated through a combination of salaries, commissions
and bonuses, at levels commensurate with each individual's qualifications and
responsibilities. Commissions are based primarily upon the individual's results
in generating new business for Quest Diagnostics. Quest Diagnostics is currently
changing its commission structure so that compensation is tied to the
profitability of (rather than revenues from) new business. See "--Business
Strategy--Preferred Provider."
Quest Diagnostics' account representatives interact with customers on an ongoing
basis. Account representatives monitor the status of services being provided to
customers, act as problem-solvers, provide information on new testing
developments and serve as the customer's regular point of contact with Quest
Diagnostics. Account representatives are compensated with a combination of
salaries and bonuses commensurate with each individual's qualifications and
responsibilities.
Quest Diagnostics believes that the clinical laboratory service business is
shifting away from the traditional direct sales structure and into one in which
the purchasing decisions for laboratory services are increasingly made by
managed care organizations, integrated health delivery systems, insurance plans,
employers and by patients themselves. In view of these changes, Quest
Diagnostics has completed a rigorous regional market strategy process and has
reorganized its sales and marketing organization structure to support these
strategies and emerging customers.
Quest Diagnostics believes that, given the increasing regulation and complexity
of the clinical laboratory marketplace, training of its sales force is of
paramount importance. With this goal in mind, during 1995 Quest Diagnostics
enhanced its comprehensive sales training program and compliance training. See
"--Compliance Program."
Effect of the Growth of the Managed Care Sector on the
Clinical Laboratory Business
The managed care industry is growing as well as undergoing rapid consolidation
which has created large managed care companies that control the delivery of
health care services for millions of people, and have significant bargaining
power in negotiating fees with health care providers, including clinical
laboratories. Quest Diagnostics believes that there are potential opportunities
for large, low-cost, clinical laboratories such as Quest Diagnostics to capture
additional testing volume from managed care organizations. The larger regional
and national managed care organizations typically prefer to utilize large
independent clinical laboratories, like Quest Diagnostics, that can service
their organizations on a national or a regional basis. In addition, smaller
laboratories are unlikely to be able to achieve the low cost structures
necessary to profitably service managed care organizations.
The growth of the managed care sector presents various challenges to
independent clinical laboratories, including Quest Diagnostics. Managed care
organizations typically negotiate capitated payment contracts, whereby the
clinical laboratory receives a monthly fee per covered individual. The fixed
monthly payment generally covers all laboratory tests (excluding certain
tests, such as esoteric tests and anatomic pathology services) performed
during the month, regardless of the number or cost of the tests performed.
Unlike fee-for-service indemnity insurance, such contracts shift the risks of
additional routine testing beyond that covered by the capitated payment to
the clinical laboratory. In certain cases, however, the monthly payment may
be subject to prospective or retroactive adjustment if the number of tests
performed exceeds (or is less than) certain thresholds. Quest Diagnostics
expects the amount of clinical laboratory testing performed for managed care
organizations under capitated rate agreements to continue to grow.
Laboratory services agreements with managed care organizations have historically
been priced aggressively due to competitive pressures and the expectation that a
laboratory would capture not only the volume of testing to be covered under the
contract, but also the additional fee-for-service business from patients of
participating physicians who are not covered under the managed care plan.
However, as the number of patients covered under managed care plans continues to
increase, there is less such fee-for-service business and, accordingly, less
high margin business to offset the low margin (and often unprofitable) managed
care business. Furthermore, increasingly, physicians are affiliated with more
than one managed care organization and as a result may be required to refer
clinical laboratory tests to different clinical laboratories, depending on the
coverage of their patients. As a result, a clinical laboratory might not receive
any fee-for-service testing from such physicians. The level of pricing charged
to managed care organizations, including under capitated payment contracts, if
continued, may adversely affect the pricing of the clinical laboratory industry.
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<PAGE>
During the nine months ended September 30, 1996, services to managed care
organizations under capitated rate agreements accounted for approximately 6% of
Quest Diagnostics' net revenues from clinical laboratory testing and
approximately 15% of the number of tests performed by Quest Diagnostics. Quest
Diagnostics believes that the prices charged by the independent clinical
laboratory testing companies to managed care organizations can and must be
increased. Quest Diagnostics is currently reviewing its pricing structures for
agreements with managed care organizations and intends to insure that all such
agreements are profitably priced. However, there can be no assurance that Quest
Diagnostics will be able to increase the prices charged to managed care
organizations or that Quest Diagnostics will not lose market share in the
managed care market to other clinical laboratories who continue to aggressively
price laboratory services agreements with managed care organizations. Quest
Diagnostics believes that the growth of the managed care sector presents both
challenges and opportunities. Quest Diagnostics, as part of its preferred
provider strategy, will seek to capitalize on the opportunity and meet the
challenge by seeking to secure large-volume, profitable managed care contracts
through providing low cost, high quality testing services at rational prices.
Expansion Opportunities
Quest Diagnostics believes that there are several expansion opportunities.
Quest Diagnostics believes that it can take advantage of these opportunities
without incurring significant capital expenditures or deploying significant
resources.
Hospital Alliances. In response to the growth of the managed care sector and
the developments described under "--Effect of the Growth of the Managed Care
Sector on the Clinical Laboratory Business," many health care providers have
established new alliances. Hospital-physician networks are emerging in many
markets in order to offer comprehensive, integrated service capabilities,
either to managed care plans or directly to employers.
Since Quest Diagnostics has traditionally derived a substantial portion of its
esoteric testing revenues from referrals from hospitals, which perform
approximately half of all clinical laboratory tests in the United States, Quest
Diagnostics established a hospital business venture group whose primary goal is
to develop additional nontraditional hospital arrangements, including management
and consulting agreements, shared service arrangements and joint ventures.
Under federal cost containment legislation enacted in 1985, treatment provided
to hospital inpatients covered by Medicare is classified into diagnosis-related
groups ("DRGs") which prescribe the maximum reimbursable payments for all
services, including laboratory testing services, provided on behalf of an
inpatient under each DRG. As a result of this payment structure, and similar
price constraints from managed care organizations and other third-party payors,
hospitals have an economic incentive to seek the most cost-effective laboratory
testing services for their patients. Quest Diagnostics believes that in many
cases, by managing a hospital laboratory or entering into a joint venture with a
hospital, Quest Diagnostics can improve a hospital laboratory's economic
structure and preserve hospital capital that would be required for needed
laboratory improvements while providing accurate and timely testing services due
to greater economies of scale, increased utilization of expensive testing and
data processing equipment through optimization of the mix between on-site and
off-site testing and more efficient use of laboratory employees. Quest
Diagnostics has several such arrangements with hospitals, including a joint
venture with two hospitals in Erie, Pennsylvania that performs outreach testing
and a management agreement with a group of approximately 25 hospitals in eastern
Nebraska and Sioux City, Iowa. These two laboratory arrangements, which provide
testing for both the hospitals and the commercial outreach markets in their
geographical areas, serve as two of Quest Diagnostics' laboratory facilities.
Quest Diagnostics also manages the laboratories at several hospitals in the
eastern United States. However, despite the potential cost savings and
additional revenues available to hospitals through such arrangements, Quest
Diagnostics believes that only a small percentage of the hospitals in the United
States have entered into such arrangements with independent clinical
laboratories. Nonetheless, Quest Diagnostics expects to enter into alliances
with various hospitals in the future and believes that this market has
potential. Quest Diagnostics recently signed a letter of intent with the
University of Pittsburgh Medical Center to explore a potential relationship,
including the possibility of an equity or non-equity partnership. As an
alternative service for hospitals that are entering into integrated delivery
systems, Quest Diagnostics is beginning to market consulting support and
technical solutions for integrating diverse laboratory infrastructures, systems
and data.
Employer Market. Quest Diagnostics is considering expanding its business in the
employer market to include the provision of laboratory services to large
employers on a basis comparable to that offered to managed care organizations,
whereby laboratory services paid under self-insured indemnity plans may be
relatively fixed (rather than on a fee-for-service basis). These services could
be offered in alliance with other service providers, including pharmaceutical
benefits and diagnostic imaging services. Quest Diagnostics recently organized
National Imaging Associates Inc. ("NIA"), a company offering diagnostic imaging
benefit management services to employers, payors and managed care organizations.
NIA seeks to carve out the imaging component of a health care plan service
offering and manage it at lower cost through utilization controls and provider
price concessions.
Medical Information. The market need for medical information, particularly
disease-specific information about provider practices and patient care, is
growing rapidly. Large customers of clinical laboratories are increasingly
interested in using infor-
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<PAGE>
mation from clinical laboratory data on their covered population to answer
financial, marketing and quality related questions. Integrated data from
clinical laboratories and other health encounters provides additional insights
to these questions. To meet these emerging needs, Quest Diagnostics created the
Medical Informatics ("Medical Informatics") division which focuses solely on the
medical information needs of managed care organizations, integrated healthcare
delivery networks and other large customers. Through internal development, Quest
Diagnostics now has a portfolio of information products based primarily upon its
extensive database. A combination of advanced information technology and
experienced analytical and data integration skills provides the platform for
delivery of these products.
As market interest has increased, the Medical Informatics division has
devoted experienced account executives to work with customers to meet their
information needs. Current information products include provider profiles and
benchmarks, high-risk patient registries based on customer disease management
initiatives, normative comparisons with other populations, and quantitative
clinical outcomes based on laboratory measures. Quest Diagnostics believes
that health care customers will increasingly see value in the information
obtained from clinical laboratory results.
Information Systems
The need for information systems to support laboratory, billing, customer
service, logistics, medical data, and other business requirements is
significant and will continue to place high demands on Quest Diagnostics'
information systems staff. Quest Diagnostics has historically not
standardized the billing, laboratory and other information systems at
laboratories that it has acquired. As a result, Quest Diagnostics has
numerous different information systems to handle billing, test result
reporting and financial data and transactions. Quest Diagnostics believes
that the efficient handling of information involving customers, patients,
payors, and other parties will be critical to Quest Diagnostics' future
success.
To this end, Quest Diagnostics has chosen standard billing and laboratory
systems. During the third quarter of 1996, Quest Diagnostics recorded a
charge of $13.7 million to write off capitalized software as a result of its
decision to abandon the billing system which had been intended as its
company-wide billing system. Management now plans to standardize using a SYS
billing system which has already been implemented in seven of its 22 billing
sites, which seven sites account for 35% of Quest Diagnostics' net revenues.
The standard laboratory system is already operational in nine of its 22
billing sites, which account for 30% of Quest Diagnostics' net revenues. Such
sites are not necessarily the same sites as those with standard billing
systems. Quest Diagnostics is beginning to convert the remaining nonstandard
billing and laboratory systems to the standard systems, prioritized on an
impact basis. The most critical conversions will be completed within three
years. The New York/New Jersey (Teterboro) laboratory is the first priority
and is expected to be converted by 1998. The conversion costs are expected to
average approximately $3 million per billing system and $1 million to $3
million per laboratory system. As more billing sites are converted to the
standard billing system, consolidation of billing sites is expected to occur,
which will reduce overall conversion costs and improve billing efficiencies.
Quest Diagnostics anticipates that the cost of converting all billing and
laboratory systems to the standard systems over the next several years will
cost between approximately $55 million and $85 million, depending on the
number of billing consolidations that occur.* Quest Diagnostics does not
anticipate that the conversion costs will result in a significant increase in
capital expenditures over the levels spent during the last several years.
Quest Diagnostics is developing systems that will permit managed care
organizations and other providers to have electronic access to test orders and
results for participating physicians, which will permit managed care
organizations to better monitor and control the utilization of testing services.
Billing
Billing for laboratory services is a complicated process. Laboratories must
bill different payors such as doctors, patients, insurance companies,
Medicare, Medicaid and employer groups, all of whom have different billing
requirements. Quest Diagnostics believes that less than 30% of its bad debt
expense is attributable to specific credit or payment issues of its
customers. The remainder of the bad debt expense is the result of many
non-credit related issues which slow the billing process, create backlogs of
unbilled requisitions and generally increase the aging of accounts
receivable. A primary cause of bad debt expense is missing or incorrect
billing information on requisitions. Typically approximately one-third of the
requisitions that Quest Diagnostics receives either do not provide all the
necessary data or provide incorrect data. Quest Diagnostics believes that
this experience is similar to that of its primary competitors. Quest
Diagnostics performs the requested tests and reports back the test results
regardless of whether billing information has been provided at all or has
been provided incorrectly. Quest Diagnostics subsequently attempts to obtain
any missing information or rectify any incorrect billing information received
from the health care provider. Among the many other factors complicating the
billing pro-
* This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See "--Important
Factors Regarding Forward Looking Statements." In particular see factors
(d), (j) and (k).
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<PAGE>
cess are pricing differences between the fee schedules of Quest Diagnostics and
the payor, disputes between payors as to the party responsible for payment of
the bill and auditing for specific compliance issues. Ultimately, if all issues
are not resolved in a timely manner, the related receivables are written off to
bad debt expense.
Quest Diagnostics' bad debt expense has increased each year since 1993 due
principally to four developments that have further complicated the billing
process: (1) increased complexity in the health care system; (2) increased
requirements in complying with fraud and abuse regulations; (3) deterioration in
reimbursement as the payor mix shifts; and (4) changes in Medicare reimbursement
policies. These four factors have placed additional requirements on the billing
process, including the need for specific test coding, additional research on
processing rejected claims that comply with prior practices, increased audits
for compliance, and management of a large number of contracts which have very
different information requirements for pricing and reimbursement. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations." Quest Diagnostics' billing has also been hampered by the existence
of multiple billing information systems. In 1995 Quest Diagnostics had severe
billing problems at its largest laboratory site in Teterboro, New Jersey. A new
billing information system developed with outside consultants experienced
significant implementation problems, including excessive downtime, which
severely impacted Quest Diagnostics' ability to efficiently bill for its
services from the Teterboro location. The problem was compounded by a lack of
experienced staff as the result of work force reductions made to meet cost
reduction initiatives undertaken in anticipation of greater efficiencies from
the new billing information system. As a result of all of these factors, Quest
Diagnostics recorded a charge to bad debt of $62 million in the third quarter of
1995. Of this amount, approximately $35 million was attributable to the
Teterboro location. At the time of charge, the backlog of unbilled requisitions
was estimated at over 2 million requisitions and DSOs for the clinical testing
business were 90 days. In addition, significant backlogs existed in (1)
reconciling cash received to payment of specific bills, (2) rejected claims that
needed to be researched and (3) correspondence from customers attempting to
resolve billing problems.
Integration of a standardized billing system is a priority of Quest
Diagnostics and Quest Diagnostics is in the process of integrating a billing
system with proven reliability throughout its network. The SYS system is in
use at seven of Quest Diagnostics' laboratories. Its reliability is evidenced
by both the improvement in the laboratories' bad debt experience after SYS
was implemented and the improved capability to handle new billing
requirements as compared with non-SYS laboratories, such as Teterboro. For
example, bad debt expense for the nine months ended September 30, 1996 for
the combined SYS laboratories is 6.4% of sales, versus 7.1% for all other
laboratories combined. The use of a standard system will also provide for
operational efficiencies as redundant programming efforts are eliminated and
the ability to consolidate billing sites will become more feasible. See
"--Information Systems." Standardizing billing systems presents conversion
risk to Quest Diagnostics as key databases and masterfiles are transferred to
the SYS system and because the billing workflow is interrupted during the
conversion, which may cause backlogs. Quest Diagnostics, however, has already
completed seven conversions to this system and has retained key people who
have been involved in those conversions.
Quest Diagnostics has focused on improving its billing operations in the last
year. Over the last twelve months, the backlog of unbilled requisitions has
been reduced by approximately 30%, DSOs for the clinical testing business
have been reduced to 74 days, bad debt expense as a percentage of net
revenues has decreased, the percentage of requisitions received with missing
billing information has been reduced by approximately 30% and backlogs in
rejected claims, unapplied cash and customer correspondence have been
significantly reduced. These improvements were achieved in spite of a higher
level of information requirements necessary for correct billing, especially
those bills relating to Medicare. However, additional requirements to provide
documentation of the "medical necessity" of testing have added to the backlog
of unbilled receivables and caused third quarter 1996 bad debt expense as a
percentage of revenues to increase above the rate Quest Diagnostics had
experienced during the first two quarters of 1996. See "--Regulation and
Reimbursement--Regulation of Reimbursement for Clinical Laboratory Services."
Acquisitions and Dispositions
MetPath, Quest Diagnostics' predecessor, originally commenced operations in 1967
with laboratories only in the New York metropolitan area. Most of Quest
Diagnostics' other regional laboratories have been added through acquisitions.
Principally as the result of the acquisitions discussed below that were
completed in 1993 and 1994, Quest Diagnostics' revenues have almost tripled
since 1991. However, this increase in revenues is not reflected in the Financial
Statements because several of the major acquisitions are accounted for as a
pooling of interests. Acquisition activity has diminished significantly since
May 1995, in part so that Quest Diagnostics could concentrate on the integration
of the laboratory networks that had been acquired in 1993 and 1994. Quest
Diagnostics may resume making acquisitions in the future, most likely focusing
on acquisitions of smaller laboratories that can be folded into existing
laboratories where Quest Diagnostics can expect to achieve significant cost
savings and other benefits resulting from the elimination of redundant
facilities and equipment and reductions in staffing or personnel.
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Quest Diagnostics is evaluating its strategic alternatives relative to units
whose profitability does not meet its internal goals. These alternatives may
include joint ventures, alliances or dispositions. However, there are no
negotiations or definitive plans with respect to any such dispositions.
During 1994 Corning acquired three large clinical laboratory testing companies,
each of which was accounted for as a pooling of interests. In June 1994, Corning
acquired Maryland Medical Laboratory, Inc. ("MML"), a regional laboratory based
in Baltimore, Maryland with approximately $90 million in annual revenues. In
August 1994, Corning acquired the stock of Nichols Institute, a national
esoteric clinical laboratory with approximately $280 million in annual revenues.
In October 1994, Corning acquired Bioran, a regional laboratory based in
Cambridge, Massachusetts with approximately $65 million in annual revenues.
In August 1993, Corning acquired Damon, a national clinical testing laboratory
with approximately $330 million in annualized revenue. The acquisition was
accounted for as a purchase. The assets of Damon's California-based laboratories
were sold in April 1994 to Physicians Clinical Laboratory Inc. In November 1993,
Quest Diagnostics acquired the clinical testing laboratories of Unilab in
Dallas, Denver and Phoenix, in exchange for Quest Diagnostics' then 43%
ownership of Unilab and the assumption of approximately $70 million of
indebtedness of Unilab. In a separate transaction, Quest Diagnostics transferred
to Unilab Quest Diagnostics' investment in J.S. Pathology PLC, a clinical
testing laboratory based in the United Kingdom, in exchange for a small equity
interest in Unilab. Quest Diagnostics currently owns approximately 4% of
Unilab's outstanding common stock. In May 1993, Corning acquired and contributed
to Quest Diagnostics DeYor Laboratory Inc., a regional laboratory based in Ohio,
Pennsylvania and Tennessee with approximately $20 million of annual revenues.
This transaction was accounted for under the pooling of interests method,
although Quest Diagnostics' consolidated financial statements for prior periods
have not been restated since this acquisition is not material. See Note 3 to the
Audited Financial Statements. In addition to the acquisitions discussed above,
since January 1993 Quest Diagnostics has acquired approximately 25 other smaller
clinical laboratories and customer lists, principally in assets acquisitions.
Only one such acquisition has been completed since May 1995.
Competition
The clinical laboratory testing business is intensely competitive. Quest
Diagnostics believes that in 1995 the entire United States clinical laboratory
testing industry had revenues exceeding $30 billion; approximately 56% of such
revenues were attributable to hospital-affiliated laboratories, approximately
36% were attributable to independent clinical laboratories and approximately 8%
were attributable to physicians in their offices and laboratories. As recently
as 1993, there were seven laboratories that provided clinical laboratory testing
services on a national basis: Quest Diagnostics, SmithKline, National Health
Laboratories Inc. ("NHL"), Roche Biomedical Laboratories Inc. ("Roche"), Damon,
Allied Clinical Laboratories Inc. ("Allied") and Nichols Institute. In April
1995 Roche merged into NHL (under the name LabCorp), which had acquired Allied
in June 1994. Quest Diagnostics acquired Nichols Institute in August 1994 and
Damon in August 1993. In addition, in the last several years a number of large
regional laboratories have been acquired by national clinical laboratories.
There are presently three national independent clinical laboratories: Quest
Diagnostics, which had approximately $1.63 billion in revenues from clinical
laboratory testing in 1995; LabCorp, which had approximately $1.68 billion in
revenues from clinical laboratory testing in 1995 on a pro forma basis, after
giving effect to the April 1995 merger of Roche into NHL; and SmithKline, which
had approximately $1.29 billion in revenues from clinical laboratory testing in
1995. Both LabCorp and SmithKline are affiliated with large corporations that
have greater financial resources than Quest Diagnostics. SmithKline is wholly
owned by SmithKline Beecham Ltd. and F. Hoffman La Roche Ltd. beneficially owns
approximately 49.9% of the outstanding capital stock of LabCorp.
In addition to the three national clinical laboratories, Quest Diagnostics
competes on a regional basis with many smaller regional independent clinical
laboratories as well as laboratories owned by hospitals and physicians. Quest
Diagnostics has the leading market share in most of the northeast, mid-Atlantic
and midwest routine testing markets, while its market share is much lower in the
routine testing market in the rest of the country. Approximately 66% of Quest
Diagnostics' net revenues and almost all of its EBITDA currently is generated
from markets in which Quest Diagnostics believes that it has the largest market
share. In most of these markets Quest Diagnostics believes that it also is the
lowest cost provider. Quest Diagnostics does not generally compete in the
California routine testing market other than in the San Diego metropolitan area.
Quest Diagnostics believes that the following factors, among others, are often
used by health care providers in selecting a laboratory: (i) pricing of the
laboratory's testing services; (ii) accuracy, timeliness and consistency in
reporting test results; (iii) number and type of tests performed; (iv) service
capability and convenience offered by the laboratory; and (v) its reputation in
the medical community. Quest Diagnostics believes that it competes favorably
with its principal competitors in each of these areas and is currently
implementing strategies to improve its competitive position. See "--Business
Strategy."
Quest Diagnostics believes that consolidation will continue in the clinical
laboratory testing business. In addition, Quest Diagnostics believes that it and
the other large independent clinical laboratory testing companies will be able
to increase their share of the overall
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<PAGE>
clinical laboratories testing market due to a number of external factors
including cost efficiencies afforded by large-scale automated testing, Medicare
reimbursement reductions and the growth of managed health care entities which
require low-cost testing services and large service networks. In addition, legal
restrictions on physician referrals and the ownership of laboratories as well as
increased regulation of laboratories are expected to contribute to the
continuing consolidation of the industry.
Quality Assurance
Quest Diagnostics maintains a comprehensive quality assurance program for all
of its laboratories and patient service centers. The goal is to ensure
optimal patient care by continually improving the processes used for
collection, storage and transportation of patient specimens, as well as the
precision and accuracy of analysis and result reporting.
The Quest Diagnostics quality assurance efforts focus on: proficiency testing,
process audits, statistical process control, credentialing and personnel
training.
Internal Quality Control and Audits. Quality control samples are processed in
parallel with the analysis of patient specimens. The results of tests on such
samples are then monitored to identify drift, shift or imprecision in the
analytical processes. In addition, Quest Diagnostics administers an extensive
internal program of "blind" proficiency testing. These samples are processed
through the Quest Diagnostics system as routine patient samples, unknown to the
laboratory as quality control samples. Samples are then handled, processed and
reported with patient specimens. This provides a system to assure accuracy of
the entire pre-and post-analytical testing process. Another element of the Quest
Diagnostics comprehensive quality assurance program includes performance of
internal process audits.
External Proficiency Testing and Accreditation. All Quest Diagnostics
laboratories participate in numerous externally conducted, blind sample quality
surveillance programs. These include proficiency testing programs administered
by the College of American Pathologists ("CAP"), as well as many state agencies.
These programs supplement all other quality assurance procedures.
All Quest Diagnostics laboratories are accredited by CAP. Accreditation includes
on-site inspections and participation in the CAP Proficiency Test Program. CAP
is an independent nongovernmental organization of board certified pathologists
that offers an accreditation program to which laboratories may voluntarily
subscribe. CAP is approved by HCFA to inspect clinical laboratories to determine
compliance with the standards required by the Clinical Laboratory Improvement
Amendments of 1988 ("CLIA").
Regulation and Reimbursement
Overview. The clinical laboratory industry is subject to significant
governmental regulation at the federal and state levels. All Quest
Diagnostics laboratories and patient service centers are appropriately
licensed and accredited by various state and federal agencies.
The health care industry is undergoing significant change as third-party
payors, such as Medicare (which principally serves patients 65 and older),
Medicaid (which principally serves indigent patients), private insurers and
large employers increase their efforts to control the cost, utilization and
delivery of health care services. In an effort to address the problem of
increasing health care costs, legislation has been proposed or enacted at
both the federal and state levels to regulate health care delivery in general
and clinical laboratories in particular. Some of the proposals include
managed competition, global budgeting and price controls. Although the
Clinton Administration's health care reform proposal, initially advanced in
1994, was not enacted, such proposal or other proposals may be considered in
the future. In particular, Quest Diagnostics believes that reductions in
reimbursement for Medicare services will continue to be implemented from time
to time. Reductions in the reimbursement rates of other third-party payors
are likely to occur as well. Quest Diagnostics cannot predict the effect
health care reform, if enacted, would have on its business, and there can be
no assurance that such reforms, if enacted, would not have a material adverse
effect on Quest Diagnostics' business and operations.
Regulation of Clinical Laboratory Operations. The CLIA standards were designed
to ensure that all clinical laboratory testing services are uniformly accurate
and of high quality by using a single set of requirements. On February 28, 1992,
the final rules implementing CLIA were published in the Federal Register. These
regulations extended federal oversight, with few exceptions, to virtually all
clinical laboratories regardless of size, type, location or ownership of the
laboratory. The regulations generally became effective in 1992. However, certain
quality control and proficiency testing requirements are still being phased in.
The standards for laboratory personnel, quality control, quality assurance and
patient test management are based on complexity and risk factors. Laboratories
categorized as "high" complexity are required to meet more stringent
requirements than either "moderate" or "waived" (tests regarded as having a low
potential for error and requiring little or no oversight) laboratories.
Most of the Quest Diagnostics laboratories are categorized as high complexity
and these laboratories are in compliance with the more stringent standards
for personnel, quality control, quality assurance and patient test
management. A few Quest Diagnostics laboratories are categorized as moderate
complexity (some STAT laboratories) or waived (only patient service centers).
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The sanction for failure to comply with these regulations may be suspension,
revocation or limitation of a laboratory's CLIA certificate necessary to
conduct business, significant fines or criminal penalties. The loss of a
license, imposition of a fine or future changes in such federal, state and
local laws and regulations (or in the interpretation of current laws and
regulations) could have a material adverse effect on Quest Diagnostics.
Quest Diagnostics is also subject to state regulation. CLIA permits states to
adopt regulations that are more stringent than federal law. For example,
state law may require that laboratory personnel meet certain more stringent
qualifications, specify certain quality control standards, maintain certain
records and undergo additional proficiency testing. For example, certain of
Quest Diagnostics' laboratories are subject to the State of New York's
clinical laboratory regulations, which contain provisions that are
significantly more stringent than federal law.
Quest Diagnostics believes it is in material compliance with the foregoing
standards. See "--Compliance Program."
Drug Testing. Drug testing for public sector employees is regulated by the
Substance Abuse and Mental Health Services Administration ("SAMHSA") (formerly
the National Institute on Drug Abuse), which has established detailed
performance and quality standards that laboratories must meet in order to be
approved to perform drug testing on employees of federal government contractors
and certain other entities. To the extent that Quest Diagnostics' laboratories
perform such testing, each must be certified by HHS as meeting SAMHSA standards.
Seven of Quest Diagnostics' laboratories are SAMHSA certified.
Controlled Substances. The use of controlled substances in testing for drug
abuse is regulated by the federal Drug Enforcement Administration ("DEA").
All Quest Diagnostics laboratories using controlled substances for testing
purposes are licensed by the DEA.
Medical Wastes and Radioactive Materials. Quest Diagnostics is subject to
licensing and regulation under federal, state and local laws relating to the
handling and disposal of medical specimens and hazardous waste and
radioactive materials as well as to the safety and health of laboratory
employees. All Quest Diagnostics laboratories are operated in material
compliance with applicable federal and state laws and regulations relating to
disposal of all laboratory specimens. Quest Diagnostics utilizes outside
vendors for disposal of specimens. Although Quest Diagnostics believes that
it is currently in compliance in all material respects with such federal,
state and local laws, failure to comply could subject Quest Diagnostics to
denial of the right to conduct business, fines, criminal penalties and other
enforcement actions.
Occupational Safety. In addition to its comprehensive regulation of safety in
the workplace, the federal Occupational Safety and Health Administration
("OSHA") has established extensive requirements relating to workplace safety
for health care employers, including clinical laboratories, whose workers may
be exposed to blood-borne pathogens such as HIV and the hepatitis B virus.
These regulations, among other things, require work practice controls,
protective clothing and equipment, training, medical follow-up, vaccinations
and other measures designed to minimize exposure to chemicals and
transmission of blood-borne and airborne pathogens.
Specimen Transportation. Regulations of the Department of Transportation, the
Public Health Service and the Postal Service apply to the surface and air
transportation of clinical laboratory specimens.
Regulation of Reimbursement for Clinical Laboratory Services. Containment of
health care costs, including reimbursement for clinical laboratory services,
has been a focus of ongoing governmental activity. In 1984, Congress
established a Medicare fee schedule for clinical laboratory services
performed for patients covered under Part B of the Medicare program.
Subsequently, Congress imposed a national ceiling on the amount that would be
paid under the Medicare fee schedule. Laboratories must bill the program
directly and must accept the scheduled amount as payment in full for most
tests performed on behalf of Medicare beneficiaries. In addition, state
Medicaid programs are prohibited from paying more (and in most instances, pay
significantly less) than the Medicare fee schedule for clinical laboratory
testing services furnished to Medicaid recipients. In 1995, Quest Diagnostics
derived approximately 20% and 3% of its net revenues from tests performed for
beneficiaries of Medicare and Medicaid programs, respectively. Since 1984,
Congress has periodically reduced the ceilings on Medicare reimbursement to
clinical laboratories from previously authorized levels. In 1993, pursuant to
the Omnibus Budget and Reconciliation Act of 1993 ("OBRA '93"), Congress
reduced, effective January 1, 1994, the Medicare national fee schedule
limitations from 88% of the 1984 national median to 76% of the 1984 national
median, which reductions were phased in from 1994 through 1996 (to 84% in
1994, 80% in 1995 and 76% in 1996, in each case as a percentage of the 1984
national median). The 1996 reduction to 76% was implemented as scheduled on
January 1, 1996. OBRA '93 also eliminated the provision for annual fee
schedule increases based upon the consumer price index for 1994 and 1995.
Medicare reimbursement reductions have a direct adverse effect on Quest
Diagnostics' net earnings and cash flows. Quest Diagnostics cannot predict if
additional Medicare reductions will be implemented. The Senate and House
Medicare proposal (the Medicare Preservation Act of 1995) passed in October
1995 would have reduced the national limitation to 65% beginning in 1997 and
would have eliminated all annual consumer price index adjustments through
2002. This reduction in laboratory reimbursement rates was retained in the
House-Senate conference report agreed upon in November 1995. The President
vetoed this bill in December 1995.
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Effective January 1, 1996, HCFA adopted a new policy on reimbursement for
chemistry panel tests. As of January 1, 1996, 22 automated tests (rather than 19
tests) became reimbursable by Medicare as part of an automated chemistry
profile. An additional allowance of $0.50 per test is authorized when more than
19 tests are billed in a panel. HCFA retains the authority to expand in the
future the list of tests included in a panel. Effective as of March 1, 1996,
HCFA eliminated its prior policy of permitting payment for all tests contained
in an automated chemistry panel when at least one of the tests in the panel is
medically necessary. Under the new policy, Medicare payment will not exceed the
amount that would be payable if only the tests that are "medically necessary"
had been ordered. In addition, since 1995 most Medicare carriers have begun to
require clinical laboratories to submit documentation supporting the medical
necessity, as judged by ordering physicians, for many commonly ordered tests.
Quest Diagnostics expects to incur additional reimbursement reductions and
additional costs associated with the implementation of these requirements of
HCFA and Medicare carriers. The amount of the reductions in reimbursements and
additional costs cannot be determined at this time. See "--Billing."
Major clinical laboratories, including Quest Diagnostics, use dual fee
schedules: "client" fees charged to physicians, hospitals, and institutions with
which a laboratory deals on a bulk basis and "patient" fees charged to
individual patients and third-party payors, including Medicare and Medicaid, who
generally require separate bills or claims for each requisition. Medicare and
other third party payors also set maximum fees that they will pay which are
substantially lower than the patient fees otherwise charged by Quest
Diagnostics, but are generally higher than Quest Diagnostics' client fees, which
may be subject to negotiation or discount. Federal and some state regulatory
programs prohibit clinical laboratories from charging government programs more
than certain charges to other customers. During 1992, in issuing final
regulations implementing the federal statutory prohibition against charging
Medicare substantially in excess of a provider's usual charge, the OIG declined
to provide any guidance concerning the interpretation of this legislation,
including whether or not discounting or the dual fee structure employed by
clinical laboratories might raise issues under the provision.
Medicare budget proposals developed by the Clinton Administration in 1993 and
1994, along with proposals incorporated in many major health reform bills
considered by Congress in 1994, called for the reinstatement of 20% Medicare
clinical laboratory co-insurance (which was last in effect in 1984). While
co-insurance was in effect, clinical laboratories received from Medicare
carriers only 80% of their Medicare reimbursement rates and were required to
bill Medicare beneficiaries for the balance of the charges. A co-insurance
proposal was not included in any of the Congressional Medicare reform packages
considered to date in the 1995 and 1996 legislative sessions. However, it is
still possible a co-insurance provision will be proposed in the future and, if
enacted, such a proposal could materially adversely affect the revenues and
costs of the clinical laboratory industry, including Quest Diagnostics, by
exposing the testing laboratory to the credit of individuals and by increasing
the number of bills. In addition, a laboratory could be subject to potential
fraud and abuse violations if adequate procedures to bill and collect the
co-insurance payments are not established and followed.
Proposals have also been developed to procure Medicare and Medicaid laboratory
testing services through competitive bidding mechanisms. To date, none of the
Congressional Medicare reform packages introduced in the 1995 and 1996
legislative sessions have included a competitive bidding provision for clinical
laboratory tests. However, President Clinton's Medicare reform proposal would
have established competitive bidding for clinical laboratory services. If
competitive bidding were implemented, such action could materially adversely
affect the revenues of the clinical laboratory industry, including Quest
Diagnostics. HCFA is currently developing a demonstration project to determine
whether competitive bidding can be used to provide quality laboratory services
at prices below current Medicare reimbursement rates. The demonstration is
expected to be conducted in Kentucky and to commence in 1997.
Future changes in federal, state and local regulations (or in the interpretation
of current regulations) affecting governmental reimbursement for clinical
laboratory testing could have a material adverse effect on Quest Diagnostics.
Quest Diagnostics is unable to predict, however, whether and what type of
legislation will be enacted into law.
Fraud and Abuse Regulations. The Medicare and Medicaid anti-kickback laws
prohibit clinical laboratories from, among other things, making payments or
furnishing other benefits to influence the referral of tests billed to Medicare,
Medicaid or other federal programs. Penalties for violations of these federal
laws include exclusion from participation in the Medicare/ Medicaid programs,
assets forfeitures, and civil and criminal penalties. Civil administrative
penalties for a wide range of offenses may be up to $2,000 per item and twice
the amount claimed. Under the Health Insurance Portability and Accountability
Act of 1996 (the "Health Insurance Act"), the penalties will be increased,
effective January 1, 1997 to up to $10,000 per item plus three times the amount
claimed. In the case of certain offenses, exclusion from participation in
Medicare and Medicaid is a mandatory penalty.
The fraud and abuse provisions are interpreted liberally and enforced
aggressively by various enforcing agencies of the federal government,
including the Federal Bureau of Investigation ("FBI") and the OIG. According
to public statements by the DOJ, health care fraud has been elevated to the
second-highest priority of the DOJ, and FBI agents have been transferred from
investigating counterintelligence activities to health care provider fraud.
The OIG also is involved in such investigations and has,
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according to recent workplans, targeted certain laboratory practices for study,
investigation and prosecution. The federal government's involvement in
curtailing fraud and abuse is likely to increase as a result of the enactment in
August 1996 of the Health Insurance Act which will require, by January 1, 1997,
the U.S. Attorney General and the OIG to jointly establish a program to (a)
coordinate federal, state and local enforcement programs to control fraud and
abuse with respect to health care, (b) conduct investigations, audits,
evaluations and inspections relating to the delivery and payment for health
care, (c) facilitate the enforcement of the health care fraud and abuse laws,
(d) provide for the modification and establishment of safe harbors and to issue
advisory opinions and Special Fraud Alerts and (e) provide for a data collection
system for the reporting and disclosure of adverse actions taken against health
care providers. The Health Insurance Act also authorizes the establishment of an
anti-fraud and abuse trust fund funded through the collection of penalties and
fines for violations of the health care anti-fraud laws as well as amounts
authorized therefor by Congress. The Health Insurance Act also requires HHS to
establish a program to encourage Medicare beneficiaries and others to report
violations of the health care anti-fraud laws, including by paying to the
reporting person a portion of any fines and penalties collected.
In October 1994, the OIG issued a Special Fraud Alert, which set forth a number
of practices allegedly engaged in by clinical laboratories and health care
providers that the OIG believes violate the anti-kickback laws. These practices
include providing employees to collect patient samples at physician offices if
the employees perform additional services for physicians that are typically the
responsibility of the physicians' staff; selling laboratory services to renal
dialysis centers at prices that are below fair market value in return for
referrals of Medicare tests which are billed to Medicare at higher rates;
providing free testing to a physician's HMO patients in situations where the
referring physicians benefit from lower utilization; providing free pickup and
disposal of bio-hazardous waste for physicians for items unrelated to a
laboratory's testing services; providing facsimile machines or computers to
physicians that are not exclusively used in connection with the laboratory
services performed; and providing free testing for health care providers, their
families and their employees (professional courtesy testing). The OIG stressed
in the Special Fraud Alert that when one purpose of the arrangements is to
induce referral of program-reimbursed laboratory testing, both the clinical
laboratory and the health care provider or physician may be liable under the
anti-kickback laws and may be subject to criminal prosecution and exclusion from
participation in the Medicare and Medicaid programs. The Special Fraud Alert was
issued in part at the request of the American Clinical Laboratory Association,
which requested clarification of certain of these rules. Quest Diagnostics does
not believe that it has been negatively affected by the issuance of the Special
Fraud Alert.
Many of these statutes and regulations, including those relating to joint
ventures and alliances, are vague or indefinite and have not been interpreted
by the courts. In addition, regulators have generally offered little guidance
to the clinical laboratory industry. Despite requests from the American
Clinical Laboratory Association for clarification of the anti-fraud and abuse
rules, since 1992, OIG has issued only two fraud alerts specifically with
regard to clinical laboratory practices and has insisted that it lacked
statutory authority to issue advisory opinions. Legislation requiring OIG to
issue fraud alerts and advisory opinions was enacted in August 1996, and as a
result Quest Diagnostics is hopeful that additional regulatory guidance will
be given to the clinical laboratory industry.
According to the 1995 work plan of the OIG, its recently established Office
of Civil Fraud and Administrative Adjudication ("OCFAA") will be responsible
for protecting the government-funded health care programs and deterring
fraudulent conduct by health care providers through the negotiation and
imposition of civil monetary penalties, assessments and program exclusions.
The OCFAA works very closely with the DOJ, the Office of General Counsel of
HHS and the OIG investigative and audit offices in combating fraud and abuse.
In addition, the OIG stated in its 1995 work plan that it will determine the
extent to which laboratories supply physicians' offices with phlebotomists
(blood-drawing technicians), offer management services or medical waste
pick-up to physicians, provide training to physicians or engage in other
financial arrangements with purchasers of laboratories' services. The OIG
will assess the potential benefits of such arrangements as well as the extent
to which such arrangements might be unlawful.
A federal "self-referral" law commonly known as the "Stark" law has, since
1992, generally prohibited (with certain exceptions) Medicare payments for
laboratory tests referred by physicians who have (personally or through a
family member) an investment interest in, or a compensation arrangement with,
the testing laboratory. Since January 1995, these restrictions apply to
Medicaid-covered services as well. Physicians may, however, be reimbursed by
Medicare and Medicaid for testing performed by or under the supervision of
the physician or the group practice to which the physician belongs. In
addition, a physician may refer specimens to a laboratory owned by a company,
such as Quest Diagnostics, whose stock is traded on a public exchange and
which has stockholders' equity exceeding $75 million even if the physician
owns stock of that company. An amendment to the Stark law in August 1993
makes it clear that ordinary day-to-day transactions between laboratories and
their customers, including, but not limited to, discounts granted by
laboratories to their customers, are not covered by the compensation
arrangement provisions of the Medicare statute. Sanctions for laboratory
violations of the prohibition include denial of Medicare pay-
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ments, refunds, civil money penalties of up to $15,000 for each service billed
in violation of the prohibition and exclusion from the Medicare and Medicaid
programs.
The 1995 House Medicare reform proposal contained, and the House-Senate report
adopted, provisions that would significantly narrow the scope of the Stark
anti-referral laws. That proposal would, among other changes, have ended the ban
on physician referrals to laboratories based on any "compensation arrangements"
between the laboratory and the physician. The President vetoed this bill on
December 6, 1995.
Government Investigations and Related Claims
Quest Diagnostics has settled various government and private claims (i.e.,
nongovernmental claims such as those by private insurers) totalling
approximately $192 million relating primarily to industry-wide billing and
marketing practices that had been substantially discontinued by early 1993.
Specifically, Quest Diagnostics has entered into, (i) for an aggregate of
approximately $180 million, five settlements with the OIG and the DOJ
(including, the MetPath and the Damon settlements discussed below) and two
settlements with state governments with respect to Medicare and Medicaid
marketing and billing practices of Quest Diagnostics and certain companies
acquired by Quest Diagnostics prior to their acquisition and (ii) twelve
completed settlements and one tentative settlement relating to private claims
totalling approximately $12 million. In addition, there are pending
investigations by the OIG and DOJ into billing and marketing practices at three
regional laboratories operated by Nichols prior to its acquisition by Quest
Diagnostics. There are no other private claims presently pending other than
routine claims that are not material in the aggregate.
Government Settlements
The MetPath Settlement. In September 1993, Quest Diagnostics (under the name
MetPath Inc.) entered into an agreement with the DOJ and the OIG pursuant to
which Quest Diagnostics paid a total of approximately $36 million in
settlement of civil claims by the United States that the company had
wrongfully induced physicians to order certain laboratory tests without their
realizing that such tests would be billed to Medicare at rates higher than
those the physicians believed were applicable.
The Damon Settlement. By issuance of a civil subpoena in August 1993, the
government began a formal investigation of Damon, a company acquired by Corning
in August 1993. Subsequent to September 1993, several additional subpoenas were
issued. By a plea agreement and civil settlement agreement and release dated
October 9, 1996, between DOJ and Damon, all federal criminal matters within the
scope of the various federal investigations against Damon, and all claims
included in the civil qui tam cases underlying the civil investigations, were
settled for an aggregate of $119 million, which sum was reimbursed to Quest
Diagnostics by Corning. The settlement included base recoupments of
approximately $40 million (which did not differ materially from management's
estimate at June 30, 1996) and total criminal and civil payments in excess of
base recoupments of approximately $80 million. At the time Quest Diagnostics
began its settlement negotiations with DOJ in April 1996, it believed it had
meritorious defenses to a number of charges and claims made by the government.
Reserves established for such settlements in the second quarter of 1996 were
based on Quest Diagnostics' and its counsel's belief that the merits of its
factual and legal arguments would be given more weight by the government.
Certain of these positions were ultimately rejected by criminal and civil
prosecutors in the final rounds of negotiations which occurred in late September
1996, resulting in a total settlement substantially in excess of what had
earlier been anticipated. The Damon settlement does not exclude Quest
Diagnostics from future participation in any federal health care programs on
account of Damon's practices. For further information regarding the Damon
Settlement, see Note 13 to the Audited Quest Diagnostics Financial Statements
and Note 2 to the Quest Diagnostics Interim Financial Statements.
Other Governmental Settlements. In addition to the MetPath settlement and the
Damon settlement, since 1992 Quest Diagnostics has settled five other federal
and state billing-related claims for a total of approximately $25 million.
Ongoing Government Investigations
The Nichols Investigation. By issuance of a civil subpoena in August 1993,
the government began a formal investigation of Nichols, a company acquired by
Corning in August 1994. The investigation of Nichols remains open. While
Quest Diagnostics has established reserves in respect of the Nichols
investigations, at present there are no settlement discussions pending
between DOJ and Quest Diagnostics regarding Nichols, and it is too early to
predict the outcome of this investigation. Remedies available to the
government include exclusion from participation in the Medicare and Medicaid
programs, criminal fines, civil recoveries plus civil penalties and asset
forfeitures. Although application of such remedies and penalties could
materially and adversely affect Quest Diagnostics' business, financial
condition, results of operations and prospects, management believes that the
possibility of this happening is remote. Quest Diagnostics derived
approximately 23% and 22% of its net revenues for the year ended December 31,
1995 and the nine months ended September 30, 1996, respectively, from
Medicare and Medicaid programs. However, in light of the Corporate Integrity
Agreement referred to below entered into between Quest Diagnostics and the
OIG in connection with the Damon settlement, the fact that the matters being
investigated were corrected with or before Quest Diagnostics' acquisition of
Nichols and Quest Diagnostics' cooperation in this investigation, Quest
Diagnostics believes the prospect of such exclusion on account of the
investigation is remote.
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As discussed below, Corning has agreed to indemnify Quest Diagnostics against
any monetary penalties, fines or settlements for any governmental claims that
may arise as a result of the Nichols investigations.
The Damon Officer Investigations. Quest Diagnostics understands that the Boston
United States Attorney's Office has designated several former officers and
employees of Damon as targets of its criminal investigation, and will seek
indictments against them. Under the agreement and plan of merger under which
Damon was acquired by Corning, Quest Diagnostics is obligated to indemnify
former officers and directors of Damon to the fullest extent permitted by
Delaware law with respect to this investigation. These obligations will remain
those of Quest Diagnostics and will not be indemnified by Corning. In addition,
as part of the Damon settlement, Corning agreed to cooperate with DOJ in its
continuing investigation of individuals formerly associated with Damon and, in
connection therewith, Quest Diagnostics is providing additional information
pursuant to several subpoenas.
Other Government Investigations. In December 1995, Quest Diagnostics received a
subpoena from the OIG seeking information as to Quest Diagnostics' policies in
instances in which specimens were received and tested by a laboratory without
first receiving or verifying specific test requisitions. While compliance with
the subpoena is ongoing, Quest Diagnostics has concluded the occurrence of this
practice was relatively rare and was engaged in primarily to preserve the
integrity of test results from specimens subject to rapid deterioration. During
1996, Quest Diagnostics voluntarily self-reported (or intends to self-report
prior to the Distribution Date) to the government a few isolated events,
involving billings of approximately $16 million, that may have resulted in
overpayment by Medicare and Medicaid to Quest Diagnostics. It is Quest
Diagnostics' policy to internally investigate all such incidents and to
self-report and reimburse payors as appropriate. Although Quest Diagnostics has
commenced internal investigations to quantify the amounts that may be recouped
by the government and corrective action has been taken as to each such event, it
is too early to predict the outcome of these disclosures to the government. As
discussed below, Corning has agreed to indemnify Quest Diagnostics against any
monetary penalties, fines or settlements for any governmental claims that may
arise as a result of the investigations described in this paragraph.
Outlook for Future Government Investigations
The Damon settlement involved, and a settlement regarding Nichols is expected
to involve, only matters predating Corning's acquisition of both such
companies, and turned on, or will turn on, facts unique to those companies
and other factors individual government enforcement personnel may take into
account. However, recent experience in Quest Diagnostics' settlement of the
Damon case and public announcements by various government officials indicate
that the government's position on health care fraud is still hardening and
collections of amounts greatly in excess of mere recoupment of overcharges
from laboratories and other providers will be more prevalent. In addition,
the newly adopted Health Insurance Act includes provisions to combat health
care fraud and abuse will give federal enforcement personnel substantially
increased funding, powers and remedies to pursue suspected fraud and abuse.
In connection with the Damon settlement, Quest Diagnostics signed a Corporate
Integrity Agreement pursuant to which Quest Diagnostics will maintain its
corporate compliance program, modify certain of its marketing materials, make
periodic reports to the OIG and take certain other steps to demonstrate Quest
Diagnostics' integrity as a provider of services to federally sponsored
health care programs. This agreement also includes an obligation to
self-report instances of noncompliance that are uncovered by Quest
Diagnostics, but also gives Quest Diagnostics the opportunity to obtain
clearer guidance on matters of compliance and to resolve compliance issues
directly with OIG. Importantly, the agreement gives Quest Diagnostics the
opportunity to cure any asserted breaches and to otherwise initiate
corrective actions, which Quest Diagnostics believes should help to avoid
enforcement actions outside of the process provided in the agreement. See
"--Compliance Program."
Private Settlements and Claims
Since 1992 Quest Diagnostics has settled thirteen private actions relating to
the governmental settlements described above for an aggregate of approximately
$12 million. There are no other private claims presently pending other than
routine claims that are not material in the aggregate.
Corning Indemnity
In connection with the Distributions, Corning has agreed to indemnify Quest
Diagnostics against all monetary penalties, fines or settlements for any
governmental claims arising out of alleged violations of applicable federal
fraud and health care statutes and relating to billing practices of Quest
Diagnostics and its predecessors that have been settled or are pending on the
Distribution Date. This includes the settlements described under "--Government
Settlements" above and the claims described under "--Ongoing Government
Investigations--The Nichols Investigation" and "--Other Government
Investigations." Corning has also agreed to indemnify Quest Diagnostics for 50%
of the aggregate of all judgment or settlement payments made by Quest
Diagnostics that are in excess of $42.0 million in respect of claims by private
parties (i.e., nongovernmental parties such as private insurers) that relate to
indemnified or previously settled governmental claims (such as the Damon
settlement) and that allege overbillings by Quest Diagnostics or any existing
subsidiaries of Quest Diagnostics, for services provided prior to the
Distribution Date; provided, however, such indemnification will not exceed $25.0
million in the aggregate and that all amounts indemnified against by Corning for
the benefit of Quest Diagnostics will be calculated on a net after-tax basis by
taking into account any deductions and other tax ben-
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efits realized by Quest Diagnostics (or a consolidated group of which
Quest Diagnostics is a member after the Distributions (the "Quest Diagnostics
Group")) in respect of the underlying settlement, judgment payment, or other
loss (or portion thereof) indemnified against by Corning generally at the
time and to the extent such deductions or tax benefits are deemed to reduce
the tax liability of Quest Diagnostics or the Quest Diagnostics Group.
Corning will not indemnify Quest Diagnostics against (i) any governmental claims
that arise after the Distribution Date pursuant to service of subpoena or other
notice of such investigation after the Distribution Date, (ii) any
nongovernmental claims unrelated to the indemnified governmental claims or
investigations, (iii) any nongovernmental claims not settled prior to five years
after the Distribution Date, (iv) any consequential or incidental damages
relating to the billing claims, including losses of revenues and profits as a
consequence of exclusion for participation in federal or state health care
programs or (v) the fees and expenses of litigation. Quest Diagnostics will
control the defense of any governmental claim or investigation unless Corning
elects to assume such defense. However, in the case of all nongovernmental
claims related to indemnified governmental claims related to alleged
overbillings, Quest Diagnostics will control the defense. All disputes under the
Transaction Agreement are subject to binding arbitration. See "The
Distributions--Transaction Agreement."
Quest Diagnostics' Reserves
Quest Diagnostics' aggregate reserve with respect to all governmental and
private claims, including litigation costs of approximately $6.6 million, was
$215 million at September 30, 1996 and is estimated to be $85 million at the
Distribution Date. The approximately $130 million reduction in the reserve is
due to the subsequent payment of the Damon settlement ($119 million), the
settlement of an investigation into billing of certain hematology indices
(reserved at $7 million) and the settlement of a private claim (reserved at
$6 million). These settlements have been or will be funded by contributions
to Quest Diagnostics' capital by Corning. The $85 million reserve represents
amounts for future government and private settlements of matters which are
either presently pending or anticipated as a consequence of the government
and private settlements and self-reported matters described above. Based on
information available to management and Quest Diagnostics' experience with
past settlements, especially the Damon settlement, and the fact that the
aggregate amount of such settlement was significantly in excess of
established reserves, management has reassessed its reserve levels and
believes that its current level of reserves is adequate. However, it is
possible that the additional information may become available (such as the
indication by the government of criminal activity, additional tests being
questioned or other changes in the government's theories of wrongdoing) which
may cause the final resolution of these matters to be in excess of
established reserves by an amount which could be material to Quest
Diagnostics' results of operations and, for non-indemnified claims, Quest
Diagnostics' cash flows in the period in which such claims are settled. While
none of the governmental or nongovernmental investigations or claims is
covered by insurance, Quest Diagnostics does not believe that these matters
will have a material adverse effect on Quest Diagnostics' overall financial
condition.
Compliance Program
Because of evolving interpretations of regulations and the national debate
over health care, compliance with all Medicare, Medicaid and other
government-established rules and regulations has become a significant concern
throughout the clinical laboratory industry. Quest Diagnostics began the
implementation of a compliance program early in 1993. The objective of the
program is to develop aggressive and reliable compliance safeguards. Emphasis
is placed on developing training programs for personnel intended to assure
the strict implementation and observance of all applicable rules and
regulations. Further, in-depth reviews of procedures, personnel and
facilities are conducted to assure regulatory compliance throughout Quest
Diagnostics. Quest Diagnostics' current compliance plan establishes a
Compliance Committee of the Board and requires periodic reporting of
compliance operations by management to the Compliance Committee. Such
sharpened focus on regulatory standards and procedures will continue to be a
priority for Quest Diagnostics in the future.
Quest Diagnostics has established a comprehensive program designed to ensure
that it is in compliance in all material respects with all statutes, regulations
and other requirements applicable to its clinical laboratory operations. This
program was publicly cited with approval by government officials at the time the
Damon settlement was announced and characterized as a "model" for the industry.
In addition, the government advised Quest Diagnostics representatives that Quest
Diagnostics' compliance program, coupled with corrective action taken by Quest
Diagnostics after its acquisition of Damon, greatly reduced the amounts of fines
and penalties, and was influential in causing the OIG not to seek exclusion of
Quest Diagnostics from future participation in governmental health care
programs. Pursuant to the Damon settlement, Quest Diagnostics signed a five year
Corporate Integrity Agreement with the OIG pursuant to which Quest Diagnostics
will, among other things, maintain its corporate compliance program, make
certain changes to its test order forms, provide certain additional notices to
ordering physicians, provide to the OIG data on certain test ordering patterns,
adopt certain pricing guidelines, audit laboratory operations, deliver annual
reports on compliance activities, and investigate and report instances of
noncompliance, including any corrective actions and disciplinary steps.
Importantly, the agreement gives Quest Diagnostics the opportunity to cure any
asserted breaches and to otherwise initiate corrective actions, which Quest
Diagnostics believes should help to avoid enforcement actions outside of the
process provided in the agreement. The agreement gives Quest Diagnostics the
opportunity to obtain clearer guidance on matters of compliance and to resolve
compliance issues directly with the OIG. Quest
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<PAGE>
Diagnostics has been advised that its principal competitors will be obliged to
execute similar agreements at the conclusion of investigations pending against
them and that the OIG will likely publish to the clinical laboratory testing
industry a guideline on the essential elements of a satisfactory compliance
program. This latter step may help create a fairer competitive environment for
Quest Diagnostics. None of the undertakings included in the agreement is
expected to have any material adverse affect on Quest Diagnostics' business,
financial condition, results of operations and prospects. The clinical
laboratory testing industry is, however, subject to extensive regulation. Quest
Diagnostics believes that it is in all material respects in compliance with all
applicable statutes and regulations. However, there can be no assurance that any
statutes or regulations might not be interpreted or applied by a prosecutorial,
regulatory or judicial authority in a manner that would adversely affect Quest
Diagnostics. Potential sanctions for violation of these statutes and regulations
include significant fines and the loss of various licenses, certificates and
authorizations.
Insurance
Quest Diagnostics maintains liability insurance (subject to maximum limits
and self-insured retentions) for claims, which may be substantial, that could
result from providing or failing to provide clinical laboratory testing
services, including inaccurate testing results. While there can be no
assurance that coverage will be adequate to cover all future exposure,
management believes that the present levels of coverage are adequate to cover
currently estimated exposures. Although Quest Diagnostics believes that it
will be able to obtain adequate insurance coverage in the future at
acceptable costs, there can be no assurance that Quest Diagnostics will be
able to obtain such coverage or will be able to do so at an acceptable cost
or that Quest Diagnostics will not incur significant liabilities in excess of
policy limits.
Employees
At September 30, 1996, Quest Diagnostics employed approximately 18,700
people. These include approximately 16,500 full-time employees and
approximately 2,200 part-time employees. Quest Diagnostics has no collective
bargaining agreements with any unions and believes that its overall relations
with its employees are good.
Seasonality
During the summer months, year-end holiday periods and other major holidays,
volume of testing declines, reducing net revenues and resulting cash flows
below annual averages during the third and fourth quarters each year. Winter
months are also subject to declines in testing volume due to inclement
weather. As a result, comparisons of the results of successive quarters may
not accurately reflect trends or results for the full year. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Overview."
Properties
Quest Diagnostics' principal laboratories (listed alphabetically by state)
are located in the following metropolitan areas:
<TABLE>
<CAPTION>
Location Type of Laboratory Leased or Owned
- -------- ------------------ ---------------
<S> <C> <C>
Phoenix, Arizona Regional Leased
San Diego, California Regional Leased
San Juan Capistrano, California Esoteric Owned
Denver, Colorado Regional Leased
New Haven, Connecticut Regional Owned
Miami, Florida Branch Leased
Tampa, Florida Regional Leased
Atlanta, Georgia Regional Leased
Chicago, Illinois Regional Leased
Indianapolis, Indiana Branch Leased
Baltimore, Maryland Regional Owned
Boston, Massachusetts Regional Owned subject to put/call
with option to lease
Detroit, Michigan Regional Leased
Grand Rapids, Michigan Branch Leased
Kansas City, Missouri Branch Leased
St. Louis, Missouri Regional Leased
Billings, Montana Branch Leased
Lincoln, Nebraska Regional Managed (hospital)
Teterboro, New Jersey/New York, New York Regional Owned
Albuquerque, New Mexico Branch Leased
Buffalo, New York Branch Owned
Long Island, New York Branch Leased
Cleveland, Ohio Branch Owned
Columbus, Ohio Branch Leased
Portland, Oregon Regional Leased
Erie, Pennsylvania Branch Leased by joint venture
Philadelphia, Pennsylvania Regional Leased
64
<PAGE>
Location Type of Laboratory Leased or Owned
- -------- ------------------ ---------------
Pittsburgh, Pennsylvania Regional Leased
Nashville, Tennessee Branch Owned
Dallas, Texas Regional Leased
El Paso, Texas Branch Leased
Salt Lake City, Utah Branch Leased
</TABLE>
Quest Diagnostics executive offices are located in Teterboro, New Jersey in the
building that serves as Quest Diagnostics' regional laboratory in the New York
City metropolitan area. Quest Diagnostics owns its branch laboratory facility in
Mexico City. Quest Diagnostics believes that, in general, its laboratory
facilities are suitable and adequate for its current and anticipated future
levels of operation. Quest Diagnostics believes that if it were unable to renew
the lease on any of its testing facilities, it could find alternative space at
competitive market rates and relocate its operations to such new locations.
Legal Proceedings
In addition to the investigations described in "--Government Investigations and
Related Claims," Quest Diagnostics is involved in various legal proceedings
arising in the ordinary course of business. Some of the proceedings against
Quest Diagnostics involve claims that are substantial in amount. Although it is
not feasible to predict the outcome of such proceedings or any claims made
against Quest Diagnostics, it does not anticipate that the ultimate liability of
such proceedings or claims will have a material adverse effect on Quest
Diagnostics' financial position or results of operations as they primarily
relate to professional liability for which Quest Diagnostics believes it has
adequate insurance coverage. Quest Diagnostics maintains professional liability
insurance for its professional liability claims. See "--Insurance."
IMPORTANT FACTORS REGARDING FORWARD LOOKING STATEMENTS
Quest Diagnostics wishes to caution investors that the following factors are
hereby identified as important factors that could cause Quest Diagnostics'
actual financial results to differ materially from those projected, forecast,
estimated, or budgeted by Quest Diagnostics in forward-looking statements.
(a) Heightened competition, including the intensification of price
competition. See "Risk Factors--Intense Competition."
(b) Impact of changes in payor mix, including the shift from traditional,
fee-for-service medicine to managed-cost health care. See "Risk
Factors--Role of Managed Care."
(c) Adverse actions by governmental or other third-party payors, including
unilateral reduction of fee schedules payable to Quest Diagnostics.
(d) The impact upon Quest Diagnostics' collection rates or general or
administrative expenses resulting from compliance with Medicare
administrative policies, including specifically the recent
requirements of Medicare carriers to provide diagnosis codes for
commonly ordered tests and the policy of HCFA to limit Medicare
reimbursement for tests contained in automated chemistry panels to the
amount that would have been paid if only the covered tests, determined
on the basis of demonstrable "medical necessity," had been ordered.
See "Risk Factors--Reliance on Medicare/Medicaid Reimbursements" and
"Risk Factors--Government Regulation."
(e) Adverse results from pending governmental investigations, including in
particular significant monetary damages and/or exclusion from the
Medicare and Medicaid programs and/or other significant litigation
matters. Also, the absence of indemnification from Corning for private
claims unrelated to the indemnified governmental claims or
investigations and for private claims that are not settled within five
years of the Distribution Date. See "Risk Factors--Government
Investigations and Related Claims."
(f) Failure to obtain new customers, retain existing customers or
reduction in tests ordered or specimens submitted by existing
customers.
(g) Inability to obtain professional liability insurance coverage or a
material increase in premiums for such coverage.
(h) Denial of CLIA certification or other licensure of any of Quest
Diagnostics' clinical laboratories under CLIA, by HCFA for Medicare
and Medicaid programs or other federal, state and local agencies. See
"Risk Factors--Government Regulation."
(i) Adverse publicity and news coverage about Quest Diagnostics or the
clinical laboratory industry.
(j) Computer or other system failures that affect the ability of Quest
Diagnostics to perform tests, report test results or properly bill
customers. See "Risk Factors--Billing."
(k) Development of technologies that substantially alter the practice of
laboratory medicine.
65
<PAGE>
Management
Management
Directors. Certain information with respect to the persons who will serve as
directors of Quest Diagnostics following the Distributions is set forth
below. Prior to the closing of the Offering and the Quest Diagnostics
Spin-Off Distribution, one of the current directors will resign and the
prospective directors listed below will be elected. As provided in the
certificate of incorporation (the "Certificate"), the board of directors (the
"Board") will be divided into three classes effective upon the Distributions
and one class of the Board will be elected for a three-year term at each
annual meeting of stockholders. Included in the information set forth below
are the names of the directors of each class. The term for which each
director will initially be elected has not yet been determined. Quest
Diagnostics is contemplating the selection of additional independent
directors, which selection may occur prior to the Distributions. Quest
Diagnostics does not intend to hold an annual meeting of stockholders until
the Spring of 1998.
Name Age
Kenneth W. Freeman 46
Van C. Campbell 58
David A. Duke 61
Gail R. Wilensky 53
Kenneth W. Freeman was elected President and Chief Executive Officer of Quest
Diagnostics in May 1995 and has been a director of Quest Diagnostics since
July 1995. Prior to 1995, he served in a variety of key financial and
managerial positions at Corning, which he joined in 1972. He was elected
controller and a vice president of Corning in 1985, senior vice president in
1987, and general manager of the Science Products Division in 1989. He was
appointed president and chief operating officer of Corning Asahi Video
Products Company in 1990. In 1993, he was elected executive vice president.
Van C. Campbell is the Vice Chairman of Corning, which he joined in 1964. He
was elected assistant treasurer in 1971, treasurer in 1972, a vice president
in 1973, financial vice president in 1975 and senior vice president for
finance in 1980. He became general manager of the Consumer Products Division
in 1981. Mr. Campbell was elected vice chairman and a director in 1983 and
during 1995 was appointed to the additional position of chairman of Corning
Life Sciences, Inc. He is a director of Armstrong World Industries, Inc. and
General Signal Corporation. Mr. Campbell has been a director of Quest
Diagnostics since January 1991.
David A. Duke is a Retired Vice Chairman of Corning. Dr. Duke joined Corning
in 1962 and served in a succession of research and management positions. He
was elected vice president--Telecommunications Products in 1980, elected a
senior vice president in 1984 and named director of Research and Development
in 1985. He became responsible for Engineering in March 1987 and was elected
as a director and Vice Chairman of Corning in 1988. He resigned as a director
of Corning in April 1996 and retired in June 1996. Dr. Duke is a director of
Armco, Inc. Dr. Duke was a director of Quest Diagnostics from October 1994 to
July 1996 and was re-elected a director of Quest Diagnostics in October 1996.
Gail R. Wilensky is the John M. Olin Senior Fellow at Project HOPE, an
international non-profit health foundation, which she joined in 1993. She is
currently the chair of the Physician Payment Review Commission which advises
Congress on physician payment and other Medicare issues. In 1992 and 1993,
Dr. Wilensky served as a deputy assistant to the President for policy
development relating to health and welfare issues. From 1990 to 1992, she was
the administrator of the Health Care Financing Administration where she
directed the Medicare and Medicaid programs. Dr. Wilensky is a director of
Advance Tissue Sciences Inc., Capstone Pharmacy Inc., Coram Healthcare Corp.,
Neopath Inc., St. Jude Medical Corp., SMS Corporation, Syncor Corporation and
United Healthcare Corporation.
Directors' Compensation. Each director of Quest Diagnostics, other than a
director who is an employee of Quest Diagnostics, will receive $18,000
annually for service as a director and will also be paid $1,000 for each
meeting of the Board and $500 for each meeting of any committee thereof which
he or she attends. In addition, directors serving as committee chairs would
receive an additional annual retainer of $1,500.
Quest Diagnostics has adopted, effective the Distribution Date, a deferred
compensation plan for directors pursuant to which each director may elect to
defer until a date specified by him receipt of all or a portion of his
compensation. Such plan provides that amounts deferred may be allocated to
(i) a cash account upon which amounts deferred may earn interest, compounded
quarterly, at the base rate of Citibank, N.A. in effect on certain specified
dates, (ii) a market value account, the value of which will be based upon the
market value of Quest Diagnostics Common Stock from time to time, or (iii) a
combination of such accounts. All non-employee directors will be eligible to
participate in the plan.
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<PAGE>
Quest Diagnostics has adopted, effective the Distribution Date, a restricted
stock plan for non-employee directors, pursuant to which Quest Diagnostics
will issue to each non-employee director elected 750 shares of Quest
Diagnostics Common Stock for each year specified in the term of service for
which such director was elected, subject to forfeiture and restrictions on
transfer, and 5,000 shares upon such director's election, subject to
forfeiture and restrictions on transfer.
Committees of the Board of Directors. Prior to the Distributions, the Board
is expected to establish and designate specific functions and areas of
oversight to an Audit and Finance Committee, a Compensation Committee
("Compensation Committee") and a Compliance Committee. The Audit and Finance
Committee will examine and consider matters relating to the financial affairs
of Quest Diagnostics, including reviewing Quest Diagnostics' annual financial
statements, the scope of the independent and internal audits and the
independent auditor's letter to management concerning the effectiveness of
Quest Diagnostics' internal financial and accounting controls. The
Compensation Committee will make recommendations to the Board with respect to
programs for human resource development and management organization and
succession, determine senior executive compensation, make recommendations to
the Board with respect to compensation matters and policies and employee
benefit and incentive plans, administer such plans, and administer Quest
Diagnostics' stock option and equity based plans and grant stock options and
other rights under such plans. The Compliance Committee will oversee Quest
Diagnostics' compliance program, which is administered by management's
compliance council. The council will prepare for review and action by the
Compliance Committee reports on such matters as audits and investigations.
See "Business--Compliance Program."
Executive Officers. In addition to Mr. Freeman, the following persons will
serve as executive officers of Quest Diagnostics after the Distributions:
Robert A. Carothers (60) will become Vice President and Chief Financial
Officer at the Distribution Date. Mr. Carothers joined Corning in 1959 and
has served in a number of key financial positions in the United States and
Japan. He was elected Assistant Controller in 1991. In January 1996 he was
appointed Assistant to the President of Quest Diagnostics.
James D. Chambers (40) is Vice President-Billing. Mr. Chambers joined Corning
in 1986 and has served in a variety of managerial and financial positions for
Corning and its subsidiaries, becoming Assistant Treasurer in 1991. Mr.
Chambers joined Quest Diagnostics in 1992 as Treasurer and served as Chief
Financial Officer from 1994 through 1995. In 1995 Mr. Chambers assumed his
current responsibilities overseeing Quest Diagnostics' billing process. At
the Distribution Date, Mr. Chambers will also assume responsibility for
investor relations.
Gregory C. Critchfield, M.D. (45) is Senior Vice President, and Chief Medical
and Science Officer. Dr. Critchfield joined Quest Diagnostics in 1995 as
Chief Laboratory Officer and assumed his current responsibilities in May
1996. Dr. Critchfield has served as a consultant to the National Institutes
of Health in the capacity of a reviewer for more than ten years and was
selected as Study Section Chair of several Multidisciplinary Review Teams
during the last two years. Prior to joining Quest Diagnostics, Dr.
Critchfield was a clinical pathologist with Intermountain Health Care ("IHC")
for eight years and served in various director positions with IHC Laboratory
Services, including Director of Clinical Pathology. Dr. Critchfield also
served as Chairman of the Department of Pathology at Utah Valley Regional
Medical Center from 1994 through 1995.
Kurt R. Fischer (41) is Vice President-Human Resources. Mr. Fischer joined
Corning in 1976 and has served in a variety of Human Resources positions. He
was appointed Human Resource Manager for the Research, Development and
Engineering Group in 1986 and Director-Quality and Performance Management for
the Specialty Materials Group in 1991. Mr. Fischer assumed his present
responsibilities with Quest Diagnostics in December 1995.
Delbert A. Fisher, M.D. (68) is Vice President of Corning Nichols Institute
and currently serves as President of its Academic Associates, a select group
of eminent physicians and scientists who advise the company on new medical
and scientific developments. Dr. Fisher joined Nichols Institute in 1991 as
President of its esoteric laboratory facility and assumed his present
responsibilities in 1993. Prior to joining Nichols, he was a professor of
pediatrics and the Associate Chairman of the Department of Pediatrics of the
UCLA School of Medicine for 23 years.
Raymond Gambino, M.D. (70) is Chief Medical Officer Emeritus. Dr. Gambino
joined Quest Diagnostics in 1983 as President of the Eastern Region. From
1984 to 1994, Dr. Gambino served as Chief Medical Officer and Executive Vice
President, at which time his appointment was changed to emeritus. He
continues to serve Quest Diagnostics as a senior medical advisor.
Don M. Hardison, Jr. (45) is Senior Vice President-Sales and Marketing, with
overall responsibility for all commercial activities. Mr. Hardison joined
Quest Diagnostics in January 1996. Prior to joining Quest Diagnostics, Mr.
Hardison had 18 years experience in health care with subsidiaries of
SmithKline Beecham and its predecessor entities, including seven years with
the clinical laboratory division of SmithKline, where he held a succession of
positions including Director of Marketing; Vice President of Sales-Northern;
Vice President-General Manager of the Atlanta Operation; and Vice President
of Sales and Marketing.
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<PAGE>
Paul A. Krieger, M.D. (50) is Vice President-Anatomic Pathology. Dr. Krieger
joined Quest Diagnostics in 1975 and served as Vice President, Director of
Anatomic Pathology at Quest Diagnostics' regional laboratory in Teterboro,
New Jersey until 1995, when he was appointed to his present position.
Concurrent with his employment with Quest Diagnostics, Dr. Krieger has served
as an Adjunct Assistant Professor at the College of Physicians and Surgeons
of Columbia University.
Raymond C. Marier (51) is Vice President, Secretary and General Counsel. Mr.
Marier joined Corning's Legal Department in 1973 as an Assistant Counsel,
where he worked with a number of Corning's operating units, including its
Medical and Science Products Divisions. He has held his present position
since 1992.
C. Kim McCarthy (41) is Vice President-Compliance and Government Affairs. Ms.
McCarthy joined Quest Diagnostics in 1987 as Director of Federal Government
Affairs and Legislative Counsel. She became Vice President of Public Affairs
of Quest Diagnostics in 1992 and Senior Vice President of Corporate Affairs
in 1994. Ms. McCarthy assumed her present responsibilities in June 1996.
Alister W. Reynolds (39) is Vice President-Information Technology. Mr.
Reynolds joined Quest Diagnostics in 1982 and has served in a variety of
staff, executive and general management positions. Mr. Reynolds assumed his
current responsibilities in 1995.
Douglas M. VanOort (40) will become Senior Vice President-Operations at the
Distribution Date. Mr. VanOort joined Corning in 1982 and has served in
various finance, analysis and control positions. He became Vice President and
Chief Financial Officer of Corning's Life Sciences division in 1990, Senior
Vice President-Finance and New Business Development of Corning's Life
Sciences division in 1993 and Executive Vice President and Chief Financial
Officer of Quest Diagnostics in 1995.
Executive Compensation
Historical Compensation. The following table sets forth information with
respect to annual and long-term compensation expected to be paid by Quest
Diagnostics and its subsidiaries to each of the chief executive officer and
the four other most highly compensated executive officers (the "named
executive officers") of Quest Diagnostics for services to be rendered in all
capacities in fiscal year 1996 and such compensation paid or accrued during
the years ended December 31, 1995 and December 31, 1994 for services rendered
by each of the named executive officers. All references in the following
tables to stock and stock options relate to awards of, and options to
purchase, Corning Common Stock.
Summary Compensation Table
<TABLE>
<CAPTION>
Annual Compensation
--------------------------------------
Name and Other Annual
Principal Position Year Salary(1) Bonus(2) Compensation(3)
- ------------------------- --------- ---------- --------- ----------------
<S> <C> <C> <C> <C>
Kenneth W. Freeman, 1996 385,000 211,750 10,440
President and Chief 1995 316,667 249,918 7,200
Executive Officer 1994 240,000 244,634 6,900
Robert A. Carothers, 1996 250,000 136,714 1,800
Vice President and 1995 173,000 68,337 --
Chief Financial Officer 1994 165,250 84,180 --
Gregory C. Critchfield, 1996 310,000 182,900 40,909
Senior Vice President 1995(6) 70,000 122,920 --
and Chief Medical and
Science Officer
Don M. Hardison, Jr., 1996 260,000 159,467 2,880
Senior Vice President-
Sales and Manufacturing
Douglas M. VanOort, 1996 325,000 178,750 2,880
Senior Vice President- 1995 251,912 56,754 7,200
Operations 1994 228,333 165,969 6,900
</TABLE>
<TABLE>
<CAPTION>
Long-Term Compensation
------------------------------------
Awards Payouts
------------------------- -----------
Restricted Securities Incentive
Name and Stock Underlying Plan All Other
Principal Position Awards(4) Options Payouts Compensation(5)
- ------------------------- ------------ ------------ ----------- ---------------
<S> <C> <C> <C> <C>
Kenneth W. Freeman, -- -- -- 16,690
President and Chief 326,926 87,000 -- 14,057
Executive Officer 406,766 20,000 162,679 13,376
Robert A. Carothers, -- -- -- 8,254
Vice President and -- 16,500 -- 8,561
Chief Financial Officer -- 6,092 -- 7,557
Gregory C. Critchfield, -- 2,000 -- 65,690
Senior Vice President -- 3,000 -- 2,370
and Chief Medical and
Science Officer
Don M. Hardison, Jr., -- 24,000 -- 17,123
Senior Vice President-
Sales and Marketing
Douglas M. VanOort, -- -- -- 4,750
Senior Vice President- 98,626 60,000 -- 4,620
Operations 109,652 20,000 -- 4,178
</TABLE>
(1) Reflects for 1996 current salaries on an annualized basis, including
amounts deferred.
(2) Reflects for 1996 projected performance-based annual cash compensation
awards at target levels.
(3) Includes dividends on shares of restricted stock granted but not earned
within one year from date of grant and tax gross-up payments.
(4) Messrs. Freeman, Carothers, Hardison and VanOort held an aggregate of
97,930, 2,500, 4,000 and 43,627 shares of restricted stock of Corning,
respectively, having an aggregate value on September 30, 1996 of $3,819,270,
$97,500, $156,000 and $1,701,453, respectively. Certain of such shares, net
of forfeitures, were subject to performance-based conditions on vesting and
are subject to forfeiture upon termination and restrictions on transfer
prior to stated dates. Certain other shares ("Career Shares") are subject to
restrictions on transfer until the executive officer retires at or after age
60 and are subject to forfeiture prior to age 60 in whole if such officer
voluntarily terminates employment with Quest Diagnostics and in part if such
officer's employment is terminated by Quest Diagnostics. On or prior to the
Distribution Date (a) all forfeiture conditions and transfer restrictions
will be removed from performance based shares, (b) all restrictions on
transfer will be removed from shares which are no longer subject to
forfeiture and (c) Career Shares which
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<PAGE>
are subject to forfeiture conditions and transfer restrictions, except
for 50% of such shares held by Mr. Freeman, will be forfeited, and in
lieu thereof restricted shares and/or options to purchase shares of Quest
Diagnostics Common Stock will thereafter be granted pursuant to the terms
of the Quest Diagnostics Employee Equity Participation Plan (as defined
below). Dividends are paid to such individuals on all shares of
restricted Corning Common Stock held by them.
(5) Includes the following amounts to be contributed by Quest Diagnostics to
the Quest Diagnostics Profit Sharing Plan (as defined below) for 1996:
$3,850 for Mr. Freeman, $4,283 for Mr. Hardison and $4,750 for Mr.
VanOort. Also includes $12,840 automobile allowance received by each of
Messrs. Freeman and Hardison and $9,480 for Dr. Critchfield. Also
includes 50% of a $100,000 interest-free loan made by Quest Diagnostics
to Dr. Critchfield together with imputed interest thereon, which loan is
to be forgiven over a two-year period provided Dr. Critchfield continues
to be employed by Quest Diagnostics and was made to assist Dr.
Critchfield in relocating to the New Jersey area.
(6) Dr. Critchfield commenced employment with Quest Diagnostics in October
1995.
Option Grants. The following table sets forth certain information regarding
options granted in 1995 (except for Mr. Hardison whose options were granted on
February 7, 1996) to the named executive officers pursuant to Corning stock
option plans. No other options were granted to the named executive officers in
1996. Employees of Quest Diagnostics who hold at the Distribution Date Corning
stock options other than those granted on December 6, 1995 and February 7, 1996
will continue to hold Corning stock options following the Quest Diagnostics
Spin-Off Distribution. It is anticipated that appropriate adjustments to the
number of shares subject to options and to the exercise prices will be made to
reflect the Quest Diagnostics Spin-Off Distribution. A portion of the options
granted on December 6, 1995 and February 7, 1996 will be converted into options
to purchase shares of Quest Diagnostics Common Stock ("New Options") under the
Quest Diagnostics Stock Option Plan (as defined below). The remainder of the
options granted on December 6, 1995 and February 7, 1996 will be cancelled. It
is anticipated that such cancelled options will be replaced by options to be
granted under the Quest Diagnostics Stock Option Plan.
The exercise prices and the number of shares of Quest Diagnostics Common
Stock subject to New Options will be determined as of the time of the
Distributions so as to preserve the investment basis and intrinsic gain
associated with the Corning options surrendered as of the date of the Quest
Diagnostics Spin-Off Distribution. Generally, the expiration dates and the
dates on which New Options are exercisable will be identical to those under
the corresponding Corning options at the time of the Distributions. Certain
New Options will provide that upon exercise of such option through the
surrender of previously owned shares of Quest Diagnostics Common Stock, the
participant will be entitled to receive options covering the same number of
shares so surrendered, with an exercise price equal to the fair market value
of the shares at the time of the exercise of the New Option.
Option/SAR Grants in Fiscal Year 1995 (1)
<TABLE>
<CAPTION>
Individual Grants
----------------------------------------------------
Number of % of Total
Securities Options
Underlying Granted
Options to Employees Exercise Expiration
Name Granted(2) in Fiscal Year Price Date
------------------------------ --------------------------- --------- ------------
<S> <C> <C> <C> <C>
Kenneth W. Freeman 87,000 2.6% 31.25 12/5/2005
Robert A. Carothers 1,500 0.0% 31.75 6/7/2005
15,000 0.4% 31.25 12/5/2005
Gregory C. Critchfield 3,000 0.1% 27.50 10/3/2005
Don M. Hardison, Jr. 24,000 0.7% 33.69 2/6/2006
Douglas M. VanOort 60,000 1.8% 31.25 12/5/2005
All Optionees as a Group (4) 3,389,100 100.0% 31.34 2005
</TABLE>
<TABLE>
<CAPTION>
Potential Realizable Value at
Assumed Annual Rates of Stock
Price Appreciation for
Option Term (3)
-------------------------------------
Gain at Gain at Gain at
Name 0% (4) 5% 10%
------------------------------ --------------------- -------------
<S> <C> <C> <C>
Kenneth W. Freeman 0 1,709,807 4,332,987
Robert A. Carothers 0 29,951 75,902
0 294,794 747,067
Gregory C. Critchfield 0 51,884 131,484
Don M. Hardison, Jr. 0 508,499 1,288,636
Douglas M. VanOort 0 1,179,177 2,988,267
All Optionees as a Group (4) 0 66,797,662 169,278,390
</TABLE>
(1) No SARs were granted.
(2) The stock option agreements with Messrs. Freeman, Carothers (with respect
to the 15,000 share grant), Hardison and VanOort provide that one-half of
the options will become exercisable on February 1, 1999 and all options
will become exercisable on February 1, 2000. The stock option agreement
with Dr. Critchfield provides that one-half of the options will become
exercisable on October 4, 1996 and all of the options will become
exercisable on October 4, 1997. The stock option agreement with Mr.
Carothers with respect to the 1,500 share grant provides that one-half of
the options became exercisable on June 6, 1996 and all of the options
will become exercisable on June 6, 1997. All such agreements also provide
that an additional option may be granted when the optionee uses shares of
Corning Common Stock to pay the purchase price of an option. The
additional option will be exercisable for the number of shares tendered
in payment of the
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<PAGE>
option price, will be exercisable at the then fair market value of the
Corning Common Stock, will become exercisable only after the lapse of twelve
months and will expire on the expiration date of the original option.
(3) The dollar amounts set forth under these columns are the result of
calculations at 0% and at the 5% and 10% rates established by the
Commission and therefore are not intended to forecast future appreciation
of Corning Common Stock.
(4) No gain to the optionees is possible without an appreciation in stock
price, an event which will also benefit all stockholders. If the stock
price does not appreciate, the optionees will realize no benefit.
Option Exercises and Fiscal Year-End Values. The following table sets forth
the number of shares of Corning Common Stock covered by both exercisable and
unexercisable stock options as of December 31, 1995, for the named executive
officers. The named executive officers exercised no options in 1996.
Aggregated Option/SAR Exercises in Fiscal
Year 1995 and 1995 Fiscal Year-End Option/SAR Values (1)
<TABLE>
<CAPTION>
Number of Securities
Underlying Unexercised Value of Unexercised
Options at In-the-Money Options
Fiscal Year End At Fiscal Year End
------------------------------- -------------------------------
Shares Acquired Value
Name on Exercise Realized Exercisable Unexercisable Exercisable Unexercisable
- ------------------------ --------------- ----------- -------------- ---------------- -------------- ----------------
<S> <C> <C> <C> <C> <C> <C>
Kenneth W. Freeman 0 0 103,500 127,000 827,784 107,500
Robert A. Carothers 0 0 12,483 15,749 0 0
Gregory C. Critchfield 0 0 0 5,000 0 10,688
Don M. Hardison, Jr. -- -- -- -- -- --
Douglas M. VanOort 0 0 11,500 88,000 19,729 55,750
</TABLE>
(1) There are no SARs outstanding.
Corporate Performance Plan Activity. Awards of performance-based shares of
Corning Common Stock have been granted to Quest Diagnostics' executive
officers pursuant to a series of performance-based plans (the "Corporate
Performance Plan"). The Corporate Performance Plan provides the mechanisms to
reward improvement in corporate performance as measured by net income,
earnings per share and/or return on equity. Each year minimum, target and
maximum goals are set and shares awarded (at target levels) which are subject
to forfeiture in whole or in part if performance goals are not met. The
percentage of awards that may be earned ranges from 0% to 150% of target.
Shares earned remain subject to forfeiture and restrictions on transfer for
two years following the end of the performance period.
The following table sets forth the number of performance-based shares awarded
under the Corporate Performance Plan. The dollar value of shares earned for
1995 is reflected in the "Restricted Stock Awards" column of the Summary
Compensation Table.
In late 1996, the Compensation Committee of the board of directors of Corning
(the "Corning Board") will assess performance against goals, determine the
number of shares earned of those granted on December 6, 1995 and February 7,
1996 and remove all possibility of forfeiture and restrictions on transfer
from such shares.
Corporate Performance Plan Activity Table
<TABLE>
<CAPTION>
Number Number Number
Grant of Shares Performance of Shares of Shares Vesting Date of
Name Year Date Granted Period Forfeited Earned Earned Shares
- ------------------------ ------ ------------------ ------------- ------------ ----------- ---------------
<S> <C> <C> <C> <C> <C> <C> <C>
Kenneth W. Freeman 1996 12/95 14,500 1996 2/99
1995 12/94 10,000 1995 10,740 2/98
1994 12/93 10,000 1994 14,690 2/97
Robert A. Carothers 1996 12/95 2,500 1996 2/99
1995 0
1994 0
Gregory C. Critchfield 1996 0
1995 0
Don M. Hardison, Jr. 1996 2/96 4,000 1996 2/99
Douglas M. VanOort 1996 12/95 10,000 1996 2/99
1995 12/94 10,000 1995 6,760 3,240 2/98
1994 12/93 4,000 1994 40 3,960 2/97
</TABLE>
70
<PAGE>
Variable Compensation. Quest Diagnostics has adopted, effective upon the
Distributions, a variable compensation plan (the "Plan"), an annual incentive
cash compensation plan for approximately 950 supervisory, management and
executive employees similar to an annual performance plan currently maintained
by Quest Diagnostics. The terms of the Plan are as follows.
The performance-based annual cash incentive awards payable under the Plan will
be grounded in financial goals such as net income, cash flow, operating margin,
return on equity, or earnings per share, or a combination thereof, and
quantifiable non-financial goals. Each participant will be assigned a target
award, as a percentage of base salary in effect at the end of the performance
year for which the target is set, payable if the target is achieved. Actual
results will be compared to the scale of targets with each gradation of desired
result corresponding to a percentage, which will be multiplied by the employee's
assigned target award. If the actual result is below target, awards will be less
than target, down to a point below which no awards are earned. If the desired
result is above target, awards will be greater than target, up to a stated
maximum award. The maximum award assigned to the chief executive officer may not
exceed 200% of base salary in effect on the date the Compensation Committee sets
the target for the performance year. The Compensation Committee retains the
right to reduce any award if it believes individual performance does not warrant
the award calculated by reference to the result.
Employee Equity Participation Program. Quest Diagnostics has adopted, effective
upon the Distributions, the Employee Equity Participation Program (the
"Program") consisting of two plans: (a) a stock option plan (the "Quest
Diagnostics Stock Option Plan") and (b) an incentive stock plan (the "Quest
Diagnostics Incentive Stock Plan"). The Program is designed to provide a
flexible mechanism to permit key employees of Quest Diagnostics and of any
subsidiary to obtain significant equity ownership in Quest Diagnostics, thereby
increasing their proprietary interest in the growth and success of Quest
Diagnostics.
The Program, which will be administered by the Compensation Committee, provides
for the grant to eligible employees of either non-qualified or "incentive stock"
options, or both, to purchase shares of Quest Diagnostics Common Stock at no
less than fair market value on the date of grant. The Compensation Committee may
also provide that options may not be exercised in whole or in part for any
period or periods of time; provided, however, that no option will be exercisable
until at least twelve months from the date of grant. All options shall expire
not more than ten years from the date of grant. Options will not be assignable
or transferable except for limited circumstances on death. During the lifetime
of the employee an option may be exercised only by him. The option price is
payable upon exercise. The optionee may pay the option price in cash or with
shares of Quest Diagnostics Common Stock owned by him. The optionee will have no
rights as a stockholder with respect to the shares subject to option until
shares are issued upon exercise of the option. The Compensation Committee may
grant options pursuant to which an optionee who uses shares of Quest Diagnostics
Common Stock to pay the purchase price of an option will receive automatically
on the date of exercise an additional option to purchase shares of Quest
Diagnostics Common Stock. Such additional option will cover the number of shares
tendered in payment of the option price, will be exercisable at the then fair
market value of Quest Diagnostics Common Stock, will become exercisable only
after the lapse of twelve months and will expire no later than the expiration
date of the original option.
The Program also authorizes the Compensation Committee to award to eligible
employees shares, or the right to receive shares, of Quest Diagnostics Common
Stock, the equivalent value in cash or a combination thereof (as determined by
the Compensation Committee). The Compensation Committee shall determine the
number of shares which are to be awarded to individual employees and the number
of rights covering shares to be issued upon attainment of predetermined
performance objectives for specified periods. The shares awarded directly to
individual employees may be made subject to certain restrictions prohibiting
sale or other disposition and may be made subject to forfeiture in certain
events. Shares may be issued to recognize past performance either generally or
upon attainment of specific objectives. Shares issuable for performance (based
upon specific predetermined objectives) will be payable only to the extent that
the Compensation Committee determines that an eligible employee has met such
objectives and will be valued as of the date of such determination. Upon
issuance, such shares may (but need not) be made subject to the possibility of
forfeiture or certain restrictions on transfer.
Key executive, managerial and technical employees (including officers and
employees who are directors) of Quest Diagnostics and of any subsidiary will be
eligible to participate in the Program and the plans thereunder. The selection
of employees eligible to participate in any plan under the Program is within the
discretion of the Compensation Committee. Approximately 150 employees would have
been eligible to participate in the plans under the Program had the Program been
in effect in 1996.
Under the Program, the maximum number of shares of Quest Diagnostics Common
Stock which may be optioned or granted to eligible employees will be 3,000,000.
Shares from expired or terminated options under the Quest Diagnostics Stock
Option Plan will be available again for option grant under the Program. Shares
which are issued but not earned, or which are forfeited under
71
<PAGE>
the Quest Diagnostics Incentive Stock Plan, will be available again for issuance
under the Program. The Program provides for appropriate adjustments in the
aggregate number of shares subject to the Program and in the number of shares
and the price per share, or either, of outstanding options in the case of
changes in the capital stock of Quest Diagnostics resulting from any
recapitalization, stock or unusual cash dividend, stock distribution, stock
split or any other increase or decrease effected without receipt of
consideration by Quest Diagnostics, or a merger or consolidation in which Quest
Diagnostics is the surviving corporation.
The Program has a term of five years and no shares may be optioned or awarded
and no rights to receive shares may be granted after the expiration of the
Program. The Board is authorized to terminate or amend the Program, except
that it may not increase the number of shares available thereunder, decrease
the price at which options may be granted, change the class of employees
eligible to participate, or extend the term of the Program or options granted
thereunder without the approval of the holders of a majority of the
outstanding shares of Quest Diagnostics Common Stock.
Quest Diagnostics believes that the federal income tax consequences of the
Program are as follows. An optionee who exercises a non-qualified option granted
under the Quest Diagnostics Stock Option Plan will recognize compensation
taxable as ordinary income (subject to withholding) in an amount equal to the
difference between the option price and the fair market value of the shares on
the date of exercise and Quest Diagnostics or the subsidiary employing the
optionee will be entitled to a deduction from income in the same amount. The
optionee's basis in such shares will be increased by the amount taxable as
compensation, and his capital gain or loss when he disposes of the shares will
be calculated using such increased basis.
If all applicable requirements of the Code with respect to incentive stock
options are met, no income to the optionee will be recognized and no deduction
will be allowable to Quest Diagnostics at the time of the grant or exercise of
an incentive stock option. The excess of the fair market value of the shares at
the time of exercise of an incentive stock option over the amount paid is an
item of tax preference which may be subject to the alternative minimum tax. In
general, if an incentive stock option is exercised three months or more after
termination of employment, the optionee will recognize ordinary income in an
amount equal to the difference between the option price and the fair market
value of the shares on the date of exercise and Quest Diagnostics or the
subsidiary employing the optionee will be entitled to a deduction in the same
amount. If the shares acquired subject to the option are sold within one year of
the date of exercise or two years from the date of grant, the optionee will
recognize ordinary income in an amount equal to the difference between the
option price and the lesser of the fair market value of the shares on the date
of exercise or the sale price and Quest Diagnostics or the employing subsidiary
will be entitled to a deduction from income in the same amount. Any excess of
the sale price over the fair market value on the date of exercise will be taxed
as a capital gain.
Shares of Quest Diagnostics Common Stock which are not subject to restrictions
and possibility of forfeiture and which are awarded to an employee under the
Quest Diagnostics Incentive Stock Plan will be treated as ordinary income,
subject to withholding, to an employee at the time of the transfer of the shares
to him and the value of such awards will be deductible by Quest Diagnostics or
by the subsidiary employing the employee at the same time in the same amount.
Shares granted subject to restrictions and possibility of forfeiture will not be
subject to tax nor will such grant result in a tax deduction for Quest
Diagnostics at the time of award. However, when such shares become free of
restrictions and possibility of forfeiture, the fair market value of such shares
at that time (i) will be treated as ordinary income to the employee and (ii)
will be deductible by Quest Diagnostics or by the subsidiary employing the
employee.
The tax treatment upon disposition of shares acquired under the Program will
depend upon how long the shares have been held and on whether or not the shares
were acquired by exercising an incentive stock option. There are no tax
consequences to Quest Diagnostics upon a participant's disposition of shares
acquired under the Program, except that Quest Diagnostics may take a deduction
equal to the amount the participant must recognize as ordinary income in the
case of the disposition of shares acquired under incentive stock options before
the applicable holding period has been satisfied.
Pension Plans. None of the executive officers of Quest Diagnostics is currently
an active participant in a qualified defined benefit plan of Quest Diagnostics.
Prior to June 1, 1995, December 1, 1996 and January 1, 1995, respectively,
Messrs. Freeman, Carothers and VanOort were eligible to participate in, and
accrue benefits under, Corning's Salaried Pension Plan (the "Corning Salaried
Pension Plan"), a defined benefit plan, contributions to which are determined
by Corning's actuaries and are not made on an individual basis. Benefits paid
under this plan are based upon career earnings (regular salary and cash
awards paid under Corning's variable compensation plans) and years of
credited service. The Corning Salaried Pension Plan provides that salaried
employees of Corning who retire on or after December 31, 1993 will receive
pension benefits equal to the greater of (a) benefits provided by a formula
pursuant to which they shall receive for each year of credited service an
amount equal to 1.5% of annual earnings up to the social security wage base
and 2% of annual earnings in excess of such base or (b) benefits calculated
pursuant to a formula which provides that retirees will receive for each year
of credited service prior to January 1, 1994 an amount equal to 1%
72
<PAGE>
of the first $24,000 of average earnings for the highest five consecutive years
of annual earnings in the ten years of credited service immediately prior to
1994 and 1.5% of such average earnings in excess of $24,000. Effective upon
commencement of employment, salaried employees may contribute to the Corning
Salaried Pension Plan 2% of their annual earnings up to the social security wage
base. Such employees will receive for each year of credited service after
December 31, 1990, in lieu of the amount described in (a) above, an amount equal
to 2% of annual earnings. The benefit formula is reviewed and adjusted
periodically for inflationary and other factors.
Corning maintains a non-qualified Executive Supplemental Pension Plan (the
"Executive Supplemental Plan") pursuant to which it will pay to certain
executives amounts approximately equal to the difference between the benefits
provided for under the Corning Salaried Pension Plan and benefits which would
have been payable thereunder but for the provisions of the Employee Retirement
Income Security Act of 1974, as amended ("ERISA").
It is anticipated that, prior to the Distribution Date, the Compensation
Committee of the Corning Board will adopt a transferee supplemental pension plan
(the "Transferee Supplemental Plan"), a nonqualified, unfunded defined benefit
plan for the benefit of key employees and executive officers of Quest
Diagnostics who are former employees of Corning, including Messrs. Freeman and
VanOort, effective immediately after the Distribution Date. The Transferee
Supplemental Plan will provide benefits approximately equal to the difference
between the benefits provided for under the Corning Salaried Pension Plan and
the Executive Supplemental Plan and benefits which would have been payable
thereunder but for the termination of employment with Corning of such employees.
Maximum annual benefits calculated under the straight life annuity option form
of pension payable to participants at age 65, the normal retirement age
specified in the Corning Salaried Pension Plan, are illustrated in the table set
forth below. The table below does not reflect any limitations on benefits
imposed by ERISA. It is estimated that Messrs. Freeman and VanOort, who have 25
and 15 years of credited service, respectively, would receive each year if they
worked to age 65, the normal retirement age specified in the Corning Salaried
Pension Plan, $256,170 and $165,332, respectively, under the Corning Salaried
Pension Plan, the Executive Supplemental Plan and the Transferee Supplemental
Plan.
<TABLE>
<CAPTION>
Years of Service
----------------------------------------------------------------
Remuneration 15 20 25 30 35 40
- ------------ --------- --------- --------- --------- --------- ----------
<S> <C> <C> <C> <C> <C> <C>
$ 100,000 20,500 27,300 34,100 41,000 47,800 55,300
200,000 43,000 57,300 71,600 86,000 100,300 115,300
300,000 65,500 87,300 109,100 131,000 152,800 175,300
400,000 88,000 117,300 146,600 176,000 205,300 235,300
500,000 110,500 147,300 184,100 221,000 257,800 295,300
600,000 133,000 177,300 221,600 266,000 310,300 355,300
700,000 155,500 207,300 259,100 311,000 362,800 415,300
800,000 178,000 237,300 296,600 356,000 415,300 475,300
900,000 200,500 267,300 334,100 401,000 467,800 535,300
1,000,000 223,000 297,300 371,600 446,000 520,300 595,300
1,100,000 245,500 327,300 409,100 491,000 572,800 655,300
1,200,000 268,000 357,300 446,600 536,000 625,300 715,300
</TABLE>
Quest Diagnostics Profit Sharing Plan. Most of the employees of Quest
Diagnostics and its subsidiaries have been eligible to participate in a
tax-qualified, defined contribution plan known as the Quest Diagnostics Profit
Sharing Plan (the "Quest Diagnostics Profit Sharing Plan"), which provides for
investment of employee contributions, including tax-deferred contributions under
Section 401(k) of the Code, and matching contributions made by their employers,
in several investment funds, including Corning Common Stock, at the employees'
discretion. Effective as of the Distribution Date, Quest Diagnostics Common
Stock will be added as an investment fund and a portion of the employer matching
contributions will automatically be invested in Quest Diagnostics Common Stock.
Corning Common Stock will no longer be available as an investment fund except
with respect to amounts already so invested under the Quest Diagnostics Profit
Sharing Plan.
Effective as of the Distribution Date, the Quest Diagnostics Profit Sharing Plan
will be amended to permit participating employees' employers to make
discretionary contributions, other than matching contributions, to the Quest
Diagnostics Profit Sharing Plan for the benefit of such employees, which
contributions may be invested in Quest Diagnostics Common Stock.
Quest Diagnostics Employee Stock Ownership Plan. Quest Diagnostics has adopted,
effective upon the Distributions, an employee stock ownership plan, as defined
in Section 4975(e)(7) of the Code and related regulations and intended to
qualify as a retirement plan under Section 401(a) of the Code, to be known as
the Quest Diagnostics Employee Stock Ownership Plan (the "Quest Diagnostics
ESOP").
73
<PAGE>
Shares of Quest Diagnostics Common Stock will be credited under the Quest
Diagnostics ESOP for the account of all active regular employees of Quest
Diagnostics and its domestic wholly owned subsidiaries as of the Distribution
Date, with 50 shares being credited for all full time employees (employees who
are regularly scheduled to work 30 hours or more a week) and 25 shares being
credited for all part time employees. Approximately 900,000 shares of Quest
Diagnostics Common Stock are expected to be issued under the ESOP.
Amounts contributed to the Quest Diagnostics ESOP for the benefit of
participating employees will be 100% vested at age 65, the normal retirement age
specified in the Quest Diagnostics ESOP, or at death, disability or termination
of employment following completion of two years of credited service.
Contributions to the Quest Diagnostics ESOP will not currently be taxable income
to the participating employees and will not generally be available to them until
termination of employment.
Employee Stock Purchase Plan. Quest Diagnostics has adopted, as of the
Distribution Date, the Employee Stock Purchase Plan (the "Quest Diagnostics
Stock Purchase Plan"), pursuant to which Quest Diagnostics may make available
for sale to employees shares of its Common Stock at a price equal to 85% of the
market value on the first or last day of each calendar quarter, whichever is
lower.
The Quest Diagnostics Stock Purchase Plan, which will be administered by the
Compensation Committee, is designed to give eligible employees (generally,
employees of Quest Diagnostics and its subsidiaries) the opportunity to purchase
shares of Quest Diagnostics Common Stock through payroll deductions up to 10% of
compensation in a series of quarterly offerings commencing January 1, 1997, and
ending no later than December 31, 2001.
Any eligible employee may elect to participate in the Quest Diagnostics Stock
Purchase Plan on a quarterly basis and may terminate his payroll deduction at
any time or increase or reduce prospectively the amount of his deduction at the
beginning of any calendar quarter. At the end of each calendar quarter, a
participating employee will purchase shares of Quest Diagnostics Common Stock
with the funds deducted. The number of shares purchased will be a number
determined by dividing the amount withheld by the lower of 85% of the closing
price of a share of Quest Diagnostics Common Stock as reported in The Wall
Street Journal on the first or last business day of the particular calendar
quarter. An employee will have no interest in any shares of Quest Diagnostics
Common Stock until such shares are actually purchased by him.
Under the Quest Diagnostics Stock Purchase Plan, the maximum number of shares of
Quest Diagnostics Common Stock which may be purchased by eligible employees will
be 2,000,000 shares, subject to adjustment in the case of changes in the capital
stock of Quest Diagnostics resulting from any recapitalization, stock dividend,
stock split or any other increase or decrease effected without receipt of
consideration by Quest Diagnostics.
The Quest Diagnostics Stock Purchase Plan has a term of five years and no shares
of Quest Diagnostics Common Stock may be offered for sale or sold under the
Quest Diagnostics Stock Purchase Plan after the fifth anniversary of the
effective date. The Board is authorized to terminate or amend the Quest
Diagnostics Stock Purchase Plan, except that it may not increase the number of
shares of Quest Diagnostics Common Stock available thereunder, decrease the
price at which such shares may be offered for sale or change the designation of
subsidiaries eligible to participate in the plan without the approval of the
holders of a majority of the shares of the capital stock of Quest Diagnostics
cast at a meeting at which such matter is considered.
Employment Agreements; Severance Arrangements. It is anticipated that Mr.
Freeman will enter into an employment agreement with Quest Diagnostics. The
agreement will expire on or before December 31, 1999. The agreement will
include provisions for an annual salary of no less than $500,000, with
increases subject to the discretion of the Quest Diagnostics Board; annual
target participation in the Variable Compensation Plan of Quest Diagnostics
in amounts no less than 65% of annual salary in effect at the time
performance goals are established; and severance payments following a
termination by Mr. Freeman for "Good Reason" or by Quest Diagnostics, without
cause in accordance with the severance policy described below, except that
Mr. Freeman will receive three times his base annual salary and three times
his annual award of variable compensation. "Good Reason" is defined as
assignment of Mr. Freeman without his consent to mutually inconsistent duties
or responsibilities, a failure to re-elect Mr. Freeman to the position of
President and Chief Executive Officer, a greater than 75 mile office
relocation without his consent and a Change of Control (as detailed in the
next paragraph). The agreement will also include provision for reimbursement
of up to $10,000 per month until the earlier of Mr. Freeman's obtaining
suitable housing in the New York metropolitan area or June 30, 1998;
eligibility for a $400,000 interest-free relocation loan to be forgiven over
a five-year period; and, in the event the agreement is not renewed upon its
expiration, a payment equal to two times the highest annual cash compensation
paid to Mr. Freeman during the term of the agreement and health benefits for
eighteen months following expiration of the agreement. Mr. Freeman will also
be entitled under the agreement to a retirement pension benefit equivalent to
benefits under the Corning Salaried Pension Plan and the Executive
Supplemental Plan based on not less than 34 years of credited service in the
event of termination for reasons other than cause. Mr. Freeman's pension
benefits will be initially secured by a $5.4 million letter of credit (such
amount based on initial assumptions for pricing pension benefits) issued
under the Credit Facility.
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<PAGE>
On or before the Distribution Date, Quest Diagnostics will adopt a severance
policy pursuant to which it will provide to each executive officer other than
Mr. Freeman and Drs. Fisher and Gambino upon the termination of employment by
Quest Diagnostics, other than for cause upon a determination that the business
needs of Quest Diagnostics require the replacement of such executive officer and
other than in connection with a change of control, compensation equal to two
times the executive officer's base annual salary at the annual rate in effect on
the date of termination and two times the annual award of variable compensation
at the most recent target level. Such executive officer will also be entitled to
participate in Quest Diagnostics' health and benefits plans (to the extent
permitted by the administrative provisions of such plans and applicable federal
and state law) for a period of up to two years or until such officer is covered
by a successor employer's benefit plans, whichever first occurs. Pursuant to
such policy, upon a change of control Quest Diagnostics will provide to each
such executive officer upon the termination of employment by Quest Diagnostics,
other than for cause during the twelve months following a change in control,
compensation equal to three times annual base salary and three times the award
of annual variable compensation at the most recent target level and such officer
will be entitled to participate in Quest Diagnostics' health and benefit plans
for a period of up to three years or until such officer is covered by a
successor employer's benefits plans, whichever first occurs (to the extent
permitted by the administrative provisions of such plans and applicable federal
and state law). A "Change in Control" is defined in the policy to include the
following: the acquisition by a person of 20% or more of the voting stock of
Quest Diagnostics; the membership of the Board changes as a result of a
contested election such that a majority of the Board members at any particular
time were initially placed on the Board as a result of such contested election;
or approval by Quest Diagnostics' stockholders of a merger or consolidation in
which Quest Diagnostics is not the survivor thereof, or a sale or disposition of
all or substantially all of Quest Diagnostics' assets or a plan of partial or
complete liquidation.
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<PAGE>
Security Ownership by Certain Beneficial
Owners and Management
All of the outstanding shares of Quest Diagnostics Common Stock are currently
held by Corning. The following table sets forth the number of shares of Quest
Diagnostics Common Stock that are projected to be beneficially owned after the
Quest Diagnostics Spin-Off Distribution by the directors, by the named executive
officers and by all directors and executive officers of Quest Diagnostics as a
group. The projections are based on the number of shares of Corning Common Stock
held by such persons and such group as of October 31, 1996 (including certain
restricted shares that may be forfeited prior to the Distribution Date but
excluding Career Shares that will not receive the Distributions and Corning
Common Stock held in the Quest Diagnostics Profit Sharing Plan and the Corning
Investment Plans) and on the number of options to acquire Corning Common Stock
held as of such date and exercisable within 60 days thereof. With respect to the
shares of Quest Diagnostics Common Stock, the number reflects the distribution
ratio of one share of Quest Diagnostics Common Stock for every eight shares of
Corning Common Stock and with respect to options the number reflects the actual
number of shares of Corning Common Stock subject to options. The stock options
held by the directors and executive officers of Quest Diagnostics will not
affect the security ownership of Quest Diagnostics unless (i) such options are
exercised prior to the Record Date and the underlying shares of Corning Common
Stock are held on the Record Date or (ii) such options are converted into
options to purchase shares of Quest Diagnostics Common Stock.
<TABLE>
<CAPTION>
Number of Shares
Beneficially Number of
Name Owned(1) Exercisable Options
---------------------------- -------------------- ---------------------
<S> <C> <C>
Van C. Campbell 17,850 (2) 127,457
Robert A. Carothers 316 12,483
Gregory C. Critchfield 0 1,500
David A. Duke 10,878 (2) 82,000
Kenneth W. Freeman 14,461 103,500
Don M. Hardison, Jr. 500 0
Douglas M. VanOort 5,965 11,500
Gail R. Wilensky 5,000 (2) 0
All Directors and Executive
Officers as a Group 66,280 398,562
</TABLE>
(1) Does not include 3,954 shares owned by the spouses and minor children of
certain executive officers and directors as to which such officers and
directors (or trusts of which families of such executive officers are
beneficiaries) disclaim beneficial ownership.
(2) Includes 5,000 shares of Quest Diagnostics Common Stock which each
non-employee director will receive in connection with their election but
does not include 750 shares of Quest Diagnostics Common Stock for each
year specified in the term of service as a director. See
"Management--Management--Directors' Compensation."
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<PAGE>
Description of the Credit Facility
In order to pay approximately $350 million of the Intercompany Debt owed by
Quest Diagnostics in connection with the Quest Diagnostics Spin-Off
Distribution, and to meet its future capital requirements including the funding
of operating activities and further acquisitions, Quest Diagnostics entered into
a credit agreement (the "Credit Agreement") with several banks providing for a
$450 million credit facility (the "Credit Facility"). Morgan Guaranty Trust
Company of New York ("Morgan"), NationsBank, N.A. ("NationsBank") and Wachovia
Bank of Georgia, N.A. ("Wachovia") arranged the Credit Facility. A copy of the
proposed form of the Credit Agreement has been filed as an exhibit to the
Registration Statement of which this Prospectus forms a part. This summary of
the material terms and conditions of the Credit Facility and the Credit
Agreement does not purport to be complete, and is qualified in its entirety by
references to such proposed form, including the definitions therein.
The $450 million commitment under the Credit Facility is comprised of three
sub-facilities: (i) a $300 million six-year amortizing term loan (the "Tranche A
Loan"), (ii) a seven-year $50 million term loan with minimal amortization until
the seventh year (the "Tranche B Loan") and (iii) a $100 million six-year
revolving working capital credit facility (the "Working Capital Facility").
Under the Working Capital Facility, up to $20 million may be used for Letters of
Credit to be issued by one or more Issuing Banks (initially NationsBank), and up
to $10 million may be used to borrow from Wachovia, as the Swingline Bank, under
a Swingline Facility. All Working Capital Banks are required to ratably share
the exposure of the Issuing Banks under the Letters of Credit and, at the
request of the Swingline Bank, must purchase ratable participations in the
Swingline Loans. With the exception of Swingline borrowings and Letters of
Credit, borrowings under the Working Capital Facility must be at least $10
million for LIBOR based borrowings and $5 million for Base Rate based
borrowings. Under the Swingline Facility, borrowings must be at least $1
million. The Credit Facility is secured by substantially all accounts receivable
of Quest Diagnostics and by a guaranty from, and a pledge of all capital stock
and accounts receivable (including intercompany loans) of, substantially all of
Quest Diagnostics' present and future material U.S. Subsidiaries, excluding
certain Joint Ventures, Covance and Covance's Subsidiaries. The borrowings under
the Credit Facility will rank senior in priority of repayment to any Permitted
Subordinated Debt, including the Senior Subordinated Notes and any of Quest
Diagnostics' remaining debt to Corning. At the time of the Distributions, Quest
Diagnostics' debt to Corning must be extinguished except to the extent it is
included in the $150 million of Permitted Subordinated Debt.
Interest Rate Calculations. Interest is payable on each sub-facility
quarterly, or at the end of the relevant interest period, if earlier, at a
per annum rate equal to the Base Rate or (except for Swingline Loans) the
Eurodollar Rate plus the relevant Applicable Margin. The Base Rate is a
fluctuating rate calculated on a daily basis as the higher of (a) the rate of
interest publicly announced by Morgan for the day in question and (b) 0.5%
over the weighted average of the rates, rounded up to the nearest basis
point, on overnight Federal Funds transactions with members of the Federal
Reserve System as arranged by Federal Funds brokers on the day in question.
The Eurodollar Rate is the average of the annual rate at which deposits in
U.S. dollars are offered to each of the Reference Banks in the London
interbank market, adjusted for reserve requirements ("Adjusted LIBOR"). The
initial Applicable Margin payable for Adjusted LIBOR borrowings will be 1.75%
per annum for the Tranche A Loan and the Working Capital Loan and 2.25% per
annum for the Tranche B Loan. The initial Applicable Margin payable for Base
Rate borrowings will be 0.75% per annum for the Tranche A Loan and the
Working Capital Loan and 1.25% per annum for the Tranche B Loan. After
December 31, 1996, the Applicable Margin will be determined by a pricing
formula based on Quest Diagnostics' Debt Coverage Ratio. The Applicable
Margin range for the Tranche A Loan and the Working Capital Loan may vary,
depending on the Debt Coverage Ratio, from 0% to 1% for Base Rate Advances,
and from 0.5% to 2% per annum for Eurodollar Rate Advances. The Swingline
Loans will accrue interest at a rate equal to the Base Rate plus the relevant
Applicable Margin for the Tranche A and Working Capital Base Rate Loans. The
Applicable Margin for the Tranche B Loan will remain fixed throughout the
life of the loan at the initial Applicable Margin levels. Any overdue
principal or interest payable on any Eurodollar loan will incur interest at
the greater of Adjusted LIBOR or LIBOR plus the Applicable Margin plus 2% per
annum. Any overdue principal or interest payable on a Base Rate loan will
incur interest at the Base Rate plus the Applicable Margin plus 2% per annum.
The Credit Agreement also requires the payment of a quarterly Commitment Fee
on the average daily unused portion of the Banks' aggregate commitments under
the Working Capital Facility. The initial Commitment Fee Rate will be 0.375%
per annum. After December 31, 1996, the Commitment Fee Rate will be
determined based on Quest Diagnostics' Debt Coverage Ratio, and will range
from 0.175% to 0.5% per annum.
Quest Diagnostics shall also pay the Issuing Banks in proportion to their
Letter of Credit Exposure a fee of 0.125% per annum on any amounts
outstanding on undrawn Letters of Credit. Additionally, Quest Diagnostics
shall pay directly to the Issuing Bank all customary fees connected with the
issuing of a Letter of Credit.
Quest Diagnostics will also pay Morgan a negotiated fee for its services as
Administrative Agent under the Credit Facility.
Covenants and Conditions. The Credit Agreement includes covenants which,
subject to certain specific exceptions and limitations, require Quest
Diagnostics and its Subsidiaries to: (i) provide certain financial
information to the Banks including, Quest Diagnostics' consolidated audited
financial reports, financial ratio data, annual business plans and
projections and certification that no defaults have occurred; (ii) pay or
discharge all material obligations and liabilities; (iii) keep property in
good working order and maintain sufficient insurance cover-
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age on all property; (iv) maintain corporate existence; (v) pursue the same or
substantially similar lines of business to the ones in which they are currently
engaged; (vi) comply with all laws, including ERISA and environmental
regulations; (vii) allow any Bank to inspect accounting records; (viii) not
permit modification to or waiver of any Transaction Documents including any
documents connected with the Permitted Subordinated Debt or the Permitted
Preferred Stock; (ix) not hold or acquire any investments other than those
allowed by the Credit Agreement; (x) not create or allow to be created any liens
other than those permitted by the Credit Agreement; (xi) refrain from engaging
in a consolidation, acquisition, merger or sale of assets except as allowed in
the Credit Agreement; (xii) not engage in any transaction with or for the
benefit of any Affiliate other than certain arm's-length transactions; (xiii)
prevent the existence of any agreement that prevents Quest Diagnostics'
Subsidiaries from paying dividends or other distributions on capital stock;
(xiv) refrain from making certain Restricted Payments as detailed below; (xv)
not incur Debt other than Debt allowed under the Credit Agreement; (xvi)
maintain certain financial ratios as detailed below; and (xvii) not make
Consolidated Capital Expenditures in excess of $95,000,000 (less the
consideration paid for certain acquisitions) in any fiscal year.
Quest Diagnostics may, subject to certain limitations and exceptions contained
in the Credit Agreement, make certain Restricted Payments so long as there are
no current or continuing Defaults, and the otherwise Restricted Payment would
not cause a Default. Allowed payments include: (i) the repayment of Permitted
Subordinated Debt from the proceeds of any newly issued Senior Subordinated
Notes, (ii) interest and fees on the Senior Subordinated Notes and certain other
Permitted Subordinated Debt, (iii) dividends paid on any Permitted Preferred
Stock, (iv) repurchases of shares pursuant to certain employee benefit and
compensation plans and (v) certain payments to Corning required to be made
pursuant to the Spin-Off Transactions. Restricted Payments include: (i) any
other dividends or distributions on any of the shares of capital stock of Quest
Diagnostics except dividends or distributions paid solely in shares of Quest
Diagnostics capital stock, (ii) any other payment on Subordinated Debt and (iii)
any payment, including those to sinking funds, made to redeem, repurchase,
acquire or retire any of the Subordinated Debt or the shares of capital stock,
or the rights to acquire shares, of Quest Diagnostics or its Subsidiaries.
Quest Diagnostics will be required to maintain: (i) a ratio (the "Leverage
Ratio") of (A) Consolidated Total Debt to (B) Consolidated Total Capitalization
equal to or below between 0.55 to 1.0 at the outset, decreasing over time to
0.45 to 1.0; (ii) a ratio (the "Debt Coverage Ratio") of (A) Consolidated Total
Debt to (B) Consolidated EBITDA equal to or below between 3.8 to 1.0 at the
outset, increasing over time to 2.0 to 1.0; and (iii) a ratio (the "Coverage
Ratio") of (A) the sum of (1) Consolidated EBITDA and (2) Consolidated Rental
Expense to (B) the sum of (1) Consolidated Interest Expense and (2) Consolidated
Rental Expense equal to or above 1.8 to 1.0 at the outset, increasing over time
to 3.0 to 1.0. Quest Diagnostics is required to have a Leverage Ratio no greater
than 0.55 to 1.0 through December 31, 1997, a Debt Coverage Ratio of less than
3.8 to 1.0 through June 30, 1997 and a Coverage Ratio of at least 1.8 to 1.0
from January 1, 1997 through June 30, 1997. After giving pro forma effect to the
Distributions, $350 million of borrowings under the Credit Facility and to the
Permitted Subordinated Debt, Quest Diagnostics would have had a Leverage Ratio
of 0.47 to 1.0 at September 30, 1996, a Debt Coverage Ratio of 3.2 to 1.0 for
the quarter ended September 30, 1996 and a Coverage Ratio of 2.2 to 1.0 for the
quarter ended September 30, 1996.
Events of Default. Events of Default include: (i) the failure to make payment
under the Credit Agreement of any principal when due or any interest, fees or
other amounts within three business days after becoming due; (ii) any
representation, warranty, certification or statement made by Quest Diagnostics
proving to have been incorrect in any material respect when made; (iii) the
failure by Quest Diagnostics or its Subsidiaries to perform or observe any term,
covenant or agreement under the Credit Agreement (subject to certain cure
periods); (iv) the failure of Quest Diagnostics to make payment on any Material
Financial Obligation (totalling in aggregate more than $10 million) within the
applicable grace period; (v) the occurrence of an event that causes the
acceleration of, or enables another of Quest Diagnostics' creditors to
accelerate, any of Quest Diagnostics' other Material Debt (totalling in
aggregate more than $10 million); (vi) the commencement of a voluntary or
involuntary bankruptcy proceeding by or against Quest Diagnostics; (vii) the
failure to pay when due ERISA obligations in excess of $10 million; (viii) the
rendering of a judgment or judgments against Quest Diagnostics the aggregate
amounts of which are in excess of $10 million and remain unsatisfied or unstayed
for more than 30 days, or the placing by a judgment creditor of a levy on the
assets of Quest Diagnostics or its Subsidiaries; (ix) at any time after the
Spin-Off, a person or group obtains beneficial ownership of 20% or more of the
common stock of Quest Diagnostics, or, during any period of 12 calendar months,
the individuals who constituted the members of the board of directors of Quest
Diagnostics on the first day of that period (together with persons whose
nominations were approved by a majority of such directors) no longer constitute
a majority of the board; or (x) any security interest that was purported to be
created by the related security documents ceases to exist or be valid.
If an Event of Default occurs and continues beyond the allowed time period
for curing the default in question, the Banks, by a vote of more than 50% of
the aggregate Commitments, may terminate their Commitments to lend to Quest
Diagnostics. The Banks may further choose, by a separate vote representing
more than 50% of the aggregate principal amount of all of the Loans, to
accelerate the outstanding principal and interest. Additionally, during an
Event of Default the Letter of Credit Participants, by a more than 50% vote
of the amount of the total outstanding of the Letter of Credit Exposure, may
require that Quest Diagnostics fully cash collateralize the outstanding
Letter of Credit Exposure. In the case of a voluntary or involuntary
bankruptcy proceeding, all credit facilities shall terminate and all
outstanding amounts shall become immediately due and payable without any
action by the Banks.
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Description of the Notes
The Notes will be issued by the Company pursuant to an Indenture, to be dated
as of December 16, 1996 (the "Indenture"), between the Company and The
Bank of New York, as trustee (the "Trustee").
The Indenture is subject to and governed by the Trust Indenture Act of 1939,
as amended. The statements under this caption relating to the Notes and the
Indenture are summaries and do not purport to be complete, and are subject
to, and are qualified in their entirety by reference to, all the provisions
of the Indenture, including the definitions therein of certain terms.
Wherever defined terms or particular sections of the Indenture are referred
to, such defined terms and sections are incorporated herein by reference. A
copy of the Indenture has been filed as an exhibit to the Registration
Statement of which this Prospectus constitutes a part. All references in this
section to the "Company" refer solely to Quest Diagnostics Incorporated, a
Delaware corporation, and not to its subsidiaries.
General
The Notes will to the extent described herein be fully and unconditionally
guaranteed by the existing Restricted Subsidiaries of the Company, and the
Company will covenant to cause any future Restricted Subsidiaries to fully
and unconditionally guarantee the Notes, in each case jointly and severally
on a senior subordinated basis (such guarantees, the "Senior Subordinated
Guarantees" and such guarantors, the "Guarantors"). The Senior Subordinated
Guarantees will be unsecured senior subordinated obligations of the
Guarantors, will be subordinate in right of payment to the prior payment in
full of all Senior Guarantees (as defined under "Senior Subordinated
Guarantees") to substantially the same extent as the Notes are subordinated
to Senior Debt and will automatically terminate if and to the extent the
related guarantees of the Credit Facility are terminated.
The Notes are effectively subordinated to all existing and future
indebtedness and other liabilities (including trade payables and capital
lease obligations) of the Company's Subsidiaries that are Unrestricted
Subsidiaries, and thus not Guarantors, and would be so subordinated to all
existing and future indebtedness of the Guarantors if the Senior Subordinated
Guarantees were avoided or subordinated in favor of the Guarantors' other
creditors. See "Risk Factors--Subordination; Ranking of the Notes as
Unsecured Obligations" and "--Fraudulent Conveyance."
The Notes will be issued only in fully registered form, without coupons, in
denominations of $1,000 and any integral multiple thereof. No service charge
will be made for any registration of transfer or exchange of Notes, but the
Company may require payment of a sum sufficient to cover any tax or other
governmental charge payable in connection therewith. (Sections 203 and 305).
Principal, Stated Maturity and Interest
The Notes will be unsecured senior subordinated obligations of the Company,
will be limited to $150.0 million aggregate principal amount and will mature
on December 15, 2006. The Notes will bear interest at the rate per annum
shown on the front cover of this Prospectus from the Closing Date or from the
most recent Interest Payment Date to which interest has been paid or provided
for, payable semi-annually on June 15 and December 15 of each year,
commencing June 15, 1997, until the principal thereof is paid or made
available for payment, to the Person in whose name the Note (or any
Predecessor Note) is registered at the close of business on the preceding
June 1 or December 1, as the case may be. Interest on the Notes will be
computed on the basis of a 360-day year of twelve 30-day months. The
principal of (and premium, if any,) and interest on the Notes will be
payable, and the transfer of Notes will be registrable, at the office or
agency of the Company in The Borough of Manhattan, The City of New York. In
addition, payment of interest may, at the option of the Company, be made by
check mailed to the address of the Person entitled thereto as it appears in
the Security Register; provided, however, that all payments of the principal
(and premium, if any) and interest on Notes the Holders of which have given
wire transfer instructions to the Company or its agent at least 10 Business
Days prior to the applicable payment date will be required to be made by wire
transfer of immediately available funds to the accounts specified by such
Holders in such instructions. (Section 301).
Optional Redemption
Except as set forth below, the Notes are not redeemable at the option of the
Company prior to December 15, 2001. On or after such date, the Notes will be
subject to redemption, in whole or in part, at the option of the Company at
any time prior to maturity, upon not less than 30 nor more than 60 days'
notice mailed to each Holder of Notes to be redeemed at his address appearing
in the Security Register, in amounts of $1,000 or an integral multiple of
$1,000, at the following Redemption Prices (expressed as percentages of
principal amount) plus accrued interest to but excluding the Redemption Date
(subject to the right of Holders of record on the relevant Regular Record
Date to receive interest due on an Interest Payment Date that is on or prior
to the Redemption Date), if redeemed during the twelve-month period beginning
on December 15 of each of the years indicated below:
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Redemption
Year Price
- ---- ----------
2001 105.3750%
2002 103.5833
2003 101.7917
2004 and thereafter 100.0000%
If less than all the Notes are to be redeemed, the particular Notes to be
redeemed will be selected not more than 60 days prior to the Redemption Date
by the Trustee, from the Outstanding Notes not previously called for
redemption, by such method as the Trustee shall deem fair and appropriate and
which may provide for the selection for redemption of portions (equal to
$1,000 or any integral multiple thereof) of the principal amount of Notes of
a denomination larger than $1,000. (Sections 1101, 1103, 1104 and 1105).
If as a result of an event outside the control of Corning, Quest Diagnostics
and Covance, the Distributions do not occur on or prior to March 31, 1997,
the Notes will be subject to redemption, as a whole and not in part, at the
option of Quest Diagnostics, on or prior to June 30, 1997, at a redemption
price equal to 101% of the principal amount of the Notes plus accrued and
unpaid interest to but excluding the Redemption Date. Notice of such
redemption will be given by notice, mailed and published, not more than 30
and not less than 15 days prior to the Redemption Date. (Section 1101).
Mandatory Redemption
Except as described below under "Repurchase at the Option of Holders--Asset
Dispositions" and "--Change of Control," the Notes will not have the benefit
of any mandatory redemption or sinking fund obligations of the Company.
Repurchase at the Option of Holders
Asset Dispositions
The Company may not make, and may not permit any Restricted Subsidiary to make,
any Asset Disposition in one or more transactions in any fiscal year unless: (i)
the Company (or such Restricted Subsidiary, as the case may be) receives
consideration at the time of such disposition at least equal to the fair market
value of the shares or the assets disposed of, as determined in good faith by
the Board of Directors; and (ii) 100% of the Net Available Proceeds from such
disposition (including from the sale of any Cash Equivalents received therein)
are applied by the Company (or such Restricted Subsidiary, as the case may be)
(A) first, either (I) within 270 days of such disposition, to repayment of
Senior Debt then outstanding under any agreements or instruments which would
require such application or which would prohibit payments pursuant to Clause (B)
following or (II) within 60 days before or 270 days after such disposition, to
reinvest in assets that will be used in a Permitted Business (provided, however,
that such application will not be required to be made pursuant to this Clause
(A) until the cumulative Net Available Proceeds (less any Net Available Proceeds
applied pursuant to this covenant) (such difference being the "Excess Proceeds")
exceed $5.0 million); (B) second, to the extent the Excess Proceeds exceeds $5.0
million, to purchases of Outstanding Notes pursuant to an Offer to Purchase (to
the extent such an offer is not prohibited by the terms of any Senior Debt then
outstanding) at a purchase price equal to 100% of their principal amount plus
accrued interest to the date of purchase (provided, however, that installments
of interest whose Stated Maturity is on or prior to the Purchase Date will be
payable to the Holders of such Notes, or one or more Predecessor Notes,
registered as such at the close of business on the relevant Record Dates
according to their terms and the provisions in the Indenture); and (C) third, if
and only if an Offer to Purchase has been made as described in Clause (B) above,
and to the extent of any remaining Excess Proceeds following completion of such
Offer to Purchase and after giving effect to Clauses (A) and (B) above, to
general corporate purposes. (Section 1014).
Any Offer to Purchase required by the provisions described above will be
effected by the sending of the written terms and conditions thereof (the
"Offer Document"), by first class mail, to Holders of the Notes within 270
days after the relevant disposition is completed. The contents of the Offer
to Purchase and the requirements that a Holder must satisfy to tender any
Note pursuant to such Offer to Purchase are substantially the same as those
described below under "--Change of Control."
Change of Control
Within 30 days following the date of the consummation of a transaction that
results in a Change of Control (as defined below), the Company will commence
an Offer to Purchase all Outstanding Notes, at a purchase price equal to 101%
of their aggregate principal amount plus accrued interest to the date of
purchase. Such obligation will not continue after a defeasance or covenant
defeasance of the Notes as described under "Defeasance."
A "Change of Control" means the occurrence of any of the following events
after the date of the Indenture: (i) any Person, or any Persons acting
together that would constitute a "group" (a "Group" ) for purposes of Section
13(d) of the Securities
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Exchange Act of 1934, as amended (the "Exchange Act"), beneficially owns 35% or
more of the total voting power of all classes of Voting Stock of the Company,
(ii) any Person or Group succeeds in having sufficient of its nominees elected
to the Board of Directors such that such nominees, when added to any existing
director remaining on the Board of Directors after such election who is an
Affiliate or Related Person of such Person or Group, will constitute a majority
of the Board of Directors or (iii) the occurrence of any transaction or series
of related transactions (excluding the Spin-Off Distributions), in which the
beneficial owners of the Voting Stock of the Company immediately prior to such
transaction (or series) do not, immediately after such transaction (or series),
beneficially own Voting Stock representing more than 35% of the voting power of
all classes of Voting Stock of the Company (or in the case of a transaction (or
series) in which another entity becomes a successor to the Company, of the
successor entity). (Section 1017).
The Company will comply with the requirements of Rule 14e-1 under the
Exchange Act and any other securities laws and regulations thereunder to the
extent such laws and regulations are applicable in connection with the
repurchase of the Notes resulting from a Change of Control.
Within 30 days of a Change of Control, an Offer Document will be sent, by
first class mail, to Holders of the Notes, accompanied by such information
regarding the Company and its Subsidiaries as the Company in good faith
believes will enable such Holders to make an informed decision with respect
to the Offer to Purchase, which at a minimum will include (a) the most recent
annual and quarterly financial statements and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" contained in the
documents required to be filed with the Trustee pursuant to the provisions
described under "Certain Covenants--Provision of Financial Information" below
(which requirements may be satisfied by delivery of such documents together
with the Offer to Purchase), (b) a description of the events requiring the
Company to make the Offer to Purchase), (c) if applicable, appropriate pro
forma financial information concerning the Offer to Purchase and the events
requiring the Company to make the Offer to Purchase and (d) any other
information required by applicable law to be included therein. The Offer
Document will contain all instructions and materials necessary to enable
Holders of the Notes to tender Notes pursuant to the Offer to Purchase. The
Offer Document will also state (i) that a Change of Control has occurred (or,
if the offer to purchase is delivered in connection with an Asset
Disposition, that an Asset Disposition has occurred) and that the Company
will Offer to purchase the Holder's Notes, (ii) the Expiration Date of the
Offer Document, which will be, subject to any contrary requirements of
applicable law, not less than 30 days or more than 60 days after the date of
such Offer Document, (iii) the Purchase Date for the purchase of Notes which
will be within three Business Days after the Expiration Date, (iv) the
aggregate principal amount of Notes to be purchased (including, if less than
100%, the manner by which such purchase has been determined pursuant to the
Indenture) and the purchase price, and (v) a description of the procedure
which a Holder must follow to tender all or any portion of the Notes.
(Sections 101 and 1017).
Prior to the mailing of an Offer Document, but in any event within 30 days
following any Change of Control, the Company will to the extent required
either (i) repay all outstanding Senior Debt or (ii) obtain the requisite
consents, if any, under all agreements governing outstanding Senior Debt to
permit the making of the Offer to Purchase and the purchase of Notes required
by this covenant. The failure to repay any such Senior Debt or to obtain any
such consents will not relieve the Company of its obligation to make the
Offer to Purchase or to purchase Notes pursuant to the Offer to Purchase
required by this covenant and the failure of the Company to make an Offer to
Purchase, or to purchase the Notes pursuant to an Offer to Purchase, will
constitute an Event of Default under the Indenture. See "--Events of
Default." The terms of the Credit Facility prohibit any repurchase of Notes
by the Company in the event of a Change of Control, unless all indebtedness
then outstanding under the Credit Facility is first repaid. In order to repay
such indebtedness (and any other outstanding Senior Debt with a similar
restriction) and repurchase the Notes, it may be necessary for the Company to
recapitalize and/or refinance some or all of its outstanding indebtedness.
There can be no assurance that such recapitalization or refinancing, if
required, would be accomplished on favorable terms, in a timely manner, or at
all. Were any obligation of the Company to repurchase Notes upon a Change of
Control to result in a default under the Credit Facility or any other Senior
Debt, payments owing on the Notes could be blocked pursuant to the
subordination provisions of the Notes. See "Subordination."
To tender any Note, a Holder must surrender such Note at the place or places
specified in the Offer Document prior to the close of business on the
Expiration Date (such Note being, if the Company or the Trustee so requires,
duly endorsed by, or accompanied by a written instrument of transfer in form
satisfactory to the Company and the Trustee duly executed by, the Holder
thereof or his attorney duly authorized in writing). Holders will be entitled
to withdraw all or any portion of Notes tendered if the Company (or its
Paying Agent) receives, not later than the close of business on the
Expiration Date, a telegram, telex, facsimile transmission or letter setting
forth the name of the Holder, the principal amount of the Note the Holder
tendered, the certificate number of the Note the Holder tendered and a
statement that such Holder is withdrawing all or a portion of his tender. Any
portion of a Note tendered must be tendered in an integral multiple of $1,000
principal amount. (Section 101).
The Indenture does not contain any other change of control provisions.
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Subordination
The payment of the principal of (and premium, if any) and interest on the Notes
will, in certain circumstances as set forth in the Indenture, be subordinated in
right of payment to the prior payment in full of all Senior Debt. Upon any
payment or distribution of assets of the Company to creditors upon any
liquidation, dissolution, winding up, reorganization, assignment for the benefit
of creditors, marshalling of assets and liabilities or any bankruptcy,
insolvency or similar proceedings of the Company, the holders of Senior Debt
will be entitled to receive payment in full of the principal of (and premium, if
any) and interest on such Senior Debt, including all amounts due or to become
due on all Senior Debt, or provision will be made for payment in cash or cash
equivalents or otherwise in a manner satisfactory to the holders of such Senior
Debt, before the Holders of Notes are entitled to receive any Securities
Payments. "Securities Payment" means any payment or distribution of any kind,
whether in cash, property or securities (including any payment or distribution
deliverable by reason of the payment of any other Debt subordinated to the Notes
but excluding any payment or distribution made with shares of stock or
securities of the Company that are subordinate in right of payment to all Senior
Debt to substantially the same extent as the Notes are so subordinated) on
account of the principal of (and premium, if any) or interest on the Notes or on
account of the purchase or redemption or other acquisition of Notes by the
Company or any Subsidiary of the Company. In the event that, notwithstanding the
foregoing, upon any payment or distribution of assets of the Company to
creditors upon any liquidation, dissolution, winding up, reorganization,
assignment for the benefit of creditors, marshalling of assets and liabilities
or any bankruptcy, insolvency or similar proceedings of the Company, the Trustee
or the Holder of any Note receives any Securities Payment before all Senior Debt
is paid in full or payment thereof is provided for in cash or cash equivalents
or otherwise in a manner satisfactory to the holders of such Senior Debt, then
and in such event such Securities Payment will be required to be paid over or
delivered forthwith for application to the payment of all Senior Debt remaining
unpaid, to the extent necessary to pay the Senior Debt in full. (Sections 1201
and 1202).
The Company may not make any Securities Payments if there has occurred and is
continuing a default in the payment of the principal of (or premium, if any) or
interest on Senior Debt (a "Senior Payment Default"). In addition, if any
default (other than a Senior Payment Default), with respect to any Senior Debt
permitting after notice or lapse of time (or both) the holders thereof (or a
trustee on behalf thereof) to accelerate the maturity thereof (a "Senior
Nonmonetary Default") has occurred and is continuing and the Company and the
Trustee have received written notice thereof from the Administrative Agent under
the Credit Facility (or if the Credit Facility has been terminated, from any
holder of Senior Debt with a principal amount in excess of $15.0 million), then
the Company may not make any Securities Payments for a period (a "blockage
period") commencing on the date the Company and the Trustee receive such written
notice and ending on the earlier of (x) 179 days after such date and (y) the
date, if any, on which the Senior Debt to which such default relates is
discharged or such default is waived or otherwise cured. (Section 1203).
In any event, not more than one blockage period may be commenced during any
period of 360 consecutive days, and there must be a period of at least 181
consecutive days in each period of 360 consecutive days when no blockage
period is in effect. No Senior Nonmonetary Default that existed or was
continuing on the date of commencement of any blockage period with respect to
the Senior Debt will be, or can be, made the basis for the commencement of a
subsequent blockage period, unless such default has been cured or waived for
a period of not less than 90 consecutive days. In the event that,
notwithstanding the foregoing, the Company makes any Securities Payment to
the Trustee or any Holder of a Note prohibited by the subordination
provisions, then and in such event such Securities Payment will be required
to be paid over and delivered forthwith. (Section 1203).
By reason of such subordination, in the event of insolvency, creditors of the
Company who are not holders of Senior Debt or of the Notes may recover less,
ratably, than holders of Senior Debt and may recover more, ratably, than the
Holders of the Notes.
The subordination provisions described above will cease to be applicable to the
Notes upon any defeasance or covenant defeasance of the Notes as described under
"Defeasance."
On a pro forma basis, as of September 30, 1996, after giving effect to the
Spin-Off Distributions, the sale of the Notes and the application of the
proceeds thereof and $350.0 million of borrowings under the Term Loans, there
was $367 million of Senior Debt of the Company outstanding, of which $350
million would have been guaranteed by the Guarantors on a senior basis. While
the Indenture will limit, subject to certain financial tests, the amount of
additional Debt that the Company and its Restricted Subsidiaries can Incur, the
Company may from time to time hereafter Incur additional Debt constituting
Senior Debt, including up to $100.0 million under the Working Capital Facility,
substantially all of which is anticipated to be available at the Closing Date.
See "--Certain Covenants--Limitation on Incurrence of Debt."
Senior Subordinated Guarantees
The Guarantors will, jointly and severally, on a senior subordinated basis,
fully and unconditionally guarantee the due and punctual payment of principal
of (and premium, if any) and interest on the Notes, when and as the same
shall become due and
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payable, whether at the maturity date, by declaration of acceleration, call
for redemption or otherwise. As described below, the Senior Subordinated
Guarantees will automatically terminate if the related guarantees of the
Credit Facility are terminated.
The Senior Subordinated Guarantees will be subordinate in right of payment to
the prior payment in full of all Senior Guarantees to substantially the same
extent as the Notes are subordinated to Senior Debt. The term "Senior
Guarantees" means all obligations of the Guarantors under guarantees of Senior
Debt of the Company. No payment will be made by the Guarantors under the Senior
Subordinated Guarantees in respect of the Notes during any period that payments
by the Company on the Notes are suspended by the subordination provisions of the
Indenture as described above under "Subordination." By reason of these
provisions, in the event of insolvency, Holders of the Notes and the related
Senior Subordinated Guarantees may recover less, ratably, than other creditors
of the Company, including holders of Senior Guarantees. (Sections 1401 and
1402).
The Senior Subordinated Guarantees will remain in effect with respect to each
Guarantor until the entire principal of, premium, if any, and interest on the
Notes shall have been paid in full or otherwise discharged in accordance with
the provisions of the Indenture; provided, however, that if (i) such Guarantor
ceases to be a Restricted Subsidiary, (ii) such Guarantor ceases to guarantee
the Credit Facility, (iii) the Notes are defeased and discharged as described
under Clause (A) under "Defeasance" or (iv) all or substantially all of the
assets of such Guarantor or all of the Capital Stock of such Guarantor is sold
(including by issuance, merger, consolidation or otherwise) by the Company or
any of its Subsidiaries in a transaction constituting an Asset Disposition and
the Net Available Proceeds from such Asset Disposition are applied in accordance
with the provisions described under "Repurchase at the Option of Holders--Asset
Dispositions," then in each case of (i), (ii), (iii) and (iv) above, such
Guarantor or the corporation acquiring such assets (in the event of a sale or
other disposition of all or substantially all of the assets or Capital Stock of
such Guarantor) shall be released and discharged of its Senior Subordinated
Guarantee obligations.
Subject to payment in full of all Senior Guarantees, the rights of the
Holders of the Notes under the related Senior Subordinated Guarantees will be
subrogated to the rights of the holders of Senior Guarantees to receive
payments or distributions of cash, property or securities of the Guarantors
applicable to Senior Guarantees.
Certain Covenants
The Indenture contains, among others, the following covenants:
Limitation on Incurrence of Debt
The Company may not, and may not permit any Restricted Subsidiary to, Incur any
Debt unless, immediately after giving effect to the Incurrence of such Debt and
the receipt and application of the proceeds thereof, the Consolidated EBITDA
Coverage Ratio of the Company for the four full fiscal quarters for which
internal financial statements are available immediately preceding the Incurrence
of such Debt, calculated on a pro forma basis as if such Debt had been Incurred
and the proceeds thereof had been received and so applied at the beginning of
the four full fiscal quarters, would be greater than 2.50 to 1.0 if such date is
on or prior to December 31, 1998, 2.75 to 1.0 if such date is after December 31,
1998 and on or prior to December 31, 1999 and 3.0 to 1.0 if thereafter. (Section
1008).
Without regard to the foregoing limitations, the Company or any Restricted
Subsidiary of the Company may Incur the following Debt:
(i) Debt under the Credit Facility in an aggregate principal amount at
any one time outstanding not to exceed $450.0 million less (A) principal
payments on any term loan facility under the Credit Facility required to
be made by the terms of the Credit Facility as in effect on the date of the
Indenture and actually made and (B) any amounts by which the Working
Capital Facility commitments are permanently reduced by the terms of the
Credit Facility as in effect on the date of the Indenture; provided, that
Clause (B) shall not apply to a refinancing or refunding of the Working
Capital Facility so long as such refinancing or refunding complies with
Clause (vii) below
(ii) Debt evidenced by the Notes;
(iii) Debt of the Company or any Restricted Subsidiary (other than Debt
referred to in Clauses (i) and (ii) above) outstanding on the date of the
Indenture;
(iv) Debt owed by the Company to any Wholly Owned Restricted Subsidiary or
Debt owed by a Wholly Owned Restricted Subsidiary to the Company; provided,
however, that (a) any such Debt owing by the Company to a Wholly Owned
Restricted Subsidiary shall be Subordinated Debt and (b) upon either (1) the
transfer or other disposition by such Wholly Owned Restricted Subsidiary or
the Company of any Debt so permitted to a Person other than the Company or
another Wholly Owned Restricted Subsidiary or (2) the issuance (other than
directors' qualifying shares), sale, lease, transfer or other disposition of
shares of Capital Stock (including by consolidation or merger) of such Wholly
Owned Restricted Subsidiary to a Person other than the Company or another such
Wholly Owned Restricted Subsidiary, the provisions of this
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Clause (iv) shall no longer be applicable to such Debt and such Debt shall
be deemed to have been Incurred at the time of such transfer or other
disposition or such issuance, sale, lease, transfer, or other disposition;
(v) Obligations under Interest Rate Agreements in respect of Debt permitted
to be incurred by the Company pursuant to the Indenture to the extent the
notional principal amount of such Interest Rate Agreements does not exceed the
aggregate principal amount of the Debt to which such Interest Rate Agreements
relate; provided, however, that (A) such Interest Rate Agreements are used
solely to hedge the related Debt and (B) the profits and losses with respect
to the Interest Rate Agreements are included as interest expense under
generally accepted accounting principles;
(vi) Debt Incurred by the Company or any Restricted Subsidiary in respect of
(x) bid or performance bonds entered into in favor of governmental entities or
(y) surety or appeal bonds, which, in each case are entered into in the
ordinary course of business;
(vii) Debt Incurred to renew, extend, refinance or refund any outstanding
Debt permitted by Clauses (i), (ii) and (iii) above or this Clause (vii);
provided, however, that such Debt does not exceed the principal amount of Debt
(or, in the case of Debt issued at a discount from its principal amount, the
amount then payable upon an acceleration thereof) so renewed, extended,
refinanced or refunded (plus accrued interest, fees, expenses, premiums and
other amounts payable in connection therewith in an amount not in excess of 1%
of the principal amount (or, in the case of Debt issued at a discount, the
amount payable upon acceleration) of the Debt being renewed, extended,
refinanced or refunded); and provided further, that (A) Debt the proceeds of
which are used to refinance or refund Debt which is Pari Passu to the Notes or
Debt which is subordinate in right of payment to the Notes shall only be
permitted if in the case of any refinancing or refunding of Debt which is Pari
Passu to the Notes, the refinancing or refunding Debt is made Pari Passu to
the Notes or subordinated to the Notes, and, in the case of any refinancing or
refunding of Debt which is subordinated to the Notes, the refinancing or
refunding Debt is made subordinate to the Notes on terms at least as favorable
to the Holders of Notes as those contained in the documentation governing the
Debt being refinanced or refunded and (B) such refinancing or refunding Debt
(x) does not have a final scheduled maturity earlier than the final scheduled
maturity of the refinanced or refunded Debt or permit redemption or other
retirement of such Debt (including pursuant to an offer to purchase by the
Company) at the option of the holder thereof prior to the final stated
maturity of the Debt being refinanced or refunded, other than a redemption or
other retirement at the option of the holder of such Debt on terms at least as
favorable to the Holders of the Notes as those contained in the Debt being
refinanced or refunded and (y) does not have a Weighted Average Life less than
the Weighted Average Life of the Debt being refinanced or refunded; and
(viii) Debt in addition to that otherwise permitted to be Incurred pursuant
to Clauses (i) through (vii) above, which, together with any other outstanding
Debt Incurred pursuant to this Clause (viii), has an aggregate principal
amount not in excess of $20.0 million at any one time outstanding. (Section
1008).
Limitation on Layered and Junior Debt
The Company may not (i) Incur or suffer to exist any Debt that is by its terms
subordinate in right of payment to any other Debt of the Company unless such
Debt is also Pari Passu with or subordinate by its terms in right of payment to
the Notes or (ii) permit any Guarantor to Incur or suffer to exist any Debt that
is by its terms subordinate in right of payment to any other Debt of the
Guarantor unless such Debt is also Pari Passu with or subordinate by its terms
in right of payment to the Senior Subordinated Guarantees. (Section 1009).
Limitation on Restricted Payments
The Company may not directly or indirectly, (i) declare or pay any dividend, or
make any distribution, of any kind or character (whether in cash, property or
securities) in respect of its Capital Stock or to the holders thereof in their
capacity as such (excluding the Spin-Off Payments and any dividends or
distributions payable solely in shares of its Capital Stock (other than
Redeemable Interests) or in options, warrants or other rights to acquire its
Capital Stock (other than Redeemable Interests)), (ii) purchase, redeem or
otherwise acquire or retire for value, or permit any Restricted Subsidiary to
purchase, redeem or otherwise acquire or retire for value (a) any Capital Stock
of the Company or any Capital Stock of or other ownership interests in any
Subsidiary or any Affiliate or Related Person of the Company (other than any
such acquisition which results in such Subsidiary, Affiliate or Related Person
becoming a Restricted Subsidiary) or (b) any options, warrants or rights to
purchase or acquire shares of Capital Stock of the Company or any Capital Stock
of or other ownership interests in any Subsidiary or any Affiliate or Related
Person of the Company (excluding the redemption or repurchase by any Restricted
Subsidiary of any of its Capital Stock, other ownership interests or options,
warrants or rights to purchase such Capital Stock or other ownership interests,
in each case, owned by the Company or a Wholly Owned Restricted Subsidiary and
any such acquisition that results in such Subsidiary, Affiliate or Related
Person becoming a Restricted Subsidiary), (iii) permit any Restricted Subsidiary
to declare or pay
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any dividend, or make any distribution, of any kind or character (whether in
cash, property or securities) in respect of the Capital Stock of or other
ownership interests in such Restricted Subsidiary or to the holders of such
Restricted Subsidiary's Capital Stock or other ownership interests (excluding
any dividends or distributions payable solely in shares of Capital Stock of or
other ownership interests in such Restricted Subsidiary (other than Redeemable
Interests) or in options, warrants or other rights to acquire Capital Stock of
or other ownership interests in such Restricted Subsidiary (other than
Redeemable Interests)) other than (A) the payment by any Restricted Subsidiary
of dividends or other distributions to the Company or a Wholly Owned Restricted
Subsidiary, or (B) the payment of pro rata dividends to holders of both minority
and majority interests in the Capital Stock or other ownership interests of any
such Restricted Subsidiary, (iv) make, or permit any Restricted Subsidiary to
make, any Investment in any Person that is not a Permitted Investment or (v)
redeem, defease, repurchase, retire or otherwise acquire or retire for value
prior to any scheduled maturity, repayment or sinking fund payment, Debt of the
Company (other than the Notes) that is Pari Passu with or subordinate in right
of payment to the Notes (each of the transactions described in Clauses (i)
through (v) being a "Restricted Payment"), if:
(1) an Event of Default, or an event that with the lapse of time or the
giving of notice, or both, would constitute an Event of Default, shall have
occurred and be continuing;
(2) the Company would, at the time of such Restricted Payment and after
giving pro forma effect thereto as if such Restricted Payment had been made
at the beginning of the most recently ended four full fiscal quarter period
for which internal financial statements are available immediately preceding
the date of such Restricted Payment, not have been permitted to Incur at
least $1.00 of additional Debt pursuant to the Consolidated EBITDA Coverage
Ratio test set forth in the first paragraph under "Limitation on Incurrence
of Debt" above; or
(3) upon giving effect to such Restricted Payment, the aggregate of all
Restricted Payments (excluding Restricted Payments permitted by Clauses (i)
through (vii) of the next succeeding paragraph) from the date of the
Indenture (the amount so expended, if other than in cash, determined in
good faith by the Board of Directors) exceeds the sum, without duplication,
of: (a) 50% of the cumulative Consolidated Net Income of the Company (or,
in the case such Consolidated Net Income shall be negative, less 100% of
such deficit) for the period (taken as one accounting period) from the
beginning of the first fiscal quarter commencing after the date of the
Indenture to the end of the Company's most recently ended fiscal quarter
for which internal financial statements are available at the time of such
Restricted Payment; provided that for purposes of this clause (a),
Consolidated Net Income of the Company will be calculated excluding
extraordinary losses resulting from the Spin-Off Distributions; plus (b)
100% of the aggregate net cash proceeds from the issuance and sale (other
than to a Restricted Subsidiary of the Company) of Capital Stock (other
than Redeemable Interests) of the Company and options, warrants or other
rights on Capital Stock (other than Redeemable Interests and Debt
convertible into Capital Stock) of the Company and the principal amount of
Debt and Redeemable Interests of the Company that has been converted into
Capital Stock (other than Redeemable Interests) of the Company after the
date of the Indenture, provided that any such net proceeds received by the
Company from an employee stock ownership plan financed by loans from the
Company or a Subsidiary of the Company shall be included only to the extent
such loans have been repaid with cash on or prior to the date of
determination; plus (c) 50% of any dividends received by the Company or a
Wholly Owned Restricted Subsidiary after the date of the Indenture from an
Unrestricted Subsidiary of the Company; plus (d) to the extent not
otherwise taken into account in this subsection (3), any return of a
capital investment made by the Company in another Person and treated as a
Restricted Payment under Clause (ii) or (iv) to the extent received in cash
or Cash Equivalents and in an amount not in excess of such Restricted
Payment plus (e) $10.0 million. (Section 1010).
The foregoing covenant will not be violated by reason of:
(i) the payment of any dividend within 60 days after declaration thereof
if at the declaration date such payment would have complied with the
foregoing covenant and the amount of such dividend was included in the
aggregate amount of Restricted Payments pursuant to Clause (3) above;
(ii) any renewal, extension, refinancing or refunding of Debt permitted
pursuant to Clause (vii) in the second paragraph under "Limitation on
Incurrence of Debt" above;
(iii) the purchase, redemption or other acquisition or retirement for
value of any Capital Stock of the Company or any options, warrants or
rights to purchase or acquire shares of Capital Stock of the Company in
exchange for, or out of the net cash proceeds of, the substantially
concurrent issuance or sale (other than to a Restricted Subsidiary of the
Company) of Capital Stock (other than Redeemable Interests) of the Company;
provided that the amount of any such net cash proceeds that are utilized
for any such purchase, redemption or other acquisition or retirement for
value shall be excluded from Clause (3)(b) in the foregoing paragraph;
(iv) any purchase or other acquisition of Common Stock of the Company
that is contributed to any employee plan qualified under Section 401(a) of
the Internal Revenue Code or an employee stock purchase plan, in either
case that was either funded by employee contributions or deducted as an
expense in determining Consolidated Net Income of the Company;
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(v) the sale, lease or other disposition of any Non-Core Asset; provided
that the Board of Directors determines that such sale, lease or other
disposition is in the best interests of the Company;
(vi) any Permitted Joint Venture Investment made after the date of the
Indenture; provided that the Consolidated EBITDA of the Company
attributable to such Investment for the four full fiscal quarters for which
internal financial statements are available immediately preceding the date
of such Investment, together with the Consolidated EBITDA of the Company
attributable to any other Permitted Joint Venture Investment made pursuant
to this Clause (vi), shall not exceed 10% of the Consolidated EBITDA of the
Company for the four full fiscal quarters for which internal financial
statements are available immediately preceding the making of such Permitted
Joint Venture Investment; and provided, further, that the Company would, at
the time the Company makes a Permitted Joint Venture Investment pursuant to
this Clause (vi) and after giving pro forma effect thereto as if such
Permitted Joint Venture Investment had occurred at the beginning of the
most recently ended four full fiscal quarter period for which internal
financial statements are available immediately preceding the date of such
Permitted Joint Venture Investment, have been permitted to Incur at least
$1.00 of additional Debt pursuant to the Consolidated EBITDA Coverage Ratio
test set forth in the first paragraph under "--Limitation on Incurrence of
Debt;" or
(vii) the redemption of Quest Diagnostics Rights pursuant to the Quest
Diagnostics Rights Agreement (or any successor agreement) in an amount not
to exceed $.01 per Quest Diagnostics Right.
Upon the designation of any Restricted Subsidiary as an Unrestricted
Subsidiary (other than pursuant to Clauses (v) and (vi) above), an amount
equal to the fair market value of all of the assets of such Restricted
Subsidiary prior to such change will be deemed to be a Restricted Payment for
purposes of calculating the aggregate amount of Restricted Payments pursuant
to Clause (3) above. (Section 1010)
Limitation on Leases
The Company may not, and may not permit any Restricted Subsidiary to, Incur
any Operating Lease except:
(i) any Operating Lease in effect on the date of the Indenture;
(ii) any Operating Lease relating to personal property used in the
Company's or a Restricted Subsidiary's ordinary course of business;
(iii) any Operating Lease of real property having an annualized Rental
Expense of less than $0.625 million;
(iv) any Operating Lease (A) Incurred by a Person prior to the time such
Person became a Restricted Subsidiary, (B) acquired by the Company or any
Restricted Subsidiary through a purchase or other acquisition of assets or (C)
Incurred by a Restricted Subsidiary in connection with a merger or
consolidation with or into another Person (other than a Restricted Subsidiary)
in a transaction in which such Person becomes a Restricted Subsidiary of the
Company; provided, that, in the case of any Operating Lease Incurred pursuant
to Clause (A) or (C) of this Clause (iv), such Operating Lease was not
Incurred in anticipation of such transaction and was outstanding prior to such
transaction; and provided further, that the difference, if any, (but not less
than zero) of (A) the annualized Rental Expense of such Operating Lease and
(B) the annualized Rental Expense of any equivalent or similar Operating Lease
relating to assets or properties disposed of in connection with such
transaction and as to which the Company or such Restricted Subsidiary is no
longer, directly or indirectly, liable or obligated under or as to which
another Person with a Credit Rating equal to or greater than the Company shall
have agreed to indemnify and hold harmless the Company or such Restricted
Subsidiary with respect to all of its liabilities and obligations under such
Operating Lease, together with the annualized Rental Expense of any other
Operating Lease Incurred pursuant to this Clause (iv), shall not exceed $3.0
million in any fiscal year;
(v) any Operating Lease in addition to those described in Clauses (i)
through (iv) above and Clauses (vi) through (viii) below Incurred after the
date of the Indenture the annualized Rental Expense of which, together with
the annualized Rental Expense of any other Operating Lease Incurred pursuant
to this internal Clause (v), shall not exceed 3% of the Consolidated
EBITDA of the Company for the four full fiscal quarters for which internal
financial statements are available immediately preceding the Incurrence of
such Operating Lease;
(vi) any Operating Lease between the Company and a Wholly Owned
Restricted Subsidiary or between a Wholly Owned Restricted Subsidiary and
the Company or another Wholly Owned Restricted Subsidiary; provided,
however, that in the case of the issuance (other than directors' qualifying
shares), sale, lease, transfer or other disposition of shares of Capital
Stock (including by a consolidation or merger) of such Wholly Owned
Restricted Subsidiary to a Person other than the Company or another Wholly
Owned Restricted Subsidiary, the provisions of this Clause (vi) shall no
longer be applicable to such Operating Lease and such Operating Lease shall
be deemed to have been Incurred at that time;
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(vii) at the election of the Company, any Operating Lease in addition to
that permitted to be Incurred pursuant to Clauses (i) through (vi) above
and Clause (viii) below if (a) the Company treats the Attributable Value of
such Operating Lease as Debt for all purposes under the Indenture,
including for purposes of the pro forma calculation required by this Clause
(vii), (b) the portion of Rental Expense in respect of such Operating Lease
that would have been allocable to interest expense in accordance with
generally accepted accounting principles if such Operating Lease was
treated as a Capitalized Lease Obligation is treated as Consolidated
Interest Expense of the Company for all purposes of the Indenture,
including for purposes of the pro forma calculation required by this Clause
(vii), and (c) the Company would, at the time of such Incurrence and after
giving pro forma effect thereto as if such Incurrence had occurred at the
beginning of the most recently ended four full fiscal quarter period for
which internal financial statements are available immediately preceding the
date of such Incurrence, have been permitted to Incur at least $1.00 of
additional Debt pursuant to the Consolidated EBITDA Coverage Ratio test set
forth in the first paragraph under "--Limitation on Incurrence of Debt";
and
(viii) any renewal, extension or replacement (each a "replacement") of any
Operating Lease permitted by Clause (i), (iv), (v) or (vii) or this Clause
(viii); provided, that the Incurrence of an Operating Lease shall be deemed to
be the replacement of another Operating Lease so long as the obligation to pay
rent or other amounts does not begin earlier than one year prior to the end of
the term of the Operating Lease being replaced. (Section 1011).
Limitations Concerning Distributions by Subsidiaries, Etc.
The Company may not, and may not permit any Restricted Subsidiary to, suffer to
exist any consensual encumbrance or restriction on the ability of any Restricted
Subsidiary (i) to pay, directly or indirectly, dividends or make any other
distributions in respect of its Capital Stock or other ownership interests or
pay any Debt or other obligation owed to the Company or any other Restricted
Subsidiary; (ii) to make loans or advances to the Company or any Restricted
Subsidiary; or (iii) to sell, lease or transfer any of its property or assets to
the Company or any Wholly Owned Restricted Subsidiary, except, in any such case,
any encumbrance or restriction: (a) pursuant to the Notes, the Indenture, the
Credit Facility and any other agreement in effect on the date of the Indenture,
(b) pursuant to an agreement relating to any Debt Incurred by a Restricted
Subsidiary prior to the date on which such Restricted Subsidiary was acquired by
the Company and outstanding on such date and not Incurred in anticipation of
becoming a Restricted Subsidiary, (c) pursuant to an agreement which has been
entered into for the pending sale or disposition of all or substantially all of
the assets of such Restricted Subsidiary or all or substantially all of the
Capital Stock of such Restricted Subsidiary owned by the Company or any other
Restricted Subsidiary, provided that such restriction terminates upon
consummation of such disposition, (d) pursuant to customary provisions
restricting assignments of contracts or subleases of leases, in each case,
entered into in the ordinary course of business, (e) pursuant to purchase money
obligations for property acquired in the ordinary course of business that impose
restrictions of the nature described in Clause (iii) above on the property so
acquired, (f) pursuant to an agreement effecting a renewal, extension,
refinancing or refunding of Debt Incurred pursuant to an agreement referred to
in Clause (a) or (b) above (provided that the provisions relating to such
encumbrance or restriction contained in such renewal, extension, refinancing or
refunding are no more restrictive in any material respect than the provisions
contained in the agreement it replaces) or (g) pursuant to or by reason of
applicable law. (Section 1012).
Limitation on Liens
The Company may not, and may not permit any Restricted Subsidiary to, Incur any
Lien on property or assets of the Company or such Restricted Subsidiary to
secure Debt that is Pari Passu or subordinate in right of payment to the Notes
without making, or causing such Restricted Subsidiary to make, effective
provision for securing the Notes (and, if the Company may so determine, any
other Debt of the Company or of such Restricted Subsidiary that is not Pari
Passu or subordinate to the Notes) (i) in the case of Debt that is Pari Passu
with the Notes, Pari Passu with such Debt and (ii) in the case of Debt that is
subordinated in right of payment to the Notes prior to such Debt, in each case,
as to such property for so long as such Debt will be so secured. (Section 1013).
The Company may not, and may not permit any Restricted Subsidiary to, Incur
any Lien (other than Permitted Liens) on property or assets of the Company or
such Restricted Subsidiary to secure Debt that is not Pari Passu or
subordinate in right of payment to the Notes without making, or causing such
Restricted Subsidiary to make, effective provision for securing the Notes
(and, if the Company may so determine, any other Debt of the Company or of
such Restricted Subsidiary that is not subordinate to the Notes) equally and
ratably with (or prior to) such Debt as to such property for so long as such
Debt will be so secured. (Section 1013).
Limitation on Transactions with Affiliates and Related Persons
The Company may not, and may not permit any Restricted Subsidiary of the
Company to, directly or indirectly, enter into any transaction after the date
of the Indenture with any Affiliate or Related Person of the Company unless
(i) such Affiliate or Related Person is (both before and after such
transaction) (a) a Wholly Owned Subsidiary of the Company or (b) another Sub-
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sidiary of the Company the minority interests in which are not held by any
Affiliate or Related Person of the Company; (ii) such transaction is the payment
of directors' fees; (iii) such transaction is the entering into of a laboratory
services agreement in the ordinary course of the Company's or a Restricted
Subsidiary's business on terms that are no less favorable to the Company or such
Restricted Subsidiary as those that could be obtained in a comparable arm's
length transaction; (iv) such transaction is the entering into a compensation
arrangement between the Company or a Restricted Subsidiary and one of its
employees, which transaction is approved by the compensation committee of the
Board of Directors; (v) the transaction contemplated by Clause (ix) of the
definition of Permitted Investments; or (vi) the following action is taken: (a)
if the total consideration paid by the Company or such Restricted Subsidiary in
such transaction (or series of transactions) of which it is a part (including
cash, the fair value of non-cash property and the principal amount of any Debt
assumed) (the "Consideration") is less than $5 million, then a duly authorized
executive officer of the Company will deliver an officer's certificate to the
Trustee within 10 days of such transaction (or series of transactions) wherein
such officer certifies on behalf of the Company that in his or her good faith
judgment the terms of the transaction (or series of transactions) are in the
best interests of the Company and are no less favorable to the Company than
those that could be obtained in a comparable arm's length transaction (or series
of transactions) with an entity that is not a Affiliate or a Related Person; (b)
if the Consideration is between $5 million and $15 million, then the
determinations referred to in Clause (a) above must be made by a majority of the
disinterested members of the Board of Directors; and (c) if the Consideration is
greater than $15 million, then the determinations referred to in Clause (a)
above, in addition to the action required by Clause (b) above, must also be
confirmed by a nationally recognized investment banking firm (which may not be
an Affiliate or Related Person of the Company), in a written opinion delivered
to the Board of Directors prior to consummation of such transaction (or series
of transactions); provided, however, that the foregoing restriction will not
apply to the Intercompany Agreements as in effect on the date of the Indenture
or the transactions contemplated thereby. (Section 1015).
Limitation on Sale of Capital Stock of Restricted Subsidiaries
The Company may not, and may not permit any Restricted Subsidiary to, issue,
transfer, convey or otherwise dispose of any shares of Capital Stock (other than
Preferred Stock that is not required or permitted to be redeemed or otherwise
repaid, at the option of such Restricted Subsidiary or the holders thereof,
prior to the final Stated Maturity of the Notes) of a Restricted Subsidiary or
securities convertible or exchangeable into, or options, warrants, rights or any
other interest with respect to, Capital Stock of a Restricted Subsidiary to any
Person other than the Company or a Wholly Owned Restricted Subsidiary except in
a transaction consisting of a sale of all of the Capital Stock of such
Restricted Subsidiary owned by the Company and any Subsidiary of the Company and
that complies with the provisions described under "Repurchase at the Option of
Holders--Asset Dispositions" above to the extent such provisions apply. (Section
1016).
Provision of Financial Information
Whether or not the Company is subject to the reporting requirements of Section
13(a) or 15(d) of the Exchange Act, the Company will file with the Commission
the annual reports, quarterly reports and other documents that the Company would
have been required to file with the Commission pursuant to Section 13(a) or
15(d) if the Company were subject to such Section and will also provide to all
Holders and file with the Trustee copies of such reports. (Section 1018).
Unrestricted Subsidiaries
The Company may at any time designate any Person that after the date of the
Indenture becomes a Subsidiary of the Company as an "Unrestricted
Subsidiary," whereupon (and until such Person ceases to be an Unrestricted
Subsidiary) such Person and each other Person that is then or thereafter
becomes a Subsidiary of such Person will be deemed to be an Unrestricted
Subsidiary. In addition, the Company may at any time terminate the status of
any Subsidiary of the Company as an Unrestricted Subsidiary, whereupon such
Subsidiary and each other Subsidiary of the Company (if any) of which such
Subsidiary is a Subsidiary will cease to be an Unrestricted Subsidiary.
(Section 1019).
Notwithstanding the foregoing, no change in the status of a Subsidiary of the
Company from a Restricted Subsidiary to an Unrestricted Subsidiary or an
Unrestricted Subsidiary to a Restricted Subsidiary (other than the change in
status of a Non-Core Asset from a Restricted Subsidiary holding only Non-Core
Assets to an Unrestricted Subsidiary) will be effective, unless (i) the Company
would, at the time of such designation and after giving pro forma effect thereto
as if such designation had occurred at the beginning of the most recently ended
four full fiscal quarter period for which internal financial statements are
available immediately preceding the date of such designation, have been
permitted to Incur at least $1.00 of additional Debt pursuant to the
Consolidated EBITDA Coverage Ratio test set forth in the first paragraph under
"--Limitation on Incurrence of Debt"; (ii) in the case of any change in status
of such a Subsidiary from a Restricted Subsidiary to an Unrestricted Subsidiary
(other than pursuant to Clause (vi) of "Limitation on Restricted Payments"
covenant), the fair market value of all assets of such Restricted Subsidiary
prior to such change will be deemed a Restricted Payment for purposes of
calculating the aggregate amount of
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Restricted Payments pursuant to the provisions described in the first paragraph
under "Limitation on Restricted Payments" above, and the incurrence of such
Restricted Payment would be permitted by such covenant and (iii) such change
would not otherwise result (after the giving of notice or the lapse of time, or
both) in an Event of Default. In addition and notwithstanding the foregoing, no
change in the status of a Subsidiary of the Company from a Restricted Subsidiary
to an Unrestricted Subsidiary, and the status of any Subsidiary of the Company
as an Unrestricted Subsidiary will be deemed to have been immediately terminated
(with the effect described in the immediately preceding sentence) at any time
when, (i) such Subsidiary (A) has outstanding Debt that is Unpermitted Debt or
(B) owns or holds any Capital Stock of or other ownership interests in, or a
Lien on any property or other assets of, the Company or any of its Restricted
Subsidiaries, (ii) the Company or any Restricted Subsidiary (A) provides credit
support for, or a Guaranty of, any Debt of such Subsidiary (including any
undertaking, agreement or instrument evidencing such Debt) or (B) is directly or
indirectly liable for any Debt of such Subsidiary or (iii) if and only if such
Subsidiary does business under the name "Quest" or "Quest Diagnostics", such
Subsidiary fails to notify in writing the holders of its Debt that such Debt is
without recourse to the property and assets of the Company and its Restricted
Subsidiaries. Any such termination otherwise prohibited by the restrictions
described in the first sentence of this paragraph will be deemed to result in a
default under the Indenture. "Unpermitted Debt" means any Debt of a Subsidiary
of the Company if (x) a default thereunder (or under any instrument or agreement
pursuant to or by which such Debt is issued, secured or evidenced), or any right
that the holders thereof may have to take enforcement action against such
Subsidiary or its property or other assets, would permit (whether or not after
the giving of notice or the lapse of time or both) the holders of any Debt of
the Company or any Restricted Subsidiary to declare the same due and payable
prior to the date on which it otherwise would have become due and payable or
otherwise to take any enforcement action against the Company or any such
Restricted Subsidiary or (y) such Debt is secured by a Lien on any property or
other assets of the Company and any of its Restricted Subsidiaries. (Section
1019).
Mergers, Consolidations and Certain Sales of Assets
The Company (i) may not consolidate with or merge into any Person (other than a
Wholly Owned Restricted Subsidiary) or permit any Person (other than a Wholly
Owned Restricted Subsidiary) to consolidate with or merge into the Company; and
(ii) may not, directly or indirectly, in one or a series of transactions,
transfer, convey, sell, lease or otherwise dispose of all or substantially all
of its properties and assets; unless, in each case: (1) immediately before and
after giving effect to such transaction (or series) and treating any Debt
Incurred by the Company or a Restricted Subsidiary as a result of such
transaction (or series) as having been Incurred by the Company or such
Restricted Subsidiary at the time of the transaction (or series), no Event of
Default or event that with the passing of time or the giving of notice, or both,
will constitute an Event of Default shall have occurred and be continuing; (2)
in a transaction (or series) in which the Company does not survive or in which
the Company transfers, conveys, sells, leases or otherwise disposes of all or
substantially all of its properties and assets, the successor entity is a
corporation, partnership, limited liability company or business trust and is
organized and validly existing under the laws of the United States of America,
any State thereof or the District of Columbia and expressly assumes, by a
supplemental indenture executed and delivered to the Trustee in form
satisfactory to the Trustee, all the Company's obligations under the Indenture;
(3) immediately after giving effect to such transaction (or series), the Company
or the successor entity would have a Consolidated Net Worth not less than 95% of
the Consolidated Net Worth of the Company immediately prior to such transaction
(or series); (4) the Company would, at the time of such transaction (or series)
and after giving pro forma effect thereto as if such transaction (or series) had
occurred at the beginning of the most recently ended four full fiscal quarter
period for which internal financial statements are available immediately
preceding the date of such transaction (or series), have been permitted to Incur
at least $1.00 of additional Debt pursuant to the Consolidated EBITDA Coverage
Ratio test set forth in the first paragraph under "Certain Covenants--Limitation
on Incurrence of Debt" above; (5) if, as a result of any such transaction,
property or assets of the Company or any Restricted Subsidiary would become
subject to a Lien prohibited by the "Certain Covenants--Limitation on Liens"
covenant, the Company or the successor entity will have secured the Notes as
required by such covenant; and (6) the Company has delivered to the Trustee an
Officers' Certificate and an Opinion of Counsel as specified in the Indenture.
(Section 801).
Certain Definitions
Set forth below is a summary of certain of the defined terms used in the
Indenture. Reference is made to the Indenture for the full definition of all
such terms, as well as any other terms used herein for which no definition is
provided. (Section 101).
"Affiliate" of any Person means any other Person directly or indirectly
controlling or controlled by or under direct or indirect common control with
such Person. For the purposes of this definition, "control" when used with
respect to any Person means the power to direct the management and policies
of such Person, directly or indirectly, whether through the ownership of
voting securities, by contract or otherwise; and the terms "controlling" and
"controlled" have meanings correlative to the foregoing.
"Asset Disposition" by any Person means any transfer, conveyance, sale, lease
or other disposition by such Person (including a consolidation or merger or
other sale of any Restricted Subsidiary with, into or to another Person in a
transaction in which such
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Restricted Subsidiary ceases to be a Subsidiary of such Person) of (i) shares of
Capital Stock (other than directors' qualifying shares) or other ownership
interests of a Restricted Subsidiary or (ii) the property or assets of such
Person or any Restricted Subsidiary representing a division or line of business
or (iii) other assets or rights of such Person or any Restricted Subsidiary
outside of the ordinary course of business: but excluding (i) one or more Asset
Dispositions that in any fiscal year result in aggregate net proceeds of less
than $1.0 million, (ii) the disposition of all or substantially all of the
assets of the Company in a manner permitted pursuant to the provisions described
above under "Mergers, Consolidations and Certain Sales of Assets," (iii) any
disposition that constitutes a Restricted Payment or Permitted Investment that
is permitted pursuant to the provisions described under "Certain
Covenants--Limitation on Restricted Payments" and (iv) any transfer, conveyance,
lease, sale or other disposition of the Company's laboratory facility in Boston,
Massachusetts.
"Attributable Value" means, as to any Operating Lease of any Person, and at any
date as of which the amount thereof is to be determined, the total net amount of
rent required to be paid by such Person under such lease during the initial term
thereof as determined in accordance with generally accepted accounting
principles, discounted from the last date of such initial term to the date of
determination at a rate per annum equal to the discount rate which would be
applicable to a Capital Lease Obligation with like term in accordance with
generally accepted accounting principles. The net amount of rent required to be
paid under any such lease for any such period shall be the aggregate amount of
rent payable by the lessee with respect to such period excluding amounts
required to be paid on account of insurance, taxes, assessments, utility,
operating and labor costs and similar charges. In the case of any lease which is
terminable by the lessee upon the payment of penalty, such net amount shall also
include the lesser of the amount of such penalty (in which case no rent shall be
considered as required to be paid under such lease subsequent to the first date
upon which it may be so terminated) or the rent which would otherwise be
required to be paid if such lease is not so terminated.
"Board of Directors" means the Board of Directors of the Company or a duly
authorized committee thereof.
"Capital Lease Obligation" of any Person means the obligation to pay rent or
other payment amounts under a lease of (or other arrangements conveying the
right to use) real or personal property of such Person which is required to be
classified and accounted for as a capital lease or a liability on the face of a
balance sheet of such Person in accordance with generally accepted accounting
principles. The stated maturity of such obligation shall be the date of the last
payment of rent or any other amount due under such lease prior to the first date
upon which such lease may be terminated by the lessee without payment of a
penalty.
"Capital Stock" of any Person means any and all shares, interests,
participations or other equivalents (however designated) of equity interests of
such Person.
"Cash Equivalents" means, at any time, (i) any Debt (other than any Debt issued
at a discount) fully guaranteed as to principal and interest by the United
States of America or any agency or instrumentality thereof (provided that the
full faith and credit of the United States is pledged in support thereof); (ii)
certificates of deposit of any financial institution that has combined capital
and surplus and undivided profits of not less than $50,000,000 (or the
equivalent thereof in another currency) and has a long-term debt rating of at
least "AA" by Standard & Poor's Ratings Group ("S&P") or at least "Aa3" by
Moody's Investors Service, Inc. ("Moody's"), (iii) repurchase obligations for
underlying securities of the type described in Clause (i) above entered into
with any financial institution meeting the qualifications specified in Clause
(ii) above or (iv) commercial paper issued by a corporation (other than Corning)
organized under the laws of any State of the United States and rated at least
A-1 by S&P or at least P-1 by Moody's or (v) readily marketable securities
(other than securities issued at a discount) issued or fully and unconditionally
guaranteed by any state of the United States of America, or by any political
subdivision or taxing authority thereof, and rated at least A-1 by S&P or at
least P-1 by Moody's.
"Common Stock" of any Person means Capital Stock of such Person that does not
rank prior, as to the payment of dividends or as to the distribution of assets
upon any voluntary or involuntary liquidation, dissolution or winding up of such
Person, to shares of Capital Stock of any other class of such Person.
"Consolidated EBITDA" of any Person means for any period the Consolidated Net
Income of such Person for such period increased by the sum of (i) Consolidated
Interest Expense of such Person for such period, plus (ii) Consolidated Income
Tax Expense of such Person for such period, plus (iii) the consolidated
depreciation and amortization expense deducted in determining the Consolidated
Net Income of such Person for such period; provided, however, that the
Consolidated Interest Expense, Consolidated Income Tax Expense and consolidated
depreciation and amortization expense of a Consolidated Subsidiary of such
Person shall be added to the Consolidated Net Income pursuant to the foregoing
only (x) to the extent and, in the case of a Restricted Subsidiary that is not a
Wholly Owned Restricted Subsidiary, in the same proportion that the Consolidated
Net Income of such Consolidated Subsidiary was included in calculating the
Consolidated Net Income of such Person and (y) only to the extent that the
amount specified in Clause (x) is not subject to restrictions that prevent the
payment of dividends or the making of distributions to such Person.
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"Consolidated EBITDA Coverage Ratio" of any Person means for any period (the
"Reference Perod") with respect to any date of computation (the "Transaction
Date") the ratio of (i) Consolidated EBITDA of such Person for such period to
(ii) Consolidated Interest Expense of such Person for such period. In making the
foregoing calculation, (A) pro forma effect shall be given to any Debt Incurred
during such Reference Period or subsequent to the end of such Reference Period
and on or prior to the Transaction Date to the extent such Debt is outstanding
at the Transaction Date, in each case as if such Debt had been Incurred on the
first day of such Reference Period and after giving pro forma effect to the
application of the proceeds thereof as if such application had occurred on such
first day; (B) Consolidated Interest Expense attributable to interest on any
Debt (whether existing or being Incurred) computed on a pro forma basis and
bearing a floating interest rate shall be computed as if the rate in effect on
the Transaction Date (taking into account any Interest Rate Agreement applicable
to such Debt if such Interest Rate Agreement has a remaining term in excess of
12 months or at least equal to the remaining term of such Debt) had been the
applicable rate for the entire period; (C) there shall be excluded from
Consolidated Interest Expense any Consolidated Interest Expense related to any
amount of Debt that was outstanding during such Reference Period or thereafter
but that is not outstanding or is to be repaid on the Transaction Date; and (D)
pro forma effect shall be given to asset dispositions and asset acquisitions by
such Person (including giving pro forma effect to the application of proceeds of
any asset disposition) that occur during such Reference Period or thereafter and
prior to the Transaction Date as if they had occurred and such proceeds had been
applied on the first day of such Reference Period.
"Consolidated Income Tax Expense" of any Person means for any period the
consolidated provision for income taxes of such Person and its Consolidated
Subsidiaries for such period determined in accordance with generally accepted
accounting principles.
"Consolidated Interest Expense" of any Person means for any period the
consolidated interest expense included in a consolidated income statement
(without deduction of interest income) of such Person and its Consolidated
Subsidiaries for such period determined in accordance with generally accepted
accounting principles, including without limitation or duplication (or, to the
extent not so included, with the addition of), (i) the portion of any rental
obligation in respect of any Capital Lease Obligation allocable to interest
expense in accordance with generally accepted accounting principles; (ii) the
amortization of Debt discounts; (iii) any payments or fees with respect to
letters of credit, bankers' acceptances or similar facilities; (iv) fees with
respect to Interest Rate Agreements or foreign currency hedge, exchange or
similar agreements; (v) an amount calculated by dividing the Preferred Stock
dividends declared and paid or payable in cash by a number equal to (a) one
minus (b) the then current combined federal, state and local statutory tax rate
of such Person, expressed as a decimal; (vi) the portion of the rental
obligation in respect of any Sale and Leaseback Transaction allocable to
interest expense (determined as if such obligation were a Capital Lease
Obligation); (vii) any interest capitalized in accordance with generally
accepted accounting principles and (viii) the portion of any Rental Expense in
respect of any Specified Operating Lease which would have been allocable to
interest expense in accordance with generally accepted accounting principles if
such Specified Operating Lease were treated as a Capitalized Lease Obligation.
"Consolidated Net Income" of any Person means for any period the consolidated
net income (or loss) of such Person and its Consolidated Subsidiaries for such
period determined in accordance with generally accepted accounting principles;
provided that there shall be excluded therefrom to the extent included therein,
without duplication, (a) the net income (or loss) of any Person acquired by such
Person or a Restricted Subsidiary of such Person in a pooling-of-interests
transaction for any period prior to the date of such transaction, (b) the net
income (but not net loss) of any Consolidated Subsidiary of such Person that is
subject to restrictions that prevent the payment of dividends or the making of
distributions to such Person to the extent of such restrictions, (c) the net
income (or loss) of any Person that is not a Consolidated Subsidiary of such
Person except to the extent of the amount of dividends or other distributions
actually paid to such Person by such other Person during such period, (d) net
gains or losses on asset dispositions by such Person or its Consolidated
Subsidiaries, (e) any net income (loss) of a Consolidated Subsidiary that is
attributable to a minority interest in such Consolidated Subsidiary, (f) all
extraordinary gains and extraordinary losses except to the extent such gain or
loss involves a present or future cash payment, (g) all write-offs of goodwill
and other items and non-cash adjustments, including charges associated with
grants or awards of restricted stock, (h) $46.0 million and $155.7 million of
charges taken in the second and third quarters, respectively, of fiscal 1996 and
up to a $25.0 million charge to be taken in the fourth fiscal quarter of 1996 in
connection with the Spin-Off Distributions (provided that, except to the extent
provided by Clause (i) below, any cash payments made with respect to such
charges on or after January 1, 1997, shall be subtracted from Consolidated Net
Income in the period actually paid) and (i) any charge taken by the Company
after the date of the Indenture to the extent the Company is reimbursed in cash
for such charge pursuant to, and in accordance with, the Transaction Agreement.
"Consolidated Net Worth" of any Person means the consolidated stockholders'
equity of such Person and its Consolidated Subsidiaries, as determined on a
consolidated basis in accordance with generally accepted accounting principles,
less amounts attributable to Redeemable Interests of such Person; provided,
however, that, with respect to the Company and its Consolidated Subsidiaries,
adjustments following the date of the Indenture to the accounting books and
records of the Company and its Consolidated Subsidiaries (other than the change
in accounting policy for intangible assets as described in the first paragraph
under
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"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Changes in Accounting Policies") in accordance with Accounting
Principles Board Opinions Nos. 16 and 17 (or successor opinions thereto) or
otherwise resulting from the acquisition of control of the Company by another
Person shall not be given effect to.
"Consolidated Subsidiaries" of any Person means all other Persons that would be
accounted for as consolidated Persons in such Person's financial statements in
accordance with generally accepted accounting principles; provided, however,
that, for any particular period during which any Subsidiary was an Unrestricted
Subsidiary, "Consolidated Subsidiaries" will exclude such Subsidiary for such
period (or portion thereof) during which it was an Unrestricted Subsidiary.
"Credit Facility" means the Credit Agreement, dated as of December 5, 1996,
among the Company, the banks named therein, NationsBank, N.A., as Issuing Bank,
Wachovia Bank of Georgia, N.A., as Swingline Bank, and Morgan Guaranty Trust
Company of New York, as Administrative Agent (and any related guarantee
agreements), as amended from time to time, and including any and all renewals,
refinancings, refundings or replacements thereof and successive renewals,
refinancings, refundings and replacements thereof.
"Credit Rating" means the long-term unsecured debt rating provided by either
S&P or Moody's, or any successor to either thereof; provided, however, that
if there is a difference in such ratings the lower rating shall be used.
"Debt" means (without duplication), with respect to any Person, whether recourse
is to all or a portion of the assets of such Person, (i) every obligation of
such Person for money borrowed, (ii) every obligation of such Person evidenced
by bonds, debentures, notes or other similar instruments, including obligations
incurred in connection with the acquisition of property, assets or businesses,
(iii) every reimbursement obligation of such Person with respect to letters of
credit, bankers' acceptances or similar facilities issued for the account of
such Person, (iv) every obligation of such Person issued or assumed as the
deferred purchase price of property or services (but excluding trade accounts
payable or accrued liabilities arising in the ordinary course of business), (v)
every Capital Lease Obligation of such Person, (vi) the Attributable Value in
respect of any Specified Operating Lease, (vii) the maximum fixed redemption or
repurchase price of Redeemable Interests of such Person at the time of
determination, (viii) every payment obligation of such Person under Interest
Rate Agreements or foreign currency hedge, exchange or similar agreements at the
time of determination and (ix) every obligation of the type referred to in
Clauses (i) through (viii) of another Person and all dividends of another Person
the payment of which, in either case, such Person has Guaranteed or for which
such Person is responsible or liable, directly or indirectly, jointly or
severally, as obligor, Guarantor or otherwise.
"Guaranty" by any Person means any obligation, contingent or otherwise, of such
Person guaranteeing any Debt, or dividends or distributions on any equity
security, of any other Person (the "primary obligor") in any manner, whether
directly or indirectly, and including, without limitation, any obligation of
such Person (i) to purchase or pay (or advance or supply funds for the purchase
or payment of) such Debt or to purchase (or to advance or supply funds for the
purchase of) any security for the payment of such Debt, (ii) to purchase
property, securities or services for the purpose of assuring the holder of such
Debt of the payment of such Debt, or (iii) to maintain working capital, equity
capital or other financial statement condition or liquidity of the primary
obligor so as to enable the primary obligor to pay such Debt (and "Guaranteed,"
"Guaranteeing" and "Guarantor" shall have meanings correlative to the
foregoing); provided, however, that the Guaranty by any Person shall not include
endorsements by such Person for collection or deposit, in either case, in the
ordinary course of business.
"Incur" means, with respect to any Debt, Operating Lease, or other obligation of
any Person, to create, issue, incur (by conversion, exchange or otherwise),
assume, Guarantee or otherwise become liable in respect of such Debt or other
obligation or the recording, as required pursuant to generally accepted
accounting principles or otherwise, of any such Debt or other obligation on the
balance sheet of such Person (and "Incurrence," "Incurred," "Incurrable" and
"Incurring" shall have meanings correlative to the foregoing); provided,
however, that a change in generally accepted accounting principles that results
in an obligation of such Person that exists at such time becoming Debt shall not
be deemed an incurrence of such Debt.
"Intercompany Agreement" means the Transaction Agreement, the Corning/Quest
Diagnostics Spin-Off Tax Indemnification Agreement, the Quest
Diagnostics/Covance Spin-Off Tax Indemnification Agreement, the Tax Sharing
Agreement and any other agreements contemplated by the foregoing.
"Interest Rate Agreement" means, with respect to any Person, any interest rate
swap agreement, interest rate cap agreement or other similar agreement designed
to protect such Person or its Subsidiaries (or in the case of the Company, the
Company and its Restricted Subsidiaries) against fluctuations in interest rates.
"Investment" by any Person in any other Person means (i) any direct or indirect
loan, advance or other extension of credit or capital contribution to or for the
account of such other Person (by means of any transfer of cash or other property
to any Person or any payment for property or services for the account or use of
any Person, or otherwise), (ii) any direct or indirect purchase or other
acquisition, including by way of merger or consolidation, of any Capital Stock,
bond, note, debenture or other debt or
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equity security or evidence of Debt, or any other ownership interest, issued by
such other Person, whether or not such acquisition is from such or any other
Person, (iii) any direct or indirect payment by such Person on a Guaranty of any
obligation of or for the account of such other Person or any direct or indirect
issuance by such Person of such a Guaranty or (iv) any other investment of cash
or other property by such Person in or for the account of such other Person.
"Lien" means, with respect to any property or assets, any mortgage or deed of
trust, pledge, hypothecation, assignment, deposit arrangement, security
interest, lien, charge, easement or title exception, encumbrance, preference,
priority or other security agreement or preferential arrangement of any kind
or nature whatsoever on or with respect to such property or assets (including
any conditional sale or other title retention agreement having substantially
the same economic effect as any of the foregoing).
"Net Available Proceeds" from any Asset Disposition by any Person means cash or
Cash Equivalents received (including by way of sale or discounting of a note,
installment receivable or other receivable, but excluding any other
consideration received in the form of assumption by the acquiree of Debt or
other obligations relating to such properties or assets or received in any other
noncash form) therefrom by such Person, net of (i) all legal, title and
recording tax expenses, commissions and other fees and expenses Incurred and all
federal, state, provincial, foreign and local taxes required to be accrued as a
liability as a consequence of such Asset Disposition, (ii) all payments made by
such Person or its Restricted Subsidiaries on any Debt that is secured by such
assets in accordance with the terms of any Lien upon or with respect to such
assets or that must, by the terms of such Lien, or in order to obtain a
necessary consent to such Asset Disposition, or by applicable law, be repaid out
of the proceeds from such Asset Disposition, (iii) all distributions and other
payments made to minority interest holders in Restricted Subsidiaries of such
Person or joint ventures as a result of such Asset Disposition and (iv) any
amounts required to be escrowed or reserved by such Person or its Restricted
Subsidiaries with respect to liabilities retained by such Person or its
Restricted Subsidiaries, including any indemnification or purchase price
adjustments (provided that when such amounts are released from escrow or such
reserve, such amounts will be treated as Net Available Proceeds and applied as
required by the Indenture).
"Non-Core Assets" means (i) the Company's domestic diagnostic kits business and
(ii) those of the Company's domestic regional laboratories (and the assets and
liabilities related thereto, including branch laboratories and patient service
centers) (each hereinafter, a "Specified Laboratory") which had Operating Margin
(as defined below) less than 3% for the nine month period ended September 30,
1996 as reflected in the internal financial statements of the Company for such
period; provided, however, that, in the case of Clause (ii), a Specified
Laboratory shall cease to be a Non-Core Asset if the Operating Margin of such
Specified Laboratory for any four full fiscal quarters commencing with the four
fiscal quarters ended December 31, 1996 exceeds 5% as reflected in the internal
financial statements of the Company for such period. "Operating Margin" means
with respect to a Specified Laboratory, the quotient of (x) the Consolidated
EBITDA of the Company attributable to such Specified Laboratory (assuming for
this purpose that corporate overhead is allocated to the Specified Laboratory in
an amount equal to 5% of the revenues of such Specified Laboratory) and (y) the
Company's net revenues attributable to such Specified Laboratory, in each case,
as reflected in the internal financial statements of the Company. Five of the
Company's regional laboratories are Specified Laboratories. The aggregate net
revenues and EBITDA of the Company related to the Non-Core Assets for the year
ended December 31, 1995 were $312.8 million and $18.6 million, respectively, and
for the nine months ended September 30, 1996 were $233.6 million and $5.2
million, respectively. The Non-Core Assets had a tangible asset value of $116.7
million at September 30, 1996.
"Operating Lease" of any Person means the obligation of such Person to pay rent
or other payment amounts under a lease of (or other Debt arrangements conveying
the right to use) real or personal property, other than a Capital Lease
Obligation or a Sale and Leaseback Transaction; but excluding the Company's
laboratory facility in Cambridge, Massachusetts..
"Pari Passu", when used with respect to the ranking of any Debt of any Person in
relation to other Debt of such Person, means that each such Debt (a) either (i)
is not subordinated in right of payment to any other Debt of such Person or (ii)
is subordinate in right of payment to the same Debt of such Person as is the
other and is so subordinate to the same extent and (b) is not subordinate in
right of payment to the other or to any Debt of such Person as to which the
other is not so subordinate.
"Permitted Business" of the Company or any Restricted Subsidiary means a
business carried on by the Company or any Restricted Subsidiary at the date of
the Indenture and any business related, ancillary or complementary to any such
business.
"Permitted Investment" means (i) any Investment in a Wholly Owned Subsidiary of
such Person, (ii) securities either issued directly or fully guaranteed or
insured by the government of the United States of America or any agency or
instrumentality thereof (provided that the full faith and credit of the United
States is pledged in support thereof) having maturities of not more than one
year, (iii) time deposits and certificates of deposit, having maturities of not
more than one year from the date of deposit, of any domestic commercial bank
having capital and surplus in excess of $500.0 million and having peer group
rating of B or better (or the equivalent thereof) by Thompson BankWatch, Inc. or
outstanding long-term debt rated BBB or better (or the equivalent thereof) by
S&P or Baa or better (or the equivalent thereof) by Moody's, (iv) repurchase
obligations with a term
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of not more than seven days for underlying securities of the types described in
Clauses (ii) and (iii) above entered into with any bank meeting the
qualifications specified in Clause (iii) above, (v) commercial paper (other than
commercial paper issued by an Affiliate or Related Person) rated A-1 or the
equivalent thereof by S&P or P-1 or the equivalent thereof by Moody's, and in
each case maturing within 90 days, (vi) any Investment in a Person that, as a
consequence of such Investment, becomes a Restricted Subsidiary and that is
engaged in a Permitted Business if (A) the Company would, at the time of such
Investment and after giving pro forma effect thereto as if such Investment had
been made at the beginning of the most recently ended four full fiscal quarter
period for which internal financial statements are available immediately
preceding the date of such Investment, have been permitted to Incur at least
$1.00 of additional Debt pursuant to the Consolidated EBITDA Coverage Ratio test
set forth in the first paragraph under "Certain Covenants--Limitation on
Incurrence of Debt" above and (B) immediately after giving effect to such
Investment, the Company would have a Consolidated Net Worth not less than 95% of
the Consolidated Net Worth of the Company immediately prior to such Investment,
(vii) receivables owing to the Company or a Subsidiary of the Company if created
or acquired in the ordinary course of business and payable or dischargeable in
accordance with customary trade terms, (viii) extensions of trade credit made in
the ordinary course of business and on customary terms, (ix) the letter of
credit issued pursuant to the Credit Facility in favor of Kenneth W. Freeman to
secure his pension benefits in an amount not to exceed $10.0 million and (x) any
Investment in addition to Investments permitted to be made by Clauses (i)
through (ix) above if the aggregate amount (including cash and the fair value of
property other than cash, as determined by the Board of Directors) of such
Investment, together with all other investments made pursuant to this Clause (x)
and then held by the Company and its Restricted Subsidiaries (determined as of
the time made), does not exceed $5.0 million.
"Permitted Joint Venture" means any Person which is engaged in the acquisition,
ownership, operation or management of assets in a Permitted Business.
"Permitted Joint Venture Investment" means an Investment in a Permitted Joint
Venture.
"Permitted Liens" means (i) Liens existing at the date of the Indenture; (ii)
Liens securing only Senior Debt; (iii) Liens securing only the Notes; (iv) Liens
in favor of only the Company; (v) Liens on property of a Person existing at the
time such Person is merged into or consolidated with the Company (provided that
such Lein was not Incurred in anticipation of such transaction and was in
existence prior to such transaction); (vi) Liens on property existing
immediately prior to the acquisition thereof (provided that such Lien was not
Incurred in anticipation of such transaction and was in existence prior to such
transaction); (vii) Liens to secure Debt Incurred for the purpose of financing
all or any part of the purchase price or the cost of construction or improvement
of the property subject to such Liens; provided that (a) the principal amount of
any Debt secured by such Lien does not exceed 100% of such purchase price or
cost, (b) such Lien does not extend to or cover any other property other than
such item of property and any improvements on such item, (c) such Lien is
incurred prior to or within 270 days after the acquisition of such property or
the completion of the relevant improvements and (d) the Incurrence of such Debt
is permitted pursuant to the covenants described under "Certain
Covenants--Limitation on Incurrence of Debt" and "--Limitation on Layered and
Junior Debt"; (viii) Liens on property of the Company or any of its Subsidiaries
in favor of the United States of America or any state thereof, or any
instrumentality of either, to secure certain payments pursuant to any contract
or statute; (ix) Liens for taxes or assessments or other governmental charges or
levies which are being contested in good faith and for which adequate reserves
are being maintained, to the extent required by generally accepted accounting
principles; (x) title exceptions, easements and other similar Liens that are not
consensual and that do not materially impair the use of the property subject
thereto; (xi) Liens to secure obligations under workmen's compensation laws,
unemployment compensation, old-age pensions and other social security benefits
or similar legislation, including Liens with respect to judgments which are not
currently dischargeable; (xii) warehousemen's, materialmen's and other similar
Liens for sums being contested in good faith and with respect to which adequate
reserves are being maintained, to the extent required by generally accepted
accounting principles; (xiii) Liens Incurred to secure the performance of
statutory obligations, surety or appeal bonds, performance or return-of-money
bonds or other obligations of a like nature incurred in the ordinary course of
business; (xiv) Liens to secure payment of the Company's sinking fund
obligations in respect of certain Debt of the Company outstanding at the date of
the Indenture in the amount of (pound)5 million in connection with the Company's
acquisition of J.S. Pathology PLC in 1992; and (xv) Liens to secure any
extension, renewal, refinancing or refunding (or successive extensions,
renewals, refinancings or refundings), in whole or in part, of any Debt secured
by Liens referred to in the foregoing Clauses (i) to (xiv) so long as such Lien
does not extend to any other property and the Debt so secured is not increased.
"Preferred Stock", as applied to the Capital Stock of any Person, means Capital
Stock of such Person of any class or classes (however designated) that ranks
prior, as to the payment of dividends or as to the distribution of assets upon
any voluntary or involuntary liquidation, dissolution or winding up of such
Person, to shares of Capital Stock of any other class of such Person.
"Redeemable Interest" of any Person means any equity security of or other
ownership interest in such Person that by its terms or otherwise is required to
be redeemed or repaid prior to the Stated Maturity of the Notes or is redeemable
or repayable at the option of the holder thereof at any time prior to the Stated
Maturity of the Notes.
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"Related Person" of any Person means any other Person owning (a) 5% or more of
the outstanding Common Stock of such Person or (b) 5% or more of the Voting
Stock of such Person.
"Rental Expense" in respect of an Operating Lease means the total rental expense
under such Operating Lease determined in accordance with generally accepted
accounting principles.
"Restricted Subsidiary" means any Subsidiary of the Company other than an
Unrestricted Subsidiary.
"Sale and Leaseback Transaction" means an arrangement with any lender or
investor or to which such lender or investor is a party (excluding the Company's
laboratory facility in Cambridge, Massachusetts and the real property leased by
the Company in Des Plaines, Illinois) providing for the leasing by a Person of
any property or asset of such Person which has been or is being sold or
transferred by such Person more than 270 days after the acquisition thereof or
the completion of construction or commencement of operation thereof to such
lender or investor or to any person to whom funds have been or are to be
advanced by such lender or investor on the security of such property or asset.
The stated maturity of such arrangement shall be the date of the last payment of
rent or any other amount due under such arrangement prior to the first date on
which such arrangement may be terminated by the lessee without payment of a
penalty.
"Senior Debt" means (i) Debt of the Company created pursuant to the Credit
Facility including all reborrowings by the Company, (ii) all other Debt of the
Company referred to in clauses (i), (ii), (iii) or (viii) of the definition of
Debt, whether Incurred on or prior to the date of the Indenture or thereafter
Incurred and (iii) amendments, modifications, renewals, extensions, refinancings
and refundings by the Company of any such Debt; provided, however, the following
shall not constitute Senior Debt: (A) any Debt owed to a Person when such Person
is a Subsidiary of the Company, (B) any Debt which by the terms of the
instrument creating or evidencing the same is not superior in right of payment
to the Notes, (C) any Debt Incurred in violation of the Indenture or (D) any
Debt which is subordinated in right of payment in any respect to any other Debt
of the Company. For purposes of this definition, "Debt" includes any obligation
to pay principal, premium (if any), interest, penalties, reimbursement or
indemnity amounts, fees and expenses (including interest accruing on or after
the filing of any petition in bankruptcy or for reorganization relating to the
Company whether or not a claim for post-petition interest is allowed in such
proceeding).
"Specified Operating Lease" means any Operating Lease that the Company elects to
Incur pursuant to Clause (vii) of the provisions of the Indenture described
under "Certain Covenants--Limitation on Leases."
"Spin-Off Distributions" means, collectively, (i) the distribution to holders of
common stock of Corning of all of the outstanding shares of common stock of the
Company and (ii) the distribution to holders of common stock of the Company of
all of the outstanding shares of common stock of Covance.
"Spin-Off Payments" means: (i) the distribution to holders of Company Common
Stock of all of the outstanding shares of Covance Common Stock, (ii) the
repayment of $500 million (A) intercompany obligations owed to Corning by the
Company and (B) payments under the Tax Sharing Agreement; (iii) the issuance by
the Company of up to $1.0 million liquidation preference preferred stock to
Corning and the payment of cash dividends thereon; provided, however, that the
aggregate amount of all such dividends following the date of the Indenture shall
not exceed $150,000 per year; (iv) the transfer of $140 million from Covance to
the Company and subsequent transfer from the Company to Corning of such $140
million in repayment of intercompany debt owed by Covance to Corning and the
Company and in repayment of certain tax liabilities of Covance and in
satisfaction of a dividend from Covance to the Company and (v) the payment of
any amount of cash by the Company to Corning that may be necessary so that the
Company will not have more than $40 million of cash at the time of the
Distribution Date plus the Net Available Proceeds from any asset dispositions
made prior to the Distribution Date.
"Subordinated Debt" means Debt of the Company as to which the payment of
principal of (and premium, if any) and interest and other payment obligations in
respect of such Debt shall be subordinate to the prior payment in full of the
Notes to at least the following extent: (i) no payments of principal of (or
premium, if any) or interest on or otherwise due in respect of such Debt may be
permitted for so long as any default in the payment of principal (or premium, if
any) or interest on the Notes exists; (ii) in the event that any other default
that with the passing of time or the giving of notice, or both, would constitute
an event of default exists with respect to the Notes, upon notice by 25% or more
in principal amount of the Notes to the Trustee, the Trustee shall have the
right to give notice to the Company and the holders of such Debt (or trustees or
agents therefor) of a payment blockage, and thereafter no payments of principal
of (or premium, if any) or interest on or otherwise due in respect of such Debt
may be made for a period of 179 days from the date of such notice; and (iii)
such Debt may not (x) provide for payments of principal of such Debt at the
stated maturity thereof or by way of a sinking fund applicable thereto or by way
of any mandatory redemption, defeasance, retirement or repurchase thereof by the
Company (including any redemption, retirement or repurchase which is contingent
upon events or circumstances, but excluding any retirement required by virtue of
acceleration of such Debt upon an event of default thereunder), in each case
prior to the final Stated Maturity of the Notes or (y) permit redemption or
other retirement (including pursuant to an offer to purchase made by the
Company) of such other Debt at the
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option of the holder thereof prior to the final Stated Maturity of the Notes,
other than a redemption or other retirement at the option of the holder of such
Debt (including pursuant to an offer to purchase made by the Company) which is
conditioned upon a change of control of the Company pursuant to provisions
substantially similar to those described under "Repurchase at the Option of
Holders--Change of Control" (and which shall provide that such Debt will not be
repurchased pursuant to such provisions prior to the Company's repurchase of the
Notes required to be repurchased by the Company pursuant to the provisions
described under "Repurchase at the Option of Holders--Change of Control").
"Subsidiary" of any Person means (i) a corporation more than 50% of the
outstanding Voting Stock of which is owned, directly or indirectly, by such
Person or by one or more other Subsidiaries of such Person or by such Person and
one or more Subsidiaries thereof, (ii) a partnership of which such Person, or
one or more other Subsidiaries of such Person or such Person and one or more
other Subsidiaries thereof, directly or indirectly, is the general partner and
has the power to direct the policies, management and affairs or (iii) any other
Person (other than a corporation or partnership) in which such Person, or one or
more other Subsidiaries of such Person or such Person and one or more other
Subsidiaries thereof, directly or indirectly, has at least a majority ownership
interest and power to direct the policies, management and affairs thereof.
"Transaction Agreement" means the Transaction Agreement among Corning, the
Company Corning Life Sciences Inc., Corning Clinical Laboratories Inc. (MI) and
Covance dated December __, 1996.
"Unrestricted Subsidiary" means Associated Clinical Laboratories L.P., Damon
Investment Holdings, Inc., Corning Laboratorios Clinicos, S.A. de C.V.,
Laboratorios Clinicos de Mexico, S.A. de C.V., Servicios de Laboratorio, S.A. de
C.V., Laboratorios de Frontera Polanco, S.A. de C.V., Laboratorios de Analisis
Biomedicos, S.A., Metpath Europe Limited, Nichols Institute International
Holding B.V., Nichols Institute Sales Corporation, Nichols Institute Diagnostics
Limited, Nichols Institute Diagnostics Trading S.A.; Nichols Institute
Diagnostika GMBH, Nichols Institute Diagnostics B.V., Analisis, S.A., Nomad
Massachusetts Inc., Trans United Casualty and Indemnity Insurance Company, and
each other Subsidiary of the Company that is deemed to be an Unrestricted
Subsidiary in accordance with the provisions in the Indenture described under
the caption "Certain Covenants--Unrestricted Subsidiaries." The aggregate net
revenues, and net loss from the Unrestricted Subsidiaries for the year ended
December 31, 1995 were $21.7 million, and $0.5 million, respectively. The
Unrestricted Subsidiaries had an aggregate net book value of $0.1 million, at
December 31, 1995. The aggregate net revenues and net income for the
Unrestricted Subsidiaries was less than 3% of the Company's net revenues and net
income for the nine months ended September 30, 1996. The Unrestricted
Subsidiaries had an aggregate net book value of less than 3% of the Company's
net book value at September 30, 1996.
"U.S. Government Obligations" means securities that are (x) direct
obligations of the United States of America for the payment of which its full
faith and credit is pledged or (y) obligations of a Person controlled or
supervised by and acting as an agency or instrumentality of the United States
of America the payment of which is unconditionally guaranteed as a full faith
and credit obligation by the United States of America, which, in either case,
are not callable or redeemable at the option of the issuer thereof, and shall
also include a depository receipt issued by a bank (as defined in Section 3
(a) (2) of the Securities Act of 1933, as amended) as custodian with respect
to any such U.S. Government Obligation or a specific payment of principal of
or interest on any such U.S. Government Obligation held by such custodian for
the account of the holder of such depository receipt, provided that (except
as required by law) such custodian is not authorized to make any deduction
from the amount payable to the holder of such depository receipt from any
amount received by the custodian in respect of the U.S. Government Obligation
or the specific payment of principal of or interest on the U.S. Government
Obligation evidenced by such depository receipt.
"Voting Stock" of any Person means Capital Stock of such Person that
ordinarily has voting power for the election of directors (or persons
performing similar functions) of such Person, whether at all times or only so
long as no senior class of securities has such voting power by reason of any
contingency.
"Weighted Average Life" means, as of the date of determination, with respect
to any Debt, the quotient obtained by dividing (i) the sum of the products of
the number of years from the date of determination to the dates of each
successive scheduled principal payment of such Debt and the amount of such
principal by (ii) the sum of all such principal payments.
"Wholly Owned" means, with respect to any Subsidiary of any Person, the
ownership of all of the outstanding Capital Stock or other ownership
interests of such Subsidiary (other than directors' qualifying shares or
Investments by foreign nationals mandated by applicable law) by such Person
or one or more Wholly Owned Subsidiaries of such Person or any combination of
the foregoing.
Events of Default
The following will be Events of Default under the Indenture: (a) failure to
pay any interest on any Note when due (whether or not prohibited by the
subordination provisions described under "Subordination" above), continued
for 30 days; (b) failure to pay principal of (or premium, if any, on) any
Note when due (whether or not prohibited by the subordination provisions
described
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under "Subordination" above); (c) failure to perform or comply with the
provisions described under "Mergers, Consolidations and Certain Sales of Assets"
or the provisions described under "Repurchase at the Option of Holders--Asset
Dispositions" and "--Change of Control"; (d) failure to perform any other
covenant or warranty of the Company in the Indenture, continued for 60 days
after written notice to the Company as provided in the Indenture; (e) a default
or defaults under any bonds, debentures, notes or other evidences of, or
obligations constituting, Debt by the Company or any Restricted Subsidiary or
under any mortgages, indentures, instruments or agreements under which there may
be issued or existing or by which there may be secured or evidenced any Debt of
the Company or any such Restricted Subsidiary with a principal or similar amount
then outstanding, individually or in the aggregate, in excess of $15.0 million,
whether such Debt now exists or is hereafter created, which default or defaults
constitute a failure to pay any portion of the principal of such Debt at final
stated maturity when due and payable after the expiration of any applicable
grace period with respect thereto or will have resulted in such Debt becoming or
being declared due and payable prior to the date on which it would otherwise
have become due and payable; (f) the rendering of a final judgment or judgments
(not subject to appeal) against the Company or any of its Restricted
Subsidiaries in an aggregate amount in excess of $15.0 million which remains
unstayed, undischarged or unbonded for a period of 60 days thereafter; and (g)
certain events of bankruptcy, insolvency or reorganization affecting the Company
or any Restricted Subsidiary of the Company. (Section 501).
Subject to the provisions of the Indenture relating to the duties of the Trustee
in case an Event of Default occurs and is continuing, the Trustee will be under
no obligation to exercise any of its rights or powers under the Indenture at the
request or direction of any of the Holders, unless such Holders have offered to
the Trustee reasonable indemnity. (Section 603). Subject to such provisions for
the indemnification of the Trustee, the Holders of a majority in aggregate
principal amount of the Outstanding Notes will have the right to direct the
time, method and place of conducting any proceeding for any remedy available to
the Trustee or exercising any trust or power conferred on the Trustee. (Section
512).
If an Event of Default (other than an Event of Default of the type described in
Clause (g) above insofar as the Company is concerned) occurs and is continuing,
either the Trustee or the Holders of at least 25% in aggregate principal amount
of the Outstanding Notes may accelerate the maturity of all Notes, and if an
Event of Default of the type described in Clause (g) above occurs insofar as the
Company is concerned, the principal of and any accrued interest on the Notes
then outstanding will become immediately due and payable; provided, however,
that after such acceleration, but before a judgment or decree based on
acceleration, the Holders of a majority in aggregate principal amount of
Outstanding Notes may, under certain circumstances, rescind and annul such
acceleration if all Events of Default, other than the non-payment of accelerated
principal, have been cured or waived as provided in the Indenture. (Section
502). For information as to waiver of defaults, see "Modification and Waiver."
No Holder of any Note will have any right to institute any proceeding with
respect to the Indenture or for any remedy thereunder, unless such Holder has
previously given to the Trustee written notice of a continuing Event of Default
and unless also the Holders of at least 25% in aggregate principal amount of the
Outstanding Notes have made written request, and offered reasonable indemnity,
to the Trustee to institute such proceeding as trustee, and the Trustee has not
received from the Holders of a majority in aggregate principal amount of the
Outstanding Notes a direction inconsistent with such request, and the Trustee
has failed to institute such proceeding within 60 days of receipt of such
written notice. However, such limitations do not apply to a suit instituted by a
Holder of a Note for enforcement of payment of the principal of (and premium, if
any) or interest on such Note on or after the respective due dates expressed in
such Note. (Sections 507 and 508).
In the case of any Event of Default occurring by reason of any willful action
(or inaction) taken (or not taken) by or on behalf of the Company with the
intention of avoiding payment of the premium that the Company would have had to
pay if the Company then had elected to redeem the Notes pursuant to the
provisions described in the first paragraph above under "Optional Redemption,"
an equivalent premium will also become and be immediately due and payable upon
the acceleration of the Notes.
The Company will be required to furnish to the Trustee annually a statement as
to the performance by the Company of certain of its obligations under the
Indenture and as to any default in such performance. The Company will be
required to deliver to the Trustee, as soon as possible and in any event within
10 days after the Company becomes aware of the occurrence of an Event of Default
or an event which, with notice or the lapse of time or both, would constitute an
Event of Default, an Officers' Certificate setting forth the details of such
Event of Default or default, and the action which the Company proposes to take
with respect thereto. (Section 1020).
Defeasance
The Indenture will provide that (A) if applicable, the Company will be
discharged from any and all obligations in respect of the Outstanding Notes
(including the provisions described under "Subordination") or (B) if applicable,
the Company may omit to comply with certain restrictive covenants, and that such
omission will not be deemed to be an Event of Default under the
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Indenture and the Notes and the provisions described under "Subordination" shall
cease to apply, in either case (A) or (B) upon irrevocable deposit with the
Trustee, in trust, of money and/or U.S. Government Obligations that will provide
money in an amount sufficient in the opinion of a nationally recognized firm of
independent certified public accountants to pay the principal of, and premium,
if any, and each installment of interest, if any, on the Outstanding Notes. With
respect to clause (B), the obligations under the Indenture other than with
respect to such covenants and the Events of Default other than the Event of
Default relating to such covenants above will remain in full force and effect.
Such trust may only be established if, among other things (i) with respect to
clause (A), the Company has received from, or there has been published by, the
Internal Revenue Service a ruling or there has been a change in law, which in
the Opinion of Counsel provides that Holders of the Notes will not recognize
gain or loss for Federal income tax purposes as a result of such deposit,
defeasance and discharge and will be subject to Federal income tax on the same
amount, in the same manner and at the same times as would have been the case if
such deposit, defeasance and discharge had not occurred; or, with respect to
clause (B), the Company has delivered to the Trustee an Opinion of Counsel to
the effect that the Holders of the Notes will not recognize gain or loss for
Federal income tax purposes as a result of such deposit and defeasance and will
be subject to Federal income tax on the same amount, in the same manner and at
the same times as would have been the case if such deposit and defeasance had
not occurred; (ii) no Event of Default (or event that with the passing of time
or the giving of notice, or both, will constitute an Event of Default) shall
have occurred or be continuing; (iii) the Company has delivered to the Trustee
an Opinion of Counsel to the effect that such deposit shall not cause the
Trustee or the trust so created to be subject to the Investment Company Act of
1940; (iv) no default on any Senior Debt shall have occurred and be continuing;
and (v) certain other customary conditions precedent are satisfied. (Sections
1501, 1502, 1503 and 1504).
In the event the Company omits to comply with its remaining obligations under
the Indenture and the Notes after a defeasance of the Indenture with respect to
the Notes as described under Clause (B) above and the Notes are declared due and
payable because of the occurrence of any Event of Default, the amount of money
and U.S. Government Obligations on deposit with the Trustee may be insufficient
to pay amounts due on the Notes at the time of the acceleration resulting from
such Event of Default. However, the Company will remain liable in respect of
such payments.
Modification and Waiver
Modifications and amendments of the Indenture may be made by the Company and the
Trustee with the consent of the Holders of a majority in aggregate principal
amount of the Outstanding Notes; provided, however, that no such modification or
amendment may, without the consent of the Holder of each Outstanding Note
affected thereby, (a) change the Stated Maturity of the principal of, or any
installment of interest on, any Note, (b) reduce the principal amount of (or the
premium, if any), or interest on, any Note, (c) change the place or currency of
payment of principal of (or premium, if any), or interest on, any Note, (d)
impair the right to institute suit for the enforcement of any payment on or with
respect to any Note, (e) reduce the above-stated percentage of Outstanding Notes
necessary to modify or amend the Indenture, (f) reduce the percentage of
aggregate principal amount of Outstanding Notes necessary for waiver of
compliance with certain provisions of the Indenture or for waiver of certain
defaults, (g) modify any provisions of the Indenture relating to the
modification and amendment of the Indenture or the waiver of past defaults or
covenants, except as otherwise specified, (h) modify any of the provisions of
the Indenture relating to the subordination of the Notes in a manner adverse to
the Holders or (i) modify the provisions described under "Repurchase at the
Option of Holders--Asset Dispositions" and under "--Change of Control" in a
manner adverse to the Holders thereof. (Section 902).
The Holders of a majority in aggregate principal amount of the Outstanding Notes
may waive compliance by the Company with certain restrictive provisions of the
Indenture. (Section 1021). The Holders of a majority in aggregate principal
amount of the Outstanding Notes may waive any past default under the Indenture,
except a default in the payment of principal (or premium, if any) or interest.
(Section 513).
Notices
Notices to Holders of Notes will be given by mail to the addresses of such
Holders as they may appear in the Security Register. (Sections 101 and 106).
Title
The Company, the Trustee and any agent of the Company or the Trustee may treat
the Person in whose name a Note is registered as the absolute owner thereof
(whether or not such Note may be overdue) for the purpose of making payment and
for all other purposes. (Section 308).
Governing Law
The Indenture and the Notes will be governed by, and construed in accordance
with, the law of the State of New York. (Section 112).
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Underwriting
Under the terms and subject to the conditions in an Underwriting Agreement,
dated December 11, 1996 (the "Underwriting Agreement"), each of the Underwriters
named below (the "Underwriters") has severally agreed to purchase, and Quest
Diagnostics has agreed to sell to it, the principal amount of the Notes set
forth opposite its name below:
<TABLE>
<CAPTION>
Principal
Amount
Underwriter of Notes
- ----------- ---------
<S> <C>
J.P. Morgan Securities Inc. $ 60,000,000
Goldman, Sachs & Co. 45,000,000
Lazard Freres & Co. LLC 45,000,000
------------
TOTAL $150,000,000
============
</TABLE>
Under the terms and conditions of the Underwriting Agreement, the Underwriters
are committed to take and pay for all of the Notes, if any are taken. Under
certain circumstances, the commitments of non-defaulting Underwriters may be
increased as provided in the Underwriting Agreement.
The Underwriters propose to offer the Notes in part directly to the public at
the initial public offering price set forth on the cover page of this
Prospectus and in part to certain securities dealers at such price less a
concession of 1.000% of the principal amount of the Notes. The Underwriters may
allow, and such dealers may reallow, a concession not to exceed .250% of the
principal amount of the Notes to certain brokers and dealers. After the Notes
are released for sale to the public, the offering price and other selling
terms may from time to time be varied by the Underwriters.
The Notes will be issued prior to the consummation of the Distributions. See
"The Distributions."
The Notes are a new issue of securities with no established trading market. The
Notes have been approved for listing on the New York Stock Exchange, subject to
official notice of issuance. Quest Diagnostics has been advised by the
Underwriters that the Underwriters intend to make a market in the Notes but they
are not obligated to do so and may discontinue any such market making at any
time without notice. No assurance can be given as to the liquidity of the
trading market for the Notes. See "Risk Factors--Absence of a Prior Public
Market."
Corning has engaged Goldman, Sachs & Co. and Lazard Freres & Co. LLC as its
financial advisors in connection with the Distributions and has agreed to pay
Goldman, Sachs & Co. and Lazard Freres & Co. LLC a customary fee for their
services and to indemnify Goldman, Sachs & Co. and Lazard Freres & Co. LLC
against certain liabilities. J.P. Morgan Securities, Inc. is the Administration
Agent under the Credit Facility and is entitled to certain fees and
indemnification in that capacity, see "Description of the Credit Facility," and
has provided structuring and capital markets advice to Corning in connection
with the Offering and the Distributions for which it is receiving a fee of
$500,000 and is entitled to indemnification in connection therewith. The
Underwriters also perform other investment banking and financial advisory
services for Corning from time to time.
Quest Diagnostics and Corning have agreed to indemnify the several
Underwriters against certain liabilities, including liabilities under the
Securities Act of 1933.
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Validity of the Notes and Guarantees
The validity of the Notes and Guarantees offered hereby will be passed upon
for Quest Diagnostics by Shearman & Sterling, New York, New York and for the
Underwriters by Sullivan & Cromwell, New York, New York. In rendering their
opinions on the validity of the Guarantees, Shearman & Sterling and Sullivan
& Cromwell will express no opinion as to Federal or state laws relating to
fraudulent transfers. See "Risk Factors--Fraudulent Conveyance."
Experts
The combined financial statements of Corning Clinical Laboratories Inc. at
December 31, 1995 and 1994 and for the years then ended, included in this
Prospectus have been so included in reliance on the report of Price
Waterhouse LLP, independent accountants, given on the authority of said firm
as experts in auditing and accounting. The combined financial statements of
Corning Clinical Laboratories Inc. for the year ended December 31, 1993
included in this Prospectus have been so included in reliance on the report
of Price Waterhouse LLP, independent accountants, which is based in part on
(i) the report of Deloitte & Touche LLP, independent auditors, in respect of
the consolidated financial statements of Nichols Institute for the year ended
December 31, 1993 (not presented separately in this Prospectus) which report
includes explanatory paragraphs related to uncertainties as to an
investigation by the Office of the Inspector General of the Department of
Health and Human Services and substantial doubt as to the Company's ability
to continue as a going concern, (ii) the report of Ernst and Young LLP,
independent auditors, in respect of the combined financial statements of
Maryland Medical Laboratory, Inc. and affiliates as of and for the year ended
March 31, 1994 (not presented separately in this Prospectus), and (iii) the
report of Leverone & Company, independent accountants, in respect of the
financial statements of Moran Research Labs (d/b/a Bioran Medical Laboratory,
a Massachusetts Business Trust) as of and for the year ended December 31,
1993 (not presented separately in this Prospectus). The combined financial
statements of Corning Clinical Laboratories Inc. for the year ended December
31, 1993, included in this Prospectus have been so included in reliance on
the reports of said firms, given on the authority of such firms as experts in
accounting and auditing.
100
<PAGE>
Index to Financial Statements
<TABLE>
<CAPTION>
Page
----
<S> <C>
FINANCIAL STATEMENTS OF Corning Clinical Laboratories Inc.
(to be renamed Quest Diagnostics Incorporated)
Report of Price Waterhouse LLP--Independent Accountants F-2
Report of Deloitte and Touch LLP--Independent Auditors F-3
Report of Ernst & Young LLP--Independent Auditors F-4
Report of Leverone and Company--Independent Accountants F-5
Combined Financial Statements:
Combined Balance Sheets--December 31, 1995 and 1994 F-6
Combined Statements of Operations--Years ended December 31, 1995, 1994 and 1993 F-7
Combined Statements of Cash Flows--Years ended December 31, 1995, 1994 and 1993 F-8
Combined Statements of Stockholder's Equity--Years ended December 31, 1995, 1994 and 1993 F-9
Notes to Combined Financial Statements F-10
Quarterly Operating Results (unaudited) F-22
Interim Combined Financial Statements (unaudited):
Combined Balance Sheets--September 30, 1996 and December 31, 1995 F-23
Combined Statements of Operations--Three and Nine Months ended September 30, 1996
and 1995 F-24
Combined Statements of Cash Flows--Nine Months ended September 30, 1996 and 1995 F-25
Notes to Interim Combined Financial Statements F-26
</TABLE>
F-1
<PAGE>
Report of Independent Accountants
To the Boards of Directors and Stockholders
of Corning Incorporated and Corning Clinical Laboratories Inc.
In our opinion, based upon our audits and the reports of other auditors,
the accompanying combined balance sheets and the related combined statements
of operations and of cash flows and of stockholder's equity appearing on
pages F-6 through F-21 present fairly, in all material respects, the
financial position of Corning Clinical Laboratories Inc. (to be renamed Quest
Diagnostics Incorporated) and the combined companies as discussed in Note 1
(collectively, the "Company"), a wholly-owned business of Corning
Incorporated, at December 31, 1995 and 1994, and the results of their
operations and their cash flows for each of the three years in the period
ended December 31, 1995, in conformity with generally accepted accounting
principles. These financial statements are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We did not audit the 1993 financial
statements of Maryland Medical Laboratory, Inc., Nichols Institute and Bioran
Medical Laboratory, which were acquired by the Company in 1994 in separate
transactions accounted for as poolings of interests and which collectively
reflect total revenues of $438 million for the year ended December 31, 1993.
Those statements were audited by other auditors whose reports thereon have
been furnished to us, and our opinion expressed herein, insofar as it relates
to the amounts included for Maryland Medical Laboratory, Inc., Nichols
Institute and Bioran Medical Laboratory, is based solely on the reports of
the other auditors. We conducted our audits of these statements in accordance
with generally accepted auditing standards which require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on
a test basis, evidence supporting the amounts and disclosures in the
financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits and the reports
of other auditors provide a reasonable basis for the opinion expressed above.
As discussed in Note 2 to the combined financial statements, in 1993 the
Company adopted Statement of Financial Accounting Standards No. 109,
"Accounting for Income Taxes."
/s/ Price Waterhouse LLP
Price Waterhouse LLP
New York, New York
September 20, 1996, except for Note 13
as to which the date is November 4, 1996
F-2
<PAGE>
Report of Independent Auditors
To the Board of Directors and Stockholders of
Nichols Institute:
We have audited the consolidated statements of operations, stockholders'
equity and cash flows for the year ended December 31, 1993 of Nichols
Institute and its subsidiaries (the Company) (not presented separately
herein). These consolidated financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on
these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in
all material respects, the results of operations and cash flows of Nichols
Institute and its subsidiaries for the year ended December 31, 1993, in
conformity with generally accepted accounting principles.
As discussed in Note 11 to the consolidated financial statements, the
Company has received a subpoena from the Office of the Inspector General of
the Department of Health and Human Services (OIG) requesting documents in
connection with an investigation and internal review concerning the possible
submission of false or improper claims to the Medicare and Medicaid programs.
No claim or charges have been made against the Company relating to this
investigation. The ultimate outcome of this investigation cannot presently be
determined. Accordingly, no provision for any loss that may result from this
investigation has been made in the accompanying consolidated financial
statements.
As discussed in Notes 1 and 3 to the consolidated financial statements, at
December 31, 1993, the Company was not in compliance with certain covenants
of its senior note agreements and the senior lenders have not waived those
covenants. The senior note agreements provide that, as a result of failure to
comply with the covenants, the note holders have the right to declare the
entire unpaid balance immediately due and payable, and if that were to occur,
the Company would not have the funds required to retire the debt unless
alternative financing is obtained. Management's plans in regard to these
matters are described in Notes 1 and 3. The note holders' right to declare
the entire unpaid balance under the note agreements immediately due and
payable raises substantial doubt about the Company's ability to continue as a
going concern. The accompanying consolidated financial statements have been
prepared assuming that the Company will continue as a going concern. The
financial statements do not include any adjustments that might result from
the outcome of this uncertainty, except for the classification of amounts due
under the senior note agreements as current.
/s/ Deloitte & Touche LLP
Deloitte & Touche LLP
Costa Mesa, California
February 28, 1994
F-3
<PAGE>
Report of Independent Auditors
Board of Directors
Maryland Medical Laboratory, Inc.
We have audited the combined balance sheet of Maryland Medical Laboratory,
Inc. and affiliates as of March 31, 1994, and the related combined statements
of income, changes in equity and cash flows for the year then ended (not
presented separately herein). These financial statements are the
responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the combined financial position of Maryland Medical
Laboratory, Inc. and affiliates at March 31, 1994, and the combined results
of their operations and their cash flows for the year then ended in
conformity with generally accepted accounting principles.
/s/ Ernst & Young LLP
Ernst & Young LLP
Baltimore, Maryland
May 19, 1994
F-4
<PAGE>
Report of Independent Accountants
To the Board of Directors
Moran Research Labs
415 Massachusetts Avenue
Cambridge, MA 02139
We have audited the accompanying balance sheet of Moran Research Labs
(d/b/a Bioran Medical Laboratory, a Massachusetts Business Trust) as of
December 31, 1993, and the related statements of income, retained earnings,
and cash flows for the year then ended. These financial statements are the
responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements.
An audit includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Moran Research Labs
(d/b/a Bioran Medical Laboratory, a Massachusetts Business Trust) at December
31, 1993 and the results of its operations and its cash flows for the year
then ended in conformity with generally accepted accounting principles.
/s/ Leverone & Company
Leverone & Company
Billerica, Massachusetts
November 10, 1994
F-5
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
Combined Balance Sheets
December 31, 1995 and 1994
(in thousands)
<TABLE>
<CAPTION>
1995 1994
------------- -------------
<S> <C> <C>
ASSETS
Current Assets:
Cash and cash equivalents $ 36,446 $ 38,719
Accounts receivable, net of allowance of $147,947 and
$74,829 for 1995 and 1994, respectively 318,252 360,410
Inventories 26,601 28,248
Deferred taxes on income 98,845 53,696
Prepaid expenses and other assets 22,014 19,241
------------- -------------
Total current assets 502,158 500,314
Property, plant and equipment, net 296,116 287,562
Intangible assets, net 1,030,633 1,053,194
Deferred taxes on income 6,062 19,593
Other assets 18,416 22,000
------------- -------------
TOTAL ASSETS $1,853,385 $1,882,663
============= =============
LIABILITIES AND STOCKHOLDER'S EQUITY
Current Liabilities:
Accounts payable and accrued expenses $ 240,525 $ 236,887
Current portion of long-term debt 12,148 12,572
Income taxes payable 39,766 30,454
Due to Corning Incorporated and affiliates 8,979 6,043
------------- -------------
Total current liabilities 301,418 285,956
Long-term debt (principally due to Corning Incorporated) 1,195,566 1,153,054
Other liabilities 60,600 56,841
------------- -------------
Total liabilities 1,557,584 1,495,851
------------- -------------
Commitments and Contingencies
Stockholder's Equity:
Contributed capital 297,823 297,823
Retained earnings (accumulated deficit) (3,118) 85,893
Cumulative translation adjustment 2,325 3,096
Market valuation adjustment (1,229) --
------------- -------------
Total stockholder's equity 295,801 386,812
------------- -------------
TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY $1,853,385 $1,882,663
============= =============
</TABLE>
The accompanying notes are an integral part of these statements.
F-6
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
Combined Statements of Operations
For the Years Ended December 31, 1995, 1994 and 1993
(in thousands)
<TABLE>
<CAPTION>
1995 1994 1993
------------- ------------- -------------
<S> <C> <C> <C>
Net revenues $1,629,388 $1,633,699 $1,416,338
Costs and expenses:
Cost of services 980,232 969,844 805,729
Selling, general and administrative 523,271 411,939 363,579
Provision for restructuring and other special charges 50,560 79,814 99,600
Interest expense, net 82,016 63,295 41,898
Amortization of intangible assets 44,656 42,588 28,421
Other, net 6,221 3,464 6,423
------------- ------------- -------------
Total 1,686,956 1,570,944 1,345,650
------------- ------------- -------------
Income (loss) before taxes (57,568) 62,755 70,688
Income tax expense (benefit) (5,516) 34,410 25,929
------------- ------------- -------------
Income (loss) before cumulative effect of change in
accounting principle (52,052) 28,345 44,759
Cumulative effect of change in accounting principle -- -- (10,562)
------------- ------------- -------------
Net income (loss) $ (52,052) $ 28,345 $ 34,197
============= ============= =============
</TABLE>
The accompanying notes are an integral part of these statements.
F-7
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
Combined Statements of Cash Flows
For the Years Ended December 31, 1995, 1994 and 1993
(in thousands)
<TABLE>
<CAPTION>
1995 1994 1993
------------- ------------ ------------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss) $ (52,052) $ 28,345 $ 34,197
Adjustments to reconcile net income (loss) to net cash provided by
operating activities:
Depreciation and amortization 101,513 89,517 66,479
Provision for doubtful accounts 152,590 59,480 47,240
Provision for restructuring and other special charges 50,560 79,814 99,600
Deferred income tax provision (32,384) (4,742) (23,841)
Cumulative effect of change in accounting principle -- -- 10,562
Other, net 8,303 14,600 1,765
Changes in operating assets and liabilities:
Accounts receivable (109,500) (103,402) (61,828)
Accounts payable and accrued expenses 14,604 (32,756) (33,903)
Restructuring, integration and other special charges (57,768) (88,093) (46,917)
Due from/to Corning Incorporated and affiliates 2,934 14,783 (2,581)
Other assets and liabilities, net 7,028 (19,583) 8,841
------------- ------------ ------------
Net cash provided by operating activities 85,828 37,963 99,614
------------- ------------ ------------
Cash flows from investing activities:
Capital expenditures (74,045) (93,354) (65,317)
Proceeds from disposition of assets 2,880 55,762 --
Acquisition of businesses, net of cash acquired (22,907) (12,154) (401,428)
Decrease (increase) in investments 985 3,560 (6,942)
------------- ------------ ------------
Net cash used in investing activities (93,087) (46,186) (473,687)
------------- ------------ ------------
Cash flows from financing activities:
Proceeds from borrowings, primarily with Corning Incorporated 55,729 186,046 709,630
Repayment of long-term debt (13,784) (118,046) (265,196)
Dividends paid (36,959) (60,468) (51,478)
------------- ------------ ------------
Net cash provided by financing activities 4,986 7,532 392,956
------------- ------------ ------------
Net change in cash and cash equivalents (2,273) (691) 18,883
Cash and cash equivalents, beginning of year 38,719 39,410 20,527
------------- ------------ ------------
Cash and cash equivalents, end of year $ 36,446 $ 38,719 $ 39,410
============= ============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
F-8
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
Combined Statements of Stockholder's Equity For the Years Ended December 31,
1995, 1994 and 1993
(in thousands)
<TABLE>
<CAPTION>
Cumulative Market Total
Retained Translation Valuation Stockholder's
Contributed Capital Earnings Adjustment Adjustment Equity
------------------- -------- ----------- ---------- -------------
<S> <C> <C> <C> <C> <C>
Balance, December 31, 1992 $261,499 $146,938 $ (288) $ $ 408,149
Net income 34,197 34,197
Dividends to CLSI (28,088) (28,088)
Dividends to S-Corporation
shareholders (23,390) (23,390)
Equity of pooled entity 4,150 (4,096) 54
Translation adjustment 4,587 4,587
-------------------------------- ------------- ------------- ---------------
Balance, December 31, 1993 265,649 125,561 4,299 395,509
Net income 28,345 28,345
Dividends to CLSI (33,275) (33,275)
Dividends to S-Corporation
shareholders (27,193) (27,193)
Dividends in-kind to S-Corporation
shareholders (7,545) (7,545)
Capital contribution 32,174 32,174
Translation adjustment (1,203) (1,203)
-------------------------------- ------------- ------------- ---------------
Balance, December 31, 1994 297,823 85,893 3,096 386,812
Net loss (52,052) (52,052)
Dividends to CLSI (36,959) (36,959)
Translation adjustment (771) (771)
Market valuation adjustment (1,229) (1,229)
-------------------------------- ------------- ------------- ---------------
Balance, December 31, 1995 $297,823 $ (3,118) $2,325 $(1,229) $ 295,801
================================ ============= ============= ===============
</TABLE>
The accompanying notes are an integral part of these statements.
F-9
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS
(dollars in thousands, unless otherwise indicated)
1. BASIS OF PRESENTATION
Corning Clinical Laboratories Inc. and Corning Nichols Institute Inc.
(collectively referred to as "CCL" or the "Company") are wholly-owned
subsidiaries of Corning Life Sciences Inc. ("CLSI") which in turn is a
wholly-owned subsidiary of Corning Incorporated ("Corning"). The Company is one
of the largest clinical laboratory testing businesses in the United States. The
accompanying financial statements present the carved-out results of operations,
cash flows and financial position of Corning's clinical laboratory testing
business. Covance Inc. (formerly Corning Pharmaceutical Services Inc.), a
subsidiary of CCL, and its related entities ("Covance") as well as environmental
testing services formerly provided by CCL are excluded. In 1994, Corning
acquired three clinical laboratory testing businesses on the behalf of CCL in
separate transactions accounted for as poolings of interests (see Note 3).
Results presented for 1994 and 1993 include the results of CCL and the pooled
entities on a combined basis. Corning Clinical Laboratories Inc.
In May 1996, Corning's Board of Directors approved a plan to distribute to
its shareholders on a pro rata basis all of the shares of CCL and Covance
(the "CCL and Covance Spin-Off Distributions"). The result of the plan will
be the creation of two independent, publicly-owned companies. As a result of
the Spin-Off Distributions, CCL will operate Corning's clinical laboratory
testing business as an independent public company and Covance will own and
operate Corning's contract research business as an independent public
company. The Spin-Off Distributions will be effected by the distribution of a
dividend to holders of Corning Common Stock of all of the outstanding CCL
Common Stock, followed immediately by the distribution of a dividend to the
holders of CCL Common Stock of all of the Covance Common Stock. Corning has
submitted to the Internal Revenue Service a request for a ruling that the
Spin-Off Distributions qualify as tax-free distributions under the Internal
Revenue Code of 1986. Coincident with the Spin-Off Distributions, the Company
will be renamed Quest Diagnostics Incorporated.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The combined financial statements include the accounts of all laboratory
entities controlled by the Company. The equity method of accounting is used
for investments in affiliates which are not Company controlled and in which
the Company's interest is generally between 20 and 50 percent. All
significant intercompany accounts and transactions are eliminated.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Revenue Recognition
The Company generally recognizes revenue as services are rendered upon
completion of the testing process. Billings for services under third-party
payor programs, including Medicare and Medicaid, are recorded as revenues net
of allowances for differences between amounts billed and the estimated
receipts under such programs. Adjustments to the estimated receipts, based on
final settlement with the third-party payors, are recorded upon settlement.
In 1995, 1994 and 1993, approximately 23%, 28% and 25%, respectively, of net
revenues were generated by Medicare and Medicaid programs.
Concentrations of Credit Risk
Concentrations of credit risk with respect to accounts receivable are
limited due to the diversity of the Company's clients as well as their
dispersion across many different geographic regions.
Taxes on Income
The Company uses the asset and liability approach to account for income
taxes. Under this method, deferred tax assets and liabilities are recognized
for the expected future tax consequences of differences between the carrying
amounts of assets and liabilities and their respective tax bases using
enacted tax rates in effect for the year in which the differences are
expected to reverse. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period when the change is
enacted. In 1993 the Company adopted Statement of Financial Accounting
Standards No. 109, "Accounting for Income Taxes" (SFAS 109). The adoption of
SFAS 109 resulted in a charge to net income of $10.6 million, principally
representing a reduction in the Company's deferred tax assets to reflect the
then enacted statutory tax rate.
F-10
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
Cash and Cash Equivalents
Cash and cash equivalents include all highly-liquid investments with
original maturities at the time acquired by the Company of three months or
less, and consist principally of amounts temporarily invested in a U.S.
government money market fund.
Inventories
Inventories, which consist principally of supplies, are valued at the
lower of cost (first in, first out method) or market.
Property, Plant and Equipment
Property, plant and equipment are recorded at cost. Depreciation and
amortization are provided on the straight-line method at rates adequate to
allocate the cost of the applicable assets over their expected useful lives,
which range from three to forty years.
Intangible Assets
Acquisition costs in excess of the fair value of net tangible assets
acquired are capitalized and amortized over appropriate periods not exceeding
forty years. Other intangible assets are recorded at cost and amortized over
periods not exceeding fifteen years.
Investments
The Company accounts for investments in equity securities, which are
included in other assets, in conformity with Statement of Financial
Accounting Standards No. 115 (SFAS 115), "Accounting for Certain Investments
in Debt and Equity Securities." SFAS 115 requires the use of fair value
accounting for trading or available-for-sale securities. Unrealized losses
for available-for-sale securities are recorded as a separate component within
stockholder's equity. Investments in equity securities are not material to
the Company.
Impairment Accounting
The Company adopted Statement of Financial Accounting Standards No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets
to Be Disposed Of" (SFAS 121) in 1995. The Company reviews the recoverability
of its long-lived assets, including related goodwill and intangible assets,
when events or changes in circumstances occur that indicate that the carrying
value of the asset may not be recoverable. Evaluation of possible impairment
is based on the Company's ability to recover the asset from the expected
future pre-tax cash flows (undiscounted and without interest charges) of the
related operations. If the expected undiscounted pre-tax cash flows are less
than the carrying value of such asset, an impairment loss is recognized for
the difference between estimated fair value and carrying value. This
assessment of impairment requires management to make estimates of expected
future cash flows. It is at least reasonably possible that future events or
circumstances could cause these estimates to change.
In addition, the carrying value of intangible assets has historically been
subject to a separate evaluation based on estimating expected future
undiscounted cash flows from operating activities. If these estimated cash
flows are less than the carrying amount of the intangible assets, the Company
would recognize an impairment loss in an amount necessary to write down the
intangible assets to fair value.
Earnings Per Share
Earnings per share are computed by dividing net income by the weighted
average number of common shares outstanding. Historical earnings per share
data is not meaningful as the Company's historical capital structure is not
comparable to periods subsequent to the CCL Spin-Off Distribution.
F-11
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
3. BUSINESS COMBINATIONS AND DIVESTITURES
Acquisitions
During 1995, the Company acquired several laboratories in separate
transactions accounted for under the purchase method. The total cost of the
acquired businesses aggregated approximately $23 million and was financed
through borrowings from Corning. Intangible assets of approximately $21.6
million resulted from the transactions and are being amortized over periods
not to exceed forty years.
During 1994, Corning acquired three clinical laboratory testing companies
on behalf of the Company in separate transactions accounted for as poolings
of interests. In June 1994, Corning acquired the stock of Maryland Medical
Laboratory, Inc. ("MML") in exchange for approximately 4.5 million shares of
Corning common stock; in August 1994, Corning acquired the stock of Nichols
Institute ("Nichols") in exchange for approximately 7.5 million shares of
Corning common stock and reserved an additional 1.1 million shares for future
issuance upon the exercise of stock options; and, in October 1994, Corning
acquired the stock of Bioran Medical Laboratory ("Bioran") in exchange for
approximately 6.0 million shares of Corning common stock. Results presented
for 1994 and 1993 include the results of the Company, MML, Nichols and Bioran
on a combined basis.
In 1994, the Company also acquired several other laboratories in separate
transactions accounted for under the purchase method. The total cost of the
acquired businesses aggregated approximately $26 million and was financed
through the issuance of Corning stock and borrowings from Corning. Intangible
assets of approximately $24 million resulted from these transactions and are
being amortized over periods not to exceed forty years.
In the third quarter of 1993, Corning acquired on behalf of the Company
the outstanding shares of common stock of Damon Corporation ("Damon"), a
clinical-testing business, for $405 million, including acquisition costs,
financed through borrowings from Corning. In addition, approximately $167
million of Damon's indebtedness was refinanced. Goodwill of approximately
$600 million resulted from the transaction and is being amortized over forty
years. Reserves aggregating $79 million were established for the costs of
closing Damon facilities as a result of the integration of Damon operations.
In the fourth quarter of 1993, the Company acquired the clinical-testing
laboratories of Unilab Corporation ("Unilab") in Denver, Dallas and Phoenix
in exchange for its ownership interest in Unilab operations, the assumption
of approximately $70 million of Unilab debt, and the Company's investment in
J.S. Pathology PLC. Goodwill of approximately $200 million resulted from this
transaction and is being amortized over forty years. As a result of this
transaction, the Company received a small equity investment in Unilab. The
Company previously owned 43% of Unilab.
The operations of the businesses, subsequent to the dates they were
acquired, are included in the combined financial statements. The pro forma
effect of the 1995 acquisitions on periods prior to the acquisitions is not
material.
In 1993, Corning also acquired and contributed to the Company DeYor
Laboratory, Inc., in a transaction accounted for as a pooling of interests,
by issuing 840,000 shares of Corning common stock. The Company's combined
financial statements for periods prior to this acquisition have not been
restated, since this acquisition was not material to the Company's financial
position or the results of its operations for such periods.
Divestitures
In the second quarter of 1994, the Company sold the California clinical
laboratory testing operations acquired in the Damon transaction to Physicians
Clinical Laboratory, Inc. for cash proceeds of $51 million.
4. TAXES ON INCOME
The Company is included in the consolidated Federal income tax return
filed by Corning. CLSI and its subsidiaries, including the Company, have a
tax sharing agreement with Corning, pursuant to which they are required to
compute their provision for income taxes on a separate return basis and pay
to Corning the separate Federal income tax return liability so computed.
F-12
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
The components of the provision (benefit) for income taxes for 1995, 1994
and 1993 are as follows:
<TABLE>
<CAPTION>
1995 1994 1993
--------- -------- ---------
<S> <C> <C> <C>
Current:
Federal $ 22,786 $31,598 $ 46,215
State and local 3,556 7,019 2,815
Foreign 526 535 740
Deferred (benefit):
Federal (28,109) (1,339) (23,818)
State and local (4,275) (3,403) (23)
----------- -------- -------
Income tax expense (benefit) $ (5,516) $34,410 $ 25,929
=========== ======== =======
</TABLE>
Prior to acquisition by Corning, Bioran and certain MML operations were
S-Corporations; accordingly, no federal provision for income taxes has been
reflected relative to these operations.
A reconciliation of the Federal statutory rate to the Company's effective
tax rate for 1995, 1994 and 1993 is as follows:
<TABLE>
<CAPTION>
1995 1994 1993
--------- --------- ----------
<S> <C> <C> <C>
Taxes at statutory rate (35.0%) 35.0% 35.0%
State and local income taxes, net of federal tax benefit (0.8%) 3.8% 2.6%
Income from partnership and S-Corporations not subject to
federal and state income tax 1.7% (10.3%) (11.1%)
Goodwill 17.6% 14.3% 4.8%
Non-deductible items 6.0% 8.6% 3.4%
Other, net 0.9% 3.4% 2.0%
--------- --------- ----------
Effective tax rate (9.6%) 54.8% 36.7%
========= ========= ==========
</TABLE>
The tax effects of temporary differences that give rise to significant
portions of the net deferred tax assets at December 31, 1995 and 1994 are as
follows:
<TABLE>
<CAPTION>
1995 1994
----------------------
<S> <C> <C>
Current deferred tax asset:
Accounts receivable reserve $ 48,584 $ 16,692
Liabilities not currently deductible 49,222 34,422
Other 1,039 2,582
----------------------
Current deferred tax asset $ 98,845 $ 53,696
======================
Non-current deferred tax asset (liability):
Liabilities not currently deductible $ 21,152 $ 33,572
Depreciation and amortization (15,090) (13,979)
----------------------
Non-current deferred tax asset $ 6,062 $ 19,593
======================
</TABLE>
F-13
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
Income taxes payable at December 31, 1995 and 1994 consist of Federal
income taxes payable of $34.2 million and $28.7 million, respectively, state
income taxes payable of $5.0 million and $1.5 million, respectively, and
foreign income taxes payable of $0.6 million and $0.3 million, respectively.
The Company paid income taxes of $21.7 million, $58.5 million and $52.0
million during 1995, 1994 and 1993, respectively.
5. PROVISION FOR RESTRUCTURING AND OTHER SPECIAL CHARGES
In the second quarter of 1995, the Company recorded a provision for
restructuring totaling $33.0 million primarily for workforce reduction
programs and the costs of exiting a number of leased facilities.
Additionally, in the first quarter of 1995, the Company recorded a special
charge of $12.8 million for the settlement of claims related to inadvertent
billing errors of certain laboratory tests that were not completely and/or
successfully performed or reported due to insufficient samples and/or invalid
results. Additionally, in the fourth quarter of 1995, the Company recorded a
charge of $4.8 million related to claims by the Civil Division of the U.S.
Department of Justice ("DOJ") of alleged billing errors related to a
laboratory test performed by Bioran prior to its acquisition by the Company.
In the third quarter of 1994, the Company recorded a provision for
restructuring and other special charges totaling $79.8 million which included
$48.2 million of integration costs, $21.6 million of transaction expenses
related to the Nichols, MML and Bioran acquisitions, and $10 million of
settlement reserves primarily related to government investigations of billing
practices by Nichols prior to its acquisition by the Company. The integration
costs represent the expected costs for closing clinical laboratories in
certain markets where duplicate Company, Nichols, MML or Bioran facilities
existed at the time of the acquisitions.
In the third quarter of 1993, the Company recorded a provision for
restructuring costs and other special charges totaling $99.6 million. The
restructuring component of this special charge aggregated $56.6 million and
consisted primarily of asset write-offs, facility related costs and costs for
workforce reduction programs related principally to the integration of the
Company's operations with those acquired in the Damon acquisition.
The special charge of $43 million consists of a $36.5 million charge to
reflect the settlement and related legal expenses associated with a
compromise agreement with the DOJ to settle claims brought on behalf of the
Inspector General, U.S. Department of Health and Human Services and a $6.5
million charge for related asserted and unasserted claims. The DOJ claims
related to the marketing, sale, pricing and billing of certain blood-test
series provided to Medicare patients. The DOJ settlement does not constitute
an admission with respect to any issue arising from subsequent civil actions.
The following summarizes the Company's restructuring activity (in
millions):
<TABLE>
<CAPTION>
1993 and 1994 Amounts Balance at 1995 Amounts Balance at
Restructuring Utilized December 31, Restructuring Utilized December 31,
Provisions Through 1994 1994 Provision in 1995 1995
--------------- --------------- -------------- --------------- --------- --------------
<S> <C> <C> <C> <C> <C> <C>
Employee
termination costs $ 32.5 $14.8 $17.7 $23.4 $27.0 $14.1
Write-off of fixed
assets 35.6 19.1 16.5 3.7 9.2 11.0
Costs of exiting
leased facilities 21.7 9.3 12.4 3.1 6.8 8.7
Other 15.0 13.4 1.6 2.8 .5 3.9
--------------- --------------- -------------- --------------- --------- --------------
Total $104.8 $56.6 $48.2 $33.0 $43.5 $37.7
=============== =============== ============== =============== ========= ==============
</TABLE>
F-14
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
The substantial portion of the balance at December 31, 1995 is expected to
be expended in 1996.
Employee termination costs included severance benefits related to
approximately 3,300 employees (700, 2,000 and 600 in 1995, 1994 and 1993,
respectively). The estimated number of employees to be terminated has been
reduced to 2,355, all of which have been terminated or notified of their
termination at December 31, 1995. Management expects that approximately 300
terminations and the remaining business or facility exits will occur by the
end of 1996. The decrease in the number of actual versus anticipated employee
terminations is primarily attributable to higher than expected attrition. As
a result of higher than expected average termination costs, management's
estimate of total employee termination costs is unchanged. Certain severance
and facility exit costs have payment terms extending beyond 1997.
6. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment at December 31, 1995 and 1994 consist of the
following:
1995 1994
------------ ------------
Land $ 18,568 $ 18,969
Buildings and improvements 186,192 173,546
Laboratory equipment, furniture and fixtures 286,326 247,200
Leasehold improvements 39,078 30,050
Construction-in-progress 19,490 33,508
------------ ------------
Property and equipment, at cost 549,654 503,273
Less: accumulated depreciation and amortization (253,538) (215,711)
------------ ------------
Property and equipment, net $ 296,116 $ 287,562
============ ============
Depreciation and amortization expense aggregated $56.8 million, $46.9
million and $38.1 million for 1995, 1994 and 1993, respectively.
7. INTANGIBLE ASSETS
Intangible assets at December 31, 1995 and 1994 consist of the following:
1995 1994
------------- -------------
Goodwill $1,056,073 $1,043,089
Customer lists 84,558 100,428
Other (principally non-compete covenants) 50,626 61,401
------------- -------------
Intangible assets, at cost 1,191,257 1,204,918
Less: accumulated amortization (160,624) (151,724)
------------- -------------
Intangible assets, net $1,030,633 $1,053,194
============= =============
Amortization expense aggregated $44.7 million, $42.6 million and $28.4
million for 1995, 1994 and 1993, respectively.
8. ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses at December 31, 1995 and 1994
consist of the following:
<TABLE>
<CAPTION>
1995 1994
----------- -----------
<S> <C> <C>
Accrued wages and benefits $ 81,985 $ 74,519
Restructuring, integration and other special charges 61,878 69,812
Accrued expenses 57,338 34,851
Trade accounts payable 31,129 36,169
Accrued acquisition commitments 8,195 21,536
----------- -----------
Accounts payable and accrued expenses $240,525 $236,887
=========== ===========
</TABLE>
F-15
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
9. LONG-TERM DEBT
Long-term debt, exclusive of current maturities, at December 31, 1995 and
1994, respectively, consists of the following:
<TABLE>
<CAPTION>
1995 1994
------------- ------------
<S> <C> <C>
Notes payable to Corning:
Revolving credit notes--interest at the London Interbank
offered rate ("LIBOR") plus 1/8% to 1/4%, maturing 1997 $ 605,636 $ 551,982
Installment note with interest at 9%, maturing 2001 90,000 100,000
Term note with interest at 6.24%, maturing 2003 100,000 100,000
Term note with interest at 6.93%, maturing 2013 100,000 100,000
Term note with interest at 7.17%, maturing 2004 150,000 150,000
Term note with interest at 7.77%, maturing 2024 100,000 100,000
Note payable denominated in pounds Sterling, interest at the
London Interbank Sterling Rate minus 1%, due 2002 8,049 8,516
Mortgage note payable through 2011, interest at 9.25% 6,138 6,355
Capital lease obligations expiring through 2031 32,518 32,538
Other 3,225 3,663
------------- ------------
Total $1,195,566 $1,153,054
============= ============
</TABLE>
Current maturities on long-term debt totaled $12.1 million and $12.6
million at December 31, 1995 and 1994, respectively.
Long-term debt, including capital leases, maturing in each of the years
subsequent to December 31, 1996 is as follows:
<TABLE>
<CAPTION>
<S> <C>
Fiscal year ending December 31,
1997 $ 261,131
1998 10,493
1999 10,530
2000 10,576
2001 and thereafter 902,836
------------
Total long-term debt $1,195,566
============
</TABLE>
Future minimum payments under capital leases and the present value thereof
are as follows:
<TABLE>
<CAPTION>
<S> <C>
Fiscal year ending December 31,
1997 $ 4,061
1998 3,846
1999 3,840
2000 3,948
2001 and thereafter 116,102
----------
Total future minimum payments under capital leases 131,797
Less amount representing interest (99,279)
----------
Present value of minimum payments under capital leases $ 32,518
==========
</TABLE>
F-16
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
The Company paid interest of $74.2 million, $60.2 million and $41.2
million during 1995, 1994 and 1993, respectively.
Based on borrowing rates currently available to the Company for loans with
similar terms and maturities, the fair value of loans payable to third
parties (carrying amount of approximately $50.0 million) was approximately
$62.0 million at December 31, 1995.
As discussed in Note 14, the Company is currently pursuing the issuance of
$150 million of Senior Subordinated Notes due in 2006 which will be used to
repay certain intercompany indebtedness owed to Corning. The Senior Subordinated
Notes will be guaranteed, fully, jointly and severally, and unconditionally, on
a senior subordinated basis by each of the Company's wholly-owned, domestic
subsidiaries (Subsidiary Guarantors). Non-guarantor subsidiaries, individually
and in the aggregate, are inconsequential to the Company. Full financial
statements of the Subsidiary Guarantors are not presented because management
believes they are not material to investors. The following is summarized
financial information of the Subsidiary Guarantors as of December 31, 1995 and
1994 and for each of the three years in the period ended December 31, 1995.
<TABLE>
<CAPTION>
December 31,
-----------------------
1995 1994
----------- -----------
<S> <C> <C>
Current assets $244,547 $248,793
Noncurrent assets 864,351 916,499
Current liabilities 71,828 84,223
Noncurrent liabilities 682,805 692,742
Stockholder's equity 354,265 388,227
</TABLE>
<TABLE>
<CAPTION>
For the Year Ended December 31,
-----------------------------------
1995 1994 1993
----------- ---------- -----------
<S> <C> <C> <C>
Net revenues $930,472 $923,205 $749,090
Cost of services 587,100 581,397 447,246
Net income (loss) (33,961) (44,056) 258
</TABLE>
10. EMPLOYEE RETIREMENT PLANS
Defined Benefit Plans
An acquired entity had a defined benefit pension plan which in 1990 was
frozen as to the further accrual of benefits. At December 31, 1995 the
present value of the projected benefit obligation using a discount rate of
7.5% was $22.6 million and the fair value of the plan assets (publicly traded
corporate debt and equity securities, government obligations and money market
funds) was $17.4 million. The difference between the projected benefit
obligation and the fair value of plan assets is included in other long-term
liabilities in the accompanying combined balance sheet.
Defined Contribution Plans
The Company has several defined contribution plans covering substantially
all of its full-time employees. Company contributions to these plans
aggregated $18.5 million, $15.9 million and $7.3 million for 1995, 1994 and
1993, respectively.
11. RELATED PARTY TRANSACTIONS
The Company, in the ordinary course of business, conducts a number of
transactions with Corning and its affiliates. The significant transactions
occurring during the years ended December 31, 1995, 1994 and 1993 are as
follows:
<TABLE>
<CAPTION>
1995 1994 1993
--------- -------- ----------
<S> <C> <C> <C>
Interest expense on borrowings $78,930 $55,835 $28,400
Purchase of laboratory supplies 11,261 11,607 7,338
Corporate fees 2,800 2,800 2,450
</TABLE>
F-17
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
Certain executives of the Company are included in various stock
compensation programs of Corning. Expenses related to these programs have
been included in the Company's combined financial statements.
In 1994, Corning contributed capital of $25.2 million through the
reduction of revolving credit notes and former S-Corporation shareholders
contributed capital of a building approximating $4.4 million.
12. COMMITMENTS AND CONTINGENCIES
Minimum rental commitments under noncancellable operating leases,
primarily real estate, in effect at December 31, 1995 are as follows:
<TABLE>
<CAPTION>
<S> <C>
Year ending December 31,
1996 $ 40,459
1997 30,481
1998 20,527
1999 14,877
2000 12,532
2001 and thereafter 65,920
----------
Net minimum lease payments $184,796
==========
</TABLE>
Operating lease rental expense for 1995, 1994 and 1993 aggregated $46.9
million, $49.4 million and $46.9 million, respectively.
The Company is self-insured for substantially all casualty losses and
maintains supplemental coverage on a claims made basis. The basis for the
insurance reserve at December 31, 1995 and 1994 is the actuarially determined
projected losses for each program (within the self-insured retention) based
upon the Company's loss experience.
The Company has entered into several settlement agreements with various
governmental and private payors during recent years. At present, government
investigations of certain practices by clinical laboratories acquired in
recent years are ongoing. In addition, certain payors are reviewing their
reimbursement practices for laboratory tests. The results of these
investigations and reviews may result in additional settlement payments or
reductions in reimbursements for certain tests. The recorded reserves of
approximately $37.0 million are included in accrued liabilities and represent
management's best estimate at December 31, 1995. Based on information then
available to CCL, management did not believe that the exposure to claims in
excess of recorded reserves would be material (see Note 13).
13. SUBSEQUENT EVENTS
As disclosed in Note 12, federal government investigations of certain
practices by clinical laboratories acquired in recent years are ongoing. In
the second quarter of 1996, the DOJ notified the Company that it has taken
issue with certain payments received by Damon from federally funded
healthcare programs prior to its acquisition by the Company. Specifically, in
late April 1996, the DOJ for the first time disclosed to CCL the total amount
of the claims that it proposed to assert against Damon. The government
presented its claim for the base recoupment (by lab, by test, by year) and
discussed various theories on which criminal and civil payments of up to
three times the various base recoupment amounts could be assessed. During May
and June, CCL management analyzed the government's claim in detail. CCL
management and outside counsel then believed that there were meritorious
defenses to a number of the claims for recoupments and potential payments in
excess of the base recoupment and these were presented to the government in
early July 1996.
At the end of the second quarter, CCL recorded a $46 million charge to
increase its reserves to $72 million, to equal management's estimate of the low
end of the range of amounts necessary to satisfy claims related to Damon and
other related and similar investigations. With respect to the Damon
investigation, the low end of the range was estimated to be equal to the base
recoupment sought by the government reflecting the basis on which CCL had
settled an earlier claim with the government in 1993. The low end of the range
for the Nichols and other government investigations was based on the base
recoupment estimated by management from internal investigations. Reserves for
pending private claims were estimated based on CCL's experience in settling
private claims following its 1993 government settlement.
F-18
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
CCL management considered the potential for some payments to be assessed in
excess of the base recoupment in estimating its liability at June 30, 1996.
Management estimated that the range of reasonably possible amounts necessary to
satisfy claims related to Damon and other related and similar investigations was
between $72 million and approximately $300 million at June 30, 1996, and,
because no amount in the range was more probable than other amounts, CCL
increased its reserves to equal the low end of the range. This position was
based on CCL's experience with the government in 1993, in which the recovery in
excess of base recoupments was not significant, the government's
representatives' invitation to present information and arguments to them and
their stated intention not to consider the issue of payment multiples until the
base recoupment amount had been established, and management's and counsel's
belief that it had meritorious factual, legal and equitable defenses and
mitigations of the government claims.
CCL management was aware that similar investigations of other clinical
laboratories in the industry were ongoing. Other than CCL's 1993 settlement,
the only other similar settlement known to management was the 1992 civil
Medicare settlement by a major competitor for $100 million. CCL had reviewed
the publicly-available information about that settlement, including press
releases and the settlement agreement. The competitor's settlement agreement
did not specify whether the civil settlement included substantial payments to
be assessed in excess of the base recoupment. It was believed by CCL that it
did not. Although the competitor and its chief executive officer each pleaded
guilty to criminal charges, the fine was only $1 million for conduct that was
contemporaneous with, and considered by CCL management and its counsel to be
more egregious than, that of Damon.
During the third quarter 1996, CCL management met with the government
several times to evaluate the substance of the government's allegations.
During a meeting with the government in mid-August, further information and
legal arguments were exchanged. Importantly, at this time, the government for
the first time began to disclose to CCL and its outside counsel grand jury
testimony and other evidence that was inconsistent with certain of CCL's
defenses.
The final settlement discussions began in late September. The government
responded to and rejected many of CCL's defenses and made its tentative final
settlement offer, which included significant payments in excess of base
recoupments, to CCL. Negotiations on the final settlement amount and terms
(including releases from various federal and state payors, compliance program
requirements, etc.) continued into early October and ended with the
settlement agreement dated October 9, 1996. The settlement included base
recoupments of approximately $40 million (which did not differ materially
from management's estimate at June 30, 1996) and total criminal and civil
payments in excess of base recoupments of approximately $80 million.
This settlement concludes all federal and Medicaid claims relating to the
billing by Damon of certain blood tests to Medicare and Medicaid patients and
other matters relating to Damon being investigated by the DOJ. Additionally,
the Company entered into a separate settlement agreement with the DOJ
totaling $6.9 million related to billings of hematology indices provided with
hematology test results. This claim will be paid during the fourth quarter of
1996.
As a result of these settlement agreements, CCL management has reassessed
the level of reserves recorded for other asserted and unasserted claims
related to the Damon and other similar government investigations, including
the investigation of billing practices by Nichols prior to its acquisition by
the Company in 1994. The Company recorded a charge totaling $142 million in
the third quarter 1996 to establish additional reserves to provide for the
above settlement agreements and management's best estimate of potential
amounts which could be required to satisfy the remaining claims. At September
30, 1996, recorded reserves approximated $215 million (including the $119
million Damon settlement paid in October 1996). Based on information
currently available to CCL, management does not believe that the exposure to
claims in excess of recorded claims is material. Although the Damon
settlement was substantially in excess of amounts anticipated by management,
it was primarily due to the civil and criminal payments in excess of the base
recoupment assessed by the government and CCL has now increased its reserves
for asserted and unasserted claims to approximate the amount that may be
required to settle the Nichols and other government civil claims taking into
account the basis for the Damon civil settlement. In addition, although there
is the possibility that CCL could be excluded from participation in Medicare
and Medicaid programs, management believes that the possibility is remote as
a result of the Damon settlement, which included CCL's signing a Corporate
Integrity Agreement, and due to the fact that the government has publicly
commended CCL for its cooperation in the investigation and cited CCL as
having one of the "model" compliance programs in the industry.
In October 1996, Corning contributed $119 million to CCL's capital to fund
the Damon settlement. Additionally, Corning has agreed to fund any additional
settlements prior to the CCL Spin-Off Distribution and to indemnify CCL
against all settlements for any governmental claims relating to billing
practices of CCL and its predecessors that have been settled or are pending
on the Distribution Date. Corning will also agree to indemnify CCL for 50% of
the aggregate of all settlement payments made by CCL that are in excess of
$42 million to private parties that relate to indemnified or previously
settled governmental claims (such as the Damon settlement) for services
provided prior to the Distribution Date; however, the indemnification of
F-19
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
private party claims will not exceed $25 million and will be paid on an
after-tax basis. Such indemnification will not cover any nongovernmental
claims not settled prior to five years after the Distribution Date.
Coincident with the CCL Spin-Off Distribution, the Company will record a
receivable and a contribution of capital from Corning currently estimated at
$25 million which is equal to 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.
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 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, for
non-indemnified claims, the Company's cash flows in the period in which such
claims are settled. The Company does not believe that these issues will have
a material adverse effect on the Company's overall financial condition.
In addition to the $142 million special charge discussed above, in the
third quarter of 1996, the Company recorded a special charge of $13.7 million
to write off capitalized software as a result of its decision to abandon the
billing system which had been intended as its standard company-wide billing
system. Management now plans to standardize billing systems using a system
already implemented in seven of its sites.
14. SPIN-OFF DISTRIBUTION (unaudited)
Coincident with the CCL Spin-Off Distribution, the Company plans to record
a non-recurring charge of approximately $20 million ($13 million after tax)
associated with the CCL Spin-Off Distribution. The largest component of the
charge will be the cost of establishing an employee stock ownership plan ($11
million). The remainder of the charge will consist principally of the costs
for advisors and other fees associated with establishing the Company as a
separate publicly-traded entity. The amount of the charge is subject to
change based on the price of the CCL stock on the Distribution Date.
Prior to the CCL Spin-Off Distribution, the Company will borrow
approximately $500 million in long-term debt to repay Corning for certain
intercompany borrowings. The debt is assumed to consist of $350 million of
bank borrowings and $150 million of publicly-registered high-yield notes.
Corning will contribute the remaining debt to the Company's equity prior to
the CCL Spin-Off Distribution. The credit facility governing the bank
borrowings and the indenture governing the notes will contain various
customary affirmative and negative covenants, including the maintenance of
certain financial ratios and tests. The credit facility prohibits the Company
from paying cash dividends on the CCL common stock. Further, the indenture
will restrict the Company's ability to pay cash dividends based on a
percentage of the Company's cash flow.
In conjunction with the CCL Spin-Off Distribution, Corning and the Company
will enter into an indemnification agreement whereby Corning agrees to
indemnify CCL, on an after-tax basis, for any losses arising out of any
federal, criminal, civil or administrative investigations or claims that are
pending as of the Distribution Date to the extent that such investigations or
claims arise out of or are related to alleged violations of federal laws by
reason of CCL, its affiliates, officers or directors billing any federal
program or agency for services rendered to beneficiaries of such program or
agency.
Corning, CCL and Covance will enter into tax indemnification agreements
that will prohibit CCL and Covance for a period of two years after the
Spin-Off Distributions from taking certain actions that might jeopardize the
favorable tax treatment of the Distributions under section 355 of the
Internal Revenue Code of 1986, as amended and will provide Corning and CCL
with certain rights of indemnification against CCL and Covance. The tax
indemnification agreements will also require CCL and Covance to take such
actions as Corning may request to preserve the favorable tax treatment
provided for in any rulings obtained from the Internal Revenue Service in
respect of the Distributions.
Corning, CCL and Covance will also enter into a tax sharing agreement
which will allocate among Corning, CCL and Covance responsibility for
federal, state and local taxes relating to taxable periods before and after
the Spin-Off Distributions and provide for computing and apportioning tax
liabilities and tax benefits for such periods among the parties.
15. PLANNED CHANGE IN ACCOUNTING POLICY (unaudited)
Coincident with the CCL Spin-Off Distribution, CCL management will adopt a
new accounting policy for evaluating the recoverability of intangible assets
and measuring possible impairment under Statement of the Accounting
Principles Board No. 17. Most of CCL's intangible assets resulted from
purchase business combinations in 1993. Significant changes in the clinical
F-20
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
laboratory and health care industries subsequent to 1993, including increased
government regulation and movement from traditional fee-for-service care to
managed cost health care, have caused the fair value of CCL's intangible assets
to be significantly less than carrying value. CCL management believes that a
valuation of intangible assets based on the amount for which each regional
laboratory could be sold in an arm's-length transaction is preferable to using
projected undiscounted pre-tax cash flows. CCL believes fair value is a better
indicator of the extent to which the intangible assets may be recoverable and
therefore, may be impaired. This change in method of evaluating the
recoverability of intangible assets will result in CCL recording a charge of
between $400 million and $450 million to operations coincident with the CCL
Spin-Off Distribution to reflect the impairment of intangible assets. This will
result in a reduction of amortization expense of approximately $10 million to
$11.3 million annually and $2.5 million to $2.8 million quarterly.
The fair value method will be applied to each of CCL's regional laboratories.
Management's estimate of fair value will primarily be based on multiples of
forecasted revenue or multiples of forecasted EBITDA. The multiples will
primarily be determined based upon publicly available information regarding
comparable publicly-traded companies in the industry, but will also consider (i)
the financial projections of each regional laboratory, (ii) the future prospects
of each regional laboratory, including its growth opportunities, managed care
concentration and likely operational improvements, and (iii) comparable sales
prices, if available. Multiples of revenues will be used to estimate fair value
in cases where the Company believes that the likely acquirer of a regional
laboratory would be a strategic buyer within the industry which would realize
synergies from such an acquisition. In regions where management does not believe
there is a potential strategic buyer within the industry, and, accordingly,
believes the likely buyer would not have synergy opportunities, multiples of
EBITDA will be used for estimating fair value. Regional laboratories with lower
levels of profitability valued using revenue multiples would generally be
ascribed a higher value than if multiples of EBITDA were used, due to assumed
synergy opportunities. Management's estimate of fair value is currently based on
multiples of revenue primarily ranging from 0.5 to 0.7 times revenue and on
multiples of EBITDA primarily ranging from 5 to 6 times EBITDA. While management
believes the estimation methods are reasonable and reflective of common
valuation practices, there can be no assurance that a sale to a buyer for the
estimated value ascribed to a regional laboratory could be completed. Changes to
the method of valuing regional laboratories will be made only when there is a
significant and fundamental change in facts and circumstances, such as
significant changes in market position or the entrance or exit of a significant
competitor from a regional market.
For purposes of estimating the fair value of each of the regional
laboratories, management assumed that a potential buyer would seek to be
indemnified for litigation or other contingencies resulting from
preacquisition activities. Therefore, the reserves recorded for potential,
and settled, billing and marketing claims were not allocated to the regional
laboratories for purposes of estimating their fair value.
On a quarterly basis, CCL management will perform a review of each regional
laboratory to determine if events or changes in circumstances have occurred
which could have a material adverse effect on the fair value of the business and
its intangible assets. If such events or changes in circumstances were deemed to
have occurred, management would consult with one or more of its investment
bankers in estimating the impact on fair value of the regional laboratory.
Should the estimated fair value of a regional laboratory be less than the net
book value for such laboratory at the end of a quarter, the Company would record
a charge to operations to recognize an impairment of its intangible assets for
such difference.
F-21
<PAGE>
Quarterly Operating Results (unaudited)
<TABLE>
<CAPTION>
First Second Third Fourth Total
Quarter Quarter Quarter Quarter Year
------------- --------------- --------------- --------------- -------------
<S> <C> <C> <C> <C> <C>
1996
Net revenues $401,395 $ 424,543 $ 405,352
Gross profit 154,277 158,242 149,962
Loss before taxes (1,642) (37,518) (1) (162,989)(1)
Net loss (1,511) (37,922) (119,436)
1995
Net revenues $417,662 $ 421,853 $ 399,959 $ 389,914 $1,629,388
Gross profit 168,606 175,793 159,091 145,666 649,156
Income (loss) before taxes 19,827 (1) (5,088) (1) (56,405) (2) (15,902) (1) (57,568)
Net income (loss) 4,423 (3,852) (38,595) (14,028) (52,052)
1994
Net revenues $399,063 $ 422,942 $ 408,478 $ 403,216 $1,633,699
Gross profit 159,050 182,050 163,391 159,364 663,855
Income (loss) before taxes 40,624 45,109 (51,250) (1) 28,272 62,755
Net income (loss) 24,152 24,148 (36,535) 16,580 28,345
</TABLE>
(1) Includes impact of restructuring and other special charges of $46.0
million, $155.7 million, $12.8 million, $33.0 million, $4.8 million and
$79.8 million in second quarter 1996, third quarter 1996, first quarter
1995, second quarter 1995, fourth quarter 1995 and third quarter 1994,
respectively, which are discussed in Notes 5 and 13 to the CCL Combined
Financial Statements.
(2) Includes a $62.0 million charge to increase the reserve for doubtful
accounts and allowances resulting from billing systems implementation and
integration problems at certain laboratories and increased regulatory
requirements.
F-22
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
Combined Balance Sheets
September 30, 1996 and December 31, 1995
(in thousands)
<TABLE>
<CAPTION>
September 30, December 31,
1996 1995
--------------- --------------
(unaudited)
<S> <C> <C>
ASSETS
Current Assets:
Cash and cash equivalents $ 48,319 $ 36,446
Accounts receivable, net of allowance of $116,996 and $147,947 for
September 30, 1996 and December 31, 1995, respectively 323,171 318,252
Inventories 25,559 26,601
Deferred taxes on income 126,906 98,845
Prepaid expenses and other assets 25,217 22,014
--------------- --------------
Total current assets 549,172 502,158
Property and equipment, net 293,490 296,116
Intangible assets, net 1,001,500 1,030,633
Other assets 42,216 24,478
--------------- --------------
TOTAL ASSETS $1,886,378 $1,853,385
=============== ==============
LIABILITIES AND STOCKHOLDER'S EQUITY
Current Liabilities:
Accounts payable and accrued expenses $ 374,058 $ 240,525
Current portion of long-term debt 11,885 12,148
Income taxes payable 34,212 39,766
Due to Corning Incorporated and affiliates 14,299 8,979
--------------- --------------
Total current liabilities 434,454 301,418
Long-term debt (principally due to Corning Incorporated) 1,219,900 1,195,566
Other liabilities 99,354 60,600
--------------- --------------
Total liabilities 1,753,708 1,557,584
=============== ==============
Stockholder's Equity:
Contributed capital 297,823 297,823
Accumulated deficit (163,158) (3,118)
Cumulative translation adjustment 1,801 2,325
Market valuation adjustment (3,796) (1,229)
--------------- --------------
Total stockholder's equity 132,670 295,801
--------------- --------------
TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY $1,886,378 $1,853,385
=============== ==============
</TABLE>
The accompanying notes are an integral part of these statements.
F-23
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
Combined Statements of Operations
For the Three and Nine Months Ended September 30, 1996 and 1995
(in thousands)
(unaudited)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30, September 30, September 30,
1996 1995 1996 1995
--------------- --------------- --------------- ---------------
<S> <C> <C> <C> <C>
Net revenues $ 405,352 $399,959 $1,231,290 $1,239,474
Costs and expenses:
Cost of services 255,390 240,868 768,809 735,984
Selling, general and administrative 125,190 181,346 371,439 399,635
Provision for restructuring and
other special
charges 155,730 -- 201,730 45,885
Interest expense, net 19,866 20,927 59,887 61,529
Amortization of intangible assets 10,328 11,293 31,772 33,678
Other, net 1,837 1,930 (198) 4,429
--------------- --------------- --------------- ---------------
Total 568,341 456,364 1,433,439 1,281,140
--------------- --------------- --------------- ---------------
Loss before taxes (162,989) (56,405) (202,149) (41,666)
Income tax benefit (43,553) (17,810) (43,280) (3,642)
--------------- --------------- --------------- ---------------
Net loss $(119,436) $(38,595) $ (158,869) $ (38,024)
=============== =============== =============== ===============
</TABLE>
The accompanying notes are an integral part of these statements.
F-24
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
Combined Statements of Cash Flows
For the Nine Months Ended September 30, 1996 and 1995
(in thousands)
(unaudited)
<TABLE>
<CAPTION>
1996 1995
------------- ------------
<S> <C> <C>
Cash flows from operating activities:
Net loss $(158,869) $ (38,024)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization 75,232 76,036
Provision for doubtful accounts 81,891 127,297
Provision for restructuring and other special charges 201,730 45,885
Deferred income tax provision (31,612) (39,403)
Other, net (753) 4,984
Changes in operating assets and liabilities:
Accounts receivable (87,339) (112,110)
Accounts payable and accrued expenses 3,355 18,732
Restructuring, integration and other special charges (19,863) (49,836)
Due from/to Corning Incorporated and affiliates 5,320 4,572
Changes in other assets and liabilities (27,155) 15,656
------------- ------------
Net cash provided by operating activities 41,937 53,789
------------- ------------
Cash flows from investing activities:
Capital expenditures (58,802) (56,062)
Acquisition of businesses, net of cash acquired -- (22,907)
(Increase) decrease in investments (7,580) 1,058
Proceeds from sale of assets 13,285 --
------------- ------------
Net cash used in investing activities (53,097) (77,911)
------------- ------------
Cash flows from financing activities:
Proceeds from borrowings, primarily with Corning Incorporated 59,090 63,795
Repayment of long-term debt (34,885) (3,766)
Dividends paid (1,172) (27,718)
------------- ------------
Net cash provided by financing activities 23,033 32,311
------------- ------------
Net change in cash and cash equivalents 11,873 8,189
Cash and cash equivalents, beginning of year 36,446 38,719
------------- ------------
Cash and cash equivalents, end of period $ 48,319 $ 46,908
============= ============
</TABLE>
The accompanying notes are an integral part of these statements.
F-25
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated
(a wholly-owned business of Corning Incorporated)
NOTES TO INTERIM COMBINED FINANCIAL STATEMENTS
(unaudited)
1. BASIS OF PRESENTATION
Corning Clinical Laboratories Inc. and Corning Nichols Institute Inc.
(collectively referred to as "CCL" or the "Company") are wholly-owned
subsidiaries of Corning Life Sciences Inc. ("CLSI") which in turn is a
wholly-owned subsidiary of Corning Incorporated ("Corning"). The Company is
one of the largest clinical laboratory testing businesses in the United
States. These financial statements present the carved-out results of
operations, cash flows and financial position of Corning's clinical
laboratory testing business. Covance Inc. (formerly Corning Pharmaceutical
Services Inc.), a subsidiary of CCL, and its related entities ("Covance") as
well as environmental testing services formerly provided by CCL are excluded.
In May 1996, Corning's Board of Directors approved a plan to distribute to
its shareholders on a pro rata basis all of the shares of CCL and Covance
(the "CCL and Covance Spin-Off Distributions"). The result of the plan will
be the creation of two independent, publicly-owned companies. As a result of
the Spin-Off Distributions, CCL will operate Corning's clinical laboratory
testing business as an independent public company and Covance will own and
operate Corning's contract research business as an independent public
company. The Spin-Off Distributions will be effected by the distribution of a
dividend to holders of Corning Common Stock of all of the outstanding CCL
Common Stock, followed immediately by the distribution of a dividend to the
holders of CCL Common Stock of all of the Covance Common Stock. Corning has
submitted to the Internal Revenue Service a request for a ruling that the
Spin-Off Distributions qualify as tax-free distributions under the Internal
Revenue Code of 1986. Coincident with the Spin-Off Distributions, the Company
will be renamed Quest Diagnostics Incorporated.
The interim combined financial statements reflect all adjustments which,
in the opinion of management, are necessary for a fair statement of the
results of operations for the periods presented. All such adjustments are of
a normal recurring nature. The interim combined financial statements have
been compiled without audit and are subject to year-end adjustments. These
interim combined financial statements should be read in conjunction with the
historical combined financial statements of CCL for the years ended December
31, 1995, 1994 and 1993 included elsewhere herein.
2. COMMITMENTS AND CONTINGENCIES
As disclosed in the Company's 1995 combined financial statements, federal
government investigations of certain practices by clinical laboratories
acquired in recent years are ongoing. In the second quarter of 1996, the U.S.
Department of Justice ("DOJ") notified the Company that it has taken issue
with certain payments received by Damon Corporation ("Damon") from federally
funded healthcare programs prior to its acquisition by the Company.
Specifically, in late April 1996, the DOJ for the first time disclosed to CCL
the total amount of the claims that it proposed to assert against Damon. The
government presented its claim for the base recoupment (by lab, by test, by
year) and discussed various theories on which criminal and civil payments of
up to three times the various base recoupment amounts could be assessed.
During May and June, CCL management analyzed the government's claim in
detail. CCL management and outside counsel then believed that there were
meritorious defenses to a number of the claims for recoupments and potential
payments in excess of the base recoupment and these were presented to the
government in early July 1996.
At the end of the second quarter, CCL recorded a $46 million charge to
increase its reserves to $72 million, to equal management's estimate of the low
end of the range of amounts necessary to satisfy claims related to Damon and
other related and similar investigations. With respect to the Damon
investigation, the low end of the range was estimated to be equal to the base
recoupment sought by the government reflecting the basis on which CCL had
settled an earlier claim with the government in 1993. The low end of the range
for the Nichols and other government investigations was based on the base
recoupment estimated by management from internal investigations. Reserves for
pending private claims were estimated based on CCL's experience in settling
private claims following its 1993 government settlement.
CCL management considered the potential for some payments to be assessed in
excess of the base recoupment in estimating its liability at June 30, 1996.
Management estimated that the range of reasonably possible amounts necessary to
satisfy claims related to Damon and other related and similar investigations was
between $72 million and approximately $300 million at June 30, 1996, and,
because no amount in the range was more probable than other amounts, CCL
increased its reserves to equal the low end of the range. This position was
based on CCL's experience with the government in 1993, in which the recovery in
excess of base recoupments was not significant, the government's
representatives' invitation to present information and arguments to them and
their stated intention not to consider the issue of payment multiples until the
base recoupment amount had been established, and management's and counsel's
belief that it had meritorious factual, legal and equitable defenses and
mitigations of the government claims.
F-26
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated
(a wholly-owned business of Corning Incorporated)
NOTES TO INTERIM COMBINED FINANCIAL STATEMENTS (Continued)
(unaudited)
CCL management was aware that similar investigations of other clinical
laboratories in the industry were ongoing. Other than CCL's 1993 settlement,
the only other similar settlement known to management was the 1992 civil
Medicare settlement by a major competitor for $100 million. CCL had reviewed
the publicly-available information about that settlement, including press
releases and the settlement agreement. The competitor's settlement agreement
did not specify whether the civil settlement included substantial payments to
be assessed in excess of the base recoupment. It was believed by CCL that it
did not. Although the competitor and its chief executive officer each pleaded
guilty to criminal charges, the fine was only $1 million for conduct that was
contemporaneous with, and considered by CCL management and its counsel to be
more egregious than, that of Damon.
During the third quarter 1996, CCL management met with the government
several times to evaluate the substance of the government's allegations.
During a meeting with the government in mid-August, further information and
legal arguments were exchanged. Importantly, at this time, the government for
the first time began to disclose to CCL and its outside counsel grand jury
testimony and other evidence that was inconsistent with certain of CCL's
defenses.
The final settlement discussions began in late September. The government
responded to and rejected many of CCL's defenses and made its tentative final
settlement offer, which included significant payments in excess of base
recoupments, to CCL. Negotiations on the final settlement amount and terms
(including releases from various federal and state payors, compliance program
requirements, etc.) continued into early October and ended with the
settlement agreement dated October 9, 1996. The settlement included base
recoupments of approximately $40 million (which did not differ materially
from management's estimate at June 30, 1996) and total criminal and civil
payments in excess of base recoupments of approximately $80 million.
This settlement concludes all federal and Medicaid claims relating to the
billing by Damon of certain blood tests to Medicare and Medicaid patients and
other matters relating to Damon being investigated by the DOJ. Additionally,
the Company entered into a separate settlement agreement with the DOJ
totaling $6.9 million related to billings of hematology indices provided with
hematology test results. This claim will be paid during the fourth quarter of
1996.
As a result of these settlement agreements, CCL management has reassessed
the level of reserves recorded for other asserted and unasserted claims
related to the Damon and other similar government investigations, including
the investigation of billing practices by Nichols Institute ("Nichols") prior
to its acquisition by the Company in 1994. The Company recorded a charge
totaling $142 million in the third quarter 1996 to establish additional
reserves to provide for the above settlement agreements and management's best
estimate of potential amounts which could be required to satisfy the
remaining claims. At September 30, 1996, recorded reserves approximated $215
million (including the $119 million Damon settlement paid in October 1996).
Based on information currently available to CCL, management does not believe
that the exposure to claims in excess of recorded claims is material.
Although the Damon settlement was substantially in excess of amounts
anticipated by management, it was primarily due to the civil and criminal
payments in excess of the base recoupment assessed by the government and CCL
has now increased its reserves for asserted and unasserted claims to
approximate the amount that may be required to settle the Nichols and other
government civil claims taking into account the basis for the Damon civil
settlement. In addition, although there is the possibility that CCL could be
excluded from participation in Medicare and Medicaid programs, management
believes that the possibility is remote as a result of the Damon settlement,
which included CCL's signing a Corporate Integrity Agreement, and due to the
fact that the government has publicly commended CCL for its cooperation in
the investigation and cited CCL as having one of the "model" compliance
programs in the industry.
In October 1996, Corning contributed $119 million to CCL's capital to fund
the Damon settlement. Additionally, Corning has agreed to fund any additional
settlements prior to the CCL Spin-Off Distribution and to indemnify CCL
against all settlements for any governmental claims relating to billing
practices of CCL and its predecessors that have been settled or are pending
on the Distribution Date. Corning will also agree to indemnify CCL for 50% of
the aggregate of all settlement payments made by CCL that are in excess of
$42 million to private parties that relate to indemnified or previously
settled governmental claims (such as the Damon settlement) for services
provided prior to the Distribution Date; however, the indemnification of
private party claims will not exceed $25 million and will be paid on an
after-tax basis. Such indemnification will not cover any nongovernmental
claims not settled prior to five years after the Distribution Date.
Coincident with the CCL Spin-Off Distribution, the Company will record a
receivable and a contribution of capital from Corning currently estimated at
$25 million which is equal to 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.
F-27
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated
(a wholly-owned business of Corning Incorporated)
NOTES TO INTERIM COMBINED FINANCIAL STATEMENTS (Continued)
(unaudited)
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 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, for
non-indemnified claims, the Company's cash flow in the period in which such
claims are settled. The Company does not believe that these issues will have
a material adverse impact on the Company's overall financial condition.
3. PROVISION FOR RESTRUCTURING AND OTHER SPECIAL CHARGES
In addition to the $142 million special charge discussed in Note 2, in the
third quarter of 1996, the Company recorded a special charge of $13.7 million
to write off capitalized software as a result of its decision to abandon the
development of a billing system which had been intended as its standard
company-wide billing system. Management now plans to standardize billing
systems using a system already implemented in seven of its sites.
4. RESTRUCTURING RESERVES
As described in Note 5 to the CCL Combined Financial statements, CCL has
recorded charges for restructuring plans in previous years. Reserves relating
to these programs totaled approximately $37.7 million and $23.5 million at
December 31, 1995 and September 30, 1996, respectively. Management believes
that the costs of the restructuring plans will be financed through cash from
operations and does not anticipate any significant impact on its liquidity as
a result of the restructuring plans.
5. SPIN-OFF DISTRIBUTION
Coincident with the CCL Spin-Off Distribution, the Company plans to record
a non-recurring charge of approximately $20 million ($13 million after tax)
associated with the CCL Spin-Off Distribution. The largest component of the
charge will be the cost of establishing an employee stock ownership plan ($11
million). The remainder of the charge will consist principally of the costs
for advisors and other fees associated with establishing the Company as a
separate publicly-traded entity. The amount of the charge is subject to
change based on the price of the CCL stock on the Distribution Date.
Prior to the CCL Spin-Off Distribution, the Company will borrow
approximately $500 million in long-term debt to repay Corning for certain
intercompany borrowings. The debt is assumed to consist of $350 million of
bank borrowings and $150 million of publicly-registered high-yield notes.
Corning will contribute the remaining debt to the Company's equity prior to
the CCL Spin-Off Distribution. The credit facility governing the bank
borrowings and the indenture governing the notes will contain various
customary affirmative and negative covenants , including the maintenance of
certain financial ratios and tests. The credit facility prohibits the Company
from paying cash dividends on the CCL common stock. Further, the indenture
will restrict the Company's ability to pay cash dividends based on a
percentage of the Company's cash flow.
In conjunction with the CCL Spin-Off Distribution, Corning and the Company
will enter into an indemnification agreement whereby Corning agrees to
indemnify CCL, on an after-tax basis, for any losses arising out of any
federal, criminal, civil or administrative investigations or claims that are
pending as of the Distribution Date to the extent that such investigations or
claims arise out of or are related to alleged violations of federal laws by
reason of CCL, its affiliates, officers or directors billing any federal
program or agency for services rendered to beneficiaries of such program or
agency.
Corning, CCL and Covance will enter into tax indemnification agreements
that will prohibit CCL and Covance for a period of two years after the
Spin-Off Distributions from taking certain actions that might jeopardize the
favorable tax treatment of the Distributions under section 355 of the
Internal Revenue Code of 1986, as amended and will provide Corning and CCL
with certain rights of indemnification against CCL and Covance. The tax
indemnification agreements will also require CCL and Covance to take such
actions as Corning may request to preserve the favorable tax treatment
provided for in any rulings obtained from the Internal Revenue Service in
respect of the Distributions.
Corning, CCL and Covance will also enter into a tax sharing agreement
which will allocate among Corning, CCL and Covance responsibility for
federal, state and local taxes relating to taxable periods before and after
the Spin-Off Distributions and provide for computing and apportioning tax
liabilities and tax benefits for such periods among the parties.
F-28
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated
(a wholly-owned business of Corning Incorporated)
NOTES TO INTERIM COMBINED FINANCIAL STATEMENTS (Continued)
(unaudited)
6. PLANNED CHANGE IN ACCOUNTING POLICY
Coincident with the CCL Spin-Off Distribution, CCL management will adopt a
new accounting policy for evaluating the recoverability of intangible assets
and measuring possible impairment under Statement of the Accounting
Principles Board No. 17. Most of CCL's intangible assets resulted from purchase
business combinations in 1993. Significant changes in the clinical laboratory
and health care industries subsequent to 1993, including increased government
regulation and movement from traditional fee-for-service care to managed cost
health care, have caused the fair value of CCL's intangible assets to be
significantly less than carrying value. CCL management believes that a valuation
of intangible assets based on the amount for which each regional laboratory
could be sold in an arm's-length transaction is preferable to using projected
undiscounted pre-tax cash flows. CCL believes fair value is a better indicator
of the extent to which the intangible assets may be recoverable and therefore,
may be impaired. This change in method of evaluating the recoverability of
intangible assets will result in CCL recording a charge of between $400 million
and $450 million to operations coincident with the CCL Spin-Off Distribution to
reflect the impairment of intangible assets. This will result in a reduction of
amortization expense of approximately $10 million to $11.3 million annually and
$2.5 million to $2.8 million quarterly.
The fair value method will be applied to each of CCL's regional laboratories.
Management's estimate of fair value will primarily be based on multiples of
forecasted revenue or multiples of forecasted EBITDA. The multiples will
primarily be determined based upon publicly available information regarding
comparable publicly-traded companies in the industry, but will also consider (i)
the financial projections of each regional laboratory, (ii) the future prospects
of each regional laboratory, including its growth opportunities, managed care
concentration and likely operational improvements, and (iii) comparable sales
prices, if available. Multiples of revenues will be used to estimate fair value
in cases where the Company believes that the likely acquirer of a regional
laboratory would be a strategic buyer within the industry which would realize
synergies from such an acquisition. In regions where management does not believe
there is a potential strategic buyer within the industry, and, accordingly,
believes the likely buyer would not have synergy opportunities, multiples of
EBITDA will be used for estimating fair value. Regional laboratories with lower
levels of profitability valued using revenue multiples would generally be
ascribed a higher value than if multiples of EBITDA were used, due to assumed
synergy opportunities. Management's estimate of fair value is currently based on
multiples of revenue primarily ranging from 0.5 to 0.7 times revenue and on
multiples of EBITDA primarily ranging from 5 to 6 times EBITDA. While management
believes the estimation methods are reasonable and reflective of common
valuation practices, there can be no assurance that a sale to a buyer for the
estimated value ascribed to a regional laboratory could be completed. Changes to
the method of valuing regional laboratories will be made only when there is a
significant and fundamental change in facts and circumstances, such as
significant changes in market position or the entrance or exit of a significant
competitor from a regional market.
For purposes of estimating the fair value of each of the regional
laboratories, management assumed that a potential buyer would seek to be
indemnified for litigation or other contingencies resulting from
preacquisition activities. Therefore, the reserves recorded for potential,
and settled, billing and marketing claims were not allocated to the regional
laboratories for purposes of estimating their fair value.
On a quarterly basis, CCL management will perform a review of each regional
laboratory to determine if events or changes in circumstances have occurred
which could have a material adverse effect on the fair value of the business and
its intangible assets. If such events or changes in circumstances were deemed to
have occurred, management would consult with one or more of its investment
bankers in estimating the impact on fair value of the regional laboratory.
Should the estimated fair value of a regional laboratory be less than the net
book value for such laboratory at the end of a quarter, the Company would record
a charge to operations to recognize an impairment of its intangible assets for
such difference.
F-29
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated
(a wholly-owned business of Corning Incorporated)
NOTES TO INTERIM COMBINED FINANCIAL STATEMENTS (Continued)
(unaudited)
7. SUMMARIZED FINANCIAL INFORMATION
As discussed in Note 5, the Company is currently pursuing the issuance of
$150 million of Senior Subordinated Notes due in 2006 which will be used to
repay certain intercompany indebtedness owed to Corning. The Senior Subordinated
Notes will be guaranteed, fully, jointly and severally, and unconditionally, on
a senior subordinated basis by each of the Company's wholly-owned, domestic
subsidiaries (Subsidiary Guarantors). Non-guarantor subsidiaries, individually
and in the aggregate, are inconsequential to the Company. Full financial
statements of the Subsidiary Guarantors are not presented because management
believes they are not material to investors. The following is summarized
financial information of the Subsidiary Guarantors as of September 30, 1996 and
December 31, 1995 and for the nine months ended September 30, 1996 and September
30, 1995.
<TABLE>
<CAPTION>
September 30, December 31,
1996 1995
--------------- ---------------
<S> <C> <C>
Current assets $234,183 $244,547
Noncurrent assets 865,265 864,351
Current liabilities 71,416 71,828
Noncurrent liabilities 694,331 682,805
Stockholder's equity 333,701 354,265
For the nine months ended
September 30,
-------------------------------
1996 1995
--------------- ---------------
Net revenues $677,489 $709,317
Cost of services 427,583 444,705
Net loss (20,564) (26,435)
</TABLE>
F-30
<PAGE>
Inside Back Cover
Photo Descriptions
- ------------------
Photo of Corning Clinical Lab testing machinery:
Caption: As one of the nation's leading providers of clinical laboratory testing
services, Quest Diagnostics processes approximately 60 million requisitions for
diagnostic tests a year.
Photo of robot.
Caption: A test for lead poisoning once required several manual steps. Now, with
robots, the test is fully automated from specimen preparation to reporting
results.
Photo of meeting.
Caption: With this unusual microscope, more than a dozen Quest Diagnostics
doctors or technicians can simultaneously view the same slide and discuss
results.
Photo molecular biologist.
Caption: A Quest Diagnostics molecular biologist studies an autoradiogram,
looking for mutated genes as part of a molecular genetics test.
<PAGE>
OUTSIDE BACK COVER
[LOGO] QUEST DIAGNOSTICS
