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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
- --------------------------------------------------------------------------------
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarter ended September 30, 2002
Commission file number 1-12215
Quest Diagnostics Incorporated
One Malcolm Avenue
Teterboro, NJ 07608
(201) 393-5000
Delaware
(State of Incorporation)
16-1387862
(I.R.S. Employer Identification Number)
- --------------------------------------------------------------------------------
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
--- ---
As of October 28, 2002, there were outstanding 97,796,624 shares of Common
Stock, $.01 par value.
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Index to consolidated financial statements filed as part of this report:
Page
Consolidated Statements of Operations for the
Three and Nine months ended September 30, 2002 and 2001 2
Consolidated Balance Sheets as of
September 30, 2002 and December 31, 2001 3
Consolidated Statements of Cash Flows for the
Nine months ended September 30, 2002 and 2001 4
Notes to Consolidated Financial Statements 5
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
Management's Discussion and Analysis of Financial
Condition and Results of Operations 19
Item 3. Quantitative and Qualitative Disclosures About Market Risk
See Item 2. "Management's Discussion and Analysis of Financial Condition
and Results of Operations"
Item 4. Controls and Procedures
Controls and Procedures 27
1
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE AND NINE MONTHS ENDED
SEPTEMBER 30, 2002 AND 2001
(in thousands, except per share data)
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------- --------------------------
2002 2001 2002 2001
---- ---- ---- ----
Net revenues .......................................... $1,058,714 $903,189 $3,074,286 $2,717,331
---------- -------- ---------- ----------
Costs and expenses:
Cost of services ................................... 625,075 535,564 1,813,071 1,614,020
Selling, general and administrative ................ 272,587 251,048 807,811 760,324
Interest expense, net .............................. 13,388 14,810 40,979 57,968
Amortization of goodwill and other intangible assets 2,023 11,442 6,243 34,681
Provision for special charge ....................... - - - 5,997
Minority share of income ........................... 3,661 2,876 11,481 6,843
Other, net ......................................... (4,165) (2,437) (10,439) (3,571)
---------- -------- ---------- ----------
Total ............................................ 912,569 813,303 2,669,146 2,476,262
---------- -------- ---------- ----------
Income before taxes and extraordinary loss ............ 146,145 89,886 405,140 241,069
Income tax expense .................................... 59,528 39,764 164,683 108,095
---------- -------- ---------- ----------
Income before extraordinary loss ...................... 86,617 50,122 240,457 132,974
Extraordinary loss, net of taxes ...................... - - - (21,609)
---------- -------- ---------- ----------
Net income ............................................ $ 86,617 $ 50,122 $ 240,457 $ 111,365
========== ======== ========== ==========
Basic earnings per common share:
Income before extraordinary loss ...................... $ 0.89 $ 0.54 $ 2.50 $ 1.43
Extraordinary loss, net of taxes ...................... - - - (0.23)
---------- -------- ---------- ----------
Net income ............................................ $ 0.89 $ 0.54 $ 2.50 $ 1.20
========== ======== ========== ==========
Diluted earnings per common share:
Income before extraordinary loss ...................... $ 0.87 $ 0.51 $ 2.41 $ 1.37
Extraordinary loss, net of taxes ...................... - - - (0.23)
---------- -------- ---------- ----------
Net income ............................................ $ 0.87 $ 0.51 $ 2.41 $ 1.14
========== ======== ========== ==========
Weighted average common shares
outstanding - basic ................................ 96,900 93,382 96,238 92,612
Weighted average common shares
outstanding - diluted .............................. 99,712 98,046 99,772 97,323
The accompanying notes are an integral part of these statements.
2
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, 2002 AND DECEMBER 31, 2001
(in thousands, except per share data)
(unaudited)
September 30, December 31,
2002 2001
---------- ----------
Assets
Current assets:
Cash and cash equivalents ................................................ $ 113,854 $ 122,332
Accounts receivable, net of allowance of $207,174 and $216,203 at
September 30, 2002 and December 31, 2001, respectively ................. 576,461 508,340
Inventories .............................................................. 59,015 49,906
Deferred taxes on income ................................................. 139,812 157,649
Prepaid expenses and other current assets ................................ 41,003 38,287
---------- ----------
Total current assets ................................................... 930,145 876,514
Property, plant and equipment, net .......................................... 571,516 508,619
Goodwill, net ............................................................... 1,789,452 1,351,123
Intangible assets, net ...................................................... 22,261 28,020
Deferred taxes on income .................................................... 53,087 52,678
Other assets ................................................................ 99,276 113,601
---------- ----------
Total assets ................................................................ $3,465,737 $2,930,555
========== ==========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses .................................... $ 610,407 $ 657,219
Short-term borrowings and current portion of long-term debt .............. 251,100 1,404
---------- ----------
Total current liabilities .............................................. 861,507 658,623
Long-term debt .............................................................. 796,778 820,337
Other liabilities ........................................................... 129,726 115,608
Commitments and contingencies
Common stockholders' equity:
Common stock, par value $0.01 per share; 300,000 shares authorized;
97,738 and 96,024 shares issued and outstanding at September 30,
2002 and December 31, 2001, respectively ............................... 977 960
Additional paid-in capital ............................................... 1,807,585 1,714,676
Accumulated deficit ...................................................... (122,469) (362,926)
Unearned compensation .................................................... (5,530) (13,253)
Accumulated other comprehensive loss ..................................... (2,837) (3,470)
---------- ----------
Total common stockholders' equity ...................................... 1,677,726 1,335,987
---------- ----------
Total liabilities and stockholders' equity .................................. $3,465,737 $2,930,555
========== ==========
The accompanying notes are an integral part of these statements.
3
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001
(in thousands)
(unaudited)
2002 2001
--------- ---------
Cash flows from operating activities:
Net income................................................................... $ 240,457 $ 111,365
Extraordinary loss, net of taxes............................................. - 21,609
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation and amortization............................................. 96,697 108,000
Provision for doubtful accounts........................................... 164,892 165,670
Provision for special charge.............................................. - 5,997
Deferred income tax provision............................................. 18,046 5,224
Minority share of income.................................................. 11,481 6,843
Stock compensation expense................................................ 6,829 16,457
Tax benefits associated with stock-based compensation plans............... 41,307 40,664
Other, net................................................................ (6,003) 1,078
Changes in operating assets and liabilities:
Accounts receivable..................................................... (170,047) (193,734)
Accounts payable and accrued expenses................................... (40,808) (2,254)
Integration, settlement and other special charges....................... (26,469) (41,397)
Other assets and liabilities, net....................................... 13,545 55,758
--------- ---------
Net cash provided by operating activities.................................... 349,927 301,280
--------- ---------
Cash flows from investing activities:
Business acquisitions, net of cash acquired.................................. (333,512) (55,746)
Capital expenditures......................................................... (118,403) (110,183)
Collection of note receivable ............................................... 10,660 2,989
Proceeds from disposition of assets.......................................... 5,919 21,562
Increase in investments and other assets..................................... (4,450) (11,206)
--------- ---------
Net cash used in investing activities........................................ (439,786) (152,584)
--------- ---------
Cash flows from financing activities:
Repayments of debt........................................................... (408,842) (790,126)
Proceeds from borrowings..................................................... 475,237 722,439
Costs paid in connection with debt refinancing............................... - (25,164)
Exercise of stock options.................................................... 24,251 17,512
Distributions to minority partners........................................... (9,071) (5,779)
Preferred stock dividends paid............................................... - (176)
Other........................................................................ (194) -
--------- ---------
Net cash provided by (used in) financing activities.......................... 81,381 (81,294)
--------- ---------
Net change in cash and cash equivalents...................................... (8,478) 67,402
Cash and cash equivalents, beginning of year................................. 122,332 171,477
--------- ---------
Cash and cash equivalents, end of period..................................... $ 113,854 $ 238,879
========= =========
Cash paid during the period for:
Interest..................................................................... $ 52,224 $ 56,300
Income taxes................................................................. 82,776 23,048
Businesses acquired:
Fair value of assets acquired................................................ $ 559,540 $ 55,746
Fair value of liabilities assumed............................................ 214,083 -
The accompanying notes are an integral part of these statements.
4
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, unless otherwise indicated)
(unaudited)
1. BASIS OF PRESENTATION
Background
Quest Diagnostics Incorporated and its subsidiaries ("Quest
Diagnostics" or the "Company") is the largest clinical laboratory testing
business in the United States. As the nation's leading provider of diagnostic
testing and related services for the healthcare industry, Quest Diagnostics
offers a broad range of clinical laboratory testing services to physicians,
hospitals, managed care organizations, employers, governmental institutions and
other independent clinical laboratories. Quest Diagnostics has the leading
market share in clinical laboratory testing and esoteric testing, including
molecular diagnostics, as well as non-hospital based anatomic pathology services
and testing for drugs of abuse. Through the Company's national network of
laboratories and patient service centers, and its esoteric testing laboratory
and development facilities, Quest Diagnostics offers comprehensive and
innovative diagnostic testing, information and related services used by
physicians and other healthcare customers to diagnose, treat and monitor
diseases and other medical conditions. Quest Diagnostics also offers clinical
testing and services to support clinical trials of new pharmaceuticals
worldwide.
On an annualized basis, Quest Diagnostics processes over 115 million
requisitions through its extensive network of laboratories and patient service
centers in virtually every major metropolitan area throughout the United States.
Basis of Presentation
The interim consolidated financial statements reflect all adjustments
which, in the opinion of management, are necessary for a fair statement of
financial condition and results of operations for the periods presented. Except
as otherwise disclosed, all such adjustments are of a normal recurring nature.
The interim consolidated financial statements have been compiled without audit.
Operating results for the interim periods are not necessarily indicative of the
results that may be expected for the full year. These interim consolidated
financial statements should be read in conjunction with the audited consolidated
financial statements included in the Company's 2001 Annual Report on Form 10-K.
Earnings Per Share
Basic earnings per common share is calculated by dividing net income,
less preferred stock dividends (approximately $30 thousand per quarter in 2001),
by the weighted average number of common shares outstanding. Diluted earnings
per common share is calculated by dividing net income, less preferred stock
dividends, by the weighted average number of common shares outstanding after
giving effect to all potentially dilutive common shares outstanding during the
period. The if-converted method is used in determining the dilutive effect of
the Company's 1 3/4% contingent convertible debentures in periods when the
holders of such securities are permitted to exercise their conversion rights.
Potentially dilutive common shares include outstanding stock options and
restricted common shares granted under the Company's Employees Equity
Participation Program. These dilutive securities increased the weighted average
number of common shares outstanding by 2.8 and 3.5 million shares for the three
and nine months ended September 30, 2002, respectively. For both the three and
nine months ended September 30, 2001, these dilutive securities increased the
weighted average number of common shares outstanding by 4.7 million shares.
During the fourth quarter of 2001, the Company redeemed all of its then issued
and outstanding shares of preferred stock.
Stock-Based Compensation
Quest Diagnostics has adopted the disclosure-only provisions of
Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for
Stock-Based Compensation" ("SFAS 123"), and follows Accounting Principles Board
Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees" ("APB 25"),
and related interpretations to account for its stock-based compensation plans.
Under this approach, the cost of restricted stock awards is expensed over their
vesting period, while the imputed cost of stock option grants and discounts
offered under the Company's Employee Stock Purchase Plan ("ESPP") is disclosed,
based on the vesting provisions of the individual grants, but not charged to
expense. Stock-based compensation expense recorded in accordance with APB 25,
related to restricted stock awards, was $1.9 million and $4.6 million for the
three months ended September 30, 2002 and 2001, respectively, and $6.8 million
and $16.5 million for the nine months ended September 30, 2002 and 2001,
respectively.
5
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
The following table presents net income and basic and diluted earnings
per common share, had the Company elected to recognize compensation cost based
on the fair value at the grant dates for stock option awards and discounts
granted for stock purchases under the Company's ESPP, consistent with the method
prescribed by SFAS 123:
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- -------------------------
2002 2001 2002 2001
-------- ------- -------- --------
Net income:
Net income ..................................... $ 86,617 $50,122 $240,457 $111,365
Impact of recognizing compensation cost pursuant
to provisions of SFAS 123 ................... (10,232) (7,095) (28,185) (17,105)
-------- ------- -------- --------
Net income, adjusted for impact of SFAS 123 .... $ 76,385 $43,027 $212,272 $ 94,260
======== ======= ======== ========
Basic earnings per common share:
Net income ..................................... $0.89 $0.54 $2.50 $1.20
Impact of recognizing compensation cost pursuant
to provisions of SFAS 123 ................... (0.10) (0.08) (0.29) (0.18)
-------- ------- -------- --------
Net income, adjusted for impact of SFAS 123 .... $0.79 $0.46 $2.21 $1.02
======== ======= ======== ========
Diluted earnings per common share:
Net income ..................................... $0.87 $0.51 $2.41 $1.14
Impact of recognizing compensation cost pursuant
to provisions of SFAS 123 ................... (0.10) (0.07) (0.28) (0.17)
-------- ------- -------- --------
Net income, adjusted for impact of SFAS 123 .... $0.77 $0.44 $2.13 $0.97
======== ======= ======== ========
The fair value of each option grant was estimated on the date of grant
using the Black-Scholes option-pricing model with the following weighted average
assumptions:
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ --------------------
2002 2001 2002 2001
---- ---- ---- ----
Dividend yield ......................... 0.0% 0.0% 0.0% 0.0%
Risk-free interest rate ................ 3.8% 5.1% 4.2% 5.2%
Expected volatility .................... 46.2% 47.7% 45.2% 47.7%
Expected holding period, in years ...... 5 5 5 5
New Accounting Standards
In August 2001, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 144, "Accounting for Impairment or Disposal of Long-Lived
Assets" ("SFAS 144"), which supercedes SFAS No. 121, "Accounting for the
Impairment of Long-Lived Assets to be Disposed Of" ("SFAS 121"). SFAS 144
further refines SFAS 121's requirement that companies recognize an impairment
loss if the carrying amount of a long-lived asset is not recoverable based on
its undiscounted future cash flows and measure an impairment loss as the
difference between the carrying amount and fair value of the asset. In addition,
SFAS 144 provides guidance on accounting and disclosure issues surrounding
long-lived assets to be disposed of by sale. SFAS 144 also extends the
presentation of discontinued operations to include more disposal transactions.
SFAS 144 is effective for all fiscal quarters of all fiscal years beginning
after December 15, 2001 (January 1, 2002 for the Company). The Company's
adoption of SFAS 144 did not result in any impairment loss being recorded.
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections" ("SFAS 145"). SFAS 145 rescinds SFAS No. 4, "Reporting Gains and
Losses from Extinguishment of Debt" ("SFAS 4"), SFAS No. 44, "Accounting for
Intangible Assets of Motor Carriers" ("SFAS 44") and SFAS No. 64,
"Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements" ("SFAS 64")
and
6
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
amends SFAS No. 13, "Accounting for Leases" ("SFAS 13"). This statement updates,
clarifies and simplifies existing accounting pronouncements. As a result of
rescinding SFAS 4 and SFAS 64, the criteria in APB No. 30, "Reporting the
Results of Operations-Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions", will be used to classify gains and losses from extinguishment of
debt. SFAS 44 was no longer necessary because the transitions under the Motor
Carrier Act of 1980 were completed. SFAS 13 was amended to eliminate an
inconsistency between the required accounting for sale-leaseback transactions
and the required accounting for certain lease modifications that have economic
effects that are similar to sale-leaseback transactions and makes technical
corrections to existing pronouncements. The provisions of SFAS 145 are effective
for fiscal years beginning after May 15, 2002, with earlier application
encouraged. The Company expects to adopt SFAS 145 effective January 1, 2003 and
reflect any necessary reclassifications in its consolidated statements of
operations. The adoption of SFAS 145 will not have a material impact on the
Company's financial position.
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities" ("SFAS 146"), which addresses the
recognition, measurement, and reporting of costs associated with exit or
disposal activities, and supercedes Emerging Issues Task Force Issue No. 94-3,
"Liability Recognition for Certain Employee Termination Benefits and Other Costs
to Exit an Activity (including Certain Costs Incurred in a Restructuring)"
("EITF 94-3"). The principal difference between SFAS 146 and EITF 94-3 relates
to the requirements for recognition of a liability for a cost associated with an
exit or disposal activity. SFAS 146 requires that a liability for a cost
associated with an exit or disposal activity, including those related to
employee termination benefits and obligations under operating leases and other
contracts, be recognized when the liability is incurred, and not necessarily the
date of an entity's commitment to an exit plan, as under EITF 94-3. SFAS 146
also establishes that the initial measurement of a liability recognized under
SFAS 146 be based on fair value. The provisions of SFAS 146 are effective for
exit or disposal activities that are initiated after December 31, 2002, with
early application encouraged. The Company expects to adopt SFAS 146, effective
January 1, 2003.
2. ACCOUNTING FOR GOODWILL AND OTHER INTANGIBLE ASSETS
In July 2001, the FASB issued SFAS No. 142, "Goodwill and Other
Intangible Assets" ("SFAS 142"), which broadens the criteria for recording
intangible assets separate from goodwill. SFAS 142 requires the use of a
nonamortization approach to account for purchased goodwill and certain
intangibles. Under a nonamortization approach, goodwill and certain intangibles
are not amortized into results of operations, but instead are reviewed for
impairment and an impairment charge is recorded in the periods in which the
recorded carrying value of goodwill and certain intangibles is more than its
estimated fair value. The Company adopted SFAS 142 effective January 1, 2002.
The provisions of SFAS 142 require that a transitional impairment test be
performed as of the beginning of the year the statement is adopted. The
provisions of SFAS 142 also require that a goodwill impairment test be performed
annually or in the case of other events that indicate a potential impairment.
The new criteria for recording intangible assets separate from goodwill did not
require the Company to reclassify any of its intangible assets. The Company's
transitional impairment test indicated that there was no impairment of goodwill
upon adoption of SFAS 142. The annual impairment test of goodwill will be
performed at the end of the Company's fiscal year on December 31st.
Effective January 1, 2002, the Company evaluates the recoverability and
measures the possible impairment of its goodwill under SFAS 142. The impairment
test is a two-step process that begins with the estimation of the fair value of
the reporting unit. The first step screens for potential impairment and the
second step measures the amount of the impairment, if any. Management's estimate
of fair value considers publicly available information regarding the market
capitalization of the Company as well as (i) publicly available information
regarding comparable publicly-traded companies in the clinical laboratory
testing industry, (ii) the financial projections and future prospects of the
Company's business, including its growth opportunities and likely operational
improvements, and (iii) comparable sales prices, if available. As part of the
first step to assess potential impairment, management compares the estimate of
fair value for the Company to the book value of the Company's consolidated net
assets. If the book value of the consolidated net assets is greater than the
estimate of fair value, the Company would then proceed to the second step to
measure the impairment, if any. The second step compares the implied fair value
of goodwill with its carrying value. The implied fair value is determined by
allocating the fair value of the reporting unit to all of the assets and
liabilities of that unit as if the reporting unit had been acquired in a
business combination and the fair value of the reporting unit was the purchase
price paid to acquire the reporting unit. The excess of the fair value of the
reporting unit over the amounts assigned to its assets and liabilities is the
implied fair value of goodwill. If the carrying amount of the reporting unit's
goodwill is greater than its implied fair value, an impairment loss will be
recognized in the
7
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
amount of the excess. Management believes its estimation methods are reasonable
and reflective of common valuation practices.
On a quarterly basis, management performs a review of the Company's
business to determine if events or changes in circumstances have occurred which
could have a material adverse effect on the fair value of the Company and its
goodwill. If such events or changes in circumstances were deemed to have
occurred, the Company would perform an impairment test of goodwill as of the end
of the quarter, consistent with the annual impairment test, and record any noted
impairment loss.
The following table presents net income and basic and diluted earnings
per common share, adjusted to reflect results as if the nonamortization
provisions of SFAS 142 had been in effect for the periods presented:
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- --------------------------
2002 2001 2002 2001
------- ------- -------- --------
Net income:
Reported net income ............................. $86,617 $50,122 $240,457 $111,365
Add back: Amortization of goodwill, net of taxes - 8,887 - 27,077
------- ------- -------- --------
Adjusted net income ............................. $86,617 $59,009 $240,457 $138,442
======= ======= ======== ========
Income before extraordinary loss, adjusted to
exclude amortization of goodwill, net of taxes $86,617 $59,009 $240,457 $160,051
Basic earnings per common share:
Reported net income ............................. $ 0.89 $ 0.54 $ 2.50 $ 1.20
Amortization of goodwill, net of taxes .......... - 0.09 - 0.29
------- ------- -------- --------
Adjusted net income ............................. $ 0.89 $ 0.63 $ 2.50 $ 1.49
======= ======= ======== ========
Income before extraordinary loss, adjusted to
exclude amortization of goodwill, net of taxes $ 0.89 $ 0.63 $ 2.50 $ 1.73
Diluted earnings per common share:
Reported net income ............................. $ 0.87 $ 0.51 $ 2.41 $ 1.14
Amortization of goodwill, net of taxes .......... - 0.09 - 0.28
------- ------- -------- --------
Adjusted net income ............................. $ 0.87 $ 0.60 $ 2.41 $ 1.42
======= ======= ======== ========
Income before extraordinary loss, adjusted to
exclude amortization of goodwill, net of
taxes ........................................ $ 0.87 $ 0.60 $ 2.41 $ 1.64
8
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Other intangible assets consist of the following:
Weighted
Average
Amortization
Period September 30, 2002 December 31, 2001
------------ ----------------------------------------- ---------------------------------------
Accumulated Accumulated
Cost Amortization Net Cost Amortization Net
-------- ------------- ------- ------ ------------ -------
Non-compete
agreements . 5 years $43,943 $(30,757) $13,186 $43,943 $(26,566) $17,377
Customer lists 15 years 41,301 (33,307) 7,994 41,331 (31,787) 9,544
Other ........ 12 years 3,267 (2,186) 1,081 3,067 (1,968) 1,099
------- -------- ------- ------- -------- -------
Total ..... 8 years $88,511 $(66,250) $22,261 $88,341 $(60,321) $28,020
======= ======== ======= ======= ======== =======
For the three months ended September 30, 2002 and 2001, amortization
expense related to other intangible assets was $2,023 and $1,940, respectively.
For the nine months ended September 30, 2002 and 2001, amortization expense
related to other intangible assets was $6,243 and $5,792, respectively.
The estimated amortization expense related to other intangible assets
for each of the five succeeding fiscal years and thereafter as of September 30,
2002 is as follows:
Fiscal Year Ending
December 31,
----------------------
Remainder of 2002 .... $ 1,845
2003 ................. 7,355
2004 ................. 5,830
2005 ................. 2,503
2006 ................. 1,389
2007 ................. 639
Thereafter ........... 2,700
-------
Total .............. $22,261
=======
3. BUSINESS ACQUISITION
Acquisition of American Medical Laboratories, Incorporated
On April 1, 2002, the Company completed its previously announced
acquisition of all of the outstanding voting stock of American Medical
Laboratories, Incorporated, ("AML") and an affiliated company of AML, LabPortal,
Inc. ("LabPortal"), a provider of electronic connectivity products, in an
all-cash transaction with a combined value of approximately $500 million, which
included the assumption of approximately $160 million in debt.
Through the acquisition of AML, Quest Diagnostics acquired all of AML's
operations, including two full-service laboratories, 51 patient service centers,
and hospital sales, service and logistics capabilities. The all-cash purchase
price of approximately $335 million and related transaction costs, together with
the repayment of approximately $150 million of principal and related accrued
interest, representing substantially all of AML's debt, was financed by Quest
Diagnostics with cash on-hand, $300 million of borrowings under its secured
receivables credit facility and $175 million of borrowings under its unsecured
revolving credit facility. During the second and third quarters of 2002, Quest
Diagnostics repaid all of the $175 million borrowed under the Company's
unsecured revolving credit facility and $75 million borrowed under the Company's
9
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
secured receivables credit facility, respectively. An additional $60 million of
the secured receivables facility was repaid on October 24, 2002.
The acquisition of AML was accounted for under the purchase method of
accounting. As such, the cost to acquire AML has been allocated on a preliminary
basis to the assets and liabilities acquired based on estimated fair values as
of the closing date. The consolidated financial statements include the results
of operations of AML subsequent to the closing of the acquisition.
The following table summarizes the Company's preliminary purchase price
allocation related to the acquisition of AML based on the estimated fair value
of the assets acquired and liabilities assumed on the acquisition date. The
purchase price allocation will be finalized after completion of the valuation of
certain assets and liabilities.
Estimated
Fair Values
as of
April 1, 2002
---------------
Current assets............................................ $ 83,403
Property, plant and equipment............................. 31,475
Goodwill.................................................. 429,664
Other assets.............................................. 3,134
--------
Total assets acquired................................... 547,676
--------
Current portion of long-term debt......................... 11,834
Other current liabilities................................. 49,676
Long-term debt............................................ 139,465
Other liabilities......................................... 4,925
--------
Total liabilities assumed............................... 205,900
--------
Net assets acquired..................................... $341,776
========
Based on management's review of the net assets acquired and
consultations with valuation specialists, no intangible assets meeting the
criteria under SFAS No. 141, "Business Combinations", were identified. Of the
$430 million allocated to goodwill, approximately $17 million is expected to be
deductible for tax purposes.
10
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
The following unaudited pro forma combined financial information for
the nine months ended September 30, 2002 and for the three and nine months ended
September 30, 2001 assumes that the AML acquisition was effected on January 1,
2001 (in thousands, except per share data):
Three Months
Ended
Nine Months Ended September 30, September 30,
2002 2001 2001
---------- ---------- --------
Net revenues ....................................... $3,152,701 $2,938,653 $979,691
Income before extraordinary loss ................... 240,054 142,478 53,055
Net income ......................................... 240,054 120,870 53,055
Basic earnings per common share:
Income before extraordinary loss ................... $2.49 $1.54 $0.57
Net income ......................................... 2.49 1.31 0.57
Weighted average common shares outstanding - basic . 96,238 92,612 93,382
Diluted earnings per common share:
Income before extraordinary loss ................... $2.41 $1.46 $0.54
Net income ......................................... 2.41 1.24 0.54
Weighted average common shares outstanding - diluted 99,772 97,323 98,046
Pro forma results for the nine months ended September 30, 2002 exclude
$14.5 million of non-recurring merger costs, which were incurred and expensed
by AML immediately prior to the closing of the AML acquisition.
The all-cash purchase price for LabPortal of approximately $4 million
and related transaction costs, together with the repayment of all of LabPortal's
outstanding debt of approximately $7 million and related accrued interest, was
financed by Quest Diagnostics with cash on-hand. The acquisition of LabPortal
was accounted for under the purchase method of accounting. As such, the cost to
acquire LabPortal has been allocated on a preliminary basis to the assets and
liabilities acquired based on estimated fair values as of the closing date,
including approximately $8 million of goodwill. The consolidated financial
statements include the results of operations of LabPortal subsequent to the
closing of the acquisition.
Integration of AML
During the third quarter of 2002, the Company finalized its plan
related to the integration of AML into Quest Diagnostics' laboratory network.
The plan focuses principally on improving customer service by enabling the
Company to perform esoteric testing on the east and west coasts of the United
States, and redirecting certain physician testing volumes within its national
network to provide more local testing. As part of the plan, the Company's
Chantilly, Virginia laboratory, acquired as part of the AML acquisition, will
become the primary esoteric testing laboratory and hospital service center for
the eastern United States and will complement the Company's Nichols Institute
esoteric testing facility in San Juan Capistrano, California. Esoteric testing
volumes will be redirected within the Company's national network to provide
customers with improved turnaround time and customer service. Certain routine
clinical laboratory testing currently performed in the Chantilly, Virginia
laboratory will transition over time to other testing facilities within the
Company's regional laboratory network. A reduction in staffing will occur as the
Company executes the integration plan and consolidates duplicate or overlapping
functions and facilities. Employee groups being affected as a result of this
plan include those involved in the collection and testing of specimens, as well
as administrative and other support functions.
In connection with the AML integration plan, the Company recorded $11
million of costs associated with executing the plan. The majority of these
integration costs related to employee severance and contractual obligations
associated with leased facilities and equipment. Of the total costs indicated
above, $9.5 million, related to actions that impact the employees and operations
of AML, was accounted for as a cost of the AML acquisition and included in
goodwill. Of the $9.5 million, $5.9 million related to employee severance
benefits for approximately 200 employees, with the remainder primarily related
to contractual obligations associated with leased facilities and equipment. In
addition, $1.5 million of integration costs, related to actions that impact
Quest Diagnostics' employees and operations and comprised principally of
employee severance benefits
11
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
for approximately 100 employees, were accounted for as a charge to earnings in
the third quarter of 2002 and included in "other, net" within the consolidated
statements of operations. While the majority of the integration costs are
expected to be paid in 2003, there are certain severance and facility exit costs
that have payment terms extending beyond 2003.
4. PROVISION FOR SPECIAL CHARGE
During the second quarter of 2001, the Company recorded a special
charge of $6 million in connection with the refinancing of its debt and
settlement of the Company's interest rate swap agreements. Prior to the
Company's debt refinancing in June 2001, the Company's secured credit agreement
required the Company to maintain interest rate swap agreements to mitigate the
risk of changes in interest rates associated with a portion of its variable
interest rate indebtedness. These interest rate swap agreements were considered
a hedge against changes in the amount of future cash flows associated with the
interest payments of the Company's variable rate debt obligations. Accordingly,
the interest rate swap agreements were recorded at their estimated fair value in
the Company's consolidated balance sheet and the related losses on these
contracts were deferred in stockholders' equity as a component of comprehensive
income. In conjunction with the debt refinancing, the interest rate swap
agreements were terminated and the losses which were included in stockholders'
equity as a component of comprehensive income were reflected as a special charge
in the consolidated statement of operations for the nine months ended September
30, 2001.
5. EXTRAORDINARY LOSS
In conjunction with the Company's debt refinancing in the second
quarter of 2001, the Company recorded an extraordinary loss of $36 million, ($22
million, net of taxes). The loss represented the write-off of deferred financing
costs of $23 million, associated with the Company's debt which was refinanced,
and $12.8 million of payments related primarily to the tender premium incurred
in connection with the Company's cash tender offer of the Company's 10 3/4%
Senior Subordinated Notes. See Note 1,"New Accounting Standards", for a
discussion regarding the impact of SFAS 145.
6. COMMITMENTS AND CONTINGENCIES
The Company has entered into several settlement agreements with various
governmental and private payers during recent years relating to industry-wide
billing and marketing practices that had been substantially discontinued by
early 1993. In addition, the Company is aware of several pending lawsuits filed
under the qui tam provisions of the civil False Claims Act and has received
notices of private claims relating to billing issues similar to those that were
the subject of prior settlements with various governmental payers. Some of the
proceedings against the Company involve claims that are substantial in amount.
Some of the cases involve the operations of SmithKline Beecham Clinical
Laboratories, Inc. ("SBCL") prior to the closing of the SBCL acquisition.
SmithKline Beecham plc ("SmithKline Beecham") has agreed to indemnify
Quest Diagnostics, on an after-tax basis, against monetary payments for
governmental claims or investigations relating to the billing practices of SBCL
that had been settled before or were pending as of the closing date of the SBCL
acquisition. SmithKline Beecham has also agreed to indemnify the Company, on an
after-tax basis, against all monetary payments relating to professional
liability claims of SBCL for services provided prior to the closing of the SBCL
acquisition. Amounts due from SmithKline Beecham at September 30, 2002, related
principally to indemnified professional liability claims discussed above,
totaled approximately $11 million. The estimated reserves and related amounts
due from SmithKline Beecham are subject to change as additional information
regarding the outstanding claims is gathered and evaluated.
At September 30, 2002, recorded reserves relating to billing claims
approximated $10 million. Although management believes that established reserves
for both indemnified and non-indemnified claims are sufficient, it is possible
that additional information (such as the indication by the government of
criminal activity, additional tests being questioned or other changes in the
government's or private claimants' theories of wrongdoing) may become available
which may cause the final resolution of these matters to exceed established
reserves by an amount which could be material to the Company's results of
operations and cash flows in the period in which such claims are settled. The
Company does not believe that these issues will have a material adverse effect
on its overall financial condition.
12
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
In addition to the billing-related settlement reserves discussed above,
the Company is involved in various legal proceedings arising in the ordinary
course of business. Some of the proceedings against the Company involve claims
that are substantial in amount. Some of these claims involve contracts of SBCL
that were terminated following the Company's acquisition of SBCL. During the
three and nine months ended September 30, 2002, the Company paid approximately
$13 million and $18 million, respectively, to settle claims related to contracts
of SBCL that were terminated following the Company's acquisition of SBCL. The
settlements had been fully reserved for. Although management cannot predict the
outcome of such proceedings or any claims made against the Company, management
does not anticipate that the ultimate outcome of the various proceedings or
claims will have a material adverse effect on the Company's financial position
but may be material to the Company's results of operations and cash flows in the
period in which such claims are resolved.
As a general matter, providers of clinical laboratory testing services
may be subject to lawsuits alleging negligence or other similar legal claims.
These suits could involve claims for substantial damages. Any professional
liability litigation could also have an adverse impact on the Company's client
base and reputation. The Company maintains various liability insurance programs
for claims that could result from providing or failing to provide clinical
laboratory testing services, including inaccurate testing results and other
exposures. The Company's insurance coverage limits its maximum exposure on
individual claims; however, the Company is essentially self-insured for a
significant portion of these claims. The basis for claims reserves incorporates
the actuarially determined projected losses based upon the Company's historical
and projected loss experience. Management believes that present insurance
coverage and reserves are sufficient to cover currently estimated exposures.
Although management cannot predict the outcome of any claims made against the
Company, management does not anticipate that the ultimate outcome of any such
proceedings or claims will have a material adverse effect on the Company's
financial position but may be material to the Company's results of operations
and cash flows in the period in which such claims are resolved.
7. COMMON STOCKHOLDERS' EQUITY
Changes in common stockholders' equity for the nine months ended
September 30, 2002 were as follows:
Accumulated
Additional Other
Common Paid-In Accumulated Unearned Comprehensive Comprehensive
Stock Capital Deficit Compensation (Loss) Income
------------------------------------------------------------------------------------
Balance,
December 31, 2001 $960 $1,714,676 $(362,926) $(13,253) $(3,470)
Net income.................... 240,457 $240,457
Other comprehensive income.... 633 633
--------
Comprehensive income........ $241,090
========
Issuance of common stock under
benefit plans (373 common
shares)..................... 4 27,364
Exercise of options (1,341
common shares).............. 13 24,238
Tax benefits associated with
stock-based compensation
plans ..................... 41,307
Amortization of unearned
compensation................ 7,723
------------------------------------------------------------------------
Balance,
September 30, 2002 $977 $1,807,585 $(122,469) $ (5,530) $(2,837)
========================================================================
13
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Changes in common stockholders' equity for the nine months ended
September 30, 2001 were as follows:
Accumulated
Additional Other
Common Paid-In Accumulated Unearned Comprehensive Comprehensive
Stock Capital Deficit Compensation (Loss) Income
--------------------------------------------------------------------------------------
Balance,
December 31, 2000 $465 $1,591,976 $(525,111) $(31,077) $(5,458)
Net income.................... 111,365 $111,365
Other comprehensive income.... 2,218 2,218
--------
Comprehensive income........ $113,583
========
Two-for-one stock split (47,149
common shares).............. 472 (472)
Preferred dividends declared (88)
Issuance of common stock under
benefit plans (247 common
shares)..................... 3 26,517 (3,599)
Exercise of options (1,422
common shares).............. 14 17,498
Shares to cover employee
payroll tax withholdings on
exercised options (2 common
shares)..................... (189)
Tax benefits associated with
stock-based compensation
plans....................... 40,664
Amortization of unearned
compensation................ 17,124
Other......................... 600
------------------------------------------------------------------------
Balance,
September 30, 2001 $954 $1,676,594 $(413,834) $(17,552) $(3,240)
========================================================================
During the nine months ended September 30, 2001, two thousand common
shares were surrendered to cover employee payroll tax withholdings related to
the exercise of stock options. For reporting purposes, these shares were
accounted for as treasury purchases which were immediately retired.
For the nine months ended September 30, 2001, other comprehensive
income included the cumulative effect of the change in accounting for derivative
financial instruments upon adoption of SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities", as amended, which reduced comprehensive
income by approximately $1 million. In addition, in conjunction with the
Company's debt refinancing, the interest rate swap agreements were terminated
and the losses which were included in stockholders' equity as a component of
comprehensive income were reflected as a special charge in the consolidated
statements of operations for the nine months ended September 30, 2001 (see
Note 4).
8. PENDING ACQUISITION
Acquisition of Unilab Corporation
On April 2, 2002, the Company entered into a definitive agreement with
Unilab Corporation ("Unilab"), which provides that Quest Diagnostics will
acquire all of the outstanding shares of Unilab common stock and assume Unilab's
existing debt of approximately $200 million. In exchange for their Unilab
shares, Unilab stockholders may elect to receive $26.50 in cash, 0.3256 shares
of Quest Diagnostics common stock or a combination of cash and stock. The
aggregate amount of cash available to Unilab stockholders will be limited to 30%
of the total consideration available for the Unilab shares. Unilab has
approximately 37.4 million shares of common stock outstanding on a fully diluted
basis. If
14
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Unilab stockholders elect to receive 30% of the consideration in cash and if all
options are exercised, Quest Diagnostics would issue approximately 8.5 million
shares and pay $297 million in cash to the stockholders of Unilab. If Unilab
stockholders elect to receive 100% of the consideration in Quest Diagnostics
common stock and all Unilab options were exercised, Quest Diagnostics would
issue approximately 12.2 million common shares to the stockholders of Unilab.
The transaction, which has been approved by the Boards of Directors of both
companies, is subject to the satisfaction of customary conditions, including the
tender of a majority of Unilab's common stock on a fully diluted basis, and
regulatory review.
During the second quarter of 2002, the Company and Unilab received a
request for additional information (commonly referred to as a "second request")
from the Federal Trade Commission ("FTC") under the Hart-Scott-Rodino Antitrust
Improvements Act (the "HSR Act") in connection with the Company's pending
acquisition of Unilab. The Company and Unilab are continuing their discussions
with the FTC regarding the proposed transaction, including settlement
discussions, and the process is taking longer than anticipated. During the third
quarter of 2002, the Company and Unilab extended the termination date of their
merger agreement to November 30, 2002. All other provisions of the agreement
remain in effect. The completion of the transaction is subject to completion of
the HSR process and satisfaction of the other conditions to the cash election
exchange offer and the agreement and plan of merger. The Company continues to
believe that the transaction is not anti-competitive, and hopes to close the
transaction in the fourth quarter of 2002.
As part of the acquisition, Quest Diagnostics would acquire all of
Unilab's operations, including its primary testing facilities in Los Angeles,
San Jose and Sacramento, California, its more than 400 regional service and
testing facilities located throughout California and its operations in Arizona.
The Company expects to finance the cash portion of the purchase price and any
retirements of Unilab's existing debt with the proceeds from a new $450 million
five-year amortizing term loan commitment, which is available for the
acquisition of Unilab, available borrowings under its unsecured revolving credit
facility and its secured receivables credit facility and cash on-hand. The term
loan, which is contingent upon the completion of the Unilab transaction, will
carry interest at LIBOR plus 1.3125% and require principal repayments of the
initial amount borrowed equal to 15%, 20%, 20%, 20% and 25% in years one through
five, respectively. Effective September 20, 2002, the term loan commitment was
amended to extend the maturity of the commitment from September 30, 2002 to
December 31, 2002. Since the transaction has yet to close, a preliminary
purchase price allocation is not practical at this time.
9. SUMMARIZED FINANCIAL INFORMATION
The Company's 6 3/4% senior notes due 2006, 7 1/2% senior notes due
2011 and 1 3/4% contingent convertible debentures due 2021 are guaranteed by
each of the Company's wholly owned subsidiaries that operate clinical
laboratories in the United States (the "Subsidiary Guarantors"). With the
exception of Quest Diagnostics Receivables Incorporated (see paragraph below),
the non-guarantor subsidiaries are primarily foreign and less than wholly owned
subsidiaries.
In conjunction with the Company's receivables financing in July 2000,
the Company formed a new wholly owned non-guarantor subsidiary, Quest
Diagnostics Receivables Incorporated ("QDRI"). The Company and the Subsidiary
Guarantors, with the exception of AML, transfer all private domestic receivables
(principally excluding receivables due from Medicare, Medicaid and other federal
programs, and receivables due from customers of its joint ventures) to QDRI.
QDRI utilizes the transferred receivables to collateralize the Company's secured
receivables credit facility. The Company and the Subsidiary Guarantors provide
collection services to QDRI. QDRI uses cash collections principally to purchase
new receivables from the Company and the Subsidiary Guarantors.
The following condensed consolidating financial data illustrates the
composition of the combined guarantors. Investments in subsidiaries are
accounted for by the parent using the equity method for purposes of the
supplemental consolidating presentation. Earnings (losses) of subsidiaries are
therefore reflected in the parent's investment accounts and earnings. The
principal elimination entries relate to investments in subsidiaries and
intercompany balances and transactions. On April 1, 2002, Quest Diagnostics
acquired AML (see Note 3), which has been included in the accompanying condensed
consolidating financial data, subsequent to the closing of the acquisition, as a
Subsidiary Guarantor.
15
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Condensed Consolidating Statement of Operations
Nine months ended September 30, 2002
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
Net revenues.............................. $ 552,819 $2,361,661 $368,758 $(208,952) $3,074,286
Costs and expenses:
Cost of services........................ 364,779 1,336,666 111,626 - 1,813,071
Selling, general and administrative..... 124,895 498,447 195,905 (11,436) 807,811
Interest, net........................... 59,120 172,689 6,686 (197,516) 40,979
Amortization of intangible assets....... 1,420 4,823 - - 6,243
Royalty (income) expense................ (186,533) 186,533 - - -
Other, net.............................. 64 350 628 - 1,042
--------- ---------- -------- --------- ----------
Total.................................. 363,745 2,199,508 314,845 (208,952) 2,669,146
--------- ---------- -------- --------- ----------
Income before taxes....................... 189,074 162,153 53,913 - 405,140
Income tax expense........................ 75,091 64,861 24,731 - 164,683
--------- ---------- -------- --------- ----------
Income before equity earnings............. 113,983 97,292 29,182 - 240,457
Equity earnings from subsidiaries......... 126,474 - - (126,474) -
--------- ---------- -------- --------- ----------
Net income................................ $ 240,457 $ 97,292 $ 29,182 $(126,474) $ 240,457
========= ========== ======== ========= ==========
Condensed Consolidating Statement of Operations
Nine months ended September 30, 2001
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------- ---------- ------------ ------------ ------------
Net revenues.............................. $ 446,000 $2,156,202 $328,614 $(213,485) $2,717,331
Costs and expenses:
Cost of services........................ 327,934 1,209,313 76,773 - 1,614,020
Selling, general and administrative..... 115,682 467,581 188,065 (11,004) 760,324
Interest, net........................... 47,987 194,931 17,531 (202,481) 57,968
Amortization of goodwill and other
intangible assets..................... 3,436 30,803 442 - 34,681
Provision for special charge............ 5,997 - - - 5,997
Royalty (income) expense................ (183,325) 183,325 - - -
Other, net.............................. 2,820 (938) 1,390 - 3,272
--------- ---------- --------- ---------- ----------
Total.................................. 320,531 2,085,015 284,201 (213,485) 2,476,262
--------- ---------- --------- ---------- ----------
Income before taxes and extraordinary loss 125,469 71,187 44,413 - 241,069
Income tax expense........................ 52,584 36,482 19,029 - 108,095
--------- ---------- --------- ---------- ----------
Income before equity earnings and
extraordinary loss...................... 72,885 34,705 25,384 - 132,974
Equity earnings from subsidiaries......... 42,360 - - (42,360) -
--------- ---------- --------- ---------- ----------
Income before extraordinary loss.......... 115,245 34,705 25,384 (42,360) 132,974
Extraordinary loss, net of taxes.......... (3,880) (15,567) (2,162) - (21,609)
--------- ---------- --------- ---------- ----------
Net income................................ $ 111,365 $ 19,138 $ 23,222 $ (42,360) $ 111,365
========= ========== ========= ========== ==========
16
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Condensed Consolidating Balance Sheet
September 30, 2002
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
Assets
Current assets:
Cash and cash equivalents................... $ 101,396 $ 3,736 $ 8,722 $ - $ 113,854
Accounts receivable, net.................... 10,285 107,835 458,341 - 576,461
Other current assets........................ 88,064 59,776 91,990 - 239,830
---------- ---------- --------- ----------- ----------
Total current assets..................... 199,745 171,347 559,053 - 930,145
Property, plant and equipment, net.......... 226,629 319,492 25,395 - 571,516
Intangible assets, net ..................... 153,889 1,613,951 43,873 - 1,811,713
Intercompany receivable (payable)........... (39,070) 298,355 (259,285) - -
Investment in subsidiaries.................. 1,746,049 - - (1,746,049) -
Other assets................................ 72,988 38,015 41,360 - 152,363
---------- ---------- --------- ----------- ----------
Total assets............................. $2,360,230 $2,441,160 $ 410,396 $(1,746,049) $3,465,737
========== ========== ========= =========== ==========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses....... $ 321,468 $ 261,907 $ 27,032 $ - $ 610,407
Short-term borrowings and current portion of
long-term debt............................ - 25,757 225,343 - 251,100
---------- ---------- --------- ----------- ----------
Total current liabilities................ 321,468 287,664 252,375 - 861,507
Long-term debt.............................. 315,247 478,997 2,534 - 796,778
Other liabilities........................... 45,789 66,125 17,812 - 129,726
Common stockholders' equity................. 1,677,726 1,608,374 137,675 (1,746,049) 1,677,726
---------- ---------- --------- ----------- ----------
Total liabilities and stockholders' equity $2,360,230 $2,441,160 $ 410,396 $(1,746,049) $3,465,737
========== ========== ========= =========== ==========
Condensed Consolidating Balance Sheet
December 31, 2001
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
Assets
Current assets:
Cash and cash equivalents................... $ - $ 110,571 $ 11,761 $ - $ 122,332
Accounts receivable, net.................... 9,083 52,232 447,025 - 508,340
Other current assets........................ 93,144 52,755 99,943 - 245,842
---------- ---------- --------- ----------- ----------
Total current assets..................... 102,227 215,558 558,729 - 876,514
Property, plant and equipment, net.......... 170,494 320,244 17,881 - 508,619
Intangible assets, net ..................... 154,809 1,188,031 36,303 - 1,379,143
Intercompany receivable (payable)........... 425,735 92,378 (518,113) - -
Investment in subsidiaries.................. 1,096,647 - - (1,096,647) -
Other assets................................ 75,633 54,998 35,648 - 166,279
---------- ---------- --------- ----------- ----------
Total assets............................. $2,025,545 $1,871,209 $ 130,448 $(1,096,647) $2,930,555
========== ========== ========= =========== ==========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses....... $ 334,666 $ 290,039 $ 32,514 $ - $ 657,219
Short-term borrowings and current portion
of long-term debt......................... 21 1,040 343 - 1,404
---------- ---------- --------- ----------- ----------
Total current liabilities................ 334,687 291,079 32,857 - 658,623
Long-term debt.............................. 310,690 502,519 7,128 - 820,337
Other liabilities........................... 44,181 57,469 13,958 - 115,608
Common stockholders' equity................. 1,335,987 1,020,142 76,505 (1,096,647) 1,335,987
---------- ---------- --------- ----------- ----------
Total liabilities and stockholders' equity $2,025,545 $1,871,209 $ 130,448 $(1,096,647) $2,930,555
========== ========== ========= =========== ==========
17
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Condensed Consolidating Statement of Cash Flows
Nine months ended September 30, 2002
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
Cash flows from operating activities:
Net income.................................. $ 240,457 $ 97,292 $ 29,182 $(126,474) $ 240,457
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization............. 33,779 57,541 5,377 - 96,697
Provision for doubtful accounts........... 4,307 23,773 136,812 - 164,892
Other, net................................ (78,037) 6,660 16,563 126,474 71,660
Changes in operating assets and liabilities 93,317 (176,487) (140,609) - (223,779)
--------- --------- --------- --------- ---------
Net cash provided by operating activities... 293,823 8,779 47,325 - 349,927
Net cash used in investing activities....... (219,894) (18,757) (3,147) (197,988) (439,786)
Net cash provided by (used in) financing
activities................................ 27,467 (96,857) (47,217) 197,988 81,381
--------- --------- --------- --------- ---------
Net change in cash and cash equivalents..... 101,396 (106,835) (3,039) - (8,478)
Cash and cash equivalents, beginning of year - 110,571 11,761 - 122,332
--------- --------- --------- --------- ---------
Cash and cash equivalents, end of period.... $ 101,396 $ 3,736 $ 8,722 $ - $ 113,854
========= ========= ========= ========= =========
Condensed Consolidating Statement of Cash Flows
Nine months ended September 30, 2001
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
Cash flows from operating activities:
Net income.................................. $ 111,365 $ 19,138 $ 23,222 $(42,360) $ 111,365
Extraordinary loss, net of taxes 3,880 15,567 2,162 - 21,609
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization............. 29,291 75,083 3,626 - 108,000
Provision for doubtful accounts........... 664 15,554 149,452 - 165,670
Provision for special charge.............. 5,997 - - - 5,997
Other, net................................ 21,797 41,771 (35,662) 42,360 70,266
Changes in operating assets and liabilities (147,125) 45,270 (79,772) - (181,627)
--------- --------- -------- -------- ---------
Net cash provided by operating activities... 25,869 212,383 63,028 - 301,280
Net cash used in investing activities....... (38,730) (107,404) (894) (5,556) (152,584)
Net cash provided by (used in) financing
activities................................ 12,861 (37,967) (61,744) 5,556 (81,294)
--------- --------- -------- -------- ---------
Net change in cash and cash equivalents..... - 67,012 390 - 67,402
Cash and cash equivalents, beginning of year - 163,863 7,614 - 171,477
--------- --------- -------- -------- ---------
Cash and cash equivalents, end of period.... $ - $ 230,875 $ 8,004 $ - $ 238,879
========= ========= ======== ======== =========
18
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Critical Accounting Policies
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires us to make estimates
and assumptions and select accounting policies that affect the reported amounts
of assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements, as well as the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from those estimates.
While many operational aspects of our business are subject to complex
federal, state and local regulations, the accounting for our business is
generally straightforward with net revenues primarily recognized upon completion
of the testing process. Our revenues are primarily comprised of a high volume of
relatively low dollar transactions, and about half of all our costs and expenses
consist of employee compensation and benefits. Due to the nature of our
business, several of our accounting policies involve significant estimates and
judgments. These accounting policies have been described in our 2001 Annual
Report on Form 10-K, with the following accounting policy adopted effective
January 1, 2002:
Accounting for and recoverability of goodwill
In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and
Other Intangible Assets" ("SFAS 142"). The impact of adopting SFAS 142 is
summarized in Note 2 to the interim consolidated financial statements.
Effective January 1, 2002, we evaluate the recoverability and measure
the possible impairment of our goodwill under SFAS 142. The impairment test is a
two-step process that begins with the estimation of the fair value of the
reporting unit. The first step screens for potential impairment and the second
step measures the amount of the impairment, if any. Our estimate of fair value
considers publicly available information regarding the market capitalization of
our Company, as well as (i) publicly available information regarding comparable
publicly-traded companies in the clinical laboratory testing industry, (ii) the
financial projections and future prospects of our business, including its growth
opportunities and likely operational improvements, and (iii) comparable sales
prices, if available. As part of the first step to assess potential impairment,
we compare our estimate of fair value for the Company to the book value of our
consolidated net assets. If the book value of our consolidated net assets is
greater than our estimate of fair value, we would then proceed to the second
step to measure the impairment, if any. The second step compares the implied
fair value of goodwill with its carrying value. The implied fair value is
determined by allocating the fair value of the reporting unit to all of the
assets and liabilities of that unit as if the reporting unit had been acquired
in a business combination and the fair value of the reporting unit was the
purchase price paid to acquire the reporting unit. The excess of the fair value
of the reporting unit over the amounts assigned to its assets and liabilities is
the implied fair value of goodwill. If the carrying amount of the reporting unit
goodwill is greater than its implied fair value, an impairment loss will be
recognized in the amount of the excess. We believe our estimation methods are
reasonable and reflective of common valuation practices.
On a quarterly basis, we perform a review of our business to determine
if events or changes in circumstances have occurred which could have a material
adverse effect on the fair value of the Company and its goodwill. If such events
or changes in circumstances were deemed to have occurred, we would perform an
impairment test of goodwill as of the end of the quarter, consistent with the
annual impairment test, and record any noted impairment loss.
Integration of Acquired Businesses
American Medical Laboratories, Incorporated
On April 1, 2002, we completed our previously announced acquisition of
all of the outstanding voting stock of American Medical Laboratories,
Incorporated, ("AML"). See Note 3 to the interim consolidated financial
statements for a full discussion of this transaction.
During the third quarter of 2002, we finalized our plan related to the
integration of AML into our laboratory network. The plan focuses principally on
improving customer service by enabling us to perform esoteric testing on the
east and west coasts of the United States, and redirecting certain physician
testing volumes within our national network to provide more local testing. As
part of the plan, our Chantilly, Virginia laboratory, acquired as part of the
AML acquisition, will become our primary esoteric testing laboratory and
hospital service center for the eastern United States and will complement our
Nichols Institute esoteric testing facility in San Juan Capistrano, California.
Esoteric testing volumes will be redirected
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within our national network to provide customers with improved turnaround time
and customer service. Certain routine clinical laboratory testing currently
performed in our Chantilly, Virginia laboratory will transition over time to
other testing facilities within our regional laboratory network. A reduction in
staffing will occur as we execute the integration plan and consolidate duplicate
or overlapping functions and facilities. Employee groups being affected as a
result of this plan include those involved in the collection and testing of
specimens, as well as administrative and other support functions.
In connection with the AML integration plan, we recorded $11 million of
costs associated with executing the plan. The majority of these integration
costs related to employee severance and contractual obligations associated with
leased facilities and equipment. Of the total costs indicated above, $9.5
million, related to actions that impact the employees and operations of AML, was
accounted for as a cost of the AML acquisition and included in goodwill. Of the
$9.5 million, $5.9 million related to employee severance benefits for
approximately 200 employees, with the remainder primarily related to contractual
obligations associated with leased facilities and equipment. In addition, $1.5
million of integration costs, related to actions that impact Quest Diagnostics'
employees and operations and comprised principally of employee severance
benefits for approximately 100 employees, were accounted for as a charge to
earnings in the third quarter of 2002 and included in "other, net" within the
consolidated statements of operations. While the majority of the integration
costs are expected to be paid in 2003, there are certain severance and facility
exit costs that have payment terms extending beyond 2003. We plan to fund the
costs to integrate AML through cash from operations. Upon completion of the AML
integration, we expect to realize approximately $15 million of annual synergies
and we expect to achieve this annual rate of synergies by the end of 2003.
Unilab Corporation
On April 2, 2002, we entered into a definitive agreement with Unilab
Corporation ("Unilab"), which provides that we will acquire all of the
outstanding shares of Unilab common stock. See Note 8 to the interim
consolidated financial statements for a full discussion of this transaction.
We hope to close the transaction in the fourth quarter of 2002, and
estimate that we will incur up to $20 million of costs to integrate Quest
Diagnostics and Unilab. A significant portion of these costs is expected to
require cash outlays and is expected to primarily relate to severance and other
integration-related costs during 2003, including the elimination of excess
capacity and workforce reductions. These estimates are preliminary and will be
subject to revisions as integration plans are developed and finalized. To the
extent that the costs relate to actions that impact the employees and operations
of Unilab, such costs will be accounted for as a cost of the Unilab acquisition
and included in goodwill. To the extent that the costs relate to actions that
impact Quest Diagnostics' employees and operations, such costs will be accounted
for as a charge to earnings in the period that the integration plans are
approved and communicated. We hope to finalize and record these costs during the
fourth quarter of 2002.
Results of Operations
Three and Nine months ended September 30, 2002 Compared with Three and
Nine months ended September 30, 2001
Reported net income for the three months ended September 30, 2002
increased to $87 million from $50 million for the prior year period. Net income
for the three months ended September 30, 2002 increased by $28 million, or 47%,
from $59 million for the three months ended September 30, 2001, assuming that
the nonamortization provisions of SFAS 142 had been in effect in 2001. This
increase in earnings was primarily attributable to revenue growth, driven by
improvements in clinical testing volume and average revenue per requisition,
and improved efficiencies generated from our Six Sigma and Standardization
initiatives, partially offset by increases in employee compensation and
supply costs, depreciation expense and investments in our information
technology strategy and strategic growth opportunities. In addition, we
estimate that the September 11th, 2001 national tragedy reduced our net
revenues for the third quarter of 2001 by approximately $8 million, or 1%
of net revenues, and reduced net income during the third quarter of 2001
by approximately $3 million.
Reported net income for the nine months ended September 30, 2002
increased to $240 million from $111 million for the prior year period. Assuming
that the nonamortization provisions of SFAS 142 had been in effect in 2001, net
income for the nine months ended September 30, 2001 would have been $138
million. In addition, results for the nine months ended September 30, 2001
included an extraordinary loss of $36 million ($22 million, net of taxes) and a
special charge of $6.0 million ($3.6 million, net of taxes), both of which were
incurred in conjunction with our debt refinancing in the second quarter of 2001.
Assuming that SFAS 142 had been in effect during 2001, and excluding the
extraordinary loss and special charge in 2001, income for the nine months ended
September 30, 2002 increased by $77 million, compared to the prior year period,
an
20
increase of 47%. This increase in earnings was primarily attributable to revenue
growth, driven by improvements in clinical testing volume and average revenue
per requisition, improved efficiencies generated from our Six Sigma and
Standardization initiatives, and a reduction in net interest expense, partially
offset by increases in employee compensation and supply costs, depreciation
expense and investments in our information technology strategy and strategic
growth opportunities.
Net Revenues
Net revenues for the three and nine months ended September 30, 2002
grew by 17.2% and 13.1%, respectively, compared to the prior year period. The
acquisition of AML, which was completed on April 1, 2002, contributed
approximately 55% and 45% to the increase in net revenues for the three and nine
months ended September 30, 2002. For the three and nine months ended September
30, 2002, clinical testing volume, measured by the number of requisitions,
increased 13.7% and 9.4%, respectively, compared to the prior year period.
Assuming AML had been part of Quest Diagnostics in 2001, clinical testing volume
would have increased above the prior year levels by 5.0% and 4.0%, respectively,
on a pro forma basis, for the three and nine months ended September 30, 2002.
Our clinical testing volume and revenue comparisons to the prior year were
impacted by the events of September 11th, 2001, and reduced revenues by
approximately $8 million and requisition volume by approximately 1% during the
third quarter of 2001. We continue to see strong growth in our gene-based and
esoteric testing with gene-based testing revenues growing at more than 20%,
compared to the prior year. Our drugs-of-abuse testing business which accounted
for approximately 8% of our volume and 4% of our revenues, remained essentially
flat during the third quarter of 2002, compared to the prior year period. This
is a significant improvement from the 9% year-over-year volume decline
experienced in the second quarter of 2002, which had the impact of reducing
total company volume by approximately 1%. The improvement is the result of a
temporary increase in drug screenings for potential candidates for newly created
airport security positions within the Federal Aviation Administration ("FAA").
The additional volume from the FAA is expected to scale back to normal levels
early in the fourth quarter of 2002. Average revenue per requisition increased
2.9% and 3.1%, respectively, for the three and nine months ended September 30,
2002, compared to the prior year period. The improvement in average revenue per
requisition was primarily attributable to a continuing shift in test mix to
higher value testing, including gene-based testing, which contributed more than
half of the improvement, and a shift in payer mix to higher priced
fee-for-service reimbursement.
Operating Costs and Expenses
Total operating costs for the three and nine months ended September 30,
2002 increased $111 million and $247 million, respectively, from the prior year
period primarily due to increases in our clinical testing volume, largely as a
result of the AML acquisition, employee compensation and supply costs and
depreciation expense; partially offset by a reduction in bad debt expense. While
our cost structure has been favorably impacted by the synergies realized as a
result of the integration of SmithKline Beecham Clinical Laboratories, Inc.
("SBCL") and the improved efficiencies generated from our Six Sigma and
Standardization initiatives, we continue to make investments to enhance our
infrastructure to pursue our overall business strategy. These investments
include those related to:
o Skills training for all employees, which together with our
competitive pay and benefits, helps to increase employee
satisfaction and performance, which we believe will result in
better service to our customers;
o Our information technology strategy, which is designed to result
in better service to our customers; and
o Our strategic growth opportunities.
Cost of services, which includes the costs of obtaining, transporting
and testing specimens was 59.0% of net revenues for the three months ended
September 30, 2002, decreasing from 59.3% in the prior year period. For the nine
months ended September 30, 2002, costs of services, as a percentage of net
revenues, decreased to 59.0% from 59.4% a year ago. The positive impact of our
Six Sigma and Standardization efforts and the increase in average revenue per
requisition, which reduced cost of services as a percentage of net revenues, was
partially offset by the addition of AML's higher cost of services as of April 1,
2002.
Selling, general and administrative expenses, which include the costs
of the sales force, billing operations, bad debt expense and general management
and administrative support, decreased during the three months ended September
30, 2002 as a percentage of net revenues to 25.7% from 27.8% in the prior year
period. For the nine months ended September 30, 2002, selling, general and
administrative expenses decreased as a percentage of net revenues to 26.3% from
28.0% in the prior year period. These decreases were primarily due to
efficiencies from our Six Sigma and Standardization efforts, in particular bad
debt expense, the improvement in average revenue per requisition and the
addition of AML's cost structure as
21
of April 1, 2002. During the third quarter of 2002, bad debt expense improved to
5.1% of net revenues, compared to 6.1% of net revenues a year ago. For the nine
months ended September 30, 2002, bad debt expense was 5.4% of net revenues,
compared to 6.1% of net revenues in the prior year. The improvements in bad debt
expense were principally attributable to the continued progress that we have
made in our overall collection experience through process improvements, driven
by our Six Sigma and Standardization initiatives. These improvements primarily
relate to the collection of diagnosis, patient and insurance information
necessary to effectively bill for services performed. We believe that our Six
Sigma and Standardization initiatives will provide additional opportunities to
further improve our overall collection experience.
Interest, Net
Net interest expense for the three and nine months ended September 30,
2002 decreased from the prior year periods by $1.4 million and $17.0 million,
respectively. For the three months ended September 30, 2002, the reduction was
primarily due to a favorable interest rate environment, compared to the prior
year period. For the nine months ended September 30, 2002, the reduction was
primarily due to the favorable impact of our debt refinancings in 2001 and a
favorable interest rate environment.
Amortization of Goodwill and Other Intangible Assets
Amortization of goodwill and other intangible assets for the three and
nine months ended September 30, 2002 decreased from the prior year period by
$9.4 million and $28 million, respectively, principally as the result of
adopting SFAS 142, effective January 1, 2002. See Note 2 to the interim
consolidated financial statements for further details regarding the impact of
SFAS 142.
Provision for Special Charge
During the second quarter of 2001, we recorded a special charge of $6
million in connection with the refinancing of our debt and settlement of our
interest rate swap agreements. Prior to our debt refinancing in June 2001, our
secured credit agreement required us to maintain interest rate swap agreements
to mitigate the risk of changes in interest rates associated with a portion of
our variable interest rate indebtedness. These interest rate swap agreements
were considered a hedge against changes in the amount of future cash flows
associated with the interest payments of our variable rate debt obligations.
Accordingly, the interest rate swap agreements were recorded at their estimated
fair value in our consolidated balance sheet and the related losses on these
contracts were deferred in stockholders' equity as a component of comprehensive
income. In conjunction with the debt refinancing, the interest rate swap
agreements were terminated and the losses, which were reflected in stockholders'
equity as a component of comprehensive income, were reflected as a special
charge in the consolidated statement of operations for the nine months ended
September 30, 2001.
Minority Share of Income
Minority share of income for the three and nine months ended September
30, 2002 increased from the prior year level, primarily due to the improved
performance of our consolidated joint ventures.
Other, Net
"Other, net", which represents income for each of the periods
presented, and includes equity earnings from our unconsolidated joint ventures
and miscellaneous gains and losses, increased $1.7 million and $6.9 million, for
the three and nine months ended September 30, 2002, respectively. For the
three-month period, the increase was primarily due to a $3.8 million gain on an
investment, partially offset by a $1.5 million charge associated with the
integration of AML, both of which were recorded in the third quarter of 2002.
For the nine-month period, the increase was principally due to improved
operating performance at our unconsolidated joint ventures, which generated an
increase of $4.0 million in equity earnings. The nine-month period of 2001
reflects the net impact of writing off $7.0 million of impaired assets,
partially offset by a $6.3 million gain on the sale of an investment.
Income Taxes
During 2001, our effective tax rate was significantly impacted by
goodwill amortization, the majority of which was not deductible for tax
purposes, and had the effect of increasing the overall tax rate. The reduction
in the effective tax rate for
22
the three and nine months ended September 30, 2002 was primarily due to the
reduction in amortization of goodwill (as a result of adopting SFAS 142,
effective January 1, 2002) the majority of which was not deductible for tax
purposes.
Extraordinary Loss
In conjunction with our debt refinancing in the second quarter of 2001,
we recorded an extraordinary loss of $36 million, ($22 million, net of taxes).
The loss represented the write-off of deferred financing costs of $23 million,
associated with our debt which was refinanced, and $12.8 million of payments
related primarily to the tender premium incurred in connection with our cash
tender offer of our 10 3/4% senior subordinated notes due 2006 (the
"Subordinated Notes").
EBITDA
EBITDA represents income before net interest expense, income taxes,
depreciation and amortization, and special items in 2001. The special items
represented the extraordinary loss and the special charge associated with our
debt refinancing in the second quarter of 2001. EBITDA is presented and
discussed because management believes it is a useful adjunct to net income and
other measurements under accounting principles generally accepted in the United
States since it is a meaningful measure of a 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 accounting principles generally accepted in the United States and should
not be considered as an alternative to (i) net income (or any other measure of
performance under accounting principles generally accepted in the United States)
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.
EBITDA for the three months ended September 30, 2002 improved to $192
million, or 18.2% of net revenues, from $142 million, or 15.7% of net revenues,
in 2001. For the nine months ended September 30, 2002, EBITDA improved to $543
million, or 17.7% of net revenues, from $413 million, or 15.2% of net revenues,
in 2001. The increases in EBITDA were primarily due to revenue growth, driven by
improvements in clinical testing volume and average revenue per requisition, and
improved efficiencies generated from our Six Sigma and Standardization
initiatives, partially offset by increases in employee compensation and supply
costs, and investments in our information technology strategy and strategic
growth opportunities. The improvements in EBITDA as a percentage of net revenues
were also driven by these same factors and were partially offset by the
acquisition of AML, which had EBITDA percentages lower than those of Quest
Diagnostics.
Impact of Contingent Convertible Debentures on Diluted Earnings per
Common Share
On November 26, 2001, we completed our $250 million offering of 1 3/4%
contingent convertible debentures due 2021 (the "Debentures"). Each one thousand
dollar principal amount of Debentures is convertible into 11.429 shares of our
common stock, which represents an initial conversion price of $87.50 per share.
Holders may surrender the Debentures for conversion into shares of our common
stock under any of the following circumstances: (i) if the sales price of our
common stock is above 120% of the conversion price (or $105 per share) for
specified periods; (ii) if we call the Debentures or (iii) if specified
corporate transactions have occurred. See Note 12 to the Consolidated Financial
Statements contained in our 2001 Annual Report on Form 10-K for a further
discussion of the Debentures.
The if-converted method is used in determining the dilutive effect of
the Debentures in periods when the holders of such securities are permitted to
exercise their conversion rights. As of and for the three and nine months ended
September 30, 2002, the holders of our Debentures did not have the ability to
exercise their conversion rights. Had the requirements to allow the holders to
exercise their conversion rights been met and the Debentures remained
outstanding for the entire period, diluted earnings per common share would have
been reduced by approximately 2% during the quarter and nine months ended
September 30, 2002.
Quantitative and Qualitative Disclosures About Market Risk
We address our exposure to market risks, principally the market risk of
changes in interest rates, through a controlled program of risk management that
may include the use of derivative financial instruments. We do not hold or issue
derivative financial instruments for trading purposes. We do not believe that
our foreign exchange exposure is material to our financial position or results
of operations taken as a whole. See Note 2 to the Consolidated Financial
Statements contained in our 2001 Annual Report on Form 10-K for additional
discussion of our financial instruments and hedging activities.
23
At September 30, 2002 and December 31, 2001, the fair value of our debt
was estimated at approximately $1.1 billion and $857 million, respectively,
using quoted market prices and yields for the same or similar types of
borrowings, taking into account the underlying terms of the debt instruments. At
September 30, 2002 and December 31, 2001, the estimated fair value exceeded the
carrying value of the debt by approximately $78 million and $35 million,
respectively. An assumed 10% increase in interest rates (representing
approximately 50 basis points) would potentially reduce the estimated fair value
of our debt by approximately $10 million and $26 million at September 30, 2002
and December 31, 2001, respectively.
Our Debentures have a contingent interest component that will require
us to pay contingent interest based on certain thresholds, as outlined in the
Indenture. The contingent interest component, which is more fully described in
Note 12 to the Consolidated Financial Statements contained in our 2001 Annual
Report on Form 10-K, is considered to be a derivative instrument subject to SFAS
No. 133, "Accounting for Derivative Instruments and Hedging Activities", as
amended. As such, the derivative was recorded at its fair value in the
consolidated balance sheet and was not material at September 30, 2002 and
December 31, 2001.
Borrowings under our unsecured revolving credit facility under our
Credit Agreement and our secured receivables credit facility are subject to
variable interest rates. Interest rates on our unsecured revolving credit
facility are also subject to a pricing schedule that fluctuates over an
approximate range of 50 basis points, based on changes in our credit rating. As
such, our borrowing cost under these credit facilities will be subject to both
fluctuations in interest rates and changes in our credit rating. As of September
30, 2002, our borrowing rate for LIBOR-based loans was LIBOR plus 1.3125%. At
September 30, 2002 and December 31, 2001, we had approximately $232 million and
$7 million, respectively, of variable interest rate debt outstanding, which
included $225 million outstanding under our secured receivables credit facility
at September 30, 2002.
Based on our net exposure to interest rate changes, an assumed 10%
change in interest rates on our variable rate indebtedness (representing
approximately 20 basis points) would impact net interest expense by
approximately $0.4 million on an annual basis, assuming no changes to the debt
outstanding at September 30, 2002.
Liquidity and Capital Resources
Cash and Cash Equivalents
Cash and cash equivalents at September 30, 2002 totaled $114 million,
compared to $122 million at December 31, 2001. Cash flows from operating
activities in 2002 provided cash of $350 million, which along with cash flows
from financing activities of $81 million, were used to fund investing
activities, which required cash of $440 million. Cash and cash equivalents at
September 30, 2001 totaled $239 million, an increase of $67 million from
December 31, 2000. Cash flows from operating activities in 2001 provided cash of
$301 million, which was used to fund investing and financing activities, which
required cash of $234 million.
Cash From Operating Activities
Net cash from operating activities for 2002 was $49 million higher than
the 2001 level. This increase was primarily due to improved operating
performance, efficiencies in our billing and collection processes, and a
reduction in SBCL integration costs paid. The increase was partially offset by
settlement payments, primarily related to contractual disputes previously
reserved for, and a decrease in accrued interest expense reflecting a change
in the timing of scheduled interest payments. The year-over-year comparisons
were also impacted by the payment of indemnified tax matters in 2002 and cash
received from Corning Incorporated in 2001 related to an indemnified
billing-related claim. Days sales outstanding, a measure of billing and
collection efficiency, decreased to 51 days at September 30, 2002 from
54 days at December 31, 2001.
Cash From Investing Activities
Net cash used in investing activities in 2002 was $440 million,
consisting primarily of acquisition and related costs of $334 million, primarily
to acquire the outstanding voting stock of AML, and capital expenditures of $118
million. Net cash used in investing activities in 2001 was $153 million,
consisting primarily of capital expenditures of $110 million, acquisition and
related costs of $56 million, including $47 million to acquire the assets of
Clinical Laboratories of Colorado, Inc., and $22 million in proceeds from the
disposition of assets, principally related to the sale of an investment in the
second quarter of 2001.
24
Cash From Financing Activities
Net cash provided by financing activities in 2002 was $81 million,
consisting primarily of the net cash activity associated with our acquisition of
AML and proceeds from the exercise of stock options. We financed AML's all-cash
purchase price of approximately $335 million and related transaction costs,
together with the repayment of approximately $150 million of acquired AML debt
and accrued interest with cash on-hand, $300 million of borrowings under our
existing secured receivables credit facility and $175 million of borrowings
under our existing unsecured revolving credit facility. During the second and
third quarters of 2002, we repaid all of the $175 million borrowed under our
unsecured revolving credit facility and $75 million borrowed under our secured
receivables credit facility, respectively.
Net cash used in financing activities for 2001 was $81 million,
consisting primarily of the net cash activity associated with our debt
refinancing in the second quarter of 2001 and debt prepayments of $56 million in
the third quarter of 2001, partially offset by $17.5 million of proceeds from
the exercise of stock options. During the second quarter of 2001, we refinanced
the majority of our long-term debt. The gross proceeds of $722 million from our
senior notes offering and the new term loan under our unsecured credit
agreement, together with cash on-hand, was used to repay the entire outstanding
principal under our then existing secured credit agreement and to consummate the
cash tender offer and consent solicitation for our Subordinated Notes. Of the
$790 million in debt repayments for the nine months ended September 30, 2001,
$584 million related to the repayment of the entire outstanding principal under
our then existing secured credit agreement and $147 million represented the
aggregate principal amount of outstanding Subordinated Notes which were
tendered. During the remainder of 2001, we redeemed all of the remaining $3
million of our outstanding Subordinated Notes. During 2001, we incurred
approximately $31 million of costs associated with the debt refinancing. Of that
amount, $25 million was included in financing activities and principally
represented $12 million of costs associated with placing the new debt, and a
$12.8 million tender premium incurred in conjunction with our cash tender offer
of the Subordinated Notes, which was included in the extraordinary loss recorded
in the second quarter of 2001. The remaining $6 million was reflected in cash
from operations and represented the cost to settle the interest rate swap
agreements on the debt which was refinanced.
Dividend Policy
We have never declared or paid cash dividends on our common stock and
do not anticipate paying dividends on our common stock in the foreseeable
future. We currently intend to retain all available funds and any future
earnings to retire debt and fund the growth of our business.
Contractual Obligations and Commitments
A full description of the terms of our indebtedness, related debt
service requirements and our future payments under certain of our contractual
obligations is contained in Note 12 to the Consolidated Financial Statements in
our 2001 Annual Report on Form 10-K. A full discussion and analysis regarding
our minimum rental commitments under noncancelable operating leases,
noncancelable commitments to purchase products or services, and reserves with
respect to insurance claims at December 31, 2001 is contained in Note 17 to the
Consolidated Financial Statements in our 2001 Annual Report on Form 10-K. See
Note 6 to the interim consolidated financial statements for information
regarding the status of billing-related claims. See Note 3 to the interim
consolidated financial statements for a full discussion and analysis regarding
our acquisition of AML.
Our Credit Agreement relating to our unsecured revolving credit
facility contains various covenants and conditions, including the maintenance of
certain financial ratios, that could impact our ability to, among other things,
incur additional indebtedness, repurchase shares of our outstanding common
stock, make additional investments and consummate acquisitions. We do not expect
these covenants to adversely impact our ability to execute our growth strategy
or conduct normal business operations.
As more fully described in Note 12 to the Consolidated Financial
Statements in our 2001 Annual Report on Form 10-K, the borrowings outstanding
under our secured receivables credit facility are classified as a current
liability. It is our current intention to roll-over this facility annually, as
we have done since 2001. If we are not able to roll-over all or a part of this
facility, we will need to refinance the secured receivables credit facility with
cash on-hand, our unsecured revolving credit facility or a new financing
agreement.
On September 24, 2002, we reduced the size of our secured receivables
credit facility from $300 million to $250 million, because our borrowing
capacity and cash generation are more than sufficient to meet our current and
anticipated needs. Prompting our decision to reduce the size of the secured
receivables credit facility was the decision by one of the banks
25
to not renew its participation. Another bank in the group offered to increase
its participation to fully offset the exiting bank. We did not accept this offer
for the reasons cited above.
On October 24, 2002, we repaid $60 million of the borrowings
outstanding under our secured receivables credit facility. Since the acquisition
of AML on April 1, 2002, we have repaid $310 million of the $475 million
borrowed to complete the AML acquisition.
On April 2, 2002, we entered into a definitive agreement with Unilab to
acquire all of the outstanding shares of Unilab common stock and assume Unilab's
debt of approximately $200 million. See Note 8 to the interim consolidated
financial statements for a full discussion and analysis regarding the
transaction.
Unconsolidated Joint Ventures
At September 30, 2002 and December 31, 2001, we had investments in
unconsolidated joint ventures in Phoenix, Arizona; Indianapolis, Indiana; and
Dayton, Ohio. At September 30, 2002, as a result of the AML acquisition, we also
had an investment in an unconsolidated joint venture in Chesapeake, Virginia.
Our investments in unconsolidated joint ventures are accounted for under the
equity method of accounting. We believe that our transactions with our joint
ventures are conducted at arm's length, reflecting current market conditions and
pricing. Total annual net revenues of our unconsolidated joint ventures, on a
combined basis, are less than 6% of our consolidated net revenues. As of
September 30, 2002 and December 31, 2001, total assets associated with our
unconsolidated joint ventures are less than 3% of our consolidated total assets.
We have no material obligations or guarantees to, or in support of, our
unconsolidated joint ventures and their operations.
Requirements and Capital Resources
We estimate that we will invest approximately $160 million to $165
million during 2002 for capital expenditures, principally related to investments
in information technology, equipment, and facility upgrades and expansions.
Other than the reduction for outstanding letters of credit under our unsecured
revolving credit facility, which approximated $33 million at September 30, 2002,
all of our $325 million unsecured revolving credit facility remains available to
us for future borrowing. In addition, after repaying $60 million of principal
outstanding under our secured receivables credit facility on October 24, 2002,
$85 million of that facility remains available to us for future borrowing.
We believe that cash from operations and our borrowing capacity under
our revolving credit facilities will provide sufficient financial flexibility to
meet seasonal working capital requirements and to fund capital expenditures,
debt service requirements and additional growth opportunities for the
foreseeable future. Improvements in our industry and in particular our financial
performance have resulted in improvements to our credit ratings from both
Standard & Poor's and Moody's Investor Services. Our investment grade credit
ratings have had a favorable impact on our cost of and access to capital. We
believe that our improved financial performance should provide us with access to
additional financing, if necessary, to fund growth opportunities that cannot be
funded from existing sources.
As discussed above in "Contractual Obligations and Commitments", on
April 2, 2002, we entered into a definitive agreement with Unilab to acquire all
of the outstanding shares of Unilab common stock and assume Unilab's debt of
approximately $200 million. We have obtained a commitment, which is contingent
upon the completion of the Unilab acquisition, for a $450 million five-year
amortizing term loan to be used to finance the transaction. See Note 8 to the
interim consolidated financial statements for a full discussion and analysis
regarding the transaction.
Impact of New Accounting Standards
In August 2001, the FASB issued SFAS No. 144 "Accounting for Impairment
or Disposal of Long-Lived Assets". In April 2002, the FASB issued SFAS No. 145,
"Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement
No. 13, and Technical Corrections". In July 2002, the FASB issued SFAS No. 146,
"Accounting for Costs Associated with Exit or Disposal Activities".
The impact of the above referenced accounting standards is discussed in
Note 1 to the interim consolidated financial statements.
26
Forward Looking Statements
Some statements and disclosures in this document are forward-looking
statements. Forward-looking statements include all statements that do not relate
solely to historical or current facts and can be identified by the use of words
such as "may", "believe", "will", "expect", "project", "estimate", "anticipate",
"plan" or "continue". These forward-looking statements are based on our current
plans and expectations and are subject to a number of risks and uncertainties
that could significantly cause our plans and expectations, including actual
results, to differ materially from the forward-looking statements. The Private
Securities Litigation Reform Act of 1995 provides a "safe harbor" for
forward-looking statements to encourage companies to provide prospective
information about their companies without fear of litigation.
We would like to take advantage of the "safe harbor" provisions of the
Litigation Reform Act in connection with the forward-looking statements included
in this document. The risks and other factors that could cause our actual
financial results to differ materially from those projected, forecasted or
estimated by us in forward-looking statements may include, but are not limited
to, unanticipated expenditures, changing relationships with customers, suppliers
and strategic partners, conditions of the economy and other factors described in
our 2001 Annual Report on Form 10-K and subsequent filings.
Item 4. Controls and Procedures
(a) Our Chief Executive Officer and Chief Financial Officer have evaluated
the effectiveness of the design and operation of our disclosure
controls and procedures (as defined under Rules 13a-14 and 15d-14 of
the Securities Exchange Act of 1934, as amended) as of a date within
ninety days of the filing date of this report. Based upon that
evaluation, our Chief Executive Officer and Chief Financial Officer
have concluded that our disclosure controls and procedures are adequate
and effective.
(b) There were no significant changes in our internal controls or in other
factors that could significantly affect our internal controls
subsequent to the date of such evaluation.
27
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
See Note 6 to the interim consolidated financial statements for
information regarding the status of government investigations and private
claims, including those related to SBCL.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits:
10.1 First Amendment to Credit Agreement dated as of September 20,
2002 among Quest Diagnostics Incorporated, certain subsidiary
guarantors of the Company, the lenders party thereto, and Bank
of America, N.A., as Administrative Agent.
10.2 Waiver and Amendment No. 4 to the Amended and Restated Credit
and Security Agreement dated as of September 24, 2002 among
Quest Diagnostics Receivables Inc., as Borrower, the Company, as
Initial Servicer, each of the lenders party thereto and Wachovia
Bank, National Association, as Administrative Agent.
10.3 Omnibus Amendment to the Amended and Restated Credit and
Security Agreement dated as of October 15, 2002 among Quest
Diagnostics Receivables Inc., as Borrower, the Company, as
Initial Servicer, each of the lenders party thereto and Wachovia
Bank, National Association, as Administrative Agent.
10.4 Amendment No. 3 to the Agreement and Plan of Merger, dated as of
September 25, 2002 among the Company, Quest Diagnostics Newco
Incorporated and Unilab Corporation (incorporated by reference
to Exhibit (a) (ii) of Amendment No. 12 to the Company's
Schedule T-O with respect to Unilab Corporation).
10.5 The Quest Diagnostics Incorporated 1996 Employee Equity
Participation Program, as amended.
10.6 The Quest Diagnostics Incorporated Stock Option Plan for
Non-Employee Directors, as amended.
(b) Report on Form 8-K:
On August 13, 2002, the Company filed a current report on Form 8-K
(Date of Report: August 12, 2002) reporting under Item 9 sworn
statements of its Chief Executive Officer and Chief Financial Officer
pursuant to Securities and Exchange Commission Order 4-460 and Section
906 of the Sarbanes-Oxley Act of 2002.
28
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
October 31, 2002
Quest Diagnostics Incorporated
By /s/ Kenneth W. Freeman
-----------------------
Kenneth W. Freeman Chairman of the Board and
Chief Executive Officer
By /s/ Robert A. Hagemann
-----------------------
Robert A. Hagemann Vice President and
Chief Financial Officer
29
Certifications
I, Kenneth W. Freeman, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Quest Diagnostics
Incorporated;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of
the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
October 31, 2002
By /s/ Kenneth W. Freeman
----------------------
Kenneth W. Freeman
Chairman of the Board and
Chief Executive Officer
30
I, Robert A. Hagemann, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Quest Diagnostics
Incorporated;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
October 31, 2002
By /s/ Robert A. Hagemann
----------------------
Robert A. Hagemann
Vice President and
Chief Financial Officer
31