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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 March 31, 2003
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 April 28, 2003, there were outstanding 105,333,961 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 Months Ended March 31, 2003 and 2002 2
Consolidated Balance Sheets as of
March 31, 2003 and December 31, 2002 3
Consolidated Statements of Cash Flows for the
Three Months Ended March 31, 2003 and 2002 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 16
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 21
1
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002
(in thousands, except per share data)
(unaudited)
2003 2002
---------- --------
Net revenues .......................................... $1,092,797 $946,762
---------- --------
Costs and expenses:
Cost of services ................................... 648,097 557,738
Selling, general and administrative ................ 279,199 258,403
Interest expense, net .............................. 13,909 12,675
Amortization of intangible assets .................. 2,023 2,155
Minority share of income ........................... 3,803 3,882
Other, net ......................................... (3,028) (614)
---------- --------
Total ........................................... 944,003 834,239
---------- --------
Income before taxes ................................... 148,794 112,523
Income tax expense .................................... 60,758 45,834
---------- --------
Net income ............................................ $ 88,036 $ 66,689
========== ========
Basic earnings per common share:
Net income............................................. $ 0.88 $ 0.70
========== ========
Diluted earnings per common share:
Net income............................................. $ 0.86 $ 0.67
========== ========
Weighted average common shares
outstanding - basic ................................ 100,037 95,422
Weighted average common shares
outstanding - diluted .............................. 102,455 99,307
The accompanying notes are an integral part of these statements.
2
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
MARCH 31, 2003 AND DECEMBER 31, 2002
(in thousands, except per share data)
(unaudited)
March 31, December 31,
2003 2002
---------- ------------
Assets
Current assets:
Cash and cash equivalents...................................... $ 55,597 $ 96,777
Accounts receivable, net of allowance of $197,380 and $193,456
at March 31, 2003 and December 31, 2002, respectively....... 613,638 522,131
Inventories.................................................... 67,068 60,899
Deferred income taxes.......................................... 116,386 102,700
Prepaid expenses and other current assets...................... 54,231 41,936
---------- ----------
Total current assets........................................ 906,920 824,443
Property, plant and equipment, net................................ 583,303 570,149
Goodwill, net..................................................... 2,516,432 1,788,850
Intangible assets, net............................................ 21,193 22,083
Deferred income taxes............................................. 64,658 29,756
Other assets...................................................... 93,789 88,916
---------- ----------
Total assets...................................................... $4,186,295 $3,324,197
========== ==========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses.......................... $ 592,299 $ 609,945
Short-term borrowings and current portion of long-term debt.... 80,624 26,032
---------- ----------
Total current liabilities................................... 672,923 635,977
Long-term debt.................................................... 1,144,355 796,507
Other liabilities................................................. 125,942 122,850
Commitments and contingencies
Common stockholders' equity:
Common stock, par value $0.01 per share; 300,000 shares
authorized; 105,257 and 97,963 shares issued and outstanding
at March 31, 2003 and December 31, 2002, respectively....... 1,053 980
Additional paid-in capital..................................... 2,206,224 1,817,511
Retained earnings (accumulated deficit) ....................... 47,264 (40,772)
Unearned compensation.......................................... (6,686) (3,332)
Accumulated other comprehensive loss........................... (4,780) (5,524)
---------- ----------
Total common stockholders' equity........................... 2,243,075 1,768,863
---------- ----------
Total liabilities and stockholders' equity........................ $4,186,295 $3,324,197
========== ==========
The accompanying notes are an integral part of these statements.
3
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002
(in thousands)
(unaudited)
2003 2002
--------- --------
Cash flows from operating activities:
Net income .......................................................... $ 88,036 $ 66,689
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation and amortization .................................... 36,701 30,310
Provision for doubtful accounts .................................. 54,629 55,315
Deferred income tax provision .................................... 10,046 4,894
Minority share of income ......................................... 3,803 3,882
Stock compensation expense ....................................... 1,536 2,457
Tax benefits associated with stock-based compensation plans ...... 5,637 19,226
Other, net ....................................................... (1,027) 394
Changes in operating assets and liabilities:
Accounts receivable ........................................... (84,316) (95,375)
Accounts payable and accrued expenses ......................... (96,236) (44,638)
Integration, settlement and other special charges ............. (4,898) (4,626)
Income taxes payable .......................................... 40,038 20,505
Other assets and liabilities, net ............................. 4,352 (6,179)
--------- --------
Net cash provided by operating activities ........................... 58,301 52,854
--------- --------
Cash flows from investing activities:
Business acquisitions, net of cash acquired ......................... (236,396) (1,275)
Capital expenditures ................................................ (37,481) (41,266)
Collection of note receivable ....................................... -- 10,660
Proceeds from disposition of assets ................................. 9 127
Increase in investments and other assets ............................ (2,628) (549)
--------- --------
Net cash used in investing activities ............................... (276,496) (32,303)
--------- --------
Cash flows from financing activities:
Proceeds from borrowings ............................................ 450,000 --
Repayments of debt .................................................. (268,987) (283)
Financing costs paid ................................................ (4,224) --
Distributions to minority partners .................................. (3,002) (2,977)
Exercise of stock options ........................................... 2,799 9,879
Other ............................................................... 429 (75)
--------- --------
Net cash provided by financing activities ........................... 177,015 6,544
--------- --------
Net change in cash and cash equivalents ............................. (41,180) 27,095
Cash and cash equivalents, beginning of period ...................... 96,777 122,332
--------- --------
Cash and cash equivalents, end of period ............................ $ 55,597 $149,427
========= ========
Cash paid during the period for:
Interest ............................................................ $ 27,111 $ 22,284
Income taxes ........................................................ 7,198 1,230
Businesses acquired:
Fair value of assets acquired ....................................... $ 972,764 $ --
Fair value of liabilities assumed ................................... 275,349 --
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 is the leading provider of esoteric
testing, including gene-based testing, and testing for drugs of abuse. The
Company is also a leading provider of anatomic pathology services and testing to
support clinical trials of new pharmaceuticals worldwide. 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.
On an annualized basis, Quest Diagnostics processes over 130 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 2002 Annual Report on Form 10-K.
Earnings Per Share
Basic earnings per common share is calculated by dividing net income by the
weighted average number of common shares outstanding. Diluted earnings per
common share is calculated by dividing net income 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 2.4 and
3.9 million shares for the three months ended March 31, 2003 and 2002,
respectively.
Stock-Based Compensation
The Company has chosen to adopt the disclosure only provisions of Statement
of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123"), as amended by SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure - an amendment of FASB
Statement No. 123" ("SFAS 148") and continue to account for stock-based
compensation using the intrinsic value method prescribed in Accounting
Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to
Employees" ("APB 25"), and related interpretations. 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 $1.5 million and $2.5 million for the three months ended March
31, 2003 and 2002, respectively.
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
5
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
granted for stock purchases under the Company's ESPP, consistent with the method
prescribed by SFAS 123, as amended by SFAS 148:
Three Months Ended
March 31,
-------------------
2003 2002
-------- --------
Net income:
Net income, as reported....................... $ 88,036 $ 66,689
Add: Stock-based compensation under APB 25.... 1,536 2,457
Deduct: Total stock-based compensation expense
determined under fair value method for all
awards, net of related tax effects......... (14,805) (10,501)
-------- --------
Pro forma net income.......................... $ 74,767 $ 58,645
======== ========
Earnings per common share:
Basic - as reported........................ $ 0.88 $ 0.70
-------- --------
Basic - pro forma.......................... $ 0.75 $ 0.61
-------- --------
Diluted - as reported...................... $ 0.86 $ 0.67
-------- --------
Diluted - pro forma........................ $ 0.74 $ 0.59
-------- --------
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
March 31,
------------------
2003 2002
---- -----
Dividend yield...................... 0.0% 0.0%
Risk-free interest rate............. 2.9% 4.1%
Expected volatility................. 48.1% 45.2%
Expected holding period, in years... 5 5
New Accounting Standards
In April 2002, the Financial Accounting Standards Board ("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 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 Opinion 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", is 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. The Company adopted SFAS 145 effective January 1, 2003. The adoption of
SFAS 145 did not have a material impact on the Company's financial position and
had no impact on the Company's consolidated statements of operations for the
periods presented.
6
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
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. The
Company adopted SFAS 146 effective January 1, 2003.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 requires a guarantor to
recognize a liability, at the inception of the guarantee, for the fair value of
obligations it has undertaken in issuing the guarantee and also include more
detailed disclosures with respect to guarantees. FIN 45 is effective on a
prospective basis for guarantees issued or modified starting January 1, 2003 and
requires the additional disclosures in interim and annual financial statements
effective for the period ended December 31, 2002. The Company's adoption of the
initial recognition and measurement provisions of FIN 45 effective January 1,
2003, did not have a material impact on the Company's results of operations or
financial position.
2. BUSINESS ACQUISITION
Acquisition of Unilab Corporation
On February 26, 2003, the Company accepted for payment more than 99% of the
outstanding capital stock of Unilab Corporation ("Unilab"), the leading
independent clinical laboratory in California. On February 28, 2003, the Company
acquired the remaining shares of Unilab through a merger. In connection with the
acquisition, the Company paid $297 million in cash and issued 7.1 million shares
of Quest Diagnostics common stock to acquire all of the outstanding capital
stock of Unilab. In addition, the Company reserved approximately 0.3 million
shares of Quest Diagnostics common stock for outstanding stock options of Unilab
which were converted upon the completion of the acquisition into options to
acquire shares of Quest Diagnostics common stock (the "converted options").
The aggregate purchase price of $697 million included the cash portion of
the purchase price of $297 million and transaction costs of approximately $19
million with the remaining portion of the purchase price paid through the
issuance of 7.1 million shares of Quest Diagnostics common stock (valued at $372
million or $52.80 per share, based on the average closing stock price of Quest
Diagnostics common stock for the five trading days ended March 4, 2003) and the
issuance of approximately 0.3 million converted options (valued at approximately
$9 million, based on the Black Scholes option-pricing model). Of the total
transaction costs incurred, approximately $8 million was paid during fiscal
2002.
In conjunction with the acquisition of Unilab, the Company repaid $220
million of debt, representing substantially all of Unilab's then existing
outstanding debt, and related accrued interest. Of the $220 million, $124
million represents payments related to the Company's cash tender offer which was
completed on March 7, 2003, for all of the outstanding $100.8 million principal
amount and related accrued interest of Unilab's 12 3/4% Senior Subordinated
Notes due 2009 and $23 million of related tender premium and associated tender
offer costs.
The Company financed the cash portion of the purchase price and related
transaction costs, and the repayment of substantially all of Unilab's
outstanding debt and related accrued interest with the proceeds from a new $450
million amortizing term loan facility (the "term loan") and cash on-hand. The
term loan carries interest at LIBOR plus an applicable margin that can fluctuate
over a range of up to 80 basis points, based on changes in the Company's credit
rating. At the option of the Company, it may elect to enter into LIBOR-based
interest rate contracts for periods up to 180 days. Interest on any outstanding
amounts not covered under the LIBOR-based interest rate contracts is based on an
alternate base rate, which is calculated by reference to the prime rate or
federal funds rate. As of March 31, 2003, the Company's borrowing rate for
LIBOR-based loans was LIBOR plus 1.3125%. The term loan requires principal
repayments of the initial amount borrowed equal to 16.25%, 20%, 20%, 21.25% and
22.5% in years one through five, respectively. The term loan is guaranteed by
each
7
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
of the Company's wholly owned subsidiaries that operate clinical laboratories in
the United States. The term loan contains various covenants including the
maintenance of certain financial ratios, which could impact the Company's
ability to, among other things, incur additional indebtedness, repurchase shares
of its outstanding common stock, make additional investments and consummate
acquisitions.
As part of the acquisition, Quest Diagnostics acquired all of Unilab's
operations, including its primary testing facilities in Los Angeles, San Jose
and Sacramento, California, and approximately 365 patient service centers and 35
rapid response laboratories and approximately 4,100 employees. The Company
expects to realize significant benefits from the acquisition of Unilab. As the
leading independent clinical laboratory in California, the acquisition of
Unilab positions the Company to capitalize on its leading position within the
laboratory testing industry, further enhancing its national network and access
to its comprehensive range of services.
In connection with the acquisition of Unilab, as part of a settlement
agreement with the United States Federal Trade Commission, the Company entered
into an agreement to sell to Laboratory Corporation of America Holdings, Inc.,
("LabCorp"), certain assets in northern California, including the assignment of
agreements with four independent physician associations ("IPA") and leases for
46 patient service centers (five of which also serve as rapid response
laboratories) for $4.5 million (the "Divestiture"). Approximately $27 million in
annual net revenues are generated by capitated fees under the IPA contracts and
associated fee for service testing for physicians whose patients use these
patient service centers, as well as from specimens received directly from the
IPA physicians. None of these assets have yet been assigned to LabCorp. The
Company expects to complete the transaction by August 2003.
The acquisition of Unilab was accounted for under the purchase method of
accounting. As such, the cost to acquire Unilab 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 Unilab subsequent to the closing of the acquisition.
The following table summarizes the Company's preliminary purchase price
allocation related to the acquisition of Unilab 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
February 28, 2003
-----------------
Current assets ............................................ $186,613
Property, plant and equipment ............................. 11,289
Goodwill .................................................. 730,143
Other assets .............................................. 44,719
--------
Total assets acquired .................................. 972,764
--------
Current liabilities ....................................... 54,058
Long-term debt ............................................ 221,291
--------
Total liabilities assumed .............................. 275,349
--------
Net assets acquired .................................... $697,415
========
Based on management's review of the net assets acquired and consultations
with third-party valuation specialists, no intangible assets meeting the
criteria under SFAS No. 141, "Business Combinations", were identified. Of the
$730 million allocated to goodwill, approximately $85 million is expected to be
deductible for tax purposes.
8
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
three months ended March 31, 2003 and 2002 assumes that Unilab and American
Medical Laboratories, Incorporated, ("AML"), which the Company acquired on April
1, 2002, were acquired on January 1, 2002 (in thousands, except per share data):
Three Months Ended March 31,
----------------------------
2003 2002
---------- ----------
Net revenues ........................................... $1,167,226 $1,131,226
Net income ............................................. 97,156 75,759
Basic earnings per common share:
Net income ............................................. $ 0.93 $ 0.74
Weighted average common shares outstanding - basic ..... 104,583 102,476
Diluted earnings per common share:
Net income ............................................. $ 0.91 $ 0.71
Weighted average common shares outstanding - diluted ... 107,036 106,448
The pro forma combined financial information presented above reflects
certain reclassifications to the historical financial statements of Unilab and
AML to conform the acquired companies' accounting policies and classification of
certain costs and expenses to that of Quest Diagnostics. These adjustments had
no impact on pro forma net income. No adjustment has been made to the pro
forma combined financial information to reflect the impact of the Divestiture,
which would not have a material impact on Quest Diagnostics' financial
condition, results of operations or cash flow. Pro forma results for the three
months ended March 31, 2003 exclude $14.5 million of direct transaction costs,
which were incurred and expensed by Unilab immediately prior to the closing of
the Unilab acquisition.
3. GOODWILL AND INTANGIBLE ASSETS
The changes in the carrying amount of goodwill, net for the period ended
March 31, 2003 and for the year ended December 31, 2002 are as follows:
March 31, 2003 December 31, 2002
-------------- -----------------
Balance at beginning of period ........ $1,788,850 $1,351,123
Goodwill acquired during the period ... 727,582 437,727
---------- ----------
Balance at end of period .............. $2,516,432 $1,788,850
========== ==========
Intangible assets at March 31, 2003 and December 31, 2002 consisted of the
following:
Weighted March 31, 2003 December 31, 2002
Average -------------------------------- --------------------------------
Amortization Accumulated Accumulated
Period Cost Amortization Net Cost Amortization Net
------------ ------- ------------ ------- ------- ------------ -------
Non-compete agreements ... 5 years $44,782 $(33,708) $11,074 $44,482 $(32,268) $12,214
Customer lists ........... 15 years 42,035 (34,158) 7,877 41,301 (33,751) 7,550
Other .................... 10 years 4,580 (2,338) 2,242 4,580 (2,261) 2,319
------- -------- ------- ------- -------- -------
Total ................. 10 years $91,397 $(70,204) $21,193 $90,363 $(68,280) $22,083
======= ======== ======= ======= ======== =======
9
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Amortization expense related to intangible assets was $2,023 and $2,155 for
the three months ended March 31, 2003 and 2002, respectively.
The estimated amortization expense related to intangible assets for each of
the five succeeding fiscal years and thereafter as of March 31, 2003 is as
follows:
Fiscal Year Ending
December 31,
- ---------------------------
Remainder of 2003.......... $ 5,894
2004....................... 6,329
2005....................... 2,872
2006....................... 1,758
2007....................... 1,008
2008....................... 761
Thereafter................. 2,571
-------
Total................... $21,193
=======
4. COMMITMENTS AND CONTINGENCIES
The Company has standby letters of credit issued under its unsecured
revolving credit facility to ensure its performance or payment to third parties,
which amounted to $48 million and $33 million at March 31, 2003 and December 31,
2002, respectively. The letters of credit, which are renewed annually, primarily
represent collateral for current and future automobile liability and workers'
compensation loss payments.
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 Unilab prior to the closing of the
Unilab acquisition.
At March 31, 2003 recorded reserves, relating primarily to billing claims
approximated $11 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.
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. 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 its 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
actuarially determined losses based upon the Company's historical and projected
loss experience.
10
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
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.
5. COMMON STOCKHOLDERS' EQUITY
Changes in common stockholders' equity for the three months ended March 31,
2003 were as follows:
Retained Accumulated
Additional Earnings Other Compre-
Common Paid-In (Accumulated Unearned Comprehensive hensive
Stock Capital Deficit) Compensation Income (Loss) Income
------ ----------- ------------ ------------ ------------- --------
Balance,
December 31, 2002................. $ 980 $1,817,511 $(40,772) $(3,332) $(5,524)
Net income........................... 88,036 $88,036
Other comprehensive income........... 744 744
-------
Comprehensive income............... $88,780
Shares issued to acquire Unilab =======
(7,055 common shares).............. 71 372,393
Fair value of Unilab converted
options............................ 8,452
Issuance of common stock under
benefit plans (205 common
shares)........................... 2 8,095 (5,041)
Exercise of options (197 common
shares)........................... 2 2,797
Shares to cover employee payroll tax
withholdings on stock issued under
benefit plans (163
common shares).................... (2) (8,661)
Tax benefits associated with
stock-based compensation plans.... 5,637
Amortization of unearned
compensation...................... 1,687
------ ---------- -------- ------- -------
Balance,
March 31, 2003.................... $1,053 $2,206,224 $ 47,264 $(6,686) $(4,780)
====== ========== ======== ======= =======
During the three months ended March 31, 2003, 163 thousand shares were
surrendered to cover employee payroll tax withholdings related to the vesting of
restricted stock. For reporting purposes, these shares were accounted for as
treasury shares, which were immediately retired.
11
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Changes in common stockholders' equity for the three months ended March 31,
2002 were as follows:
Accumulated
Additional Other Compre-
Common Paid-In Accumulated Unearned Comprehensive hensive
Stock Capital Deficit Compensation Income (Loss) Income
------ ---------- ----------- ------------ ------------- -------
Balance,
December 31, 2001................. $960 $1,714,676 $(362,926) $(13,253) $(3,470)
Net income........................... 66,689 $66,689
Other comprehensive income........... 535 535
-------
Comprehensive income.............. $67,224
Issuance of common stock under =======
benefit plans (165 common
shares)........................... 2 10,751
Exercise of options (540 common
shares)........................... 5 9,874
Tax benefits associated with
stock-based compensation plans.... 19,226
Amortization of unearned
compensation...................... 2,529
---- ---------- --------- -------- -------
Balance,
March 31, 2002.................... $967 $1,754,527 $(296,237) $(10,724) $(2,935)
==== ========== ========= ======== =======
6. 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 and Unilab, 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, which has been included in the accompanying condensed
consolidating financial data, subsequent to the closing of the acquisition, as a
Subsidiary Guarantor. On February 28, 2003, Quest Diagnostics acquired Unilab,
which has been included in the accompanying condensed consolidating financial
data, subsequent to the closing of the acquisition, as a Subsidiary Guarantor.
12
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Condensed Consolidating Statement of Operations
Three Months Ended March 31, 2003
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
-------- ---------- ------------- ------------ ------------
Net revenues................................ $191,631 $849,370 $112,980 $(61,184) $1,092,797
Costs and expenses:
Cost of services......................... 115,506 495,786 36,805 -- 648,097
Selling, general and administrative...... 19,227 207,039 56,757 (3,824) 279,199
Interest, net............................ 17,784 51,819 1,666 (57,360) 13,909
Amortization of intangible assets........ 289 1,734 -- -- 2,023
Royalty (income) expense................. (69,304) 69,304 -- -- --
Other, net............................... (484) 1,282 (23) -- 775
--------- -------- -------- -------- ----------
Total................................. 83,018 826,964 95,205 (61,184) 944,003
-------- -------- -------- -------- ----------
Income before taxes......................... 108,613 22,406 17,775 -- 148,794
Income tax expense.......................... 44,191 8,963 7,604 -- 60,758
-------- -------- -------- -------- ----------
Income before equity earnings............... 64,422 13,443 10,171 -- 88,036
Equity earnings from subsidiaries........... 23,614 -- -- (23,614) --
-------- -------- -------- -------- ----------
Net income.................................. $ 88,036 $ 13,443 $ 10,171 $(23,614) $ 88,036
======== ======== ======== ======== ==========
Condensed Consolidating Statement of Operations
Three Months Ended March 31, 2002
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
-------- ---------- ------------- ------------ ------------
Net revenues................................ $168,208 $730,552 $120,939 $(72,937) $946,762
Costs and expenses:
Cost of services.......................... 119,948 405,068 32,722 -- 557,738
Selling, general and administrative....... 41,278 153,764 67,120 (3,759) 258,403
Interest, net............................. 18,178 60,943 2,732 (69,178) 12,675
Amortization of intangible assets......... 590 1,565 -- -- 2,155
Royalty (income) expense.................. (61,521) 61,521 -- -- --
Other, net................................ 2,994 (18) 292 -- 3,268
-------- -------- -------- -------- --------
Total.................................... 121,467 682,843 102,866 (72,937) 834,239
-------- -------- -------- -------- --------
Income before taxes......................... 46,741 47,709 18,073 -- 112,523
Income tax expense ......................... 23,270 15,391 7,173 -- 45,834
-------- -------- -------- -------- --------
Income before equity earnings............... 23,471 32,318 10,900 -- 66,689
Equity earnings from subsidiaries........... 43,218 -- -- (43,218) --
-------- -------- -------- -------- --------
Net income ................................. $ 66,689 $ 32,318 $ 10,900 $(43,218) $ 66,689
======== ======== ======== ======== ========
13
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Condensed Consolidating Balance Sheet
March 31, 2003
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
---------- ---------- ------------- ------------ ------------
Assets
Current assets:
Cash and cash equivalents...................... $ 42,968 $ 4,841 $ 7,788 $ -- $ 55,597
Accounts receivable, net....................... 14,117 154,624 444,897 -- 613,638
Other current assets........................... 57,366 105,813 74,506 -- 237,685
---------- ---------- --------- ----------- -----------
Total current assets........................ 114,451 265,278 527,191 -- 906,920
Property, plant and equipment, net............. 228,984 328,001 26,318 -- 583,303
Intangible assets, net ........................ 158,440 2,333,817 45,368 -- 2,537,625
Intercompany receivable (payable).............. 324,065 116,161 (440,226) -- --
Investment in subsidiaries..................... 2,084,853 -- -- (2,084,853) --
Other assets................................... 57,182 66,663 34,602 -- 158,447
---------- ---------- --------- ----------- -----------
Total assets................................ $2,967,975 $3,109,920 $ 193,253 $(2,084,853) $ 4,186,295
========== ========== ========= =========== ===========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses.......... $ 365,639 $ 200,094 $ 26,566 $ -- $ 592,299
Short-term borrowings and current portion of
long-term debt.............................. -- 80,281 343 -- 80,624
---------- ---------- --------- ----------- -----------
Total current liabilities................... 365,639 280,375 26,909 -- 672,923
Long-term debt................................. 315,403 826,998 1,954 -- 1,144,355
Other liabilities.............................. 43,858 63,432 18,652 -- 125,942
Common stockholders' equity.................... 2,243,075 1,939,115 145,738 (2,084,853) 2,243,075
---------- ---------- --------- ----------- -----------
Total liabilities and stockholders' equity.. $2,967,975 $3,109,920 $ 193,253 $(2,084,853) $ 4,186,295
========== ========== ========= =========== ===========
Condensed Consolidating Balance Sheet
December 31, 2002
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
---------- ---------- ------------- ------------ ------------
Assets
Current assets:
Cash and cash equivalents...................... $ 79,015 $ 7,377 $ 10,385 $ -- $ 96,777
Accounts receivable, net....................... 15,032 89,626 417,473 -- 522,131
Other current assets........................... 52,952 63,148 89,435 -- 205,535
---------- ---------- --------- ----------- -----------
Total current assets........................ 146,999 160,151 517,293 -- 824,443
Property, plant and equipment, net............. 227,263 317,243 25,643 -- 570,149
Intangible assets, net ........................ 159,293 1,607,767 43,873 -- 1,810,933
Intercompany receivable (payable).............. 194,874 236,752 (431,626) -- --
Investment in subsidiaries..................... 1,631,868 -- -- (1,631,868) --
Other assets................................... 61,653 26,905 30,114 -- 118,672
---------- ---------- --------- ----------- -----------
Total assets................................ $2,421,950 $2,348,818 $ 185,297 $(1,631,868) $ 3,324,197
========== ========== ========= =========== ===========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses.......... $ 295,479 $ 287,539 $ 26,927 $ -- $ 609,945
Current portion of long-term debt.............. -- 25,689 343 -- 26,032
---------- ---------- --------- ----------- -----------
Total current liabilities................... 295,479 313,228 27,270 -- 635,977
Long-term debt................................. 315,109 478,863 2,535 -- 796,507
Other liabilities.............................. 42,499 62,339 18,012 -- 122,850
Common stockholders' equity.................... 1,768,863 1,494,388 137,480 (1,631,868) 1,768,863
---------- ---------- --------- ----------- -----------
Total liabilities and stockholders' equity.. $2,421,950 $2,348,818 $ 185,297 $(1,631,868) $ 3,324,197
========== ========== ========= =========== ===========
14
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Condensed Consolidating Statement of Cash Flows
Three Months Ended March 31, 2003
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
--------- ---------- ------------- ------------ ------------
Cash flows from operating activities:
Net income...................................... $ 88,036 $ 13,443 $ 10,171 $ (23,614) $ 88,036
Adjustments to reconcile net income to net
cash provided by (used in) operating
activities:
Depreciation and amortization................ 13,417 21,306 1,978 -- 36,701
Provision for doubtful accounts.............. 1,757 11,184 41,688 -- 54,629
Other, net................................... (7,421) (5,913) 9,715 23,614 19,995
Changes in operating assets and liabilities.. 7,536 (85,134) (63,462) -- (141,060)
--------- -------- -------- --------- ---------
Net cash provided by (used in) operating
activities................................... 103,325 (45,114) 90 -- 58,301
Net cash used in investing activities........... (546,659) (20,633) (4,334) 295,130 (276,496)
Net cash provided by financing activities....... 407,287 63,211 1,647 (295,130) 177,015
--------- -------- -------- --------- ---------
Net change in cash and cash equivalents......... (36,047) (2,536) (2,597) -- (41,180)
Cash and cash equivalents, beginning of period.. 79,015 7,377 10,385 -- 96,777
--------- -------- -------- --------- ---------
Cash and cash equivalents, end of period........ $ 42,968 $ 4,841 $ 7,788 $ -- $ 55,597
========= ======== ======== ========= =========
Condensed Consolidating Statement of Cash Flows
Three Months Ended March 31, 2002
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
--------- ---------- ------------- ------------ ------------
Cash flows from operating activities:
Net income...................................... $ 66,689 $ 32,318 $ 10,900 $(43,218) $ 66,689
Adjustments to reconcile net income to net
cash provided by (used in) operating
activities:
Depreciation and amortization................ 11,351 17,600 1,359 -- 30,310
Provision for doubtful accounts.............. 1,729 4,243 49,343 -- 55,315
Other, net................................... (25,908) 8,354 5,189 43,218 30,853
Changes in operating assets and liabilities.. (51,955) (609) (77,749) -- (130,313)
--------- -------- -------- -------- ---------
Net cash provided by (used in) operating
activities................................... 1,906 61,906 (10,958) -- 52,854
Net cash used in investing activities........... (11,620) (30,374) (533) 10,224 (32,303)
Net cash provided by (used in) financing
activities................................... 9,714 (192) 7,246 (10,224) 6,544
--------- -------- -------- -------- ---------
Net change in cash and cash equivalents......... -- 31,340 (4,245) -- 27,095
Cash and cash equivalents, beginning of period.. -- 110,571 11,761 -- 122,332
--------- -------- -------- -------- ---------
Cash and cash equivalents, end of period........ $ -- $141,911 $ 7,516 $ -- $ 149,427
========= ======== ======== ======== =========
15
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 2002 Annual
Report on Form 10-K.
Acquisition of Unilab Corporation
On February 26, 2003, we accepted for payment more than 99% of the
outstanding capital stock of Unilab Corporation ("Unilab"), the leading
independent clinical laboratory in California. On February 28, 2003, we acquired
the remaining shares of Unilab through a merger. In connection with the
acquisition, we paid $297 million in cash and issued 7.1 million shares of Quest
Diagnostics common stock to acquire all of the outstanding capital stock of
Unilab. In addition, we reserved approximately 0.3 million shares of Quest
Diagnostics common stock for outstanding stock options of Unilab which were
converted upon the completion of the acquisition into options to acquire shares
of Quest Diagnostics common stock (the "converted options"). See Note 2 to the
interim consolidated financial statements for a full discussion of the Unilab
acquisition.
We 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 through the first half of 2005, including the
elimination of excess capacity and workforce reductions. These estimates are
preliminary and will be subject to revisions as detail 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
periods that the related actions are taken. Upon completion of the Unilab
integration, we expect to realize approximately $25 million to $30 million of
annual synergies and we expect to achieve this annual rate of synergies by the
end of 2005.
Results of Operations
Three Months Ended March 31, 2003 Compared with Three Months Ended March
31, 2002
Net income for the three months ended March 31, 2003 increased to $88
million from $67 million for the prior year period. This increase in earnings
was primarily attributable to revenue growth and improved efficiencies generated
from our Six Sigma and Standardization initiatives. These improvements were
partially offset by the impact of severe winter weather and the recent strike by
New Jersey physicians during the first quarter of 2003, as well as increases in
employee compensation and benefit costs and investments in our information
technology strategy.
Net Revenues
Net revenues for the three months ended March 31, 2003 grew by 15.4% over
the prior year level and include the results of Unilab for one month and
American Medical Laboratories, Incorporated ("AML") for the full quarter, which
was acquired on April 1, 2002. Pro forma revenue growth, assuming that both
Unilab and AML had been part of Quest Diagnostics since January 1, 2002, was
3.2%.
For the three months ended March 31, 2003, clinical testing volume,
measured by the number of requisitions, increased 11.9% compared to the prior
year period. The impact of AML and Unilab contributed about 8% and 5%,
respectively, to the overall volume growth during the first quarter of 2003.
Severe winter storms and the New Jersey physicians' strike, reduced volume by
approximately 1.6% for the quarter, compared to the prior year period. Pro forma
testing volume, assuming that both Unilab and AML had been part of Quest
Diagnostics since January 1, 2002, declined
16
approximately 1% compared to the prior year period, reflecting the impact of the
severe winter storms and the physicians' strike. In addition, our drugs-of-abuse
testing business, which is most directly impacted by economic conditions,
declined during the quarter, reducing company-wide volume growth by
approximately half a percentage point.
Average revenue per requisition increased 3.6% for the quarter, compared to
the prior year period, primarily attributable to a continuing shift in test mix
to higher value testing, including gene-based testing, which continued to grow
at a rate greater than 20% over the prior year level. In addition, a shift in
payer mix contributed a portion of the increase in revenue per requisition. The
inclusion of Unilab's results for one month during the quarter reduced average
revenue per requisition by approximately half a percentage point since Unilab's
business has lower revenue per requisition than the rest of our business.
Operating Costs and Expenses
Total operating costs for the three months ended March 31, 2003 increased
$111 million from the prior year period primarily due to increases in our
clinical testing volume, largely as a result of the Unilab and AML acquisitions,
employee compensation and benefits, supply costs and depreciation expense;
partially offset by a reduction in bad debt expense. While our cost structure
has been favorably impacted by 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.
Cost of services, which includes the costs of obtaining, transporting and
testing specimens was 59.3% of net revenues for the three months ended March 31,
2003, increasing slightly from 58.9% in the prior year period. The addition of
AML's higher cost of services as of April 1, 2002, which increased cost of
services as a percentage of net revenues, was partially offset by the positive
impact of our Six Sigma and Standardization efforts and the increase in average
revenue per requisition. Additionally, reflected in the cost of services are the
one-time installation costs of deploying our Internet-based orders and results
systems in physicians' offices. The increased use of the Internet for ordering
and resulting are improving the initial collection of billing information and
generating savings in the cost of billing and bad debt expense, both of which
are components of selling, general and administrative expenses. The severe
winter storms and the New Jersey physicians' strike, which reduced volume growth
during the quarter, also had the impact of increasing cost of sales as a
percentage of revenues, since generally there were no reductions of fixed costs
associated with the decreased volume. The estimated impact during the quarter
was to increase cost of sales as a percentage of revenues by 0.4%.
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 March 31, 2003
as a percentage of net revenues to 25.5% from 27.3% in the prior year period.
The decrease was 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 of
April 1, 2002. During the first quarter of 2003, bad debt expense improved to
5.0% of net revenues, compared to 5.8% of net revenues a year ago, despite the
addition of Unilab, which has higher levels of bad debt than the rest of Quest
Diagnostics. The improvement in bad debt expense was 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 and cost structure. The severe winter storms and the New Jersey
physicians' strike, which reduced volume growth during the quarter, also had the
impact of increasing selling, general and administrative expenses as a
percentage of revenues, since generally there were no reductions of fixed costs
associated with the decreased volume. The estimated impact during the quarter
was to increase selling, general and administrative expenses as a percentage of
revenues by 0.3%.
Interest, Net
Net interest expense for the three months ended March 31, 2003 increased
from the prior year period by $1.2 million primarily attributable to the amounts
borrowed to finance the acquisition of Unilab and to repay substantially all of
Unilab's outstanding debt.
17
Amortization of Intangible Assets
Amortization of intangible assets for the three months ended March 31, 2003
decreased slightly from the prior year period principally as the result of
certain intangible assets becoming fully amortized during the remainder of 2002.
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 $2.4 million for the three months
ended March 31, 2003, compared to the prior year period. The increase was
primarily due to the cost of a contract settlement which was recorded in the
prior year quarter.
Impact of Contingent Convertible Debentures on Diluted Earnings per Common
Share
The if-converted method is used in determining the dilutive effect of our 1
3/4% contingent convertible debentures due 2021 (the "Debentures") in periods
when the holders of such securities are permitted to exercise their conversion
rights. As of and for the three months ended March 31, 2003, 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
ended March 31, 2003. See Note 12 to the Consolidated Financial Statements
contained in our 2002 Annual Report on Form 10-K for a further discussion of the
Debentures.
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. See Note 2 to the Consolidated Financial Statements contained in
our 2002 Annual Report on Form 10-K for additional discussion of our financial
instruments and hedging activities.
At March 31, 2003 and December 31, 2002, the fair value of our debt was
estimated at approximately $1.3 billion and $899 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 March 31,
2003 and December 31, 2002, the estimated fair value exceeded the carrying value
of the debt by approximately $64 million and $77 million, respectively. An
assumed 10% increase in interest rates (representing approximately 50 and 60
basis points at March 31, 2003 and December 31, 2002, respectively) would
potentially reduce the estimated fair value of our debt by approximately $14
million and $21 million at March 31, 2003 and December 31, 2002, 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 2002 Annual
Report on Form 10-K, is considered to be a derivative instrument subject to
Statement of Financial Accounting Standards ("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 March 31, 2003 and December 31, 2002.
Borrowings under our unsecured revolving credit facility under our credit
agreement, our term loan and our secured receivables credit facility are subject
to variable interest rates, unless fixed through interest rate swap or other
agreements. Interest rates on our unsecured revolving credit facility and term
loan are subject to a pricing schedule that can fluctuate over a range of up to
80 basis points, based on changes in our credit rating. As such, our borrowing
cost under these credit arrangements will be subject to both fluctuations in
interest rates and changes in our credit rating. As of March 31, 2003, our
borrowing rate for LIBOR-based loans was LIBOR plus 1.3125%. At March 31, 2003,
there was $408 million outstanding under our term loan and there were no
borrowings outstanding under our unsecured revolving credit facility or against
our secured receivables credit facility.
Based on our net exposure to interest rate changes, an assumed 10% change
in interest rates on our variable rate indebtedness (representing approximately
15 basis points) would impact annual net interest expense by approximately $0.5
million, assuming no changes to the debt outstanding at March 31, 2003.
18
Liquidity and Capital Resources
Cash and Cash Equivalents
Cash and cash equivalents at March 31, 2003 totaled $56 million, compared
to $97 million at December 31, 2002. Cash flows from operating activities in
2003 provided cash of $58 million, which along with cash flows from financing
activities of $177 million, were used to fund investing activities, which
required cash of $276 million. Cash and cash equivalents at March 31, 2002
totaled $149 million, an increase of $27 million from December 31, 2001. Cash
flows from operating and financing activities in 2002 provided cash of $53
million and $6 million, respectively, which were used to fund investing
activities, which required cash of $32 million.
Cash From Operating Activities
Net cash from operating activities for 2003 was $58 million compared to $53
million in 2002. This increase was primarily due to improved operating
performance and efficiencies in our billing and collection processes, partially
offset by a decrease in the tax benefits realized associated with the exercise
of employee stock options. First quarter cash flow from operations is seasonally
lower than other quarters of the year due to the timing of certain annual
payments, principally associated with variable compensation and employee
vacation earned in the prior year. Days sales outstanding, a measure of billing
and collection efficiency, decreased to 49 days at March 31, 2003 from 52 days
at March 31, 2002.
Cash From Investing Activities
Net cash used in investing activities was $276 million for the first
quarter of 2003, consisting primarily of acquisition and related transaction
costs of $236 million to acquire the outstanding capital stock of Unilab, and
capital expenditures of $37 million. The acquisition and related transaction
costs included the cash portion of the Unilab purchase price of $297 million and
approximately $11 million of transaction costs paid in the first quarter of
2003, partially offset by $72 million of cash acquired from Unilab. Net cash
used in investing activities in 2002 was $32.3 million for the first quarter,
consisting primarily of capital expenditures of $41.3 million offset by a $10.7
million collection of a note receivable.
Cash From Financing Activities
Net cash provided by financing activities in 2003 was $177 million,
consisting primarily of $450 million of borrowings under our term loan facility,
partially offset by debt repayments totaling $269 million. Borrowings under our
term loan facility were used to finance the cash portion of the purchase price
and related transaction costs associated with the acquisition of Unilab, and to
repay $220 million of debt, representing substantially all of Unilab's then
existing outstanding debt, and related accrued interest. Of the $220 million,
$124 million represents payments related to our cash tender offer on March 7,
2003, for all of the outstanding $100.8 million principal amount of Unilab's 12
3/4% Senior Subordinated Notes due 2009 and $23 million of related tender
premium and associated tender offer costs. The remaining debt repayments in the
first quarter of 2003 consisted primarily of a $42 million repayment under the
term loan and a $6 million capital lease repayment.
Net cash provided by financing activities for 2002 was $6.5 million,
consisting primarily of $9.9 million of proceeds from the exercise of stock
options, partially offset by $3.0 million of distributions to minority partners.
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.
Contractual Obligations and Commitments
A 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 2002 Annual Report on Form 10-K. A discussion of our acquisition of
Unilab, including the terms of our term loan facility used to finance the
acquisition of Unilab and repay substantially all of Unilab's outstanding debt,
is contained in Note 2 to the interim consolidated financial statements. A
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, 2002
is contained in Note 17 to the Consolidated Financial Statements in our 2002
Annual
19
Report on Form 10-K. See Note 4 to the interim consolidated financial statements
for information regarding the status of our remaining contractual obligations
and commitments, including billing-related claims.
Our credit agreements relating to our unsecured revolving credit facility
and our term loan facility contain 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.
Unconsolidated Joint Ventures
At March 31, 2003 and December 31, 2002, we had investments in
unconsolidated joint ventures in Phoenix, Arizona; Indianapolis, Indiana;
Dayton, Ohio; and Chesapeake, Virginia, which 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 net revenues of our unconsolidated joint ventures, on a combined basis,
are less than 6% of our consolidated net revenues. Total assets associated with
our unconsolidated joint ventures are less than 3% of our consolidated total
assets. We have no material unconditional 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 $180 million to $190 million
during 2003 for capital expenditures to support and expand our existing
operations, principally related to investments in information technology,
equipment, and facility upgrades. Other than the reduction for outstanding
letters of credit, which approximated $48 million at March 31, 2003, all of the
$325 million revolving credit facility under the credit agreement and all of the
$250 million secured receivables credit facility remained available to us for
future borrowing at March 31, 2003.
We believe that cash from operations and our borrowing capacity under our
unsecured revolving credit facility and secured receivables credit facility 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.
Impact of New Accounting Standards
In April 2002, the Financial Accounting Standards Board ("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." In November 2002, the FASB issued Interpretation No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others."
The impact of the above referenced accounting standards is discussed in
Note 1 to the interim consolidated financial statements.
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 ("Litigation Reform Act") provides a
"safe harbor" for forward-looking statements to encourage companies to provide
prospective information about their companies without fear of litigation.
20
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 2002 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.
21
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
See Note 4 to the interim consolidated financial statements for information
regarding the status of government investigations and private claims.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits:
10.1 Fourth Supplemental Indenture dated as of March 19, 2003, among Unilab
Corporation (f/k/a Quest Diagnostics Newco Incorporated), Quest
Diagnostics Incorporated, The Bank Of New York, and the Subsidiary
Guarantors.
99.1 Statement Pursuant to 18. U.S.C. 'SS' 1350 of Chief Executive
Officer dated April 30, 2003
99.2 Statement Pursuant to 18. U.S.C. 'SS' 1350 of Chief Financial
Officer dated April 30, 2003
(b) Report on Form 8-K filed during the first quarter of 2003:
On March 13, 2003, the Company filed a current report on Form 8-K (Date of
Report: February 26, 2003) reporting under Item 2 on the acquisition of the
outstanding capital stock of Unilab Corporation.
22
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.
April 30, 2003
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
23
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.
April 30, 2003
By /s/ Kenneth W. Freeman
------------------------------------
Kenneth W. Freeman
Chairman of the Board and
Chief Executive Officer
24
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.
April 30, 2003
By /s/ Robert A. Hagemann
----------------------------------
Robert A. Hagemann
Vice President and
Chief Financial Officer
25
STATEMENT OF DIFFERENCES
The section symbol shall be expressed as.................... 'SS'