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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, 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)
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Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [_]
As of October 28, 2003, there were outstanding 103,953,001 shares of the
registrant's common stock, $.01 par value.
PART I - FINANCIAL INFORMATION
Page
----
Item 1. Financial Statements
Index to consolidated financial statements filed as part of this report:
Consolidated Statements of Operations for the
Three and Nine Months Ended September 30, 2003 and 2002 2
Consolidated Balance Sheets as of
September 30, 2003 and December 31, 2002 3
Consolidated Statements of Cash Flows for the
Nine Months Ended September 30, 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 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" 26
Item 4. Controls and Procedures
Controls and Procedures 26
1
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
(in thousands, except per share data)
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- -----------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Net revenues ...................................... $1,221,221 $1,058,714 $3,533,953 $3,074,286
---------- ---------- ---------- ----------
Operating costs and expenses:
Cost of services .................................. 711,180 625,075 2,062,401 1,813,071
Selling, general and administrative ............... 292,413 272,587 867,674 807,811
Amortization of intangible assets ................. 2,055 2,023 6,146 6,243
Other operating (income) expense, net ............. (1,950) 1,074 (1,717) 2,901
---------- ---------- ---------- ----------
Total operating cost and expenses .............. 1,003,698 900,759 2,934,504 2,630,026
---------- ---------- ---------- ----------
Operating income .................................. 217,523 157,955 599,449 444,260
Other income (expense):
Interest expense, net ............................. (14,472) (13,388) (45,247) (40,979)
Minority share of income .......................... (4,607) (3,661) (12,825) (11,481)
Equity earnings in unconsolidated joint ventures .. 4,371 3,834 12,981 11,762
Other income (expense), net ....................... (62) 1,405 594 1,578
---------- ---------- ---------- ----------
Total non-operating expenses, net............... (14,770) (11,810) (44,497) (39,120)
---------- ---------- ---------- ----------
Income before taxes ............................... 202,753 146,145 554,952 405,140
Income tax expense ................................ 82,729 59,528 226,480 164,683
---------- ---------- ---------- ----------
Net income ........................................ $ 120,024 $ 86,617 $ 328,472 $ 240,457
========== ========== ========== ==========
=======================================================================================================
Basic earnings per common share:
Net income ........................................ $ 1.15 $ 0.89 $ 3.18 $ 2.50
Weighted average common shares
outstanding - basic ............................ 104,787 96,900 103,291 96,238
=======================================================================================================
Diluted earnings per common share:
Net income ........................................ $ 1.12 $ 0.87 $ 3.10 $ 2.41
Weighted average common shares
outstanding - diluted .......................... 107,278 99,712 105,804 99,772
The accompanying notes are an integral part of these statements.
2
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, 2003 AND DECEMBER 31, 2002
(in thousands, except per share data)
(unaudited)
September 30, December 31,
2003 2002
------------- ------------
Assets
Current assets:
Cash and cash equivalents ..................................................... $ 91,068 $ 96,777
Accounts receivable, net of allowance of $211,922 and $193,456 at
September 30, 2003 and December 31, 2002, respectively ..................... 643,840 522,131
Inventories ................................................................... 68,424 60,899
Deferred income taxes ......................................................... 115,665 102,700
Prepaid expenses and other current assets ..................................... 53,005 41,936
---------- ----------
Total current assets ....................................................... 972,002 824,443
Property, plant and equipment, net ............................................ 592,099 570,149
Goodwill ...................................................................... 2,518,683 1,788,850
Intangible assets, net ........................................................ 17,694 22,083
Deferred income taxes ......................................................... 57,201 29,756
Other assets .................................................................. 103,087 88,916
---------- ----------
Total assets .................................................................. $4,260,766 $3,324,197
========== ==========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses ......................................... $ 617,260 $ 609,945
Short-term borrowings and current portion of long-term debt ................... 56,290 26,032
---------- ----------
Total current liabilities .................................................. 673,550 635,977
Long-term debt ................................................................ 1,065,141 796,507
Other liabilities ............................................................. 140,715 122,850
Commitments and contingencies
Stockholders' equity:
Common stock, par value $0.01 per share; 300,000 shares authorized;
106,101 and 97,963 shares issued at September 30, 2003 and
December 31, 2002, respectively ............................................ 1,061 980
Additional paid-in capital .................................................... 2,238,199 1,817,511
Retained earnings (accumulated deficit) ....................................... 287,700 (40,772)
Unearned compensation ......................................................... (3,604) (3,332)
Accumulated other comprehensive loss .......................................... (662) (5,524)
Treasury stock, at cost; 2,355 shares at September 30, 2003 ................... (141,334) --
---------- ----------
Total stockholders' equity ................................................. 2,381,360 1,768,863
---------- ----------
Total liabilities and stockholders' equity .................................... $4,260,766 $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 NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
(in thousands)
(unaudited)
2003 2002
--------- ----------
Cash flows from operating activities:
Net income .............................................................. $ 328,472 $ 240,457
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation and amortization ........................................... 113,500 96,697
Provision for doubtful accounts ......................................... 172,102 164,892
Deferred income tax provision ........................................... 16,589 18,046
Minority share of income ................................................ 12,825 11,481
Stock compensation expense .............................................. 4,093 6,829
Tax benefits associated with stock-based compensation plans ............. 17,880 41,307
Other, net .............................................................. (1,791) (6,003)
Changes in operating assets and liabilities:
Accounts receivable .................................................. (231,991) (170,047)
Accounts payable and accrued expenses ................................ (67,359) (40,808)
Integration, settlement and other special charges .................... (13,769) (26,469)
Income taxes payable ................................................. 43,707 21,569
Other assets and liabilities, net .................................... 6,255 (8,024)
--------- ---------
Net cash provided by operating activities ............................... 400,513 349,927
--------- ---------
Cash flows from investing activities:
Business acquisitions, net of cash acquired ............................. (237,538) (333,512)
Capital expenditures .................................................... (121,690) (118,403)
Increase in investments and other assets ................................ (11,450) (4,450)
Proceeds from disposition of assets ..................................... 9,034 5,919
Collection of note receivable ........................................... -- 10,660
--------- ---------
Net cash used in investing activities ................................... (361,644) (439,786)
--------- ---------
Cash flows from financing activities:
Proceeds from borrowings ................................................ 450,000 475,237
Repayments of debt ...................................................... (372,806) (408,842)
Purchases of treasury stock ............................................. (124,081) --
Exercise of stock options ............................................... 16,773 24,251
Distributions to minority partners ...................................... (10,580) (9,071)
Financing costs paid .................................................... (4,227) --
Other ................................................................... 343 (194)
--------- ---------
Net cash (used in) provided by financing activities ..................... (44,578) 81,381
--------- ---------
Net change in cash and cash equivalents ................................. (5,709) (8,478)
Cash and cash equivalents, beginning of period .......................... 96,777 122,332
--------- ---------
Cash and cash equivalents, end of period ................................ $ 91,068 $ 113,854
========= =========
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.
Certain amounts reported in the Company's consolidated statements of operations
for the three and nine months ended September 30, 2002 have been reclassified to
conform to the 2003 presentation.
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 Employee Equity Participation Program. These dilutive
securities increased the weighted average number of common shares outstanding by
2.5 million shares for both the three and nine months ended September 30, 2003.
For the three and nine months ended September 30, 2002, these dilutive
securities increased the weighted average number of common shares outstanding by
2.8 million and 3.5 million shares, 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 $1.2 million and $1.9 million for the three months ended
September 30, 2003 and 2002, respectively, and $4.1 million and $6.8 million
for the nine months ended September 30, 2003 and 2002, 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 discount
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 Nine Months Ended
September 30, September 30,
------------------- -------------------
2003 2002 2003 2002
-------- -------- -------- --------
Net income:
Net income, as reported............................. $120,024 $ 86,617 $328,472 $240,457
Add: Stock-based compensation under APB 25.......... 1,217 1,876 4,093 6,829
Deduct: Total stock-based compensation expense
determined under fair value method for all
awards, net of related tax effects............... (12,215) (12,108) (40,144) (35,014)
-------- -------- -------- --------
Pro forma net income................................ $109,026 $ 76,385 $292,421 $212,272
======== ======== ======== ========
Earnings per common share:
Basic - as reported................................. $ 1.15 $ 0.89 $ 3.18 $ 2.50
-------- -------- -------- --------
Basic - pro forma................................... $ 1.04 $ 0.79 $ 2.83 $ 2.21
-------- -------- -------- --------
Diluted - as reported............................... $ 1.12 $ 0.87 $ 3.10 $ 2.41
-------- -------- -------- --------
Diluted - pro forma................................. $ 1.03 $ 0.77 $ 2.80 $ 2.13
-------- -------- -------- --------
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,
------------------ -----------------
2003 2002 2003 2002
---- ---- ---- ----
Dividend yield ..................................... 0.0% 0.0% 0.0% 0.0%
Risk-free interest rate ............................ 3.3% 3.8% 2.8% 4.2%
Expected volatility ................................ 48.1% 46.2% 48.1% 45.2%
Expected holding period, in years .................. 5 5 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's adoption of SFAS 145 effective January 1, 2003, did not have
a material impact on the Company's results of operations or financial position.
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.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation
of Variable Interest Entities" ("FIN 46"). FIN 46 requires a variable interest
entity to be consolidated by a company if that company is subject to a majority
of the risk of loss from the variable interest entity's activities or entitled
to receive a majority of the entity's residual returns or both. Historically,
entities generally were not consolidated unless the entity was controlled
through voting interests. FIN 46 also requires disclosures about variable
interest entities that a company is not required to consolidate but in which it
has a significant variable interest. The consolidation requirements of FIN 46
apply immediately to variable interest entities created after January 31, 2003.
On October 8, 2003, the FASB deferred the implementation date for FIN 46 as it
relates to variable interest entities that existed prior to February 1, 2003.
The consolidation requirements of FIN 46 will apply to variable interest
entities that existed prior to February 1, 2003 in financial statements issued
for periods ending after December 15, 2003 (December 31, 2003 for the Company).
Also, certain disclosure requirements apply to all financial statements issued
after January 31, 2003, regardless of when the variable interest entity was
established. The adoption of this standard is not expected to have a material
impact on the Company's consolidated financial statements.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement
133 on Derivative Instruments and Hedging Activities" ("SFAS 149"), which amends
and clarifies financial accounting and reporting for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities under SFAS 133. SFAS 149 is effective for contracts entered
into or modified after June 30, 2003, and for hedging relationships designated
after June 30, 2003. The adoption of SFAS 149, effective July 1, 2003, did not
have a material impact on the Company's results of operations or financial
position.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150"),
which establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. SFAS
150 is effective for financial instruments entered into or modified after May
31, 2003, and otherwise is effective at the beginning of the first interim
period beginning after June 15, 2003. The Company's adoption of the initial
recognition and initial measurement provisions of SFAS 150, effective June 1,
2003, did not have a material impact on the Company's results of operations or
financial position.
7
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
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 $698 million included the cash portion
of the purchase price of $297 million and transaction costs of approximately $20
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 $101 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 September 30, 2003, the Company's borrowing rate for
LIBOR-based loans was LIBOR plus 1.1875%. 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 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. Through September 30, 2003, the Company has repaid
$127 million of principal under the term loan.
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. The Company completed the transfer of assets and assignment of
the
8
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
IPA agreements to LabCorp during the third quarter of 2003. A gain of $1.5
million was recognized in the third quarter of 2003 in connection with the
Divestiture.
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..................... $188,221
Property, plant and equipment...... 11,282
Goodwill........................... 733,645
Other assets....................... 44,351
--------
Total assets acquired........... 977,499
--------
Current liabilities................ 55,468
Long-term liabilities.............. 3,119
Long-term debt..................... 221,291
--------
Total liabilities assumed....... 279,878
--------
Net assets acquired............. $697,621
========
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 $734 million allocated to goodwill, approximately $85 million
is expected to be deductible for tax purposes.
The following unaudited pro forma combined financial information for
the three months ended March 31, 2003, and for the nine months ended September
30, 2003 assumes that Unilab was acquired on January 1, 2003 (in thousands,
except per share data):
Three Months Ended Nine Months
------------------------------------- Ended
March 31, June 30, September 30, September 30,
2003 2003 2003 2003
---------- ---------- ------------ -------------
Pro forma Historical Historical Pro forma
Net revenues .......................................... $1,167,226 $1,219,935 $1,221,221 $3,608,382
Net income ............................................ 97,156 120,412 120,024 337,592
Basic earnings per common share:
Net income ............................................ $ 0.93 $ 1.15 $ 1.15 $ 3.22
Weighted average common shares outstanding - basic..... 104,583 105,049 104,787 104,807
Diluted earnings per common share:
Net income ............................................ $ 0.91 $ 1.12 $ 1.12 $ 3.15
Weighted average common shares outstanding - diluted... 107,036 107,677 107,278 107,333
9
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 each of the quarters and the nine months ended September 30, 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 Nine Months
--------------------------------------- Ended
March 31, June 30, September 30, September 30,
2002 2002 2002 2002
---------- ---------- ------------- -------------
Pro forma Pro forma Pro forma Pro forma
Net revenues ..................................... $1,131,226 $1,180,232 $1,171,437 $3,482,895
Net income ....................................... 75,759 98,894 100,311 274,964
Basic earnings per common share:
Net income ....................................... $ 0.74 $ 0.96 $ 0.96 $ 2.66
Weighted average common shares outstanding - basic 102,476 103,447 103,954 103,293
Diluted earnings per common share:
Net income ....................................... $ 0.71 $ 0.92 $ 0.94 $ 2.57
Weighted average common shares outstanding -
diluted ....................................... 106,448 107,453 106,838 106,913
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 in conjunction with its acquisition by Quest
Diagnostics. Pro forma results for the three months ended June 30, 2002 and
September 30, 2002 exclude $14.5 million and $4.5 million, respectively, of
direct transaction costs, which were incurred and expensed by AML and Unilab,
respectively, in conjunction with their acquisitions by Quest Diagnostics.
3. GOODWILL AND INTANGIBLE ASSETS
The changes in the carrying amount of goodwill for the period ended
September 30, 2003 and for the year ended December 31, 2002 are as follows:
September 30, December 31,
2003 2002
------------- ------------
Balance at beginning of period ............... $1,788,850 $1,351,123
Goodwill acquired during the period .......... 729,833 437,727
---------- ----------
Balance at end of period ..................... $2,518,683 $1,788,850
========== ==========
10
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Intangible assets at September 30, 2003 and December 31, 2002
consisted of the following:
Weighted September 30, 2003 December 31, 2002
Average --------------------------------- --------------------------------
Amortization Accumulated Accumulated
Period Cost Amortization Net Cost Amortization Net
------- ------------ -------- ------- ------------ -------
Non-compete
agreements.... 5 years $44,862 $(36,522) $ 8,340 $44,482 $(32,268) $12,214
Customer lists... 15 years 42,035 (35,114) 6,921 41,301 (33,751) 7,550
Other............ 10 years 4,925 (2,492) 2,433 4,580 (2,261) 2,319
------- -------- ------- ------- -------- -------
Total......... 10 years $91,822 $(74,128) $17,694 $90,363 $(68,280) $22,083
======= ======== ======= ======= ======== =======
Amortization expense related to intangible assets was $2,055 and
$2,023 for the three months ended September 30, 2003 and 2002, respectively. For
the nine months ended September 30, 2003 and 2002, amortization expense related
to intangible assets was $6,146 and $6,243, respectively.
The estimated amortization expense related to intangible assets for
each of the five succeeding fiscal years and thereafter as of September 30, 2003
is as follows:
Fiscal Year Ending
December 31,
- --------------------
Remainder of 2003... $ 1,933
2004................ 6,450
2005................ 2,941
2006................ 1,712
2007................ 928
2008................ 754
Thereafter.......... 2,976
-------
Total............. $17,694
=======
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 $50 million and $33 million at September 30, 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.
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
11
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
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 position.
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 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
actuarially determined 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.
5. STOCKHOLDERS' EQUITY
Changes in stockholders' equity for the nine months ended September
30, 2003 were as follows:
Retained Accumulated
Additional Earnings Other
Common Paid-In (Accumulated Unearned Comprehensive Treasury Comprehensive
Stock Capital Deficit) Compensation Income(Loss) Stock Income
---------------------------------------------------------------------------------------------
Balance,
December 31, 2002........ $ 980 $1,817,511 $(40,772) $(3,332) $(5,524) $ --
Net income.................. 328,472 $328,472
Other comprehensive income.. 4,862 4,862
--------
Comprehensive income..... $333,334
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 (329
common shares)........... 3 14,527 (4,365)
Exercise of options (928
common shares)........... 9 16,764
Shares to cover employee
payroll tax withholdings
on stock issued under
benefit plans (174
common shares)........... (2) (9,328)
Tax benefits associated with
stock-based compensation
plans.................... 17,880
Amortization of unearned
compensation............. 4,093
Purchases of treasury stock
(2,355 common shares).... (141,334)
------------------------------------------------------------------------------
Balance,
September 30, 2003....... $1,061 $2,238,199 $287,700 $(3,604) $ (662) $(141,334)
==============================================================================
12
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
During the nine months ended September 30, 2003, 174 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 and were immediately retired.
In May 2003, the Company's Board of Directors authorized a share
repurchase program, which permits the Company to purchase up to $300 million of
its common stock. In October 2003, the Company's Board of Directors increased
the share repurchase authorization by an additional $300 million. Through
September 30, 2003, the Company has repurchased 2.4 million shares of its common
stock at an average price of $60.00 per share for a total of $141 million. At
September 30, 2003, $17 million of the purchases had not been settled and as
such are not included in "cash flows from financing activities" on the
consolidated statement of cash flows.
Changes in 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 Income (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)
6. SUPPLEMENTAL CASH FLOW & OTHER DATA
Three Months Ended Nine Months Ended
September 30, September 30,
------------------- -------------------
2003 2002 2003 2002
-------- -------- -------- --------
Depreciation expense........................ $ 36,473 $ 30,859 $107,354 $ 90,454
Interest expense............................ (14,580) (14,115) (45,758) (42,751)
Interest income............................. 108 727 511 1,772
-------- -------- -------- --------
Interest expense, net....................... (14,472) (13,388) (45,247) (40,979)
Interest paid............................... 22,455 21,720 55,000 52,224
Income taxes paid........................... 49,637 44,016 150,267 82,776
Businesses acquired:
Fair value of assets acquired............... $ 1,129 $ 9,593 $978,995 $559,540
Fair value of liabilities assumed........... 1,129 9,593 280,639 214,083
Non-cash financing activities:
Treasury stock purchases not settled........ $ 17,253 $ -- $ 17,253 $ --
Fair value of common stock issued to acquire
Unilab................................... -- -- 372,464 --
Fair value of converted options issued in
conjunction with the Unilab acquisition.. -- -- 8,452 --
7. 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.
14
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 September 30, 2003
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
--------- ---------- ------------- ------------ ------------
Net revenues............................... $199,163 $962,175 $113,763 $(53,880) $1,221,221
Operating costs and expenses:
Cost of services........................ 118,426 551,450 41,304 -- 711,180
Selling, general and administrative..... 17,602 223,405 55,398 (3,992) 292,413
Amortization of intangible assets....... 218 1,828 9 -- 2,055
Royalty (income) expense................ (73,098) 73,098 -- -- --
Other operating (income) expense, net... -- (2,217) 267 -- (1,950)
-------- -------- -------- -------- ----------
Total operating costs and expenses... 63,148 847,564 96,978 (3,992) 1,003,698
-------- -------- -------- -------- ----------
Operating income........................... 136,015 114,611 16,785 (49,888) 217,523
Non-operating expenses, net................ (15,953) (47,250) (1,455) 49,888 (14,770)
-------- -------- -------- -------- ----------
Income before taxes........................ 120,062 67,361 15,330 -- 202,753
Income tax expense......................... 49,813 26,945 5,971 -- 82,729
-------- -------- -------- -------- ----------
Income before equity earnings.............. 70,249 40,416 9,359 -- 120,024
Equity earnings from subsidiaries.......... 49,775 -- -- (49,775) --
-------- -------- -------- -------- ----------
Net income................................. $120,024 $ 40,416 $ 9,359 $(49,775) $ 120,024
======== ======== ======== ======== ==========
Condensed Consolidating Statement of Operations
Three Months Ended September 30, 2002
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
-------- ---------- ------------- ------------ ------------
Net revenues............................... $189,550 $816,044 $113,900 $(60,780) $1,058,714
Operating costs and expenses:
Cost of services........................ 120,666 468,855 35,554 -- 625,075
Selling, general and administrative..... 40,324 170,789 65,272 (3,798) 272,587
Amortization of intangible assets....... 424 1,599 -- -- 2,023
Royalty (income) expense................ (62,376) 62,376 -- -- --
Other operating (income) expense, net... 1,071 (245) 248 -- 1,074
-------- --------- -------- -------- ----------
Total operating costs and expenses... 100,109 703,374 101,074 (3,798) 900,759
-------- --------- -------- -------- ----------
Operating income........................... 89,441 112,670 12,826 (56,982) 157,955
Non-operating expenses, net................ (16,017) (51,351) (1,424) 56,982 (11,810)
-------- --------- -------- -------- ----------
Income before taxes........................ 73,424 61,319 11,402 -- 146,145
Income tax expense......................... 29,997 24,350 5,181 -- 59,528
-------- --------- -------- -------- ----------
Income before equity earnings.............. 43,427 36,969 6,221 -- 86,617
Equity earnings from subsidiaries.......... 43,190 -- -- (43,190) --
-------- --------- -------- -------- ----------
Net income................................. $ 86,617 $ 36,969 $ 6,221 $(43,190) $ 86,617
======== ======== ======== ======== ==========
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, 2003
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
--------- ---------- ------------- ------------ ------------
Net revenues............................... $ 594,443 $2,768,500 $349,472 $(178,462) $3,533,953
Operating costs and expenses:
Cost of services........................ 347,796 1,595,731 118,874 -- 2,062,401
Selling, general and administrative..... 54,874 656,213 168,365 (11,778) 867,674
Amortization of intangible assets....... 1,328 4,809 9 -- 6,146
Royalty (income) expense................ (213,063) 213,063 -- -- --
Other operating (income) expense, net... -- (2,224) 507 -- (1,717)
--------- ---------- -------- --------- -----------
Total operating costs and expenses... 190,935 2,467,592 287,755 (11,778) 2,934,504
--------- ---------- -------- --------- ----------
Operating income........................... 403,508 300,908 61,717 (166,684) 599,449
Non-operating expenses, net................ (50,792) (156,115) (4,274) 166,684 (44,497)
--------- ---------- -------- --------- ----------
Income before taxes........................ 352,716 144,793 57,443 -- 554,952
Income tax expense......................... 144,932 57,917 23,631 -- 226,480
--------- ---------- -------- --------- ----------
Income before equity earnings.............. 207,784 86,876 33,812 -- 328,472
Equity earnings from subsidiaries.......... 120,688 -- -- (120,688) --
--------- ---------- -------- --------- ----------
Net income................................. $ 328,472 $ 86,876 $ 33,812 $(120,688) $ 328,472
========= ========== ======== ========= ==========
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
Operating 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
Amortization of intangible assets....... 1,420 4,823 -- -- 6,243
Royalty (income) expense................ (186,533) 186,533 -- -- --
Other operating (income) expense, net... 2,930 (922) 893 -- 2,901
--------- ---------- -------- --------- ----------
Total operating costs and expenses... 307,491 2,025,547 308,424 (11,436) 2,630,026
--------- ---------- -------- --------- ----------
Operating income........................... 245,328 336,114 60,334 (197,516) 444,260
Non-operating expenses, net................ (56,254) (173,961) (6,421) 197,516 (39,120)
--------- ---------- -------- --------- ----------
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
========= ========== ======== ========= ==========
16
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Condensed Consolidating Balance Sheet
September 30, 2003
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
---------- ---------- ------------- ------------ ------------
Assets
Current assets:
Cash and cash equivalents .......................... $ 79,301 $ 3,167 $ 8,600 $ -- $ 91,068
Accounts receivable, net ........................... 18,493 185,915 439,432 -- 643,840
Other current assets ............................... 56,588 95,800 84,706 -- 237,094
---------- ---------- --------- ----------- ----------
Total current assets ............................ 154,382 284,882 532,738 -- 972,002
Property, plant and equipment, net ................. 225,996 337,961 28,142 -- 592,099
Intangible assets, net ............................. 158,151 2,332,807 45,419 -- 2,536,377
Intercompany receivable (payable) .................. 592,568 (166,188) (426,380) -- --
Investment in subsidiaries ......................... 1,907,899 -- -- (1,907,899) --
Other assets ....................................... 51,934 71,428 36,926 -- 160,288
---------- ---------- --------- ----------- ----------
Total assets .................................... $3,090,930 $2,860,890 $ 216,845 $(1,907,899) $4,260,766
========== ========== ========= =========== ==========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses .............. $ 346,983 $ 240,411 $ 29,866 $ -- $ 617,260
Short-term borrowings and current portion of
long-term debt .................................... -- 55,947 343 -- 56,290
---------- ---------- --------- ----------- ----------
Total current liabilities ....................... 346,983 296,358 30,209 -- 673,550
Long-term debt ..................................... 315,796 747,390 1,955 -- 1,065,141
Other liabilities .................................. 46,791 73,152 20,772 -- 140,715
Stockholders' equity ............................... 2,381,360 1,743,990 163,909 (1,907,899) 2,381,360
---------- ---------- --------- ----------- ----------
Total liabilities and stockholders' equity ...... $3,090,930 $2,860,890 $ 216,845 $(1,907,899) $4,260,766
========== ========== ========= =========== ==========
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
Short-term borrowings and 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
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
========== ========== ========= =========== ==========
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, 2003
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
--------- ---------- ------------- ------------ ------------
Cash flows from operating activities:
Net income ....................................... $ 328,472 $ 86,876 $ 33,812 $(120,688) $ 328,472
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization ................. 39,945 67,017 6,538 -- 113,500
Provision for doubtful accounts ............... 4,468 47,867 119,767 -- 172,102
Other, net .................................... (76,240) (6,874) 12,022 120,688 49,596
Changes in operating assets and liabilities ... (15,149) (140,340) (107,668) -- (263,157)
--------- --------- --------- --------- ---------
Net cash provided by operating activities ........ 281,496 54,546 64,471 -- 400,513
Net cash used in investing activities ............ (265,518) (62,282) (13,202) (20,642) (361,644)
Net cash (used in) provided by financing
activities .................................... (15,692) 3,526 (53,054) 20,642 (44,578)
--------- --------- --------- --------- ---------
Net change in cash and cash equivalents .......... 286 (4,210) (1,785) -- (5,709)
Cash and cash equivalents, beginning of period ... 79,015 7,377 10,385 -- 96,777
--------- --------- --------- --------- ---------
Cash and cash equivalents, end of period ......... $ 79,301 $ 3,167 $ 8,600 $ -- $ 91,068
========= ========= ========= ========= =========
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 period ... -- 110,571 11,761 -- 122,332
--------- --------- --------- --------- ---------
Cash and cash equivalents, end of period ......... $ 101,396 $ 3,736 $ 8,722 $ -- $ 113,854
========= ========= ========= ========= =========
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 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. In connection with the acquisition of Unilab,
as part of a settlement agreement with the United States Federal Trade
Commission, we entered into an agreement to sell to Laboratory Corporation of
America Holdings, Inc., certain assets in northern California, including the
assignment of agreements with four independent physician associations and leases
for 46 patient service centers (five of which also serve as rapid response
laboratories) for $4.5 million (the "Divestiture"). See Note 2 to the interim
consolidated financial statements for a full discussion of the Unilab
acquisition and the Divestiture.
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 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
implemented. 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 and Nine Months Ended September 30, 2003 Compared with Three and
Nine Months Ended September 30, 2002
Net income for the three months ended September 30, 2003 increased to
$120 million from $87 million for the prior year period. For the nine months
ended September 30, 2003, net income increased to $328 million from $240 million
for the prior year period. These increases in earnings were primarily
attributable to revenue growth and improved efficiencies generated from our Six
Sigma and standardization initiatives.
19
Net Revenues
Net revenues for the three months ended September 30, 2003 grew by
15.3% over the prior year level, driven by the acquisition of Unilab and by
continued strength in average revenue per requisition. Net revenues for the nine
months ended September 30, 2003 grew by 15.0% over the prior year level and
include the results of Unilab for seven months and American Medical
Laboratories, Incorporated ("AML"), which was acquired on April 1, 2002, for
nine months. Pro forma revenue growth, assuming that the Unilab and AML
acquisitions and the Divestiture had been completed on January 1, 2002, was 4.6%
and 3.7% for the three and nine months ended September 30, 2003, respectively,
compared to the prior year periods.
For both the three and nine months ended September 30, 2003, clinical
testing volume, measured by the number of requisitions, increased 10.8% compared
to the prior year periods. The acquisition of Unilab contributed about 12.5% and
10% to the overall volume growth during the three and nine months ended
September 30, 2003, respectively. The acquisition of AML contributed more than
2% to the overall volume growth during the nine months ended September 30, 2003.
Hurricane Isabel and the blackout on the East Coast negatively impacted volume
by approximately a quarter of a percentage point during the third quarter of
2003. The combined effect of the severe winter storms and the New Jersey
physicians' strike during the first quarter of 2003 and Hurricane Isabel and the
blackout in the third quarter of 2003 reduced year-to-date volume by
approximately half a percentage point for the nine months ended September 30,
2003. In addition, our drugs-of-abuse testing business, which is most directly
impacted by economic conditions, declined during the three and nine months ended
September 30, 2003, reducing company-wide volume growth by approximately 1% and
0.5%, respectively. Pro forma testing volume, assuming that the Unilab and AML
acquisitions and the Divestiture had been completed on January 1, 2002, declined
approximately 1.5% and 1.6% for the three and nine months ended September 30,
2003, respectively, compared to the prior year periods. Both reported volume
and pro forma volume for the three and nine months ended September 30, 2003,
have been impacted by general economic conditions, which have increased the
number of uninsured and unemployed, and we believe have reduced utilization of
healthcare services.
Average revenue per requisition improved 3.8% and 3.7% for the three
and nine months ended September 30, 2003, compared to the prior year periods,
primarily attributable to a continuing shift in test mix to higher value
testing, including gene-based testing, which continued to grow at approximately
a 20% rate over the prior year level. In addition, a shift in payer mix
contributed a portion of the increase in average revenue per requisition for
both the three and nine months ended September 30, 2003. The inclusion of
Unilab's results subsequent to February 28, 2003 reduced average revenue per
requisition by approximately 1.5% and 1% for the three and nine months ended
September 30, 2003, respectively, since Unilab's business has lower revenue per
requisition than the rest of our business.
Our businesses, other than clinical laboratory testing, which
represent approximately 4% of our consolidated net revenues, contributed about
0.7% and 0.5% to the reported growth in revenues for the three and nine months
ended September 30, 2003, respectively.
Operating Costs and Expenses
Total operating costs and expenses for the three and nine months ended
September 30, 2003 increased $103 million and $304 million, respectively, from
the prior year periods primarily due to increases in our clinical testing
volume, largely as a result of the Unilab acquisition, employee compensation and
benefits, supply costs and depreciation expense; partially offset by a reduction
in bad debt expense as a percentage of revenues. Total operating costs for the
nine months ended September 30, 2003 were also impacted by the AML acquisition.
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 58.2% of net revenues for the three months ended
September 30, 2003, decreasing from 59.0% of net revenues in the prior year
period. For the nine months ended September 30, 2003, cost of services, as a
percentage of net revenues, decreased to 58.4% from 59.0% in the prior year
period. These improvements were primarily the result of efficiency gains
resulting from our Six Sigma and standardization efforts and the increase in
average revenue per requisition. These improvements were partially offset by
initial installation costs of deploying our Internet-based orders and results
systems in physicians' offices. The increase in the number of orders and test
results reported via our Internet-based systems is improving the initial
collection of billing information which is reducing the cost of billing and bad
debt expense, both of which are components of selling, general and
administrative expenses. At September 30, 2003, approximately 20% of our orders
and approximately 25% of our test results were transmitted via the Internet.
20
Additionally, we are seeing an increase in the number of physicians who no
longer draw blood in their office, which is resulting in an increase in the
number of blood draws in our patient service centers. This shift has increased
our operating costs associated with our patient service centers, but is reducing
costs in accessioning and other parts of our operations due to improved billing
information and a reduction in the number of inadequate patient samples obtained
by our trained phlebotomists compared to samples collected in physicians'
offices.
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, 2003, as a percentage of net revenues, to 23.9% from 25.7% in the prior year
period. For the nine months ended September 30, 2003, selling, general and
administrative expenses decreased as a percentage of net revenues to 24.6% from
26.3% in the prior year period. These improvements were primarily due to
efficiencies from our Six Sigma and standardization efforts, in particular bad
debt expense, and the improvement in average revenue per requisition. During the
third quarter of 2003, bad debt expense improved to 4.8% of net revenues,
compared to 5.1% of net revenues in the prior year period. For the nine months
ended September 30, 2003, bad debt expense was 4.9% of net revenues, compared to
5.4% of net revenues in the prior year period. The reduction in bad debt expense
as a percentage of net revenues in both the three and nine months ended
September 30, 2003, occurred despite the addition of Unilab, which has higher
levels of bad debt than the rest of Quest Diagnostics. These improvements
primarily relate to the collection of diagnosis, patient and insurance
information necessary to more 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.
Amortization of intangible assets for the three and nine months ended
September 30, 2003 was comparable to the prior year periods.
Other operating (income) expense, net represents miscellaneous income
and expense items related to operating activities, such as gains and losses
associated with the disposal of operating assets. For the three and nine months
ended September 30, 2003, other operating (income) expense, net primarily
includes $3.3 million of gains on the sale of certain operating assets,
partially offset by a $1.1 million charge associated with the integration of
Unilab, primarily comprised of severance benefits for employees of Quest
Diagnostics. For the three and nine months ended September 30, 2002, other
operating (income) expense, net includes a $1.5 million charge associated with
the integration of AML, primarily comprised of severance benefits for employees
of Quest Diagnostics. In addition, other operating (income) expense, net for the
nine months ended September 30, 2002 includes the costs of a contract
settlement.
Operating Income
Operating income for the three months ended September 30, 2003
improved to $218 million, or 17.8% of net revenues, from $158 million, or 14.9%
of net revenues, in 2002. For the nine months ended September 30, 2003,
operating income improved to $599 million, or 17.0% of net revenues, from $444
million, or 14.5% of net revenues, in 2002. The increases in operating income
were primarily due to revenue growth and improved efficiencies generated from
our Six Sigma and standardization initiatives.
Other Income (Expense)
Net interest expense for the three and nine months ended September 30,
2003 increased from the prior year periods by $1.1 million and $4.3 million,
respectively, and was primarily attributable to the amounts borrowed to finance
the acquisition of Unilab and to repay substantially all of Unilab's outstanding
debt, partially offset by decreased amounts borrowed under our secured
receivables credit facility.
Other income (expense), net represents miscellaneous income and
expense items related to non-operating activities such as gains and losses
associated with investments and other non-operating assets. For the three and
nine months ended September 30, 2002, other income (expense), net includes a
$3.8 million gain on the sale of an investment, partially offset by losses on
miscellaneous non-operating assets.
21
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 and nine months ended September 30,
2003, the holders of the 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 three and nine months ended September 30, 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 September 30, 2003 and December 31, 2002, the fair value of our debt
was estimated at approximately $1.2 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
September 30, 2003 and December 31, 2002, the estimated fair value exceeded the
carrying value of the debt by approximately $75 million and $77 million,
respectively. An assumed 10% increase in interest rates (representing
approximately 50 and 60 basis points at September 30, 2003 and December 31,
2002, respectively) would potentially reduce the estimated fair value of our
debt by approximately $18 million and $21 million at September 30, 2003 and
December 31, 2002, respectively.
The Debentures have a contingent interest component that will require
us to pay contingent interest based on certain thresholds, as outlined in the
indenture governing the Debentures. 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 September 30, 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 September
30, 2003, our borrowing rate for LIBOR-based loans was LIBOR plus 1.1875%. At
September 30, 2003, there was $323 million outstanding under our term loan and
there were no borrowings outstanding under our unsecured revolving credit
facility or 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 11 basis points) would impact annual net interest expense by
approximately $0.4 million, assuming no changes to the debt outstanding at
September 30, 2003.
Liquidity and Capital Resources
Cash and Cash Equivalents
Cash and cash equivalents at September 30, 2003 totaled $91 million,
compared to $97 million at December 31, 2002. Cash flows from operating
activities for the nine months ended September 30, 2003 provided cash of $401
million, which together with cash on-hand were used to fund investing and
financing activities, which required cash of $362 million and $45 million,
respectively. Cash and cash equivalents at September 30, 2002 totaled $114
million, a decrease of $8 million from December 31, 2001. Cash flows from
operating activities for the nine months ended September 30, 2002 provided cash
of $350 million, which together with cash flows from financing activities of $81
million and cash on-hand, were used to fund investing activities, which required
cash of $440 million.
22
Cash Flows From Operating Activities
Net cash provided by operating activities for the nine months ended
September 30, 2003 was $401 million compared to $350 million in the prior year
period. This increase was primarily due to improved operating performance,
partially offset by an increase in net working capital, which was principally
due to an increase in accounts receivable associated with growth in revenues.
Days sales outstanding, a measure of billing and collection efficiency, improved
to 48 days at September 30, 2003 from 51 days at September 30, 2002.
Cash Flows From Investing Activities
Net cash used in investing activities for the nine months ended
September 30, 2003 was $362 million, consisting primarily of acquisition and
related transaction costs of $238 million to acquire the outstanding capital
stock of Unilab, and capital expenditures of $122 million. The acquisition and
related transaction costs included the cash portion of the Unilab purchase price
of $297 million and approximately $12 million of transaction costs paid in 2003,
partially offset by $72 million of cash acquired from Unilab. Net cash used in
investing activities for the nine months ended September 30, 2002 was $440
million, consisting primarily of acquisition and related costs of $334 million
to acquire the outstanding voting stock of AML, and capital expenditures of $118
million.
Cash Flows From Financing Activities
Net cash used in financing activities for the nine months ended
September 30, 2003 was $45 million, consisting primarily of $450 million of
borrowings under our term loan facility, partially offset by debt repayments
totaling $373 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, which was completed on March 7, 2003, for all
of the outstanding $101 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 2003 consisted
primarily of $127 million of repayments under our term loan facility and $24
million of capital lease repayments. In addition, during the nine months ended
September 30, 2003, we repurchased 2.4 million shares of our common stock at an
average price of $60.00 per share for a total of $141 million. At September 30,
2003, $17 million of the purchases had not been settled and as such are not
included in "cash flows from financing activities" on the consolidated statement
of cash flows.
Net cash provided by financing activities for the nine months ended
September 30, 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. 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, was financed by us 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.
Dividend Policy
Through September 30, 2003, we have never declared or paid cash
dividends on our common stock. On October 21, 2003, we announced that our Board
of Directors had approved the payment of a quarterly cash dividend of $0.15 per
common share. The initial quarterly dividend will be payable on January 23, 2004
to shareholders of record on January 8, 2004. We expect to fund the dividend
payment with cash flows from operations, and do not expect the dividend to have
a material impact on our ability to finance future growth.
Share Repurchase Plan
In May 2003, our Board of Directors authorized a share repurchase
program, which permits us to purchase up to $300 million of our common stock. In
October 2003, our Board of Directors increased our share repurchase
authorization by an additional $300 million. Through September 30, 2003, we have
repurchased 2.4 million shares of our common stock at an average price of $60.00
per share for a total of $141 million under the program. We expect to fund the
share repurchase program with cash flows from operations. We do not expect the
share repurchase program to have a material impact on our ability to finance
future growth.
23
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 repayment of substantially all of Unilab's outstanding debt, is
contained in Note 2 to the interim consolidated financial statements. On June
27, 2003, we extended the expiration date of the back-up facilities of our
secured receivables credit facility from July 21, 2003 to April 21, 2004. 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 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 September 30, 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 $170 million to $180
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 $50 million at September 30, 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 September 30, 2003.
We believe that cash flows 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, cash dividends on common shares, share repurchases and additional
growth opportunities for the foreseeable future, exclusive of any potential
temporary impact of the Health Insurance Portability and Accountability Act of
1996, as discussed below. Our investment grade credit ratings have had a
favorable impact on our cost of and access to capital, and 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.
Health Insurance Portability and Accountability Act of 1996
The Secretary of the Department of Human Health and Services, or HHS,
has issued final regulations under the Health Insurance Portability and
Accountability Act of 1996 ("HIPAA"), designed to improve the efficiency and
effectiveness of the health care system by facilitating the electronic exchange
of information in certain financial and administrative transactions while
protecting the privacy and security of the information exchanged. Three
principal regulations have been issued: privacy regulations, security
regulations, and standards for electronic transactions.
We implemented the HIPAA privacy regulations by April 2003, as
required, and are conducting an analysis to determine the proper security
measures to reasonably and appropriately implement the standards and
implementation specifications of the security regulations by the compliance
deadline of April 20, 2005.
24
The HIPAA regulations on electronic transactions, which we refer to as
the transaction standards, establish uniform standards for electronic
transactions and code sets, including the electronic transactions and code sets
used for claims, remittance advices, enrollment and eligibility. The transaction
standards became effective in October 2002, although covered entities were
eligible to obtain a one-year extension if approved through an application to
the Secretary of HHS. We received this one-year extension through October 16,
2003 from HHS.
The HIPAA transaction standards are complex, and subject to
differences in interpretation by payers. For instance, certain types of
information, including demographic information not usually provided to us by
physicians, could be required by certain payers. As a result of inconsistent
application of requirements or inability to obtain billing information, we could
face increased costs and complexity, a temporary disruption in receipts and
ongoing reductions in reimbursements and net revenues. We are working closely
with our payers to establish acceptable requirements for claims submissions and
with our trade association and an industry coalition to present issues and
problems as they arise to the appropriate regulators and standards setting
organizations.
HHS issued Guidance on July 24, 2003 stating that it will not penalize
a covered entity for post-implementation date transactions that are not fully
compliant with the transactions standards, if the covered entity can demonstrate
its good faith efforts to comply with the standards. HHS' stated purpose for
this flexible enforcement position was to "permit health plans to mitigate
unintended adverse effects on covered entities' cash flow and business
operations during the transition to the standards, as well as on the
availability and quality of patient care."
On September 23, 2003, The Centers for Medicare and Medicaid Services
("CMS") announced that it will implement a contingency plan for the Medicare
program to accept electronic transactions that are not fully compliant with the
transaction standards after the October 16, 2003 compliance deadline. CMS'
contingency plan allows Medicare carriers to continue to accept and process
Medicare claims in the traditional electronic formats now in use in order to
give its healthcare providers additional time to complete the testing process,
provided they are making a good faith effort to comply with the new standards.
As part of its plan, CMS is expected to regularly reassess the readiness of its
healthcare providers to determine how long the contingency plan will remain in
effect.
In its announcement, CMS encouraged other payers to assess the
readiness of their trading partners and to implement contingency plans, if
appropriate. A number of other major payers have announced they intend to follow
CMS' lead, but we cannot assure you that all payers will develop similar
contingency plans. Many of our payers were not ready to implement the
transaction standards by the October 2003 compliance deadline and many payers
were not ready to test or trouble-shoot claims submissions. We are
working with our payers in good faith to reach agreement on each payer's data
requirements and to test claims submissions, while, at the same time,
implementing contingency plans to minimize the potential impact in cases where
payers have not been successfully converted to the new standards as of the
October 2003 compliance deadline. At this time, we cannot estimate the potential
impact of implementing (or failing to implement) the HIPAA transaction standards
on our cash flows and results of operations.
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". In January 2003, the FASB issued
Interpretation No. 46, "Consolidation of Variable Interest Entities". In April
2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative
Instruments and Hedging Activities". In May 2003, the FASB issued SFAS No. 150,
"Accounting for Certain Instruments with Characteristics of both Liabilities and
Equity".
The impact of the above referenced accounting standards is discussed
in Note 1 to the interim consolidated financial statements.
25
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 (the "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.
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, payers,
suppliers and strategic partners, competitive environment, changes in government
regulations, conditions of the economy and other factors described in our 2002
Annual Report on Form 10-K and subsequent filings.
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
(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-15(e) and
15d-15(e) of the Securities Exchange Act of 1934, as amended) as of
the end of the period covered by 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) During the quarterly period covered by this report, there were no
changes in our internal control over financial reporting that have
materially affected, or are reasonably likely to materially affect,
our internal control over financial reporting.
26
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 Second Amended and Restated Credit and Security Agreement dated
as of September 30, 2003 among Quest Diagnostics Receivables
Inc., as Borrower, Quest Diagnostics Incorporated, as Servicer,
each of the lenders party thereto and Wachovia Bank, National
Association, as Administrative Agent
10.2 Amended and Restated Receivables Sale Agreement dated as of
September 30, 2003 among Quest Diagnostics Incorporated and each
of its direct or indirect wholly-owned subsidiaries who is or
hereafter becomes a seller hereunder, as the Sellers, and Quest
Diagnostics Receivables Inc., as the Buyer
31.1 Certification of Chief Executive Officer Pursuant to Section 302
of the Sarbanes-Oxley Act of 2002
31.2 Certification of Chief Financial Officer Pursuant to Section 302
of the Sarbanes-Oxley Act of 2002
32.1 Certification of Chief Executive Officer Pursuant to 18
U.S.C. 'SS' 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer Pursuant to 18
U.S.C. 'SS' 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K filed during the third quarter of 2003:
None.
27
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, 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
28
STATEMENT OF DIFFERENCES
The section symbol shall be expressed as............................... 'SS'