SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarter ended March 31, 2003
Commission file number 1-12215
Quest Diagnostics Incorporated
One Malcolm Avenue
Teterboro, NJ 07608
(201) 393-5000
Delaware
(State of Incorporation)
16-1387862
(I.R.S. Employer Identification Number)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [_]
As of April 28, 2003, there were outstanding 105,333,961 shares of Common Stock, $.01 par value.
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Index to consolidated financial statements filed as part of this report:
Page
----
Consolidated Statements of Operations for the
Three Months Ended March 31, 2003 and 2002 2
Consolidated Balance Sheets as of
March 31, 2003 and December 31, 2002 3
Consolidated Statements of Cash Flows for the
Three Months Ended March 31, 2003 and 2002 4
Notes to Consolidated Financial Statements 5
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Management's Discussion and Analysis of Financial Condition and Results of
Operations 16
Item 3. Quantitative and Qualitative Disclosures About Market Risk
See Item 2. "Management's Discussion and Analysis of Financial Condition
and Results of Operations"
Item 4. Controls and Procedures
Controls and Procedures 21
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QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002
(in thousands, except per share data)
(unaudited)
2003 2002
---------- --------
Net revenues .......................................... $1,092,797 $946,762
---------- --------
Costs and expenses:
Cost of services ................................... 648,097 557,738
Selling, general and administrative ................ 279,199 258,403
Interest expense, net .............................. 13,909 12,675
Amortization of intangible assets .................. 2,023 2,155
Minority share of income ........................... 3,803 3,882
Other, net ......................................... (3,028) (614)
---------- --------
Total ........................................... 944,003 834,239
---------- --------
Income before taxes ................................... 148,794 112,523
Income tax expense .................................... 60,758 45,834
---------- --------
Net income ............................................ $ 88,036 $ 66,689
========== ========
Basic earnings per common share:
Net income............................................. $ 0.88 $ 0.70
========== ========
Diluted earnings per common share:
Net income............................................. $ 0.86 $ 0.67
========== ========
Weighted average common shares
outstanding - basic ................................ 100,037 95,422
Weighted average common shares
outstanding - diluted .............................. 102,455 99,307
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The accompanying notes are an integral part of these statements.
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
MARCH 31, 2003 AND DECEMBER 31, 2002
(in thousands, except per share data)
(unaudited)
March 31, December 31,
2003 2002
---------- ------------
Assets
Current assets:
Cash and cash equivalents...................................... $ 55,597 $ 96,777
Accounts receivable, net of allowance of $197,380 and $193,456
at March 31, 2003 and December 31, 2002, respectively....... 613,638 522,131
Inventories.................................................... 67,068 60,899
Deferred income taxes.......................................... 116,386 102,700
Prepaid expenses and other current assets...................... 54,231 41,936
---------- ----------
Total current assets........................................ 906,920 824,443
Property, plant and equipment, net................................ 583,303 570,149
Goodwill, net..................................................... 2,516,432 1,788,850
Intangible assets, net............................................ 21,193 22,083
Deferred income taxes............................................. 64,658 29,756
Other assets...................................................... 93,789 88,916
---------- ----------
Total assets...................................................... $4,186,295 $3,324,197
========== ==========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses.......................... $ 592,299 $ 609,945
Short-term borrowings and current portion of long-term debt.... 80,624 26,032
---------- ----------
Total current liabilities................................... 672,923 635,977
Long-term debt.................................................... 1,144,355 796,507
Other liabilities................................................. 125,942 122,850
Commitments and contingencies
Common stockholders' equity:
Common stock, par value $0.01 per share; 300,000 shares
authorized; 105,257 and 97,963 shares issued and outstanding
at March 31, 2003 and December 31, 2002, respectively....... 1,053 980
Additional paid-in capital..................................... 2,206,224 1,817,511
Retained earnings (accumulated deficit) ....................... 47,264 (40,772)
Unearned compensation.......................................... (6,686) (3,332)
Accumulated other comprehensive loss........................... (4,780) (5,524)
---------- ----------
Total common stockholders' equity........................... 2,243,075 1,768,863
---------- ----------
Total liabilities and stockholders' equity........................ $4,186,295 $3,324,197
========== ==========
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The accompanying notes are an integral part of these statements.
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002
(in thousands)
(unaudited)
2003 2002
--------- --------
Cash flows from operating activities:
Net income .......................................................... $ 88,036 $ 66,689
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation and amortization .................................... 36,701 30,310
Provision for doubtful accounts .................................. 54,629 55,315
Deferred income tax provision .................................... 10,046 4,894
Minority share of income ......................................... 3,803 3,882
Stock compensation expense ....................................... 1,536 2,457
Tax benefits associated with stock-based compensation plans ...... 5,637 19,226
Other, net ....................................................... (1,027) 394
Changes in operating assets and liabilities:
Accounts receivable ........................................... (84,316) (95,375)
Accounts payable and accrued expenses ......................... (96,236) (44,638)
Integration, settlement and other special charges ............. (4,898) (4,626)
Income taxes payable .......................................... 40,038 20,505
Other assets and liabilities, net ............................. 4,352 (6,179)
--------- --------
Net cash provided by operating activities ........................... 58,301 52,854
--------- --------
Cash flows from investing activities:
Business acquisitions, net of cash acquired ......................... (236,396) (1,275)
Capital expenditures ................................................ (37,481) (41,266)
Collection of note receivable ....................................... -- 10,660
Proceeds from disposition of assets ................................. 9 127
Increase in investments and other assets ............................ (2,628) (549)
--------- --------
Net cash used in investing activities ............................... (276,496) (32,303)
--------- --------
Cash flows from financing activities:
Proceeds from borrowings ............................................ 450,000 --
Repayments of debt .................................................. (268,987) (283)
Financing costs paid ................................................ (4,224) --
Distributions to minority partners .................................. (3,002) (2,977)
Exercise of stock options ........................................... 2,799 9,879
Other ............................................................... 429 (75)
--------- --------
Net cash provided by financing activities ........................... 177,015 6,544
--------- --------
Net change in cash and cash equivalents ............................. (41,180) 27,095
Cash and cash equivalents, beginning of period ...................... 96,777 122,332
--------- --------
Cash and cash equivalents, end of period ............................ $ 55,597 $149,427
========= ========
Cash paid during the period for:
Interest ............................................................ $ 27,111 $ 22,284
Income taxes ........................................................ 7,198 1,230
Businesses acquired:
Fair value of assets acquired ....................................... $ 972,764 $ --
Fair value of liabilities assumed ................................... 275,349 --
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The accompanying notes are an integral part of these statements.
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, unless otherwise indicated)
(unaudited)
1. BASIS OF PRESENTATION
Background
Quest Diagnostics Incorporated and its subsidiaries ("Quest Diagnostics" or the "Company") is the largest clinical laboratory testing business in the United States. As the nation's leading provider of diagnostic testing and related services for the healthcare industry, Quest Diagnostics offers a broad range of clinical laboratory testing services to physicians, hospitals, managed care organizations, employers, governmental institutions and other independent clinical laboratories. Quest Diagnostics is the leading provider of esoteric testing, including gene-based testing, and testing for drugs of abuse. The Company is also a leading provider of anatomic pathology services and testing to support clinical trials of new pharmaceuticals worldwide. Through the Company's national network of laboratories and patient service centers, and its esoteric testing laboratory and development facilities, Quest Diagnostics offers comprehensive and innovative diagnostic testing, information and related services used by physicians and other healthcare customers to diagnose, treat and monitor diseases and other medical conditions.
On an annualized basis, Quest Diagnostics processes over 130 million requisitions through its extensive network of laboratories and patient service centers in virtually every major metropolitan area throughout the United States.
Basis of Presentation
The interim consolidated financial statements reflect all adjustments which, in the opinion of management, are necessary for a fair statement of financial condition and results of operations for the periods presented. Except as otherwise disclosed, all such adjustments are of a normal recurring nature. The interim consolidated financial statements have been compiled without audit. Operating results for the interim periods are not necessarily indicative of the results that may be expected for the full year. These interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in the Company's 2002 Annual Report on Form 10-K.
Earnings Per Share
Basic earnings per common share is calculated by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per common share is calculated by dividing net income by the weighted average number of common shares outstanding after giving effect to all potentially dilutive common shares outstanding during the period. The if-converted method is used in determining the dilutive effect of the Company's 1 3/4% contingent convertible debentures in periods when the holders of such securities are permitted to exercise their conversion rights. Potentially dilutive common shares include outstanding stock options and restricted common shares granted under the Company's Employees Equity Participation Program. These dilutive securities increased the weighted average number of common shares outstanding by 2.4 and 3.9 million shares for the three months ended March 31, 2003 and 2002, respectively.
Stock-Based Compensation
The Company has chosen to adopt the disclosure only provisions of Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), as amended by SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment of FASB Statement No. 123" ("SFAS 148") and continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), and related interpretations. Under this approach, the cost of restricted stock awards is expensed over their vesting period, while the imputed cost of stock option grants and discounts offered under the Company's Employee Stock Purchase Plan ("ESPP") is disclosed, based on the vesting provisions of the individual grants, but not charged to expense. Stock-based compensation expense recorded in accordance with APB 25, related to restricted stock awards, was $1.5 million and $2.5 million for the three months ended March 31, 2003 and 2002, respectively.
The following table presents net income and basic and diluted earnings per common share, had the Company elected to recognize compensation cost based on the fair value at the grant dates for stock option awards and discounts
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
granted for stock purchases under the Company's ESPP, consistent with the method prescribed by SFAS 123, as amended by SFAS 148:
Three Months Ended
March 31,
-------------------
2003 2002
-------- --------
Net income:
Net income, as reported....................... $ 88,036 $ 66,689
Add: Stock-based compensation under APB 25.... 1,536 2,457
Deduct: Total stock-based compensation expense
determined under fair value method for all
awards, net of related tax effects......... (14,805) (10,501)
-------- --------
Pro forma net income.......................... $ 74,767 $ 58,645
======== ========
Earnings per common share:
Basic - as reported........................ $ 0.88 $ 0.70
-------- --------
Basic - pro forma.......................... $ 0.75 $ 0.61
-------- --------
Diluted - as reported...................... $ 0.86 $ 0.67
-------- --------
Diluted - pro forma........................ $ 0.74 $ 0.59
-------- --------
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The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions:
Three Months Ended
March 31,
------------------
2003 2002
---- -----
Dividend yield...................... 0.0% 0.0%
Risk-free interest rate............. 2.9% 4.1%
Expected volatility................. 48.1% 45.2%
Expected holding period, in years... 5 5
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New Accounting Standards
In April 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections" ("SFAS 145"). SFAS 145 rescinds SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt" ("SFAS 4"), SFAS No. 44, "Accounting for Intangible Assets of Motor Carriers" ("SFAS 44") and SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements" ("SFAS 64") and amends SFAS No. 13, "Accounting for Leases" ("SFAS 13"). This statement updates, clarifies and simplifies existing accounting pronouncements. As a result of rescinding SFAS 4 and SFAS 64, the criteria in APB Opinion No. 30, "Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions", is used to classify gains and losses from extinguishment of debt. SFAS 44 was no longer necessary because the transitions under the Motor Carrier Act of 1980 were completed. SFAS 13 was amended to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions and makes technical corrections to existing pronouncements. The provisions of SFAS 145 are effective for fiscal years beginning after May 15, 2002. The Company adopted SFAS 145 effective January 1, 2003. The adoption of SFAS 145 did not have a material impact on the Company's financial position and had no impact on the Company's consolidated statements of operations for the periods presented.
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" ("SFAS 146"), which addresses the recognition, measurement, and reporting of costs associated with exit or disposal activities, and supercedes Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)" ("EITF 94-3"). The principal difference between SFAS 146 and EITF 94-3 relates to the requirements for recognition of a liability for a cost associated with an exit or disposal activity. SFAS 146 requires that a liability for a cost associated with an exit or disposal activity, including those related to employee termination benefits and obligations under operating leases and other contracts, be recognized when the liability is incurred, and not necessarily the date of an entity's commitment to an exit plan, as under EITF 94-3. SFAS 146 also establishes that the initial measurement of a liability recognized under SFAS 146 be based on fair value. The provisions of SFAS 146 are effective for exit or disposal activities that are initiated after December 31, 2002. The Company adopted SFAS 146 effective January 1, 2003.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 requires a guarantor to recognize a liability, at the inception of the guarantee, for the fair value of obligations it has undertaken in issuing the guarantee and also include more detailed disclosures with respect to guarantees. FIN 45 is effective on a prospective basis for guarantees issued or modified starting January 1, 2003 and requires the additional disclosures in interim and annual financial statements effective for the period ended December 31, 2002. The Company's adoption of the initial recognition and measurement provisions of FIN 45 effective January 1, 2003, did not have a material impact on the Company's results of operations or financial position.
2. BUSINESS ACQUISITION
Acquisition of Unilab Corporation
On February 26, 2003, the Company accepted for payment more than 99% of the outstanding capital stock of Unilab Corporation ("Unilab"), the leading independent clinical laboratory in California. On February 28, 2003, the Company acquired the remaining shares of Unilab through a merger. In connection with the acquisition, the Company paid $297 million in cash and issued 7.1 million shares of Quest Diagnostics common stock to acquire all of the outstanding capital stock of Unilab. In addition, the Company reserved approximately 0.3 million shares of Quest Diagnostics common stock for outstanding stock options of Unilab which were converted upon the completion of the acquisition into options to acquire shares of Quest Diagnostics common stock (the "converted options").
The aggregate purchase price of $697 million included the cash portion of the purchase price of $297 million and transaction costs of approximately $19 million with the remaining portion of the purchase price paid through the issuance of 7.1 million shares of Quest Diagnostics common stock (valued at $372 million or $52.80 per share, based on the average closing stock price of Quest Diagnostics common stock for the five trading days ended March 4, 2003) and the issuance of approximately 0.3 million converted options (valued at approximately $9 million, based on the Black Scholes option-pricing model). Of the total transaction costs incurred, approximately $8 million was paid during fiscal 2002.
In conjunction with the acquisition of Unilab, the Company repaid $220 million of debt, representing substantially all of Unilab's then existing outstanding debt, and related accrued interest. Of the $220 million, $124 million represents payments related to the Company's cash tender offer which was completed on March 7, 2003, for all of the outstanding $100.8 million principal amount and related accrued interest of Unilab's 12 3/4% Senior Subordinated Notes due 2009 and $23 million of related tender premium and associated tender offer costs.
The Company financed the cash portion of the purchase price and related transaction costs, and the repayment of substantially all of Unilab's outstanding debt and related accrued interest with the proceeds from a new $450 million amortizing term loan facility (the "term loan") and cash on-hand. The term loan carries interest at LIBOR plus an applicable margin that can fluctuate over a range of up to 80 basis points, based on changes in the Company's credit rating. At the option of the Company, it may elect to enter into LIBOR-based interest rate contracts for periods up to 180 days. Interest on any outstanding amounts not covered under the LIBOR-based interest rate contracts is based on an alternate base rate, which is calculated by reference to the prime rate or federal funds rate. As of March 31, 2003, the Company's borrowing rate for LIBOR-based loans was LIBOR plus 1.3125%. The term loan requires principal repayments of the initial amount borrowed equal to 16.25%, 20%, 20%, 21.25% and 22.5% in years one through five, respectively. The term loan is guaranteed by each
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
of the Company's wholly owned subsidiaries that operate clinical laboratories in the United States. The term loan contains various covenants including the maintenance of certain financial ratios, which could impact the Company's ability to, among other things, incur additional indebtedness, repurchase shares of its outstanding common stock, make additional investments and consummate acquisitions.
As part of the acquisition, Quest Diagnostics acquired all of Unilab's operations, including its primary testing facilities in Los Angeles, San Jose and Sacramento, California, and approximately 365 patient service centers and 35 rapid response laboratories and approximately 4,100 employees. The Company expects to realize significant benefits from the acquisition of Unilab. As the leading independent clinical laboratory in California, the acquisition of Unilab positions the Company to capitalize on its leading position within the laboratory testing industry, further enhancing its national network and access to its comprehensive range of services.
In connection with the acquisition of Unilab, as part of a settlement agreement with the United States Federal Trade Commission, the Company entered into an agreement to sell to Laboratory Corporation of America Holdings, Inc., ("LabCorp"), certain assets in northern California, including the assignment of agreements with four independent physician associations ("IPA") and leases for 46 patient service centers (five of which also serve as rapid response laboratories) for $4.5 million (the "Divestiture"). Approximately $27 million in annual net revenues are generated by capitated fees under the IPA contracts and associated fee for service testing for physicians whose patients use these patient service centers, as well as from specimens received directly from the IPA physicians. None of these assets have yet been assigned to LabCorp. The Company expects to complete the transaction by August 2003.
The acquisition of Unilab was accounted for under the purchase method of accounting. As such, the cost to acquire Unilab has been allocated on a preliminary basis to the assets and liabilities acquired based on estimated fair values as of the closing date. The consolidated financial statements include the results of operations of Unilab subsequent to the closing of the acquisition.
The following table summarizes the Company's preliminary purchase price allocation related to the acquisition of Unilab based on the estimated fair value of the assets acquired and liabilities assumed on the acquisition date. The purchase price allocation will be finalized after completion of the valuation of certain assets and liabilities.
Estimated Fair
Values as of
February 28, 2003
-----------------
Current assets ............................................ $186,613
Property, plant and equipment ............................. 11,289
Goodwill .................................................. 730,143
Other assets .............................................. 44,719
--------
Total assets acquired .................................. 972,764
--------
Current liabilities ....................................... 54,058
Long-term debt ............................................ 221,291
--------
Total liabilities assumed .............................. 275,349
--------
Net assets acquired .................................... $697,415
========
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Based on management's review of the net assets acquired and consultations with third-party valuation specialists, no intangible assets meeting the criteria under SFAS No. 141, "Business Combinations", were identified. Of the $730 million allocated to goodwill, approximately $85 million is expected to be deductible for tax purposes.
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
The following unaudited pro forma combined financial information for the three months ended March 31, 2003 and 2002 assumes that Unilab and American Medical Laboratories, Incorporated, ("AML"), which the Company acquired on April 1, 2002, were acquired on January 1, 2002 (in thousands, except per share data):
Three Months Ended March 31,
----------------------------
2003 2002
---------- ----------
Net revenues ........................................... $1,167,226 $1,131,226
Net income ............................................. 97,156 75,759
Basic earnings per common share:
Net income ............................................. $ 0.93 $ 0.74
Weighted average common shares outstanding - basic ..... 104,583 102,476
Diluted earnings per common share:
Net income ............................................. $ 0.91 $ 0.71
Weighted average common shares outstanding - diluted ... 107,036 106,448
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The pro forma combined financial information presented above reflects certain reclassifications to the historical financial statements of Unilab and AML to conform the acquired companies' accounting policies and classification of certain costs and expenses to that of Quest Diagnostics. These adjustments had no impact on pro forma net income. No adjustment has been made to the pro forma combined financial information to reflect the impact of the Divestiture, which would not have a material impact on Quest Diagnostics' financial condition, results of operations or cash flow. Pro forma results for the three months ended March 31, 2003 exclude $14.5 million of direct transaction costs, which were incurred and expensed by Unilab immediately prior to the closing of the Unilab acquisition.
3. GOODWILL AND INTANGIBLE ASSETS
The changes in the carrying amount of goodwill, net for the period ended March 31, 2003 and for the year ended December 31, 2002 are as follows:
March 31, 2003 December 31, 2002
-------------- -----------------
Balance at beginning of period ........ $1,788,850 $1,351,123
Goodwill acquired during the period ... 727,582 437,727
---------- ----------
Balance at end of period .............. $2,516,432 $1,788,850
========== ==========
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Intangible assets at March 31, 2003 and December 31, 2002 consisted of the following:
Weighted March 31, 2003 December 31, 2002
Average -------------------------------- --------------------------------
Amortization Accumulated Accumulated
Period Cost Amortization Net Cost Amortization Net
------------ ------- ------------ ------- ------- ------------ -------
Non-compete agreements ... 5 years $44,782 $(33,708) $11,074 $44,482 $(32,268) $12,214
Customer lists ........... 15 years 42,035 (34,158) 7,877 41,301 (33,751) 7,550
Other .................... 10 years 4,580 (2,338) 2,242 4,580 (2,261) 2,319
------- -------- ------- ------- -------- -------
Total ................. 10 years $91,397 $(70,204) $21,193 $90,363 $(68,280) $22,083
======= ======== ======= ======= ======== =======
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QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Amortization expense related to intangible assets was $2,023 and $2,155 for the three months ended March 31, 2003 and 2002, respectively.
The estimated amortization expense related to intangible assets for each of the five succeeding fiscal years and thereafter as of March 31, 2003 is as follows:
Fiscal Year Ending
December 31,
---------------------------
Remainder of 2003.......... $ 5,894
2004....................... 6,329
2005....................... 2,872
2006....................... 1,758
2007....................... 1,008
2008....................... 761
Thereafter................. 2,571
-------
Total................... $21,193
=======
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4. COMMITMENTS AND CONTINGENCIES
The Company has standby letters of credit issued under its unsecured revolving credit facility to ensure its performance or payment to third parties, which amounted to $48 million and $33 million at March 31, 2003 and December 31, 2002, respectively. The letters of credit, which are renewed annually, primarily represent collateral for current and future automobile liability and workers' compensation loss payments.
The Company has entered into several settlement agreements with various governmental and private payers during recent years relating to industry-wide billing and marketing practices that had been substantially discontinued by early 1993. In addition, the Company is aware of several pending lawsuits filed under the qui tam provisions of the civil False Claims Act and has received notices of private claims relating to billing issues similar to those that were the subject of prior settlements with various governmental payers. Some of the proceedings against the Company involve claims that are substantial in amount. Some of the cases involve the operations of Unilab prior to the closing of the Unilab acquisition.
At March 31, 2003 recorded reserves, relating primarily to billing claims approximated $11 million. Although management believes that established reserves for both indemnified and non-indemnified claims are sufficient, it is possible that additional information (such as the indication by the government of criminal activity, additional tests being questioned or other changes in the government's or private claimants' theories of wrongdoing) may become available which may cause the final resolution of these matters to exceed established reserves by an amount which could be material to the Company's results of operations and cash flows in the period in which such claims are settled. The Company does not believe that these issues will have a material adverse effect on its overall financial condition.
In addition to the billing-related settlement reserves discussed above, the Company is involved in various legal proceedings arising in the ordinary course of business. Some of the proceedings against the Company involve claims that are substantial in amount. Although management cannot predict the outcome of such proceedings or any claims made against the Company, management does not anticipate that the ultimate outcome of the various proceedings or claims will have a material adverse effect on its financial position but may be material to the Company's results of operations and cash flows in the period in which such claims are resolved.
As a general matter, providers of clinical laboratory testing services may be subject to lawsuits alleging negligence or other similar legal claims. These suits could involve claims for substantial damages. Any professional liability litigation could also have an adverse impact on the Company's client base and reputation. The Company maintains various liability insurance programs for claims that could result from providing or failing to provide clinical laboratory testing services, including inaccurate testing results and other exposures. The Company's insurance coverage limits its maximum exposure on individual claims; however, the Company is essentially self-insured for a significant portion of these claims. The basis for claims reserves incorporates actuarially determined losses based upon the Company's historical and projected loss experience.
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Management believes that present insurance coverage and reserves are sufficient to cover currently estimated exposures. Although management cannot predict the outcome of any claims made against the Company, management does not anticipate that the ultimate outcome of any such proceedings or claims will have a material adverse effect on the Company's financial position but may be material to the Company's results of operations and cash flows in the period in which such claims are resolved.
5. COMMON STOCKHOLDERS' EQUITY
Changes in common stockholders' equity for the three months ended March 31, 2003 were as follows:
Retained Accumulated
Additional Earnings Other Compre-
Common Paid-In (Accumulated Unearned Comprehensive hensive
Stock Capital Deficit) Compensation Income (Loss) Income
------ ----------- ------------ ------------ ------------- --------
Balance,
December 31, 2002................. $ 980 $1,817,511 $(40,772) $(3,332) $(5,524)
Net income........................... 88,036 $88,036
Other comprehensive income........... 744 744
-------
Comprehensive income............... $88,780
Shares issued to acquire Unilab =======
(7,055 common shares).............. 71 372,393
Fair value of Unilab converted
options............................ 8,452
Issuance of common stock under
benefit plans (205 common
shares)........................... 2 8,095 (5,041)
Exercise of options (197 common
shares)........................... 2 2,797
Shares to cover employee payroll tax
withholdings on stock issued under
benefit plans (163
common shares).................... (2) (8,661)
Tax benefits associated with
stock-based compensation plans.... 5,637
Amortization of unearned
compensation...................... 1,687
------ ---------- -------- ------- -------
Balance,
March 31, 2003.................... $1,053 $2,206,224 $ 47,264 $(6,686) $(4,780)
====== ========== ======== ======= =======
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During the three months ended March 31, 2003, 163 thousand shares were surrendered to cover employee payroll tax withholdings related to the vesting of restricted stock. For reporting purposes, these shares were accounted for as treasury shares, which were immediately retired.
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Changes in common stockholders' equity for the three months ended March 31, 2002 were as follows:
Accumulated
Additional Other Compre-
Common Paid-In Accumulated Unearned Comprehensive hensive
Stock Capital Deficit Compensation Income (Loss) Income
------ ---------- ----------- ------------ ------------- -------
Balance,
December 31, 2001................. $960 $1,714,676 $(362,926) $(13,253) $(3,470)
Net income........................... 66,689 $66,689
Other comprehensive income........... 535 535
-------
Comprehensive income.............. $67,224
Issuance of common stock under =======
benefit plans (165 common
shares)........................... 2 10,751
Exercise of options (540 common
shares)........................... 5 9,874
Tax benefits associated with
stock-based compensation plans.... 19,226
Amortization of unearned
compensation...................... 2,529
---- ---------- --------- -------- -------
Balance,
March 31, 2002.................... $967 $1,754,527 $(296,237) $(10,724) $(2,935)
==== ========== ========= ======== =======
|
6. SUMMARIZED FINANCIAL INFORMATION
The Company's 6 3/4% senior notes due 2006, 7 1/2% senior notes due 2011 and 1 3/4% contingent convertible debentures due 2021 are guaranteed by each of the Company's wholly owned subsidiaries that operate clinical laboratories in the United States (the "Subsidiary Guarantors"). With the exception of Quest Diagnostics Receivables Incorporated (see paragraph below), the non-guarantor subsidiaries are primarily foreign and less than wholly owned subsidiaries.
In conjunction with the Company's receivables financing in July 2000, the Company formed a new wholly owned non-guarantor subsidiary, Quest Diagnostics Receivables Incorporated ("QDRI"). The Company and the Subsidiary Guarantors, with the exception of AML and Unilab, transfer all private domestic receivables (principally excluding receivables due from Medicare, Medicaid and other federal programs, and receivables due from customers of its joint ventures) to QDRI. QDRI utilizes the transferred receivables to collateralize the Company's secured receivables credit facility. The Company and the Subsidiary Guarantors provide collection services to QDRI. QDRI uses cash collections principally to purchase new receivables from the Company and the Subsidiary Guarantors.
The following condensed consolidating financial data illustrates the composition of the combined guarantors. Investments in subsidiaries are accounted for by the parent using the equity method for purposes of the supplemental consolidating presentation. Earnings (losses) of subsidiaries are therefore reflected in the parent's investment accounts and earnings. The principal elimination entries relate to investments in subsidiaries and intercompany balances and transactions. On April 1, 2002, Quest Diagnostics acquired AML, which has been included in the accompanying condensed consolidating financial data, subsequent to the closing of the acquisition, as a Subsidiary Guarantor. On February 28, 2003, Quest Diagnostics acquired Unilab, which has been included in the accompanying condensed consolidating financial data, subsequent to the closing of the acquisition, as a Subsidiary Guarantor.
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Condensed Consolidating Statement of Operations Three Months Ended March 31, 2003
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
-------- ---------- ------------- ------------ ------------
Net revenues................................ $191,631 $849,370 $112,980 $(61,184) $1,092,797
Costs and expenses:
Cost of services......................... 115,506 495,786 36,805 -- 648,097
Selling, general and administrative...... 19,227 207,039 56,757 (3,824) 279,199
Interest, net............................ 17,784 51,819 1,666 (57,360) 13,909
Amortization of intangible assets........ 289 1,734 -- -- 2,023
Royalty (income) expense................. (69,304) 69,304 -- -- --
Other, net............................... (484) 1,282 (23) -- 775
--------- -------- -------- -------- ----------
Total................................. 83,018 826,964 95,205 (61,184) 944,003
-------- -------- -------- -------- ----------
Income before taxes......................... 108,613 22,406 17,775 -- 148,794
Income tax expense.......................... 44,191 8,963 7,604 -- 60,758
-------- -------- -------- -------- ----------
Income before equity earnings............... 64,422 13,443 10,171 -- 88,036
Equity earnings from subsidiaries........... 23,614 -- -- (23,614) --
-------- -------- -------- -------- ----------
Net income.................................. $ 88,036 $ 13,443 $ 10,171 $(23,614) $ 88,036
======== ======== ======== ======== ==========
|
Condensed Consolidating Statement of Operations Three Months Ended March 31, 2002
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
-------- ---------- ------------- ------------ ------------
Net revenues................................ $168,208 $730,552 $120,939 $(72,937) $946,762
Costs and expenses:
Cost of services.......................... 119,948 405,068 32,722 -- 557,738
Selling, general and administrative....... 41,278 153,764 67,120 (3,759) 258,403
Interest, net............................. 18,178 60,943 2,732 (69,178) 12,675
Amortization of intangible assets......... 590 1,565 -- -- 2,155
Royalty (income) expense.................. (61,521) 61,521 -- -- --
Other, net................................ 2,994 (18) 292 -- 3,268
-------- -------- -------- -------- --------
Total.................................... 121,467 682,843 102,866 (72,937) 834,239
-------- -------- -------- -------- --------
Income before taxes......................... 46,741 47,709 18,073 -- 112,523
Income tax expense ......................... 23,270 15,391 7,173 -- 45,834
-------- -------- -------- -------- --------
Income before equity earnings............... 23,471 32,318 10,900 -- 66,689
Equity earnings from subsidiaries........... 43,218 -- -- (43,218) --
-------- -------- -------- -------- --------
Net income ................................. $ 66,689 $ 32,318 $ 10,900 $(43,218) $ 66,689
======== ======== ======== ======== ========
|
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Condensed Consolidating Balance Sheet
March 31, 2003
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
---------- ---------- ------------- ------------ ------------
Assets
Current assets:
Cash and cash equivalents...................... $ 42,968 $ 4,841 $ 7,788 $ -- $ 55,597
Accounts receivable, net....................... 14,117 154,624 444,897 -- 613,638
Other current assets........................... 57,366 105,813 74,506 -- 237,685
---------- ---------- --------- ----------- -----------
Total current assets........................ 114,451 265,278 527,191 -- 906,920
Property, plant and equipment, net............. 228,984 328,001 26,318 -- 583,303
Intangible assets, net ........................ 158,440 2,333,817 45,368 -- 2,537,625
Intercompany receivable (payable).............. 324,065 116,161 (440,226) -- --
Investment in subsidiaries..................... 2,084,853 -- -- (2,084,853) --
Other assets................................... 57,182 66,663 34,602 -- 158,447
---------- ---------- --------- ----------- -----------
Total assets................................ $2,967,975 $3,109,920 $ 193,253 $(2,084,853) $ 4,186,295
========== ========== ========= =========== ===========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses.......... $ 365,639 $ 200,094 $ 26,566 $ -- $ 592,299
Short-term borrowings and current portion of
long-term debt.............................. -- 80,281 343 -- 80,624
---------- ---------- --------- ----------- -----------
Total current liabilities................... 365,639 280,375 26,909 -- 672,923
Long-term debt................................. 315,403 826,998 1,954 -- 1,144,355
Other liabilities.............................. 43,858 63,432 18,652 -- 125,942
Common stockholders' equity.................... 2,243,075 1,939,115 145,738 (2,084,853) 2,243,075
---------- ---------- --------- ----------- -----------
Total liabilities and stockholders' equity.. $2,967,975 $3,109,920 $ 193,253 $(2,084,853) $ 4,186,295
========== ========== ========= =========== ===========
|
Condensed Consolidating Balance Sheet
December 31, 2002
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
---------- ---------- ------------- ------------ ------------
Assets
Current assets:
Cash and cash equivalents...................... $ 79,015 $ 7,377 $ 10,385 $ -- $ 96,777
Accounts receivable, net....................... 15,032 89,626 417,473 -- 522,131
Other current assets........................... 52,952 63,148 89,435 -- 205,535
---------- ---------- --------- ----------- -----------
Total current assets........................ 146,999 160,151 517,293 -- 824,443
Property, plant and equipment, net............. 227,263 317,243 25,643 -- 570,149
Intangible assets, net ........................ 159,293 1,607,767 43,873 -- 1,810,933
Intercompany receivable (payable).............. 194,874 236,752 (431,626) -- --
Investment in subsidiaries..................... 1,631,868 -- -- (1,631,868) --
Other assets................................... 61,653 26,905 30,114 -- 118,672
---------- ---------- --------- ----------- -----------
Total assets................................ $2,421,950 $2,348,818 $ 185,297 $(1,631,868) $ 3,324,197
========== ========== ========= =========== ===========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses.......... $ 295,479 $ 287,539 $ 26,927 $ -- $ 609,945
Current portion of long-term debt.............. -- 25,689 343 -- 26,032
---------- ---------- --------- ----------- -----------
Total current liabilities................... 295,479 313,228 27,270 -- 635,977
Long-term debt................................. 315,109 478,863 2,535 -- 796,507
Other liabilities.............................. 42,499 62,339 18,012 -- 122,850
Common stockholders' equity.................... 1,768,863 1,494,388 137,480 (1,631,868) 1,768,863
---------- ---------- --------- ----------- -----------
Total liabilities and stockholders' equity.. $2,421,950 $2,348,818 $ 185,297 $(1,631,868) $ 3,324,197
========== ========== ========= =========== ===========
|
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(in thousands, unless otherwise indicated)
(unaudited)
Condensed Consolidating Statement of Cash Flows Three Months Ended March 31, 2003
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
--------- ---------- ------------- ------------ ------------
Cash flows from operating activities:
Net income...................................... $ 88,036 $ 13,443 $ 10,171 $ (23,614) $ 88,036
Adjustments to reconcile net income to net
cash provided by (used in) operating
activities:
Depreciation and amortization................ 13,417 21,306 1,978 -- 36,701
Provision for doubtful accounts.............. 1,757 11,184 41,688 -- 54,629
Other, net................................... (7,421) (5,913) 9,715 23,614 19,995
Changes in operating assets and liabilities.. 7,536 (85,134) (63,462) -- (141,060)
--------- -------- -------- --------- ---------
Net cash provided by (used in) operating
activities................................... 103,325 (45,114) 90 -- 58,301
Net cash used in investing activities........... (546,659) (20,633) (4,334) 295,130 (276,496)
Net cash provided by financing activities....... 407,287 63,211 1,647 (295,130) 177,015
--------- -------- -------- --------- ---------
Net change in cash and cash equivalents......... (36,047) (2,536) (2,597) -- (41,180)
Cash and cash equivalents, beginning of period.. 79,015 7,377 10,385 -- 96,777
--------- -------- -------- --------- ---------
Cash and cash equivalents, end of period........ $ 42,968 $ 4,841 $ 7,788 $ -- $ 55,597
========= ======== ======== ========= =========
|
Condensed Consolidating Statement of Cash Flows Three Months Ended March 31, 2002
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
--------- ---------- ------------- ------------ ------------
Cash flows from operating activities:
Net income...................................... $ 66,689 $ 32,318 $ 10,900 $(43,218) $ 66,689
Adjustments to reconcile net income to net
cash provided by (used in) operating
activities:
Depreciation and amortization................ 11,351 17,600 1,359 -- 30,310
Provision for doubtful accounts.............. 1,729 4,243 49,343 -- 55,315
Other, net................................... (25,908) 8,354 5,189 43,218 30,853
Changes in operating assets and liabilities.. (51,955) (609) (77,749) -- (130,313)
--------- -------- -------- -------- ---------
Net cash provided by (used in) operating
activities................................... 1,906 61,906 (10,958) -- 52,854
Net cash used in investing activities........... (11,620) (30,374) (533) 10,224 (32,303)
Net cash provided by (used in) financing
activities................................... 9,714 (192) 7,246 (10,224) 6,544
--------- -------- -------- -------- ---------
Net change in cash and cash equivalents......... -- 31,340 (4,245) -- 27,095
Cash and cash equivalents, beginning of period.. -- 110,571 11,761 -- 122,332
--------- -------- -------- -------- ---------
Cash and cash equivalents, end of period........ $ -- $141,911 $ 7,516 $ -- $ 149,427
========= ======== ======== ======== =========
|
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Critical Accounting Policies
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions and select accounting policies that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
While many operational aspects of our business are subject to complex federal, state and local regulations, the accounting for our business is generally straightforward with net revenues primarily recognized upon completion of the testing process. Our revenues are primarily comprised of a high volume of relatively low dollar transactions, and about half of all our costs and expenses consist of employee compensation and benefits. Due to the nature of our business, several of our accounting policies involve significant estimates and judgments. These accounting policies have been described in our 2002 Annual Report on Form 10-K.
Acquisition of Unilab Corporation
On February 26, 2003, we accepted for payment more than 99% of the outstanding capital stock of Unilab Corporation ("Unilab"), the leading independent clinical laboratory in California. On February 28, 2003, we acquired the remaining shares of Unilab through a merger. In connection with the acquisition, we paid $297 million in cash and issued 7.1 million shares of Quest Diagnostics common stock to acquire all of the outstanding capital stock of Unilab. In addition, we reserved approximately 0.3 million shares of Quest Diagnostics common stock for outstanding stock options of Unilab which were converted upon the completion of the acquisition into options to acquire shares of Quest Diagnostics common stock (the "converted options"). See Note 2 to the interim consolidated financial statements for a full discussion of the Unilab acquisition.
We estimate that we will incur up to $20 million of costs to integrate Quest Diagnostics and Unilab. A significant portion of these costs is expected to require cash outlays and is expected to primarily relate to severance and other integration-related costs through the first half of 2005, including the elimination of excess capacity and workforce reductions. These estimates are preliminary and will be subject to revisions as detail integration plans are developed and finalized. To the extent that the costs relate to actions that impact the employees and operations of Unilab, such costs will be accounted for as a cost of the Unilab acquisition and included in goodwill. To the extent that the costs relate to actions that impact Quest Diagnostics' employees and operations, such costs will be accounted for as a charge to earnings in the periods that the related actions are taken. Upon completion of the Unilab integration, we expect to realize approximately $25 million to $30 million of annual synergies and we expect to achieve this annual rate of synergies by the end of 2005.
Results of Operations
Three Months Ended March 31, 2003 Compared with Three Months Ended March 31, 2002
Net income for the three months ended March 31, 2003 increased to $88 million from $67 million for the prior year period. This increase in earnings was primarily attributable to revenue growth and improved efficiencies generated from our Six Sigma and Standardization initiatives. These improvements were partially offset by the impact of severe winter weather and the recent strike by New Jersey physicians during the first quarter of 2003, as well as increases in employee compensation and benefit costs and investments in our information technology strategy.
Net Revenues
Net revenues for the three months ended March 31, 2003 grew by 15.4% over the prior year level and include the results of Unilab for one month and American Medical Laboratories, Incorporated ("AML") for the full quarter, which was acquired on April 1, 2002. Pro forma revenue growth, assuming that both Unilab and AML had been part of Quest Diagnostics since January 1, 2002, was 3.2%.
For the three months ended March 31, 2003, clinical testing volume, measured by the number of requisitions, increased 11.9% compared to the prior year period. The impact of AML and Unilab contributed about 8% and 5%, respectively, to the overall volume growth during the first quarter of 2003. Severe winter storms and the New Jersey physicians' strike, reduced volume by approximately 1.6% for the quarter, compared to the prior year period. Pro forma testing volume, assuming that both Unilab and AML had been part of Quest Diagnostics since January 1, 2002, declined
approximately 1% compared to the prior year period, reflecting the impact of the severe winter storms and the physicians' strike. In addition, our drugs-of-abuse testing business, which is most directly impacted by economic conditions, declined during the quarter, reducing company-wide volume growth by approximately half a percentage point.
Average revenue per requisition increased 3.6% for the quarter, compared to the prior year period, primarily attributable to a continuing shift in test mix to higher value testing, including gene-based testing, which continued to grow at a rate greater than 20% over the prior year level. In addition, a shift in payer mix contributed a portion of the increase in revenue per requisition. The inclusion of Unilab's results for one month during the quarter reduced average revenue per requisition by approximately half a percentage point since Unilab's business has lower revenue per requisition than the rest of our business.
Operating Costs and Expenses
Total operating costs for the three months ended March 31, 2003 increased $111 million from the prior year period primarily due to increases in our clinical testing volume, largely as a result of the Unilab and AML acquisitions, employee compensation and benefits, supply costs and depreciation expense; partially offset by a reduction in bad debt expense. While our cost structure has been favorably impacted by the improved efficiencies generated from our Six Sigma and Standardization initiatives, we continue to make investments to enhance our infrastructure to pursue our overall business strategy.
Cost of services, which includes the costs of obtaining, transporting and testing specimens was 59.3% of net revenues for the three months ended March 31, 2003, increasing slightly from 58.9% in the prior year period. The addition of AML's higher cost of services as of April 1, 2002, which increased cost of services as a percentage of net revenues, was partially offset by the positive impact of our Six Sigma and Standardization efforts and the increase in average revenue per requisition. Additionally, reflected in the cost of services are the one-time installation costs of deploying our Internet-based orders and results systems in physicians' offices. The increased use of the Internet for ordering and resulting are improving the initial collection of billing information and generating savings in the cost of billing and bad debt expense, both of which are components of selling, general and administrative expenses. The severe winter storms and the New Jersey physicians' strike, which reduced volume growth during the quarter, also had the impact of increasing cost of sales as a percentage of revenues, since generally there were no reductions of fixed costs associated with the decreased volume. The estimated impact during the quarter was to increase cost of sales as a percentage of revenues by 0.4%.
Selling, general and administrative expenses, which include the costs of the sales force, billing operations, bad debt expense and general management and administrative support, decreased during the three months ended March 31, 2003 as a percentage of net revenues to 25.5% from 27.3% in the prior year period. The decrease was primarily due to efficiencies from our Six Sigma and Standardization efforts, in particular bad debt expense, the improvement in average revenue per requisition and the addition of AML's cost structure as of April 1, 2002. During the first quarter of 2003, bad debt expense improved to 5.0% of net revenues, compared to 5.8% of net revenues a year ago, despite the addition of Unilab, which has higher levels of bad debt than the rest of Quest Diagnostics. The improvement in bad debt expense was principally attributable to the continued progress that we have made in our overall collection experience through process improvements, driven by our Six Sigma and Standardization initiatives. These improvements primarily relate to the collection of diagnosis, patient and insurance information necessary to effectively bill for services performed. We believe that our Six Sigma and Standardization initiatives will provide additional opportunities to further improve our overall collection experience and cost structure. The severe winter storms and the New Jersey physicians' strike, which reduced volume growth during the quarter, also had the impact of increasing selling, general and administrative expenses as a percentage of revenues, since generally there were no reductions of fixed costs associated with the decreased volume. The estimated impact during the quarter was to increase selling, general and administrative expenses as a percentage of revenues by 0.3%.
Interest, Net
Net interest expense for the three months ended March 31, 2003 increased from the prior year period by $1.2 million primarily attributable to the amounts borrowed to finance the acquisition of Unilab and to repay substantially all of Unilab's outstanding debt.
Amortization of Intangible Assets
Amortization of intangible assets for the three months ended March 31, 2003 decreased slightly from the prior year period principally as the result of certain intangible assets becoming fully amortized during the remainder of 2002.
Other, Net
"Other, net", which represents income for each of the periods presented, and includes equity earnings from our unconsolidated joint ventures and miscellaneous gains and losses, increased $2.4 million for the three months ended March 31, 2003, compared to the prior year period. The increase was primarily due to the cost of a contract settlement which was recorded in the prior year quarter.
Impact of Contingent Convertible Debentures on Diluted Earnings per Common Share
The if-converted method is used in determining the dilutive effect of our 1 3/4% contingent convertible debentures due 2021 (the "Debentures") in periods when the holders of such securities are permitted to exercise their conversion rights. As of and for the three months ended March 31, 2003, the holders of our Debentures did not have the ability to exercise their conversion rights. Had the requirements to allow the holders to exercise their conversion rights been met and the Debentures remained outstanding for the entire period, diluted earnings per common share would have been reduced by approximately 2% during the quarter ended March 31, 2003. See Note 12 to the Consolidated Financial Statements contained in our 2002 Annual Report on Form 10-K for a further discussion of the Debentures.
Quantitative and Qualitative Disclosures About Market Risk
We address our exposure to market risks, principally the market risk of changes in interest rates, through a controlled program of risk management that may include the use of derivative financial instruments. We do not hold or issue derivative financial instruments for trading purposes. We do not believe that our foreign exchange exposure is material to our financial position or results of operations. See Note 2 to the Consolidated Financial Statements contained in our 2002 Annual Report on Form 10-K for additional discussion of our financial instruments and hedging activities.
At March 31, 2003 and December 31, 2002, the fair value of our debt was estimated at approximately $1.3 billion and $899 million, respectively, using quoted market prices and yields for the same or similar types of borrowings, taking into account the underlying terms of the debt instruments. At March 31, 2003 and December 31, 2002, the estimated fair value exceeded the carrying value of the debt by approximately $64 million and $77 million, respectively. An assumed 10% increase in interest rates (representing approximately 50 and 60 basis points at March 31, 2003 and December 31, 2002, respectively) would potentially reduce the estimated fair value of our debt by approximately $14 million and $21 million at March 31, 2003 and December 31, 2002, respectively.
Our Debentures have a contingent interest component that will require us to pay contingent interest based on certain thresholds, as outlined in the Indenture. The contingent interest component, which is more fully described in Note 12 to the Consolidated Financial Statements contained in our 2002 Annual Report on Form 10-K, is considered to be a derivative instrument subject to Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities", as amended. As such, the derivative was recorded at its fair value in the consolidated balance sheet and was not material at March 31, 2003 and December 31, 2002.
Borrowings under our unsecured revolving credit facility under our credit agreement, our term loan and our secured receivables credit facility are subject to variable interest rates, unless fixed through interest rate swap or other agreements. Interest rates on our unsecured revolving credit facility and term loan are subject to a pricing schedule that can fluctuate over a range of up to 80 basis points, based on changes in our credit rating. As such, our borrowing cost under these credit arrangements will be subject to both fluctuations in interest rates and changes in our credit rating. As of March 31, 2003, our borrowing rate for LIBOR-based loans was LIBOR plus 1.3125%. At March 31, 2003, there was $408 million outstanding under our term loan and there were no borrowings outstanding under our unsecured revolving credit facility or against our secured receivables credit facility.
Based on our net exposure to interest rate changes, an assumed 10% change in interest rates on our variable rate indebtedness (representing approximately 15 basis points) would impact annual net interest expense by approximately $0.5 million, assuming no changes to the debt outstanding at March 31, 2003.
Liquidity and Capital Resources
Cash and Cash Equivalents
Cash and cash equivalents at March 31, 2003 totaled $56 million, compared to $97 million at December 31, 2002. Cash flows from operating activities in 2003 provided cash of $58 million, which along with cash flows from financing activities of $177 million, were used to fund investing activities, which required cash of $276 million. Cash and cash equivalents at March 31, 2002 totaled $149 million, an increase of $27 million from December 31, 2001. Cash flows from operating and financing activities in 2002 provided cash of $53 million and $6 million, respectively, which were used to fund investing activities, which required cash of $32 million.
Cash From Operating Activities
Net cash from operating activities for 2003 was $58 million compared to $53 million in 2002. This increase was primarily due to improved operating performance and efficiencies in our billing and collection processes, partially offset by a decrease in the tax benefits realized associated with the exercise of employee stock options. First quarter cash flow from operations is seasonally lower than other quarters of the year due to the timing of certain annual payments, principally associated with variable compensation and employee vacation earned in the prior year. Days sales outstanding, a measure of billing and collection efficiency, decreased to 49 days at March 31, 2003 from 52 days at March 31, 2002.
Cash From Investing Activities
Net cash used in investing activities was $276 million for the first quarter of 2003, consisting primarily of acquisition and related transaction costs of $236 million to acquire the outstanding capital stock of Unilab, and capital expenditures of $37 million. The acquisition and related transaction costs included the cash portion of the Unilab purchase price of $297 million and approximately $11 million of transaction costs paid in the first quarter of 2003, partially offset by $72 million of cash acquired from Unilab. Net cash used in investing activities in 2002 was $32.3 million for the first quarter, consisting primarily of capital expenditures of $41.3 million offset by a $10.7 million collection of a note receivable.
Cash From Financing Activities
Net cash provided by financing activities in 2003 was $177 million, consisting primarily of $450 million of borrowings under our term loan facility, partially offset by debt repayments totaling $269 million. Borrowings under our term loan facility were used to finance the cash portion of the purchase price and related transaction costs associated with the acquisition of Unilab, and to repay $220 million of debt, representing substantially all of Unilab's then existing outstanding debt, and related accrued interest. Of the $220 million, $124 million represents payments related to our cash tender offer on March 7, 2003, for all of the outstanding $100.8 million principal amount of Unilab's 12 3/4% Senior Subordinated Notes due 2009 and $23 million of related tender premium and associated tender offer costs. The remaining debt repayments in the first quarter of 2003 consisted primarily of a $42 million repayment under the term loan and a $6 million capital lease repayment.
Net cash provided by financing activities for 2002 was $6.5 million, consisting primarily of $9.9 million of proceeds from the exercise of stock options, partially offset by $3.0 million of distributions to minority partners.
Dividend Policy
We have never declared or paid cash dividends on our common stock and do not anticipate paying dividends on our common stock in the foreseeable future.
Contractual Obligations and Commitments
A description of the terms of our indebtedness, related debt service requirements and our future payments under certain of our contractual obligations is contained in Note 12 to the Consolidated Financial Statements in our 2002 Annual Report on Form 10-K. A discussion of our acquisition of Unilab, including the terms of our term loan facility used to finance the acquisition of Unilab and repay substantially all of Unilab's outstanding debt, is contained in Note 2 to the interim consolidated financial statements. A discussion and analysis regarding our minimum rental commitments under noncancelable operating leases, noncancelable commitments to purchase products or services, and reserves with respect to insurance claims at December 31, 2002 is contained in Note 17 to the Consolidated Financial Statements in our 2002 Annual
Report on Form 10-K. See Note 4 to the interim consolidated financial statements for information regarding the status of our remaining contractual obligations and commitments, including billing-related claims.
Our credit agreements relating to our unsecured revolving credit facility and our term loan facility contain various covenants and conditions, including the maintenance of certain financial ratios, that could impact our ability to, among other things, incur additional indebtedness, repurchase shares of our outstanding common stock, make additional investments and consummate acquisitions. We do not expect these covenants to adversely impact our ability to execute our growth strategy or conduct normal business operations.
Unconsolidated Joint Ventures
At March 31, 2003 and December 31, 2002, we had investments in unconsolidated joint ventures in Phoenix, Arizona; Indianapolis, Indiana; Dayton, Ohio; and Chesapeake, Virginia, which are accounted for under the equity method of accounting. We believe that our transactions with our joint ventures are conducted at arm's length, reflecting current market conditions and pricing. Total net revenues of our unconsolidated joint ventures, on a combined basis, are less than 6% of our consolidated net revenues. Total assets associated with our unconsolidated joint ventures are less than 3% of our consolidated total assets. We have no material unconditional obligations or guarantees to, or in support of, our unconsolidated joint ventures and their operations.
Requirements and Capital Resources
We estimate that we will invest approximately $180 million to $190 million during 2003 for capital expenditures to support and expand our existing operations, principally related to investments in information technology, equipment, and facility upgrades. Other than the reduction for outstanding letters of credit, which approximated $48 million at March 31, 2003, all of the $325 million revolving credit facility under the credit agreement and all of the $250 million secured receivables credit facility remained available to us for future borrowing at March 31, 2003.
We believe that cash from operations and our borrowing capacity under our unsecured revolving credit facility and secured receivables credit facility will provide sufficient financial flexibility to meet seasonal working capital requirements and to fund capital expenditures, debt service requirements and additional growth opportunities for the foreseeable future. Improvements in our industry and in particular our financial performance have resulted in improvements to our credit ratings from both Standard & Poor's and Moody's Investor Services. Our investment grade credit ratings have had a favorable impact on our cost of and access to capital. We believe that our improved financial performance should provide us with access to additional financing, if necessary, to fund growth opportunities that cannot be funded from existing sources.
Impact of New Accounting Standards
In April 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections". In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others."
The impact of the above referenced accounting standards is discussed in Note 1 to the interim consolidated financial statements.
Forward-Looking Statements
Some statements and disclosures in this document are forward-looking statements. Forward-looking statements include all statements that do not relate solely to historical or current facts and can be identified by the use of words such as "may", "believe", "will", "expect", "project", "estimate", "anticipate", "plan" or "continue". These forward-looking statements are based on our current plans and expectations and are subject to a number of risks and uncertainties that could significantly cause our plans and expectations, including actual results, to differ materially from the forward-looking statements. The Private Securities Litigation Reform Act of 1995 ("Litigation Reform Act") provides a "safe harbor" for forward-looking statements to encourage companies to provide prospective information about their companies without fear of litigation.
We would like to take advantage of the "safe harbor" provisions of the Litigation Reform Act in connection with the forward-looking statements included in this document. The risks and other factors that could cause our actual financial results to differ materially from those projected, forecasted or estimated by us in forward-looking statements may include, but are not limited to, unanticipated expenditures, changing relationships with customers, suppliers and strategic partners, conditions of the economy and other factors described in our 2002 Annual Report on Form 10-K and subsequent filings.
Item 4. Controls and Procedures
(a) Our Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined under Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934, as amended) as of a date within ninety days of the filing date of this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are adequate and effective.
(b) There were no significant changes in our internal controls or in other factors that could significantly affect our internal controls subsequent to the date of such evaluation.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
See Note 4 to the interim consolidated financial statements for information regarding the status of government investigations and private claims.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits:
10.1 Fourth Supplemental Indenture dated as of March 19, 2003, among Unilab Corporation (f/k/a Quest Diagnostics Newco Incorporated), Quest Diagnostics Incorporated, The Bank Of New York, and the Subsidiary Guarantors.
99.1 Statement Pursuant to 18. U.S.C. 'SS' 1350 of Chief Executive Officer dated April 30, 2003
99.2 Statement Pursuant to 18. U.S.C. 'SS' 1350 of Chief Financial Officer dated April 30, 2003
(b) Report on Form 8-K filed during the first quarter of 2003:
On March 13, 2003, the Company filed a current report on Form 8-K (Date of Report: February 26, 2003) reporting under Item 2 on the acquisition of the outstanding capital stock of Unilab Corporation.
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
April 30, 2003
Quest Diagnostics Incorporated
By /s/ Kenneth W. Freeman
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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
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Certifications
I, Kenneth W. Freeman, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Quest Diagnostics Incorporated;
2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
April 30, 2003
By /s/ Kenneth W. Freeman
------------------------------------
Kenneth W. Freeman
Chairman of the Board and
Chief Executive Officer
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I, Robert A. Hagemann, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Quest Diagnostics Incorporated;
2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
April 30, 2003
By /s/ Robert A. Hagemann
----------------------------------
Robert A. Hagemann
Vice President and
Chief Financial Officer
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STATEMENT OF DIFFERENCES
The section symbol shall be expressed as.................... 'SS'
Exhibit 10.1
FOURTH SUPPLEMENTAL INDENTURE
SUPPLEMENTAL INDENTURE dated as of March 19, 2003, (this "Fourth Supplemental Indenture"), among UNILAB CORPORATION (f/k/a Quest Diagnostics Newco Incorporated), (the "Additional Subsidiary Guarantor"), QUEST DIAGNOSTICS INCORPORATED, a Delaware corporation (the "Company"), THE BANK OF NEW YORK, a New York banking corporation as Trustee (the "Trustee"), and the Subsidiary Guarantors (as defined in the Indenture referred to herein).
RECITALS OF THE COMPANY
WHEREAS, the Company, the Trustee and the Initial Subsidiary Guarantors executed and delivered an Indenture, dated as of June 27, 2001 (the "Base Indenture"), as supplemented by the first Supplemental Indenture as of June 27, 2001 (the "First Supplemental Indenture"), as further supplemented by the second Supplemental Indenture as of November 26, 2001 (the "Second Supplemental Indenture") as further supplemented by the third Supplemental Indenture as of April 4, 2002 (the "Third Supplemental Indenture"), and as further supplemented by this Fourth Supplemental Indenture (collectively, the "Indenture"), to provide for the issuance by the Company from time to time of Securities to be issued in one or mores series as provided in the Indenture;
WHEREAS, Additional Subsidiary Guarantor intends to guarantee the Securities under the Indenture and the issuance of guarantees has been authorized by resolutions adopted by the Board of Directors of Additional Subsidiary Guarantor;
WHEREAS, Section 901(11) of the Indenture provides that without the consent of Holders of the Securities of any series issued under the Indenture, the Company, when authorized by a Board Resolution, and the Trustee may enter into one or more indentures supplemental to the Indenture to add a guarantor or guarantors for any series or all series of the Securities;
WHEREAS, pursuant to Sections 904, 1601, 1602 and 1604 of the Indenture, by delivery of a Supplemental Indenture to the Trustee in accordance with the terms of the Indenture, each Person that becomes a Subsidiary Guarantor after the date of the Base Indenture will be deemed to have executed and delivered the Subsidiary Guarantee for the benefit of the Holder of the Security upon which the Subsidiary Guarantee is endorsed, with the same effect as if such Subsidiary Guarantor had been named thereon and had executed and delivered the Subsidiary Guarantee;
WHEREAS, all things necessary to make this Fourth Supplemental Indenture a valid supplement to the Indenture according to its terms and the terms of the Indenture have been done.
NOW, THEREFORE, for and in consideration of the foregoing, the parties hereto hereby enter into this Fourth Supplemental Indenture, for the equal and proportionate benefit of all Holders of the Securities, as follows:
SECTION 1 Certain Terms Defined in the Indenture.
All capitalized terms used but not defined herein shall have the meanings assigned to them in the Indenture.
SECTION 2 Agreement to Guarantee.
Additional Subsidiary Guarantor, by its signature below, agrees to become an Additional Subsidiary Guarantor under the Indenture with the same force and effect as if originally named therein as a Subsidiary Guarantor. Additional Subsidiary Guarantor hereby agrees to all the terms and provisions of the Indenture applicable to it as Additional Subsidiary Guarantor thereunder and each reference to a "Subsidiary Guarantor" in the Indenture shall be deemed to include Additional Subsidiary Guarantor.
SECTION 3 Indenture remains in Full Force and Effect.
Except as expressly supplemented by this Fourth Supplemental Indenture, the Indenture shall remain in full force and effect in accordance with its terms.
SECTION 4 New York Law to Govern.
THIS FOURTH SUPPLEMENTAL INDENTURE SHALL BE GOVERNED BY AND CONSTRUED IN ACCORDANCE WITH THE LAWS OF THE STATE OF NEW YORK, WITHOUT REGARD TO PRINCIPLES OF CONFLICT OF LAWS.
SECTION 5 Separability.
In case any one or more of the provisions contained in this Fourth Supplemental Indenture should be held invalid, illegal or unenforceable in any respect, the validity, legality and enforceability of the remaining provisions contained herein and in the Indenture shall not in any way be affected or impaired. The parties hereto shall endeavor in good faith negotiations to replace any invalid, illegal or enforceable provisions herein with valid provisions, the economic effect of which comes as close as possible to that of the invalid, illegal or unenforceable provisions.
SECTION 6 May be Executed in Counterparts.
This Fourth Supplemental Indenture may be executed in counterparts, each of which when taken together shall constitute one and the same instrument. This Fourth Supplemental Indenture shall become effective when the Trustee shall have received a counterpart thereof that bears the signature of the Additional Subsidiary Guarantor.
IN WITNESS WHEREOF, the Company, the Additional Subsidiary Guarantor, and the Trustee have duly executed this Fourth Supplemental Indenture as of the day and year first above written.
Attest: QUEST DIAGNOSTICS INCORPORATED,
a Delaware corporation, as Company
___________________ By:
----------------------------------------
Leo C. Farrenkopf, Jr. Name: Joseph P. Manory
Secretary Title: Vice President and Treasurer
Attest: UNILAB CORPORATION,
as Additional Subsidiary Guarantor
--------------------
Leo C. Farrenkopf, Jr. By:_____________________________________
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Secretary Name: Joseph P. Manory Title: Vice President and Treasurer
Attest: THE BANK OF NEW YORK, as Trustee
_______________________ By:
-------------------------------------
Title:__________________________________
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Exhibit 99.1
STATEMENT PURSUANT TO 18 U.S.C. 'SS' 1350
Pursuant to 18 U.S.C. 'SS' 1350, the undersigned certifies that, to the best of my knowledge, the Quarterly Report on Form 10-Q for the period ended March 31, 2003 of Quest Diagnostics Incorporated, as being filed with the Securities and Exchange Commission concurrently herewith, fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 'SS' 78m or 78o(d)) and that the information contained in the Quarterly Report fairly presents, in all material respects, the financial condition and results of operations of Quest Diagnostics Incorporated.
Dated: April 30, 2003 /s/ Kenneth W. Freeman
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Kenneth W. Freeman
Chief Executive Officer
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Exhibit 99.2
STATEMENT PURSUANT TO 18 U.S.C. 'SS' 1350
Pursuant to 18 U.S.C. 'SS' 1350, the undersigned certifies that, to the best of my knowledge, the Quarterly Report on Form 10-Q for the period ended March 31, 2003 of Quest Diagnostics Incorporated, as being filed with the Securities and Exchange Commission concurrently herewith, fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 'SS' 78m or 78o(d)) and that the information contained in the Quarterly Report fairly presents, in all material respects, the financial condition and results of operations of Quest Diagnostics Incorporated.
Dated: April 30, 2003 /s/ Robert A. Hagemann
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Robert A. Hagemann
Chief Financial Officer
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