UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
[LOGO] Quest
Diagnostics
Annual Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the Fiscal Year Ended December 31, 2001
Commission File Number 1-12215
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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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Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on Which Registered
Common Stock
with attached Preferred Share Purchase Right New York Stock Exchange
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Securities registered pursuant to Section 12(g) of the Act: None
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 if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K. [x]
As of February 22, 2002, the aggregate market value of the approximately 73.5
million shares of voting and non-voting common equity held by non-affiliates of
the registrant was approximately $5.3 billion, based on the closing price on
such date of the Company's Common Stock on the New York Stock Exchange.
As of February 22, 2002, there were outstanding 96,293,091 shares of Common
Stock, $.01 par value.
Documents Incorporated by Reference
Part of Form 10-K into
Document which incorporated
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Portions of the Registrant's Proxy Statement to be filed by April 30, 2002.......... Part III
Such Proxy Statement, except for portions thereof which have been specifically
incorporated by reference, shall not be deemed "filed" as part of this report on
Form 10-K.
PART I
Item 1. Business
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Overview
We are the nation's leading provider of diagnostic testing, information
and related services for the healthcare industry, with annual net revenues in
excess of $3.6 billion. We offer a broad range of clinical laboratory testing
services used by physicians in the detection, diagnosis, evaluation, monitoring
and treatment of diseases and other medical conditions. We have a more extensive
national network of laboratories and patient service centers than our
competitors and for the year ended December 31, 2001 our revenues were sixty
five percent greater than those of our nearest competitor. We have the leading
market share in clinical laboratory testing and esoteric testing, including
molecular diagnostics, as well as non hospital-based anatomic pathology services
and testing for drugs of abuse.
We currently process over 105 million requisitions each year. Each
requisition form accompanies a patient specimen, indicating the tests to be
performed and the party to be billed for the tests. Our customers include
physicians, hospitals, managed care organizations, employers, governmental
institutions and other independent clinical laboratories.
We have a nationwide network of approximately 1,350 patient service
centers, 30 principal laboratories located in major metropolitan areas
throughout the United States, and 100 smaller "rapid response" laboratories
(including, in each case, facilities operated at our joint ventures). We also
operate a leading esoteric testing laboratory and development facility known as
Nichols Institute located in San Juan Capistrano, California as well as
laboratory facilities in Mexico City, Mexico and near London, England.
In addition to our laboratory testing business, our clinical trials
business is one of the leading providers of testing to support clinical trials
of new pharmaceuticals worldwide. We also collect and analyze laboratory,
pharmaceutical and other data to help pharmaceutical companies with their
marketing and disease management efforts, and to help healthcare customers
better manage the health of their patients.
We are a Delaware corporation. We sometimes refer to ourselves and our
subsidiaries as the "Company". We are the successor to MetPath Inc., a New York
corporation that was organized in 1967. From 1982 to 1996, we were a subsidiary
of Corning Incorporated ("Corning"). On December 31, 1996, Corning distributed
all of the outstanding shares of our common stock to the stockholders of
Corning. Our principal executive offices are located at One Malcolm Avenue,
Teterboro, New Jersey 07608, telephone number: (201) 393-5000.
The United States Clinical Laboratory Testing Market
Clinical laboratory testing is an essential element in the delivery of
healthcare services. Physicians use laboratory tests to assist in the detection,
diagnosis, evaluation, monitoring and treatment of diseases and other medical
conditions. Clinical laboratory testing is generally categorized as clinical
testing and anatomical pathology testing. Clinical testing is performed on body
fluids, such as blood and urine. Anatomical pathology testing is performed on
tissues and other samples, such as human cells. Most clinical laboratory tests
are considered routine and can be performed by most independent clinical
laboratories. Tests that are not routine and that require more sophisticated
equipment and highly skilled personnel are considered esoteric tests. Esoteric
tests are generally referred to laboratories that specialize in performing those
tests.
We believe that the United States diagnostics testing industry had
approximately $35 billion in annual revenues in 2001. Most laboratory tests are
performed by one of three types of laboratories: independent clinical
laboratories; hospital-affiliated laboratories; and physician-office
laboratories. In 2001, we believe that hospital-affiliated laboratories
performed over one half of the clinical laboratory tests in the United States,
independent clinical laboratories performed approximately one-third of those
tests, and physician-office laboratories performed the balance.
During the last several years, the underlying fundamentals of the
diagnostics testing industry have improved. During the early 1990s, the industry
was negatively impacted by significant government regulation and investigations
into various billing practices. In addition, the rapid growth of managed care
and excess laboratory testing capacity led to revenue and profit declines within
the diagnostics testing industry, which in turn led to industry consolidation,
particularly among commercial laboratories. As a result of these dynamics, fewer
but larger commercial laboratories have emerged which have greater economies of
scale, rigorous programs designed to assure compliance with government billing
regulations and other laws, and a more disciplined approach to pricing services.
These changes have resulted in improved profitability and a reduced risk of
non-compliance with complex government regulations. At the same time, a slowdown
in the growth of managed care and decreasing influence by managed care
organizations on the ordering of clinical laboratory testing by physicians has
led to renewed growth in testing volumes and further improvements in
profitability since 1999.
We believe that during the next several years, the industry will
continue to experience moderate growth in testing volume due to the following
factors:
o general expansion and aging of the United States population;
o increasing focus on early detection and prevention as a means to
reduce the overall cost of healthcare and development of more
sophisticated and specialized tests for early detection of disease
and disease management;
o continuing research and development in the area of genomics, which is
expected to yield new genetic tests and techniques;
o increasing volume of tests for diagnosis and monitoring of infectious
diseases such as AIDS and hepatitis C;
o increasing affordability of tests due to advances in technology and
cost efficiencies; and
o increasing awareness by consumers of the value of clinical laboratory
testing and increasing willingness of consumers to pay for tests that
may not be covered by third party payers.
Business Strategy
Our mission is to be recognized by our customers and employees as the
best provider of comprehensive and innovative diagnostic testing, information
and related services. The principal components of this strategy are to
o Capitalize on Our Leading Position Within the Laboratory Testing
Market: We are the leader in our core clinical laboratory testing
business offering the broadest national access to clinical laboratory
testing services, with facilities in substantially all of the major
metropolitan areas in the United States. Our network of approximately
1,350 patient service centers, 30 principal laboratories and 100
rapid response laboratories enable us to serve managed care
organizations, hospitals, physicians, employers and other healthcare
providers and their patients throughout the United States. We believe
that customers will increasingly seek to utilize laboratory testing
companies that have a nationwide presence and offer a comprehensive
range of services and that, as a result, we will be able to
profitably enhance our market position.
o Compete Through Providing the Highest Quality Services: We intend to
become recognized as the quality leader in the healthcare services
industry. We are implementing a Six Sigma initiative throughout our
organization. Six Sigma is a management approach that requires a
thorough understanding of customer needs and requirements, process
discipline, rigorous tracking and measuring of services, and training
of employees in methodologies so that they can be held accountable
for improving results. During the second half of 2001, we began to
integrate our Six Sigma initiative with our initiative to standardize
operations and processes across all of Quest Diagnostics by adopting
identified company best practices. We plan to continue these
initiatives during the next several years and expect that successful
implementation of these initiatives will result in measurable
improvements in customer satisfaction and generate at least $150
million in annual net benefits by the end of 2004. Our Nichols
Institute was the first clinical laboratory in North America to
achieve ISO-9001 certification. Two of our clinical trials
laboratories, our diagnostic kits facility and our informatics
business have also achieved ISO-9001 certification. In addition, five
of our laboratories, including a forensic toxicology laboratory, have
achieved ISO-9002 certification. These certifications are
international standards for quality management systems. Several
additional regional laboratories are currently pursuing ISO-9002
certification.
o Continue to Lead Innovation: We intend to build upon our reputation
as a leading innovator in the clinical laboratory industry by
continuing to introduce new tests, technology and services. As the
industry leader with the largest and broadest network and the leading
provider of esoteric tests, including gene-based tests, we believe
that we are the best channel for developers of new technology and
tests to introduce their products to the marketplace. Through our
relationship with members of the academic community and
pharmaceutical and biotechnology firms, we believe that we are one of
the leaders in transferring technical innovation to the market. For
example, we recently developed and introduced a new ultra-sensitive
Heptimax'TM' viral load test for hepatitis C, using Bayer Corp.'s
branched DNA technology. This test enables physicians to monitor
their patients' response to pegylated interferon and combination
therapy with a test that is much more sensitive than other
commercially available tests. During 2001, we established a research
and development, marketing and
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commercial alliance with Roche Diagnostics to develop and market
gene-based medical tests based primarily on Roche's polymerase chain
reaction (PCR) technology. We expect this collaboration to focus
initially on the commercialization of gene-based markers to assess an
individual's risk for stroke and asthma and on applications in
pharmacogenomics and predictive medicine. We are expanding DNA based
testing in the clinical laboratory to provide enhanced sensitivity,
accuracy and reliability of this next generation technology. We also
intend to continue to collaborate with emerging medical technology
companies that develop and commercialize novel diagnostics,
pharmaceutical and device technologies. For instance, during 2001 we
became the first laboratory to obtain from Orchid BioSciences, Inc.
commercial rights to its proprietary SNP-IT'TM' technology for
gene-based diagnostic testing services. We also exercised an option
under our agreement with diaDexus to acquire an exclusive license to
develop and commercialize proprietary genomics-based diagnostic tests
for osteoporosis and colon cancer. We will continue to introduce new
tests that we develop at Nichols Institute, one of the leading
esoteric testing laboratories in the world and the largest provider
of molecular diagnostics testing in the United States. We believe
that, with the unveiling of the human genome, new genes and the
linkages of genes with disease will continue to be discovered at an
accelerating pace, leading to research that will result in ever more
complex and thorough predictive, diagnostic and therapeutic testing.
We believe that we are well positioned to capture much of this
growth.
o Pursue Strategic Growth Opportunities: We intend to continue to
leverage our network in order to capitalize on targeted strategic
growth opportunities both inside and outside our core clinical
laboratory testing business. These opportunities are more fully
described under "Strategic Growth Opportunities" and include
continuing to make selective regional acquisitions, capturing the
growth in the areas of genomics and specialty testing, expanding our
direct-to-consumer business and expanding our clinical trials testing
and other services to the pharmaceutical and biotechnology
industries.
o Leverage Our Satisfaction Model: Our approach to conducting business
states that satisfied employees lead to satisfied customers, which in
turn benefits our stockholders. We regularly survey our employees and
customers and follow up on their concerns. We emphasize skills
training for all employees and leadership training for our
supervisory employees, which also includes Six Sigma training to
manage high-impact quality improvement projects throughout our
organization, and annual compliance training. Most importantly, we
are committed to engaging each employee with dignity and respect and
trust them to treat our customers the same way. We believe that our
treatment and training of employees, together with our competitive
pay and benefits, helps increase employee satisfaction and
performance, thereby enabling us to provide better services to our
customers.
Recent Acquisitions
On August 16, 1999, we completed the acquisition of SmithKline
Beecham Clinical Laboratories, Inc. ("SBCL"), which operated the clinical
laboratory business of SmithKline Beecham plc, or SmithKline Beecham. After
taking into account a purchase price adjustment that was finalized in October
2000 and our two for one stock split in May 2001, the purchase price consisted
of $930 million in cash and approximately 25.1 million shares of our common
stock, which represented approximately 29% of our then outstanding common stock.
During the second quarter of 2001, we completed the process of reducing
redundant facilities and infrastructure and redirecting testing volume to
provide more local testing and improve customer service. We continue to expect
that the SBCL integration will result in approximately $150 million of annual
synergies and that we will achieve this annual rate of synergies by the end of
2002. During 2001, we estimate that we realized approximately $120 million of
these synergies driven by cost reductions, and at the end of 2001, we estimate
we had achieved an annualized rate of synergies of approximately $140 million.
On February 7, 2002, we executed a definitive agreement to acquire
American Medical Laboratories, Incorporated, or AML, in an all-cash transaction
valued at $500 million, which includes the assumption of approximately $160
million in debt. AML is a national provider of esoteric testing to hospitals and
specialty physicians and is a leading provider of diagnostics testing services
in the Nevada and metropolitan Washington, D.C. markets. AML, established in
1959, has approximately 3,000 employees and in 2001 generated annual revenues of
approximately $300 million. It has reference testing relationships with almost
500 hospitals, 150 clinical laboratories and 7,000 physician offices. AML has
two full-service laboratories, located in Chantilly, Virginia and Las Vegas,
Nevada, and 51 patient service centers, most of which are located in the Nevada
and metropolitan Washington, D.C. markets. Following the acquisition, the
Virginia reference laboratory will complement our Nichols Institute reference
laboratory on the west coast. We believe that the acquisition will strengthen
our leadership position in the delivery of esoteric testing services to
hospitals and specialty physicians throughout the country. AML also has an
anatomic pathology business served by approximately 30 board-certified specialty
pathologists, which will expand the consultative capabilities and capacity of
our anatomic pathology
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services. As part of the acquisition, we will also acquire LabPortal, Inc., a
provider of electronic connectivity products. AML also is a national provider of
drugs of abuse testing, and pioneered the use of hair samples for testing. The
acquisition is expected to close during the first quarter of 2002 and will be
funded by cash on hand and our existing revolving credit facilities.
In December 2001, we acquired Clinical Diagnostics Services, Inc., a
clinical laboratory based in Englewood, New Jersey with approximately 50 patient
service centers in the New York City metropolitan area, for approximately $62
million in cash. Also in December 2001, we acquired the assets of Las Marias
Reference Lab Corp and Laboratorio Clinico Las Marias, Inc., a clinical
laboratory based in San Juan, Puerto Rico for $18.5 million in cash.
In November 2001, we acquired the outstanding voting shares of MedPlus, Inc.
("MedPlus"), a leading developer and integrator of clinical connectivity and
data management solutions for healthcare organizations and clinicians for
approximately $18 million in cash. In February 2001 we also acquired the assets
of Clinical Laboratories of Colorado, a clinical laboratory based in Denver,
Colorado for approximately $47 million in cash.
Following an acquisition, the integration process requires the
dedication of significant management resources, which could result in a loss of
momentum in the activities of our business and may cause an interruption of or
deterioration in our services. Since most of our clinical laboratory testing is
performed under arrangements that are terminable at will or on short notice, any
interruption of, or deterioration in, our services may also result in a
customer's decision to stop using us for clinical laboratory testing. These
events could have a material adverse impact on our business. However, management
believes that the successful implementation of our integration plans and our
value proposition based on expanded patient access, our broad testing
capabilities and most importantly, the quality of the services we provide, will
mitigate customer attrition.
Our Services
Our laboratory testing business consists of routine testing, esoteric
testing, and clinical trials testing. Routine testing generates approximately
83% of our net revenues, esoteric testing generates approximately 13% of our net
revenues, and clinical trials testing generates less than 3% of our net
revenues. We derive less than 2% of our net revenues from foreign operations.
Routine Testing
Routine tests measure various important bodily health parameters such
as the functions of the kidney, heart, liver, thyroid and other organs. Commonly
ordered tests include:
o blood cholesterol level tests;
o complete blood cell counts;
o pap smears;
o HIV-related tests;
o urinalyses;
o pregnancy and other prenatal tests; and
o alcohol and other substance-abuse tests.
We perform routine testing through our network of major laboratories,
rapid response laboratories, or "stat" labs, and patient service centers. We
also perform routine testing at the hospital laboratories we manage. Major
laboratories offer a full line of routine clinical tests. Rapid response
laboratories are local facilities where we can quickly perform an abbreviated
line of routine tests for customers that require rapid turnaround. Patient
service centers are facilities where specimens are collected. These centers are
typically located in or near a building used by medical professionals.
We operate 24 hours a day, 365 days a year. We perform and report
most routine procedures within 24 hours. Most test results are delivered
electronically.
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Esoteric Testing
Esoteric tests are those tests that are performed less frequently
than routine tests and require more sophisticated equipment and materials,
professional "hands-on" attention and more highly skilled personnel. Because it
is not cost-effective for most clinical laboratories to perform the low volume
of esoteric tests in-house, they generally refer many esoteric tests to an
esoteric clinical testing laboratory. Esoteric tests are generally priced higher
than routine tests.
Our Nichols Institute is one of the leading esoteric clinical testing
laboratories in the world. In 1998, Nichols Institute, located in San Juan
Capistrano, California, became the first clinical laboratory in North America to
achieve ISO-9001 certification. Nichols Institute performs hundreds of types of
esoteric tests that are not routinely performed by our regional laboratories.
These esoteric tests are generally in the following fields:
o endocrinology (the study of glands, their hormone secretions and
their effects on body growth and metabolism);
o genetics (the study of chromosomes, genes, and their protein
products and effects);
o immunology (the study of the immune system including antibodies,
immune system cells and their effects);
o microbiology (the study of microscopic forms of life including
bacteria, viruses, fungi and other infectious agents);
o oncology (the study of abnormal cell growth including benign tumors
and cancer);
o serology (a science dealing with the body fluids and their
analysis, including antibodies, proteins and other
characteristics);
o special chemistry (more sophisticated testing requiring special
expertise and technology); and
o toxicology (the study of chemicals and drugs and their effects on
the body's metabolism).
Through our relationship with members of the academic community and
pharmaceutical and biotechnology firms, we believe that we are one of the
leaders in transferring technical innovation to the market. Nichols Institute
was the first private reference laboratory to introduce a number of new tests,
including tests to measure circulating hormone levels and breast cancer
prognostic markers. We continue to develop new and more sophisticated testing to
monitor the success of therapy for cancer, AIDS and hepatitis C, and to detect
other diseases and disorders. In addition to our recent introduction of the
Heptimax'TM' test (discussed in "Business Strategy-Continue to Lead
Innovation"), we recently developed and introduced an HIV genotyping test which
predicts the drug resistance of HIV infected patients. To improve specificity of
cervical cancer screening, we recently introduced automatic reflex high-risk DNA
human papillomavirus testing for borderline ThinPrep'TM' Pap Tests'TM', using
the original specimen. In addition, we recently introduced HCV DupliType'TM'
testing to provide subtyping for a broader range of hepatitis C viral specimens
improving the predictability of drug responsiveness.
Through our Academic Associates program, leading academics and
biotechnology firms work directly with our staff scientists to monitor and
consult on existing test procedures and develop new esoteric test methods. In
addition, we have entered into licensing arrangements and co-development
agreements with biotechnology companies and academic medical centers (see
"Business Strategy-Continue to Lead Innovation").
Clinical Trials Testing
We believe that we are one of the world's three largest providers of
clinical laboratory testing performed in connection with clinical research
trials on new drugs. Clinical research trials are required by the FDA to assess
the safety and efficacy of new drugs. We have clinical trials testing centers in
the United States and in England. We also provide clinical trials testing in
Australia and South Africa through arrangements with third parties. Clinical
trials involving new drugs are increasingly being performed both inside and
outside the United States. Approximately 31% of our net revenues from clinical
trials testing in 2001 represented testing for GlaxoSmithKline plc.
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Other Services and Products
We manufacture and market diagnostic test kits and systems primarily
for esoteric testing under the Nichols Institute Diagnostics brand name. These
are sold principally to hospital and clinical laboratories, both domestically
and internationally. Our MedPlus subsidiary, which we acquired in November 2001,
is a developer and integrator for clinical connectivity and data management
solutions for healthcare organizations and clinicians primarily through its
ChartMaxx'r' electronic medical record system; and provides workflow and content
management solutions to customers in a variety of industries.
Payers and Customers
We provide testing services to a broad range of healthcare providers.
We consider a "payer" as the party that pays for the test. Depending on the
billing arrangement and applicable law, the payer may be (1) the physician or
other party (such as another laboratory or an employer) who referred the testing
to us, (2) the patient, or (3) a third party who pays the bill for the patient,
such as an insurance company, Medicare or Medicaid. Some states, including New
York, New Jersey and Rhode Island, prohibit us from billing physician clients.
We generally consider a "customer" to be the party who refers tests to us. We
also consider a managed care organization as both our customer and a payer, when
it contracts with us on an exclusive or semi-exclusive basis on behalf of its
patients.
During 2001, only two customers accounted for more than 5% of our net
revenues, and no single customer accounted for more than 7% of our net revenues.
We believe that the loss of any one of our customers would not have a material
adverse effect on our financial condition, results of operations, or cash flow.
Payers
The following table shows current estimates of the breakdown of the
percentage of our total volume of requisitions and total clinical laboratory
revenues during 2001 applicable to each payer group:
Revenue
as % of
Requisition Volume Total
as % of Clinical Laboratory
Total Volume Revenues
------------ --------
Patient................................. 2%-- 5% 5%--10%
Medicare and Medicaid................... 10%--15% 10%--15%
Physicians, Hospitals, Employers and
Other Monthly-Billed Payers............. 30%--35% 25%--30%
Third Party Fee-for-Service............. 30%--35% 40%--45%
Managed Care-Capitated.................. 15%--20% 5%--10%
Customers
Physicians
Physicians requiring testing for patients whose tests are not covered
by a managed care contract are one of the primary sources of our clinical
laboratory testing volume. We typically bill physician accounts on a
fee-for-service basis. Fees billed to physicians are based on the laboratory's
client fee schedule and are typically negotiated. Fees billed to patients and
third parties are based on the laboratory's patient fee schedule, which may be
subject to limitations on fees imposed by third-party payers and negotiation by
physicians on behalf of their patients. Medicare and Medicaid reimbursements are
based on fee schedules set by governmental authorities.
Managed Care Organizations and Other Insurance Providers
Managed care organizations and other insurance providers, which
typically contract with a limited number of clinical laboratories for their
members, represent approximately one half of our total testing volumes and one
half of our consolidated testing revenues. Larger managed care organizations and
other insurance providers typically prefer to use large independent clinical
laboratories because they can provide services on a national or regional basis
and can manage networks of local or regional laboratories. In addition, larger
laboratories are better able to achieve the low-cost
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structures necessary to profitably service large managed care organizations and
can provide test utilization data across their various plans.
While the growth in the number of patients participating in managed
care plans has slowed in recent years, over the last decade, the managed care
industry has been consolidating, resulting in fewer but larger managed care
organizations with significant bargaining power in negotiating fee arrangements
with healthcare providers, including clinical laboratories. Managed care
organizations demand that clinical laboratory service providers accept
discounted fee structures or assume all or a portion of the financial risk
associated with providing testing services to their members through capitated
payment contracts. Under capitated payment contracts, clinical laboratories
receive a fixed monthly fee per individual enrolled with the managed care
organization for all laboratory tests performed during the month regardless of
the number or cost of the tests actually performed. Some services, such as
various esoteric tests, new technologies and anatomic pathology services, may be
carved out from a capitated rate and, if carved out, are charged on a
fee-for-service basis. In 2001, we derived approximately 9% of our revenues from
capitated payment contracts with managed care organizations.
Recently, there has been a shift in the way major managed care
organizations contract with clinical laboratories. Managed care organizations
have begun to offer more freedom of choice to their affiliated physicians,
including greater freedom to determine which laboratory to use and which tests
to order. Accordingly, our agreements with most managed care organizations are
generally not exclusive arrangements, allowing us to compete for physician
business more on the basis of service and quality rather than price alone. As a
result of this emphasis on greater freedom of choice as well as our enhanced
service network and capabilities, and our focus on ensuring that overall
arrangements are profitable, pricing of managed care agreements has generally
improved over the last several years. Also, managed care organizations have
recently been giving patients greater freedom of choice and patients have
increasingly been selecting plans (such as preferred provider organizations)
that offer a greater choice of providers. Pricing for these preferred provider
organizations is typically negotiated on a fee-for-service basis, which
generally results in higher revenue per requisition than under a capitated fee
arrangement. Despite these trends, managed care organizations continue to seek
to reduce their costs in order to keep their premiums to their customers
competitive. If we are unable to agree on pricing with a managed care
organization, we would become a "non participating" provider and could then only
bill the ordering physician or the patient rather than the managed care
organization. This "non participating" status could lead to loss of business
since the physician is likely to refer testing to a participating provider whose
testing is covered by the patient's managed care benefit plan. We cannot assure
investors that we will continue to be successful in negotiating contracts with
major managed care organizations. Loss of major managed care agreements could
have a material adverse effect on our financial condition, results of operations
and cash flow.
Hospitals
We provide services to hospitals throughout the United States that
vary from esoteric testing to helping manage their laboratories. We believe that
we are the industry's market leader in servicing hospitals. Testing for
hospitals accounts for approximately 11% of our net revenues. Hospitals
generally maintain an on-site laboratory to perform testing on patients and
refer less frequently needed and highly specialized procedures to outside
laboratories, which typically charge the hospitals on a negotiated
fee-for-service basis. We believe that most hospital laboratories perform
approximately 95% to 97% of their patients' clinical laboratory tests. Many
hospitals compete with independent clinical laboratories for outreach
(non-hospital patients) testing. Most physicians have admitting privileges or
other relationships with hospitals as part of their medical practice. Many
hospitals leverage their relationships with community physicians and encourage
the physicians to send their outreach testing to the hospital's laboratory. In
addition, hospitals that own physician practices generally require the
physicians to refer tests to the hospital's affiliated laboratory. As a result,
hospital-affiliated laboratories can be both customers and competitors for
independent clinical laboratories.
We have joint venture arrangements with leading integrated health
delivery networks in several metropolitan areas. These joint venture
arrangements, which provide testing for affiliated hospitals as well as for
unaffiliated physicians and other healthcare providers in their geographic
areas, serve as our principal laboratory facilities in their service areas.
Typically, we have either a majority ownership interest in, or day-to-day
management responsibilities for, our hospital joint venture relationships. We
also manage the laboratories at a number of other hospitals.
Employers, Governmental Institutions and Other Clinical Laboratories
We provide testing services to governmental agencies, including the
Department of Defense and state and federal prison systems, and to large
employers. We believe we are the leader in the clinical laboratory industry in
providing testing to employers for substance abuse, occupational exposures, and
comprehensive wellness programs.
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Wellness programs enable employers to take an active role in lowering their
overall healthcare costs. Testing services for employers account for
approximately 4% of our net revenues. The volume of testing services for
employers, which generally have relatively low profit margins, declined
significantly during 2001, driven by a general slowing of the economy and a
corresponding slowdown in hiring. We also perform esoteric testing services for
other independent clinical laboratories that do not have the full range of our
testing capabilities. All of these customers are charged on a fee-for-service
basis.
Sales and Marketing
We market to and service our customers through our direct sales force
sales representatives, customer service and patient service representatives and
couriers.
We focus our sales efforts on pursuing and keeping profitable
accounts that generate an acceptable return. We have an active account
management process to evaluate the profitability of all of our accounts. Where
appropriate, we change the service levels, terminate accounts that are not
profitable, or adjust pricing.
Most sales representatives market routine laboratory services
primarily to physicians and hospitals. Some sales representatives focus on
particular market segments or on testing niches. For example, some
representatives concentrate on market segments such as hospitals or managed care
organizations, and others concentrate on testing niches such as substance-abuse
testing. During 2001, we created a team of sales representatives who concentrate
on gene-based and other esoteric testing.
Customer service representatives perform a number of services for
patients and customers. They monitor services, answer questions and help resolve
problems. Our couriers pick up specimens from most clients daily.
Strategic Growth Opportunities
In addition to expanding our core clinical laboratory business
through internal growth and pursuing our strategy to become a leading provider
of medical information, we intend to continue to leverage our network in order
to capitalize on targeted growth opportunities both inside and outside our core
laboratory testing business.
o Selective Regional Acquisitions: The clinical laboratory industry
is still highly fragmented. Historically, regional acquisitions
fueled our growth. We expect to focus future clinical laboratory
acquisition efforts on laboratories that can be integrated into our
existing laboratories such as our acquisition of the assets of
Clinical Laboratories of Colorado in February 2001 and the
acquisition of Clinical Diagnostics Services in the New York City
metropolitan area in December 2001. This strategy enables us to
reduce costs and improve efficiencies through the elimination of
redundant facilities and equipment, and reductions in personnel. On
February 7, 2002, we executed a definitive agreement to acquire
American Medical Laboratories, Incorporated (see "Recent
Acquisitions"). We may also consider acquisitions of ancillary
businesses as part of our overall growth strategy, such as our
November 2001 acquisition of MedPlus Inc., which develops clinical
connectivity products designed to enhance patient care (see
"Information Systems").
o Anatomic Pathology: While we are the leading provider of non
hospital-based anatomic pathology services in the United States, we
have traditionally been strongest in cytology, and specifically in
the analysis of pap smears to detect cervical cancer. During the
last several years, we have led the industry in converting
approximately 60% of our pap smear business to ThinPrep'TM', a
higher quality, and more profitable product offering. During 2001,
we began placing greater strategic and tactical emphasis on the
growth of our physician-based histology (tissue pathology)
business. We intend to continue to expand our anatomic pathology
business into higher growth segments . We estimate that the current
United States market for anatomic pathology services is
approximately $6 billion per year. We estimate that cytology, which
represents about $1 billion per year of this market, is growing
about 5% per year; and that tissue pathology, which represents
about $5 billion per year of this market, is growing more than 10%
each year fueled by the aging of the population. We perform
approximately $350 million of such services each year, representing
a market position significantly less than our share of the entire
clinical laboratory market.
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o Genomics and Esoteric Testing: We intend to remain a leading
innovator in the clinical laboratory industry by continuing to
introduce new tests, technology and services. We estimate that the
current United States market in gene based testing is in excess of $1
billion per year. We believe that we have the largest gene based
testing business in the United States, with approximately $275
million in annual revenues, and that this business is growing by more
than 20% per year. We believe that the unveiling of the human genome,
the discovery of new genes and the linkages of these genes with
disease will result in more complex and thorough predictive,
diagnostic and therapeutic testing. We believe that we are well
positioned to realize this growth. We intend to focus on
commercializing diagnostic applications of discoveries in the areas
of functional genomics (the analysis of genes and their functions),
and proteomics (the discovery of new proteins made possible by the
human genome project).
o Consumer Health: Consumers are becoming increasingly interested in
managing their own health and health records. Currently, almost all
the testing we perform is ordered directly by a physician, who then
receives the test results. However, we believe that consumers will
increasingly want to order clinical laboratory tests themselves
through the Internet or our network of patient service centers, which
already service about 80,000 patients each day, or through
third-party retailers, even if the consumers are responsible for
paying for the tests themselves. Tests particularly well suited for
direct-to-consumer delivery include tests that measure levels of
cholesterol, PSA (prostate specific antigen), glucose, hemoglobin A1c
(diabetes monitoring), and TSH (thyroid disorders). We have launched
a consumer health website, questest.com'TM', that provides easy-to-
understand information about health testing. We are currently
conducting proof-of-concept pilots by providing direct testing access
to consumers in several markets. In those states that restrict the
ability of consumers to order tests and receive results directly, we
are utilizing a physician network to facilitate the ordering of tests
and reporting of results.
o Pharmaceutical Services, including Clinical Trials and Commercial
Services (Informatics): Among our strengths are our service
relationships with physicians and our clinical laboratory results
database, which we believe to be the largest private database of its
kind in the world. This database continues to grow as we perform
tests related to over 105 million requisitions each year. We believe
that this database has substantial value since a significant portion
of all healthcare decisions and spending are impacted by laboratory
testing results. We believe that we can leverage our strengths to
assist the pharmaceutical and biotechnology industries in the
development and commercialization of their products. Large customers
of clinical laboratories, including pharmaceutical companies, are
increasingly interested in integrating our clinical laboratory data
with other healthcare information to address quality, marketing and
financial related questions. We also provide customized services for
pharmaceutical and other health product companies to support the
development and implementation of their products and services. We
maintain the security and confidentiality of individual patient
results. Beyond our current clinical trials business and informatics
database, profitable growth opportunities with pharmaceutical
companies also exist in: post-marketing (Phase IV) research, patient
recruitment, genomics (drug discovery), over-the-counter drug testing
and pharmaceutical sales and product detailing.
Information Systems
Information systems are used extensively in virtually all aspects of
our business, including laboratory testing, billing, customer service,
logistics, and management of medical data. Our success depends, in part, on the
continued and uninterrupted performance of our information technology (IT)
systems. Our computer systems are vulnerable to damage from a variety of
sources, including telecommunications failures, malicious human acts and natural
disasters. Moreover, despite network security measures, some of our servers are
potentially vulnerable to physical or electronic break-ins, computer viruses and
similar disruptive problems. Despite the precautions we have taken,
unanticipated problems affecting our systems could cause failures in our IT
systems. Sustained or repeated system failures that interrupt our ability to
process test orders, deliver test results or perform tests in a timely manner
would adversely affect our reputation and result in a loss of customers and net
revenues.
During the 1980s and early 1990s when we acquired many of our
laboratory facilities, our regional laboratories were operated as local,
decentralized units. When the laboratories were acquired, we did not make
significant changes in their method of operations and we did not standardize
their billing, laboratory, and some of their other information systems. As a
result, by the end of 1995 we had many different information systems for
billing, test results reporting, and other transactions. Over time, the growth
in the size and network of our customers and the increasing complexity of
billing demonstrated a greater need for standardized systems.
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Prior to the acquisition of SBCL, we had chosen our proprietary SYS
system as our standard billing system and our QuestLab system (which is licensed
from a third party) as our standard laboratory information system, and had begun
to convert our laboratories to these standard systems. SBCL had standardized
billing and laboratory information systems throughout its laboratory network
that were different from our existing systems. During 2002, we plan to begin to
develop and implement a standard laboratory information system and a standard
billing system. We expect that the implementation of the standardized systems
will take several years to complete and will result in significantly more
centralized systems than we have today. We expect the integration of these
systems will improve operating efficiency and provide management with more
timely and comprehensive information with which to make management decisions.
However, failure to properly implement this standardization process could
materially adversely impact us. During system conversions of this type,
workflow may be temporarily interrupted, which may cause backlogs. In addition,
the implementation process, including the transfer of databases and master files
to new data centers, presents significant conversion risks which could cause
failures in our IT systems and disrupt our operations.
We continue to invest in the development and improvement of our
connectivity products for customers and providers by developing differentiated
products that will provide friendlier, easier access to information. We have
expanded our Internet capabilities with the enhanced Quest on Demand'TM' website
offering tests orders and results online for physicians and hospitals customers.
This service will allow us to replace desktop products that we currently provide
to most physicians. In November 2001, we acquired MedPlus, Inc. Their
ChartMaxx'TM' and E. Maxx'TM' patient record systems support the creation and
management of an electronic patient record, by bringing together in one
patient-centric view information from various sources, including the physician's
records and laboratory and hospital data. We intend to consider other strategic
arrangements that will enhance our ability to introduce electronic services to a
broader variety of healthcare customers.
Billing
Billing for laboratory services is complicated. Laboratories must bill
various payers, such as patients, insurance companies, Medicare, Medicaid,
doctors and employer groups, all of which have different requirements.
Additionally, auditing for compliance with applicable laws and regulations as
well as internal compliance policies and procedures adds further complexity to
the billing process. Among many other factors complicating billing are:
o pricing differences between our fee schedules and the reimbursement
rates of the payers;
o disputes with payers as to which party is responsible for payment;
and
o disparity in coverage and information requirements among various
carriers.
We believe that most of our bad debt expense, which was 6% of our net
revenues in 2001, is the result of issues that are not credit-related, primarily
missing or incorrect billing information on requisitions received from
healthcare providers. In general, we perform the requested tests and report test
results regardless of whether the billing information is incorrect or missing.
We subsequently attempt to contact the provider to obtain any missing
information and rectify incorrect billing information. Missing or incorrect
information on requisitions adds complexity to and slows the billing process,
creates backlogs of unbilled requisitions, and generally increases the aging of
accounts receivable. When all issues relating to the missing or incorrect
information are not resolved in a timely manner, the related receivables are
written-off to the allowance for doubtful accounts.
We have implemented "best practices" for billing that have
significantly reduced the percentage of requisitions with missing billing
information from approximately 16% at the beginning of 1996 to approximately
5.5% immediately prior to the acquisition of SBCL. These initiatives, together
with progress in dealing with Medicare medical necessity documentation
requirements and standardizing billing systems, have significantly reduced bad
debt expense since 1996. During the twelve months ended July 31, 1999
(immediately prior to the acquisition of SBCL), our bad debt expense was about
6% of net revenues (adjusted to exclude the effect of testing performed by third
parties under our laboratory network management arrangements), while SBCL, which
had not implemented procedures similar to ours, had bad debt expense of about
10% of net revenues (adjusted to exclude the effect of testing performed by
third parties under SBCL's laboratory network management arrangements). Since
the acquisition, we have begun implementing our pre-acquisition billing
practices at the former SBCL facilities, which we believe should enable us to
lower overall bad debt expense (including that of SBCL) to or below the levels
immediately prior to the acquisition. As a result of implementing these billing
practices, bad debt expense improved to about 6% of net revenues during 2001,
from about 7% of net revenues in 2000, and about 8% of net revenues (adjusted to
exclude the effect of testing performed by third parties under our laboratory
network management arrangements) just after completion of the SBCL acquisition.
We believe that in the
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longer term, with a continuing focus on process discipline, bad debt as a
percentage of revenues can be reduced to 4% or less (see "Regulation of
Reimbursement for Clinical Laboratory Services"). Changes in laws and
regulations could negatively impact our ability to bill our clients. The Center
for Medicare and Medicaid Services, or CMS (formerly the Health Care Financing
Administration) establishes procedures and continuously evaluates and implements
changes in the reimbursement process.
Competition
The clinical laboratory testing business is fragmented and highly
competitive. We compete with three types of providers: hospital-affiliated
laboratories, other independent clinical laboratories, and physician-office
laboratories. We are the leading clinical laboratory provider in the United
States, with net revenues greater than $3.6 billion during 2001, and facilities
in substantially all of the country's major metropolitan areas. Our largest
competitor is Laboratory Corporation of America Holdings, or LabCorp, which had
net revenues of approximately $2.2 billion during 2001. In addition, we compete
with many smaller regional and local independent clinical laboratories, as well
as with laboratories owned by physicians and hospitals (see "Customers-
Hospitals").
We believe that healthcare providers consider a number of factors when
selecting a laboratory, including:
o service capability and quality;
o accuracy, timeliness and consistency in reporting test results;
o number and type of tests performed by the laboratory;
o number, convenience and geographic coverage of patient service
centers;
o reputation in the medical community; and
o pricing.
We believe that we compete favorably in each of these areas.
We believe that large independent clinical laboratories may be able to
increase their share of the overall clinical laboratory testing market due to
their large service networks and lower cost structures. These advantages should
enable larger clinical laboratories to more effectively serve large customers,
including managed care organizations. In addition, we believe that consolidation
in the clinical laboratory testing business will continue. However, a majority
of the clinical laboratory testing is likely to continue to be performed by
hospitals, which generally have affiliations with community physicians that
refer testing to us (see "Customers-Hospitals"). As a result of these
affiliations, we compete against hospital-affiliated laboratories primarily on
the basis of service capability and quality as well as other non-pricing
factors. Our failure to provide service superior to hospital-affiliated
laboratories and other laboratories could negatively impact our net revenues.
Advances in technology may lead to the development of more
cost-effective tests that can be performed outside of an independent clinical
laboratory such as (1) point-of-care tests that can be performed by physicians
in their offices and (2) home testing that can be performed by patients or by
physicians in their offices. Development of such technology and its use by our
customers would reduce the demand for our laboratory testing services and
negatively impact our revenues (see "Regulation of Clinical Laboratory
Operations").
Quality Assurance
Our goal is to continually improve the processes for collection,
storage and transportation of patient specimens, as well as the precision and
accuracy of analysis and result reporting. Our quality assurance efforts focus
on proficiency testing, process audits, statistical process control and
personnel training for all of our laboratories and patient service centers. We
are implementing the Six Sigma approach to help achieve our goal of becoming
recognized as the undisputed quality leader in the healthcare services industry.
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Internal Proficiency Testing, Quality Control and Audits. Quality
control samples are processed in parallel with the analysis of patient
specimens. The results of tests on quality control samples are then monitored to
identify drift, shift or imprecision in the analytical processes. In addition,
we administer an internal proficiency testing program, where proficiency testing
samples are processed through our systems as routine patient samples and
reported. We also perform internal process audits as part of our comprehensive
quality assurance program.
External Proficiency Testing and Accreditation. All our laboratories
participate in various quality surveillance programs conducted externally. These
programs supplement all other quality assurance procedures. They include
proficiency testing programs administered by the College of American
Pathologists, or CAP, as well as some state agencies.
CAP is an independent non-governmental organization of board certified
pathologists. CAP is approved by the CMS to inspect clinical laboratories to
determine compliance with the standards required by the Clinical Laboratory
Improvement Amendments of 1988. CAP offers an accreditation program to which
laboratories may voluntarily subscribe. All of the Company's major regional
laboratories are accredited by the CAP. Accreditation includes on-site
inspections and participation in the CAP (or equivalent) proficiency testing
program.
Regulation of Clinical Laboratory Operations
The clinical laboratory industry is subject to significant federal and
state regulation, including inspections and audits by governmental agencies.
Governmental authorities may impose fines or criminal penalties or take other
enforcement actions to enforce laws and regulations, including revoking a
clinical laboratory's right to conduct business. Changes in regulation may
increase the costs of performing clinical laboratory tests or increase the
administrative requirements of claims.
CLIA. All of our laboratories and patient service centers are licensed
and accredited by applicable federal and state agencies. The Clinical Laboratory
Improvement Amendments of 1988, or CLIA, regulates virtually all clinical
laboratories by requiring they be certified by the federal government to ensure
that all clinical laboratory testing services are uniformly accurate, reliable
and timely. CLIA permits states to adopt regulations that are more stringent
than federal law. For example, state laws may require additional personnel
qualifications, quality control, record maintenance and proficiency testing.
Currently, most of our clinical laboratory testing is categorized as
"high" or "moderate" complexity, and therefore subject to extensive and costly
regulation under CLIA. The cost of compliance with CLIA makes it cost
prohibitive for many physicians to operate clinical laboratories in their
offices; other laws limit the ability of physicians to have ownership in a
laboratory and refer tests to such laboratory. However, manufacturers of
laboratory equipment and test kits could seek to increase their sales by
marketing point-of-care laboratory equipment to physicians and by selling test
kits approved for home use to both physicians and patients. Diagnostic tests
approved or cleared by FDA for home use are automatically deemed to be "waived"
tests under CLIA and may then be performed in physician office laboratories as
well as by patients in their homes with minimal regulatory oversight.
Drug Testing. The Substance Abuse and Mental Health Services
Administration, or SAMHSA, regulates drug testing for public sector employees
and employees of certain federally regulated businesses. SAMHSA has established
detailed performance and quality standards that laboratories must meet to
perform drug testing on federal employees and contractors and other regulated
entities. All laboratories that perform such testing must be certified as
meeting SAMHSA standards.
Controlled Substances. The federal Drug Enforcement Administration, or
DEA, regulates access to controlled substances used to perform drugs of abuse
testing. Laboratories that use controlled substances are licensed by the DEA.
Medical Waste, Hazardous Waste and Radioactive Materials. Clinical
laboratories are also subject to federal, state and local regulations relating
to the handling and disposal of regulated medical waste, hazardous waste and
radioactive materials. We generally use outside vendors to dispose of specimens.
FDA. The Food and Drug Administration, or FDA, has regulatory
responsibility over instruments, test kits, reagents and other devices used by
clinical laboratories and has taken responsibility from the Centers for Disease
Control and Prevention, or CDC, for test classification. In 1998 a final rule
issued by the FDA became effective clarifying that certain reagents used in many
tests internally developed and performed by clinical laboratories do not require
FDA clearance or approval. However, the FDA is considering whether to regulate
laboratory developed genetic tests and
12
certain laboratory developed genotyping tests for HIV resistance. In 2001, the
FDA also issued a final rule requiring clinical laboratories that perform blood
bank testing or confirmatory tests to register with the FDA.
Occupational Safety. The federal Occupational Safety and Health
Administration, or OSHA, has established extensive requirements relating
specifically to workplace safety for healthcare employers. This includes
protecting workers from exposure to blood-borne pathogens, such as HIV and
hepatitis B and C. OSHA amended its regulations effective in 2001 to require
employers to develop a program to reduce or eliminate needle stick injuries.
During the fourth quarter of 2000, we began to provide to our employees safety
needles, which are more expensive than regular needles, throughout our patient
service center network. During the fourth quarter of 2001, we began to provide
safety needles to clients who request the same safety needles we use for the
purpose of drawing specimens referred to us for testing.
Specimen Transportation. Transportation of infectious substances such
as clinical laboratory specimens is subject to regulation by the Department of
Transportation, the Public Health Service, or PHS, the United States Postal
Service and the International Civil Aviation Organization.
Corporate Practice of Medicine. Many states, including several in which
our principal laboratories are located, prohibit corporations from engaging in
the practice of medicine. The corporate practice of medicine doctrine has been
interpreted to prohibit corporations from employing licensed healthcare
professionals to provide services on the corporation's behalf. These
restrictions may affect our ability to provide services directly to consumers.
Confidentiality of Health Information
Pursuant to the Health Insurance Portability and Accountability Act of
1996, or HIPAA, on December 28, 2000, the Secretary of the Department of Health
and Human Services, or HHS, issued final regulations that would establish
comprehensive federal privacy standards with respect to the use and disclosure
of protected health information by a health plan, healthcare provider or
healthcare data clearinghouse. The regulations establish a complex regulatory
framework on a variety of subjects, including:
o the circumstances under which uses and disclosures of protected
health information require a general patient consent, specific
authorization by the patient, or no patient consent or authorization;
o patients' rights to access, amend and receive an accounting of the
disclosures and uses of protected health information;
o the content of notices of privacy practices for protected health
information; and
o administrative, technical and physical safeguards required of
entities that use or receive protected health information.
The federal healthcare privacy regulations establish a "floor" and do
not supersede state laws that are more stringent. Therefore, we are required to
comply with both federal privacy standards and varying state privacy laws. In
addition, for healthcare data transfers relating to citizens of other countries,
we will need to comply with the laws of other countries. The federal privacy
regulations became effective in April 2001 for healthcare providers, who have
until April 2003 to comply. In addition, final standards for electronic
transactions were issued in August 2000 and will become effective in October
2002, although covered entities are eligible to obtain a one year extension if
approved through an application to the Secretary of Health and Human Services,
that includes a plan for achieving compliance by October 16, 2003. These
regulations provide uniform standards for code sets (codes representing medical
procedures and laboratory tests and diagnosis codes, which are used, among
others, in connection with the identification and billing of medical procedures
and laboratory tests), electronic claims, remittance advice, enrollment,
eligibility and other electronic transactions. Finally, the proposed security
and electronic signature regulations issued by the Secretary of HHS in August
1998 pursuant to HIPAA are expected to be finalized this year and will not be
effective until two years later. HIPAA provides for significant fines and other
penalties for wrongful disclosure of protected health information. Compliance
with the HIPAA requirements, when finalized, will require significant capital
and personnel resources from all healthcare organizations, including Quest
Diagnostics. However, we will not be able to estimate the cost of complying with
all of these regulations, which we expect to be significant, until after all the
regulations are finalized. These regulations, when finalized and effective, will
likely restrict our ability to use our laboratory database to provide medical
information for purposes other than payment, treatment or healthcare operations
(as defined by HIPAA), except for information that does not identify a patient.
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Regulation of Reimbursement for Clinical Laboratory Services
Overview. The healthcare industry has experienced significant changes
in reimbursement practices during the past several years. Governmental payers,
such as Medicare (which principally serves patients 65 years and older) and
Medicaid (which principally serves indigent patients), as well as private
insurers and large employers, have taken steps to control the cost, utilization
and delivery of healthcare services. Principally as a result of reimbursement
reductions and measures adopted by CMS to reduce utilization described below,
the percentage of our aggregate net revenues derived from Medicare and Medicaid
programs declined from 20% in 1995 to 14% in 2001. We believe that our other
business may significantly depend on continued participation in the Medicare and
Medicaid programs, because many customers may want a single laboratory to
perform all of their clinical laboratory testing services, regardless of whether
reimbursements are ultimately made by themselves, Medicare, Medicaid or other
payers.
Billing and reimbursement for clinical laboratory testing is subject to
significant and complex federal and state regulation. Penalties for violations
of laws relating to billing federal healthcare programs and for violations of
federal fraud and abuse laws include: (1) exclusion from participation in
Medicare/Medicaid programs; (2) asset forfeitures; (3) civil and criminal
penalties and fines; and (4) the loss of various licenses, certificates and
authorizations necessary to operate some or all of a clinical laboratory's
business. Civil monetary penalties for a wide range of violations are not more
than $10,000 per violation plus three times the amount claimed and, in the case
of kickback violations, not more than $50,000 per violation plus up to three
times the amount of remuneration involved. A parallel civil remedy under the
federal False Claims Act provides for damages not more than $11,000 per
violation plus up to three times the amount claimed.
Reduced Reimbursements. In 1984, Congress established a Medicare fee
schedule payment methodology for clinical laboratory services performed for
patients covered under Part B of the Medicare program. Congress then imposed a
national ceiling on the amount that carriers could pay under their local
Medicare fee schedules. Since then, Congress has periodically reduced the
national ceilings. The Medicare national fee schedule limitations were reduced
in 1996 to 76% of the 1984 national median of the local fee schedules and in
1998 to 74% of the 1984 national median. In addition, Congress also eliminated
the provision for annual fee schedule increases based on the consumer price
index through 2002. Effective January 2001, however, the limitation amount for
new clinical laboratory tests as determined by the Secretary of HHS, for which
no limitation amount has previously been established, is 100% of the median of
all the fee schedules established for that test.
Laboratories must bill the Medicare program directly and must accept
the carrier's fee schedule amount as payment in full for most tests performed on
behalf of Medicare beneficiaries. In addition, state Medicaid programs are
prohibited from paying more (and in most instances, pay significantly less) than
Medicare. Major clinical laboratories, including Quest Diagnostics, typically
use two fee schedules:
o "Client" fees charged to physicians, hospitals, and institutions to
which a laboratory supplies services on a wholesale basis and which
are billed on a monthly basis. These fees are generally subject to
negotiation or discount.
o "Patient" fees charged to individual patients and third-party payers,
like Medicare and Medicaid. These generally require separate bills
for each requisition.
The fee schedule amounts established by Medicare are typically
substantially lower than patient fees otherwise charged by us, but are sometimes
higher than our fees actually charged to certain other clients. During 1992, the
Office of the Inspector General, or OIG, of the HHS issued final regulations
that prohibited charging Medicare fees substantially in excess of a provider's
usual charges. The OIG, however, declined to provide any guidance concerning
interpretation of these rules, including whether or not discounts to
non-governmental clients and payers or the dual-fee structure might be
inconsistent with these rules.
A proposed rule released in September 1997 would have authorized the
OIG to exclude providers from participation in the Medicare program, including
clinical laboratories, that charge Medicare and other programs fees that are
"substantially in excess of . . . usual charges . . . to any of [their]
customers, clients or patients." This proposal was withdrawn by the OIG in 1998.
However, the 1997 Balanced Budget Act permits CMS to adjust statutorily
prescribed fees for some medical services, including clinical laboratory
services, if the fees are "grossly excessive." In January 1998, CMS issued an
interim final rule setting forth criteria to be used by CMS in determining
whether to exercise this power. Among the factors listed in the rule are whether
the statutorily prescribed fees are "grossly higher or lower than the payment
made for the . . . services by other purchasers in the same locality." In
November 1999, the OIG issued an
14
advisory opinion which indicated that a clinical laboratory offering discounts
on client bills may violate the "usual charges" regulation if the "charge to
Medicare substantially exceeds the amount the laboratory most frequently charges
or has contractually agreed to accept from non-Federal payors." The OIG
subsequently issued a letter clarifying that the usual charges regulation is not
a blanket prohibition on discounts to private pay customers. We cannot provide
any assurances to investors that fees payable by Medicare could not be reduced
as a result of the application of this rule or that the government might not
assert claims for reimbursement by purporting to apply this rule retroactively.
Currently, there are no Medicare co-insurance or co-payments required
for clinical laboratory testing. When co-insurance was last in effect in 1984,
clinical laboratories received from Medicare carriers only 80% of the Medicare
allowed amount and were required to bill Medicare beneficiaries for the unpaid
balance of the Medicare allowed amount. If enacted, a co-insurance proposal
could adversely affect the revenues of the clinical laboratory industry,
including us, by exposing the testing laboratory to the credit of individuals
and by increasing the number of bills. In addition, a laboratory could be
subject to potential fraud and abuse violations if adequate procedures to bill
and collect the co-insurance payments are not established and followed.
Co-payments were not part of the Bush Administration's recent budget proposal
for fiscal year 2002.
Reduced Utilization of Clinical Laboratory Testing. In recent years,
CMS has taken several steps to reduce utilization of clinical laboratory
testing. Since 1995, Medicare carriers have adopted policies under which they do
not pay for many commonly ordered clinical tests unless the ordering physician
has provided an appropriate diagnostic code supporting the medical necessity of
the test. Physicians are required by law to provide diagnostic information when
they order clinical tests for Medicare and Medicaid patients. However, CMS has
not prescribed any penalty for physicians who fail to provide diagnostic
information to laboratories.
We are generally permitted to bill patients directly for some
statutorily excluded clinical laboratory services. We are also generally
permitted to bill patients for clinical laboratory tests that Medicare does not
pay for due to "medical necessity" limitations (these tests include limited
coverage tests for which a carrier-approved diagnosis code is not provided by
the ordering physician) if the patient signs an advance beneficiary notice
(ABN) under which the patient makes an informed decision as to whether to
personally assume financial liability for laboratory tests which are likely to
be not covered by Medicare because they are deemed to be not medically
necessary. We do not have any direct contact with most of these patients and, in
such cases, cannot control the proper use of the ABN by the physician or the
physician's office staff. If the ABN is not timely completed or is not completed
properly, we end up performing tests that we cannot subsequently bill to the
patient if they are not reimbursable by Medicare. Currently CMS is considering
the adoption of a CMS-approved ABN. Adoption of the new ABN form could result in
even fewer valid ABNs and consequently prevent us from billing additional
beneficiaries for services denied by Medicare for lack of medical necessity.
Inconsistent Practices. Currently, many different local carriers
administer Medicare. They have inconsistent policies on matters such as: (1)
test coverage; (2) automated chemistry panels; (3) diagnosis coding; (4) claims
documentation; and (5) fee schedules (subject to the national limitations).
Inconsistent regulation has increased the complexity of the billing process for
clinical laboratories. As part of the 1997 Balanced Budget Act, HHS was required
to adopt uniform policies on the above matters by January 1, 1999, and replace
the current local carriers with no more than five regional carriers. Although
HHS has finalized a number of uniform policies, it has not taken any final
action to replace the local carriers with five regional carriers. However, in
November 2000, CMS published a solicitation in the Commerce Business Daily
seeking two contractors to process Part B clinical laboratory claims. In the
solicitation, CMS stated that the Secretary has decided to limit the number of
carriers processing clinical diagnostic laboratory test claims to two
contractors. The solicitation indicated that the Request for Proposal (RFP)
would be released on or before December 31, 2000 but as of February 2002, it had
not been issued; the solicitation did not indicate the effective date for a
final transition to the regional carrier model.
CMS plans to achieve standardization in part through implementing a
single claims processing system for all carriers. This initiative, however, was
suspended due to CMS's Year 2000 compliance priorities.
Competitive Bidding. The 1997 Balanced Budget Act requires CMS to
conduct five Medicare bidding demonstrations involving various types of medical
services and complete them by 2002. CMS is expected to include a clinical
laboratory demonstration project in a metropolitan statistical area as part of
the legislative mandate. Florida has issued a proposal for competitive bidding
for its Medicaid program. If competitive bidding were implemented on a regional
or national basis for clinical laboratory testing, it could materially adversely
affect the clinical laboratory industry and us.
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Future Legislation. Future changes in federal, state and local
regulations (or in the interpretation of current regulations) affecting
governmental reimbursement for clinical laboratory testing could adversely
affect us. We cannot predict, however, whether and what type of legislative
proposals will be enacted into law or what regulations will be adopted by
regulatory authorities.
Fraud and Abuse Regulations. Medicare and Medicaid anti-kickback laws
prohibit clinical laboratories from making payments or furnishing other benefits
to influence the referral of tests billed to Medicare, Medicaid or other federal
programs. As noted above, the penalties for violation of these laws may include
criminal and civil fines and penalties and/or suspension or exclusion from
participation in federal programs. Many of the anti-fraud statutes and
regulations, including those relating to joint ventures and alliances, are vague
or indefinite and have not been interpreted by the courts. We cannot predict if
some of the fraud and abuse rules will be interpreted contrary to our practices.
In November 1999, the OIG issued an advisory opinion concluding that
the industry practice of discounting client bills may constitute a kickback if
the discounted price is below a laboratory's overall cost (including overhead)
and below the amounts reimbursed by Medicare. Advisory opinions are not binding
but may be indicative of the position that prosecutors may take in enforcement
actions. The OIG's opinion, if enforced, could result in fines and possible
exclusion and could require us to eliminate offering discounts to clients below
the rates reimbursed by Medicare. The OIG subsequently issued a letter
clarifying that it did not intend to imply that discounts are a per se violation
of the federal anti-kickback statute, but may merit further investigation
depending on the facts and circumstances presented.
In addition, since 1992, a federal anti-"self-referral" law, commonly
known as the "Stark" law, prohibits, with certain exceptions, Medicare payments
for laboratory tests referred by physicians who have, personally or through a
family member, an investment interest in, or a compensation arrangement with,
the testing laboratory. Since January 1995, these restrictions have also applied
to Medicaid-covered services. Many states have similar anti-"self-referral" and
other laws that also affect investment and compensation arrangements with
physicians who refer other than government-reimbursed laboratory testing to us.
We cannot predict if some of the state laws will be interpreted contrary to our
practices.
Government Investigations and Related Claims
We are subject to extensive and frequently changing federal, state and
local laws and regulations. We believe that, based on our experience with
government settlements and public announcements by various government officials,
the federal government continues to strengthen its position on healthcare fraud.
In addition, legislative provisions relating to healthcare fraud and abuse give
federal enforcement personnel substantially increased funding, powers and
remedies to pursue suspected fraud and abuse. While we believe that we are in
material compliance with all applicable laws, many of the regulations applicable
to us, including those relating to billing and reimbursement of tests and those
relating to relationships with physicians and hospitals, are vague or indefinite
and have not been interpreted by the courts. They may be interpreted or applied
by a prosecutorial, regulatory or judicial authority in a manner that could
require us to make changes in our operations, including our billing practices.
If we fail to comply with applicable laws and regulations, we could suffer civil
and criminal penalties, including the loss of licenses or our ability to
participate in Medicare, Medicaid and other federal and state healthcare
programs.
During the mid-1990s, Quest Diagnostics and SBCL settled government
claims that primarily involved industry-wide billing and marketing practices
that both companies believed to be lawful. The aggregate amount of the
settlements for these claims exceeded $500 million. The federal or state
governments may bring additional claims based on new theories as to our
practices that we believe to be in compliance with law. The federal government
has substantial leverage in negotiating settlements since the amount of
potential fines far exceeds the rates at which we are reimbursed, and the
government has the remedy of excluding a non-compliant provider from
participation in the Medicare and Medicaid programs, which represented
approximately 14% of our consolidated net revenues during 2001.
At December 31, 2001 recorded reserves, relating primarily to billing
claims, including those indemnified by SmithKline Beecham, approximated $21
million. Note 17 to the Consolidated Financial Statements describes the
indemnification from SmithKline Beecham against certain claims. SmithKline
Beecham has also agreed to indemnify Quest Diagnostics with respect to pending
actions relating to a former SBCL employee that at times reused certain needles
when drawing blood from patients. Although management believes that established
reserves for both indemnified and non-indemnified claims are sufficient, it is
possible that additional information may become available that may cause the
final resolution of these matters to exceed established reserves by an amount
which could be material to our results of operations and cash flows in the
period in which such claims are settled. We do not believe that these issues
will have a material adverse effect on our overall financial condition. However,
we understand that there may be
16
pending qui tam claims brought by former employees or other "whistle blowers" as
to which we have not been provided with a copy of the complaint and accordingly
cannot determine the extent of any potential liability.
As an integral part of our compliance program discussed below, we
investigate all reported or suspected failures to comply with federal healthcare
reimbursement requirements. Any non-compliance that results in Medicare or
Medicaid overpayments is reported to the government and reimbursed by us. As a
result of these efforts, we have periodically identified and reported
overpayments. While we have reimbursed these overpayments and have taken
corrective action where appropriate, we cannot assure investors that in each
instance the government will necessarily accept these actions as sufficient.
Compliance Program
Compliance with all government rules and regulations has become a
significant concern throughout the clinical laboratory industry because of
evolving interpretations of regulations and the national debate over healthcare.
We began a compliance program early in 1993.
We emphasize the development of training programs intended to ensure
the strict implementation and observance of all applicable laws, regulations and
company policies. Further, we conduct in-depth reviews of procedures, personnel
and facilities to assure regulatory compliance throughout our operations. The
Quality, Safety and Compliance Committee of the Board of Directors requires
periodic reporting of compliance operations from management. Government
officials have publicly cited our program as a model for the industry. In
October 1996, we signed a five-year corporate integrity agreement with the OIG
that expired in October 2001.
We believe we comply in all material respects with all applicable
statutes and regulations. However, we cannot assure you that no statutes or
regulations will be interpreted or applied by a prosecutorial, regulatory or
judicial authority in a manner that would adversely affect us. Potential
sanctions for violation of these statutes include significant damages,
penalties, and fines, exclusion from participation in governmental healthcare
programs and the loss of various licenses, certificates and authorization
necessary to operate some or all of our business.
Insurance
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 our client base and
reputation. We maintain various liability and property insurance programs for
claims that could result from providing or failing to provide clinical
laboratory testing services, including inaccurate testing results and other
exposures but we are essentially self-insured for most of these claims. We do
maintain coverage which caps our exposure on individual claims. The basis for
our insurance reserves is the actuarially determined projected losses based upon
our historical loss experience. Management believes that present insurance
coverage and reserves are sufficient to cover currently estimated exposures, but
we cannot assure you that we will not incur liabilities in excess of recorded
reserves. Similarly, although we believe that we will be able to obtain adequate
insurance coverage in the future at acceptable costs, we cannot assure you that
we will be able to do so.
Employees
At December 31, 2001 and 2000, we employed approximately 29,000 and
27,000 people, respectively. Approximately 27,000 of our employees were
full-time at December 31, 2001. These totals exclude employees of the joint
ventures where we do not have a majority interest. We have no collective
bargaining agreements with any unions, and we believe that our overall relations
with our employees are good.
17
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Some statements and disclosures in this document are forward-looking
statements. Forward-looking statements include all statements that do not relate
solely to historical or current facts and can be identified by the use of words
such as "may", "believe", "will", "expect", "project", "estimate", "anticipate",
"plan" or "continue". These forward-looking statements are based on our current
plans and expectations and are subject to a number of risks and uncertainties
that could significantly cause our plans and expectations, including actual
results, to differ materially from the forward-looking statements. The Private
Securities Litigation Reform Act of 1995 provides a "safe harbor" for
forward-looking statements to encourage companies to provide prospective
information about their companies without fear of litigation.
We would like to take advantage of the "safe harbor" provisions of the
Litigation Reform Act in connection with the forward-looking statements included
in this document. Investors are cautioned not to unduly rely on such
forward-looking statements when evaluating the information presented in this
document. The following important factors could cause our actual financial
results to differ materially from those projected, forecasted or estimated by us
in forward-looking statements:
(a) Heightened competition, including increased pricing pressure,
competition from hospitals for testing for non-patients and
competition from physicians. See "Business - Competition."
(b) Impact of changes in payer mix, including any shift from
traditional, fee-for-service medicine to capitated managed-cost
healthcare. See "Business - Payers and Customers - Customers -
Managed Care Organizations."
(c) Adverse actions by government or other third-party payers,
including unilateral reduction of fee schedules payable to us and
an increase in the practice of negotiating for exclusive contracts
that involve aggressively priced capitated payments by managed
care organizations. See "Business - Regulation of Reimbursement
for Clinical Laboratory Services" and "Business - Payers and
Customers - Customers - Managed Care Organizations."
(d) The impact upon our volume and collected revenue or general or
administrative expenses resulting from our compliance with
Medicare and Medicaid administrative policies and requirements of
third-party payers. These include:
(1) the requirements of Medicare carriers to provide diagnosis
codes for many commonly ordered tests and the likelihood that
third-party payers will increasingly adopt similar
requirements;
(2) the policy of CMS to limit Medicare reimbursement for tests
contained in automated chemistry panels to the amount that
would have been paid if only the covered tests, determined on
the basis of demonstrable "medical necessity", had been
ordered;
(3) continued inconsistent practices among the different local
carriers administering Medicare; and
(4) proposed changes by CMS to the ABN form.
See "Business - Regulation of Reimbursement for Clinical
Laboratory Services" and "Business - Billing".
(e) Adverse results from pending or future government investigations
or private actions. These include, in particular:
(1) significant monetary damages and/or exclusion from the
Medicare and Medicaid programs and/or other significant
litigation matters;
(2) the absence of indemnification from SmithKline Beecham for:
(a) governmental claims against SBCL that arise after August
16, 1999; and
(b) private claims unrelated to the indemnified governmental
claims or investigations; and
18
(3) the absence of indemnification for consequential damages from
SmithKline Beecham.
(f) Failure to obtain new customers at profitable pricing or failure
to retain existing customers, and reduction in tests ordered or
specimens submitted by existing customers.
(g) Failure to efficiently integrate acquired clinical laboratory
businesses, or to efficiently integrate clinical laboratory
businesses from joint ventures and alliances with hospitals, and
the costs related to any such integration, or to retain key
technical and management personnel.
(h) Inability to obtain professional liability insurance coverage or a
material increase in premiums for such coverage. See "Business -
Insurance."
(i) Denial of CLIA certification or other license for any of Quest
Diagnostics' clinical laboratories under the CLIA standards, by
CMS for Medicare and Medicaid programs or other federal, state and
local agencies. See "Business - Regulation of Clinical Laboratory
Operations."
(j) Increased federal or state regulation of independent clinical
laboratories, including regulation by the FDA.
(k) Adverse publicity and news coverage about us or the clinical
laboratory industry.
(l) Computer or other system failures that affect our ability to
perform tests, report test results or properly bill customers,
including potential failures resulting from systems conversions,
including from the integration of the systems of Quest Diagnostics
and SBCL, telecommunications failures, malicious human acts (such
as electronic break-ins or computer viruses) or natural disasters.
See "Business - Information Systems" and "Business - Billing."
(m) Development of technologies that substantially alter the practice
of laboratory medicine, including technology changes that lead to
the development of more cost-effective tests such as (1)
point-of-care tests that can be performed by physicians in their
offices and (2) home testing that can be carried out without
requiring the services of clinical laboratories. See "Competition"
and "Regulation of Clinical Laboratory Operations."
(n) Issuance of patents or other property rights to our competitors or
others that could prevent, limit or interfere with our ability to
develop, perform or sell our tests or operate our business. See
"Business - The United States Clinical Laboratory Testing Market."
(o) Development of tests by our competitors or others which we may not
be able to license, or usage of our technology or similar
technologies or our trade secrets by competitors, any of which
could negatively affect our competitive position.
(p) Development of an Internet based electronic commerce business
model that does not require an extensive logistics and laboratory
network.
(q) The impact of the privacy and security regulations issued under
HIPAA on our operations (including its medical information
services) as well as the cost to comply with the regulations. See
"Business - Confidentiality of Health Information."
(r) Changes in interest rates and changes in our credit ratings from
Standard & Poor's and Moody's Investor Services causing a
substantial increase in our effective borrowing rate.
(s) An ability to hire and retain qualified personnel or the loss of
the services of one or more of our key senior management
personnel.
(t) Terrorist and other criminal activities, which could affect our
customers, transportation or power systems, or our facilities, and
for which insurance may not adequately reimburse us for.
(u) Changes in our credit ratings from Standard & Poor's and Moody's
Investor Services causing an unfavorable impact on our cost of and
access to capital.
19
Item 2. Properties
------------------
Our principal laboratories (listed alphabetically by state) are located in or
near the following metropolitan areas. In certain areas (indicated by the number
(2)), we have two principal laboratories as a result of recent acquisitions.
Location Leased or Owned
-------- ---------------
Phoenix, Arizona Leased by Joint Venture
Los Angeles, California Owned
San Diego, California Leased
San Francisco, California Owned
San Juan Capistrano, California Owned
Denver, Colorado Leased
New Haven, Connecticut Owned
Miami, Florida (2) Leased
Tampa, Florida Owned
Atlanta, Georgia Owned
Chicago, Illinois (2) One owned, one leased
Indianapolis, Indiana Leased by Joint Venture
Lexington, Kentucky Owned
New Orleans, Louisiana Owned
Baltimore, Maryland Owned
Boston, Massachusetts Leased
Detroit, Michigan Leased
St. Louis, Missouri Owned
New York, New York (Teterboro, New Jersey)(2) One owned, one leased
Long Island, New York Leased
Oklahoma City, Oklahoma Leased by Joint Venture
Portland, Oregon Leased
Philadelphia, Pennsylvania Leased
Pittsburgh, Pennsylvania Leased
Nashville, Tennessee Leased
Dallas, Texas Leased
Houston, Texas Leased
Seattle, Washington Leased
Our executive offices are located in Teterboro, New Jersey, at the
facility that also serves as our regional laboratory serving the New York City
metropolitan area. We lease an administrative office in Lyndhurst, New Jersey,
near our executive offices and lease a site in Norristown, Pennsylvania, that
serves as a billing center. We also lease under a capital lease an
administrative office in Collegeville, Pennsylvania. We own our laboratory
facility in Mexico City and lease a laboratory facility near London, England. We
believe that, in general, our laboratory facilities are suitable and adequate
for our current and anticipated future levels of operation. We believe that if
we were unable to renew a lease on any of our testing facilities, we could find
alternative space at competitive market rates and relocate our operations to
such new location.
Item 3. Legal Proceedings
-------------------------
In addition to the investigations described in "Business-Government
Investigations and Related Claims," we are involved in various legal proceedings
arising in the ordinary course of business. Some of the proceedings against us
involve claims that are substantial in amount. Some of these claims involve
contracts of SBCL that were terminated following our acquisition of SBCL.
Although we cannot predict the outcome of such proceedings or any claims made
against us, we do not anticipate that the ultimate outcome of the various
proceedings or claims will have a material adverse effect on our financial
position.
Item 4. Submission of Matters to a Vote of Security Holders
-----------------------------------------------------------
None.
20
PART II
Item 5. Market for Registrant's Common Stock and Related Stockholder Matters
----------------------------------------------------------------------------
Our common stock is listed and traded on the New York Stock Exchange
under the symbol "DGX." The following table sets forth, for the periods
indicated, the high and low sales price per share as reported on the New York
Stock Exchange Consolidated Tape (all prices have been restated to reflect the
two-for-one stock split effected on May 31, 2001 - See Note 2 to the
Consolidated Financial Statements):
High Low
---- ---
1999
First Quarter $11.41 $ 8.87
Second Quarter 13.75 10.75
Third Quarter 14.07 11.87
Fourth Quarter 16.47 11.28
2000
First Quarter 20.19 14.57
Second Quarter 37.37 18.50
Third Quarter 70.50 36.63
Fourth Quarter 73.13 41.37
2001
First Quarter 70.47 36.60
Second Quarter 75.75 42.15
Third Quarter 75.50 48.10
Fourth Quarter 72.27 55.02
As of February 22, 2002, we had approximately 6,200 record holders of
our common stock.
We have never declared or paid cash dividends on our common stock and
do not anticipate paying any dividends on our common stock in the foreseeable
future. We currently intend to retain all available funds and any future
earnings to fund the development and growth of our business.
Item 6. Selected Financial Data
-------------------------------
See page 28.
Item 7. Management's Discussion and Analysis of Financial Condition and Results
-------------------------------------------------------------------------------
of Operations
-------------
See page 31.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
-------------------------------------------------------------------
See Management's Discussion and Analysis of Financial Condition and
Results of Operations.
Item 8. Financial Statements and Supplementary Data
---------------------------------------------------
See Item 14 (a) 1 and 2.
Item 9. Changes in and Disagreements with Accountants on Accounting and
-----------------------------------------------------------------------
Financial Disclosure
--------------------
None.
21
PART III
Item 10. Directors and Executive Officers of the Registrant
-----------------------------------------------------------
Information concerning the directors of the Company is incorporated by
reference to the information in the Company's Proxy Statement to be filed on or
before April 30, 2002 (the "Proxy Statement") appearing under the caption
"Election of Directors."
Executive Officers of the Registrant
Officers of the Company are elected annually by the Board of Directors
and hold office at the discretion of the Board of Directors. The following
persons serve as executive officers of the Company:
Kenneth W. Freeman (51) is Chairman of the Board and Chief Executive
Officer of the Company. Mr. Freeman joined the Company in May 1995 as President
and Chief Executive Officer, was elected a director in July 1995 and was elected
Chairman of the Board in December 1996. Prior to 1995, he served in a variety of
financial and managerial positions at Corning, which he joined in 1972. He was
elected Controller and a Vice President of Corning in 1985, Senior Vice
President in 1987, General Manager of the Science Products Division in 1989 and
Executive Vice President in 1993. He was appointed President and Chief Executive
Officer of Corning Asahi Video Products Company in 1990.
Surya N. Mohapatra, Ph.D. (52) is President and Chief Operating
Officer. Prior to joining the Company in February 1999 as Senior Vice President
and Chief Operating Officer, he was Senior Vice President of Picker
International, a worldwide leader in advanced medical imaging technologies,
where he served in various executive positions during his 18-year tenure.
Lucia L. Quinn (49) is Senior Vice President for Advanced Diagnostics.
Ms. Quinn has overall responsibility for Science and Innovation, Business
Development, Pharmaceutical Services and Consumer Health. Ms. Quinn joined the
Company in April 2001 as Vice President, Developing Businesses. From 1999
through April 2001 she was with Allied Signal/Honeywell, serving most recently
as Vice President Strategic Marketing. From 1989 through 1999, Ms. Quinn was
employed by Digital Equipment Corporation/Compaq, most recently serving as Vice
President- Corporate Strategy. She assumed her current responsibilities in
October 2001.
Richard L. Bevan (42) is Vice President for Human Resources. From 1982
until August 1999, Mr. Bevan served in a variety of human resources positions
for SmithKline Beecham's pharmaceutical and clinical laboratory businesses, most
recently serving as Vice President and Director of Human Resources-Operations
for SBCL. Mr. Bevan was appointed Corporate Vice President for Human Resource
Strategy and Development in August 1999, and to his present position in January
2001.
Catherine Doherty (39) is Vice President for Communications and Public
Affairs. Ms. Doherty has overall responsibility for internal and external
communications and government affairs. Ms. Doherty has been employed by the
Company since 1990. She served as Chief Accounting Officer from 1996 until July
2000, when she became Vice President Investor Relations. Ms. Doherty assumed her
current responsibilities in November 2001.
Robert A. Hagemann (45) is Vice President and Chief Financial Officer.
He joined Corning Life Sciences, Inc., in 1992, where he held a variety of
senior financial positions before being named Vice President and Corporate
Controller of the Company in 1996. Prior to joining the Company, Mr. Hagemann
was employed by Prime Hospitality, Inc. and Crompton & Knowles, Inc. in senior
financial positions. He was also previously associated with Ernst & Young. Mr.
Hagemann assumed his present responsibilities in August 1998.
Gerald C. Marrone (59) is Senior Vice President, Administration and
Chief Information Officer. Mr. Marrone joined the Company in November 1997 as
Chief Information Officer, after 12 years with Citibank, N.A. While at Citibank,
he was most recently Vice President, Division Executive for Citibank's Global
Production Support Division, and was also the Chief Information Officer of
Citibank's Global Cash Management business. Prior to joining Citibank, he was
the Chief Information Officer for Memorial Sloan-Kettering Cancer Center in New
York for five years.
Michael E. Prevoznik (40) is Vice President for Legal and Compliance
and General Counsel. Prior to joining SBCL in 1994 as its Chief Legal Compliance
Officer, Mr. Prevoznik was with Dechert Price & Rhodes. In 1996, he became Vice
President and Chief Legal Compliance Officer for SmithKline Beecham Healthcare
Services. In 1998, he
22
was appointed Vice President, Compliance for SmithKline Beecham, assuming
additional responsibilities for coordinating all compliance activities within
SmithKline Beecham worldwide. Mr. Prevoznik assumed his current responsibilities
with the Company in August 1999.
Item 11. Executive Compensation
-------------------------------
The information called for by this Item is incorporated by reference to
the information under the caption "Executive Compensation" appearing in the
Proxy Statement. The information contained in the Proxy Statement under the
captions "Compensation Committee Report on Executive Compensation" and
"Performance Graph" is not incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management
-----------------------------------------------------------------------
The information called for by this Item is incorporated by reference to
the information under the caption "Security Ownership of Certain Beneficial
Owners and Management" appearing in the Proxy Statement.
Item 13. Certain Relationships and Related Transactions
-------------------------------------------------------
The information called for by this Item is incorporated by reference to
the information under the caption "Certain Relationships and Related
Transactions" appearing in the Proxy Statement.
23
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
------------------------------------------------------------------------
(a) Documents filed as part of this report:
1. Index to financial statements and supplementary data filed as
part of this report:
Item Page
Report of Independent Accountants................................ F-1
Consolidated Balance Sheets...................................... F-2
Consolidated Statements of Operations............................ F-3
Consolidated Statements of Cash Flows............................ F-4
Consolidated Statements of Stockholders' Equity.................. F-5
Notes to Consolidated Financial Statements....................... F-6
Supplementary Data: Quarterly Operating Results (unaudited)...... F-33
2. Financial Statement Schedule:
Item Page
Schedule II - Valuation Accounts and Reserves.................... F-34
3. Exhibits filed as part of this report:
See (c) below.
(b) Reports on Form 8-K filed during the last quarter of 2001:
On November 14, 2001, the Company filed a current report on Form
8-K to update all investors on its outlook, which remained
unchanged from the guidance we provided during the Third Quarter
2001 financial conference call on October 19, 2001.
On November 27, 2001, the Company filed a current report on Form
8-K with respect to its completion, on November 26, 2001, of its
previously announced public offering of $250 million of 1.75%
contingent convertible debentures due 2021 (the "Debentures
Offering").
On November 29, 2001, the Company filed a current report on Form
8-K containing an opinion by Shearman & Sterling as to certain tax
matters in connection with the Debentures Offering.
(c) Exhibits filed as part of this report:
Exhibit
Number Description
------ -----------
3.1 Restated Certificate of Incorporation (filed as an exhibit to the Company's current
report on Form 8-K (Date of Report: May 31, 2001) and incorporated herein by reference)
3.2 Amended and Restated By-Laws of the Registrant (filed as an Exhibit to the Company's 2000
annual report on Form 10-K and incorporated herein by reference)
4.1 Form of Rights Agreement dated December 31, 1996 (the "Rights Agreement") between Corning
Clinical Laboratories Inc. and Harris Trust and Savings Bank as Rights Agent
24
(filed as an Exhibit to the Company's Registration Statement on Form 10 (File No. 1-12215)
and incorporated herein by reference)
4.2 Form of Amendment No. 1 effective as of July 1, 1999 to the Rights Agreement (filed as an
exhibit to the Company's current report on Form 8-K (Date of Report: August 16, 1999) and
incorporated herein by reference)
4.3 Form of Amendment No. 2 to the Rights Agreement (filed as an Exhibit to the Company's
1999 annual report on Form 10-K and incorporated herein by reference)
4.4 Form of Amendment No. 3 to the Rights Agreement (filed as an Exhibit to the Company's
2000 annual report on Form 10-K and incorporated herein by reference)
10.1 Form of 6 3/4% Senior Notes due 2006, including the form of guarantee endorsed thereon
(filed as an exhibit to the Company's current report on Form 8-K (Date of Report: June
27, 2001) and incorporated herein by reference)
10.2 Form of 7 1/2% Senior Notes due 2011, including the form of guarantee endorsed thereon
(filed as an exhibit to the Company's current report on Form 8-K (Date of Report: June
27, 2001) and incorporated herein by reference)
10.3 Form of 1.75% Contingent Convertible Debentures due 2021, including the form of guarantee
endorsed thereon (filed as an exhibit to the Company's current report on Form 8-K (Date
of Report: November 26, 2001) and incorporated herein by reference)
10.4 Indenture dated as of June 27, 2001, among the Company, the Subsidiary Guarantors, and
the Trustee (filed as an exhibit to the Company's current report on Form 8-K (Date of
Report: June 27, 2001) and incorporated herein by reference)
10.5 First Supplemental Indenture, dated as of June 27, 2001, among the Company, the
Subsidiary Guarantors, and the Trustee to the Indenture referred to in Exhibit 10.4
(filed as an exhibit to the Company's current report on Form 8-K (Date of Report: June
27, 2001) and incorporated herein by reference)
10.6 Second Supplemental Indenture, dated as of November 26, 2001, among the Company, the
Subsidiary Guarantors, and the Trustee to the Indenture referred to in Exhibit 10.4
(filed as an exhibit to the Company's current report on Form 8-K (Date of Report:
November 26, 2001) and incorporated herein by reference)
10.7 Credit Agreement, dated as of June 27, 2001, among the Company, the Subsidiary Guarantors
and the Banks (filed as an exhibit to the Company's current report on Form 8-K (Date of
Report: June 27, 2001) and incorporated herein by reference)
10.8 Amended and Restated Credit and Security Agreement, dated as of September 28, 2001, among
Quest Diagnostics Receivables Inc., as Borrower, the Company, as Initial Servicer, each of
the Lenders party thereto and Wachovia Bank, N.A., as Administrative Agent (filed as an
exhibit to the Company's quarterly report on Form 10-Q for the quarter ended September 30,
2001 and incorporated herein by reference)
10.9 Amendment No. 1 to the Amended and Restated Credit and Security Agreement, dated as of
October 30, 2001, among Quest Diagnostics Receivables Inc., as Borrower, the Company, as
Initial Servicer, each of the Lenders party thereto and Wachovia Bank, N.A., as
Administrative Agent (filed as an exhibit to the Company's quarterly report on Form 10-Q
for the quarter ended September 30, 2001 and incorporated herein by reference)
10.10 Amendment No. 2 to the Amended and Restated Credit and Security Agreement, dated as of
January 14, 2002, among Quest Diagnostics Receivables Inc., as Borrower, the Company, as
Initial Servicer, each of the Lenders party thereto and Wachovia Bank, N.A., as
Administrative Agent
10.11 Receivables Sale Agreement dated as of July 21, 2000 between the Company, each of the
subsidiary sellers party thereto and Quest Diagnostics Receivables Inc. (filed as an exhibit
to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 2000 and
incorporated herein by reference)
10.12 Stock and Asset Purchase Agreement dated as of February 9, 1999 among SmithKline Beecham plc,
SmithKline Beecham Corporation and the Company (the "Stock and Asset Purchase Agreement") (filed
as Appendix A of the Company's Definitive Proxy Statement dated May 11, 1999 and incorporated
by reference)
10.13 Amendment No. 1 dated August 6, 1999 to the Stock and Asset Purchase Agreement (filed as
an exhibit to the Company's current report on Form 8-K (Date of Report: August 16, 1999)
and incorporated herein by reference)
10.14 Non-Competition Agreement dated as of August 16, 1999 between SmithKline Beecham plc and the
Company (filed as an exhibit to the Company's current report on Form 8-K
25
(Date of Report: August 16, 1999) and incorporated herein by reference)
10.15 Stockholders Agreement dated as of August 16, 1999 between SmithKline Beecham plc
and the Company (filed as an exhibit to the Company's current report on Form 8-K
(Date of Report: August 16, 1999) and incorporated herein by reference)
10.16 Category One Data Access Agreement dated as of August 16, 1999 between SmithKline
Beecham plc and the Company (filed as an exhibit to the Company's current report on
Form 8-K (Date of Report: August 16, 1999) and incorporated herein by reference)
10.17 Global Clinical Trials Agreement dated as of August 16, 1999 between SmithKline
Beecham plc and the Company (filed as an exhibit to the Company's current report on
Form 8-K (Date of Report: August 16, 1999) and incorporated herein by reference)
10.18 First Amendment to Global Clinical Trials Agreement, dated January 18, 2001 with an
effective date of January 1, 2000 between SmithKline Beecham plc and the Company
10.19 Form of Employees Stock Purchase Plan (filed as an Exhibit to the Company's Registration
Statement on Form 10 (File No. 1-12215) and incorporated herein by reference)
10.20 Form of 1996 Employee Equity Participation Program (filed as an Exhibit to the Company's
Registration Statement on Form 10 (File No. 1-12215) and incorporated herein by reference)
10.21 Form of 1999 Employee Equity Participation Program (filed as an Exhibit to the Company's
proxy statement for the 1999 annual meeting of shareholders and incorporated herein by
reference)
10.22 Form of Stock Option Plan for Non-Employee Directors (filed as an exhibit to the Company's
proxy statement for the 1998 annual meeting of shareholders and incorporated herein by
reference)
10.23 Employment Agreement between the Company and Kenneth W. Freeman (filed as an exhibit to
the Company's 1999 annual report on Form 10-K and incorporated herein by reference)
10.24 Amendment to the Employment Agreement between the Company and Kenneth W. Freeman (filed
as an exhibit to the Company's quarterly report on Form 10-Q for the quarter ended June
30, 2000 and incorporated herein by reference)
10.25 Form of Supplemental Deferred Compensation Plan (filed as an exhibit to the Company's
annual report on Form 10-K for the year ended December 31, 1998 and incorporated herein
by reference)
10.26 Form of Executive Retirement Supplemental Plan (filed as an Exhibit to the Company's
Registration Statement on Form 10 (File No. 1-12215) and incorporated herein by reference)
12.27 Form of Variable Compensation Plan (filed as an Exhibit to the Company's Registration
Statement on Form 10 (File No. 1-12215) and incorporated herein by reference)
21 Subsidiaries of Quest Diagnostics Incorporated
23.1 Consent of PricewaterhouseCoopers LLP
23.2 Consent of PricewaterhouseCoopers LLP
99.1 Quest Diagnostics Incorporated and Subsidiaries Selected Historical Financial Data Restated
to Reflect the Two-for-one Stock Split Effective May 31, 2001 (filed as an exhibit to the
Company's current report on Form 8-K (Date of Report: May 31, 2001) and incorporated herein
by reference)
26
Signatures
Pursuant to the requirements of Sections 13 or 15(d) 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.
Quest Diagnostics Incorporated
By /s/ Kenneth W. Freeman
----------------------------
Kenneth W. Freeman Chairman of the Board and February 27, 2002
Chief Executive Officer
By /s/ Robert A. Hagemann
----------------------------
Robert A. Hagemann Vice President and February 27, 2002
Chief Financial Officer
By /s/ Thomas F. Bongiorno
----------------------------
Thomas F. Bongiorno Vice President Controller and February 27, 2002
Chief Accounting Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant and on the dates indicated.
Capacity Date
-------- -----
/s/ Kenneth W. Freeman
----------------------------
Kenneth W. Freeman Chairman of the Board and February 27, 2002
Chief Executive Officer
/s/ Kenneth D. Brody
----------------------------
Kenneth D. Brody Director February 27, 2002
/s/ William F. Buehler
----------------------------
William F. Buehler Director February 27, 2002
/s/ Van C. Campbell
----------------------------
Van C. Campbell Director February 27, 2002
/s/ Mary A. Cirillo
----------------------------
Mary A. Cirillo Director February 27, 2002
/s/ William R. Grant
----------------------------
William R. Grant Director February 27, 2002
/s/ Rosanne Hagerty
----------------------------
Rosanne Hagerty Director February 27, 2002
/s/ Dan C. Stanzione
----------------------------
Dan C. Stanzione Director February 27, 2002
/s/ Gail R. Wilensky
----------------------------
Gail R. Wilensky Director February 27, 2002
/s/ John B. Ziegler
----------------------------
John B. Ziegler Director February 27, 2002
27
SELECTED HISTORICAL FINANCIAL DATA OF OUR COMPANY
The following table summarizes selected historical financial data of
our company and our subsidiaries at the dates and for each of the periods
presented. We derived the selected historical financial data for the years 1997
through 2001 from the audited consolidated financial statements of our company.
As discussed in Note 2 to the Consolidated Financial Statements, all per share
data has been restated to reflect our two-for-one stock split effected on May
31, 2001. The selected historical financial data is only a summary and should be
read together with the audited consolidated financial statements and related
notes of our company and management's discussion and analysis of financial
condition and results of operations included elsewhere in this Annual Report on
Form 10-K.
28
Year Ended December 31,
-----------------------------------------------------------------------------
2001 2000 1999 (a) 1998 1997
-------------- -------------- -------------- -------------- -------------
(in thousands, except per share data)
Operations Data:
Net revenues..................................$ 3,627,771 $ 3,421,162 $2,205,243 $ 1,458,607 $1,528,695
Provisions for restructuring and other
special charges............................. 5,997 (b) 2,100 (c) 73,385 (d) - 48,688 (e)
Income (loss) before extraordinary loss....... 183,912 (f) 104,948 (g) (1,274) (h) 26,885 (22,260)
Net income (loss)............................. 162,303 (f) 102,052 (g) (3,413) (h) 26,885 (22,260)
Basic net income (loss) per common share:
Income (loss) before extraordinary loss.......$ 1.98 $ 1.17 $ (0.02) $ 0.45 $ (0.38)
Net income (loss)............................. 1.74 1.14 (0.05) 0.45 (0.38)
Diluted net income (loss) per common share: (i)
Income (loss) before extraordinary loss.......$ 1.88 $ 1.11 $ (0.02) $ 0.44 $ (0.38)
Net income (loss)............................. 1.66 1.08 (0.05) 0.44 (0.38)
Balance Sheet Data (at end of year):
Accounts receivable, net......................$ 508,340 $ 485,573 $ 539,256 $ 220,861 $ 238,369
Total assets.................................. 2,930,555 2,864,536 2,878,481 1,360,240 1,400,928
Long-term debt................................ 820,337 760,705 1,171,442 413,426 482,161
Preferred stock .............................. - (j) 1,000 1,000 1,000 1,000
Common stockholders' equity................... 1,335,987 1,030,795 862,062 566,930 540,660
Other Data:
Net cash provided by operating activities.....$ 465,803 $ 369,455 $ 249,535 $ 141,382 $ 176,267
Net cash used in investing activities......... (296,616) (48,015) (1,107,990) (39,720) (35,101)
Net cash provided by (used in) financing
activities.................................. (218,332) (177,247) 682,831 (60,415) (21,465)
Provision for doubtful accounts............... 218,271 234,694 142,333 89,428 118,223 (k)
Rent expense.................................. 82,769 76,515 59,073 46,259 47,940
Capital expenditures.......................... 148,986 116,450 76,029 39,575 30,836
Adjusted EBITDA (l)........................... 556,851 459,380 237,038 158,609 153,800
(a) On August 16, 1999, we completed the acquisition of SBCL. Consolidated
operating results for 1999 include the results of operations of SBCL
subsequent to the closing of the acquisition. See Note 3 to the
Consolidated Financial Statements.
(b) Represents charges incurred in conjunction with our debt refinancing in the
second quarter of 2001 as discussed in Note 7 to the Consolidated Financial
Statements.
(c) During the second quarter of 2000, we recorded a net special charge of $2.1
million. This net charge resulted from a $13.4 million charge related to
the costs to cancel certain contracts that we believed were not
economically viable as a result of the SBCL acquisition, and which were
principally associated with the cancellation of a co-marketing agreement
for clinical trials testing services, which charges were in large part
offset by a reduction in reserves attributable to a favorable resolution of
outstanding claims for reimbursements associated with billings of certain
tests.
(d) Represents charges principally incurred in conjunction with the acquisition
and planned integration of SBCL as discussed in Note 7 to the Consolidated
Financial Statements.
(e) Includes a charge of $16 million to write-down goodwill reflecting the
estimated impairment related to our consolidation plan announced in the
fourth quarter of 1997.
(f) In conjunction with our debt refinancing in the second quarter of 2001, we
recorded an extraordinary loss of $36 million ($22 million, net of taxes).
The loss represented the write-off of deferred financing costs of $23
million, associated with the debt which was refinanced, and $12.8 million
of payments related primarily to the tender premium incurred in connection
with our cash tender offer of our 10 3/4% senior subordinated notes due
2006.
(g) During the fourth quarter of 2000, we recorded an extraordinary loss of
$4.8 million ($2.9 million, net of taxes) representing the write-off of
deferred financing costs resulting from the prepayment of $155 million of
term loans under our senior secured credit facility.
(h) In conjunction with the acquisition of SBCL, we repaid the entire amount
outstanding under our then existing credit agreement. The extraordinary
loss recorded in the third quarter of 1999 represented $3.6 million ($2.1
million, net of taxes) of deferred financing costs which were written-off
in connection with the extinguishment of the credit agreement.
(i) Potentially dilutive common shares primarily include stock options and
restricted common shares granted under our Employee Equity Participation
Program. During periods in which net income available for common
stockholders is a loss, diluted weighted average common shares outstanding
will equal basic weighted average common shares outstanding, since under
these circumstances, the incremental shares would have an anti-dilutive
effect.
(j) On December 31, 2001, the Company repurchased all of its then outstanding
preferred stock for its par value of $1 million plus accrued dividends.
29
(k) Includes a fourth quarter charge of $5.3 million, which was part of the
$6.8 million charge recorded in the same quarter, to increase the provision
for doubtful accounts to recognize the reduced recoverability of certain
receivables from accounts which will no longer be served as a result of our
consolidation plan announced in the fourth quarter of 1997.
(l) Adjusted EBITDA represents income (loss) before extraordinary loss, income
taxes, net interest expense, depreciation, amortization and special items.
Special items include the provisions for restructuring and other special
charges reflected in the selected historical financial data above, $8.9
million of costs related to the integration of SBCL which were included in
operating costs and expensed as incurred in 2000, a $3.0 million gain
related to the sale of an investment in 1999 and charges of $2.5 million
and $6.8 million recorded in selling, general and administrative expenses
in 1998 and 1997, respectively, related to the Company's consolidation of
its laboratory network announced in the fourth quarter of 1997. Adjusted
EBITDA is presented and discussed because management believes that Adjusted
EBITDA is a useful adjunct to net income and other measurements under
accounting principles generally accepted in the United States since it is a
meaningful measure of a company's performance and ability to meet its
future debt service requirements, fund capital expenditures and meet
working capital requirements. Adjusted EBITDA is not a measure of financial
performance under accounting principles generally accepted in the United
States and should not be considered as an alternative to (i) net income (or
any other measure of performance under generally accepted accounting
principles) as a measure of performance or (ii) cash flows from operating,
investing or financing activities as an indicator of cash flows or as a
measure of liquidity.
30
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
Overview
After nearly a decade of pressures to reduce reimbursement and reduce
test utilization, the underlying fundamentals of the diagnostics testing
industry are improving. During the early 1990s, the industry was negatively
impacted by significant government regulation and investigations into various
billing practices. In addition, the rapid growth of managed care, as a result of
the need to reduce overall healthcare costs, and excess laboratory testing
capacity in the industry, led to revenue and profit declines within the
laboratory testing industry, which in turn led to industry consolidation,
particularly among commercial laboratories. As a result of these dynamics,
fewer, but larger commercial laboratories have emerged which have greater
economies of scale, rigorous programs designed to assure compliance with
government billing regulations and other laws, and a more disciplined approach
to pricing services. These changes have resulted in improved profitability and a
reduced risk of non-compliance with complex government regulations. At the same
time, a slowdown in the growth of managed care and decreasing influence by
managed care organizations on the ordering of clinical laboratory testing by
physicians has led to renewed growth in testing volumes and further improvements
in profitability since 1999. In addition, the following factors are expected to
continue to fuel growth in testing volume for the industry:
o general expansion and aging of the United States population;
o increasing focus on early detection and prevention as a means to
reduce the overall cost of healthcare and development of more
sophisticated and specialized tests for early detection of disease
and disease management;
o continuing research and development in the area of genomics, which
is expected to yield new genetic tests and techniques;
o increasing volume of tests for diagnosis and monitoring of
infectious diseases such as AIDS and hepatitis C;
o increasing affordability of tests due to advances in technology and
cost efficiencies; and
o increasing awareness by consumers of the value of clinical
laboratory testing and increasing willingness of consumers to pay
for tests that may not be covered by third party payers.
Quest Diagnostics, as the largest clinical laboratory testing company
with a leading position in most of its geographic markets and service offerings,
is well positioned to benefit from the renewed growth expected in the industry.
Payments for clinical laboratory testing services are made by the
government, managed care organizations, insurance companies, physicians,
hospitals, employers and patients. Physicians, hospitals and employers are
typically billed on a fee-for-service basis based on fee schedules which are
typically negotiated. Fees billed to patients and insurance companies are based
on the laboratory's patient fee schedule, subject in some cases to limitations
on fees negotiated with the insurance companies or with physicians on behalf of
their patients. Medicare and Medicaid reimbursements are based on fee schedules
set by governmental authorities.
We incur significant additional costs as a result of our participation
in Medicare and Medicaid programs, as billing and reimbursement for clinical
laboratory testing is subject to considerable and complex federal and state
regulations. These additional costs include those related to: (1) substantive
front end billing processes; (2) training, service and education of our
customers; (3) compliance and legal costs and (4) costs related to, among other
factors, medical necessity denials. Auditing the compliance with applicable laws
and regulations, as well as internal compliance policies and procedures, adds
further complexity to the billing process. We have implemented "best practices"
for billing that have significantly reduced the percentage of requisitions with
missing billing information from approximately 16% at the beginning of 1996 to
approximately 5.5% immediately prior to the acquisition of SBCL. These
initiatives, together with progress in dealing with Medicare medical necessity
documentation requirements and standardizing billing systems, have significantly
reduced bad debt expense since 1996. While average Medicare reimbursement rates
approximate the Company's overall average reimbursement rate from all payers,
the total cost to comply with Medicare administrative requirements is
disproportionate to our cost to bill other payers, making this business
generally less profitable. Principally as a result of reimbursement reductions
and measures adopted by governmental agencies to reduce clinical laboratory
testing utilization, the percentage of our aggregate net revenues derived from
Medicare and Medicaid programs declined from approximately 20% in 1995 to
31
approximately 14% in 2001. We believe that our other business may significantly
depend on continued participation in the Medicare and Medicaid programs, because
many customers may want a single laboratory to perform all of their clinical
laboratory testing services, regardless of whether reimbursements are ultimately
made by themselves, Medicare, Medicaid or other payers.
Managed care organizations and other insurance providers, which
typically contract with a limited number of clinical laboratories for their
members, represent approximately one half of our total testing volumes and one
half of our consolidated testing revenues. Larger managed care organizations and
other insurance providers typically prefer to use large independent clinical
laboratories because they can provide services on a national or regional basis
and can manage networks of local or regional laboratories.
While the growth in the number of patients participating in managed
care plans has slowed in recent years, over the last decade, the managed care
industry has been consolidating, resulting in fewer but larger managed care
organizations with significant bargaining power to negotiate fee arrangements
with healthcare providers, including clinical laboratories. Managed care
organizations frequently negotiate capitated payment contracts for a portion of
their business, which shift the risk and cost of testing from the managed care
organization to the clinical laboratory. Under these capitated payment
contracts, the Company and managed care organization agree to a predetermined
monthly contractual rate for each member of the managed care plan regardless of
the number or cost of services provided by the Company. Capitated agreements
with managed care organizations have historically been priced aggressively,
particularly for exclusive or semi-exclusive arrangements. In 2001, we derived
approximately 9% of our revenues from capitated payment contracts with managed
care organizations. Recently, there has been a shift in the way major managed
care organizations contract with clinical laboratories. Managed care
organizations have begun to offer more freedom of choice to their affiliated
physicians, including greater freedom to determine which laboratory to use and
which tests to order. Accordingly, several agreements with major managed care
organizations have been renegotiated from exclusive contracts to non-exclusive
contracts. As a result, under these non-exclusive arrangements, physicians have
more freedom of choice in selecting laboratories, and laboratories are likely to
compete more on the basis of service and quality rather than price alone. As a
result of this emphasis on greater freedom of choice, our enhanced service
network and capabilities, and our focus on ensuring that overall arrangements
are profitable, pricing of managed care agreements has improved. Also, managed
care organizations have been giving patients greater freedom of choice and
patients have increasingly been selecting plans (such as preferred provider
organizations) that offer a greater choice of providers. Pricing for these
preferred provider organizations is typically negotiated on a fee-for-service
basis, which generally results in higher revenue per requisition than under a
capitated fee arrangement. Despite these trends, managed care organizations
continue to seek to reduce their costs in order to keep their premiums to their
customers competitive.
The clinical laboratory industry is subject to seasonal fluctuations in
operating results and cash flows. Typically, testing volume declines during the
summer months, year-end holiday periods and other major holidays, reducing net
revenues and operating cash flows below annual averages. Testing volume is also
subject to declines in winter months due to inclement weather, which varies in
severity from year to year.
The clinical laboratory industry is labor intensive. Employee
compensation and benefits constitute approximately half of our total costs and
expenses. Cost of services consists principally of costs for obtaining,
transporting and testing specimens. Selling, general and administrative expenses
consist principally of the costs associated with our sales force, billing
operations (including bad debt expense), and general management and
administrative support.
Information systems are used extensively in virtually all aspects of
our business, including laboratory testing, billing, customer service,
logistics, and management of medical data. Our success depends, in part, on the
continued and uninterrupted performance of our information technology (IT)
systems. We routinely review and test disaster recovery plans, of which IT is an
integral part, and take other precautions to minimize the risk of physical or
electronic damage to our systems. Despite the safeguards and controls that are
in place, sustained or repeated system failures that interrupt our ability to
process test orders, deliver test results or perform tests in a timely manner
would adversely affect our reputation and result in a loss of customers and net
revenues. Additionally, during 2002, we plan to begin to develop and implement a
standard laboratory information system and a standard billing system which we
expect will take several years to complete. Through proper planning and
execution of this standardization process, we expect to reduce the risks
associated with systems conversions of this type, and minimize any disruptions
in our operations.
32
Critical Accounting Policies
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America 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 and 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 straight-forward 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:
o revenues and accounts receivable;
o reserves for general and professional liability claims;
o billing-related settlement reserves; and
o recoverability of goodwill.
Revenues and accounts receivable
The process for estimating the ultimate collection of receivables
involves significant assumptions and judgments. Billings for services under
third-party payer programs, including Medicare and Medicaid, are recorded as
revenues net of allowances for differences between amounts billed and the
estimated receipts under such programs. Adjustments to the estimated receipts,
based on final settlement with the third-party payers, are recorded upon
settlement as an adjustment to net revenues.
In addition, we have implemented a monthly standardized approach to
estimate and review the collectibility of our receivables based on the aging
of our accounts receivable. Historical collection and payer reimbursement
experience is an integral part of the estimation process related to reserves for
doubtful accounts. In addition, we assess the current state of our billing
functions in order to identify any known collection or reimbursement issues
in order to assess the impact, if any, on our reserve estimates, which involve
judgment. We believe that the collectibility of our receivables is directly
linked to the quality of our billing processes, most notably those related to
obtaining the correct information in order to bill effectively for the services
we provide. As such, we have implemented "best practices" to reduce the number
of requisitions that we receive from healthcare providers with missing or
incorrect billing information. Revisions in reserve estimates are recorded as
an adjustment to bad debt expense within selling, general and administrative
expenses. We believe that our collection and reserves processes, along with our
close monitoring of our billing processes, helps to reduce the risk associated
with material revisions to reserve estimates resulting from adverse changes in
collection and reimbursement experience and billing functions.
Reserves for general and professional liability claims
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. We maintain various
insurance programs to cover this risk, but we are substantially self-insured for
most of these claims. We do maintain coverage which caps our exposure on
individual claims. The basis for our insurance reserves is the actuarially
determined projected losses based upon our historical loss experience. We
believe that present insurance coverage and reserves are sufficient to cover
currently estimated exposures, but we cannot assure you that we will not incur
liabilities in excess of recorded reserves. Similarly, although we believe that
we will be able to obtain adequate insurance coverage in the future at
acceptable costs, we cannot assure you that we will be able to do so.
Billing-related settlement reserves
Our business is subject to extensive and frequently changing federal,
state and local laws and regulations. We have 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, we are aware of several
pending lawsuits filed under the qui tam provisions of the civil False Claims
Act and have received notices of private claims relating to billing issues
similar to those that were the subject of prior settlements with various
governmental payers. We have a comprehensive compliance program that is intended
to ensure the strict
33
implementation and observance of all applicable laws, regulations and company
policies. The Quality, Safety and Compliance Committee of the Board of Directors
requires periodic reporting of compliance operations from management. Government
officials have publicly cited our program as a model for the industry. As an
integral part of our compliance program, we investigate all reported or
suspected failures to comply with federal healthcare reimbursement requirements.
Any non-compliance that results in Medicare or Medicaid overpayments is reported
to the government and reimbursed by us. As a result of these efforts, we have
periodically identified and reported overpayments. While we have reimbursed
these overpayments and have taken corrective action where appropriate, we cannot
assure you that in each instance the government will necessarily accept these
actions as sufficient.
While we believe that we are in material compliance with all applicable
laws, many of the regulations applicable to us, including those relating to
billing and reimbursement of tests and those relating to relationships with
physicians and hospitals, are vague or indefinite and have not been interpreted
by the courts. They may be interpreted or applied by a prosecutorial, regulatory
or judicial authority in a manner that could require us to make changes in our
operations, including our billing practices. If we fail to comply with
applicable laws and regulations, we could suffer civil and criminal penalties,
including the loss of licenses or our ability to participate in Medicare,
Medicaid and other federal and state healthcare programs.
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 our results of operations and cash flows in
the period in which such claims are settled. We do not believe that these issues
will have a material adverse effect on our overall financial condition.
Recoverability of goodwill
As more fully described in Note 1 to the Consolidated Financial
Statements, we evaluate the recoverability and measure the possible impairment
of our goodwill under Accounting Principles Board Opinion No. 17, "Intangible
Assets" based on a fair value methodology. We believe that a valuation of
goodwill based on the amount for which each regional laboratory could be sold
in an arm's length transaction is preferable to using projected undiscounted
pretax cash flows. We believe fair value is a better indicator of the extent
to which goodwill may be recoverable and, therefore, may be impaired. The fair
value method is applied to each of our regional laboratories. Our estimate of
fair value is primarily based on multiples of forecasted revenue or multiples
of forecasted earnings before interest, taxes, depreciation and amortization
("EBITDA"). The multiples are primarily determined based upon publicly available
information regarding comparable publicly-traded companies in the industry,
but also consider (i) the financial projections of each regional laboratory,
(ii) the future prospects of each regional laboratory, including its growth
opportunities, managed care concentration and likely operational improvements,
and (iii) comparable sales prices, if available. The process of estimating a
fair value for each of our regional laboratories involves a high degree of
judgment regarding the forecasting of revenues and EBITDA and the determination
of multiples. On a quarterly basis, we perform a review of each regional
laboratory to determine if events or changes in circumstances have occurred
which could have a material adverse effect on the fair value of the business
and its goodwill. If such events or changes in circumstances were deemed to
have occurred, we would consult with one or more of our advisors in estimating
the impact on fair value of the regional laboratory. While management believes
the estimation methods are reasonable and reflective of common valuation
practices, there can be no assurance that a regional laboratory could actually
be sold for the estimated value ascribed to the regional laboratory. Should
the estimated fair value of a regional laboratory be less than the net book
value for such laboratory at the end of a quarter, management will record a
charge to operations to recognize an impairment of our goodwill for such
difference. In July 2001, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards No. 142, "Goodwill and
Other Intangible Assets" ("SFAS 142"), which broadens the criteria for
recording intangible assets separate from goodwill (see "Impact of Recently
Issued Accounting Standards"). Management does not expect that the adoption,
on January 1, 2002, of the nonamortization approach under SFAS 142 will
result in an impairment of our recorded goodwill.
Acquisition of SmithKline Beecham's Clinical Laboratory Testing Business
On August 16, 1999, we completed the acquisition of SmithKline Beecham
Clinical Laboratories, Inc. ("SBCL") which operated the clinical laboratory
business of SmithKline Beecham plc ("SmithKline Beecham"). The original purchase
price of approximately $1.3 billion was paid through the issuance of
approximately 25.1 million shares of our common stock and the payment of $1
billion in cash, including $20 million under a non-compete agreement between
the Company and SmithKline Beecham. At the closing of the acquisition, we used
existing cash and borrowings under a new senior secured credit facility to fund
the cash purchase price and related transaction costs of the acquisition, and to
repay the entire amount outstanding under our then existing credit agreement.
The acquisition of
34
SBCL was accounted for under the purchase method of accounting. The historical
financial statements of Quest Diagnostics include the results of operations of
SBCL subsequent to the closing of the acquisition.
The SBCL acquisition agreements included a provision for a reduction in
the purchase price paid by Quest Diagnostics in the event that the combined
balance sheet of SBCL indicated that the net assets acquired, as of the
acquisition date, were below a prescribed level. On October 11, 2000, the
purchase price adjustment was finalized with the result that SmithKline Beecham
owed Quest Diagnostics $99 million. This amount was offset by $3.6 million
separately owed by Quest Diagnostics to SmithKline Beecham, resulting in a net
payment by SmithKline Beecham of $95 million. The purchase price adjustment was
recorded in the Company's financial statements in the fourth quarter of 2000 as
a reduction in the amount of goodwill recorded in conjunction with the SBCL
acquisition.
The remaining components of the purchase price allocation relating to
the SBCL acquisition were finalized during the third quarter of 2000. The
resulting adjustments to the SBCL purchase price allocation primarily related to
an increase in deferred tax assets acquired, the sale of certain assets of SBCL
at fair value to unconsolidated joint ventures of Quest Diagnostics and an
increase in accrued liabilities for costs related to pre-acquisition periods. As
a result of these adjustments, the Company reduced the amount of goodwill
recorded in conjunction with the SBCL acquisition by approximately $35 million
during the third quarter of 2000.
In conjunction with the SBCL acquisition, we recorded approximately
$820 million of goodwill, representing acquisition cost in excess of the fair
value of net assets acquired, which is amortized on the straight-line basis over
forty years. The amount paid under the non-compete agreement is amortized on the
straight-line basis over five years. See "Impact of Recently Issued Accounting
Standards".
Integration of SBCL and Quest Diagnostics Businesses
We expect to continue realizing significant benefits from combining our
existing laboratory network with that of SBCL. During the second quarter of
2001, we completed the process of reducing redundant facilities and
infrastructure, including laboratory consolidations in geographic markets served
by more than one of our laboratories, and redirecting testing volume within our
national network to provide more local testing and improve customer service. A
full discussion and analysis of the reserves related to the SBCL integration is
contained in Note 4 to the Consolidated Financial Statements.
The actions associated with the SBCL integration plan, provided for in
accruals for integration costs as of December 31, 2000, including those related
to severed employees, were completed as of June 30, 2001. The remaining accruals
associated with the SBCL integration plan mainly represent certain severance and
facility related exit costs, principally lease obligations, that have payment
terms extending beyond 2001. Other activities, for which no accruals had been
recorded as of December 31, 2000, including the standardization of information
systems, will continue beyond 2001.
We continue to expect that the SBCL integration will result in
approximately $150 million of annual synergies and that we will achieve this
annual rate of synergies by the end of 2002. We estimate that we realized
approximately $50 million of these synergies during 2000, and approximately $120
million of synergies during 2001. At the end of 2001, we estimate that we had
achieved an annualized rate of synergies of approximately $140 million.
Six Sigma and Standardization Initiatives
We intend to become recognized as the quality leader in the healthcare
services industry. We are implementing a Six Sigma initiative throughout our
organization. Six Sigma is a management approach that requires a thorough
understanding of customer needs and requirements, process discipline, rigorous
tracking and measuring of services, and training of employees in methodologies
so that they can be held accountable for improving results. During the second
half of 2001, we began to integrate our Six Sigma initiative with our initiative
to standardize operations and processes across all of Quest Diagnostics by
adopting identified company best practices. We plan to continue these
initiatives during the next several years and expect that successful
implementation of these initiatives will result in measurable improvements in
customer satisfaction and generate at least $150 million in annual net benefits
by the end of 2004.
Management anticipates that additional charges may be recorded during
the next several years associated with further consolidation activities
resulting from our Six Sigma and Standardization initiatives. Management cannot
estimate the amount or the timing of these charges at this time but expects to
fund these charges with cash from operations.
35
Results of Operations
The following table summarizes our historical consolidated results of
operations for the years 1999 through 2001 and our unaudited pro forma combined
results of operations for the year ended December 31, 1999 (in thousands, except
per share data; all per share data has been restated to reflect our two-for-one
stock split effected on May 31, 2001 - see Note 2 to the Consolidated Financial
Statements):
Year Ended December 31,
--------------------------------------------------------------------
Pro Forma
Historical Combined
---------------------------------------------------- --------------
2001 2000 1999 1999
---------------- ---------------- ---------------- --------------
Net revenues............................... $ 3,627,771 $ 3,421,162 $ 2,205,243 $3,294,810
Costs and expenses:
Cost of services......................... 2,151,594 2,056,237 1,379,989 2,132,339
Selling, general and administrative...... 1,018,680 1,001,443 643,440 948,178
Interest, net............................ 70,523 113,092 61,450 122,647
Amortization of intangible assets........ 46,107 45,665 29,784 45,247
Provisions for restructuring and other
special charges......................... 5,997 2,100 73,385 89,198
Minority share of income................. 9,953 9,359 5,431 5,431
Other, net............................... (7,687) (7,715) (2,620) (13,616)
----------- ----------- ----------- ----------
Total................................... 3,295,167 3,220,181 2,190,859 3,329,424
----------- ----------- ----------- ----------
Income (loss) before taxes and extraordinary
loss..................................... 332,604 200,981 14,384 (34,614)
Income tax expense (benefit)............... 148,692 96,033 15,658 (1,075)
----------- ----------- ----------- ----------
Income (loss) before extraordinary loss.... 183,912 104,948 (1,274) (33,539)
Extraordinary loss, net of taxes........... (21,609) (2,896) (2,139) (2,139)
----------- ----------- ----------- ----------
Net income (loss).......................... $ 162,303 $ 102,052 $ (3,413) $ (35,678)
=========== =========== =========== ==========
Income before extraordinary loss and special
items.................................... $ 187,510 $ 106,218 $ 41,150 $ 12,581
Basic net income (loss) per common share:
Income (loss) before extraordinary loss.... $ 1.98 $ 1.17 $ (0.02) $ (0.39)
Net income (loss).......................... 1.74 1.14 (0.05) (0.41)
Weighted average common shares outstanding
--basic.................................. 93,053 89,525 70,028 86,690
Diluted net income (loss) per common share:
Income (loss) before extraordinary loss.... $ 1.88 $ 1.11 $ (0.02) $ (0.39)
Net income (loss).......................... 1.66 1.08 (0.05) (0.41)
Weighted average common shares outstanding
--diluted................................ 97,610 94,300 70,028 86,690
Supplemental Data:
Provision for doubtful accounts............ $ 218,271 $ 234,694 $ 142,333 $ 258,778
Adjusted EBITDA............................ 556,851 459,380 237,038 337,378
Historical Results of Operations
Year Ended December 31, 2001 Compared with Year Ended December 31, 2000
Net income for the year ended December 31, 2001 increased to $162 million from
$102 million for the year ended December 31, 2000. Results for the years ended
December 31, 2001 and 2000 included extraordinary losses, net of taxes, of $22
million and $2.9 million, respectively, associated with the prepayment of debt.
In addition, results for the years ended December 31, 2001 and 2000 included
special charges of $6.0 million ($3.6 million, net of taxes) and $2.1 million
($1.3 million, net of taxes), reflected on the face of the consolidated
statements of operations. Excluding the special charges and extraordinary
losses, income for the year ended December 31, 2001 increased to $188 million,
compared to $106 million for the prior year period, an increase of
approximately 77%.
These earnings increases were primarily attributable to revenue growth
driven by improvements in average revenue per requisition, improved operating
performance, including the benefits to our cost structure resulting from the
SBCL integration and a reduction in net interest expense, partially offset by
increases in employee compensation, severance benefits and supply costs, and
investments in our Six Sigma and Standardization initiatives, information
technology strategy, and strategic growth opportunities.
36
Results for the year ended December 31, 2000 included the effects of
testing performed by third parties under our laboratory network management
arrangements. As laboratory network manager, we included in our consolidated
revenues and expenses the cost of testing performed by third parties. This
treatment added $49 million to both reported revenues and cost of services for
the year ended December 31, 2000. This treatment also serves to increase cost of
services as a percentage of net revenues and decrease selling, general and
administrative expenses as a percentage of net revenues. During the first
quarter of 2000, we terminated a laboratory network management arrangement with
Aetna US Healthcare, and entered into a new non-exclusive contract under which
we are no longer responsible for the cost of testing performed by third parties.
In addition, during the third quarter of 2000, we amended our laboratory network
management contract with Oxford Health to remove the financial risk associated
with testing performed by third parties. As a result of these contract
modifications, we are no longer required to include in our consolidated revenues
and expenses, the cost of testing performed by third parties. This impacts the
comparability of results between the periods presented and serves to reduce the
increase in reported net revenues during the year ended December 31, 2001 by $49
million.
Net Revenues
Excluding the effect of testing performed by third parties under our
laboratory network management arrangements in 2000, net revenues for the year
ended December 31, 2001 grew by 7.6%, compared to the prior year period,
primarily due to a 7.3% increase in revenues in our core testing business. This
increase was due to improvements in average revenue per requisition of 6.6% and
an increase in requisition volume of 1%. The improvement in average revenue
per requisition was primarily attributable to improved pricing on managed care
business, a shift in payer mix to fee-for-service reimbursement and a shift in
test mix to higher value testing. Business contributed during 2000 to our
unconsolidated joint ventures in: Phoenix, Arizona; Indianapolis, Indiana; and
Dayton, Ohio reduced our reported requisition volume for the year ended December
31, 2001 by approximately 1.4%, compared to the prior year period. After
adjusting for business contributed to unconsolidated joint ventures, requisition
volume for the year ended December 31, 2001 increased approximately 1.7% over
the prior year period. Contributing to this net increase was an increase in
volume from our principal customers, physicians and hospitals, of approximately
2.5% and volume related to our acquisitions in 2001, which contributed an
increase of approximately 1%. Partially offsetting these increases was a
decline in volumes associated with our drugs of abuse testing business, which
reduced total company volume for the year ended December 31, 2001 by about 1.8%,
compared to the prior year period. Drugs of abuse testing was impacted by a
general slowing of the economy and a corresponding slowdown in hiring. Our other
businesses, which accounted for approximately 4% of our total revenues in 2001,
grew 17.5% over the prior year and accounted for 0.6% of the consolidated
revenue increase, or approximately $22 million. Most of this increase was from
our clinical trials testing business.
Operating Costs and Expenses
Excluding the effect of testing performed by third parties under our
laboratory network management arrangements in 2000, total operating costs for
the year ended December 31, 2001 increased approximately $162 million from the
prior year. This increase was primarily due to increases in employee
compensation, severance benefits and supply costs, partially offset by a
reduction in bad debt expense. While our cost structure has been favorably
impacted by the synergies realized as a result of the SBCL integration, we
continue to make investments to enhance our infrastructure in support of our
overall business strategy. These investments include those related to:
o Our Six Sigma and Standardization initiatives which we
believe will provide us with a competitive advantage in the market
place and ultimately serve to generate net benefits of $150 million
annually by 2004;
o Skills training for all employees, which together with our
competitive pay and benefits, helps to increase employee
satisfaction and performance, thereby enabling us to provide better
services to our customers;
o Our information technology strategy; and
o Our strategic growth opportunities.
The following discussion and analysis regarding cost of services,
selling, general and administrative expenses and bad debt expense excludes the
effect of testing performed by third parties under our laboratory network
management
37
arrangements in 2000, which serves to increase cost of services as a percentage
of net revenues and reduce selling, general and administrative expenses as a
percentage of net revenues. Cost of services include the costs of obtaining,
transporting and testing specimens. Costs of services as a percentage of net
revenues for the year ended December 31, 2001, was 59.3%, which is consistent
with the prior year's level of 59.5%, as improvements in average revenue per
requisition were offset by increased employee compensation, severance benefits
and supply costs.
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 year ended December 31, 2001 as
a percentage of net revenues to 28.1% from 29.7% in the prior year period. This
decrease was primarily due to improvements in average revenue per requisition
and bad debt expense, partially offset by an increase in employee compensation
costs and severance benefits, and investments to enhance our infrastructure in
support of our overall business strategy. For the year ended December 31, 2001,
bad debt expense was 6.0% of net revenues, compared to 7.0% of net revenues in
the prior year. The reduction in bad debt expense was principally attributable
to the continued progress we have made in the overall collection experience
through process improvements, primarily related to the collection of diagnosis,
patient and insurance information necessary to effectively bill for services
performed. Based on prior experience as well as the continued sharing of
internal best practices in the billing functions, we believe that additional
opportunities exist to improve our overall collection experience.
Interest Expense, Net
Net interest expense for the year ended December 31, 2001 decreased
from the prior year period by $43 million. The reduction was primarily due to an
overall reduction in debt levels, and the favorable impact of our debt
refinancings in the second and fourth quarters of 2001 and lower interest rates,
all of which have served to lower the weighted average borrowing rate on our
outstanding debt.
Amortization of Intangible Assets
Amortization of intangible assets for the year ended December 31, 2001
increased $0.4 million over the prior year. The increase related to 2001
acquisitions and the amortization of goodwill associated with certain
investments accounted for under the equity method of accounting, in large part
offset by adjustments recorded in the third and fourth quarters of 2000 which
reduced the amount of goodwill associated with the SBCL acquisition by
approximately $130 million, as discussed earlier under "Acquisition of
SmithKline Beecham's Clinical Laboratory Testing Business".
In July 2001, the FASB issued two new accounting standards related to
business combinations and goodwill and other intangible assets. The adoption of
these accounting standards is expected to reduce our annual amortization expense
by approximately $35 million, commencing January 1, 2002 (see "Impact of
Recently Issued Accounting Standards" below for further details).
Provision for Special Charges
During the second quarter of 2001, we recorded a special charge of $6.0
million in connection with the refinancing of our debt and settlement of our
interest rate swap agreements. Prior to our debt refinancing in June 2001, our
credit agreement required us to maintain interest rate swap agreements to
mitigate the risk of changes in interest rates associated with a portion of our
variable interest rate indebtedness. These interest rate swap agreements were
considered a hedge against changes in the amount of future cash flows associated
with the interest payments of our variable rate debt obligations. Accordingly,
the interest rate swap agreements were recorded at their estimated fair value in
our consolidated balance sheet and the related losses on these contracts were
deferred in shareholders' equity as a component of comprehensive income. In
conjunction with the debt refinancing, the interest rate swap agreements were
terminated and the losses reflected in shareholders' equity as a component of
comprehensive income were reclassified to earnings and classified as a special
charge in the consolidated statement of operations for the year ended December
31, 2001.
During the second quarter of 2000, we recorded a net special charge of
$2.1 million. Of the special charge, $13.4 million represented the costs to
cancel certain contracts that we believed were not economically viable as a
result of the SBCL acquisition. These costs were principally associated with the
cancellation of a co-marketing agreement for clinical trials testing services.
The cancellation of this agreement did not have a material adverse effect on
2001 net revenues. These charges were in large part offset by a reduction in
reserves attributable to a favorable resolution of outstanding claims for
reimbursements associated with billings of certain tests.
38
During the third quarter of 2000, we reviewed our remaining
restructuring reserves initially recorded in the fourth quarter of 1999 and
revised certain estimates relative to integration activities, which resulted in
a $2.1 million reduction in accruals associated with planned restructuring
activities affecting Quest Diagnostics' operations and employees. These
revisions were principally associated with lower costs for employee severance
and reduced costs to exit certain leased facilities. This reduction in accruals
was offset by a charge to write-off fixed assets used in the operations of Quest
Diagnostics which we believe will have no future economic benefit as a result of
combining the operations of SBCL and Quest Diagnostics.
The reduction in employee severance costs was primarily attributable to
higher than anticipated volume growth and higher than expected voluntary
turnover, which reduced the number of planned severances, principally in the New
York and Philadelphia metropolitan areas. The greater than anticipated volume
growth in these regions allowed us to reassign to other positions individuals
who would have otherwise been severed. The higher than expected voluntary
turnover was a result of delays in the integration process which were outside
our control and stemmed from protracted contract renegotiations with a major
customer, and construction delays. These reductions were partially offset by the
elimination of certain senior management positions, which increased the average
cost of severance benefits per employee.
The reduction in costs to exit leased facilities is primarily related
to our New York metropolitan area operations to reflect revised assumptions
related to the costs to be paid to exit leased facilities.
While our original plan anticipated completion by the end of December
31, 2000, certain factors outside our control such as the protracted
negotiations related to contractual obligations and unexpected construction
delays at two of our laboratories had prevented us from completing our plans
within a one year time frame. During the second quarter of 2001, we completed
the planned integration of our principal laboratories in all major markets.
While certain cost estimates, relative to integration activities, were
revised during 2000, the revisions did not impact our estimate of approximately
$150 million of related annual synergies to be achieved by the end of 2002.
Minority Share of Income
Minority share of income for the year ended December 31, 2001 increased
by $0.6 million to $10.0 million compared to the prior year level.
Other, Net
Other, net for the year ended December 31, 2001 was $(7.7) million
which approximated the prior year level. Other, net includes equity earnings
primarily from our unconsolidated joint ventures which increased by
approximately $3.9 million during the year. Partially offsetting the increase in
equity earnings is the net impact of writing off $9.6 million of certain
impaired investments and realizing a gain of $6.3 million on the sale of an
investment during 2001.
Income Taxes
Our effective tax rate is significantly impacted by goodwill
amortization, the majority of which is not deductible for tax purposes, and has
the effect of increasing the overall tax rate. The reduction in the effective
tax rate for the year ended December 31, 2001 was primarily due to pretax
earnings increasing at a faster rate than goodwill amortization and other
non-deductible items. The adoption of two recently issued accounting standards
related to business combinations and goodwill and other intangibles is expected
to reduce our goodwill amortization and as a result reduce our effective tax
rate commencing January 1, 2002. See "Impact of Recently Issued Accounting
Standards" below.
Extraordinary Loss
In conjunction with our debt refinancing in the second quarter of 2001,
we recorded an extraordinary loss of $36 million, ($22 million, net of taxes).
The loss represented the write-off of deferred financing costs of $23 million,
associated with the debt which was refinanced, and $12.8 million of payments
related primarily to the tender premium incurred in connection with our cash
tender offer of our 10 3/4% senior subordinated notes due 2006 (the
"Subordinated Notes"). Our debt refinancing is more fully described under
"Liquidity and Capital Resources - Cash Flows from Financing Activities" and in
Note 12 to the Consolidated Financial Statements.
39
During the fourth quarter of 2000, we recorded an extraordinary loss of
$4.8 million ($2.9 million, net of taxes) representing the write-off of deferred
financing costs resulting from the prepayment of $155 million of term loans
under our senior secured credit facility.
Adjusted EBITDA
Adjusted EBITDA represents income before extraordinary loss, income
taxes, net interest expense, depreciation, amortization and special charges.
Adjusted EBITDA for the year ended December 31, 2000 also excludes $8.9 million
of costs associated with the SBCL integration plan which were included in
operating costs and expensed as incurred. Adjusted EBITDA is presented and
discussed because management believes it is a useful adjunct to net income and
other measurements under accounting principles generally accepted in the United
States since it is a meaningful measure of a company's performance and ability
to meet its future debt service requirements, fund capital expenditures and meet
working capital requirements. Adjusted EBITDA is not a measure of financial
performance under accounting principles generally accepted in the United States
and should not be considered as an alternative to (i) net income (or any other
measure of performance under accounting principles generally accepted in the
United States) as a measure of performance or (ii) cash flows from operating,
investing or financing activities as an indicator of cash flows or as a measure
of liquidity.
Adjusted EBITDA for the year ended December 31, 2001 improved to $557
million, or 15.3% of net revenues, from $459 million, or 13.4% of net revenues,
in the prior year period. The improvement in Adjusted EBITDA was primarily due
to improvements in the average revenue per requisition and cost synergies
resulting from the SBCL integration, partially offset by increases in employee
compensation, severance benefits and supply costs, and investments in our Six
Sigma and Standardization initiatives, information technology strategy and
strategic growth opportunities.
Year Ended December 31, 2000 Compared with Year Ended December 31, 1999
Income before an extraordinary loss for the year ended December 31,
2000 increased to $105 million from a loss of $1.3 million for the prior year.
Extraordinary losses, net of taxes, of $2.9 million and $2.1 million were
recorded in 2000 and 1999, respectively, representing the write-off of deferred
financing costs associated with the prepayment of debt. Additionally, a number
of special items were recorded in 2000 and 1999 which consisted of the
provisions for restructuring and other special charges reflected on the face of
the statement of operations of $2.1 million and $73 million, respectively, and a
$3.0 million gain related to the sale of an investment in the fourth quarter of
1999. Excluding the special items and the extraordinary loss, net income for the
year ended December 31, 2000 increased to $106 million, compared to $41 million
for the prior year period. This increase was primarily due to the SBCL
acquisition and improved operating performance of the Company.
Results for the years ended December 31, 2000 and 1999 included the
effects of testing performed by third parties under our laboratory network
management arrangements. As laboratory network manager, we included in our
consolidated revenues and expenses the cost of testing performed by third
parties. This treatment added $49 million and $92 million to both reported
revenues and cost of services for the years ended December 31, 2000 and 1999,
respectively. This treatment also serves to increase cost of services as a
percentage of net revenues and decrease selling, general and administrative
expenses as a percentage of net revenues. During the first quarter of 2000, we
terminated a laboratory network management arrangement with Aetna US Healthcare,
and entered into a new non-exclusive contract under which we are no longer
responsible for the cost of testing performed by third parties. In addition,
during the third quarter of 2000, we amended our laboratory network management
contract with Oxford Health to remove the financial risk associated with testing
performed by third parties. As such, we are no longer responsible for the cost
of testing performed by third parties under the contract with Oxford Health. On
a full year basis, these changes to the laboratory network management agreements
will reduce net revenues and cost of services by approximately $150 million.
Net Revenues
Net revenues for the year ended December 31, 2000 increased $1.2
billion over the prior year period, primarily due to the acquisition of SBCL.
Also contributing to the increase were improvements in average revenue per
requisition and requisition volume.
40
Operating Costs and Expenses
Total operating costs for the year ended December 31, 2000 increased
from the prior year period, primarily due to the acquisition of SBCL. Operating
costs and expenses for the year ended December 31, 2000 included $8.9 million of
costs related to the integration of SBCL which were not chargeable against
previously established reserves for integration costs. These costs are primarily
related to equipment and employee relocation costs, professional and consulting
fees, company identification and signage costs and the amortization of
stock-based employee compensation related to the special recognition awards
granted in the fourth quarter of 1999.
The following discussion and analysis regarding operating costs and
expenses exclude the effect of testing performed by third parties under our
laboratory network management arrangements, which serve to increase cost of
services as a percentage of net revenues and reduce selling, general and
administrative expenses as a percentage of net revenues.
Cost of services, which includes the costs of obtaining, transporting
and testing specimens, decreased during 2000, as a percentage of net revenues,
to 59.5% from 61.0% in the prior year period. This decrease was primarily due to
an improvement in average revenue per requisition and the realization of
synergies associated with the integration of SBCL. These decreases were
partially offset by an increase in employee compensation and training costs.
Selling, general and administrative expenses, which includes the costs
of the sales force, billing operations, bad debt expense, general management and
administrative support, decreased during 2000, as a percentage of net revenues,
to 29.7% from 30.4% in the prior year period. This decrease was primarily
attributable to improvements in average revenue per requisition and the impact
of the SBCL acquisition which enabled us to leverage certain of our fixed costs
across a larger revenue base, partially offset by increases in employee
compensation and training costs, investments related to our information
technology strategy and bad debt expense. For the year ended December 31, 2000,
bad debt expense was 7.0% of net revenues, compared to 6.7% of net revenues in
the prior year period. The increase in bad debt expense was principally
attributable to SBCL's collection experience which is less favorable than Quest
Diagnostics' historical experience. A significant portion of the difference is
due to Quest Diagnostics' processes in the billing area, most notably the
processes around the collection of diagnosis, patient and insurance information
necessary to effectively bill for services performed. We have made significant
progress towards improving the overall bad debt experience of the combined
company with quarter to quarter improvements in bad debt expense throughout
2000. Based on prior experience as well as the sharing of internal best
practices in the billing functions, we believe that substantial opportunities
continue to exist to improve our overall collection experience.
Interest, Net
Net interest expense increased from the prior year by $52 million. Net
interest expense for the year ended December 31, 1999 included $1.9 million of
interest income associated with a favorable state tax settlement. The remaining
increase was principally attributable to the amounts borrowed under our senior
secured credit facility in conjunction with the SBCL acquisition.
Amortization of Intangible Assets
Amortization of intangible assets increased from the prior year by
$15.9 million for the year ended December 31, 2000, principally as a result of
the SBCL acquisition.
Provisions for Restructuring and Other Special Charges
During the second quarter of 2000, we recorded a net special charge of
$2.1 million. Of the special charge, $13.4 million represented the costs to
cancel certain contracts that we believed were not economically viable as a
result of the SBCL acquisition. These costs were principally associated with the
cancellation of a co-marketing agreement for clinical trials testing services.
These charges were in large part offset by a reduction in reserves attributable
to a favorable resolution of outstanding claims for reimbursements associated
with billings of certain tests.
During the third quarter of 2000, we reviewed our remaining
restructuring reserves initially recorded in the fourth quarter of 1999 and
revised certain estimates relative to integration activities, which resulted in
a $2.1 million reduction in accruals associated with planned restructuring
activities affecting Quest Diagnostics' operations and employees. These
revisions were principally associated with lower costs for employee severance
and reduced costs to exit certain leased facilities. See Note 4 to the
Consolidated Financial Statements for details. This reduction in accruals
41
was offset by a charge to write-off fixed assets used in the operations of Quest
Diagnostics which we believe will have no future economic benefit as a result of
combining the operations of SBCL and Quest Diagnostics.
The reduction in employee severance costs was primarily attributable to
higher than anticipated volume growth and higher than expected voluntary
turnover, which reduced the number of planned severances, principally in the New
York and Philadelphia metropolitan areas. The greater than anticipated volume
growth in these regions allowed the Company to reassign to other positions
individuals who would have otherwise been severed. The higher than expected
voluntary turnover was a result of delays in the integration process which were
outside our control and stemmed from protracted contract renegotiations with a
major customer, and construction delays. These reductions were partially offset
by the elimination of certain senior management positions, which increased the
average cost of severance benefits per employee.
The reduction in costs to exit leased facilities is primarily related
to our New York metropolitan area operations to reflect revised assumptions
related to the costs to be paid to exit leased facilities.
While our original plan anticipated completion by the end of December
31, 2000, certain factors outside our control such as the protracted
negotiations related to contractual obligations and unexpected construction
delays at two of our laboratories had prevented us from completing our plans
within a one year time frame. During the second quarter of 2001, we completed
the planned integration of our principal laboratories in all major markets.
While certain cost estimates, relative to integration activities, were
revised during 2000, the revisions did not impact our estimate of approximately
$150 million of related annual synergies to be achieved by the end of 2002. We
estimate that we achieved approximately $50 million of such synergies in 2000
and at the end of 2000, we had achieved an annual rate of synergies approaching
$100 million.
During the third and fourth quarters of 1999, we recorded provisions
for restructuring and other special charges totaling $30 million and $43
million, respectively, principally incurred in connection with the acquisition
and planned integration of SBCL.
Of the total special charge recorded in the third quarter of 1999,
$19.8 million represented stock-based employee compensation of which $17.8
million related to special one-time grants of our common stock to certain
individuals of the combined company, and $2.0 million related to the accelerated
vesting, due to the completion of the SBCL acquisition, of restricted stock
grants made in previous years. In addition, during the third quarter of 1999, we
incurred $9.2 million of professional and consulting fees related to integration
planning activities. The remainder of the third quarter charge related to costs
incurred in conjunction with our planned offering of new senior subordinated
notes, the proceeds of which were expected to be used to repay our existing
Subordinated Notes. During the third quarter of 1999, we decided not to proceed
with the offering due to unsatisfactory market conditions.
Of the total special charge recorded in the fourth quarter of 1999, $36
million represented costs related to planned integration activities affecting
Quest Diagnostics' operations and employees. Of these costs, $23 million related
to employee severance costs, $9.7 million related primarily to lease obligations
for facilities and equipment and $6.7 million was associated with the write-off
of assets that we plan to dispose of in conjunction with the integration of
SBCL. Offsetting these charges was the reversal of $3.4 million of reserves
associated with our consolidation plan announced in the fourth quarter of 1997.
Upon finalizing the initial integration plans for SBCL in the fourth quarter of
1999, we determined that $3.4 million of the remaining reserves associated with
the December 1997 consolidation plan was no longer necessary due to changes in
the plan as a result of the SBCL integration. In addition to the net charge of
$36 million, we recorded $3.5 million of special recognition awards granted in
the fourth quarter of 1999 to certain employees involved in the transaction and
integration planning processes of the SBCL acquisition. The remainder of the
fourth quarter special charge was primarily attributable to professional and
consulting fees incurred in connection with integration related planning
activities.
Minority Share of Income
Minority share of income for the year ended December 31, 2000 increased
from the prior year period, primarily due to improved performance at our joint
ventures.
42
Other, Net
Other, net for the year ended December 31, 2000 decreased from the
prior year period, primarily due to an increase in equity earnings from
unconsolidated joint ventures, and to a lesser extent, the amortization of
deferred gains associated with certain investments.
Income Taxes
Our effective tax rate is significantly impacted by goodwill
amortization, the majority of which is not deductible for tax purposes, and has
the effect of increasing the overall tax rate. The reduction in the effective
tax rate for 2000 was primarily due to pretax earnings increasing at a faster
rate than goodwill amortization and other non-deductible items.
Extraordinary Loss
Extraordinary losses were recorded in 2000 and 1999 representing the
write-off of deferred financing costs associated with debt which was prepaid
during the periods.
During the fourth quarter of 2000, we prepaid $155 million of term
loans under our senior secured credit facility. The extraordinary loss recorded
in the fourth quarter of 2000 in connection with this prepayment was $4.8
million ($2.9 million, net of taxes).
In conjunction with the acquisition of SBCL, we repaid the entire
amount outstanding under our then existing credit agreement. The extraordinary
loss recorded in the third quarter of 1999 in connection with this prepayment
was $3.6 million ($2.1 million, net of taxes).
Adjusted EBITDA
Adjusted EBITDA represents income before extraordinary loss, income
taxes, net interest expense, depreciation, amortization and special items.
Special items for 2000 and 1999 included the provisions for restructuring and
other special charges reflected on the face of the statements of operations,
$8.9 million of costs related to the integration of SBCL which were included in
operating costs and expensed as incurred in 2000, and a $3.0 million gain
related to the sale of an investment in the fourth quarter of 1999. Adjusted
EBITDA is presented and discussed because management believes that Adjusted
EBITDA is a useful adjunct to net income and other measurements under accounting
principles generally accepted in the United States since it is a meaningful
measure of a company's performance and ability to meet its future debt service
requirements, fund capital expenditures and meet working capital requirements.
Adjusted EBITDA is not a measure of financial performance under accounting
principles generally accepted in the United States and should not be considered
as an alternative to (i) net income (or any other measure of performance under
accounting principles generally accepted in the United States) as a measure of
performance or (ii) cash flows from operating, investing or financing activities
as an indicator of cash flows or as a measure of liquidity.
Adjusted EBITDA for 2000 improved to $459 million, or 13.4% of net
revenues from $237 million, or 11.2% of net revenues, excluding the impact of
testing performed by third parties under our laboratory network management
arrangements, in the prior year period. The dollar increase in Adjusted EBITDA
was principally associated with the SBCL acquisition. The percentage improvement
in Adjusted EBITDA was primarily related to improvements in the operating
performance of the Company and synergies realized from the acquisition of SBCL.
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
includes 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 for
additional discussion of our financial instruments and hedging activities. Prior
to our debt refinancing in June 2001, our senior secured credit facility
required us to maintain interest rate swap agreements to mitigate the risk of
changes in interest rates associated with a portion of our variable rate bank
debt. In conjunction with our debt refinancing, the interest rate swap
agreements were terminated. No interest rate swap agreements were outstanding at
December 31, 2001. Our debt refinancings are more fully described under
"Liquidity and Capital Resources - Cash Flows from Financing Activities" and in
Note 12 to the Consolidated Financial Statements.
43
At December 31, 2001 and 2000, the fair value of our debt was estimated
at approximately $857 million and $1 billion, 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 December 31, 2001, the
estimated fair value exceeded the carrying value of the debt by approximately
$35 million. At December 31, 2000, the estimated fair value exceeded the
carrying value of the debt by approximately $5 million. An assumed 10% increase
in interest rates (representing approximately 60 basis points) would potentially
reduce the estimated fair value of our debt by approximately $26 million and $8
million, respectively, at December 31, 2001 and 2000.
At December 31, 2001 and 2000, we had $7 million and $848 million,
respectively, of variable interest rate debt outstanding. Based on our net
exposure to interest rate changes, an assumed 10% increase in interest rates,
(representing approximately 35 basis points) would not have a material impact on
our after-tax earnings and cash flows for the year ended December 31, 2001 based
on debt levels as of December 31, 2001. The primary interest rate exposures on
the variable interest rate debt are with respect to interest rates on United
States dollars as quoted in the London interbank market.
Our 1 3/4% contingent convertible debentures due 2021 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, is considered to be a derivative instrument subject to
SFAS 133,"Accounting for Derivative Instruments and Hedging Activities", as
amended. As such, the derivative is recorded at its fair value in the
consolidated balance sheet with changes in its fair value being recorded each
period in current earnings. On a quarterly basis, management consults with one
or more of its advisors to estimate the fair value of the contingent interest
derivative. The fair value of the derivative at the date of issuance and at
December 31, 2001 was not material.
Borrowings under our revolving credit facility under our Credit
Agreement and our secured receivables credit facility are subject to variable
interest rates, unless fixed through interest rate swap agreements. Interest
rates on our revolving credit facility are also subject to a pricing schedule
that fluctuates based on changes in our credit ratings from Standard & Poor's
and Moody's Investor Services. As such, our borrowing cost under these credit
facilities will be subject to both fluctuations in interest rates and changes in
our credit profile. At December 31, 2001, there were no borrowings outstanding
under our revolving credit facility and secured receivables credit facility.
Liquidity and Capital Resources
Cash and Cash Equivalents
Cash and cash equivalents at December 31, 2001 totaled $122 million, a
decrease of $49 million from December 31, 2000. Cash flows from operating
activities in 2001 provided cash of $466 million, which was used to fund
investing and financing activities which required cash of $515 million. Cash and
cash equivalents at December 31, 2000 totaled $172 million, an increase of $144
million from the prior year-end balance. Cash flows from operating activities in
2000 provided cash of $370 million, which was used to fund investing and
financing activities which required cash of $225 million. We maintain
zero-balance bank accounts for the majority of our cash disbursements. Prior to
the second quarter of 2000, we maintained our largest disbursement accounts and
primary concentration accounts at the same financial institution, giving that
financial institution the legal right of offset. As such, book overdrafts
related to the disbursement accounts were offset against cash balances in the
concentration accounts for reporting purposes. During the second quarter of
2000, we moved our primary concentration account to another financial
institution such that no offset existed at June 30, 2000. As a result, book
overdrafts in the amount of $47 million at December 31, 2000, representing
outstanding checks, were classified as liabilities and not reflected as a
reduction of cash at December 31, 2000.
Cash Flows from Operating Activities
Net cash from operating activities for 2001 was $96 million higher than
the 2000 level. Excluding the $47 million increase in 2000 cash from operations
associated with the accounting for book overdrafts discussed above, the increase
in net cash from operating activities for 2001 was $144 million, compared to the
prior year. This increase was primarily due to improved operating performance,
partially offset by increased employee incentive payments and the costs to
settle our interest rate swap agreements. Days sales outstanding, a measure of
billing and collection efficiency, was 54 days at December 31, 2001 compared to
56 days at December 31, 2000. Net cash from operating activities for 2000 was
$120 million higher than the 1999 level. Excluding the $47 million increase in
2000 cash from operations associated with the accounting for book overdrafts
discussed above, the increase in net cash from operating activities for 2000 was
$73 million, compared to the prior year. This increase was primarily due to the
impact of the SBCL acquisition
44
and improvements in the operating performance of the Company, partially offset
by an increase in payments for restructuring, integration and other special
charges.
Cash Flows from Investing Activities
Net cash used in investing activities in 2001 was $297 million,
consisting primarily of acquisition and related transaction costs of $153
million, capital expenditures of $149 million, and an increase in investments of
$20 million, partially offset by $23 million in proceeds from the disposition of
assets, including $21 million from the sale of an investment in the second
quarter of 2001. Acquisition and related costs included $47 million to acquire
the assets of Clinical Laboratories of Colorado, LLC in Denver,Colorado; $18
million to acquire the outstanding voting shares that we did not already own of
MedPlus, Inc., a leading developer and integrator of clinical connectivity and
data management solutions for healthcare organizations and clinicians; $62
million to acquire all of the voting stock of Clinical Diagnostic Services,
Inc., which operates a diagnostic testing laboratory and over 50 patient service
centers in New York and New Jersey; and $18.5 million to acquire the assets of
Las Marias Reference Lab Corp. and Laboratorio Clinico Las Marias, Inc., in San
Juan, Puerto Rico. Net cash used in investing activities in 2000 was $48
million, consisting primarily of capital expenditures of $116 million and an
increase in investments of $27 million, representing investments in two
companies. These investing activities in 2000 were partially offset by the
receipt of $95 million from SmithKline Beecham in conjunction with finalizing
the purchase price adjustment provided for in the SBCL acquisition agreements.
Cash Flows from Financing Activities
Net cash used in financing activities for 2001 was $218 million,
consisting primarily of the net cash activity associated with new borrowings and
debt repayments, primarily related to our debt refinancings in the second and
fourth quarters of 2001, partially offset by $26 million of proceeds from the
exercise of stock options.
On June 27, 2001, we refinanced a majority of our long-term debt on a
senior unsecured basis to reduce overall interest costs and obtain less
restrictive covenants. Specifically, we completed a $550 million senior notes
offering (the "Senior Notes") and entered into a new $500 million senior
unsecured credit facility (the "Credit Agreement") which included a $175 million
term loan. We used the net proceeds from the senior notes offering and new term
loan, together with cash on hand, to repay all of the $584 million which was
outstanding under our then existing senior secured credit facility, including
the costs to settle existing interest rate swap agreements, and to consummate
a cash tender offer and consent solicitation for our Subordinated Notes. The
refinancing, excluding the impact of changes in market interest rates, is
expected to lower annual interest expense by approximately $23 million. The
Senior Notes do not have a sinking fund requirement. The Senior Notes and
borrowings under the Credit Agreement are guaranteed by our domestic wholly
owned subsidiaries that operate clinical laboratories in the United States.
The Senior Notes and Credit Agreement are further described in Note 12 to the
Consolidated Financial Statements.
In conjunction with the cash tender offer for the Subordinated Notes,
approximately $147 million in aggregate principal amount, or 98% of the $150
million of outstanding Subordinated Notes was tendered. In addition, we received
the requisite consents from the holders of Subordinated Notes to amend the
indenture governing the Subordinated Notes to eliminate substantially all of its
restrictive provisions. We made payments of approximately $160 million to
holders with respect to the cash tender offer and consent solicitation,
including tender premium and related solicitation and banking fees, and accrued
interest.
We incurred approximately $31 million of costs associated with the debt
refinancing. Of that amount, $12.4 million represented costs associated with
placing the new debt which will be amortized over the term of the Senior Notes
and Credit Agreement and $6 million represented the cost to terminate the
interest rate swap agreements on the debt which was refinanced. The remaining
$12.8 million represented primarily the tender premium incurred in conjunction
with our cash tender offer of the Subordinated Notes which was included in the
extraordinary loss recorded in the second quarter of 2001 as discussed in Note 8
to the Consolidated Financial Statements.
During the third quarter of 2001, we used cash on hand to prepay $50
million of the $175 million term loan under our Credit Agreement. During the
fourth quarter of 2001, we used cash on hand to repay the remaining balance
outstanding of $125 million under the term loan included in our Credit Agreement
and to redeem all of the remaining $2.5 million of our outstanding Subordinated
Notes. Also during the fourth quarter of 2001, we used cash on hand to redeem
all of our outstanding shares of preferred stock for $1 million plus accrued
dividends.
On November 26, 2001, we completed our $250 million offering of 1 3/4%
contingent convertible debentures due 2021 (the "Debentures"). The net proceeds
of the offering, together with cash on hand, were used to repay all of the $256
45
million principal that was outstanding under our secured receivables credit
facility. The borrowing capacity under our secured receivables credit facility,
totaling $256 million at December 31, 2001and $300 million as of the date of
this filing, remains available to us for future general corporate purposes and
acquisitions.
The Debentures are guaranteed by our domestic wholly owned subsidiaries
that operate clinical laboratories in the United States and do not have a
sinking fund requirement. The Debentures, which pay a fixed rate of interest
semi-annually commencing on May 31, 2002, have a contingent interest component
that will require us to pay contingent interest based on certain thresholds,
as outlined in the Indenture. For income tax purposes, the Debentures are
considered to be a contingent payment security. As such, interest expense for
tax purposes is based on an assumed interest rate related to a debt security
issued by the Company without a conversion feature. The assumed rate was 7% at
December 31, 2001. The contingent interest component of the Debentures is
considered to be a derivative instrument subject to SFAS 133,"Accounting for
Derivative Instruments and Hedging Activities", as amended. As such, the
derivative is recorded at its fair value in the consolidated balance sheet
with changes in its fair value being recorded each period in current earnings.
The fair value of the derivative at the date of issuance and at December 31,
2001 was not material.
Each one thousand dollar principal amount of Debentures is convertible
into 11.429 shares of our common stock, which represents an initial conversion
price of $87.50 per share. Holders may surrender the Debentures for conversion
into shares of our common stock under any of the following circumstances: (1) if
the sales price of our common stock is above 120% of the conversion price (or
$105 per share) for specified periods; (2) if we call the Debentures or (3) if
specified corporate transactions have occurred.
We may call the Debentures at any time on or after November 30, 2004
for the principal amount of the Debentures plus any accrued and unpaid interest.
On November 30, 2004, 2005, 2008, 2012 and 2016 each holder of the Debentures
may require us to repurchase the holder's Debentures for the principal amount of
the Debentures plus any accrued and unpaid interest. We may repurchase the
Debentures for cash, common stock, or a combination of both. Our current intent
is to settle repurchases in cash.
We incurred approximately $3.3 million of costs associated with the
issuance of the Debentures, which will be amortized through November 30, 2004,
the initial date the holders of the Debentures may require us to repurchase the
Debentures.
Net cash used in financing activities for 2000 was $177 million,
consisting primarily of $447 million of repayments of debt under our senior
secured credit facility and $6.9 million of distributions to minority partners,
partially offset by the proceeds from the completion of a $256 million
receivables-backed financing transaction (the "secured receivables credit
facility") and $22 million of proceeds from the exercise of stock options. On
July 21, 2000, we completed the secured receivables credit facility, the
proceeds of which were used to pay down loans outstanding under our senior
secured credit facility. Approximately $48 million was used to completely repay
amounts outstanding under the capital markets loan portion of the senior secured
credit facility, with the remainder used to repay amounts outstanding under the
term loans portion of the senior secured credit facility. In addition, the
repayment of the capital markets loan reduced the borrowing spreads on all
remaining term loans under the senior secured credit facility. Borrowings
outstanding under the secured receivables credit facility are classified as a
current liability on our consolidated balance sheet since the lenders fund the
borrowings through the issuance of commercial paper which matures at various
dates up to ninety days from the date of issuance. Our secured receivables
credit facility is more fully described in Note 12 to our Consolidated Financial
Statements. During the fourth quarter of 2000, we prepaid $155 million of term
loans under our senior secured credit facility.
Stock Split
On May 8, 2001, the stockholders approved an amendment to the Company's
restated certificate of incorporation to increase the number of common shares
authorized from 100 million shares to 300 million shares. On May 31, 2001, we
effected a two-for-one stock split through the issuance of a stock dividend of
one new share of common stock for each share of common stock held by
stockholders of record on May 16, 2001. References to the number of common
shares and per common share amounts in the accompanying consolidated balance
sheets and consolidated statements of operations, including earnings per common
share calculations and related disclosures, have been restated to give
retroactive effect to the stock split for all periods presented.
Share Repurchase Program
46
In 1998, the Board of Directors authorized a limited share purchase
program which permitted the Company to purchase up to $27 million of its
outstanding common stock through 1999. Cumulative purchases under the program
through December 31, 1999 totaled $14.1 million. Shares purchased under the
program were reissued in connection with certain employee benefit plans. We
suspended purchases of our shares when we reached a preliminary understanding of
the transaction with SmithKline Beecham on January 15, 1999.
Dividend Policy
We have never declared or paid cash dividends on our common stock and
do not anticipate paying dividends on our common stock in the foreseeable
future. We currently intend to retain all available funds and any future
earnings to fund the growth of our business.
Contractual Obligations and Commitments
The following table summarizes certain of our contractual obligations
as of December 31, 2001. See Notes 12 and 17 to the Consolidated Financial
Statements for further details.
Payments due by period
Less than 1
Contractual Obligations Total year 1-3 years 4-5 years After 5 years
----------------------- ----- ---- --------- --------- -------------
Long-term debt............................... $ 821,741 $ 1,404 $ 25,283 $ 273,594 $ 521,460
Operating lease commitments.................. 469,803 92,170 183,503 79,265 114,865
Purchase commitments......................... 30,705 21,064 8,949 572 120
----------- ----------- ----------- ----------- -----------
Total contractual cash obligations......... 1,322,249 114,638 217,735 353,431 636,445
Standby letters of credit.................... 23,577 23,577 - - -
----------- ----------- ----------- ----------- -----------
Total contractual obligations.............. $ 1,345,826 $ 138,215 $ 217,735 $ 353,431 $ 636,445
============ ============ ============ ============ ============
See Note 12 to the Consolidated Financial Statements for a full
description of the terms of our indebtedness and related debt service
requirements. A full discussion and analysis regarding our minimum rental
commitments under noncancelable operating leases, noncancelable commitments to
purchase products or services, and reserves with respect to insurance and
billing-related claims is contained in Note 17 to the Consolidated Financial
Statements.
Our Credit Agreement contains various covenants and conditions,
including the maintenance of certain financial ratios, that could impact our
ability to, among other things, incur additional indebtedness, repurchase shares
of our outstanding common stock, make additional investments and consummate
acquisitions. We do not expect these covenants to adversely impact our ability
to execute our growth strategy.
Unconsolidated Joint Ventures
At December 31, 2001, we had investments in unconsolidated joint
ventures in Phoenix, Arizona; Indianapolis, Indiana; and Dayton, Ohio, 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
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 $150 million to $160
million during 2002 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 $24 million at December 31, 2001, all of
the $325 million revolving credit facility under the Credit Agreement and all of
the $256 million secured receivables credit facility remained available to us
for future borrowing at December 31, 2001. On January 14, 2002, our borrowing
capacity under the secured receivables credit facility was increased to $300
million. Borrowings under our revolving credit facility and our secured
receivables credit facility will be variable rate debt, unless
47
fixed through interest rate swap agreements. Interest rates on the $325 million
revolving credit facility are also subject to a pricing schedule which
fluctuates based on various credit ratios of the Company as well as our credit
rating. As such, our borrowing cost under our revolving credit facility and our
secured receivables credit facility are not only subject to fluctuations in
interest rates but to changes in our credit profile as well.
On February 7, 2002, we executed a definitive agreement to acquire
American Medical Laboratories, Incorporated in an all-cash transaction valued at
$500 million, which includes the assumption of approximately $160 million in
debt. We expect to use existing cash on hand, and our existing borrowing
capacity under our Credit Agreement and our secured receivables credit facility
to fund the acquisition. We expect the transaction to close sometime in the
first quarter of 2002. After the closing, we expect that a total of
approximately $125 million of unused borrowing capacity under our revolving
credit facility and our secured receivables credit facility will remain
available to us for future borrowing. See Note 18 to the Consolidated Financial
Statements for further details.
We believe that cash from operations, our borrowing capacity under our
revolving credit facility and our secured receivables credit facility, together
with the indemnification by SmithKline Beecham against monetary fines, penalties
or losses from outstanding government and other related claims, 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. Our credit ratings from both
Standard & Poor's and Moody's Investor Services have had a favorable impact on
our cost of and access to capital. Additionally, we believe that our improved
financial performance should provide us with access to additional financing, if
necessary, including utilizing our $650 million shelf registrations, to fund
growth opportunities which cannot be funded from existing sources.
Outlook
As discussed in the Overview, we believe that the underlying
fundamentals of the diagnostic testing industry continue to improve and will
fuel growth for the industry. As the leading national provider with the most
extensive network of laboratories and patient service centers throughout the
United States, Quest Diagnostics will be able to further enhance patient access
and customer service. We provide a broad range of benefits for customers,
including: continued improvements in quality; convenience and accessibility; a
broad test menu; and a broad range of medical information products to help
providers and insurers better manage their patients' health. We plan to pursue
profitable growth opportunities, including: selective acquisitions; testing for
hospitals and physician specialists; direct contracting with employers for
laboratory services; clinical trials testing for pharmaceutical companies; gene
based and other esoteric testing; and testing directly for consumers.
Finally, we believe that we will achieve our goal of $150 million of
annual net cost savings as a result of the SBCL integration by the end of 2002.
Management believes that our Six Sigma and Standardization initiatives, which
are creating competitive advantage and are expected to generate annual net
benefits of at least $150 million by the end of 2004, will enable us to achieve
earnings growth, before special charges, of at least 30% annually over the next
several years.
Inflation
The Company believes that inflation generally does not have a material
adverse effect on its operations or financial condition because the majority of
its contracts are short term.
Impact of Recently Issued Accounting Standards
In July 2001, the FASB issued SFAS No. 141, "Business Combinations"
("SFAS 141"), which requires business combinations initiated after June 30, 2001
to be accounted for using the purchase method of accounting, and SFAS No. 142,
"Goodwill and Other Intangible Assets" ("SFAS 142"), which broadens the criteria
for recording intangible assets separate from goodwill. SFAS 142 requires the
use of a nonamortization approach to account for purchased goodwill and certain
intangibles. Under a nonamortization approach, goodwill and certain intangibles
will not be amortized into results of operations, but instead will be reviewed
for impairment and an impairment charge will be recorded in the periods in which
the recorded carrying value of goodwill and certain intangibles is more than its
estimated fair value. As described in Note 2 to the Consolidated Financial
Statements under Impairment of Long-Lived Assets, we have historically reviewed
the recoverability of goodwill based on a fair value methodology similar to that
prescribed under SFAS 142. The provisions of SFAS 141 have been adopted for any
business combination consummated after June 30, 2001. Goodwill acquired in a
business combination for which the acquisition date is after June 30, 2001 will
not be amortized. We will adopt the provisions of SFAS 142, related to goodwill
acquired prior to June 30, 2001 and intangible assets, on January 1, 2002. The
adoption of these
48
accounting standards is expected to reduce the amount of amortization of
goodwill recorded in our consolidated financial statements by approximately $35
million annually, commencing January 1, 2002. We do not expect that the new
criteria for recording intangible assets separate from goodwill will require us
to reclassify any of our intangible assets. Also we do not expect that the
adoption of the nonamortization approach under SFAS 142 will result in an
impairment of our recorded goodwill.
In August 2001, the FASB issued SFAS No. 144 "Accounting for Impairment
or Disposal of Long-Lived Assets" ("SFAS 144"), which supercedes SFAS No. 121.
SFAS 144 further refines SFAS 121's requirement that companies recognize an
impairment loss if the carrying amount of a long-lived asset is not recoverable
based on its undiscounted future cash flows and measure an impairment loss as
the difference between the carrying amount and fair value of the asset. In
addition, SFAS 144 provides guidance on accounting and disclosure issues
surrounding long-lived assets to be disposed of by sale. SFAS 144 also extends
the presentation of discontinued operations to include more disposal
transactions. SFAS 144 is effective for all fiscal quarters of all fiscal years
beginning after December 15, 2001 (2002 for the Company). We believe that the
adoption of SFAS 144 will not have a material effect on our consolidated results
of operations or financial position.
Pro Forma Comparisons
The unaudited pro forma combined financial information assumes that the
SBCL acquisition and borrowings under our senior secured credit facility were
effected on January 1, 1999. The SBCL acquisition agreements included a
provision for a reduction in the purchase price paid by Quest Diagnostics in the
event that the combined balance sheet of SBCL indicated that the net assets
acquired, as of the acquisition date, were below a prescribed level. On October
11, 2000, the purchase price adjustment was finalized with the result that
SmithKline Beecham owed Quest Diagnostics $99 million. This amount was
offset by $3.6 million separately owed by Quest Diagnostics to SmithKline
Beecham, resulting in a net payment by SmithKline Beecham of $95 million. The
purchase price adjustment was recorded in the Company's financial statements in
the fourth quarter of 2000 as a reduction in the amount of goodwill recorded in
conjunction with the SBCL acquisition.
The remaining components of the purchase price allocation relating to
the SBCL acquisition were finalized during the third quarter of 2000. The
resulting adjustments to the SBCL purchase price allocation primarily related to
an increase in deferred tax assets acquired, the sale of certain assets of SBCL
at fair value to unconsolidated joint ventures of Quest Diagnostics and an
increase in accrued liabilities for costs related to pre-acquisition periods. As
a result of these adjustments, the Company reduced the amount of goodwill
recorded in conjunction with the SBCL acquisition by approximately $35 million
during the third quarter of 2000.
None of the adjustments, resulting from the reduction in the SBCL
purchase price or the completion of the purchase price allocation, had any
impact on the Company's previously reported historical financial statements.
The unaudited pro forma combined financial information is presented for
illustrative purposes only to assist in analyzing the financial implications of
the SBCL acquisition and borrowings under the senior secured credit facility.
The unaudited pro forma combined financial information may not be indicative of
the combined financial results of operations that would have been realized had
Quest Diagnostics and SBCL been a single entity during the periods presented. In
addition, the unaudited pro forma combined financial information is not
necessarily indicative of the future results that the combined company will
experience.
Significant pro forma adjustments reflected in the unaudited pro forma
combined financial information include reductions in employee benefit costs and
general corporate overhead allocated to the historical results of SBCL by
SmithKline Beecham, offset by an increase in net interest expense to reflect our
senior secured credit facility which was used to finance the SBCL acquisition.
Amortization of the goodwill, which accounts for a majority of the acquired
intangible assets, is calculated on the straight-line basis over forty years.
Income taxes have been adjusted for the estimated income tax impact of the pro
forma adjustments at the incremental tax rate of 40%. A significant portion of
the intangible assets acquired in the SBCL acquisition is not deductible for tax
purposes, which has the overall impact of increasing the effective tax rate.
Both basic and diluted weighted average common shares outstanding have
been presented on a pro forma basis giving effect to the shares issued to
SmithKline Beecham and the shares granted at closing to employees. Potentially
dilutive common shares primarily represent stock options. During periods in
which net income available for common stockholders is a loss, diluted weighted
average common shares outstanding will equal basic weighted average common
shares outstanding, since under these circumstances, the incremental shares
would have an anti-dilutive effect.
49
Historical Year Ended December 31, 2000 Compared with
Pro Forma Combined Year Ended December 31, 1999
The following discussion and analysis compares our historical results
of operations for the year ended December 31, 2000 to the pro forma combined
results of operations for the year ended December 31, 1999, assuming that SBCL
had been acquired by Quest Diagnostics on January 1, 1999. All references in
this section to the year ended December 31, 2000 refer to the historical results
of Quest Diagnostics for such period. All references in this section to the year
ended December 31, 1999 refer to the pro forma combined results of Quest
Diagnostics for such period.
Income before an extraordinary loss for the year ended December 31,
2000 increased to $105 million, compared to a loss of $34 million for the prior
year period. Extraordinary losses, net of taxes, of $2.9 million and $2.1
million were recorded in 2000 and 1999, respectively, representing the write-off
of deferred financing costs associated with the prepayment of debt.
Additionally, a number of special items were recorded in 2000 and 1999 which
consisted of the provisions for restructuring and other special charges
reflected on the face of the historical and pro forma combined statement of
operations, respectively, a $9.7 million gain recognized by SBCL on the sale of
its physician office-based teleprinter assets and network in the first quarter
of 1999 and a $3.0 million gain related to the sale of an investment in the
fourth quarter of 1999. Excluding the special items and the extraordinary loss,
net income for the year ended December 31, 2000 increased to $106 million,
compared to $12.6 million for the prior year period.
A special review of the SBCL pre-closing financial statements, called
for in the SBCL acquisition agreements, was conducted to assess the
recoverability of assets and the adequacy of liabilities existing prior to the
closing date of the acquisition. This special review resulted in adjustments,
primarily related to the recoverability of SBCL receivables and accrued
liabilities during various periods prior to the closing of the SBCL acquisition.
In addition, SBCL recorded certain other income and expense items prior to the
closing of the SBCL acquisition. The adjustments resulting from the special
review and the other income and expense items, recorded by SBCL prior to the
closing of the acquisition, served as a basis for the $99 million purchase price
adjustment which was discussed earlier. Management believes that the adjustments
resulting from the special review and the other income and expense items, both
of which have not been reflected on the face of the pro forma combined financial
information, are of a non-recurring nature and limit the comparability of
results between the periods presented. In the discussions that follow, these
matters are collectively referred to as discrete income and expense items.
Discrete expense items for the year ended December 31, 1999, totaled
$47 million, including bad debt charges of $22 million to reflect the reduced
recoverability of SBCL receivables, as a result of the special review of the
SBCL financial statements; $11.5 million of expenses recorded by SBCL prior to
the acquisition, primarily to record liabilities necessary to properly present
the closing balance sheet of SBCL; $7.1 million of losses related to a customer
contract accounted for as a loss contract beginning in the third quarter of
1999; and $5.6 million of costs for which SmithKline Beecham is obligated to
indemnify the Company associated with two incidents, the most significant of
which related to a SBCL employee who allegedly reused certain needles when
drawing blood from patients. Excluding the impact of the discrete expense items,
income before an extraordinary loss and special items for the year ended
December 31, 1999 was $41 million.
Results for the years ended December 31, 2000 and 1999 included the
effects of testing performed by third parties under our laboratory network
management arrangements. As laboratory network manager, we included in our
consolidated revenues and expenses the cost of testing performed by third
parties. This treatment added $49 million to both reported revenues and cost of
services for the year ended December 31, 2000. For the year ended December 31,
1999, this treatment added $154 million to both pro forma revenues and pro forma
cost of services. This treatment also serves to increase cost of services as a
percentage of net revenues and decrease selling, general and administrative
expenses as a percentage of net revenues. During the first quarter of 2000, we
terminated a laboratory network management arrangement with Aetna US Healthcare,
and entered into a new non-exclusive contract under which we will no longer be
responsible for the cost of testing performed by third parties. In addition,
during the third quarter of 2000, we amended our laboratory network management
contract with Oxford Health to remove the financial risk associated with testing
performed by third parties. As such, we will no longer be responsible for the
cost of testing performed by third parties under the contract with Oxford
Health. On a full year basis, these changes to the laboratory network management
agreements will reduce net revenues and cost of services by approximately $150
million.
50
Net Revenues
Net revenues for the year ended December 31, 2000 increased by $126
million or 3.8% from the prior year level. Revenue growth for the year ended
December 31, 2000 was partially offset by accounting for a customer contract as
a loss contract beginning in the second half of 1999 and the elimination of the
financial risk associated with testing performed by third parties under the
Aetna USHealthcare and Oxford Health managed care contracts modified during the
period, as discussed above. Adjusted for these changes, net revenues for the
year ended December 31, 2000 increased by 8.6%, compared to pro forma net
revenues in the prior year period. Average revenue per requisition increased by
5.9%, compared to 1999. On a full year basis, clinical testing volumes grew by
approximately 3.0%, after adjusting for the contribution of business to
unconsolidated joint ventures. Reported clinical testing volume growth was 2.5%
above the 1999 pro forma level.
Volume in the second half of 2000 grew at a slower rate than earlier in
the year, principally due to the intensified pace of integration activities, the
contribution of certain business to unconsolidated joint ventures and the loss
of certain contracts due to aggressive pricing on the part of competitors. In
addition, testing volumes were impacted by severe weather in certain service
areas during the fourth quarter of 2000. Management believes the Company is well
positioned, particularly upon completion of integration activities, to benefit
from improving industry fundamentals as well as its ability to leverage its
value proposition of offering expanded patient access, broad testing
capabilities and superior quality. While our long-standing pricing discipline
continued to favorably impact average revenue per requisition, other factors
that contributed to the increase in average revenue per requisition included
modifications to various managed care contracts, an increase in higher value
testing, and a shift to greater fee-for-service reimbursement.
Operating Costs and Expenses
Total operating costs for the year ended December 31, 2000 increased
from the prior year period, principally as a result of increased volume and
increased employee compensation and training costs. Operating costs and expenses
for the year ended December 31, 2000 included $8.9 million of costs related to
the integration of SBCL which were not chargeable against previously established
reserves for integration costs.
The following discussion and analysis regarding operating costs and
expenses exclude the effect of testing performed by third parties under our
laboratory network management arrangements, and the revenues and expenses
associated with a customer contract treated as a loss contract, beginning in the
third quarter of 1999. As discussed above, losses associated with this contract
amounted to $7.1 million for the year ended December 31, 1999. In addition,
operating costs and expenses for the year ended December 31, 1999 included $40
million of discrete expense items, recorded in SBCL's historical financial
statements prior to the closing of the SBCL acquisition.
Cost of services for the year ended December 31, 2000 decreased to
59.5% from 62.3% for the prior year period. For the year ended December 31,
1999, cost of services included $7.8 million of discrete expense items.
Excluding discrete expense items, cost of services as a percentage of net
revenues was 62.1%. Excluding the impact of the discrete expense items, the
decrease in cost of services, as a percentage of net revenues, was primarily due
to improvements in average revenue per requisition and to a lesser extent, the
impact of the SBCL integration to date on the Company's cost structure. These
decreases in cost of services were partially offset by an increase in employee
compensation and training costs.
Selling, general and administrative expenses, as a percentage of net
revenues, were 29.7% in 2000, compared to 30.5% in the prior year period.
Excluding the impact of discrete expense items of $32 million in 1999, selling,
general and administrative expenses, as a percentage of net revenues, were
29.5%. Excluding the impact of the discrete expense items in 1999, the increase
in selling, general and administrative expenses, as a percentage of net
revenues, was primarily attributable to increases in employee compensation and
training costs and investments related to the Company's information technology
strategy. These increases were in large part offset by improvements in average
revenue per requisition and bad debt expense. As discussed above, for the year
ended December 31, 1999, bad debt expense included discrete expense items of $22
million which represented bad debt charges, reflecting the reduced
recoverability of SBCL receivables, as a result of the special review of the
SBCL financial statements. Bad debt expense for 2000 improved to 7.0% of net
revenues, compared to 7.6%, excluding the impact of the discrete expense items
in 1999. This progress was primarily due to process improvements in the SBCL
billing functions, with particular focus in the areas of obtaining missing
information and reducing billing backlogs. We have made significant progress
towards improving the overall bad debt experience of the combined company with
quarter to quarter improvements in bad debt expense throughout 2000. Based on
prior experience as well as the sharing of internal best practices in the
billing functions, we believe that substantial opportunities continue to exist
to improve our overall collection experience.
51
Interest, Net
Excluding $1.9 million of interest income associated with a favorable
state tax settlement in 1999, net interest expense for the year ended December
31, 2000 decreased by $11.5 million compared to the prior year period. This
reduction was primarily due to an overall reduction in debt levels as well as
the favorable impact of the secured receivables credit facility which has served
to lower the weighted average borrowing rate on our outstanding debt.
Provisions for Restructuring and Other Special Charges
During the second quarter of 2000, we recorded a net special charge of
$2.1 million. Of the special charge, $13.4 million represented the costs to
cancel certain contracts that we believed were not economically viable as a
result of the SBCL acquisition. These costs were principally associated with the
cancellation of a co-marketing agreement for clinical trials testing services.
These charges were in large part offset by a reduction in reserves attributable
to a favorable resolution of outstanding claims for reimbursements associated
with billings of certain tests.
During the second, third and fourth quarters of 1999, we recorded
provisions for restructuring and other special charges totaling $15.8 million,
$30 million and $43 million, respectively, principally incurred in connection
with the acquisition and planned integration of SBCL.
The special charge in the second quarter of 1999 of $15.8 million
primarily related to a provision in the results of SBCL to reflect a customer
contract as a loss contract.
Of the total special charge recorded in the third quarter of 1999,
$19.8 million represented stock-based employee compensation of which $17.8
million related to special one-time grants of our common stock to certain
individuals of the combined company, and $2.0 million related to the accelerated
vesting, due to the completion of the SBCL acquisition, of restricted stock
grants made in previous years. In addition, during the third quarter of 1999, we
incurred $9.2 million of professional and consulting fees related to integration
planning activities. The remainder of the third quarter charge related to costs
incurred in conjunction with our planned offering of new senior subordinated
notes, the proceeds of which were expected to be used to repay our existing
Subordinated Notes. During the third quarter of 1999, we decided not to proceed
with the offering due to unsatisfactory market conditions.
Of the total special charge recorded in the fourth quarter of 1999, $36
million represented costs related to planned integration activities affecting
Quest Diagnostics' operations and employees. Of these costs, $23 million related
to employee severance costs, $9.7 million related primarily to lease obligations
for facilities and equipment and $6.7 million was associated with the write-off
of assets that we plan to dispose of in conjunction with the integration of
SBCL. Offsetting these charges was the reversal of $3.4 million of reserves
associated with our consolidation plan announced in the fourth quarter of 1997.
Upon finalizing the initial integration plans for SBCL in the fourth quarter of
1999, we determined that $3.4 million of the remaining reserves associated with
the December 1997 consolidation plan was no longer necessary due to changes in
the plan as a result of the SBCL integration. In addition to the net charge of
$36 million, we recorded $3.5 million of special recognition awards granted in
the fourth quarter of 1999 to certain employees involved in the transaction and
integration planning processes of the SBCL acquisition. The remainder of the
fourth quarter special charge was primarily attributable to professional and
consulting fees incurred in connection with integration related planning
activities.
Minority Share of Income
Minority share of income for the year ended December 31, 2000 increased
from the prior year periods, primarily due to the improved performance of our
joint ventures.
Other, Net
Other, net for the year ended December 31, 2000 increased from the
prior year period, primarily due to a $9.7 million gain recognized by SBCL on
the sale of its physician office-based teleprinter assets and network in the
first quarter of 1999 and a gain of $3.0 million associated with the sale of an
investment in the fourth quarter of 1999. These gains in 1999 were partially
offset by an increase in equity earnings from unconsolidated joint ventures, and
to a lesser extent, the amortization of deferred gains associated with certain
investments in 2000.
52
Income Taxes
Our effective tax rate is significantly impacted by goodwill
amortization, the majority of which is not deductible for tax purposes, and has
the effect of increasing the overall tax rate in 2000 or decreasing the overall
tax benefit in 1999.
Extraordinary Loss
Extraordinary losses were recorded in 2000 and 1999 representing the
write-off of deferred financing costs associated with debt which was prepaid
during the periods.
During the fourth quarter of 2000, we prepaid $155 million of term
loans under our senior secured credit facility. The extraordinary loss recorded
in the fourth quarter of 2000 in connection with this prepayment was $4.8
million ($2.9 million, net of taxes).
In conjunction with the acquisition of SBCL, we repaid the entire
amount outstanding under our then existing credit agreement. The extraordinary
loss recorded in the third quarter of 1999 in connection with this prepayment
was $3.6 million ($2.1 million, net of taxes).
Adjusted EBITDA
Adjusted EBITDA represents income (loss) before extraordinary loss,
income taxes, net interest expense, depreciation, amortization and special
items. For the year ended December 31, 2000, special items included the special
charges reflected on the face of the historical statement of operations and $8.9
million of costs related to the integration of SBCL which were included in
operating expenses and expensed as incurred in 2000. For the year ended December
31, 1999, special items included the provisions for restructuring and other
special charges reflected on the face of the pro forma combined statement of
operations, a $9.7 million gain recognized by SBCL on the sale of its physician
office-based teleprinter assets and network during the first quarter of 1999, a
$3.0 million gain related to the sale of an investment in the fourth quarter of
1999 and $47 million of discrete expense items, which are discussed above.
Adjusted EBITDA is presented and discussed because management believes that
Adjusted EBITDA is a useful adjunct to net income and other measurements under
accounting principles generally accepted in the United States since it is a
meaningful measure of a company's performance and ability to meet its future
debt service requirements, fund capital expenditures and meet working capital
requirements. Adjusted EBITDA is not a measure of financial performance under
accounting principles generally accepted in the United States and should not be
considered as an alternative to (i) net income (or any other measure of
performance under accounting principles generally accepted in the United States)
as a measure of performance or (ii) cash flows from operating, investing or
financing activities as an indicator of cash flows or as a measure of liquidity.
Adjusted EBITDA for the year ended December 31, 2000 improved to $459
million, or 13.4% of net revenues, compared to pro forma Adjusted EBITDA of $337
million, or 10.9% of net revenues, excluding the impact of the testing performed
by third parties under our laboratory network management arrangements and the
loss contract, in the prior year period. The increase in Adjusted EBITDA was
primarily related to improvements in the operating performance of the Company.
53
STATEMENT OF MANAGEMENT RESPONSIBILITY FOR FINANCIAL STATEMENTS
The management of Quest Diagnostics Incorporated is responsible for the
preparation, presentation and integrity of the consolidated financial statements
and other information included in this annual report. The financial statements
have been prepared in accordance with accounting principles generally accepted
in the United States of America and include certain amounts based on
management's best estimates and judgements.
Quest Diagnostics maintains a comprehensive system of internal controls
designed to provide reasonable assurance as to the reliability of the financial
statements as well as to safeguard assets from unauthorized use or disposition.
The system is reinforced by written policies, selection and training of highly
competent financial personnel, appropriate division of responsibilities and a
program of internal audits.
The Audit and Finance Committee of the Board of Directors is
responsible for reviewing and monitoring Quest Diagnostics' financial reporting
and accounting practices and recommending annually the appointment of the
independent accountants. The Audit and Finance Committee is comprised solely of
non-management directors who are, in the opinion of the Board of Directors, free
from any relationship that would interfere with the exercise of independent
judgement. The Audit and Finance Committee meets periodically with management,
the internal auditors and the independent accountants to review and assess the
activities of each. Both the independent accountants and the internal auditors
meet with the Audit and Finance Committee, without management present, to review
the results of their audits and their assessment of the adequacy of the system
of internal accounting controls and the quality of financial reporting.
The consolidated financial statements have been audited by our
independent accountants, PricewaterhouseCoopers LLP. Their responsibility is to
express an independent, professional opinion with respect to the consolidated
financial statements on the basis of an audit conducted in accordance with
auditing standards generally accepted in the United States of America.
/s/ Kenneth W. Freeman
-------------------------
Kenneth W. Freeman
Chairman of the Board and
Chief Executive Officer
/s/ Robert A. Hagemann
-------------------------
Robert A. Hagemann
Vice President and
Chief Financial Officer
54
Report of Independent Accountants
To the Board of Directors and Stockholders
of Quest Diagnostics Incorporated
In our opinion, the consolidated financial statements listed in the
index appearing under Item 14(a)(1) present fairly, in all material respects,
the financial position of Quest Diagnostics Incorporated and its subsidiaries
(the "Company") at December 31, 2001 and 2000, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2001 in conformity with accounting principles generally accepted in
the United States of America. In addition, in our opinion, the financial
statement schedule listed in the index appearing under Item 14(a)(2) presents
fairly, in all material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements. These financial
statements and financial statement schedule are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements and financial statement schedule based on our audits. We
conducted our audits of these statements in accordance with auditing standards
generally accepted in the United States of America, which require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
PricewaterhouseCoopers LLP
New York, New York
January 24, 2002, except as to Note 18, which is as of February 8, 2002
F-1
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2001 and 2000
(in thousands, except per share data)
2001 2000
---------- ----------
Assets
Current assets:
Cash and cash equivalents................................................. $ 122,332 $ 171,477
Accounts receivable, net of allowance of $216,203 and $204,358
at December 31, 2001 and 2000, respectively............................ 508,340 485,573
Inventories............................................................... 49,906 44,274
Deferred income taxes..................................................... 157,649 188,483
Prepaid expenses and other current assets................................. 38,287 90,882
---------- ----------
Total current assets.................................................... 876,514 980,689
Property, plant and equipment, net........................................... 508,619 449,856
Goodwill, net................................................................ 1,351,123 1,235,933
Intangible assets, net....................................................... 28,020 25,670
Deferred income taxes........................................................ 52,678 42,622
Other assets................................................................. 113,601 129,766
---------- ----------
Total assets................................................................. $2,930,555 $2,864,536
========== ==========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses..................................... $ 657,219 $ 689,582
Short-term borrowings and current portion of long-term debt............... 1,404 265,408
---------- ----------
Total current liabilities............................................... 658,623 954,990
Long-term debt............................................................... 820,337 760,705
Other liabilities............................................................ 115,608 117,046
Commitments and contingencies
Preferred stock ............................................................. - 1,000
Common stockholders' equity:
Common stock, par value $0.01 per share; 300,000 shares authorized; 96,024
and 93,083 shares issued and outstanding at December 31, 2001 and 2000,
respectively.............................................................. 960 465
Additional paid-in capital................................................ 1,714,676 1,591,976
Accumulated deficit....................................................... (362,926) (525,111)
Unearned compensation..................................................... (13,253) (31,077)
Accumulated other comprehensive loss...................................... (3,470) (5,458)
---------- ----------
Total common stockholders' equity....................................... 1,335,987 1,030,795
---------- ----------
Total liabilities and stockholders' equity................................... $2,930,555 $2,864,536
========== ==========
The accompanying notes are an integral part of these statements.
F-2
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
(in thousands, except per share data)
2001 2000 1999
----------- ---------- ----------
Net revenues................................................ $3,627,771 $3,421,162 $2,205,243
Costs and expenses:
Cost of services......................................... 2,151,594 2,056,237 1,379,989
Selling, general and administrative...................... 1,018,680 1,001,443 643,440
Interest, net............................................ 70,523 113,092 61,450
Amortization of intangible assets........................ 46,107 45,665 29,784
Provisions for restructuring and other special charges... 5,997 2,100 73,385
Minority share of income................................. 9,953 9,359 5,431
Other, net............................................... (7,687) (7,715) (2,620)
---------- ---------- ----------
Total.................................................. 3,295,167 3,220,181 2,190,859
---------- ---------- ----------
Income before taxes and extraordinary loss.................. 332,604 200,981 14,384
Income tax expense.......................................... 148,692 96,033 15,658
---------- ---------- ----------
Income (loss) before extraordinary loss..................... 183,912 104,948 (1,274)
Extraordinary loss, net of taxes............................ (21,609) (2,896) (2,139)
---------- ---------- ----------
Net income (loss)........................................... $ 162,303 $ 102,052 $ (3,413)
========== ========== ==========
Basic net income (loss) per common share:
Income (loss) before extraordinary loss..................... $ 1.98 $ 1.17 $ (0.02)
Extraordinary loss, net of taxes............................ (0.24) (0.03) (0.03)
---------- ---------- ----------
Net income (loss)........................................... $ 1.74 $ 1.14 $ (0.05)
========== ========== ==========
Diluted net income (loss) per common share:
Income (loss) before extraordinary loss..................... $ 1.88 $ 1.11 $ (0.02)
Extraordinary loss, net of taxes............................ (0.22) (0.03) (0.03)
---------- ---------- ----------
Net income (loss)........................................... $ 1.66 $ 1.08 $ (0.05)
========== ========== ==========
The accompanying notes are an integral part of these statements.
F-3
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
(in thousands)
2001 2000 1999
------------ --------- ----------------
Cash flows from operating activities:
Net income (loss)........................................... $ 162,303 $ 102,052 $ (3,413)
Extraordinary loss, net of taxes............................ 21,609 2,896 2,139
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization............................ 147,727 134,296 90,835
Provision for doubtful accounts.......................... 218,271 234,694 142,333
Provisions for restructuring and other special charges... 5,997 2,100 73,385
Deferred income tax (benefit) provision.................. (560) 33,837 (29,514)
Minority share of income................................. 9,953 9,359 5,431
Stock compensation expense............................... 20,672 24,592 6,068
Other, net............................................... 1,034 (4,078) 37
Changes in operating assets and liabilities:
Accounts receivable.................................... (230,131) (250,255) (118,693)
Accounts payable and accrued expenses.................. 12,788 100,223 110,929
Integration, settlement and special charges............ (48,664) (68,150) (33,326)
Tax benefits associated with stock-based compensation
plans................................................ 71,917 37,125 3,529
Other assets and liabilities, net...................... 72,887 10,764 (205)
------------ --------- -----------
Net cash provided by operating activities................... 465,803 369,455 249,535
------------ --------- -----------
Cash flows from investing activities:
Business acquisitions.................................... (152,864) 92,225 (1,034,612)
Capital expenditures..................................... (148,986) (116,450) (76,029)
Proceeds from disposition of assets...................... 22,673 3,625 12,702
Increase in investments.................................. (20,428) (27,415) (10,051)
Decrease in note receivable.............................. 2,989 - -
------------ --------- -----------
Net cash used in investing activities....................... (296,616) (48,015) (1,107,990)
------------ --------- -----------
Cash flows from financing activities:
Repayments of long-term debt............................. (1,175,489) (446,762) (412,035)
Proceeds from borrowings................................. 969,939 256,000 1,132,843
Financing costs paid..................................... (28,459) (1,732) (36,822)
Proceeds from exercise of stock options.................. 25,631 22,147 4,429
Distributions to minority partners....................... (8,718) (6,871) (4,363)
Redemption of preferred stock............................ (1,000) - -
Purchase of treasury stock............................... - - (1,103)
Preferred dividends paid................................. (236) (29) (118)
------------ --------- -----------
Net cash provided by (used in) financing activities......... (218,332) (177,247) 682,831
------------ --------- -----------
Net change in cash and cash equivalents..................... (49,145) 144,193 (175,624)
Cash and cash equivalents, beginning of year................ 171,477 27,284 202,908
------------ --------- -----------
Cash and cash equivalents, end of year...................... $ 122,332 $ 171,477 $ 27,284
============ ========= ===========
The accompanying notes are an integral part of these statements.
F-4
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
(in thousands)
Accumulated
Additional Unearned Other Comprehensive
Common Paid-In Accumulated Compen- Comprehensive Treasury Income
Stock Capital Deficit sation Income (Loss) Stock (Loss)
------ ---------- ----------- -------- ------------- -------- -------------
Balance, December 31, 1998..... $302 $1,201,006 $(623,514) $ (3,895) $(3,038) $(3,931)
Net loss....................... (3,413) $ (3,413)
Other comprehensive income..... 588 588
--------
Comprehensive loss............. (2,825)
========
Preferred dividends declared... (118)
Shares issued to acquire SBCL
(12,564 common shares)........ 126 260,584
Purchase of treasury stock
(60 common shares)............ (1,103)
Issuance of common stock under
benefit plans (1,269 common
shares and 274 treasury
shares)....................... 13 34,991 (11,253) 5,034
Exercise of stock options (279
common shares)................ 3 4,426
Tax benefits associated with
stock-based compensation
plans......................... 3,529
Adjustment to Corning
receivable.................... (1,985)
Amortization of unearned
compensation.................. 3,710
------------------------------------------------------------------------------------------------------
Balance, December 31, 1999..... 444 1,502,551 (627,045) (11,438) (2,450) -
Net income..................... 102,052 102,052
Other comprehensive loss....... (3,008) (3,008)
--------
Comprehensive income........... 99,044
========
Preferred dividends declared... (118)
Issuance of common stock under
benefit plans (868 common
shares)....................... 8 58,039 (45,357)
Exercise of stock options
(1,585 common shares)......... 16 22,131
Shares to cover payroll tax
withholdings on exercised stock
options (265 common shares)... (3) (22,012)
Tax benefits associated with
stock-based compensation
plans......................... 37,125
Adjustment to Corning
receivable.................... (5,858)
Amortization of unearned
compensation.................. 25,718
------------------------------------------------------------------------------------------------------
Balance December 31, 2000...... 465 1,591,976 (525,111) (31,077) (5,458) -
Net income..................... 162,303 162,303
Other comprehensive income..... 1,988 1,988
--------
Comprehensive income........... $164,291
========
Two-for-one stock split
(47,149 common shares)........ 472 (472)
Preferred dividends declared... (118)
Issuance of common stock under
benefit plans (233 common
shares)....................... 2 25,040 (3,540)
Exercise of stock options
(2,101 common shares)......... 21 25,610
Tax benefits associated with
stock-based compensation
plans......................... 71,917
Adjustment to Corning
receivable.................... 605
Amortization of unearned
compensation.................. 21,364
----------------------------------------------------------------
Balance, December 31, 2001..... $960 $1,714,676 $(362,926) $(13,253) $(3,470) $ -
================================================================
The accompanying notes are an integral part of these statements.
F-5
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands unless otherwise indicated)
1. DESCRIPTION OF BUSINESS
Quest Diagnostics Incorporated and its subsidiaries ("Quest
Diagnostics" or the "Company") is the largest clinical laboratory testing
business in the United States. Prior to January 1, 1997, Quest Diagnostics was a
wholly owned subsidiary of Corning Incorporated ("Corning"). On December 31,
1996, Corning distributed all of the outstanding shares of common stock of the
Company to the stockholders of Corning as part of the "Spin-Off Distribution".
As the nation's leading provider of diagnostic testing and related
services for the healthcare industry, Quest Diagnostics offers a broad range of
clinical laboratory testing services to physicians, hospitals, managed care
organizations, employers, governmental institutions and other independent
clinical laboratories. Quest Diagnostics has the leading market share in
clinical laboratory testing and esoteric testing, including molecular
diagnostics, as well as non-hospital based anatomic pathology services and
testing for drugs of abuse. Through the Company's national network of
laboratories and patient service centers, and its leading esoteric testing
laboratory and development facility known as Nichols Institute, Quest
Diagnostics offers comprehensive and innovative diagnostic testing, information
and related services used by physicians and other healthcare customers to
diagnose, treat and monitor diseases and other medical conditions. Quest
Diagnostics offers clinical testing and services to support clinical trials of
new pharmaceuticals worldwide, including collecting and analyzing laboratory,
pharmaceutical and other data to develop information products to help
pharmaceutical companies with their marketing and disease management efforts, as
well as to help healthcare customers better manage the health of their patients.
Quest Diagnostics currently processes over 105 million requisitions
each year through its extensive network of laboratories and patient service
centers in virtually every major metropolitan area throughout the United States.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of all
entities controlled by the Company. The equity method of accounting is used for
investments in affiliates which are not Company controlled, in which the
Company's ownership interest is between 20 and 50 percent and in which the
Company has significant influence. The Company's share of equity earnings
(losses) from investments in affiliates, accounted for under the equity method,
totaled $10.8 million, $5.5 million and $(0.7) million, respectively, for 2001,
2000 and 1999. The Company's share of equity earnings (losses) is included in
other, net in the consolidated statements of operations. All significant
intercompany accounts and transactions are eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.
Reclassification
Certain prior year amounts have been reclassified to conform to the
December 31, 2001 presentation.
Revenue Recognition
The Company generally recognizes revenue for services rendered upon
completion of the testing process. Billings for services under third-party payer
programs, including Medicare and Medicaid, are recorded as revenues net of
allowances for differences between amounts billed and the estimated receipts
under such programs. Adjustments to the estimated receipts, based on final
settlement with the third-party payers, are recorded upon settlement. In 2001,
2000 and 1999, approximately 14%, 13% and 14%, respectively, of net revenues
were generated by Medicare and Medicaid programs. Under capitated agreements
with managed care customers, the Company recognizes revenue based on a
predetermined monthly contractual rate for each member of the managed care plan
regardless of the number or cost of services provided by the Company.
F-6
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Taxes on Income
The Company uses the asset and liability approach to account for income
taxes. Under this method, deferred tax assets and liabilities are recognized for
the expected future tax consequences of differences between the carrying amounts
of assets and liabilities and their respective tax bases using tax rates in
effect for the year in which the differences are expected to reverse. The effect
on deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period when the change is enacted.
Earnings Per Share
On May 8, 2001, the stockholders approved an amendment to the Company's
restated certificate of incorporation to increase the number of common shares
authorized from 100 million shares to 300 million shares. On May 31, 2001, the
Company effected a two-for-one stock split through the issuance of a stock
dividend of one new share of common stock for each share of common stock held by
stockholders of record on May 16, 2001. References to the number of common
shares and per common share amounts in the accompanying consolidated balance
sheets and consolidated statements of operations, including earnings per common
share calculations and related disclosures, have been restated to give
retroactive effect to the stock split for all periods presented.
Basic net income per common share is calculated by dividing net income,
less preferred stock dividends (approximately $30 thousand per quarter), by the
weighted average number of common shares outstanding. Diluted net income per
common share is calculated by dividing net income, less preferred stock
dividends, by the weighted average number of common shares outstanding after
giving effect to all potentially dilutive common shares outstanding during the
period. Potentially dilutive common shares include outstanding stock options and
restricted common shares granted under the Company's Employee Equity
Participation Program. 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 (see Note 12). During periods in which net income available
for common stockholders is a loss, diluted weighted average common shares
outstanding will equal basic weighted average common shares outstanding, since
under these circumstances, the incremental shares would have an anti-dilutive
effect.
The computation of basic and diluted net income (loss) before
extraordinary loss per common share was as follows (in thousands except per
share data):
2001 2000 1999
---- ---- ----
Income (loss) before extraordinary loss.............................. $183,912 $ 104,948 $(1,274)
Less: Preferred stock dividends...................................... 118 118 118
-------- --------- -------
Income (loss) before extraordinary loss available to common
stockholders - basic and diluted.................................. $183,794 $ 104,830 $(1,392)
======== ========= =======
Weighted average number of common shares outstanding - basic......... 93,053 89,525 70,028
Effect of dilutive securities:
Stock options........................................................ 3,854 4,191 -
Restricted common stock.............................................. 703 584 -
-------- --------- -------
Weighted average number of common shares outstanding - diluted....... 97,610 94,300 70,028
======== ========= =======
Basic net income (loss) per common share:
Income (loss) before extraordinary loss.............................. $ 1.98 $ 1.17 $ (0.02)
======== ========= =======
Diluted net income (loss) per common share:
Income (loss) before extraordinary loss.............................. $ 1.88 $ 1.11 $ (0.02)
======== ========= =======
F-7
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
The following securities were not included in the diluted net income
(loss) per share calculation due to their antidilutive effect (in thousands):
2001 2000 1999
---- ---- ----
Stock options................................................. 1,820 126 11,482
Restricted common stock....................................... 20 22 1,136
Stock-Based Compensation
Statement of Financial Accounting Standards No. 123, "Accounting for
Stock-Based Compensation" ("SFAS 123"), encourages, but does not require,
companies to record compensation cost for stock-based compensation plans at fair
value. The Company has chosen to continue to account for stock-based
compensation using the intrinsic value method prescribed in Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees"
("APB 25"), and related interpretations.
Foreign Currency
Assets and liabilities of foreign subsidiaries are translated into U.S.
dollars at year-end exchange rates. Income and expense items are translated at
average exchange rates prevailing during the year. The translation adjustments
are recorded as a component of accumulated other comprehensive income (loss)
within stockholders' equity. Gains and losses from foreign currency transactions
are included in consolidated income. Transaction gains and losses have not been
material.
Cash and Cash Equivalents
Cash and cash equivalents include all highly-liquid investments with
maturities, at the time acquired by the Company, of three months or less.
Concentration of Credit Risk
Financial instruments that potentially subject the Company to
concentrations of credit risk are principally cash, cash equivalents, short-term
investments and accounts receivable. The Company's policy is to place its cash,
cash equivalents and short-term investments in highly rated financial
instruments and institutions. Concentration of credit risk with respect to
accounts receivable is mitigated by the diversity of the Company's clients and
their dispersion across many different geographic regions, and is limited to
certain customers who are large buyers of the Company's services. To reduce
risk, the Company routinely assesses the financial strength of these customers
and, consequently, believes that its accounts receivable credit risk exposure,
with respect to these customers, is limited. While the Company has receivables
due from federal and state governmental agencies, the Company does not believe
that such receivables represent a credit risk since the related healthcare
programs are funded by federal and state governments, and payment is primarily
dependent on submitting appropriate documentation.
Inventories
Inventories, which consist principally of supplies, are valued at the
lower of cost (first in, first out method) or market.
Property, Plant and Equipment
Property, plant and equipment are recorded at cost. Major renewals and
improvements are capitalized, while maintenance and repairs are expensed as
incurred. Costs incurred for computer software developed or obtained for
internal use are capitalized for application development activities and expensed
as incurred for preliminary project activities and post-implementation
activities. Capitalized costs include external direct costs of materials and
services consumed in developing or obtaining internal-use software, payroll and
payroll related costs for employees who are directly associated with and who
devote time to the internal-use software project and interest costs incurred,
when material, while developing internal-use software. Capitalization of such
costs ceases when the project is substantially complete and ready for its
intended purpose. Certain costs, such as maintenance and training, are expensed
as incurred. The Company capitalizes interest on borrowings during the active
construction period of major capital projects. Capitalized interest is added to
the cost of the underlying assets and is amortized over the useful lives of the
assets. Depreciation and amortization are provided on the straight-line method
over expected useful asset lives as follows: buildings and improvements, ranging
from ten to thirty
F-8
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
years; laboratory equipment and furniture and fixtures, ranging from three to
seven years; leasehold improvements, the lesser of the useful life of the
improvement or the remaining life of the building or lease, as applicable; and
computer software developed or obtained for internal use, ranging from three to
five years.
Intangible Assets
Prior to July 1, 2001, the cost of acquired businesses in excess of the
fair value of net assets acquired was recorded as goodwill and amortized on the
straight-line method over periods not exceeding forty years. Pursuant to the new
accounting standards issued in July 2001 (see New Accounting Standards below),
effective July 1, 2001, goodwill recorded in connection with acquisitions
consummated prior to that date continued to be amortized through December 31,
2001 and will not be amortized thereafter. Goodwill recognized in connection
with acquisitions consummated after June 30, 2001 has not been amortized. Other
intangible assets are recorded at cost and amortized on the straight-line method
over periods not exceeding fifteen years.
Impairment of Long-Lived Assets
The Company reviews the recoverability of its long-lived assets,
including goodwill and other intangible assets, when events or changes in
circumstances occur that indicate that the carrying value of the asset may not
be recoverable. Evaluation of possible impairment is based on the Company's
ability to recover the asset from the expected future pretax cash flows
(undiscounted and without interest charges) of the related operations. If the
expected undiscounted pretax cash flows are less than the carrying amount of
such asset, including any goodwill associated with the asset, an impairment loss
is recognized for the difference between the estimated fair value and carrying
amount of the asset.
The Company also evaluates the recoverability and measures the possible
impairment of goodwill under Accounting Principles Board Opinion No. 17,
"Intangible Assets" based on a fair value methodology. Management believes that
a valuation of goodwill based on the amount for which each regional laboratory
could be sold in an arm's-length transaction is preferable to using projected
undiscounted pretax cash flows. The Company believes fair value is a better
indicator of the extent to which goodwill may be recoverable and, therefore, may
be impaired.
The fair value method is applied to each of the regional laboratories.
Management's estimate of fair value is primarily based on multiples of
forecasted revenue or multiples of forecasted earnings before interest, taxes,
depreciation and amortization ("EBITDA"). The multiples are primarily determined
based upon publicly available information regarding comparable publicly-traded
companies in the industry, but also consider (i) the financial projections of
each regional laboratory, (ii) the future prospects of each regional laboratory,
including its growth opportunities, managed care concentration and likely
operational improvements, and (iii) comparable sales prices, if available.
Multiples of revenues are used to estimate fair value in cases where the Company
believes that the likely acquirer of a regional laboratory would be a strategic
buyer within the industry that would realize synergies from such an acquisition.
In regions where management does not believe there is a potential strategic
buyer within the industry, and, accordingly, believes the likely buyer would not
have synergy opportunities, multiples of EBITDA are used for estimating fair
value. Regional laboratories with lower levels of profitability valued using
revenue multiples would generally be ascribed a higher value than if multiples
of EBITDA were used, due to assumed synergy opportunities. Management's estimate
of fair value is currently based on multiples of revenue primarily ranging from
0.8 to 1.1 times revenue and on multiples of EBITDA primarily ranging from 7 to
9 times EBITDA. While management believes the estimation methods are reasonable
and reflective of common valuation practices, there can be no assurance that a
regional laboratory could actually be sold for the estimated value ascribed to
the regional laboratory. Changes to the method of valuing regional laboratories
will be made only when there is a significant and fundamental change in facts
and circumstances, such as significant changes in market position or the
entrance or exit of a significant competitor from a regional market. No changes
were made to the method of valuing regional laboratories in 2001 or 2000.
On a quarterly basis, management performs a review of each regional
laboratory to determine if events or changes in circumstances have occurred
which could have a material adverse effect on the fair value of the business and
its intangible assets. If such events or changes in circumstances were deemed to
have occurred, management would consult with one or more of its advisors in
estimating the impact on fair value of the regional laboratory. Should the
estimated fair value of a regional laboratory be less than the net book value
for such laboratory at the end of a quarter, the Company will record a charge to
operations to recognize an impairment of its intangible assets for such
difference. See "New Accounting Standards" below regarding two recently issued
accounting standards on business combinations and goodwill and other
intangibles.
F-9
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Investments
The Company accounts for investments in equity securities, which are
included in other assets, in conformity with Statement of Financial Accounting
Standards No. 115, "Accounting for Certain Investments in Debt and Equity
Securities" ("SFAS 115"), which requires the use of fair value accounting for
trading or available-for-sale securities. Unrealized gains and losses for
available-for-sale securities are recorded as a component of accumulated other
comprehensive income (loss) within stockholders' equity. Gains and losses on
securities sold are based on the average cost method. Other, net for the years
ended December 31, 2001 and 1999 included gains of $6.3 million and $3.0
million, respectively, associated with the sale of certain investments.
Investments in equity securities have not been material to the Company.
Financial Instruments
The Company's policy is to use financial instruments only to manage
exposure to market risks. The Company has established a control environment that
includes policies and procedures for risk assessment and the approval, reporting
and monitoring of derivative financial instrument activities. These policies
prohibit holding or issuing derivative financial instruments for trading
purposes.
Statement of Financial Accounting Standards No. 133, "Accounting for
Derivative Instruments and Hedging Activities" ("SFAS 133"), as amended,
requires that all derivative instruments be recorded on the balance sheet at
their fair value. Changes in the fair value of derivatives are recorded each
period in current earnings or other comprehensive income, depending on whether a
derivative is designated as part of a hedge transaction and, if it is, the type
of hedge transaction. Effective January 1, 2001, the Company adopted SFAS 133,
as amended. The cumulative effect of the change in accounting for derivative
financial instruments upon adoption on January 1, 2001 of SFAS 133, as amended,
reduced comprehensive income by approximately $1 million.
Fair Value of Financial Instruments
The carrying amounts of cash and cash equivalents, accounts receivable
and accounts payable and accrued expenses approximate fair value based on the
short maturity of these instruments. At December 31, 2001 and 2000, the fair
value of the Company's debt was estimated at $857 million and $1.0 billion,
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 December 31, 2001, the estimated fair value exceeded the
carrying value of the debt by approximately $35 million. At December 31, 2000,
the estimated fair value exceeded the carrying value of the debt by
approximately $5 million. At December 31, 2000, the estimated fair value of the
Company's interest rate swap agreements approximated a liability of $2 million.
In conjunction with the Company's refinancing during the second quarter of 2001
(see Note 12), the interest rate swap agreements were terminated (see Note 7).
The Company's 1 3/4% contingent convertible notes due 2021 have a
contingent interest component that will require the Company 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, is
considered to be a derivative instrument subject to SFAS 133, as amended. As
such, the derivative is recorded at its fair value in the consolidated balance
sheet with changes in its fair value being recorded each period in current
earnings. The fair value of the derivative at the date of issuance and at
December 31, 2001 was not material.
Comprehensive Income
Comprehensive income encompasses all changes in stockholders' equity
(except those arising from transactions with stockholders) and includes net
income (loss), net unrealized capital gains or losses on available-for-sale
securities and foreign currency translation adjustments.
Segment Reporting
The Company currently operates in one reportable business segment.
Substantially all of the Company's services are provided within the United
States, and substantially all of the Company's assets are located within the
United States. No one customer accounted for ten percent or more of net sales in
2001, 2000 or 1999.
F-10
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
New Accounting Standards
In July 2001, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 141, "Business Combinations" ("SFAS 141"), which requires
business combinations initiated after June 30, 2001 to be accounted for using
the purchase method of accounting, and SFAS No. 142, "Goodwill and Other
Intangible Assets" ("SFAS 142"), which broadens the criteria for recording
intangible assets separate from goodwill. SFAS 142 requires the use of a
nonamortization approach to account for purchased goodwill and certain
intangibles. Under a nonamortization approach, goodwill and certain intangibles
will not be amortized into results of operations, but instead will be reviewed
for impairment and an impairment charge will be recorded in the periods in which
the recorded carrying value of goodwill and certain intangibles is more than its
estimated fair value. As described above under Impairment of Long-Lived Assets,
the Company has historically reviewed the recoverability of goodwill based on a
fair value methodology similar to that prescribed under SFAS 142. The provisions
of SFAS 141 have been adopted for any business combination consummated after
June 30, 2001. Goodwill acquired in a business combination for which the
acquisition date is after June 30, 2001 will not be amortized. The Company will
adopt the provisions of SFAS 142, related to goodwill acquired prior to June 30,
2001 and intangible assets, on January 1, 2002. The adoption of these accounting
standards is expected to reduce the amount of amortization of goodwill recorded
in the Company's consolidated financial statements by approximately $35 million
annually, commencing January 1, 2002. Management does not expect that the new
criteria for recording intangible assets separate from goodwill will require the
Company to reclassify any of its intangible assets. Also management does not
expect that the adoption of the nonamortization approach under SFAS 142 will
result in an impairment of the Company's recorded goodwill.
In August 2001, the FASB issued SFAS No. 144 "Accounting for Impairment
or Disposal of Long-Lived Assets" ("SFAS 144"), which supercedes SFAS No. 121.
SFAS 144 further refines SFAS 121's requirement that companies recognize an
impairment loss if the carrying amount of a long-lived asset is not recoverable
based on its undiscounted future cash flows and measure an impairment loss as
the difference between the carrying amount and fair value of the asset. In
addition, SFAS 144 provides guidance on accounting and disclosure issues
surrounding long-lived assets to be disposed of by sale. SFAS 144 also extends
the presentation of discontinued operations to include more disposal
transactions. SFAS 144 is effective for all fiscal quarters of all fiscal years
beginning after December 15, 2001 (2002 for the Company). Management believes
that the adoption of SFAS 144 will not have a material effect on the Company's
consolidated results of operations or financial position.
3. BUSINESS ACQUISITIONS
2001 Acquisitions
During 2001, the Company acquired the assets of Clinical Laboratories
of Colorado, LLC ("CLC") and the assets of Las Marias Reference Lab Corp. and
Laboratorio Clinico Las Marias, Inc., a clinical laboratory based in San Juan,
Puerto Rico ("Las Marias"). During 2001, the Company also acquired the
outstanding voting shares that it did not already own of MedPlus, Inc.
("MedPlus"), a leading developer and integrator of clinical connectivity and
data management solutions for healthcare organizations and clinicians, and all
of the voting stock of Clinical Diagnostic Services, Inc. ("CDS"), which
operates a diagnostic testing laboratory and more than 50 patient service
centers in New York and New Jersey. Additionally, during 2001, the Company
acquired the minority ownership interest of a consolidated joint venture from
its joint venture partner. The combined cost of these acquisitions was $153
million, which was paid primarily in cash.
The Company accounted for the above acquisitions under the purchase
method of accounting. In connection with the above transactions, the Company
recorded approximately $153 million of goodwill, representing acquisition
costs in excess of the fair value of net assets acquired, and approximately $7.5
million associated with non-compete agreements. The amounts paid under the
non-compete agreements are being amortized on the straight-line basis over their
five-year terms.
The historical financial statements of Quest Diagnostics include the
results of operations of each acquired company subsequent to the closing of the
respective acquisition.
Acquisition of SmithKline Beecham Clinical Laboratory Testing Business
On August 16, 1999, the Company completed the acquisition of SmithKline
Beecham Clinical Laboratories, Inc. ("SBCL") which operated the clinical
laboratory business of SmithKline Beecham plc ("SmithKline Beecham"). The
original purchase price of approximately $1.3 billion was paid through the
issuance of 25,128,672 shares of common stock of the Company (valued at
approximately $261 million), representing approximately 29% of the Company's
then outstanding common stock, and the payment of $1 billion in cash,
including $20 million under a non-compete agreement between the Company and
SmithKline Beecham. At
F-11
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
the closing of the acquisition, the Company used existing cash and borrowings
under a senior secured credit facility to fund the cash purchase price and
related transaction costs of the acquisition, and to repay the entire amount
outstanding under its then existing credit agreement. The acquisition of SBCL
was accounted for under the purchase method of accounting. The historical
financial statements of Quest Diagnostics include the results of operations of
SBCL subsequent to the closing of the acquisition.
Under the terms of the acquisition agreements, Quest Diagnostics
acquired SmithKline Beecham's clinical laboratory testing business including its
domestic and foreign clinical testing operations, clinical trials testing,
corporate health services, and laboratory information products businesses.
SmithKline Beecham's national testing and service network consisted of regional
laboratories, specialty testing operations and its National Esoteric Testing
Center, as well as a number of rapid-turnaround or "stat" laboratories, and
patient service centers. In addition, SmithKline Beecham and Quest Diagnostics
entered into a long-term contract under which Quest Diagnostics is the primary
provider of testing to support SmithKline Beecham's clinical trials testing
requirements worldwide. As part of the acquisition agreements, Quest Diagnostics
granted SmithKline Beecham certain non-exclusive rights and access to use Quest
Diagnostics' proprietary clinical laboratory information database (the "Data
Access Agreements"). The Data Access Agreements were terminated as of January 1,
2001. Under the acquisition agreements, SmithKline Beecham has agreed to
indemnify Quest Diagnostics, on an after tax basis, against certain matters
primarily related to taxes and billing and professional liability claims.
Under the terms of a stockholder agreement, SmithKline Beecham has the
right to designate two nominees to Quest Diagnostics' Board of Directors as long
as SmithKline Beecham owns at least 20% of the outstanding common stock. As long
as SmithKline Beecham owns at least 10% but less than 20% of the outstanding
common stock, it will have the right to designate one nominee. Quest
Diagnostics' Board of Directors was expanded to nine directors following the
closing of the acquisition. The stockholder agreement also imposes limitations
on the right of SmithKline Beecham to sell or vote its shares and prohibits
SmithKline Beecham from purchasing in excess of 29.5% of the outstanding common
stock of Quest Diagnostics.
The SBCL acquisition agreements included a provision for a reduction in
the purchase price paid by Quest Diagnostics in the event that the combined
balance sheet of SBCL indicated that the net assets acquired, as of the
acquisition date, were below a prescribed level. On October 11, 2000, the
purchase price adjustment was finalized with the result that SmithKline Beecham
owed Quest Diagnostics $99 million. This amount was offset by $3.6 million
separately owed by Quest Diagnostics to SmithKline Beecham, resulting in a net
payment by SmithKline Beecham of $95 million. The purchase price adjustment was
recorded in the Company's financial statements in the fourth quarter of 2000 as
a reduction in the amount of goodwill recorded in conjunction with the SBCL
acquisition.
The remaining components of the purchase price allocation relating to
the SBCL acquisition were finalized during the third quarter of 2000. The
resulting adjustments to the SBCL purchase price allocation primarily related to
an increase in deferred tax assets acquired, the sale of certain assets of SBCL
at fair value to unconsolidated joint ventures of Quest Diagnostics and an
increase in accrued liabilities for costs related to pre-acquisition periods. As
a result of these adjustments, the Company reduced the amount of goodwill
recorded in conjunction with the SBCL acquisition by approximately $35 million
during the third quarter of 2000.
In conjunction with the SBCL acquisition, the Company recorded
approximately $820 million of goodwill representing acquisition cost in excess
of the fair value of net assets acquired, which is amortized on the
straight-line basis over forty years. The amount paid under the non-compete
agreement is amortized on the straight-line basis over five years. See Note 2 -
New Accounting Standards.
Pro Forma Combined Financial Information (Unaudited)
The following pro forma combined financial information for the year
ended December 31, 1999 assumes that the SBCL acquisition and borrowings under
the senior secured credit facility were effected on January 1, 1999.
The unaudited pro forma combined financial information is presented for
illustrative purposes only to assist in analyzing the financial implications of
the SBCL acquisition and borrowings under the senior secured credit facility.
The unaudited pro forma combined financial information may not be indicative of
the combined financial results of operations that would have been realized had
Quest Diagnostics and SBCL been a single entity during the period presented. In
addition, the unaudited pro forma combined financial information is not
necessarily indicative of the future results that the combined company will
experience.
Significant pro forma adjustments reflected in the unaudited pro forma
combined financial information include reductions in employee benefit costs and
general corporate overhead allocated to the historical results of SBCL by
SmithKline Beecham, offset by an
F-12
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
increase in net interest expense to reflect the Company's senior secured credit
facility which was used to finance the SBCL acquisition. Amortization of the
goodwill, which accounts for a majority of the acquired intangible assets, is
calculated on the straight-line basis over forty years. Income taxes have been
adjusted for the estimated income tax impact of the pro forma adjustments at the
incremental tax rate of 40%. A significant portion of the intangible assets
acquired in the SBCL acquisition is not deductible for tax purposes, which has
the overall impact of increasing the effective tax rate.
Both basic and diluted weighted average common shares outstanding have
been presented on a pro forma basis giving effect to the shares issued to
SmithKline Beecham and the shares granted at closing to employees. Potentially
dilutive common shares primarily represent stock options. During periods in
which net income available for common stockholders is a loss, diluted weighted
average common shares outstanding will equal basic weighted average common
shares outstanding, since under these circumstances, the incremental shares
would have an anti-dilutive effect.
Unaudited pro forma combined financial information for the year ended
December 31, 1999 was as follows (in thousands, except per share data):
1999
----
Net revenues.................................................. $3,294,810
Loss before extraordinary loss................................ (33,539)
Net loss...................................................... (35,678)
-------------------------------------------------------------------------------------
Basic and diluted loss per common share:
Loss before extraordinary loss................................ $ (0.39)
Net loss...................................................... $ (0.41)
Weighted average common shares outstanding.................... 86,690
--------------------------------------------------------------------------------------
4. INTEGRATION OF SBCL AND QUEST DIAGNOSTICS BUSINESSES
During the fourth quarter of 1999, Quest Diagnostics finalized its plan
to integrate SBCL into Quest Diagnostics' laboratory network. The plan focused
principally on laboratory consolidations in geographic markets served by more
than one of the Company's laboratories, and the redirection of testing volume
within the Company's national network to provide more local testing and improve
customer service. While the Company did not exit any geographic markets as a
result of the plan, laboratories that were closed or reduced in size were
located in the following metropolitan areas: Boston, Baltimore, Cleveland,
Dallas, Detroit, Miami, New York and Philadelphia. The Company also transferred
esoteric testing performed at SBCL's National Esoteric Testing Center in Van
Nuys, California to Nichols Institute. Employee groups impacted as a result of
these actions included those involved in the collection and testing of
specimens, as well as administrative and other support functions. During the
fourth quarter of 1999, the Company recorded the estimated costs associated with
executing the integration plan. The majority of these integration costs related
to employee severance, contractual obligations associated with leased facilities
and equipment, and the write-off of fixed assets which management believed would
have no future economic benefit upon combining the operations. Integration costs
related to planned activities affecting SBCL's operations and employees were
recorded as a cost of the acquisition. Integration costs associated with the
planned integration of SBCL affecting Quest Diagnostics' operations and
employees were recorded as a charge to earnings in the fourth quarter of 1999.
Integration costs, including write-offs of fixed assets, totaling $56
million which related to planned activities affecting SBCL assets, liabilities
and employees, were recorded in the fourth quarter of 1999 as a cost of the SBCL
acquisition. Of these costs, $34 million related to employee severance costs for
approximately 1,250 employees, and $13.4 million related to contractual
obligations including those related to facilities and equipment leases. The
remaining portion of the costs were associated with the write-off of assets that
management plans to dispose of in conjunction with the integration of SBCL.
During the fourth quarter of 1999, the Company recorded a $36 million
net charge to earnings that represented the costs related to planned integration
activities affecting Quest Diagnostics' operations and employees. Of these
costs, $23 million related to employee severance costs for approximately 1,050
employees, $9.7 million related primarily to lease obligations for facilities
and equipment and
F-13
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
$6.7 million was associated with the write-off of assets that management plans
to dispose of in conjunction with the integration of SBCL. Offsetting these
charges was the reversal of $3.4 million of reserves associated with the
Company's consolidation plan announced in the fourth quarter of 1997. Upon
finalizing the initial integration plan for SBCL in the fourth quarter of 1999,
the Company determined that $3.4 million of the remaining reserves associated
with the 1997 consolidation plan were no longer necessary due to changes in the
plan as a result of the SBCL integration.
During the third quarter of 2000, the Company reviewed its remaining
reserves initially recorded in the fourth quarter of 1999 and revised certain
estimates relative to integration activities. As a result of this review, the
Company recorded a $2.1 million increase to goodwill to reflect an increase in
the estimated costs associated with planned integration activities affecting
SBCL's operations and employees. This $2.1 million adjustment which was recorded
in conjunction with finalizing the SBCL purchase price allocation during the
third quarter of 2000, included a $3.9 million increase in accruals for employee
severance benefits, partially offset by a reduction in accruals primarily
related to facility lease obligations.
In addition, during the third quarter of 2000, the Company recorded a
$2.1 million reduction in accruals associated with planned integration
activities affecting Quest Diagnostics' operations and employees. The adjustment
was principally comprised of reductions in accruals for employee severance
benefits and costs to exit leased facilities. This reduction in accruals was
offset by a charge to write-off fixed assets used in the operations of Quest
Diagnostics.
During 2000, the Company determined that the total number of employees
expected to be severed during the initial phase of the SBCL integration was
lower than originally estimated in the fourth quarter of 1999. The total number
of SBCL employees expected to be severed was reduced to approximately 1,000
employees. The total number of Quest Diagnostics employees expected to be
severed was reduced to approximately 500 employees. While the number of
employees expected to be severed during the SBCL integration decreased, the
average cost of severance benefits per employee increased primarily due to the
elimination of certain senior management positions.
The following table summarizes the Company's accruals for integration
costs affecting the acquired operations and employees of SBCL (in millions):
Costs of
Employee Exiting
Severance Leased
Costs Facilities Other Total
----- ---------- ----- -----
Amounts recognized as a cost of the SBCL
acquisition....................................... $ 33.8 $ 5.6 $ 7.8 $ 47.2
Amounts utilized in 1999............................. (1.4) (0.1) - (1.5)
------ ----- ----- ------
Balance, December 31, 1999........................ 32.4 5.5 7.8 45.7
Amounts utilized in 2000............................. (16.4) (2.0) (5.8) (24.2)
Adjustment to accruals............................... 3.9 (1.6) (0.2) 2.1
------ ----- ------ ------
Balance, December 31, 2000......................... 19.9 1.9 1.8 23.6
Amounts utilized in 2001............................. (14.7) (1.4) (1.2) (17.3)
------ ----- ------ ------
Balance, December 31, 2001......................... $ 5.2 $ 0.5 $ 0.6 $ 6.3
====== ===== ====== ======
F-14
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
The following table summarizes the Company's accruals for restructuring
costs associated with the integration of SBCL affecting Quest Diagnostics'
operations and employees (in millions):
Costs of
Employee Exiting
Severance Leased
Costs Facilities Other Total
----- ---------- ----- -----
1999 Provision....................................... $ 23.4 $ 8.9 $ 0.8 $ 33.1
Amounts utilized in 1999............................. (2.5) - - (2.5)
------ ----- ----- ------
Balance, December 31, 1999........................ 20.9 8.9 0.8 30.6
Amounts utilized in 2000............................. (10.5) (1.5) (0.4) (12.4)
Adjustment to accruals............................... (1.6) (0.8) 0.3 (2.1)
------ ----- ----- ------
Balance, December 31, 2000......................... 8.8 6.6 0.7 16.1
Amounts utilized in 2001............................. (7.1) (2.5) (0.5) (10.1)
------ ----- ----- ------
Balance, December 31, 2001......................... $ 1.7 $ 4.1 $ 0.2 $ 6.0
====== ===== ===== ======
The actions associated with the SBCL integration plan, provided for in
accruals for integration costs as of December 31, 2000, including those related
to severed employees, were completed as of June 30, 2001. The remaining accruals
associated with the SBCL integration plan mainly represent certain severance and
facility related exit costs, principally lease obligations, that have payment
terms extending beyond 2001.
5. TAXES ON INCOME
In conjunction with the Spin-Off Distribution, the Company entered into
a tax sharing agreement with its former parent and a former subsidiary, which
allocates among them responsibility for federal, state and local taxes relating
to taxable periods before and after the Spin-Off Distribution and provides for
computing and apportioning tax liabilities and tax benefits for such periods
among the parties. The Company also entered into tax indemnification agreements
with the same entities that provide the parties with certain rights of
indemnification against each other.
The Company's pretax income (loss) consisted of approximately $332
million, $203 million and $17.7 million from U.S. operations and approximately
$0.2 million, $(1.6) million and $(3.3) million from foreign operations for the
years ended December 31, 2001, 2000 and 1999, respectively.
The components of income tax expense for 2001, 2000 and 1999 were as
follows:
2001 2000 1999
---- ---- ----
Current:
Federal.................................................... $119,265 $52,852 $ 34,314
State and local............................................ 28,497 8,506 10,073
Foreign.................................................... 1,490 838 785
Deferred:
Federal.................................................... (452) 21,776 (22,336)
State and local............................................ (108) 12,061 (7,178)
-------- ------- --------
Total.................................................... $148,692 $96,033 $ 15,658
======== ======= ========
F-15
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
A reconciliation of the federal statutory rate to the Company's
effective tax rate for 2001, 2000 and 1999 was as follows:
2001 2000 1999
---- ---- ----
Tax provision at statutory rate............................... 35.0% 35.0% 35.0%
State and local income taxes, net of federal benefit.......... 5.0 5.6 4.3
Non-deductible goodwill amortization.......................... 3.9 6.7 55.7
Impact of foreign operations.................................. 0.4 0.4 11.6
Non-deductible meals and entertainment expense................ 0.4 0.7 5.1
Other, net.................................................... - (0.6) (2.8)
---- ---- -----
Effective tax rate......................................... 44.7% 47.8% 108.9%
==== ==== =====
The tax effects of temporary differences that give rise to significant portions
of the deferred tax assets at December 31, 2001 and 2000 were as follows:
2001 2000
---- ----
Current deferred tax asset:
Accounts receivable reserve................................ $ 34,821 $ 46,266
Liabilities not currently deductible....................... 112,069 94,107
Accrued settlement reserves................................ 7,116 34,430
Accrued restructuring and integration costs................ 3,643 13,205
Other...................................................... - 475
-------- --------
Total.................................................... $157,649 $188,483
======== ========
Non-current deferred tax asset:
Liabilities not currently deductible....................... $ 41,887 $ 34,062
Accrued settlement reserves................................ - 600
Accrued restructuring and integration costs................ 945 2,763
Depreciation and amortization.............................. 6,138 1,062
Net operating losses....................................... 3,708 4,135
-------- --------
Total.................................................... $ 52,678 $ 42,622
======== ========
As of December 31, 2001, $3.7 million of deferred tax assets had been
recorded to reflect the benefit associated with approximately $97 million of net
operating losses for state income tax purposes with expiration dates through
2021.
Income taxes payable at December 31, 2001 and 2000 were $30 million and
$18.5 million, respectively, and consisted primarily of federal income taxes
payable of $36 million and $21 million, respectively.
6. SUPPLEMENTAL CASH FLOW AND OTHER DATA
2001 2000 1999
---- ---- ----
Depreciation expense.......................................... $101,620 $ 88,631 $61,051
Interest expense.............................................. 76,765 119,681 69,842
Interest income............................................... (6,242) (6,589) (8,392)
-------- -------- -------
Interest, net................................................. 70,523 113,092 61,450
Interest paid................................................. 58,537 110,227 62,662
Income taxes paid............................................. 26,384 21,821 24,545
F-16
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
During 2000, the Company terminated one of its laboratory network
management agreements with a customer which resulted in a reduction in accounts
receivable and a corresponding decrease in accrued expenses of approximately $69
million, neither reduction having a cash impact.
2001 2000 1999
---- ---- ----
Businesses acquired:
Fair value of assets acquired................................. $ 182,136 $ (66,013) $1,673,435
Fair value of liabilities assumed............................. 29,272 26,212 378,113
Common shares issued to acquire SBCL.......................... - - 260,710
7. PROVISIONS FOR RESTRUCTURING AND OTHER SPECIAL CHARGES
During the second quarter of 2001, the Company recorded a special
charge of $6.0 million in connection with the refinancing of its debt and
settlement of the Company's interest rate swap agreements. Prior to the
Company's debt refinancing in June 2001 (see Note 12), the Company's senior
secured credit agreement required the Company to maintain interest rate swap
agreements to mitigate the risk of changes in interest rates associated with a
portion of its variable interest rate indebtedness. These interest rate swap
agreements were considered a hedge against changes in the amount of future cash
flows associated with the interest payments of the Company's variable rate debt
obligations. Accordingly, the interest rate swap agreements were recorded at
their estimated fair value in the Company's consolidated balance sheet and the
related losses on these contracts were deferred in shareholders' equity as a
component of comprehensive income. In conjunction with the debt refinancing, the
interest rate swap agreements were terminated and the losses reflected in
shareholders' equity as a component of comprehensive income were reclassified to
earnings and reflected as a special charge in the consolidated statement of
operations for the year ended December 31, 2001.
During the second quarter of 2000, the Company recorded a net special
charge of $2.1 million. Of the special charge, $13.4 million represented the
costs to cancel certain contracts that management believed were not economically
viable as a result of the SBCL acquisition. These costs were principally
associated with the cancellation of a co-marketing agreement for clinical trials
testing services. These charges were in large part offset by a reduction in
reserves attributable to a favorable resolution of outstanding claims for
reimbursements associated with billings of certain tests (see Note 17).
During the third and fourth quarters of 1999, the Company recorded
provisions for restructuring and other special charges totaling $30 million and
$43 million, respectively, principally incurred in connection with the
acquisition and planned integration of SBCL.
Of the $30 million special charge recorded in the third quarter of
1999, $19.8 million represented stock-based employee compensation of which $17.8
million related to special one-time grants of the Company's common stock to
certain individuals of the combined company, and $2.0 million related to the
accelerated vesting, due to the completion of the SBCL acquisition, of
restricted stock grants made in previous years. In addition, during the third
quarter of 1999, the Company incurred $9.2 million of professional and
consulting fees related to integration planning activities. The remainder of the
third quarter charge related to costs incurred by the Company in conjunction
with its planned offering of new senior subordinated notes, the proceeds of
which were expected to be used to repay the Company's existing 10 3/4% senior
subordinated notes. During the third quarter of 1999, the Company decided not to
proceed with the offering due to unsatisfactory conditions in the high yield
market.
Of the $43 million charge recorded in the fourth quarter of 1999, $36
million represented costs related to planned integration activities affecting
Quest Diagnostics' operations and employees (see Note 4 for details). In
addition to the net charge of $36 million, the Company recorded $3.5 million of
special recognition awards granted in the fourth quarter of 1999 to certain
employees involved in the transaction and integration planning processes of the
SBCL acquisition. The remainder of the fourth quarter special charge was
primarily attributable to professional and consulting fees incurred in
connection with integration related planning activities.
F-17
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
8. EXTRAORDINARY LOSS
In conjunction with the Company's debt refinancing in the second
quarter of 2001, the Company recorded an extraordinary loss of $36 million ($22
million, net of taxes). The loss represented the write-off of deferred financing
costs of $23 million, associated with the Company's debt which was refinanced,
and $12.8 million of payments related primarily to the tender premium incurred
in connection with the Company's cash tender offer of its 10 3/4% senior
subordinated notes due 2006 (the "Subordinated Notes") (see Note 12).
Extraordinary losses were recorded in 2000 and 1999 representing the
write-off of deferred financing costs associated with debt which was prepaid
during the periods. During the fourth quarter of 2000, the Company prepaid $155
million of term loans under its senior secured credit facility. The
extraordinary loss recorded in the fourth quarter of 2000 in connection with
this prepayment was $4.8 million ($2.9 million, net of taxes).
In conjunction with the acquisition of SBCL, the Company repaid the
entire amount outstanding under its then existing credit agreement. The
extraordinary loss recorded in the third quarter of 1999 in connection with this
prepayment was $3.6 million ($2.1 million, net of taxes).
9. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment at December 31, 2001 and 2000 consisted
of the following:
2001 2000
---- ----
Land.......................................................... $ 35,331 $ 35,084
Buildings and improvements.................................... 264,639 258,433
Laboratory equipment, furniture and fixtures.................. 461,786 386,204
Leasehold improvements........................................ 98,416 60,187
Computer software developed or obtained for internal use...... 69,278 38,567
Construction-in-progress...................................... 42,577 55,078
---------- ----------
972,027 833,553
Less: accumulated depreciation and amortization............... (463,408) (383,697)
---------- ----------
Total...................................................... $ 508,619 $ 449,856
========== ==========
10. GOODWILL AND INTANGIBLE ASSETS
Goodwill and intangible assets at December 31, 2001 and 2000 consisted
of the following:
2001 2000
---- ----
Goodwill...................................................... $ 1,539,176 $ 1,387,242
Less: accumulated amortization................................ (188,053) (151,309)
------------- -------------
Goodwill, net $ 1,351,123 $ 1,235,933
============= =============
Non-compete agreements........................................ $ 43,943 $ 36,393
Customer lists................................................ 41,331 39,480
Other......................................................... 3,067 2,954
------------- -------------
88,341 78,827
Less: accumulated amortization................................ (60,321) (53,157)
------------- -------------
Intangible assets, net..................................... $ 28,020 $ 25,670
============= =============
F-18
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
11. ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses at December 31, 2001 and 2000
consisted of the following:
2001 2000
---- ----
Accrued expenses.............................................. $ 247,161 $ 199,528
Accrued wages and benefits.................................... 240,202 240,275
Trade accounts payable........................................ 112,962 112,241
Income taxes payable.......................................... 29,997 18,450
Accrued settlement reserves................................... 17,790 86,076
Accrued restructuring and integration costs................... 9,107 33,012
------------- -------------
Total...................................................... $ 657,219 $ 689,582
============= =============
12. DEBT
Short-term borrowings and current portion of long-term debt at December
31, 2001 and 2000 consisted of the following:
2001 2000
---- ----
Short-term borrowings under secured receivables credit facility $ - $ 256,000
Current portion of long-term debt............................. 1,404 9,408
------------- -------------
Total...................................................... $ 1,404 $ 265,408
============= =============
Long-term debt at December 31, 2001 and 2000 consisted of the
following:
2001 2000
---- ----
6 3/4% Senior Notes due July 2006.................................. $ 273,594 $ -
7 1/2% Senior Notes due July 2011.................................. 273,950 -
1 3/4% Contingent Convertible Debentures due November 2021......... 247,510 -
Senior secured variable rate bank term loans:
Term loan, payable through June 2006; 9.8% interest as of
December 31, 2000............................................. - 304,288
Term loan, payable through June 2006; 10.1% interest as of
December 31, 2000............................................. - 281,304
10 3/4% senior subordinated notes due 2006......................... - 150,000
Other.............................................................. 26,687 34,521
------------- -------------
Total........................................................... 821,741 770,113
Less current portion............................................... 1,404 9,408
------------- -------------
Total long-term debt............................................ $ 820,337 $ 760,705
============= =============
Debt Refinancings
On June 27, 2001, the Company refinanced a majority of its long-term
debt on a senior unsecured basis to reduce overall interest costs and obtain
less restrictive covenants. Specifically, the Company completed a $550 million
senior notes offering (the "Senior Notes") and entered into a new $500 million
senior unsecured credit facility (the "Credit Agreement") which included a five
year $325 million revolving credit agreement and a $175 million term loan. The
Company used the net proceeds from the senior notes offering and new term loan,
together with cash on hand, to repay all of the $584 million which was
outstanding under its senior secured credit agreement, including the costs to
settle existing interest rate swap agreements, and to consummate a cash tender
offer and consent solicitation for its Subordinated Notes. During the remainder
of 2001, the Company repaid the $175 million term loan.
In conjunction with the cash tender offer for the Company's
Subordinated Notes, approximately $147 million in aggregate principal amount, or
98% of the $150 million of outstanding Subordinated Notes was tendered. In
addition, the Company received the
F-19
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
requisite consents from the holders of Subordinated Notes to amend the indenture
governing the Subordinated Notes to eliminate substantially all of its
restrictive provisions. The Company made payments of approximately $160 million
to holders with respect to the cash tender offer and consent solicitation,
including tender premium and related solicitation and banking fees, and accrued
interest. On December 17, 2001, the Company redeemed the remaining Subordinated
Notes that were still outstanding as of that date.
The Senior Notes were issued in two tranches: (a) $275 million
aggregate principal amount of 6 3/4% senior notes due 2006 ("Senior Notes due
2006"), issued at a discount of approximately $1.6 million and (b) $275 million
aggregate principal amount of 7 1/2% senior notes due 2011 ("Senior Notes due
2011"), issued at a discount of approximately $1.1 million. After considering
the discounts, the effective interest rate on the Senior Notes due 2006 and
Senior Notes due 2011 is 6.9% and 7.6%, respectively. The Senior Notes require
semiannual interest payments which commenced January 12, 2002. The Senior Notes
are unsecured obligations of the Company and rank equally with the Company's
other unsecured senior obligations. The Senior Notes are guaranteed by each of
the Company's wholly owned subsidiaries that operate clinical laboratories in
the United States (the "Subsidiary Guarantors") and do not have a sinking fund
requirement.
Interest on the Credit Agreement is based on certain published rates
plus an applicable margin that will vary over an approximate range of 50 basis
points based on changes in the Company's credit ratings. 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 defined
in the Credit Agreement). Additionally, the Company has the ability to borrow up
to $200 million under the five year $325 million revolving credit facility at
rates determined by a competitive bidding process among the lenders. As of
December 31, 2001, the Company's borrowing rate for LIBOR-based loans was LIBOR
plus 1.3125%. As of December 31, 2001, there were no borrowings outstanding
under the Credit Agreement. Borrowings under the Credit Agreement are guaranteed
by our domestic wholly owned subsidiaries that operate clinical laboratories in
the United States. The Credit Agreement 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.
The Company incurred approximately $31 million of costs associated with
this debt refinancing. Of that amount, $12.4 million represented costs
associated with placing the new debt, which will be amortized over the term of
the related debt and $6.0 million represented the cost to terminate the interest
rate swap agreements on the debt which was refinanced. The remaining $12.8
million represented primarily the tender premium incurred in conjunction with
the Company's cash tender offer of the Subordinated Notes which was included in
the extraordinary loss recorded in the second quarter of 2001 (see Note 8).
On November 26, 2001, the Company completed its $250 million offering
of 1 3/4% contingent convertible debentures due 2021 (the "Debentures"). The net
proceeds of the offering, together with cash on hand, were used to repay all of
the $256 million principal that was outstanding under the Company's secured
receivables credit facility. The secured receivables credit facility remains
available for future general corporate purposes and acquisitions. The Debentures
are guaranteed by the Company's domestic wholly owned subsidiaries that operate
clinical laboratories in the United States and do not have a sinking fund
requirement. The Debentures, which pay a fixed rate of interest semi-annually
commencing on May 31, 2002, have a contingent interest component that will
require the Company to pay contingent interest based on certain thresholds, as
outlined in the Indenture. For income tax purposes, the Debentures are
considered to be a contingent payment security. As such, interest expense for
tax purposes is based on an assumed interest rate related to a debt security
issued by the Company without a conversion feature. The assumed rate was 7% at
December 31, 2001. The contingent interest component of the Debentures is
considered to be a derivative instrument subject to SFAS 133, as amended. As
such, the derivative is recorded at its fair value in the consolidated balance
sheet with changes in its fair value being recorded each period in current
earnings. The fair value of the derivative at the date of issuance and at
December 31, 2001 was not material.
Each one thousand dollar principal amount of Debentures is convertible
initially into 11.429 shares of the Company's common stock, which represents an
initial conversion price of $87.50 per share. Holders may surrender the
Debentures for conversion into shares of the Company's common stock under any of
the following circumstances: (1) if the sales price of the Company's common
stock is above 120% of the conversion price (or $105 per share) for specified
periods; (2) if the Company calls the Debentures or (3) if specified corporate
transactions have occurred.
The Company may call the Debentures at any time on or after November
30, 2004 for the principal amount of the Debentures plus any accrued and unpaid
interest. On November 30, 2004, 2005, 2008, 2012 and 2016 each holder of the
Debentures may require the Company to repurchase the holder's Debentures for the
principal amount of the Debentures plus any accrued and unpaid interest. The
Company may repurchase the Debentures for cash, common stock, or a combination
of both. The Company intends to settle any repurchases with a cash payment.
F-20
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
The Company incurred approximately $3.3 million of costs associated
with the issuance of the Debentures, which will be amortized through November
30, 2004, the initial date the holders of the Debentures may require the Company
to repurchase the Debentures.
On July 21, 2000, the Company completed a $256 million
receivables-backed financing transaction (the "secured receivables credit
facility"), the proceeds of which were used to pay down loans outstanding under
the Company's senior secured credit facility that was used to finance the
acquisition of SBCL. Approximately $48 million was used to completely repay
amounts outstanding under the capital markets loan portion of the senior secured
credit facility, with the remainder used to repay amounts outstanding under the
term loans portion of the senior secured credit facility. In addition, the
repayment of the capital markets loan reduced the borrowing spreads on all
remaining term loans under the senior secured credit facility. This secured
receivables credit facility is currently being provided by Blue Ridge Asset
Funding Corporation, a commercial paper funding vehicle administered by Wachovia
Bank, N.A., and Atlantic Asset Securitization Corporation, a commercial funding
vehicle administered by Credit Lyonnais. The secured receivables credit facility
has the benefit of one-year back-up facilities, provided on a committed basis.
The back-up facility that supports the funding from Blue Ridge is provided by
Wachovia Bank and Lloyds TSB Bank and expires on July 19, 2002, and the back-up
facility that supports the funding from Atlantic is provided by Credit Lyonnais
and expires on September 27, 2002 (see Note 18). The secured receivables credit
facility has an initial term of three years, unless extended. The secured
receivables credit facility may be terminated early under certain conditions,
including the termination of the back-up facilities to Blue Ridge and Atlantic.
The borrowings outstanding under the secured receivables credit facility are
classified as a current liability on our consolidated balance sheet since the
lenders fund the borrowings through the issuance of commercial paper which
matures at various dates up to ninety days from the date of issuance. Interest
is based on rates that are intended to approximate commercial paper rates for
highly rated issuers. There were no borrowings outstanding as of December 31,
2001. The weighted average interest rate on borrowings outstanding at December
31, 2000 was 7.2%. Long-term debt, including capital leases, maturing in each
of the years subsequent to December 31, 2002 is as follows:
Year ending December 31,
2003............................................ $ 25,283
2004............................................ -
2005............................................ -
2006............................................ 273,594
2007 and thereafter............................. 521,460
------------
Total long-term debt......................... $ 820,337
============
13. PREFERRED STOCK AND COMMON STOCKHOLDERS' EQUITY
Series Preferred Stock
Quest Diagnostics is authorized to issue up to 10 million shares of
Series Preferred Stock, par value $1.00 per share. The Company's Board of
Directors has the authority to issue such shares without stockholder approval
and to determine the designations, preferences, rights and restrictions of such
shares. Of the authorized shares, 1,300,000 shares have been designated Series A
Preferred Stock and 1,000 shares have been designated Voting Cumulative
Preferred Stock. No shares have been issued, other than the Voting Cumulative
Preferred Stock.
Voting Cumulative Preferred Stock
During the fourth quarter of 2001, the Company redeemed all of the then
issued and outstanding shares of preferred stock for $1 million plus accrued
dividends. At December 31, 2000, 1,000 shares of Voting Cumulative Preferred
Stock, which had a $1 million aggregate liquidation preference, were issued and
outstanding. Dividends were at an annual rate of 11.75% payable quarterly. The
Voting Cumulative Preferred Stock is generally entitled to one vote per share,
voting together as one class with the Company's common stock. Whenever dividends
on the Voting Cumulative Preferred Stock are in arrears, no dividends or
redemptions or purchases of shares may be made with respect to any stock ranking
junior as to dividends or liquidation to the Voting Cumulative Preferred Stock
until all such amounts have been paid. The Voting Cumulative Preferred Stock is
not convertible into shares of any other class or series of stock of the
Company. The Voting Cumulative Preferred Stock ranks senior to the Quest
Diagnostics common stock and the Series A Preferred Stock.
F-21
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Preferred Share Purchase Rights
Each share of Quest Diagnostics common stock trades with a preferred
share purchase right, which entitles stockholders to purchase one-hundredth of a
share of Series A Preferred Stock upon the occurrence of certain events. In
conjunction with the SBCL acquisition, the Board of Directors of the Company
approved an amendment to the preferred share purchase rights. The amended rights
entitle stockholders to purchase shares of Series A Preferred Stock at a
predefined price in the event a person or group (other than SmithKline Beecham)
acquires 20% or more of the Company's outstanding common stock. The preferred
share purchase rights expire December 31, 2006.
Common Stock Purchase Program
In 1998, the Board of Directors authorized a limited share purchase
program which permitted the Company to purchase up to $27 million of its
outstanding common stock through 1999. Cumulative purchases under the program
through December 31, 1999 totaled $14.1 million. Shares purchased under the
program were reissued in connection with certain employee benefit plans. The
Company suspended purchases of its shares when it reached a preliminary
understanding of the transaction with SmithKline Beecham on January 15, 1999.
Accumulated Other Comprehensive Income (Loss)
The components of accumulated other comprehensive income (loss) for
2001, 2000 and 1999 were as follows:
Foreign Accumulated Other
Currency Comprehensive
Translation Market Value Income
Adjustment Adjustment (Loss)
---------- ---------- ------
Balance, December 31, 1998................................. $ (2,094) $ (944) $ (3,038)
Translation adjustment..................................... (356) - (356)
Market value adjustment, net of tax expense of $616........ - 944 944
----------- ----------- -----------
Balance, December 31, 1999................................. (2,450) - (2,450)
Translation adjustment..................................... (758) - (758)
Market value adjustment, net of tax benefit of $1,469...... - (2,250) (2,250)
----------- ----------- -----------
Balance, December 31, 2000................................. (3,208) (2,250) (5,458)
Translation adjustment..................................... (1,178) - (1,178)
Market value adjustment, net of tax expense of $2,093...... - 3,166 3,166
----------- ----------- -----------
Balance, December 31, 2001................................. $ (4,386) $ 916 $ (3,470)
=========== =========== ===========
The market valuation adjustment for 1999 included holding gains, net of
taxes, of $2.8 million, offset by a reclassification adjustment, net of taxes,
of $1.8 million related to the gain recognized in net income associated with the
sale of an investment during the fourth quarter of 1999. The market value
adjustments for 2001 and 2000 represented unrealized holding gains (losses), net
of taxes, of $3.2 million and $(2.3) million, respectively.
For the year ended December 31, 2001, other comprehensive income
included the cumulative effect of the change in accounting for derivative
financial instruments upon adoption of SFAS 133, as amended, which reduced
comprehensive income by approximately $1 million. In addition, in conjunction
with the Company's debt refinancing, the interest rate swap agreements were
terminated and the losses reflected in shareholders' equity as a component of
comprehensive income were reclassified to earnings and reflected as a special
charge of $6.0 million in the consolidated statement of operations for the year
ended December 31, 2001 (see Note 7).
F-22
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
14. STOCK OWNERSHIP AND COMPENSATION PLANS
Employee and Non-employee Directors Stock Ownership Programs
In conjunction with the acquisition of SBCL, the Company established
the 1999 Employee Equity Participation Program (the "1999 EEPP") to replace the
Company's prior plan established in 1996 (the "1996 EEPP"). The 1999 EEPP
provides for three types of awards: (a) stock options, (b) stock appreciation
rights and (c) incentive stock awards. The 1999 EEPP provides for the grant to
eligible employees of either non-qualified or incentive stock options, or both,
to purchase shares of Quest Diagnostics' common stock at no less than the fair
market value on the date of grant. The stock options are subject to forfeiture
if employment terminates prior to the end of the prescribed vesting period, as
determined by the Board of Directors. The stock options expire on the date
designated by the Board of Directors but in no event more than eleven years from
date of grant. Grants of stock appreciation rights allow eligible employees to
receive a payment based on the appreciation of Quest Diagnostics' common stock
in cash, shares of Quest Diagnostics' common stock or a combination thereof. The
stock appreciation rights are granted at an exercise price at no less than the
fair market value of Quest Diagnostics' common stock on the date of grant. Stock
appreciation rights expire on the date designated by the Board of Directors but
in no event more than eleven years from date of grant. No stock appreciation
rights have been granted under the 1999 EEPP. Under the incentive stock
provisions of the plan, the 1999 EEPP allows eligible employees to receive
awards of shares, or the right to receive shares, of Quest Diagnostics' common
stock, the equivalent value in cash or a combination thereof. These shares are
earned on achievement of financial performance goals and are subject to
forfeiture if employment terminates prior to the end of the prescribed vesting
period, which ranges primarily from three to four years. The market value of the
shares awarded is recorded as unearned compensation. The amount of unearned
compensation is subject to adjustment based upon changes in earnings estimates
during the initial year of grant and is amortized to compensation expense over
the prescribed vesting period. Key executive, managerial and technical employees
are eligible to participate in the 1999 EEPP. The provisions of the 1996 EEPP
were similar to those outlined above for the 1999 EEPP.
The 1999 EEPP increased the maximum number of shares of Quest
Diagnostics' common stock that may be optioned or granted to 18 million shares.
In addition, any remaining shares under the 1996 EEPP are available for issuance
under the 1999 EEPP.
In 1998, the Company established the Quest Diagnostics Incorporated
Stock Option Plan for Non-employee Directors (the "Director Option Plan"). The
Director Option Plan provides for the grant to non-employee directors of
non-qualified stock options to purchase shares of Quest Diagnostics' common
stock at no less than fair market value on the date of grant. The maximum number
of shares that may be issued under the Director Option Plan is 1 million shares.
The stock options expire ten years from date of grant and generally vest over
three years. During 2001, 2000 and 1999, grants under the Director Option Plan
totaled 81, 149 and 138 thousand shares, respectively.
Transactions under the stock option plans were as follows (options in
thousands):
2001 2000 1999
---- ---- ----
Options outstanding, beginning of year................................... 9,246 11,482 5,900
Options granted.......................................................... 2,413 1,496 6,718
Options exercised........................................................ (2,576) (3,324) (588)
Options terminated....................................................... (388) (408) (548)
------ ------ -------
Options outstanding, end of year......................................... 8,695 9,246 11,482
====== ====== =======
Exercisable.............................................................. 3,168 3,618 4,444
Weighted average exercise price:
Options granted..................................................... $ 55.08 $ 31.61 $ 13.18
Options exercised................................................... 11.37 8.44 7.99
Options terminated.................................................. 25.31 14.10 12.89
Options outstanding, end of year.................................... 26.33 14.59 10.57
Exercisable, end of year............................................ 13.97 9.36 7.81
Weighted average fair value of options at grant date $ 25.79 $ 14.97 $ 6.39
F-23
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
The increase in options exercisable during 1999 was primarily related
to the completion of the SBCL acquisition which accelerated the vesting of
certain grants made in previous years in accordance with the original terms of
such option grants.
The following relates to options outstanding at December 31, 2001:
Options Outstanding Options Exercisable
--------------------------------------------------------------------------------- -----------------------------------
Weighted Average
Remaining
Range of Shares Contractual Life Weighted Average Shares Weighted Average
Exercise Price (in thousands) (in years) Exercise Price (in thousands) Exercise Price
-------------- -------------- ---------- -------------- -------------- --------------
$5.26 - $17.02 5,176 7.1 $ 11.95 2,776 $ 10.88
$17.86 - $28.53 302 8.2 17.89 102 17.96
$29.27 - $35.64 665 8.4 30.30 172 30.36
$44.00 - $52.39 1,713 9.1 52.08 38 51.44
$52.50 - $64.07 546 9.3 59.61 51 60.63
$64.65 - $75.94 294 9.4 67.33 30 66.41
The following summarizes the activity relative to incentive stock
awards granted in 2001, 2000 and 1999 (shares in thousands):
2001 2000 1999
---- ---- ----
Incentive shares, beginning of year...................................... 1,788 1,136 740
Incentive shares granted................................................. - 920 1,110
Incentive shares vested.................................................. (439) (224) (696)
Incentive shares forfeited and canceled.................................. (29) (44) (18)
----- ----- -----
Incentive shares, end of year............................................ 1,320 1,788 1,136
===== ===== =====
Weighted average fair value of incentive shares at grant date ........... $ - $23.54 $11.95
The balance of the incentive stock awards at December 31, 2001 are
subject to forfeiture if employment terminates prior to the end of the
prescribed vesting period.
Employee Stock Purchase Plan
Under the Company's Employee Stock Purchase Plan ("ESPP"),
substantially all employees can elect to have up to 10% of their annual wages
withheld to purchase Quest Diagnostics' common stock. The purchase price of the
stock is 85% of the lower of its beginning-of-quarter or end-of-quarter market
price. Under the ESPP, the maximum number of shares of Quest Diagnostics' common
stock which may be purchased by eligible employees is 4 million. Approximately
203, 463 and 412 thousand shares of common stock were purchased by eligible
employees in 2001, 2000 and 1999, respectively.
Employee Stock Ownership Plan
Prior to 1999, the Company maintained its Employee Stock Ownership Plan
("ESOP") to account for certain shares of Quest Diagnostics' common stock which
had been issued for the account of all active regular employees of the Company
as of December 31, 1996. Effective with the closing of the SBCL acquisition, the
Company modified certain provisions of the ESOP to provide an additional benefit
to employees through ownership of the Company's common stock. Substantially all
of the Company's employees are eligible to participate in the ESOP. The
Company's contributions to the ESOP trust are based on 2% of eligible employee
compensation for those employees who are actively employed or on a leave of
absence on December 31 of each year. Company contributions to the trust may be
in the form of shares of Quest Diagnostics' common stock, cash or any
combination of the above. The Company's contributions to this plan aggregated
$19.7 million, $21 million and $7.5 million for 2001, 2000 and 1999,
respectively.
F-24
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Stock-Based Compensation
Quest Diagnostics has adopted the disclosure-only provisions of SFAS
123, but follows APB 25 and related interpretations to account for its
stock-based compensation plans. Stock-based compensation expense recorded in
accordance with APB 25 was $21 million, $25 million and $27 million in 2001,
2000 and 1999, respectively. As discussed in Note 7, for the year ended December
31, 1999, the provisions for restructuring and other special charges included
approximately $20 million of stock-based compensation expense.
If the Company had elected to recognize compensation cost based on the
fair value at the grant dates for awards under its stock-based compensation
plans, consistent with the method prescribed by SFAS 123, the Company's net
income (loss) would have been $138 million, $82 million and $(11.5) million for
2001, 2000 and 1999, respectively. Basic net income (loss) per common share
would have been $1.48 per common share, $0.91 per common share and $(0.17) per
common share for 2001, 2000 and 1999, respectively. Diluted net income (loss)
per common share would have been $1.41 per common share, $0.86 per common share
and $(0.17) per common share for 2001, 2000 and 1999, respectively.
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:
2001 2000 1999
---- ---- ----
Dividend yield......................... 0.0% 0.0% 0.0%
Risk-free interest rate................ 5.1% 6.5% 5.8%
Expected volatility.................... 47.7% 43.7% 46.8%
Expected holding period, in years ..... 5 5 5
15. EMPLOYEE RETIREMENT PLAN
The Company maintains a defined contribution plan covering
substantially all of its employees. The Company's expense for its contributions
to this plan aggregated $30 million, $29 million and $18.3 million for 2001,
2000 and 1999, respectively.
16. RELATED PARTY TRANSACTIONS
As part of the SBCL acquisition agreements, SmithKline Beecham and
Quest Diagnostics entered into the following agreements: a long-term contract
under which Quest Diagnostics is the primary provider of testing to support
SmithKline Beecham's clinical trials testing requirements worldwide (the
"Clinical Trials Agreement"); data access agreements under which Quest
Diagnostics granted SmithKline Beecham and certain affiliated companies certain
non-exclusive rights and access to use Quest Diagnostics' proprietary clinical
laboratory information database (the "Data Access Agreements"); and an agreement
under which SmithKline Beecham agreed to provide, through December 31, 2000,
various administrative services that it had previously provided to SBCL prior to
its acquisition by Quest Diagnostics (the "Transitional Services Agreement").
The Data Access Agreements were terminated as of January 1, 2001.
Significant transactions with SmithKline Beecham during 2001, 2000 and
1999 included (in addition to the acquisition of SBCL during 1999):
2001 2000 1999
---- ---- ----
Clinical trials testing revenues.......................... $27,806 $31,334 $10,261
Purchases, primarily related to services rendered by
SmithKline Beecham under the Transitional Services
Agreement............................................... 184 15,901 4,577
In addition, under the SBCL acquisition agreements, SmithKline Beecham
has agreed to indemnify Quest Diagnostics, on an after tax basis, against
certain matters primarily related to taxes and billing and professional
liability claims (see Note 17).
F-25
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
At December 31, 2001, accounts payable and accrued expenses included
$29 million due to SmithKline Beecham, primarily related to tax benefits
associated with indemnified matters. At December 31, 2000, prepaid expenses and
other current assets included $45 million due from SmithKline Beecham, primarily
related to indemnified billing-related and professional liability claims. During
2001, substantially all of the billing-related claims indemnified by SmithKline
Beecham were settled (see Note 17). At December 31, 2001 and 2000, other assets
included $10.1 million and $14.1 million, respectively, due from SmithKline
Beecham, primarily related to management's best estimate of the amounts required
to satisfy certain professional liability claims indemnified by SmithKline
Beecham.
At December 31, 2000, the amount due from Corning, classified in
prepaid expenses and other current assets, was $8.1 million. The receivable from
Corning was increased (decreased) in 2001, 2000 and 1999 by $0.6 million, $(5.9)
million and $(2.0) million, respectively, through an adjustment to additional
paid-in capital, based on management's best estimate of amounts which were
probable of being received from Corning to satisfy remaining indemnified
billing-related claims. During 2001, the Company received $8.7 million from
Corning related to certain indemnified billing-related claims settled in 2001
and 2000. At December 31, 2001, there are no amounts due from Corning related to
indemnified billing-related claims (see Note 17).
17. COMMITMENTS AND CONTINGENCIES
Minimum rental commitments under noncancelable operating leases,
primarily real estate, in effect at December 31, 2001 are as follows:
Year ending December 31,
2002............................................................. $ 92,170
2003............................................................. 76,144
2004............................................................. 59,138
2005............................................................. 48,221
2006............................................................. 41,306
2007 and thereafter.............................................. 152,824
--------
Minimum lease payments........................................... 469,803
Noncancelable sub-lease income................................... (31,865)
--------
Net minimum lease payments....................................... $437,938
========
Operating lease rental expense for 2001, 2000 and 1999 aggregated $83
million, $77 million and $59 million, respectively.
The Company has certain noncancelable commitments to purchase products
or services from various suppliers, mainly for information technology consulting
and software licensing, and standing orders to purchase reagents and other
laboratory supplies. At December 31, 2001 the approximate total future purchase
commitments are $31 million, of which $21 million are expected to be incurred in
2002.
The Company is substantially self-insured for all casualty losses and
maintains excess coverage primarily on a claims made basis. The basis for
insurance reserves at December 31, 2001 and 2000 is the actuarially determined
projected losses for each program (limited by its self-insured retention) based
upon the Company's loss experience.
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 SBCL prior to the closing of the
SBCL acquisition.
In March 1997, a former subsidiary of Damon Corporation ("Damon"), an
independent clinical laboratory acquired by Corning and contributed to Quest
Diagnostics in 1993, was served a complaint in a purported class action. Quest
Diagnostics was added to the complaint by the plaintiffs in August 1999. The
complaint asserted claims relating to private reimbursement of billings that
were similar to those that were part of a prior government settlement. The
Company entered into a settlement agreement which received the final
F-26
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
approval of the court on July 14, 2000. The final settlement releases the
Company and all of its subsidiaries, other than SBCL, from potential private
claims related to the reimbursement of billings that were the subject of the
lawsuit. During the second quarter of 2000, the Company recorded a reduction in
reserves attributable to the favorable resolution of this matter (see Note 7).
In December 2000, the Company entered into a settlement agreement with
the federal government and certain state government healthcare programs for
approximately $13 million, primarily relating to prior billing and marketing
practices at several former facilities of Nichols Institute that occurred prior
to the Company's acquisition of Nichols Institute. This settlement was
indemnified by Corning pursuant to the indemnity described below.
Corning agreed to indemnify the Company against all monetary
settlements for any governmental claims relating to the billing practices of the
Company and its predecessors based on investigations that were pending on
December 31, 1996. Corning had also agreed to indemnify the Company in respect
of private claims relating to indemnified or previously settled government
claims that alleged overbillings by Quest Diagnostics or any of its existing
subsidiaries for services provided before January 1, 1997. Corning agreed to
indemnify Quest Diagnostics in respect of private claims for 50% of the
aggregate of all judgment or settlement payments made by December 31, 2001 that
exceeded $42 million. The 50% share was limited to a total amount of $25 million
and was reduced to take into account any deductions or tax benefits realized by
Quest Diagnostics. As of December 31, 2001, the Corning indemnity with respect
to private claims had expired. At December 31, 2001, there were no amounts due
from Corning under the indemnity and at December 31, 2000, the receivable from
Corning, which was classified in prepaid expenses and other current assets,
totaled $8.1 million. In accordance with the indemnity described above, the
Company received $8.1 million from Corning in January 2001 in connection with
the Company's civil settlement of claims in the fourth quarter of 2000 with
respect to Nichols Institute's former regional laboratories.
Similar to Quest Diagnostics, SBCL has entered into settlement
agreements with various governmental agencies and private payers primarily
relating to its prior billing and marketing practices. Effective in 1997, SBCL
and the United States government and various states reached a settlement with
respect to the government's civil and administrative claims. SBCL is also
responding to claims from private payers relating to billing and marketing
issues similar to those that were the subject of the settlement with the
government. The claims included ten purported class actions filed in various
jurisdictions in the United States and two non-class action complaints by a
number of insurance companies. Nine of the purported class actions were
consolidated into one complaint, which was consolidated with one of the
insurers' suits for pre-trial proceedings. During both the second and third
quarters of 2001, settlements were reached in a number of the complaints against
SBCL for approximately $30 million and $31 million, respectively. The
settlements were paid directly by SmithKline Beecham
under the terms of the indemnity described below.
SmithKline Beecham has agreed to indemnify Quest Diagnostics, on an
after-tax basis, against monetary payments for governmental claims or
investigations relating to the billing practices of SBCL that had been settled
before or were pending as of the closing date of the SBCL acquisition.
SmithKline Beecham has also agreed to indemnify Quest Diagnostics, on an
after-tax basis, against monetary payments to private payers, relating to or
arising out of the governmental claims. The indemnification with respect to
governmental claims is for 100% of those claims. SmithKline Beecham will
indemnify Quest Diagnostics, in respect of private claims for: 100% of those
claims, up to an aggregate amount of $80 million; 50% of those claims to the
extent the aggregate amount exceeds $80 million but is less than $130 million;
and 100% of such claims to the extent the aggregate amount exceeds $130 million.
The indemnification also covers 80% of out-of-pocket costs and expenses relating
to investigations of the claims indemnified against by SmithKline Beecham.
SmithKline Beecham has also agreed to indemnify the Company with respect to
pending actions relating to a former SBCL employee that at times reused certain
needles when drawing blood from patients. In addition, SmithKline Beecham has
agreed to indemnify the Company against all monetary payments relating to
professional liability claims of SBCL for services provided prior to the closing
of the SBCL acquisition. Amounts due from SmithKline Beecham at December 31,
2001, related principally to indemnified professional liability claims discussed
above, totaled approximately $16 million and represented management's best
estimate of the amounts which are probable of being received from SmithKline
Beecham to satisfy the indemnified claims on an after-tax basis. The estimated
reserves and related amounts due from SmithKline Beecham are subject to change
as additional information regarding the outstanding claims is gathered and
evaluated.
At December 31, 2001 recorded reserves, relating primarily to billing
claims, including those indemnified by SmithKline Beecham, approximated $21
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.
F-27
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
In addition to the billing-related settlement reserves discussed above,
the Company is involved in various legal proceedings arising in the ordinary
course of business. Some of the proceedings against the Company involve claims
that are substantial in amount. Some of these claims involve contracts of SBCL
that were terminated following the Company's acquisition of SBCL. 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 our
financial position.
18. SUBSEQUENT EVENTS
Acquisition of American Medical Laboratories, Incorporated
On February 7, 2002, the Company signed a definitive agreement to
acquire 100 percent of the outstanding voting stock of American Medical
Laboratories, Incorporated, ("AML"), in an all-cash transaction valued at $500
million, which includes the assumption of approximately $160 million in debt.
The transaction is subject to customary regulatory review and is expected to
close in the first quarter of 2002. As part of the transaction, Quest
Diagnostics will acquire all of AML's operations, including two full-service
laboratories, 51 patient service centers, and hospital sales, service and
logistics capabilities. Also as part of the transaction, and prior to the
closing, AML will acquire an affiliated company, LabPortal, Inc., a provider of
electronic connectivity products. The Company expects to use existing cash on
hand and its existing borrowing capacity under the Credit Agreement and the
secured receivables credit facility to fund the acquisition. The acquisition
will be accounted for under the purchase method of accounting, allocating the
cost of the acquisition to the net assets acquired based upon their estimated
fair market values, with the majority of the purchase price expected to be
allocated to goodwill. Since the transaction has yet to close, a preliminary
purchase price allocation is not practical in the circumstances.
Secured Receivables Credit Facility
On February 8, 2002, the Company extended the expiration date of the
$200 million back-up facility provided by Wachovia Bank for the secured
receivables credit facility from July 19, 2002 to January 19, 2003.
19. SUMMARIZED FINANCIAL INFORMATION
As described in Note 12, the Senior Notes and the Debentures 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 secured receivables credit facility
described in Note 12, the Company formed a new wholly owned non-guarantor
subsidiary, Quest Diagnostics Receivables Incorporated ("QDRI"). The Company and
the Subsidiary Guarantors transferred 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
utilized the transferred receivables to collateralize the 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.
F-28
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Condensed Consolidating Balance Sheet
December 31, 2001
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
Assets
Current assets:
Cash and cash equivalents................... $ - $ 110,571 $ 11,761 $ - $ 122,332
Accounts receivable, net.................... 9,083 52,232 447,025 - 508,340
Other current assets........................ 93,144 52,755 99,943 - 245,842
---------- ---------- --------- ----------- ----------
Total current assets..................... 102,227 215,558 558,729 - 876,514
Property, plant and equipment, net.......... 170,494 320,244 17,881 - 508,619
Intangible assets, net ..................... 154,809 1,188,031 36,303 - 1,379,143
Intercompany receivable (payable)........... 425,735 92,378 (518,113) - -
Investment in subsidiaries.................. 1,096,647 - - (1,096,647) -
Other assets................................ 75,633 54,998 35,648 - 166,279
---------- ---------- --------- ----------- ----------
Total assets............................. $2,025,545 $1,871,209 $ 130,448 $(1,096,647) $2,930,555
=========== ========== ========= =========== ==========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses....... $ 334,666 $ 290,039 $ 32,514 $ - $ 657,219
Short-term borrowings and current portion of
long-term debt............................ 21 1,040 343 - 1,404
---------- ---------- --------- ----------- ----------
Total current liabilities................ 334,687 291,079 32,857 - 658,623
Long-term debt.............................. 310,690 502,519 7,128 - 820,337
Other liabilities........................... 44,181 57,469 13,958 - 115,608
Common stockholders' equity................. 1,335,987 1,020,142 76,505 (1,096,647) 1,335,987
---------- ---------- --------- ----------- ----------
Total liabilities and stockholders' equity $2,025,545 $1,871,209 $ 130,448 $(1,096,647) $2,930,555
========== ========== ========= =========== ==========
Condensed Consolidating Balance Sheet
December 31, 2000
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
Assets
Current assets:
Cash and cash equivalents................... $ - $ 163,863 $ 7,614 $ - $ 171,477
Accounts receivable, net.................... 6,159 29,548 449,866 - 485,573
Other current assets........................ 191,693 129,881 9,030 (6,965) 323,639
---------- ---------- --------- ----------- ----------
Total current assets..................... 197,852 323,292 466,510 (6,965) 980,689
Property, plant and equipment, net.......... 121,159 316,630 12,067 - 449,856
Intangible assets, net ..................... 72,514 1,180,341 8,748 - 1,261,603
Intercompany receivable (payable)........... (78,538) 253,994 (175,456) - -
Investment in subsidiaries.................. 1,031,135 - - (1,031,135) -
Other assets................................ 66,623 71,692 34,073 - 172,388
---------- ---------- --------- ----------- ----------
Total assets............................. $1,410,745 $2,145,949 $ 345,942 $(1,038,100) $2,864,536
========== ========== ========= =========== ==========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses....... $ 247,558 $ 418,147 $ 30,842 $ (6,965) $ 689,582
Short-term borrowings and current portion of
long-term debt............................ 837 8,215 256,356 - 265,408
---------- ---------- --------- ----------- ----------
Total current liabilities................ 248,395 426,362 287,198 (6,965) 954,990
Long-term debt.............................. 95,711 661,340 3,654 - 760,705
Other liabilities........................... 34,844 71,159 11,043 - 117,046
Preferred stock............................. 1,000 - - - 1,000
Common stockholders' equity................. 1,030,795 987,088 44,047 (1,031,135) 1,030,795
---------- ---------- --------- ----------- ----------
Total liabilities and stockholders' equity $1,410,745 $2,145,949 $ 345,942 $(1,038,100) $2,864,536
========== ========== ========= =========== ==========
F-29
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Condensed Consolidating Statement of Operations
For the Year Ended December 31, 2001
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
Net revenues................................ $ 596,909 $2,862,536 $451,525 $(283,199) $3,627,771
Costs and expenses:
Cost of services.......................... 431,382 1,610,902 109,310 - 2,151,594
Selling, general and administrative....... 159,439 623,419 250,420 (14,598) 1,018,680
Interest, net............................. 73,499 243,978 21,647 (268,601) 70,523
Amortization of intangibles............... 3,826 41,696 585 - 46,107
Provision for special charges............. 5,997 - - - 5,997
Royalty (income) expense.................. (241,886) 241,886 - - -
Other, net................................ 2,042 (989) 1,213 - 2,266
---------- ---------- -------- --------- ----------
Total.................................... 434,299 2,760,892 383,175 (283,199) 3,295,167
---------- ---------- -------- --------- ----------
Income before taxes and extraordinary loss.. 162,610 101,644 68,350 - 332,604
Income tax expense.......................... 68,932 53,023 26,737 - 148,692
---------- ---------- -------- --------- ----------
Income before equity earnings and
extraordinary loss........................ 93,678 48,621 41,613 - 183,912
Equity earnings from subsidiaries........... 72,505 - - (72,505) -
---------- ---------- -------- --------- ----------
Income before extraordinary loss............ 166,183 48,621 41,613 (72,505) 183,912
Extraordinary loss, net of taxes............ (3,880) (15,567) (2,162) - (21,609)
---------- ---------- -------- --------- ----------
Net income.................................. $ 162,303 $ 33,054 $ 39,451 $ (72,505) $ 162,303
========== ========== ======== ========= ==========
Condensed Consolidating Statement of Operations
For the Year Ended December 31, 2000
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
Net revenues................................ $ 520,198 $2,773,568 $274,987 $(147,591) $3,421,162
Costs and expenses:
Cost of services.......................... 348,227 1,621,667 86,343 - 2,056,237
Selling, general and administrative....... 233,409 638,534 139,993 (10,493) 1,001,443
Interest, net............................. 38,436 195,614 16,140 (137,098) 113,092
Amortization of intangible assets......... 4,153 41,005 507 - 45,665
Provisions for restructuring and other
special charges.......................... 2,594 (4,134) 3,640 - 2,100
Royalty (income) expense.................. (94,959) 94,959 - - -
Other, net................................ (1,806) (322) 3,772 - 1,644
---------- ---------- -------- --------- ----------
Total.................................... 530,054 2,587,323 250,395 (147,591) 3,220,181
---------- ---------- -------- --------- ----------
Income (loss) before taxes and extraordinary (9,856) 186,245 24,592 - 200,981
loss.....................................
Income tax expense (benefit)................ (619) 86,196 10,456 - 96,033
---------- ---------- -------- --------- ----------
Income (loss) before equity earnings and
extraordinary loss........................ (9,237) 100,049 14,136 - 104,948
Equity income from subsidiaries............. 111,512 - - (111,512) -
---------- ---------- -------- --------- ----------
Income before extraordinary loss............ 102,275 100,049 14,136 (111,512) 104,948
Extraordinary loss, net of taxes............ (223) (2,673) - - (2,896)
---------- ---------- -------- --------- ----------
Net income ................................. $ 102,052 $ 97,376 $ 14,136 $(111,512) $ 102,052
========== ========== ======== ========= ==========
F-30
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Condensed Consolidating Statement of Operations
For the Year Ended December 31, 1999
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
Net revenues............................... $636,778 $1,475,064 $93,401 $ - $2,205,243
Costs and expenses:
Cost of services.......................... 407,908 915,438 56,643 - 1,379,989
Selling, general and administrative....... 232,558 380,237 30,645 - 643,440
Interest, net............................. 9,508 51,456 486 - 61,450
Amortization of intangible assets......... 7,307 22,103 374 - 29,784
Provisions for restructuring and other
special charges.......................... 62,496 8,137 2,752 - 73,385
Royalty (income) expense.................. (71,678) 71,678 - - -
Other, net................................ (3,245) (230) 6,286 - 2,811
-------- ---------- ------- ------- ----------
Total.................................... 644,854 1,448,819 97,186 - 2,190,859
-------- ---------- ------- ------- ----------
Income (loss) before taxes and extraordinary (8,076) 26,245 (3,785) - 14,384
loss....................................
Income tax expense (benefit)................ (4,524) 18,461 1,721 - 15,658
-------- ---------- ------- ------- ----------
Income (loss) before equity earnings and
extraordinary loss........................ (3,552) 7,784 (5,506) - (1,274)
Equity earnings from subsidiaries........... 2,278 - - (2,278) -
-------- ---------- ------- ------- ----------
Income (loss) before extraordinary loss..... (1,274) 7,784 (5,506) (2,278) (1,274)
Extraordinary loss, net of taxes............ (2,139) - - - (2,139)
-------- ---------- ------- ------- ----------
Net income (loss) .......................... $ (3,413) $ 7,784 $(5,506) $(2,278) $ (3,413)
======== ========== ======= ======= ==========
To be completed
Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 2001
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
Cash flows from operating activities:
Net income.................................. $ 162,303 $ 33,054 $ 39,451 $(72,505) $ 162,303
Extraordinary loss, net of taxes 3,880 15,567 2,162 - 21,609
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization............. 40,726 102,020 4,981 - 147,727
Provision for doubtful accounts........... 627 21,198 196,446 - 218,271
Provision for special charges............. 5,997 - - - 5,997
Other, net................................ (37,054) 35,735 (40,087) 72,505 31,099
Changes in operating assets and liabilities (9,845) (30,157) (81,201) - (121,203)
--------- ---------- -------- -------- ----------
Net cash provided by operating activities... 166,634 177,417 121,752 - 465,803
Net cash used in investing activities....... (395,196) (45,293) (4,087) 147,960 (296,616)
Net cash provided by (used in) financing
activities................................ 228,562 (185,416) (113,518) (147,960) (218,332)
--------- ---------- -------- -------- ----------
Net change in cash and cash equivalents..... - (53,292) 4,147 - (49,145)
Cash and cash equivalents, beginning of year - 163,863 7,614 - 171,477
--------- ----------- -------- -------- ----------
Cash and cash equivalents, end of period.... $ - $ 110,571 $ 11,761 $ - $ 122,332
========= ========== ======== ======== ==========
F-31
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 2000
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
Cash flows from operating activities:
Net income.................................... $ 102,052 $ 97,376 $ 14,136 $(111,512) $ 102,052
Extraordinary loss, net of taxes.............. 223 2,673 - - 2,896
Adjustments to reconcile net income to net
cash provided by (used in)
operating activities:
Depreciation and amortization............... 30,447 99,234 4,615 - 134,296
Provision for doubtful accounts............. 14,333 117,927 102,434 - 234,694
Provisions for restructuring and other
special charges............................ 2,594 (4,134) 3,640 - 2,100
Other, net.................................. (96,318) 140,905 15,850 3,273 63,710
Changes in operating assets and liabilities. 73,941 (168,296) (184,177) 108,239 (170,293)
----------- --------- --------- --------- -----------
Net cash provided by (used in) operating 127,272 285,685 (43,502) - 369,455
activities.................................
Net cash provided by (used in) investing 89,886 (66,325) (4,948) (66,628) (48,015)
activities.................................
Net cash provided by (used in) financing (217,158) (74,361) 47,644 66,628 (177,247)
activities................................. ----------- --------- --------- --------- -----------
Net change in cash and cash equivalents....... - 144,999 (806) - 144,193
Cash and cash equivalents, beginning of year.. - 18,864 8,420 - 27,284
----------- --------- --------- --------- -----------
Cash and cash equivalents, end of year........ $ - $ 163,863 $ 7,614 $ - $ 171,477
=========== ========= ========= ========= ===========
Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 1999
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
Cash flows from operating activities:
Net income (loss)............................. $ (3,413) $ 7,784 $ (5,506) $ (2,278) $ (3,413)
Extraordinary loss, net of taxes.............. 2,139 - - - 2,139
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Depreciation and amortization............... 32,083 55,020 3,732 - 90,835
Provision for doubtful accounts ............ 36,121 101,762 4,450 - 142,333
Provisions for restructuring and other
special charges............................ 62,496 8,137 2,752 - 73,385
Other, net.................................. (15,039) (8,954) 3,737 2,278 (17,978)
Changes in operating assets and liabilities. (53,317) 11,821 3,730 - (37,766)
----------- --------- --------- --------- -----------
Net cash provided by operating activities..... 61,070 175,570 12,895 - 249,535
Net cash used in investing activities........ (1,068,476) (30,099) (9,415) - (1,107,990)
Net cash provided by (used in) financing 816,800 (134,813) 844 - 682,831
activities................................. ----------- --------- --------- --------- -----------
Net change in cash and cash equivalents....... (190,606) 10,658 4,324 - (175,624)
Cash and cash equivalents, beginning of year.. 190,606 8,206 4,096 - 202,908
----------- --------- --------- --------- -----------
Cash and cash equivalents, end of year........ $ - $ 18,864 $ 8,420 $ - $ 27,284
=========== ========= ========= ========= ===========
F-32
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
(in thousands, except per share data)
Quarterly Operating Results (unaudited)
First Second Third Fourth Total
Quarter Quarter Quarter Quarter Year
------- ------- ------- ------- ----
2001
Net revenues.................................. $882,553 $931,589 $903,189 $910,440 $3,627,771
Gross profit.................................. 353,488 382,198 367,625 372,866 1,476,177
Income before taxes and extraordinary loss.... 65,472 85,711 (a) 89,886 91,535 332,604
Extraordinary loss............................ - (21,609)(b) - - (21,609)
Net income.................................... 35,748 25,495 50,122 50,938 162,303
Basic net income per common share:
Income before extraordinary loss.............. 0.39 0.51 0.54 0.54 1.98
Net income.................................... 0.39 0.28 0.54 0.54 1.74
Diluted net income per common share:
Income before extraordinary loss.............. 0.37 0.48 0.51 0.52 1.88
Net income.................................... 0.37 0.26 0.51 0.52 1.66
First Second Third Fourth Total
Quarter Quarter Quarter Quarter Year
------- ------- ------- ------- ----
2000
Net revenues.................................. $857,479 $877,113 $850,236 $836,334 $3,421,162
Gross profit.................................. 328,442 356,676 345,494 334,313 1,364,925
Income before taxes and extraordinary loss.... 35,196 58,213 (c) 54,019 53,553 200,981
Extraordinary loss............................ - - - (2,896)(d) (2,896)
Net income.................................... 17,809 30,168 28,712 25,363 102,052
Basic net income per common share:
Income before extraordinary loss.............. 0.20 0.34 0.32 0.31 1.17
Net income.................................... 0.20 0.34 0.32 0.28 1.14
Diluted net income per common share:
Income before extraordinary loss.............. 0.19 0.32 0.30 0.29 1.11
Net income.................................... 0.19 0.32 0.30 0.26 1.08
(a) During the second quarter of 2001, the Company recorded a special charge of
$6.0 million (see Note 7).
(b) During the second quarter of 2001, the Company refinanced a substantial
portion of its long-term debt. The extraordinary loss of $36 million ($22
million, net of taxes) represented the write-off of deferred financing
costs of $23 million, associated with the Company's debt which was
refinanced, and $12.8 million of payments related primarily to the tender
premium incurred in connection with the Company's cash tender offer of the
Subordinated Notes (see Note 8).
(c) During the second quarter of 2000, the Company recorded a net special
charge of $2.1 million (see Note 7).
(d) During the fourth quarter of 2000, the Company recorded an extraordinary
loss of $4.8 million ($2.9 million, net of taxes) representing the
write-off of deferred financing costs resulting from the prepayment of $155
million of term loans under the Company's senior secured credit facility.
(see Note 8).
F-33
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
SCHEDULE II - VALUATION ACCOUNTS AND RESERVES
(in thousands)
Balance at Provision for Net Deductions Balance at
1-1-01 Doubtful Accounts and Other 12-31-01
------ ----------------- --------- --------
Year ended December 31, 2001
Doubtful accounts and allowances............ $204,358 $218,271 $206,426 $216,203
Balance at Provision for Net Deductions Balance at
1-1-00 Doubtful Accounts and Other 12-31-00
------ ----------------- --------- --------
Year ended December 31, 2000
Doubtful accounts and allowances............ $121,550 $234,694 $151,886 $204,358
Balance at Provision for Net Deductions Balance at
1-1-99 Doubtful Accounts and Other 12-31-99
------ ----------------- --------- --------
Year ended December 31, 1999
Doubtful accounts and allowances............ $ 70,701 $142,333 $ 91,484 $121,550
F-34
STATEMENT OF DIFFERENCES
------------------------
The trademark symbol shall be expressed as............................. 'TM'
The registered trademark symbol shall be expressed as.................. 'r'