UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2006 Commission file number 001-12215
Quest Diagnostics Incorporated
1290 Wall Street West Lyndhurst, NJ 07071 (201) 393-5000
Delaware (State of Incorporation)
16-1387862 (I.R.S. Employer Identification Number)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer x Accelerated filer o Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o Nox
As of July 21, 2006, there were 197,132,513 outstanding shares of the registrant’s common stock, $.01 par value.
PART I - FINANCIAL INFORMATION
Item 1.
Financial Statements
Page
Index to consolidated financial statements filed as part of this report:
Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2006 and 2005
2
Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005
3
Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2006 and 2005
4
Notes to Consolidated Financial Statements
5
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
23
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
See Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations”
30
Item 4.
Controls and Procedures
1
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2006 AND 2005 (in thousands, except per share data) (unaudited)
Three Months EndedJune 30,
Six Months EndedJune 30,
2006
2005
Net revenues
$
1,584,335
1,377,529
3,139,743
2,697,014
Operating costs and expenses:
Cost of services
936,432
798,678
1,859,416
1,578,760
Selling, general and administrative
363,339
315,674
721,529
624,022
Amortization of intangible assets
2,257
933
4,595
1,864
Other operating expense, net
19,682
1,091
47,037
1,302
Total operating costs and expenses
1,321,710
1,116,376
2,632,577
2,205,948
Operating income
262,625
261,153
507,166
491,066
Other income (expense):
Interest expense, net
(22,662
)
(12,640
(46,186
(25,423
Minority share of income
(5,850
(5,072
(11,258
(10,085
Equity earnings in unconsolidated joint ventures
6,632
6,440
14,644
13,654
Other income (expense), net
(12,686
(544
4,754
211
Total non-operating expenses, net
(34,566
(11,816
(38,046
(21,643
Income before taxes
228,059
249,337
469,120
469,423
Income tax expense
96,082
100,248
192,507
188,723
Net income
131,977
149,089
276,613
280,700
Earnings per common share:
Basic
0.67
0.74
1.40
1.39
Diluted
0.66
0.72
1.38
1.36
Weighted average common shares outstanding:
198,013
202,597
198,204
202,158
200,586
206,554
200,810
206,348
Dividends per common share
0.10
0.09
0.20
0.18
The accompanying notes are an integral part of these statements.
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS JUNE 30, 2006 AND DECEMBER 31, 2005 (in thousands, except per share data) (unaudited)
June 30,2006
December 31,2005
Assets
Current assets:
Cash and cash equivalents
150,679
92,130
Accounts receivable, net of allowance for doubtful accounts of $198,347 and $193,754 at June 30, 2006 and December 31, 2005, respectively
800,279
732,907
Inventories
71,463
77,939
Deferred income taxes
121,282
107,442
Prepaid expenses and other current assets
75,608
59,079
Total current assets
1,219,311
1,069,497
Property, plant and equipment, net
742,030
753,663
Goodwill, net
3,200,649
3,197,227
Intangible assets, net
140,799
147,383
Other assets
144,805
138,345
Total assets
5,447,594
5,306,115
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable and accrued expenses
814,575
764,453
Short-term borrowings and current portion of long-term debt
291,935
336,839
Total current liabilities
1,106,510
1,101,292
Long-term debt
1,240,613
1,255,386
Other liabilities
197,471
186,453
Commitments and contingencies
Stockholders’ equity:
Common stock, par value $0.01 per share; 600,000 and 300,000 shares authorized at June 30, 2006 and December 31, 2005, respectively; 213,734 and 213,674 issued at June 30, 2006 and December 31, 2005, respectively
2,137
Additional paid-in capital
2,177,011
2,175,533
Retained earnings
1,529,467
1,292,510
Unearned compensation
—
(3,321
Accumulated other comprehensive loss
(1,167
(6,205
Treasury stock, at cost; 16,663 and 15,219 shares at June 30, 2006 and
December 31, 2005, respectively
(804,448
(697,670
Total stockholders’ equity
2,903,000
2,762,984
Total liabilities and stockholders’ equity
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED JUNE 30, 2006 AND 2005(in thousands)(unaudited)
Six Months Ended June 30,
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
98,620
85,531
Provision for doubtful accounts
123,773
119,266
Stock-based compensation expense
39,489
790
Provision for restructuring and other special charges
53,061
Deferred income tax benefit
(40,185
(10,439
11,258
10,085
Tax benefits associated with stock-based compensation plans
19,920
Excess tax benefits from stock-based compensation arrangements
(25,533
Other, net
(1,866
(1,135
Changes in operating assets and liabilities:
Accounts receivable
(191,144
(163,363
28,458
14,688
Integration, settlement and other special charges
(408
(1,105
Income taxes payable
49,553
30,248
Other assets and liabilities, net
(10,578
(14,677
Net cash provided by operating activities
411,111
370,509
Cash flows from investing activities:
Capital expenditures
(88,144
(123,870
Business acquisition, net of cash acquired
(1,042
(19,323
Decrease (increase) in investments and other assets
13,492
(23,664
Net cash used in investing activities
(75,694
(166,857
Cash flows from financing activities:
Repayments of debt
(60,085
(100,465
Proceeds from borrowings
99,999
Decrease in book overdrafts
(13,715
Purchases of treasury stock
(253,975
(91,988
Exercise of stock options
73,303
64,163
25,533
Dividends paid
(37,686
(33,228
Distributions to minority partners
(9,515
(11,328
Financing costs paid
(728
Net cash used in financing activities
(276,868
(72,847
Net change in cash and cash equivalents
58,549
130,805
Cash and cash equivalents, beginning of period
73,302
Cash and cash equivalents, end of period
204,107
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(in thousands, unless otherwise indicated)(unaudited)
1. BASIS OF PRESENTATION
Background
Quest Diagnostics Incorporated and its subsidiaries (“Quest Diagnostics” or the “Company”) is the largest clinical laboratory testing business in the United States. As the nation’s leading provider of diagnostic testing and services for the healthcare industry, Quest Diagnostics offers a broad range of clinical laboratory testing services to patients, physicians, hospitals, healthcare insurers, employers, governmental institutions and other commercial clinical laboratories. Quest Diagnostics is the leading provider of esoteric testing, including gene-based testing. The Company is also the leading provider of testing for drugs-of-abuse. Through the Company’s national network of laboratories and patient service centers, and its esoteric testing laboratories and development facilities, Quest Diagnostics offers comprehensive and innovative diagnostic testing, information and services used by physicians and other healthcare professionals to make decisions to improve health. The Company is also a leading provider of anatomic pathology services, testing to support clinical trials of new pharmaceuticals worldwide and risk assessment services for the life insurance industry.
On an annual basis, Quest Diagnostics processes greater than 145 million requisitions for testing through its extensive network of laboratories and patient service centers in virtually every major metropolitan area throughout the United States.
Basis of Presentation
The interim consolidated financial statements reflect all adjustments, which in the opinion of management are necessary for a fair statement of financial condition and results of operations for the periods presented. Except as otherwise disclosed, all such adjustments are of a normal recurring nature. The interim consolidated financial statements have been compiled without audit. Operating results for the interim periods are not necessarily indicative of the results that may be expected for the full year. These interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in the Company’s 2005 Annual Report on Form 10-K.
Earnings Per Share
Basic earnings per common share is calculated by dividing net income by the weighted average common shares outstanding. Diluted earnings per common share is calculated by dividing net income, adjusted for the after-tax impact of the interest expense associated with the Company’s 1¾% contingent convertible debentures due 2021 (the “Debentures”), by the weighted average common shares outstanding after giving effect to all potentially dilutive common shares outstanding during the period. Potentially dilutive common shares include the dilutive effect of outstanding stock options, performance share units and restricted common shares granted under the Company’s Amended and Restated Employee Long-Term Incentive Plan and its Amended and Restated Director Long-Term Incentive Plan and the Debentures. The Debentures were called for redemption by the Company in December 2004, and redeemed as of January 18, 2005.
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED(in thousands, unless otherwise indicated)(unaudited)
The computation of basic and diluted earnings per common share (using the if-converted method) was as follows (in thousands, except per share data):
Net income available to common stockholders – basic
Add: Interest expense associated with the Debentures, net of related tax effects
82
Net income available to common stockholders – diluted
280,782
Weighted average common shares outstanding – basic
Effect of dilutive securities:
Stock options, restricted common shares and performance share units
2,573
3,957
2,606
3,884
Debentures
306
Weighted average common shares outstanding – diluted
Basic earnings per common share
Diluted earnings per common share
Stock-Based Compensation
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123, revised 2004, “Share-Based Payment” (“SFAS 123R”). SFAS 123R requires that companies recognize compensation cost relating to share-based payment transactions based on the fair value of the equity or liability instruments issued. SFAS 123R is effective for annual periods beginning after January 1, 2006. The Company adopted SFAS 123R effective January 1, 2006 using the modified prospective approach and therefore has not restated results for prior periods. Under this approach, awards that are granted, modified or settled after January 1, 2006 will be measured and accounted for in accordance with SFAS 123R. Unvested awards that were granted prior to January 1, 2006 will continue to be accounted for in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), as amended by SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment of FASB Statement No. 123” (“SFAS 148”), except that compensation cost will be recognized in the Company’s results of operations.
Pursuant to the provisions of SFAS 123R, the Company records stock-based compensation as a charge to earnings net of the estimated impact of forfeited awards. As such, the Company recognizes stock-based compensation cost only for those stock-based awards that are estimated to ultimately vest over their requisite service period, based on the vesting provisions of the individual grants. The cumulative effect on current and prior periods of a change in the estimated forfeiture rate is recognized as compensation cost in earnings in the period of the revision. Stock-based compensation expense associated with performance share units is recognized based on management’s best estimates of the achievement of the performance goals specified in such awards and the resulting number of shares that will be earned. The cumulative effect on current and prior periods of a change in the estimated number of performance share units expected to be earned is recognized as compensation cost in earnings in the period of the revision. The Company recognizes stock-based compensation expense related to the Company’s Amended Employee Stock Purchase Plan (“ESPP”) based on the 15% discount at purchase. See Note 2 for a further discussion of stock-based compensation.
Prior to the adoption of SFAS 123R, the Company accounted 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 and chose to adopt the disclosure-only provisions of SFAS 123, as amended by SFAS 148. Under this approach, the cost of restricted stock awards was expensed over their vesting period, while the imputed cost of stock option grants and discounts offered under the Company’s ESPP was disclosed, based on the vesting provisions of the individual grants, but not charged to expense. Stock-based compensation expense recorded in
6
accordance with APB 25, relating to restricted stock awards, was $0.6 million and $0.8 million for the three and six months ended June 30, 2005.
New Accounting Standard
In July 2006, the FASB issued Financial Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with SFAS No. 109 “Accounting for Income Taxes”. FIN 48 provides guidance on recognizing, measuring, presenting and disclosing in the financial statements uncertain tax positions that a company has taken or expects to take on a tax return. FIN 48 is effective for the Company as of January 1, 2007. The Company is currently assessing the impact, if any, of FIN 48 on its financial statements.
2. STOCK-BASED COMPENSATION
For the three and six months ended June 30, 2006, the stock-based compensation expense recorded in accordance with SFAS 123R totaled $20 million ($12 million, net of tax, or $0.06 per basic and diluted share) and $39 million ($24 million, net of tax, or $0.12 per basic and diluted share), respectively. In addition, in connection with the adoption of SFAS 123R, net cash provided by operating activities decreased and net cash provided by financing activities increased in the first half of 2006 by $26 million related to excess tax benefits from stock-based compensation arrangements.
Employee and Non-employee Directors Stock Ownership Programs
In 2005, the Company established the Amended and Restated Employee Long-Term Incentive Plan (the “ELTIP”). The ELTIP provides for three types of awards: (a) stock options, (b) stock appreciation rights and (c) incentive stock awards. The ELTIP 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 seven 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 seven years from date of grant. No stock appreciation rights have been granted under the ELTIP. Under the incentive stock provisions of the plan, the ELTIP 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 generally earned on achievement of financial performance goals and are subject to forfeiture if employment terminates prior to the end of the prescribed vesting period, as determined by the Board of Directors. The actual amount of performance share awards is based on the Company’s earnings per share growth for the performance period compared to that of a peer group of companies. Key executive, managerial and technical employees are eligible to participate in the ELTIP. The maximum number of shares of Quest Diagnostics common stock that may be optioned or granted under the ELTIP is 48 million shares.
In 2005, the Company established the Amended and Restated Director Long-Term Incentive Plan (the “DLTIP”). The DLTIP 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 the fair market value on the date of grant and incentive stock awards. The incentive stock awards are generally earned on achievement of certain performance goals. The maximum number of shares that may be issued under the DLTIP is 2 million shares. The stock options expire seven years from date of grant and generally become exercisable in three equal annual installments beginning on the first anniversary date of the grant of the option regardless of whether the optionee remains a director of the Company.
Employee Stock Purchase Plan
The Company’s ESPP, which replaces the Company’s prior plan, was approved by the Company’s shareholders at the 2006 Annual Meeting of Shareholders. Under the Company’s ESPP, substantially all employees can elect to have up to 10% of their annual wages withheld to purchase Quest Diagnostics common stock at 85% of the market price of the
7
Company’s common stock on the last business day of each calendar month. Under the ESPP, the maximum number of shares of Quest Diagnostics common stock which may be purchased by eligible employees, is 5 million.
In general, the Company’s practice has been to issue shares related to its stock-based compensation program from shares of its common stock held in treasury. See Note 7 for further information regarding the Company’s share repurchase program.
The fair value of stock option awards is estimated on the date of grant using a lattice-based option-valuation model that uses the assumptions in the following table. The expected volatility under the lattice-based option-valuation model was based on the current and the historical implied volatilities from traded options of the Company’s stock. The dividend yield was based on the approved annual dividend rate in effect and current market price of the underlying common stock at the time of grant. The risk-free interest rate was based on the U.S. Treasury yield curve in effect at the time of grant for bonds with maturities ranging from one month to seven years. The expected life of the options granted was estimated using the historical exercise behavior of employees.
Weighted average fair value of options at grant date
$16.56
$14.89
$13.88
$14.18
Expected volatility
20.8%
22.4%
18.1%
23.0%
Dividend yield
0.7%
Risk-free interest rate
5.0%
3.9% - 4.0%
4.6%
Expected holding period, in years
5.9 – 6.3
5.4 – 6.2
5.6 – 6.2
The fair value of restricted stock awards and performance share units is the average market price of the Company’s common stock at the date of grant.
Transactions under stock option plans as of June 30, 2006 and changes during the six months ended June 30, 2006 were as follows:
Shares(in thousands)
WeightedAverageExercisePrice
WeightedAverageRemainingContractualTerm(in years)
AggregateIntrinsicValue(in millions)
Options outstanding at December 31, 2005
15,048
34.33
Options granted
2,462
52.48
Options exercised
(2,902
26.14
Options terminated
(188
47.00
Options outstanding at June 30, 2006
14,420
38.90
6.3
303
Vested and expected to vest at June 30, 2006
14,105
38.64
300
Exercisable at June 30, 2006
9,045
33.08
6.1
243
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company’s closing common stock price on the last trading day of the second quarter of 2006 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on June 30, 2006. This amount changes based on the fair market value of the Company’s common stock. Total intrinsic value of options exercised for the three and six months ended June 30, 2006 was $46 million and $82 million, respectively. Total intrinsic value of options exercised for the three and six months ended June 30, 2005 was $28 million and $63 million, respectively.
8
As of June 30, 2006, there was $35 million of unrecognized stock-based compensation cost related to stock options which is expected to be recognized over a weighted average period of 2.1 years.
Incentive stock awards, including restricted stock awards and performance share units, as of June 30, 2006 and changes during the six months ended June 30, 2006 were as follows:
WeightedAverageGrant DateFair Value
Nonvested incentive shares at December 31, 2005
107
49.71
Incentive shares granted
980
52.27
Incentive shares vested
(31
50.03
Incentive shares forfeited and canceled
(28
51.75
Nonvested incentive shares at June 30, 2006
1,028
52.08
As of June 30, 2006, there was $36 million of unrecognized stock-based compensation cost related to nonvested incentive stock awards which is expected to be recognized over a weighted average period of 2.2 years. Total fair value of shares vested was $0.4 million and $1.7 million for the three and six months ended June 30, 2006. Total fair value of shares vested for the three and six months ended June 30, 2005 was not material.
For the three and six months ended June 30, 2006, stock-based compensation expense totaled $20 million and $39 million, respectively. For the three and six months ended June 30, 2005, stock-based compensation expense totaled $0.6 million and $0.8 million, respectively. Income tax benefits related to stock-based compensation expense totaled $8.0 million and $15.7 million for the three and six months ended June 30, 2006, respectively. Income tax benefits related to stock-based compensation expense totaled $0.2 million and $0.3 million for the three and six months ended June 30, 2005, respectively.
The following pro forma information is presented for comparative purposes and illustrates the pro forma effect on net income and earnings per share for the periods presented, as if the Company had elected to recognize compensation cost associated with stock option awards and employee stock purchases under the Company’s ESPP, consistent with the method prescribed by SFAS 123, as amended by SFAS 148 (in thousands, except per share data):
Three Months EndedJune 30, 2005
Six Months EndedJune 30, 2005
Net income:
Net income, as reported
Add: Stock-based compensation under APB 25
600
Deduct: Total stock-based compensation expense determined under fair value method for all awards, net of related tax effects
(8,596
(19,189
Pro forma net income
141,093
262,301
Basic – as reported
Basic – pro forma
0.70
1.30
Diluted – as reported
Diluted – pro forma
0.68
1.27
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3. BUSINESS ACQUISITION
Acquisition of LabOne, Inc.
On November 1, 2005, the Company completed its acquisition of LabOne, Inc. (“LabOne”) in a transaction valued at approximately $947 million, including approximately $138 million of assumed debt of LabOne. LabOne provides health screening and risk assessment services to life insurance companies, as well as clinical diagnostic testing services to healthcare providers and drugs-of-abuse testing to employers.
Through the acquisition of LabOne, the Company acquired all of LabOne’s operations, including its health screening and risk assessment services for life insurance companies, its clinical diagnostic testing services, and its drugs-of-abuse testing for employers. LabOne had 3,100 employees and principal laboratories in Lenexa, Kansas, as well as in Cincinnati, Ohio.
The acquisition of LabOne was accounted for under the purchase method of accounting. As such, the cost to acquire LabOne was allocated to the respective assets and liabilities acquired based on their estimated fair values as of the closing date. A preliminary allocation of the costs to acquire LabOne has been made to certain assets and liabilities of LabOne based on preliminary estimates. The Company is continuing to assess the estimated fair values of the assets and liabilities acquired and the portion of goodwill allocable to its clinical laboratory testing business and its risk assessment business. The Company’s management expects to complete the purchase price allocation and the allocation of goodwill to its clinical laboratory testing business and its risk assessment business during the third quarter of 2006. The consolidated financial statements include the results of operations of LabOne subsequent to the closing of the acquisition.
Pro Forma Combined Financial Information
The following unaudited pro forma combined financial information for the three and six months ended June 30, 2005 assumes that the LabOne acquisition was completed on January 1, 2005 (in thousands, except per share data):
Three Months Ended
Six Months Ended
June 30, 2005
1,509,032
2,957,118
150,109
282,089
Basic earnings per common share:
Weighted average common shares outstanding – basic diluted
Diluted earnings per common share:
0.73
1.37
The unaudited pro forma combined financial information presented above reflects certain reclassifications to the historical financial statements of LabOne to conform LabOne’s accounting policies and classification of certain costs and expenses to that of Quest Diagnostics. These adjustments had no impact on pro forma net income. Pro forma results for the three and six months ended June 30, 2005 exclude $0.2 million and $0.6 million, respectively, of transaction related costs, which were incurred and expensed by LabOne in conjunction with its acquisition by Quest Diagnostics.
4. INTEGRATION ACTIVITIES
During the first quarter of 2006, the Company finalized its plan related to the integration of LabOne. The plan focuses on rationalizing the Company’s testing capacity, infrastructure and support services in markets, which are served by both LabOne and Quest Diagnostics.
10
In conjunction with finalizing the LabOne integration, the Company recorded $23 million of costs during the first quarter of 2006. The majority of these costs relate to employee severance. Employee groups affected as a result of this plan included those involved in the testing of specimens, as well as administrative and other support functions. Of the total costs indicated above, $21 million related to actions that impact Quest Diagnostics’ employees and its operations and were comprised principally of employee severance benefits for approximately 600 employees. These costs were accounted for as a charge to earnings and included in “other operating expenses, net” within the consolidated statements of operations.
In addition, $2.6 million of integration costs, related to actions that impact the employees and operations of LabOne, were accounted for as a cost of the LabOne acquisition and included in goodwill during the first quarter of 2006. Of the $2.6 million, $1.2 million related to asset write-offs with the remainder primarily associated with employee severance benefits for approximately 95 employees.
While the majority of the accrued integration costs at June 30, 2006 of $21 million are expected to be paid in the remainder of 2006 and 2007, there are certain severance costs that have payment terms extending into 2008.
In addition, during the first quarter of 2006, the Company recorded a $4.1 million charge related to consolidating its operations in California into a new facility. The costs, comprised primarily of employee severance costs and the write-off of certain operating assets, were accounted for as a charge to earnings and included in “other operating expenses, net” within the consolidated statements of operations.
5. GOODWILL AND INTANGIBLE ASSETS
Goodwill at June 30, 2006 and December 31, 2005 consisted of the following:
June 30,
December 31,
Goodwill
3,381,841
3,385,280
Less: accumulated amortization
(181,192
(188,053
The changes in the gross carrying amount of goodwill for the six-month period ended June 30, 2006 and for the year ended December 31, 2005 are as follows:
December 31, 2005
Balance at beginning of period
2,695,003
Goodwill acquired during the period
3,422
697,766
Other
(6,861
(7,489
Balance at end of period
For the year ended December 31, 2005, the increase in goodwill was primarily related to the acquisition of LabOne. During the fourth quarter of 2005, the Company recorded a $7.5 million charge, which was included in “other operating expense, net” in the consolidated statement of operations, to write off all of the goodwill associated with its test kit manufacturing subsidiary, NID. In connection with the Company’s decision to discontinue the operations of NID in the second quarter of 2006, the Company eliminated the goodwill and related accumulated amortization associated with NID, which had no impact on goodwill, net.
11
Intangible assets at June 30, 2006 and December 31, 2005 consisted of the following:
Weighted Average Amortization Period
June 30, 2006
Cost
Accumulated Amortization
Net
Amortizing intangible assets:
Customer-related intangibles
20 years
172,522
(43,014
129,508
(39,297
133,225
Non-compete agreements
5 years
45,732
(44,766
966
45,707
(44,221
1,486
4 years
5,027
(4,102
925
7,044
(3,772
3,272
Total
223,281
(91,882
131,399
225,273
(87,290
137,983
Amortization expense related to intangible assets was $2.3 million and $0.9 million for the three months ended June 30, 2006 and 2005, respectively. For the six months ended June 30, 2006 and 2005, amortization expense related to intangible assets was $4.6 million and $1.9 million respectively.
The estimated amortization expense related to intangible assets for each of the five succeeding fiscal years and thereafter as of June 30, 2006 is as follows:
Fiscal Year Ending
Remainder of 2006
4,455
2007
7,710
2008
7,516
2009
7,102
2010
6,854
2011
6,819
Thereafter
90,943
Intangible assets not subject to amortization at both June 30, 2006 and December 31, 2005 consisted of $9.4 million of tradenames.
6. COMMITMENTS AND CONTINGENCIES
In support of its risk management program, the Company has standby letters of credit issued under its letter of credit lines to ensure its performance or payment to third parties, which amounted to $69 million at June 30, 2006. The letters of credit, which are renewed annually, primarily represent collateral for current and future automobile liability and workers’ compensation loss payments.
The Company is subject to contingent obligations under certain leases and other instruments incurred in connection with real estate activities and other operations associated with LabOne and certain of its predecessor companies. The contingent obligations arise out of certain land leases with two Hawaiian trusts relating to land in Waikiki upon which a hotel is built and a land lease for a parking garage in Reno, Nevada. While its title and interest to the subject leases have been transferred to third parties, the land owners have not released the original obligors, including predecessors of LabOne, from their obligations under the leases. In February 2006, Chapter 11 bankruptcy proceedings involving the subtenant of the hotel
12
in Waikiki were commenced in Honolulu. The subtenant has indicated publicly that the filing will have no impact on the operations of the hotel and therefore, the Company believes the subtenant will continue to pay the rent and real estate taxes on the subject leased property. The bankruptcy court has issued an order allowing the subtenant to pay operating expenses, including the rent and real estate taxes on the subject leased property. Should the current subtenants of the leased properties fail to pay their rent and real estate taxes for the subject leased property, the default could trigger liability for LabOne as well as other sublessors. The rent payments under the Hawaiian land leases are subject to market value adjustments every ten years beginning in 2007. Given that the Hawaiian land leases are subject to market value adjustments, the total contingent obligations under such leases cannot be precisely estimated, but are likely to total several hundred million dollars. The contingent obligation of the Nevada lease is estimated to be approximately $6 million. The Company believes that the leasehold improvements on the leased properties are significantly more valuable than the related lease obligations. Based on the circumstances above, no liability has been recorded for any potential contingent obligations related to the land leases.
The Company has entered into several settlement agreements with various government and private payers during recent years relating to industry-wide billing and marketing practices that had been substantially discontinued by the mid-1990s. Many aspects of our business are subject to complex federal, state and local regulations, and federal or state governments may bring additional claims based on new theories as to the Company’s practices which management believes to be in compliance with law. In addition, certain federal and state statutes, including the qui tam provisions of the federal False Claims Act, allow private individuals to bring lawsuits against healthcare companies on behalf of government or private payers alleging inappropriate billing practices.
The Company is aware of certain pending lawsuits related to billing practices filed under the qui tam provisions of the False Claims Act and other federal and state statutes. These lawsuits include class action and individual claims by patients arising out of the Company’s billing practices. The Company also receives subpoenas and other inquiries from federal, state and local governments regarding the Company’s billing and other practices and operations. In addition, 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.
During the fourth quarter of 2004, the Company and NID each received a subpoena from the United States Attorney’s Office for the Eastern District of New York. The subpoenas request a wide range of business records, including documents regarding testing and test kits related to parathyroid hormone (“PTH”) testing. The Company and NID have been cooperating with the United States Attorney’s Office. In connection with such cooperation, the Company has been providing information and producing various witnesses and business records of NID and the Company, including documents related to testing and various test kits manufactured by NID. Many of these documents relate to tests other than PTH tests, and were not requested in the initial subpoenas. The government may issue additional subpoenas in the course of its investigation. This investigation by the United States Attorney’s Office could lead to civil and criminal damages, fines and penalties and additional liabilities from third party claims. In the second and third quarters of 2005, the U.S. Food and Drug Administration (“FDA”) conducted an inspection of NID and issued a Form 483 listing the observations made by the FDA during the course of the inspection. NID is cooperating with the FDA and has filed its responses to the Form 483. Noncompliance with the FDA regulatory requirements or failure to take adequate and timely corrective action could lead to regulatory or enforcement action against NID and/or the Company, including, but not limited to, a warning letter, injunction, suspension of production and/or distribution, seizure or recall of products, fines or penalties, denial of pre-market clearance for new or changed products, recommendation against award of government contracts and criminal prosecution. On April 19, 2006, the Company decided to discontinue the operations of NID. See Note 9 for further details.
During the second quarter of 2005, the Company received a subpoena from the United States Attorney’s Office for the District of New Jersey. The subpoena seeks the production of business and financial records regarding capitation and risk sharing arrangements with government and private payers for the years 1993 through 1999. Also, during the third quarter of 2005, the Company received a subpoena from the U.S. Department of Health and Human Services, Office of the Inspector General. The subpoena seeks the production of various business records including records regarding our relationship with health maintenance organizations, independent physician associations, group purchasing organizations, and preferred provider organizations from 1995 to the present. The Company is cooperating with the United States Attorney’s Office and the Office of the Inspector General.
During the second quarter of 2006, the Company received a subpoena from the California Attorney General’s Office. The subpoena seeks various documents including documents relating to billings to MediCal, the California Medicaid program. The subpoena seeks documents from various time frames ranging from three to ten years. The Company is cooperating with the California Attorney General’s Office.
13
Management has established reserves in accordance with generally accepted accounting principles for the matters discussed above, where appropriate. Although management cannot predict the outcome of such matters, management does not anticipate that the ultimate outcome of such matters will have a material adverse effect on the Company’s financial condition but may be material to the Company’s results of operations or cash flows in the period in which the impact of such matters is determined or paid. However, the Company understands that there may be pending qui tam claims brought by former employees or other “whistle blowers”, or other pending claims as to which the Company has not been provided with a copy of the complaint and accordingly cannot determine the extent of any potential liability.
As a general matter, providers of clinical laboratory testing services may be subject to lawsuits alleging negligence or other similar legal claims. These suits could involve claims for substantial damages. Any professional liability litigation could also have an adverse impact on the Company’s client base and reputation. The Company maintains various liability insurance coverage for claims that could result from providing or failing to provide clinical laboratory testing services, including inaccurate testing results and other exposures. The Company’s insurance coverage limits its maximum exposure on individual claims; however, the Company is essentially self-insured for a significant portion of these claims. The basis for claims reserves considers actuarially determined losses based upon the Company’s historical and projected loss experience. Management believes that present insurance coverage and reserves are sufficient to cover currently estimated exposures. Although management cannot predict the outcome of any claims made against the Company, management does not anticipate that the ultimate outcome of any such proceedings or claims will have a material adverse effect on the Company’s financial condition but may be material to the Company’s results of operations or cash flows in the period in which the impact of such claims is determined or paid.
7. STOCKHOLDERS’ EQUITY
Changes in stockholders’ equity for the six months ended June 30, 2006 were as follows:
Shares of Common Stock Outstanding
Common Stock
AdditionalPaid-In Capital
Retained Earnings
Unearned Compen-sation
AccumulatedOtherCompre-hensive Income (loss)
Treasury Stock, at Cost
Compre-hensive Income
Balance,December 31, 2005
198,455
Other comprehensive income
5,038
Comprehensive income
281,651
Dividends declared
(39,656
Reclassification upon adoption of SFAS123R
3,321
Issuance of common stock under benefit plans
380
(2,909
14,912
2,853
(58,982
132,285
Shares to cover employee payroll tax withholdings on stock issued under benefit plans
(10
(524
27,725
(4,607
Balance, June 30, 2006
197,071
For the three months ended June 30, 2006, total comprehensive income was $135 million.
For the three months ended June 30, 2006, the Company repurchased 2.6 million shares of its common stock at an average price of $57.49 per share for $150 million. For the six months ended June 30, 2006, the Company repurchased 4.6 million shares of its common stock at an average price of $55.13 per share for $254 million. For the three and six months
14
ended June 30, 2006, the Company reissued 1.5 million and 3.2 million shares, respectively, for employee benefit plans. Since the inception of the share repurchase program in May 2003 through June 30, 2006, the Company has repurchased 37.0 million shares of its common stock at an average price of $44.16 for approximately $1.6 billion. At June 30, 2006, $468 million of the share repurchase authorizations remained available.
During each of the quarters of 2006 and 2005, the Company’s Board of Directors has declared a quarterly cash dividend of $0.10 and $0.09 per common share, respectively.
Changes in stockholders’ equity for the six months ended June 30, 2005 were as follows:
Unearned Compensation
AccumulatedOther Compre-hensive Income
Balance,December 31, 2004
196,220
1,068
2,195,346
818,734
(11
3,866
(730,352
Other comprehensive loss
(3,182
277,518
Adjustment for 2-for-1 stock split
(1,068
(36,477
288
3,237
(3,928
8,808
2,508
(42,641
106,804
(5
Conversion of contingent convertible debentures
5,632
12,510
237,136
Amortization of unearned compensation
(1,816
Balance, June 30, 2005
202,832
2,136
2,187,299
1,062,957
(3,149
684
(469,592
For the three months ended June 30, 2005, total comprehensive loss was $149 million.
For the three months ended June 30, 2005, the Company repurchased approximately 0.6 million shares of its common stock at an average price of $53.03 per share for $30 million. For the six months ended June 30, 2005, the Company repurchased approximately 1.8 million shares of its common stock at an average price of $50.64 per share for $92 million. For the three and six months ended June 30, 2005, the Company reissued approximately 1.2 million and 2.7 million shares, respectively, for employee benefit plans. For the six months ended June 30, 2005, the Company reissued approximately 5.6 million shares in connection with the conversion of its Debentures.
15
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (in thousands, unless otherwise indicated) (unaudited)
8. SUPPLEMENTAL CASH FLOW & OTHER DATA
Depreciation expense
47,303
42,071
94,025
83,667
Interest expense
(24,268
(13,359
(48,755
(26,376
Interest income
1,606
719
2,569
953
Interest paid
25,641
2,974
47,537
24,975
Income taxes paid
174,260
142,581
182,873
148,977
Non-cash financing activities:
Conversion of Debentures
244,338
For the three and six months ended June 30, 2006, “other income (expense), net” included a $12.3 million charge associated with the write-down of an investment. “Other income (expense), net” for the six months ended June 30, 2006 also included a $16 million gain on the sale of an investment in the first quarter of 2006.
9. NID
During the fourth quarter of 2005, NID, the Company’s test kit manufacturing subsidiary, instituted its second voluntary product hold within a six-month period, due to quality issues, which has adversely impacted the operating performance of NID. As a result, the Company evaluated a number of strategic options for NID. On April 19, 2006, the Company decided to discontinue NID’s operations and is in the process of winding down NID’s operations. The decision to discontinue NID’s operations is currently expected to result in pre-tax charges totaling between $33 million and $38 million. Of these charges, $28 million was recorded in the second quarter of 2006 and the balance will be recorded principally in the third quarter of 2006. The $28 million charge included $7.4 million related to the write-off of inventories, which was recorded in “cost of services”. The remaining charge of $21 million recorded in the second quarter of 2006 was included in “other operating expense, net” and was comprised of asset impairment charges of $4.6 million, employee termination benefits of $5.3 million, contract termination costs of $6.0 million and $5.0 million of costs to support activities to wind down the business, principally comprised of employee costs and professional fees. The costs accrued are expected to be paid principally in 2006 and 2007.
The ongoing government investigation and regulatory review of NID continue (see Note 6). While management does not believe that these matters will have a material adverse impact on the Company’s overall financial condition, their final resolution could be material to the Company’s results of operations or cash flows in the period in which the impact of such matters is determined or paid.
The table below indicates the major classes of NID’s assets and liabilities as of June 30, 2006 (amounts in thousands):
Cash
1,245
Inventory
85
2,223
749
4,513
18,525
Net assets
(14,012
16
10. BUSINESS SEGMENT INFORMATION
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 anatomic pathology testing. Clinical testing is performed on body fluids, such as blood and urine. Anatomic pathology testing is performed on tissues, including biopsies, and other samples, such as human cells. Customers of the clinical laboratory testing business include patients, physicians, hospitals, employers, governmental institutions and other commercial clinical laboratories.
All other operating segments include the Company’s non-clinical laboratory testing businesses and consist of its risk assessment services business, its clinical trials testing business, its healthcare information technology business, MedPlus and its test kit manufacturing subsidiary, NID. The Company’s risk assessment business, acquired as part of the LabOne acquisition in 2005 (see Note 3), provides underwriting support services to the life insurance industry including teleunderwriting, specimen collection and paramedical examinations, laboratory testing, medical record retrieval, motor vehicle reports, telephone inspections and credit checks. The Company’s clinical trials testing business provides clinical laboratory testing performed in connection with clinical research trials on new drugs. MedPlus is a developer and integrator of clinical connectivity and data management solutions for healthcare organizations, physicians and clinicians. NID manufactures and markets diagnostic test kits and systems. On April 19, 2006, the Company decided to discontinue NID’s operations (see Note 9 for further details).
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.
The following table is a summary of segment information for the three and six months ended June 30, 2006 and 2005. Segment asset information is not presented since it is not reported to or used by the chief operating decision maker at the operating segment level. Operating earnings (loss) of each segment represents net revenues less directly identifiable expenses to arrive at operating income for the segment. General management and administrative corporate expenses, including amortization of intangible assets, are included in general corporate expenses below. The accounting policies of the segments are the same as those of the Company as set forth in Note 2 to the Consolidated Financial Statement contained in the Company’s 2005 Annual Report on Form 10-K and Note 1 to the interim consolidated financial statements.
Net revenues:
Clinical laboratory testing business
1,460,983
1,324,277
2,898,469
2,591,830
All other operating segments
123,352
53,252
241,274
105,184
Total net revenues
Operating earnings (loss):
323,249
(a)
284,984
607,809
(a) (b)
532,987
(27,719
) (c)
(3,800
(39,058
(2,318
General corporate expenses
(32,905
) (d)
(20,031
(61,585
(39,603
Total operating income
Non-operating expenses, net
Income before income taxes
During 2006, $11 million and $24 million of stock-based compensation expense was recorded which reduced operating income for the three and six months ended June 30, 2006, respectively.
(b)
During the six months ended June 30, 2006, operating income included $27 million of special charges, primarily associated with integration activities (See Note 4).
17
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (in thousands, unless otherwise indicated)(unaudited)
(c)
During 2006, $1.2 million and $2.1 million of stock-based compensation expense was recorded which reduced operating income for the three and six months ended June 30, 2006, respectively. In addition, NID’s performance reduced operating income for the three and six months ended June 30, 2006 by $35 million and $49 million, respectively, and included $28 million of pretax charges recorded in the second quarter of 2006 related to the wind-down of NID’s operations.
(d)
During 2006, $7.9 million and $14 million of stock-based compensation expense was recorded which reduced operating income for the three and six months ended June 30, 2006, respectively.
11. SUBSEQUENT EVENTS
Acquisition of Focus Diagnostics, Inc.
On July 5, 2006, the Company completed its previously announced acquisition of Focus Diagnostics, Inc. (“Focus”) in an all-cash transaction valued at $206 million including approximately $3 million of assumed debt of Focus. Focus is a leading provider of infectious and immunologic diseases testing and develops and markets diagnostic products. Focus offers its reference testing services to large academic medical centers, hospitals and commercial laboratories. The Company financed the acquisition and related transaction costs together with the repayment of substantially all of Focus’s debt outstanding with $135 million of borrowings under its secured receivables credit facility and with cash on hand. The acquisition will be accounted for under the purchase method of accounting.
Repayment of Senior Notes
The Company’s 6¾% senior notes due 2006, which have an aggregate principal amount of $275 million outstanding at June 30, 2006, matured in July 2006. On July 12, 2006, the Company repaid the $275 million outstanding under the 6¾% senior notes due 2006 with $165 million of borrowings under its secured receivables credit facility, $75 million of borrowings under its senior unsecured revolving credit facility and cash on hand.
12. SUMMARIZED FINANCIAL INFORMATION
The Company’s 5.125% senior notes due 2010, 5.45% senior notes due 2015, 6¾% senior notes due 2006, 7½% senior notes due 2011 and the Debentures are fully and unconditionally guaranteed by 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 subsidiaries and less than wholly owned subsidiaries. In January 2005, the Company completed its redemption of all of its outstanding Debentures (see Note 10 to the Consolidated Financial Statements included in the Company’s 2005 Annual Report on Form 10-K for further details). In July 2006, the Company repaid at maturity the $275 million outstanding under its 6¾% senior notes due 2006.
In conjunction with the Company’s secured receivables credit facility, the Company maintains a wholly owned non-guarantor subsidiary, Quest Diagnostics Receivables Incorporated (“QDRI”). The Company and Subsidiary Guarantors, with the exception of LabOne, which was acquired by Quest Diagnostics on November 1, 2005 (see Note 3), transfer all private domestic receivables to QDRI. QDRI utilizes the transferred receivables to collateralize borrowings under the Company’s secured receivables credit facility. The Company and the Subsidiary Guarantors provide collection services to QDRI. QDRI uses cash collections principally to purchase new receivables from the Company and the Subsidiary Guarantors.
The following condensed consolidating financial data illustrates the composition of the combined guarantors. Investments in subsidiaries are accounted for by the parent using the equity method for purposes of the supplemental consolidating presentation. Earnings (losses) of subsidiaries are therefore reflected in the parent’s investment accounts and earnings. The principal elimination entries relate to investments in subsidiaries and intercompany balances and transactions. LabOne has been included in the accompanying condensed consolidating financial data, subsequent to the closing of the acquisition, as a Subsidiary Guarantor.
18
Condensed Consolidating Statement of OperationsThree Months Ended June 30, 2006
Parent
SubsidiaryGuarantors
Non-GuarantorSubsidiaries
Eliminations
Consolidated
242,810
1,254,517
180,838
(93,830
126,360
747,499
62,573
40,045
265,258
63,553
(5,517
363
1,894
Royalty (income) expense
(98,068
98,068
Other operating expense (income), net
(1,359
13,017
8,024
67,341
1,125,736
134,150
175,469
128,781
46,688
(88,313
(48,096
(74,007
(776
88,313
127,373
54,774
45,912
51,993
21,909
22,180
Income before equity earnings
75,380
32,865
23,732
Equity earnings from subsidiaries
56,597
(56,597
Condensed Consolidating Statement of OperationsThree Months Ended June 30, 2005
224,352
1,086,547
132,474
(65,844
122,143
630,079
46,456
24,495
227,745
68,702
(5,268
457
467
(89,446
89,446
1,088
(2
58,737
947,735
115,172
165,615
138,812
17,302
(60,576
(15,519
(56,084
(789
60,576
150,096
82,728
16,513
60,324
33,091
6,833
89,772
49,637
9,680
59,317
(59,317
19
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (in thousands, unless otherwise indicated) (unaudited)
Condensed Consolidating Statement of OperationsSix Months Ended June 30, 2006
473,816
2,499,390
346,967
(180,430
254,504
1,483,221
121,691
74,163
524,666
133,685
(10,985
791
3,804
(193,101
193,101
590
37,857
8,590
136,947
2,242,649
263,966
336,869
256,741
83,001
(169,445
Non-operating (expenses) income, net
(65,248
(142,755
512
169,445
271,621
113,986
83,513
108,548
45,594
38,365
163,073
68,392
45,148
113,540
(113,540
Condensed Consolidating Statement of OperationsSix Months Ended June 30, 2005
431,646
2,133,730
260,093
(128,455
241,625
1,244,626
92,509
46,297
453,199
134,803
(10,277
910
936
(175,231
175,231
214
114,689
1,873,992
227,544
316,957
259,738
32,549
(118,178
(29,063
(110,661
(97
118,178
287,894
149,077
32,452
115,474
59,630
13,619
172,420
89,447
18,833
108,280
(108,280
20
Condensed Consolidating Balance Sheet June 30, 2006
136,042
8,296
6,341
Accounts receivable, net
21,028
167,091
612,160
Other current assets
62,462
117,405
88,486
268,353
219,532
292,792
706,987
197,497
518,248
26,285
Goodwill and intangible assets, net
153,701
3,142,153
3,341,448
Intercompany receivable (payable)
410,836
62,719
(473,555
Investment in subsidiaries
3,305,225
(3,305,225
114,473
7,181
41,048
(17,897
4,401,264
4,023,093
346,359
(3,323,122
476,124
293,618
44,833
35,326
255,628
981
511,450
549,246
45,814
933,111
306,523
979
53,703
134,999
26,666
Stockholders’ equity
3,032,325
272,900
Condensed Consolidating Balance Sheet December 31, 2005
76,941
4,759
10,430
31,611
152,314
548,982
43,932
116,099
84,429
244,460
152,484
273,172
643,841
200,438
523,907
29,318
156,314
3,142,702
3,344,610
418,892
(14,091
(404,801
3,199,319
(3,199,319
94,050
7,754
37,784
(1,243
4,221,497
3,933,444
351,736
(3,200,562
433,310
293,705
37,438
35,306
240,553
60,980
468,616
534,258
98,418
932,950
321,458
978
56,947
107,121
23,628
2,970,607
228,712
21
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED(in thousands, unless otherwise indicated) (unaudited)
Condensed Consolidating Statement of Cash FlowsSix Months Ended June 30, 2006
Non-Guarantor Subsidiaries
23,094
69,751
5,775
3,059
27,943
92,771
45,141
7,920
(155,492
14,440
10,675
(16,837
Changes in operating assets and liabilities
191,575
(189,600
(126,094
(124,119
338,849
36,067
36,195
(72,550
(56,102
(4,687
57,645
Net cash provided by (used in) financing activities
(207,198
23,572
(35,597
(57,645
59,101
3,537
(4,089
Condensed Consolidating Statement of Cash FlowsSix Months Ended June 30, 2005
26,426
53,946
5,159
2,690
19,788
96,788
(89,198
(1,883
2,022
19,221
21,573
(48,657
(107,125
(134,209
242,191
112,641
15,677
Net cash provided by (used in) investing activities
56,692
(101,450
(10,647
(111,452
(161,434
(13,828
(9,037
111,452
137,449
(2,637
(4,007
56,424
6,058
10,820
193,873
3,421
6,813
22
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Critical Accounting Policies
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions and select accounting policies that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
While many operational aspects of our business are subject to complex federal, state and local regulations, the accounting for it is generally straightforward with net revenues primarily recognized upon completion of the testing process. Our revenues are primarily comprised of a high volume of relatively low dollar transactions, and about one-half of total operating 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. Our critical accounting policies are detailed in our Annual Report on Form 10-K for the year ended December 31, 2005. As of June 30, 2006, our critical accounting policies have not changed from December 31, 2005, except for the Company’s accounting for stock-based compensation in connection with the adoption of Statement of Financial Accounting Standards (“SFAS”) No. 123, revised 2004, “Share-Based Payment” (“SFAS 123R”).
Stock-Based Compensation Expense
Effective January 1, 2006, we adopted SFAS 123R using the modified prospective approach and therefore have not restated results for prior periods. Under this approach, awards that are granted, modified or settled after January 1, 2006 will be measured and accounted for in accordance with SFAS 123R. Unvested awards that were granted prior to January 1, 2006 will continue to be accounted for in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), as amended by SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment of FASB Statement No. 123” (“SFAS 148”), except that compensation cost will be recognized in our results of operations. Pursuant to the provisions of SFAS 123R, we record stock-based compensation as a charge to earnings net of the estimated impact of forfeited awards. As such, we recognize stock-based compensation cost only for those stock-based awards that are estimated to ultimately vest over their requisite service period, based on the vesting provisions of the individual grants.
Prior to the adoption of SFAS 123R, the Company accounted 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 and chose to adopt the disclosure-only provisions of SFAS 123, as amended by SFAS 148. Under this approach, the cost of restricted stock awards was expensed over their vesting period, while the imputed cost of stock option grants and discounts offered under the Company’s Employee Stock Purchase Plan was disclosed, based on the vesting provisions of the individual grants, but not charged to expense.
The process of estimating the fair value of stock-based compensation awards and recognizing stock-based compensation cost over their requisite service period involves significant assumptions and judgments. We estimate the fair value of stock option awards on the date of grant using a lattice-based option-valuation model which requires management to make certain assumptions regarding: (i) the expected volatility in the market price of the Company’s common stock; (ii) dividend yield; (iii) risk-free interest rates; and (iv) the period of time employees are expected to hold the award prior to exercise (referred to as the expected holding period). The expected volatility under the lattice-based option-valuation model is based on the current and the historical implied volatilities from traded options of our stock. The dividend yield is based on the approved annual dividend rate in effect and current market price of the underlying common stock at the time of grant. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for bonds with maturities ranging from one month to seven years. The expected life of the awards granted is estimated using the historical exercise behavior of employees. In addition, SFAS 123R requires us to estimate the expected impact of forfeited awards and recognize stock-based compensation cost only for those awards expected to vest. If actual forfeiture rates are materially different from our estimates, stock-based compensation expense could be significantly different from what we have recorded in the current period. We periodically review actual forfeiture experience and revise our estimates, as considered necessary. The cumulative effect on current and prior periods of a change in the estimated forfeiture rate is recognized as compensation cost in earnings in the period of the revision. Finally, the terms of our performance share unit grants allow the recipients of such awards to earn a variable number of shares based on the achievement of the performance goals specified in the awards. The actual amount of any stock award is based on the Company’s earnings per share growth for the performance period compared to that of a peer group of companies. Stock-based compensation expense associated with performance share units is recognized based on management’s best estimates of the achievement of the performance goals specified in such awards
and the resulting number of shares that will be earned. If the actual number of performance share units earned is different from our estimates, stock-based compensation could be significantly different from what we have recorded in the current period. We periodically obtain and review publicly available financial information for the members of the peer group and the Company, including forecasted earnings estimates. This information is used to evaluate our progress towards achieving the performance criteria and our estimate of the number of performance share units expected to be earned at the end of the performance period. The cumulative effect on current and prior periods of a change in the estimated number of performance share units expected to be earned is recognized as compensation cost in earnings in the period of the revision. While the assumptions used to calculate and account for stock-based compensation awards represent management’s best estimates, these estimates involve inherent uncertainties and the application of management’s judgment. As a result, if revisions are made to our assumptions and estimates, our stock-based compensation expense could be materially different in the future. See Notes 1 and 2 to the interim consolidated financial statements for a further discussion of stock-based compensation.
Acquisition and Integration of LabOne, Inc.
On November 1, 2005, we completed the acquisition of LabOne, Inc., or LabOne, in an all-cash transaction with a combined value of approximately $947 million, including approximately $138 million of assumed debt of LabOne. See Note 3 to the Consolidated Financial Statements contained in our 2005 Annual Report on Form 10-K and Note 3 to the interim consolidated financial statements for a discussion of the LabOne acquisition.
Through the acquisition, Quest Diagnostics acquired all of LabOne’s operations, including its health screening and risk assessment services to life insurance companies, as well as its clinical diagnostic testing services to healthcare providers and drugs-of-abuse testing to employers. LabOne had 3,100 employees and principal laboratories in Lenexa, Kansas, as well as in Cincinnati, Ohio. We financed the acquisition and related transaction costs together with the repayment of substantially all of LabOne’s debt outstanding with proceeds from a $900 million private placement of senior notes, as described in Note 10 to the Consolidated Financial Statements contained in our 2005 Annual Report on Form 10-K, and from cash on hand.
During the first quarter of 2006, we finalized our plan related to the integration of LabOne and recorded $23 million of costs, primarily comprised of employee severance benefits. Employee groups affected as a result of this plan include those involved in the testing of specimens, as well as administrative and other support functions. Of the total costs indicated above, $21 million related to actions that impact Quest Diagnostics’ employees and its operations and are comprised principally of employee severance benefits for approximately 600 employees. These costs were accounted for as a charge to earnings and included in “other operating expenses, net” within the consolidated statements of operations.
In addition, $2.6 million of integration costs, related to actions that impact the employees and operations of LabOne, were accounted for as a cost of the LabOne acquisition and included in goodwill. Of the $2.6 million, $1.2 million related to asset write-offs with the remainder primarily associated with employee severance benefits for approximately 95 employees.
While the majority of the accrued integration costs are expected to be paid in 2006 and 2007, there are certain severance costs that have payment terms extending into 2008.
Upon completion of the LabOne integration, we expect to realize approximately $40 million of annual synergies and we expect to achieve this annual rate of synergies by the end of 2007.
Results of Operations
Our clinical testing business currently represents our one reportable business segment. The clinical testing business accounts for approximately 92% and 96% of consolidated net revenues in 2006 and 2005, respectively. Our other operating segments consist of our risk assessment services business, our clinical trials testing business, our healthcare information technology business, MedPlus and our test kit manufacturing subsidiary, NID. Our business segment information is disclosed in Note 10 to the interim consolidated financial statements.
Three and Six Months Ended June 30, 2006 Compared with Three and Six Months Ended June 30, 2005
Net income for the three months ended June 30, 2006 decreased to $132 million, or $0.66 per diluted share, compared to $149 million, or $0.72 per diluted share in 2005. For the six months ended June 30, 2006, net income decreased to $277 million, or $1.38 per diluted share compared to $281 million or $1.36 per diluted share in 2005. These decreases in reported earnings are a result of NID’s performance, which has more than offset the strong performance in
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our clinical testing operations. For the three and six months ended June 30, 2006, NID’s performance reduced reported earnings by $24 million or $0.12 per share, and $34 million, or $0.17 per share, respectively, and included second quarter pre-tax charges of $28 million related to the wind-down of NID’s operations. On April 19, 2006, the Company decided to discontinue the operations of NID and is in the process of winding down NID’s operations.
Our results for the three and six months ended June 30, 2006 were favorably impacted by our clinical testing business, driven by organic revenue growth and increases in operating efficiencies resulting from our Six Sigma and standardization efforts. Results for the six months ended June 30, 2006 included pre-tax special charges of $27 million, or $0.08 per share, recorded in the first quarter primarily associated with integration activities. In addition, the year-to-date results for 2006 include pre-tax net gains of $4 million, or $0.01 per diluted share, consisting of a first quarter gain of $16 million, or $0.05 per diluted share, related to a gain on the sale of an investment partially offset by a second quarter loss of $12 million, or $0.04 per diluted share, related to the write-off of an investment. Also, results for the quarter and six months ended June 30, 2006, included pre-tax expenses of $20 million, or $0.06 per share, and $39 million, or $0.12 per share, respectively, associated with stock-based compensation recorded in accordance with SFAS 123R.
Net Revenues
Net revenues for the three and six months ended June 30, 2006 grew by 15.0% and 16.4% over the prior year levels to $1.6 billion and $3.1 billion, respectively. The acquisition of LabOne contributed about 10% to the consolidated revenue growth for each period. Approximately 55% of LabOne’s net revenues are generated from risk assessment services provided to life insurance companies, with the remainder classified as clinical laboratory testing. The performance at NID reduced consolidated revenue growth by approximately 1% for both periods.
Our clinical testing business grew 10.3% and 11.8%, respectively for the three and six months ended June 30, 2006, with the acquisition of LabOne contributing almost 5% for both periods, principally reflected in volume. For the three and six months ended June 30, 2006, clinical testing volume increased 5.7% and 7.2%, respectively, compared to the prior year periods. Average revenue per requisition improved 4.4% for both periods. The increase in revenue per requisition was principally driven by a shift to a more esoteric test mix and an increase in the number of tests ordered per requisition.
Our businesses other than clinical laboratory testing accounted for approximately 8% of our consolidated net revenues for the three and six months ended June 30, 2006. These businesses include our clinical trials testing business and our healthcare information technology business (MedPlus), whose growth rates did not significantly affect our consolidated growth rate. In addition, we consider the risk assessment business, acquired as part of the LabOne acquisition, and NID to be non-clinical laboratory testing businesses. The risk assessment business represents approximately 5% of our consolidated net revenues and is currently growing at between 2% and 3% per year. On April 19, 2006, the Company decided to discontinue NID’s operations. NID’s net revenues for the three and six months ended June 30, 2006 decreased $13 million and $25 million, respectively, from the prior year levels and reduced consolidated revenue growth for each period by approximately 1%.
Operating Costs and Expenses
Total operating costs and expenses for the three and six months ended June 30, 2006 increased $205 million and $427 million, respectively, from the prior year periods primarily due to the LabOne acquisition and, to a lesser degree, organic growth in our clinical testing volume. The increased costs were primarily in the areas of employee compensation and benefits, which included $20 million and $39 million of stock-based compensation recorded in accordance with SFAS 123R, for the three and six months ended June 30, 2006, respectively, and testing supplies. While our cost structure has been favorably impacted by efficiencies generated from our Six Sigma and standardization initiatives, we continue to make investments in sales, service, science and information technology to further differentiate our company. During the second quarter of 2006, we recorded $28 million of costs related to the wind-down of NID’s operations. The $28 million charge, which is more fully described in Note 9 to the interim consolidated financial statements, included $7.4 million related to the write-off of inventories, which was recorded in “cost of services”, with the remainder recorded in “other operating expense, net”. During the first quarter of 2006, we recorded $27 million of pre-tax charges (included in “other operating expense, net”) primarily associated with integration activities.
Cost of services, which includes the costs of obtaining, transporting and testing specimens, was 59.1% of net revenues for the three months ended June 30, 2006, increasing from 58.0% of net revenues in the prior year period. For the six months ended June 30, 2006, cost of services as a percentage of net revenues, increased to 59.2% from 58.5% in
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the prior year period. The increases over the prior year are primarily due to the addition of the LabOne business, which carries a higher cost of sales percentage than the Company average and the impact of NID’s performance. Partially offsetting these increases were improvements related to the increase in average revenue per requisition and efficiency gains resulting from our Six Sigma and standardization initiatives.
Selling, general and administrative expenses, which include the costs of the sales force, billing operations, bad debt expense and general management and administrative support, were 22.9% of net revenues for the three months ended June 30, 2006, unchanged from the prior year period. For the six months ended June 30, 2006, selling, general and administrative expenses, as a percentage of net revenues, decreased to 23.0% from 23.1% in the prior year period. Revenue growth which has allowed us to leverage our expense base, as well as continued benefits from our Six Sigma and standardization efforts have reduced these expenses as a percentage of net revenues. Also serving to reduce the percentage is the addition of the LabOne business, which carries a lower selling, general and administrative expense percentage than the Company average. For the three and six months ended June 30, 2006, bad debt expense was 3.8% and 3.9% of net revenues, respectively, compared to 4.3% and 4.4% of net revenues for the comparable prior year’s periods. The lower bad debt rate primarily related to the improved collection of diagnosis, patient and insurance information necessary to more effectively bill for services performed. We believe that our Six Sigma and standardization initiatives and the increased use of electronic ordering by our customers is driving the improvement and will provide additional opportunities to further improve our overall collection experience and cost structure. Offsetting these improvements was stock-based compensation expense recorded in accordance with SFAS 123R, which increased the selling general and administrative expense percentage by approximately 1% for both the three and six months ended June 30, 2006.
Other operating expense, net represents miscellaneous income and expense items related to operating activities, including gains and losses associated with the disposal of operating assets and provisions for restructurings and other special charges. For the three and six months ended June 30, 2006, other operating expense, net included a $21 million second quarter charge related to the wind-down of NID’s operations. For the six months ended June 30, 2006, other operating expense, net also included a first quarter charge of $27 million principally associated with integration activities related to LabOne and our operations in California, which are more fully described in Note 4 to the interim consolidated financial statements.
Operating Income
Operating income for the three months ended June 30, 2006 was $263 million, or 16.6% of net revenues, compared to $261 million, or 19.0% of net revenues, in the prior year period. For the six months ended June 30, 2006, operating income was $507 million, or 16.2% of net revenues, compared to $491 million or 18.2% of net revenues, in the prior year period. Improvements in operating income over the prior year were driven by the performance of our clinical testing business. Partially offsetting these improvements was the performance of NID which reduced operating income compared to the prior year by $30 million and $44 million for the three and six months ended June 30, 2006, respectively, and $27 million of special charges recorded in the first quarter of 2006, primarily related to integration activities. Additionally, operating income for the three and six months ended June 30, 2006 included $20 million and $39 million, respectively, of stock-based compensation expense recorded pursuant to SFAS 123R.
Operating income as a percentage of net revenues for the three and six months ended June 30, 2006 compared to the prior year’s periods was reduced by approximately 1.6% and 1.2%, respectively, due to NID’s performance, by 1.3% due to stock-based compensation expense, and by 0.8% due to the results of the LabOne business which we expect will continue to carry lower margins than the rest of our operations until we have realized most of the expected $40 million in synergies. Operating income as a percentage of net revenues for the six months ended June 30, 2006 was also reduced by approximately 0.9% due to special charges recorded in the first quarter of 2006, primarily related to integration activities. Lastly, while the timing of Easter reduced operating income as a percentage of net revenues by about 0.3% for the second quarter of 2006, it had a similar but opposite impact in the first quarter of 2006 and therefore, did not impact operating income growth for the six months ended June 30, 2006.
Other Income (Expense)
Interest expense, net for the three and six months ended June 30, 2006 increased $10 million and $21 million, respectively, over the prior year periods. The increases in interest expense, net were primarily due to additional interest expense associated with our $900 million senior notes offering in October 2005 used to fund the LabOne acquisition, as described more fully in Note 10 to the Consolidated Financial Statements contained in our 2005 Annual Report on Form 10-K.
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Other income (expense), net represents miscellaneous income and expense items related to non-operating activities such as gains and losses associated with investments and other non-operating assets. For the three and six months ended June 30, 2006 other income (expense), net includes a $12 million second quarter loss associated with the write-down of an investment. For the six months ended June 30, 2006, other income (expense), net includes a $16 million first quarter gain on the sale of an investment.
Income taxes
The increase in the effective tax rate for the three and six months ended June 30, 2006, compared to the prior year periods, was primarily due to losses generated at NID’s foreign operations, for which we do not expect to realize a tax benefit as a result of our decision to discontinue NID’s operations.
NID
During the fourth quarter of 2005, NID instituted its second voluntary product hold within a six-month period, due to quality issues, which adversely impacted the operating performance of NID. As a result, the Company evaluated a number of strategic options for NID. On April 19, 2006, the Company decided to discontinue NID’s operations and is in the process of winding down NID’s operations. The decision to discontinue NID’s operations is currently expected to result in pre-tax charges totaling between $33 million and $38 million. Of these charges, $28 million was recorded in the second quarter of 2006 and the balance will be recorded principally in the third quarter of 2006. For the three and six months ended June 30, 2006, NID’s pre-tax losses totaled $35 million and $49 million, respectively, including the second quarter wind-down charge, and reduced diluted earnings per share by $0.12 and $0.17, respectively.
The ongoing government investigation and regulatory review of NID continue. While we do not believe that these matters will have a material adverse impact on our overall financial condition, their final resolution could be material to our results of operations or cash flows in the period in which the impact of such matters is determined or paid. See Note 6 to the interim consolidated financial statements for a further description of these matters.
We address our exposure to market risks, principally the market risk of changes in interest rates, through a controlled program of risk management that may include the use of derivative financial instruments. We do not hold or issue derivative financial instruments for trading purposes. We do not believe that our foreign exchange exposure is material to our financial condition or results of operations. See Note 2 to the Consolidated Financial Statements in our 2005 Annual Report on Form 10-K for additional discussion of our financial instruments and hedging activities.
At June 30, 2006 and December 31, 2005, the fair value of our debt was estimated at approximately $1.5 billion and $1.6 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 June 30, 2006, the carrying value exceeded the estimated fair value of the debt by approximately $22 million. At December 31, 2005, the estimated fair value exceeded the carrying value of the debt by approximately $39 million. An assumed 10% increase in interest rates (representing approximately 46 and 59 basis points at June 30, 2006 and December 31, 2005, respectively) would potentially reduce the estimated fair value of our debt by approximately $37 million and $36 million at June 30, 2006 and December 31, 2005, respectively.
Borrowings under our senior unsecured revolving credit facility, our secured receivables credit facility and our term loan due December 2008, are subject to variable interest rates. Interest on our secured receivables credit facility is based on rates that are intended to approximate commercial paper rates for highly rated issuers. Interest rates on our senior unsecured revolving credit facility and term loan due December 2008 are subject to a pricing schedule that can fluctuate based on changes in our credit ratings. As such, our borrowing cost under these credit arrangements will be subject to both fluctuations in interest rates and changes in our credit ratings. As of June 30, 2006, our borrowing rate for our LIBOR-based loans was LIBOR plus 0.5%. At June 30, 2006, there was $75million outstanding under our term loan due December 2008 and no borrowings outstanding under our $500 million senior unsecured revolving credit facility or our $300 million secured receivables credit facility. Based on our net exposure to interest rate changes, an assumed 10% change in interest rates on our variable rate indebtedness (representing approximately 53 basis points) would impact annual net interest expense by approximately $0.4 million, assuming no changes to the debt outstanding at June 30, 2006. See Note 11 to the interim consolidated financial statements and Note 10 to the Consolidated Financial Statements in our 2005 Annual Report on Form 10-K for details regarding our debt outstanding.
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Liquidity and Capital Resources
Cash and Cash Equivalents
Cash and cash equivalents at June 30, 2006 totaled $151 million compared to $92 million at December 31, 2005. Cash flows from operating activities in 2006 were $411 million, which were used to fund investing and financing activities of $76 million and $277 million, respectively. Cash and cash equivalents at June 30, 2005 totaled $204 million, compared to $73 million at December 31, 2004. Cash flows from operating activities in 2005 were $371 million, which were used to fund investing and financing activities of $167 million and $73 million, respectively.
Cash Flows from Operating Activities
Net cash provided by operating activities for the six months ended June 30, 2006 was $411 million compared to $371 million in the prior year period. This increase was primarily due to improved operating performance of our clinical testing business, partially offset by the performance of NID. Days sales outstanding, a measure of billing and collection efficiency, improved to 45 days at June 30, 2006 from 46 days at December 31, 2005.
Cash Flows from Investing Activities
Net cash used in investing activities for the six months ended June 30, 2006 was $76 million, consisting primarily of capital expenditures of $88 million offset by $16 million of proceeds received in connection with the sale of an investment during the first quarter of 2006. The decrease in capital expenditures versus the prior year is principally due to the completion of a new facility in California, for which there were substantial expenditures in the prior year.
Net cash used in investing activities for the six months ended June 30, 2005 was $167 million, consisting primarily of capital expenditures of $124 million, equity investments of $24 million in companies which develop diagnostic tests, and an acquisition of a small regional laboratory for $19 million.
Cash Flows from Financing Activities
Net cash used in financing activities for the six months ended June 30, 2006 was $277 million, consisting primarily of purchases of treasury stock totaling $254 million, the repayment of $60 million of principal outstanding under our secured receivables credit facility and dividend payments of $38 million, partially offset by $99 million in proceeds from the exercise of stock options, including related tax benefits. The $254 million in treasury stock purchases represents 4.6 million shares of our common stock purchased at an average price of $55.13 per share.
Net cash used in financing activities for the six months ended June 30, 2005 was $73 million, consisting primarily of purchases of treasury stock totaling $92 million and dividend payments totaling $33 million, partially offset by $64 million in proceeds from the exercise of stock options. In addition, we repaid the remaining $100 million of principal outstanding under our senior unsecured revolving credit facility with $100 million of borrowings under our secured receivables credit facility. The $92 million in treasury stock purchases represents 1.8 million shares of our common stock purchased at an average price of $50.64 per share.
Dividend Policy
During each of the quarters of 2005, our Board of Directors declared a quarterly cash dividend of $0.09 per common share. During each of the quarters of 2006, our Board of Directors has declared a quarterly cash dividend per common share of $0.10. We expect to fund future dividend payments with cash flows from operations, and do not expect the dividend to have a material impact on our ability to finance future growth.
Share Repurchase Plan
For the three months ended June 30, 2006, we repurchased 2.6 million shares of our common stock at an average price of $57.49 per share for $150 million. For the six months ended June 30, 2006, we repurchased 4.6 million shares of our common stock at an average price of $55.13 for $254 million. Through June 30, 2006, we have repurchased approximately 37 million shares of our common stock at an average price of $44.16 for approximately $1.6 billion under our share repurchase program. At June 30, 2006, the total available for repurchases under the remaining authorizations was $468 million.
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Contractual Obligations and Commitments
A full description of the terms of our indebtedness and related debt service requirements and our future payments under certain of our contractual obligations is contained in Note 10 to the Consolidated Financial Statements in our 2005 Annual Report on Form 10-K. A full discussion and analysis regarding our minimum rental commitments under noncancelable operating leases and noncancelable commitments to purchase products or services at December 31, 2005 is contained in Note 14 to the Consolidated Financial Statements in our 2005 Annual Report on Form 10-K. See Note 6 to the interim consolidated financial statements for information regarding the status of legal matters involving the Company.
Our credit agreements relating to our senior unsecured revolving credit facility and our term loan due December 2008 contain various covenants and conditions, including the maintenance of certain financial ratios, that could impact our ability to, among other things, incur additional indebtedness. We do not expect these covenants to adversely impact our ability to execute our growth strategy or conduct normal business operations.
Unconsolidated Joint Ventures
We have 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 equal less than 6% of our consolidated net revenues. Total assets associated with our unconsolidated joint ventures are less than 2% of our consolidated total assets. We have no material unconditional obligations or guarantees to, or in support of, our unconsolidated joint ventures and their operations.
On July 5, 2006, we completed our previously announced acquisition of Focus Diagnostics, Inc., or Focus, in an all-cash transaction valued at $206 million including approximately $3 million of assumed debt of Focus. Focus is a leading provider of infectious and immunologic diseases testing and develops and markets diagnostic products. Focus offers its reference testing services to large academic medical centers, hospitals and commercial laboratories. We financed the acquisition and related transaction costs together with the repayment of substantially all of Focus’s debt outstanding with $135 million of borrowings under our secured receivables credit facility and with cash on hand. The acquisition will be accounted for under the purchase method of accounting.
Requirements and Capital Resources
We estimate that we will invest approximately $210 million to $230 million during 2006 for capital expenditures to support and expand our existing operations, principally related to investments in information technology, equipment, and facility upgrades.
Our 6¾% senior notes, which have an aggregate principal amount of $275 million outstanding, matured in July 2006. On July 12, 2006, we repaid these notes with $165 million of borrowings under our secured receivables credit facility, $75 million of borrowings under our senior unsecured revolving credit facility and cash on hand.
As of July 28, 2006, $425 million of borrowing capacity was available under our existing credit facilities.
We believe that cash from operations and our borrowing capacity under our credit facilities will provide sufficient financial flexibility to meet seasonal working capital requirements and to fund capital expenditures, debt service requirements, cash dividends on common shares, share repurchases and additional growth opportunities for the foreseeable future. Our investment grade credit ratings have had a favorable impact on our cost of and access to capital, and we believe that our strong financial performance should provide us with access to additional financing, if necessary, to fund growth opportunities that cannot be funded from existing sources.
Impact of New Accounting Standards
Effective January 1, 2006, we adopted SFAS 123R using the modified prospective approach. See Notes 1 and 2 to the interim consolidated financial statements for further details.
In July 2006, the Financial Accounting Standards Board issued Financial Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (“FIN 48”). See Note 1 to the interim consolidated financial statements for further details.
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Forward-Looking Statements
Some statements and disclosures in this document are forward-looking statements. Forward-looking statements include all statements that do not relate solely to historical or current facts and can be identified by the use of words such as “may”, “believe”, “will”, “expect”, “project”, “estimate”, “anticipate”, “plan” or “continue”. These forward-looking statements are based on our current plans and expectations and are subject to a number of risks and uncertainties that could significantly cause our plans and expectations, including actual results, to differ materially from the forward-looking statements. The Private Securities Litigation Reform Act of 1995, or the Litigation Reform Act, provides a “safe harbor” for forward-looking statements to encourage companies to provide prospective information about their companies without fear of litigation.
We would like to take advantage of the “safe harbor” provisions of the Litigation Reform Act in connection with the forward-looking statements included in this document. The risks and other factors that could cause our actual financial results to differ materially from those projected, forecasted or estimated by us in forward-looking statements may include, but are not limited to, unanticipated expenditures, changing relationships with customers, payers, suppliers and strategic partners, competitive environment, changes in government regulations, conditions of the economy and other factors described in our 2005 Annual Report on Form 10-K and subsequent filings.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
See Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.
Item 4. Controls and Procedures
Our Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are adequate and effective.
During the second quarter of 2006, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
See Note 6 to the interim consolidated financial statements for information regarding the status of legal proceedings involving the Company.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
ISSUER PURCHASES OF EQUITY SECURITIES
Period
(a) Total Number of Shares Purchased
(b) Average Price Paid per Share
(c) Total Number of SharesPurchased as Part of Publicly Announced Plans or Programs
(d) Approximate Dollar Value of Shares that May Yet BePurchased Under the Plans or Programs (in thousands)
April 1, 2006 – April 30, 2006
618,046
May 1, 2006 – May 31, 2006
1,011,800
57.47
559,898
June 1, 2006 – June 30, 2006
1,597,500
57.50
468,047
2,609,300
57.49
In 2003, our Board of Directors authorized a share repurchase program, which permitted us to purchase up to $600 million of our common stock. In July 2004, our Board of Directors authorized us to purchase up to an additional $300 million of our common stock. Under a separate authorization from our Board of Directors, in December 2004 we repurchased 5.4 million shares of our common stock for approximately $254 million from GlaxoSmithKline plc. In January 2005, our Board of Directors expanded the share repurchase authorization by an additional $350 million. In January 2006, our Board of Directors expanded the share repurchase authorization by an additional $600 million.
Item 4. Submission of Matters to a Vote of Security Holders
The Annual Meeting of Shareholders of the Company was held on May 4, 2006. At the meeting the matters described below were approved by the shareholders.
The following nominees for the office of director were elected for terms expiring at the 2009 Annual Meeting of Shareholders, by the following votes:
For
Withheld
Jenne K. Britell, Ph.D.
178,255,619
3,405,767
Gail R. Wilensky, Ph.D.
176,442,745
5,218,641
Mr. John B. Ziegler
169,364,288
12,297,098
The following persons continue as directors:
John C. Baldwin, M.D.
Mr. William F. Buehler
Mr. William R. Grant
Ms. Rosanne Haggerty
Surya N. Mohapatra, Ph.D.
Mr. Gary M. Pfeiffer
Daniel C. Stanzione, Ph.D.
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The ratification of the appointment of PricewaterhouseCoopers LLP as the independent registered public accounting firm to audit the financial statements of the Company and its subsidiaries for the fiscal year ending December 31, 2006, was approved by the following number of stockholder votes for, against, and abstained:
For: 175,801,288
Against: 4,849,057
Abstained: 1,011,041
The Amendment to the Restated Certificate of Incorporation of the Company was approved by the following number of shareholder votes for, against, and abstained:
For: 148,089,324
Against: 32,560,629
Abstained: 1,011,430
The Amended and Restated Employee Stock Purchase Plan of the Company was approved by the following number of shareholder votes for, against, and abstained:
For: 160,387,888
Against: 2,854,550
Abstained: 1,389,843
Item 6. Exhibits
Exhibits:
3.1
Certification of Amendment to Restated Certificate of Incorporation of Quest Diagnostics Incorporated
10.1
Letter Agreement dated June 15, 2006 between the Company and Surya N. Mohapatra
31.1
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
Certification of Chief Executive Officer Pursuant to 18 U.S.C. §1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2
Certification of Chief Financial Officer Pursuant to 18 U.S.C. §1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
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Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
July 31, 2006Quest Diagnostics Incorporated
By
/s/
Surya N. Mohapatra
Chairman, President and
Chief Executive Officer
Robert A. Hagemann
Senior Vice President and
Chief Financial Officer
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