SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarter ended March 31, 2005
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 _______
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes
X
No ____
As of April 22, 2005 there were 101,168,879 outstanding shares of the registrant’s common stock, $.01 par value.
PART I - FINANCIAL INFORMATION
Page
Item 1.
Financial Statements
Index to consolidated financial statements filed as part of this report:
Consolidated Statements of Operations for the Three Months Ended March 31, 2005 and 2004
2
Consolidated Balance Sheets as of March 31, 2005 and December 31, 2004
3
Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2005 and 2004
4
Notes to Consolidated Financial Statements
5
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
17
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
See Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations”
21
Item 4.
Controls and Procedures
1
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE MONTHS ENDED MARCH 31, 2005 AND 2004
(in thousands, except per share data)
(unaudited)
Three Months EndedMarch 31,
2005
2004
Net revenues
$
1,319,485
1,255,742
Operating costs and expenses:
Cost of services
780,082
737,281
Selling, general and administrative
308,348
307,545
Amortization of intangible assets
931
2,064
Other operating expense (income), net
211
(27
)
Total operating costs and expenses
1,089,572
1,046,863
Operating income
229,913
208,879
Other income (expense):
Interest expense, net
(12,783
(14,644
Minority share of income
(5,013
(4,454
Equity earnings in unconsolidated joint ventures
7,214
4,557
Other income, net
755
1,199
Total non-operating expenses, net
(9,827
(13,342
Income before taxes
220,086
195,537
Income tax expense
88,475
79,388
Net income
131,611
116,149
Earnings per common share:
Basic
1.30
1.13
Diluted
1.28
1.08
Weighted average common shares outstanding:
100,859
103,142
103,071
108,599
Dividends per common share
0.18
0.15
The accompanying notes are an integral part of these statements.
CONSOLIDATED BALANCE SHEETS
MARCH 31, 2005 AND DECEMBER 31, 2004
March 31, 2005
December 31,2004
Assets
Current assets:
Cash and cash equivalents
86,162
73,302
Accounts receivable, net of allowance for doubtful accounts of $210,499 and $202,857 at March 31, 2005 and December 31, 2004, respectively
702,419
649,281
Inventories
76,260
75,327
Deferred income taxes
106,330
83,030
Prepaid expenses and other current assets
68,094
50,140
Total current assets
1,039,265
931,080
Property, plant and equipment, net
633,762
619,485
Goodwill, net
2,524,596
2,506,950
Intangible assets, net
11,281
11,462
28,326
29,374
Other assets
104,737
105,437
Total assets
4,341,967
4,203,788
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable and accrued expenses
702,149
668,987
Short-term borrowings and current portion of long-term debt
230,107
374,801
Total current liabilities
932,256
1,043,788
Long-term debt
624,086
724,021
Other liabilities
147,664
147,328
Commitments and contingencies
Stockholders’ equity:
Common stock, par value $0.01 per share; 300,000 shares authorized; 106,821 and 106,784 shares issued at March 31, 2005 and December 31, 2004, respectively
1,068
Additional paid-in capital
2,197,084
2,195,346
Retained earnings
932,135
818,734
Unearned compensation
(3,488
(11
Accumulated other comprehensive income
1,166
3,866
Treasury stock, at cost; 5,710 and 8,674 shares at March 31, 2005 and December 31, 2004, respectively
(490,004
(730,352
Total stockholders’ equity
2,637,961
2,288,651
Total liabilities and stockholders’ equity
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
42,528
41,070
Provision for doubtful accounts
59,417
56,626
Deferred income tax provision (benefit)
(15,993
11,419
5,013
4,454
Stock compensation expense
190
548
Tax benefits associated with stock-based compensation plans
11,274
24,447
Other, net
(785
(1,080
Changes in operating assets and liabilities:
Accounts receivable
(112,555
(97,950
(51,451
(63,895
Integration, settlement and other special charges
(673
(13,975
Income taxes payable
86,698
41,544
Other assets and liabilities, net
(19,245
(8,666
Net cash provided by operating activities
136,029
110,691
Cash flows from investing activities:
Capital expenditures
(55,381
(45,137
Business acquisition, net of cash acquired
(19,323
–
Increase in investments and other assets
(500
(3,614
Proceeds from disposition of assets
11
3,293
Net cash used in investing activities
(75,193
(45,458
Cash flows from financing activities:
Proceeds from borrowings
99,999
75,000
Repayments of debt
(100,402
(75,359
Purchases of treasury stock
(62,300
(44,871
Exercise of stock options
35,488
34,483
Dividends paid
(15,019
(15,429
Distributions to minority partners
(5,742
(3,940
Net cash used in financing activities
(47,976
(30,116
Net change in cash and cash equivalents
12,860
35,117
Cash and cash equivalents, beginning of period
154,958
Cash and cash equivalents, end of period
190,075
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, unless otherwise indicated)
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, and testing for drugs of abuse. The Company is also a leading provider of anatomic pathology services and testing to support clinical trials of new pharmaceuticals worldwide. Through the Company’s national network of laboratories and patient service centers, and its esoteric testing 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.
On an annual basis, Quest Diagnostics processes approximately 140 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 2004 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 the Debentures, and outstanding stock options and restricted common shares granted under the Company’s Employee Equity Participation Program.
In September 2004, the Emerging Issues Task Force reached a final consensus on Issue 04-8, “The Effect of Contingently Convertible Instruments on Diluted Earnings per Share”, (“Issue 04-8”), effective December 31, 2004. Pursuant to Issue 04-8, the Company included the dilutive effect of its Debentures in its dilutive earnings per common share calculations using the if-converted method, regardless of whether or not the holders of these securities were permitted to exercise their conversion rights, and retroactively restated previously reported diluted earnings per common share. The Debentures were called for redemption by the Company in December 2004, and redeemed as of January 18, 2005. See Note 3 for a further discussion of the Debentures. References to previously reported diluted weighted average common shares outstanding and diluted earnings per common share amounts in the accompanying consolidated statements of operations and related disclosures, have been restated to give retroactive effect of the required change in accounting for all periods presented.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
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
831
Net income available to commons stockholders – diluted
131,693
116,980
Weighted average common shares outstanding – basic
Effect of dilutive securities:
Stock options and restricted common stock
1,906
2,600
Debentures
306
2,857
Weighted average common shares outstanding – diluted
Basic earnings per common share
Diluted earnings per common share
Stock-Based Compensation
The Company has chosen to adopt the disclosure only provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure - an amendment of FASB Statement No. 123” (“SFAS 148”), and continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related interpretations. Under this approach, the cost of restricted stock awards is expensed over their vesting period, while the imputed cost of stock option grants and discounts offered under the Company’s Employee Stock Purchase Plan (“ESPP”) is disclosed, based on the vesting provisions of the individual grants, but not charged to expense. Stock-based compensation expense recorded in accordance with APB 25, related to restricted stock awards, was $0.2 million and $0.5 million for the three months ended March 31, 2005 and 2004, respectively.
6
The following table presents net income and basic and diluted earnings per common share, had the Company elected to recognize compensation cost based on the fair value at the grant dates for stock option awards and discounts granted for 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):
Net income:
Net income, as reported
Add: Stock-based compensation under APB 25
Deduct: Total stock-based compensation expense determined under fair value method for all awards, net of related tax effects
(10,581
(10,962
Pro forma net income
121,220
105,735
Basic – as reported
Basic – pro forma
1.20
1.03
Diluted – as reported
Diluted – pro forma
1.17
0.98
The fair value of each stock option award granted prior to January 1, 2005 was estimated on the date of grant using the Black-Scholes option-pricing model. The fair value of each stock option award granted subsequent to January 1, 2005 was estimated on the date of grant using a lattice-based option-valuation model. Management believes a lattice-based option-valuation model provides a more accurate measure of fair value. The expected volatility in connection with the Black-Scholes option-pricing model was based on the historical volatility of the Company’s stock, while 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 weighted average assumptions used in valuing options granted in the periods presented are noted in the following table.
Dividend yield
0.7
%
Risk-free interest rate
4.0
3.0
Expected volatility
23.3
47.3
Expected holding period, in years
New Accounting Standard
In December 2004, the FASB issued 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 June 15, 2005. The Company expects to adopt SFAS 123R effective January 1, 2006 using the modified prospective approach. 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 123 except that compensation costs will be recognized in the Company’s results of operations. The Company has not completely finalized what changes will be made to its equity compensation plans in light of the accounting change, and therefore is not yet in a position to quantify its impact.
7
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
2.
GOODWILL AND INTANGIBLE ASSETS
Goodwill at March 31, 2005 and December 31, 2004 consisted of the following:
March 31,2005
Goodwill
2,712,649
2,695,003
Less: accumulated amortization
(188,053
The changes in the gross carrying amount of goodwill for the three month period ended March 31, 2005 and for the year ended December 31, 2004 are as follows:
Balance at beginning of period
2,706,928
Goodwill acquired during the period
17,646
Other
(11,925
Balance at end of period
During the quarter ended March 31, 2005, the Company completed an acquisition of a small regional laboratory for $19 million in cash.
For the year ended December 31, 2004, the reduction in goodwill was primarily related to an increase in pre-acquisition tax net operating losses and credit carryforwards associated with businesses acquired.
Intangible assets at March 31, 2005 and December 31, 2004 consisted of the following:
December 31, 2004
WeightedAverageAmortization Period
Cost
AccumulatedAmortization
Net
Non-compete agreements
5 years
45,692
(42,824
2,868
44,942
(42,348
2,594
Customer lists
15 years
42,225
(37,463
4,762
(37,197
5,028
6 years
6,850
(3,199
3,651
(3,010
3,840
Total
10 years
94,767
(83,486
94,017
(82,555
Amortization expense related to intangible assets was $931 and $2,064 for the three months ended March 31, 2005 and 2004, respectively.
The estimated amortization expense related to intangible assets for each of the five succeeding fiscal years and thereafter as of March 31, 2005 is as follows:
8
Fiscal Year Ending December 31,
Remainder of 2005
2,839
2006
2,689
2007
1,299
2008
1,109
2009
1,012
2010
569
Thereafter
1,764
3.
DEBT
Short-term borrowings and current portion of long-term debt at March 31, 2005 and December 31, 2004 consisted of the following:
Borrowings under Secured Receivables Credit Facility
229,920
129,921
Debentures called for redemption in December 2004
244,660
Current portion of long-term debt
187
220
Total short-term borrowings and current portion of long-term debt
Long-term debt at March 31, 2005 and December 31, 2004 consisted of the following:
Term loan due December 2008
Borrowings under Credit Facility
100,000
6¾% senior notes due July 2006
274,609
274,531
7½% senior notes due July 2011
274,309
274,281
355
429
624,273
724,241
Less: current portion
Total long-term debt
In December 2004, the Company called for redemption all of its outstanding Debentures. Under the terms of the Debentures, the holders of the Debentures had an option to submit their Debentures for redemption at par plus accrued and unpaid interest or convert their Debentures into shares of the Company’s common stock at a conversion price of $87.50 per share. Through December 31, 2004, $3.2 million of principal of the Debentures were converted into less than 0.1 million shares of the Company’s common stock. The outstanding principal of the Debentures at December 31, 2004 was classified as a current liability within short-term borrowings and current portion of long-term debt on the Company’s consolidated balance sheet. As of January 18, 2005, the redemption was completed and $0.4 million of principal was redeemed for cash and $249.6 million of principal was converted into approximately 2.9 million shares of the Company’s common stock.
On January 31, 2005, the Company repaid $100 million of principal outstanding under its $500 million senior unsecured revolving credit facility (the “Credit Facility”) with $100 million of borrowings under its $300 million receivables securitization facility (the “Secured Receivables Credit Facility”).
9
4.
COMMITMENTS AND CONTINGENCIES
The Company has standby letters of credit issued under its $75 million letter of credit lines to ensure its performance or payment to third parties, which amounted to $72 million at March 31, 2005. The letters of credit, which are renewed annually, primarily represent collateral for current and future automobile liability and workers’ compensation loss payments.
The Company has entered into several settlement agreements with various government and private payers during recent years relating to industry-wide billing and marketing practices that had been substantially discontinued by the mid-1990s. The Company is aware of certain pending lawsuits related to billing practices filed under the qui tam provisions of the civil False Claims Act and other federal and state statutes. Some of the proceedings against the Company involve claims that are substantial in amount.
During the fourth quarter of 2004, the Company and its test kit manufacturing subsidiary, Nichols Institute Diagnostics, each received a subpoena from the United States Attorney’s office for the Eastern District of New York. The subpoenas seek the production of various business records, including documents related to parathyroid hormone testing and parathyroid hormone test kits manufactured by Nichols Institute Diagnostics. 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.
Although management believes that established reserves for claims are appropriate, it is possible that additional information (such as the indication by the government of criminal activity, additional tests being questioned or other changes in the government’s or private claimants’ theories of wrongdoing) may become available which may cause the final resolution of these matters to exceed established reserves by an amount which could be material to the Company’s results of operations and cash flows in the period in which such claims are settled. The Company does not believe that these issues will have a material adverse effect on its overall financial condition. 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 coverages 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 position but may be material to the Company’s results of operations and cash flows in the period in which such claims are resolved.
10
5.
STOCKHOLDERS’ EQUITY
Changes in stockholders’ equity for the three months ended March 31, 2005 were as follows:
Shares of Common Stock Outstanding
CommonStock
AdditionalPaid-InCapital
Retained Earnings
UnearnedCompensation
AccumulatedOtherCompre-hensiveIncome
Treasury Stock, at Cost
Compre-hensiveIncome
Balance, December 31, 2004
98,110
Other comprehensive loss
(2,700
Comprehensive income
128,911
Dividend declared
(18,210
Issuance of common stock under benefit plans
94
3,182
(3,667
4,801
719
(25,223
60,711
Shares to cover employee payroll tax withholdings on stock issued under benefit plans
(5
Conversion of contingent convertible debentures
2,816
12,510
237,136
Amortization of unearned compensation
(628
Balance, March 31, 2005
101,111
For the three months ended March 31, 2005, the Company repurchased approximately 628 thousand shares of its common stock at an average price of $99.16 per share for $62 million. For the three months ended March 31, 2005, the Company reissued approximately 2.8 million shares and 0.8 million shares in connection with the conversion of its Debentures and for employee benefit plans, respectively. Through March 31, 2005, the Company has repurchased approximately 12.9 million shares of its common stock at an average price of $81.45 for $1.1 billion. At March 31, 2005, $450 million of the share repurchase authorization remained available.
During the first quarter of 2005, the Company’s Board of Directors declared a quarterly cash dividend of $0.18 per common share payable on April 20, 2005 to shareholders of record on April 6, 2005.
Changes in stockholders’ equity for the three months ended March 31, 2004 were as follows:
Shares of CommonStockOutstanding
RetainedEarnings
TreasuryStock, atCost
Compre-hensive Income
Balance, December 31, 2003
102,814
2,267,014
380,559
(2,346
5,947
(257,548
(2,398
113,751
(15,557
49
3,065
1,124
(35,620
70,103
(74
(1
(6,105
(547
Balance, March 31, 2004
103,366
2,252,801
481,151
(1,798
3,549
(232,316
For the three months ended March 31, 2004, the Company purchased 547 thousand shares of its common stock at an average price of $81.97 per share for $45 million and reissued 1.0 million shares in connection with employee benefit plans.
6.
SUPPLEMENTAL CASH FLOW & OTHER DATA
Depreciation expense
41,597
39,006
Interest expense
(13,017
(15,050
Interest income
234
406
Interest paid
22,001
21,903
Income taxes paid
6,396
3,571
Non-cash financing activities:
$244,338
12
7.
SUMMARIZED FINANCIAL INFORMATION
The Company’s 6¾% senior notes due 2006, 7½% senior notes due 2011 and the Debentures are 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 3 for further details).
In conjunction with the Company’s Secured Receivables Credit Facility, the Company maintains a wholly owned non-guarantor subsidiary, Quest Diagnostics Receivables Incorporated (“QDRI”). Through March 31, 2004, the Company and the Subsidiary Guarantors, with the exception of American Medical Laboratories, Incorporated (“AML”) and Unilab Corporation (“Unilab”), transferred all private domestic receivables (principally excluding receivables due from Medicare, Medicaid and other federal programs, and receivables due from customers of its joint ventures) to QDRI. Effective with the second quarter of 2004, the Company and Subsidiary Guarantors, including AML and Unilab, transfer all private domestic receivables to QDRI. QDRI utilizes the transferred receivables to collateralize the Company’s Secured Receivables Credit Facility. The Company and the Subsidiary Guarantors provide collection services to QDRI. QDRI uses cash collections principally to purchase new receivables from the Company and the Subsidiary Guarantors.
The following condensed consolidating financial data illustrates the composition of the combined guarantors. Investments in subsidiaries are accounted for by the parent using the equity method for purposes of the supplemental consolidating presentation. Earnings (losses) of subsidiaries are therefore reflected in the parent’s investment accounts and earnings. The principal elimination entries relate to investments in subsidiaries and intercompany balances and transactions.
13
Condensed Consolidating Statement of Operations
Three Months Ended March 31, 2005
Parent
SubsidiaryGuarantors
Non-GuarantorSubsidiaries
Eliminations
Consolidated
207,294
1,047,183
127,619
(62,611
119,482
614,547
46,053
21,802
225,454
66,101
(5,009
453
469
Royalty (income) expense
(85,785
85,785
Other operating expense, net
209
55,952
926,257
112,372
151,342
120,926
15,247
(57,602
Non-operating (expenses) income, net
(13,544
(54,577
692
57,602
137,798
66,349
15,939
55,150
26,539
6,786
Income before equity earnings
82,648
39,810
9,153
Equity earnings from subsidiaries
48,963
(48,963
Three Months Ended March 31, 2004
200,225
992,321
121,658
(58,462
120,820
573,835
42,626
27,916
225,625
58,335
(4,331
523
1,532
(80,999
80,999
Other operating (income) expense, net
(736
19
690
67,524
882,010
101,660
132,701
110,311
19,998
(54,131
Non-operating expenses, net
(14,696
(51,719
(1,058
54,131
118,005
58,592
18,940
49,705
23,437
6,246
68,300
35,155
12,694
47,849
(47,849
14
Condensed Consolidating Balance Sheet
70,014
4,939
11,209
Accounts receivable, net
21,347
86,792
594,280
Other current assets
42,555
116,504
91,625
250,684
133,916
208,235
697,114
213,965
393,334
26,463
Goodwill and intangible assets, net
157,568
2,332,706
45,603
2,535,877
Intercompany receivable (payable)
474,905
(154,857
(320,048
Investment in subsidiaries
2,148,514
(2,148,514
49,276
46,246
37,541
133,063
3,178,144
2,825,664
486,673
426,323
243,423
32,403
20
167
426,343
243,590
262,323
70,516
551,613
1,957
43,324
80,627
23,713
Stockholders’ equity
1,949,834
198,680
Non-Guarantor Subsidiaries
56,424
6,058
10,820
22,365
75,359
551,557
12,032
109,100
87,365
208,497
90,821
190,517
649,742
213,416
379,952
26,117
158,021
2,315,015
45,376
2,518,412
493,578
(124,047
(369,531
2,109,612
(2,109,612
49,031
49,100
36,680
134,811
3,114,479
2,810,537
388,384
368,363
268,420
32,204
244,713
613,076
268,587
162,125
170,293
551,771
42,459
80,155
24,714
1,910,024
199,588
15
Condensed Consolidating Statement of Cash Flows
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
13,173
26,793
2,562
1,323
9,818
48,276
(51,065
978
823
(301
Changes in operating assets and liabilities
(15,916
(771
(80,539
(97,226
Net cash provided by (used in) operating activities
79,126
76,628
(19,725
Net cash provided by (used in) investing activities
76,657
(54,899
(3,031
(93,920
Net cash (used in) provided by financing activities
(142,193
(22,848
23,145
93,920
13,590
(1,119
389
13,803
24,848
2,419
1,148
15,510
39,968
9,342
(7,805
(9,598
39,788
(68,855
59,399
(133,486
(142,942
71,587
127,107
(88,003
(10,169
(23,914
(1,983
(9,392
(25,791
(103,989
90,272
9,392
35,627
(796
286
141,588
1,991
11,379
177,215
1,195
11,665
16
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. These accounting policies have been described in our 2004 Annual Report on Form 10-K.
Results of Operations
Three Months Ended March 31, 2005 Compared with Three Months Ended March 31, 2004
Net income for the three months ended March 31, 2005 increased to $132 million from $116 million for the prior year period. This increase in earnings was primarily attributable to revenue growth, partially offset by investments in our operations.
Net Revenues
Net revenues for the three months ended March 31, 2005 grew by 5.1% over the prior year level. The increase in net revenues was driven by improvements in testing volumes, measured by the number of requisitions, and increases in average revenue per requisition.
For the three months ended March 31, 2005, clinical testing volume increased 2.8% compared to the prior year period. First quarter volume growth compared to the prior year was reduced by about one percent due to the benefit from Leap Year in 2004.
Average revenue per requisition improved 2.3% compared to the prior year period. This improvement is primarily attributable to a continuing shift in test mix to higher value testing, including gene-based testing, and increases in the number of tests ordered per requisition, in addition to modest price increases. These factors are expected to continue as the primary drivers of increases in revenue per requisition, although to a lesser extent than the past several years.
Operating Costs and Expenses
Total operating costs and expenses for the three months ended March 31, 2005 increased $43 million from the prior year period primarily due to increases in our clinical testing volume. The increased costs were primarily in the areas of employee compensation and benefits 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.
Cost of services, which includes the costs of obtaining, transporting and testing specimens, was 59.1% of net revenues for the three months ended March 31, 2005, increasing from 58.7% of net revenues in the prior year period. This increase was primarily the result of increases related to testing supplies, initial installation costs associated with deploying our Internet-based orders and results systems in physicians’ offices and an increase in the number of phlebotomists in our patient service centers to support an increasing percentage of our volume generated from these sites, partially offset by the increase in average revenue per requisition and efficiency gains resulting from our Six Sigma and standardization initiatives. At March 31, 2005, 43% of our orders and 64% of our test results were being transmitted via the Internet. This compares to approximately 30% and 40%, respectively, at March 31, 2004. The increase in the number of orders and test results reported via our Internet-based systems is improving the initial collection of billing information which is reducing the cost of billing and bad debt expense, both of which are components of selling, general and administrative expenses.
Selling, general and administrative expenses, which include the costs of the sales force, billing operations, bad debt expense and general management and administrative support, was 23.4% of net revenues during the three months ended March 31, 2005, decreasing from 24.5% in the prior year period. This improvement was primarily due to revenue growth, which has allowed us to leverage our expense base, as well as efficiencies from our Six Sigma and standardization initiatives. During the first quarter of 2005, bad debt expense was 4.5% of net revenues, consistent with the prior year period. We believe that our Six Sigma and standardization initiatives and the increased use of electronic ordering by our customers will provide additional opportunities to further improve our overall collection experience and cost structure.
Operating Income
Operating income improved to $230 million, or 17.4% of net revenues, from $209 million, or 16.6% of net revenues, in the prior year period. The increase in operating income was principally driven by revenue growth and a reduction in selling, general and administrative expenses as a percentage of net revenues. Partially offsetting these improvements were increased costs of services as a percentage of net revenues as a result of investments in our operations.
Interest Expense, net
Interest expense, net for the three months ended March 31, 2005 decreased from the prior year period primarily due to the redemption of our contingent convertible debentures in January 2005, as well as our 2004 refinancing. See Note 10 to the Consolidated Financial Statements contained in our 2004 Annual Report on Form 10-K for a further discussion of the redemption and the debt refinancing.
Other Income, net
Other income, 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.
Impact of Contingent Convertible Debentures on Earnings per Common Share
Due to a required change in accounting effective December 31, 2004, we included the dilutive effect of our 1¾% contingent convertible debentures, or the Debentures, in our dilutive earnings per common share calculations using the if-converted method, regardless of whether or not the holders of these securities were permitted to exercise their conversion rights, and retroactively restated previously reported diluted earnings per common share. References to previously reported diluted weighted average common shares outstanding, including diluted earnings per common share calculations and related disclosures, have been restated to give effect to the required change in accounting for all periods presented. This change reduced previously reported diluted earnings per common share by approximately 2% for the quarter ended March 31, 2004. See Note 10 to the Consolidated Financial Statements contained in our 2004 Annual Report on Form 10-K for a further discussion of the Debentures.
We address our exposure to market risks, principally the market risk of changes in interest rates, through a controlled program of risk management that may include the use of derivative financial instruments. We do not hold or issue derivative financial instruments for trading purposes. We do not believe that our foreign exchange exposure is material to our financial position or results of operations. See Note 2 to the Consolidated Financial Statements contained in our 2004 Annual Report on Form 10-K for additional discussion of our financial instruments and hedging activities.
At March 31, 2005 and December 31, 2004, the fair value of our debt was estimated at approximately $0.9 billion and $1.2 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 March 31, 2005 and December 31, 2004, the estimated fair value exceeded the carrying value of the debt by approximately $49 million and $84 million, respectively. An assumed 10% increase in interest rates (representing approximately 55 and 45 basis points at March 31, 2005 and December 31, 2004, respectively) would reduce the estimated fair value of our debt by approximately $9 million and $17 million at March 31, 2005 and December 31, 2004, 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 the secured receivables credit facility is based on
18
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 rating. As such, our borrowing cost under these credit arrangements will be subject to both fluctuations in interest rates and changes in our credit rating. As of March 31, 2005, our borrowing rates for our LIBOR-based loans ranged from LIBOR plus 0.55% to LIBOR plus 0.625%. At March 31, 2005, there was $230 million of borrowings outstanding under our $300 million secured receivables credit facility, $75 million outstanding under our term loan due December 2008 and no borrowings outstanding under our $500 million senior unsecured revolving 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 28 basis points) would impact annual net interest expense by approximately $0.8 million, assuming no changes to the debt outstanding at March 31, 2005. See Note 3 to the interim consolidated financial statements for details regarding our debt outstanding.
Liquidity and Capital Resources
Cash and Cash Equivalents
Cash and cash equivalents at March 31, 2005 totaled $86 million, compared to $73 million at December 31, 2004. Cash flows from operating activities in 2005 were $136 million, which were used to fund investing and financing activities, which required cash of $75 million and $48 million, respectively. Cash and cash equivalents at March 31, 2004 totaled $190 million, compared to $155 million at December 31, 2003. Cash flows from operating activities in 2004 provided cash of $111 million, which were used to fund investing and financing activities of $45 million and $30 million, respectively.
Cash Flows From Operating Activities
Net cash provided by operating activities for the three months ended March 31, 2005 was $136 million compared to $111 million in the prior year period. This increase was primarily due to improved operating performance as well as the timing and net amount of various payments for taxes and other liabilities, partially offset by an increase in accounts receivable associated with growth in net revenues. Days sales outstanding, a measure of billing and collection efficiency, was 46 days at March 31, 2005, compared to 47 days at December 31, 2004.
Cash Flows From Investing Activities
Net cash used in investing activities for the three months ended March 31, 2005 was $75 million, consisting primarily of capital expenditures of $55 million and an acquisition of a small regional laboratory for $19 million.
Net cash used in investing activities for the three months ended March 31, 2004 was $45 million, consisting primarily of capital expenditures.
Cash Flows From Financing Activities
Net cash used in financing activities for the three months ended March 31, 2005 was $48 million, consisting primarily of purchases of treasury stock totaling $62 million and dividend payments of $15 million, partially offset by $35 million received 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, which carries a slightly lower borrowing cost. The $62 million in treasury stock purchases represents 628 thousand shares of our common stock purchased at an average price of $99.16 per share.
Net cash used in financing activities in the three months ended March 31, 2004 was $30 million, consisting primarily of purchases of treasury stock totaling $45 million and $15 million in dividend payments, partially offset by $34 million received from the exercise of stock options. In addition, $75 million of borrowings under our term loan due December 2008 were used to repay $75 million under our term loan due June 2007. The $45 million in treasury stock purchases represents 547 thousand shares of our common stock purchased at an average price of $81.97 per share.
Dividend Policy
On January 27, 2005, our Board of Directors increased the quarterly cash dividend per common share by $0.03 to $0.18, payable on April 20, 2005, to shareholders of record on April 6, 2005. We have paid a dividend each quarter since January 2004. 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 March 31, 2005, we repurchased 628 thousand shares of our common stock at an average price of $99.16 per share for $62 million. Through March 31, 2005, we have repurchased approximately 12.9 million shares of our common stock at an average price of $81.45 for $1.1 billion under our share repurchase program. At March 31, 2005, our remaining authorizations for share repurchases totaled $450 million.
Contractual Obligations and Commitments
A description of the terms of our indebtedness, related debt service requirements and our future payments under certain of our contractual obligations is contained in Note 10 to the Consolidated Financial Statements in our 2004 Annual Report on Form 10-K. A discussion and analysis regarding our minimum rental commitments under noncancelable operating leases and noncancelable commitments to purchase products or services at December 31, 2004 is contained in Note 14 to the Consolidated Financial Statements in our 2004 Annual Report on Form 10-K. See Note 4 to the interim consolidated financial statements for information regarding the status of our remaining contractual obligations and commitments as of March 31, 2005. See Note 3 to the interim consolidated financial statements for information regarding the components of our outstanding indebtedness.
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, on a combined basis, are less than 6% of our consolidated net revenues. Total assets associated with our unconsolidated joint ventures are less than 3% of our consolidated total assets. We have no material unconditional obligations or guarantees to, or in support of, our unconsolidated joint ventures and their operations.
Requirements and Capital Resources
We estimate that we will invest approximately $210 million to $230 million during 2005 for capital expenditures to support and expand our existing operations, principally related to investments in information technology, equipment, and facility upgrades.
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 Standard
In December 2004, the Financial Accounting Standards Board issued SFAS No. 123, revised 2004, “Share-Based Payment”. The impact of this accounting standard is discussed in Note 1 to the interim consolidated financial statements.
Forward-Looking Statements
Some statements and disclosures in this document are forward-looking statements. Forward-looking statements include all statements that do not relate solely to historical or current facts and can be identified by the use of words such as “may”, “believe”, “will”, “expect”, “project”, “estimate”, “anticipate”, “plan” or “continue”. These forward-looking statements are based on our current plans and expectations and are subject to a number of risks and uncertainties that could significantly cause our plans and expectations, including actual results, to differ materially from the forward-looking statements. The Private Securities Litigation Reform Act of 1995 (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 2004 Annual Report on Form 10-K and subsequent filings.
See Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.
(a)
Our Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are adequate and effective.
(b)
During the first quarter of 2005, 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
Legal Proceedings
See Note 4 to the interim consolidated financial statements for information regarding the status of legal proceedings involving the Company.
Unregistered Sales of Equity Securities and Use of Proceeds
ISSUER PURCHASES OF EQUITY SECURITIES
Period
(a) TotalNumber ofSharesPurchased
(b) Average PricePaid per Share
(c) Total Number of SharesPurchased as Part ofPublicly Announced Plansor Programs
(d) Approximate Dollar Valueof Shares that May Yet BePurchased Under the Plans or Programs (in thousands)
January 1, 2005 -January 31, 2005
23,600
$94.99
$509,944
February 1, 2005 -February 28, 2005
176,900
$98.61
$492,499
March 1, 2005 -March 31, 2005
427,800
$99.61
$449,886
628,300
$99.16
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 2.7 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.
Item 6.
Exhibits
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
22
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
April 29, 2005
By
/s/ Surya N. Mohapatra
Surya N. Mohapatra, Ph.D. Chairman, President and Chief Executive Officer
/s/ Robert A. Hagemann
Robert A. Hagemann Senior Vice President and Chief Financial Officer
23