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DGX > SEC Filings for DGX > Form 10-Q on 24-Oct-2012All Recent SEC Filings

Show all filings for QUEST DIAGNOSTICS INC

Form 10-Q for QUEST DIAGNOSTICS INC


24-Oct-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Our Company

Quest Diagnostics is the world's leading provider of diagnostic testing, information and services, providing insights that enable patients and physicians to make better healthcare decisions. Our clinical testing business currently represents our one reportable business segment and accounted for greater than 90% of our net revenues from continuing operations in both 2012 and 2011. Our other operating segments consist of our risk assessment services, clinical trials testing, healthcare information technology, and diagnostic products businesses. Our business segment information is disclosed in Note 14 to the interim consolidated financial statements.

We remain focused on increasing shareholder returns through a combination of improved operating performance and disciplined capital deployment. To improve operating performance, we are taking steps to drive operational excellence and restore revenue growth.

In addition, we have been conducting a comprehensive review and evaluation of our strategic priorities and examining additional means of maximizing shareholder returns. This review, along with the new organization structure described below, may result in asset impairment charges, discontinued operations, and associated gains and losses on sale of assets primarily associated with our non-clinical testing businesses. We anticipate announcing a more detailed plan before the end of the year.

Initiatives to Improve Operating Efficiency and Restore Growth

The diagnostic testing industry is labor intensive. Employee compensation and benefits constitute approximately one-half of our total costs and expenses. Cost of services consists principally of costs for obtaining, transporting and testing specimens. Selling, general and administrative expenses consist principally of the costs associated with our sales and marketing efforts, billing operations, bad debt expense and general management and administrative support. In addition, performing diagnostic testing involves significant fixed costs for facilities and other infrastructure required to obtain, transport and test specimens. Therefore, relatively small changes in volume can have a significant impact on profitability in the short-term.

We are engaged in a multi-year program called Invigorate which is designed to deliver $500 million in run-rate cost savings versus 2011 by the time we exit 2014. The Invigorate program is intended to address continued reimbursement pressures and labor and benefit cost increases, free up additional resources to invest in science, innovation and other growth initiatives, and enable us to improve operating profitability and quality. We anticipate roughly one-third of the savings from client support/billing, procurement and supply chain; one-third from laboratory operations and specimen acquisition; and one-third from selling, general and administrative expenses, including information technology. Common themes across many of the opportunities include standardizing systems and processes and data bases, increased use of automation and technology, and centralizing and selective outsourcing of certain activities.

In connection with our Invigorate program, we launched a voluntary retirement program to certain eligible employees that qualified for the program. We estimate that this program will contribute approximately $40 million of annualized savings once fully implemented, which we expect in the first quarter of 2013. Of the total estimated pre-tax charges for employee separation costs noted below, we expect to incur approximately $50 million in connection with the voluntary retirement program, $23.3 million of which has been incurred through September 30, 2012.

In October 2012, we launched a major management restructuring aimed at driving operational excellence and restoring growth. The key element of the organization change will be to eliminate the complexity associated with our existing structure and organize into two new business groups, Diagnostics Information Services and Diagnostic Solutions. The organizational changes are scheduled to take effect by January 1, 2013. With the launch of the new organizational structure, we will be able to focus more on customers, speed decision making and accelerate cost reductions. In connection with these changes, we expect to eliminate three management layers, and approximately 400 to 600 management positions, by the end of 2013, thereby contributing about $65 million in annualized savings to the previously announced cost reduction goal of $500 million associated with our Invigorate program. The management restructuring, including the reduction of management layers, will accelerate savings under our Invigorate program, and is expected to add between $15 million and $20 million to our previously disclosed range of charges associated with Invigorate, which is now included in our updated estimates below.

As a result of actions we have taken to accelerate our Invigorate program, we now expect to achieve approximately $150 million in annual run-rate cost savings, or about 30% of our $500 million goal, as we exit 2012, which is higher than our previously disclosed estimate of about 20%. The remainder of the annual run-rate savings are expected to be achieved in 2013 and 2014.


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Currently, our updated high-level estimates of the pre-tax charges expected to be incurred through 2014 in connection with our Invigorate program total $115 million to $195 million and consist of: $55 million to $100 million of employee separation costs; $30 million to $45 million of facility-related costs; $10 million to $20 million of asset impairment charges; and $20 million to $30 million of systems conversion and integration costs. Of the total estimated pre-tax charges expected to be incurred, we estimate that $105 million to $175 million are anticipated to result in cash expenditures. The actual charges incurred in connection with the multi-year course of action could be materially different from these estimates. As detailed plans to implement the multi-year course of action are approved and executed, it will result in charges to earnings.
For additional information on the Invigorate program and associated costs, see Note 4 to the interim consolidated financial statements.

Recent Acquisitions

On February 24, 2011, we signed a definitive agreement to acquire Athena Diagnostics ("Athena") from Thermo Fisher Scientific, Inc., in an all-cash transaction valued at approximately $740 million. We completed the acquisition of Athena on April 4, 2011.

On March 17, 2011, we entered into a definitive merger agreement with Celera Corporation ("Celera") under which we agreed to acquire Celera for $8 per share, in a transaction valued at approximately $344 million, net of $326 million in acquired cash and short-term marketable securities. We completed the acquisition of Celera on May 17, 2011.

On January 6, 2012, we completed the acquisition of S.E.D. Medical Laboratories ("S.E.D.") for approximately $50.5 million.

The acquisitions of Athena, Celera and S.E.D. (collectively "the acquisitions") are further described in Note 4 to the Consolidated Financial Statements in our 2011 Annual Report on Form 10-K and Note 8 to the interim consolidated financial statements.

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 our reported financial results and the disclosure of contingent assets and liabilities. 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 most of our business is generally straightforward with net revenues primarily recognized upon completion of the testing process. Our revenues are primarily comprised of a high volume of relatively low dollar transactions, and about one-half of our total 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. There have been no significant changes to our critical accounting policies from those disclosed in our 2011 Annual Report on Form 10-K.

Results of Operations

Three and Nine Months Ended September 30, 2012 Compared with Three and Nine
Months Ended September 30, 2011

Continuing Operations
                                 Three Months Ended September 30,                Nine Months Ended September 30,
                                                            % Increase                                     % Increase
                                2012            2011        (Decrease)          2012            2011       (Decrease)
                                                  (dollars in millions, except per share data)
Net revenues               $     1,851.4     $ 1,906.4         (2.9 )%     $     5,694.7     $ 5,631.2          1.1 %
Income from continuing
operations                         163.0         172.1         (5.3 )%             499.6         282.3         77.0 %
Earnings per diluted share $        1.01     $    1.08         (6.5 )%     $        3.11     $    1.75         77.7 %

Results for the three months ended September 30, 2012 included $44.6 million of pre-tax charges, or $0.17 per diluted


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share, related to restructuring and integration costs primarily associated with workforce reductions and professional fees associated with further restructuring and integrating our business.

Results for the nine months ended September 30, 2012 were affected by certain items that impacted earnings per diluted share by $0.31. During the nine months ended September 30, 2012, we incurred costs of $70.2 million, or $0.27 per diluted share, primarily associated with workforce reductions and professional fees associated with further restructuring and integrating our business. Results for the nine months ended September 30, 2012 also included $10.1 million, or $0.04 per diluted share, principally associated with separation costs and accelerated vesting of certain equity awards in connection with the succession of our prior CEO.

Results for the three months ended September 30, 2011 were affected by a number of items which impacted earnings per diluted share by $0.10. In connection with a number of cost actions that we implemented in the third quarter of 2011, we recorded pre-tax charges of $27.3 million, or $0.10 per diluted share, principally associated with workforce reductions.

Results for the nine months ended September 30, 2011 were affected by a number of items which impacted earnings per diluted share by $1.55. During the first quarter of 2011, we recorded the Medi-Cal charge of $236 million, or $1.21 per diluted share, in "other operating expense, net." In addition, results for the nine months ended September 30, 2011 included $46.7 million of pre-tax charges, or $0.18 per diluted share, principally associated with workforce reductions. Results for the nine months ended September 30, 2011 also included pre-tax charges of $19.7 million, or $0.09 per diluted share, associated with the acquisitions of Athena and Celera. Of these costs, $16.6 million, primarily related to professional fees and integration costs, were recorded in selling, general and administrative expenses and $3.1 million of financing related costs were included in interest expense, net. In addition, we estimate that the impact of severe weather during the first quarter of 2011 adversely affected operating income for the nine months ended September 30, 2011 by $18.5 million, or $0.07 per diluted share.

In addition, results for the three and nine months ended September 30, 2011 included a benefit of $0.05 per diluted share, primarily associated with the favorable resolution of certain tax contingencies.

Net Revenues

Net revenues for the three months ended September 30, 2012 were 2.9% below the prior year level.

Clinical testing revenue, which accounted for over 90% of our consolidated revenues, decreased by 2.1% for the three months ended September 30, 2012 compared to the prior year period. Clinical testing volume, measured by the number of requisitions, decreased 1.1% for the third quarter of 2012, compared to the prior year period. This decrease was principally due to fewer business days during the quarter, compared to the prior year period. Pre-employment drug testing volume grew about 7% during the third quarter of 2012.

Revenue per requisition for the three months ended September 30, 2012 decreased 1.0% from the prior year level. Favorable test mix and an increase in tests per requisition were offset by reimbursement changes, and business and payor mix changes including an increase in lower priced drugs-of-abuse testing, and a decrease in higher priced anatomic pathology testing.

Net revenues for the nine months ended September 30, 2012 were 1.1% above the prior year level with the Athena, Celera and S.E.D. acquisitions contributing approximately 1.4% to consolidated revenue growth.

Clinical testing revenue increased 1.6% for the nine months ended September 30, 2012 compared to the prior year period. The acquisitions of Athena, Celera and S.E.D. contributed about 1.2% to clinical testing revenue growth during the period. Clinical testing volume, measured by the number of requisitions, increased 1.0% compared to the prior year period. We estimate that the impact of weather favorably affected the year-over-year volume comparisons by about 0.6%, and acquisitions contributed about 0.5%. After considering the favorable impact of weather and acquisitions, underlying volume growth was essentially flat compared to the prior year period. Pre-employment drug testing volume grew about 6% during the nine months ended September 30, 2012.

Revenue per requisition for the nine months ended September 30, 2012 was 0.6% above the prior year period. Revenue per requisition continued to benefit from an increased mix in gene-based and esoteric testing, particularly from the impact of the acquired operations of Athena and Celera and an increase in the number of tests ordered per requisition. Partially offsetting these benefits were reimbursement changes, and business and payor mix changes including an increase in lower priced drugs-of-abuse testing, and a decrease in higher priced anatomic pathology testing.


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Our businesses other than clinical laboratory testing accounted for approximately 9% of our net revenues for the three and nine months ended September 30, 2012 and 2011. These businesses contain most of our international operations and include our risk assessment services, clinical trials testing, healthcare information technology and diagnostic products businesses. For the three months ended September 30, 2012, combined revenues in these businesses decreased by approximately 11%, compared to the prior year period. This decrease was primarily due to a reduction of revenues in our clinical trials testing business. For the nine months ended September 30, 2012, combined revenues in these businesses decreased approximately 4% compared the prior year level. This decrease was primarily due to a reduction in revenues within our clinical trials testing business, partially offset by increased revenues associated with our diagnostics products operations acquired as part of the Celera acquisition.

Operating Costs and Expenses

                                                   Three Months Ended September 30,
                                                                                         Increase
                                       2012                      2011                   (Decrease)
                                             % Net                      % Net                    % Net
                                  $         Revenue          $         Revenue        $         Revenue
                                                        (dollars in millions)
Cost of services             $ 1,089.7        58.9  %   $ 1,116.6        58.6 %   $  (26.9 )       0.3  %
Selling, general and
administrative expenses
(SG&A)                           432.6        23.4          446.6        23.4        (14.0 )         -
Amortization of intangible
assets                            20.0         1.1           19.4         1.0          0.6         0.1
Other operating expense, net       0.4        (0.1 )          1.8         0.1         (1.4 )      (0.2 )
Total operating costs and
expenses                     $ 1,542.7        83.3  %   $ 1,584.4        83.1 %   $  (41.7 )       0.2  %
Bad debt expense (included
in SG&A)                     $    61.2         3.3  %   $    68.4         3.6 %   $   (7.2 )      (0.3 )%



                                                   Nine Months Ended September 30,
                                                                                        Increase
                                      2012                      2011                   (Decrease)
                                             % Net                     % Net                    % Net
                                  $         Revenue         $         Revenue        $         Revenue
                                                        (dollars in millions)
Cost of services             $ 3,316.8        58.2 %   $ 3,318.0        58.9 %   $   (1.2 )      (0.7 )%
Selling, general and
administrative expenses
(SG&A)                         1,374.0        24.1       1,357.2        24.1         16.8           -
Amortization of intangible
assets                            60.4         1.1          47.8         0.9         12.6         0.2
Other operating expense, net       0.4           -         238.3         4.2       (237.9 )      (4.2 )
Total operating costs and
expenses                     $ 4,751.6        83.4 %   $ 4,961.3        88.1 %   $ (209.7 )      (4.7 )%
Bad debt expense (included
in SG&A)                     $   208.4         3.7 %   $   214.4         3.8 %   $   (6.0 )      (0.1 )%

Total Operating Costs and Expenses

For the three months ended September 30, 2012, total operating costs and expenses were $41.7 million below the prior year level, primarily driven by actions we have taken to reduce our cost structure under our Invigorate program. This decrease was partially offset by higher costs primarily associated with workforce reductions and professional fees incurred in connection with further restructuring and integrating our business.

Results for the three months ended September 30, 2012 included $44.6 million of pre-tax restructuring and integration charges ($20.1 million in cost of services and $24.5 million in selling, general and administrative expenses), primarily associated with workforce reductions and professional fees incurred in connection with further restructuring and integrating our business.

Results for the three months ended September 30, 2011 included $27.3 million of pre-tax restructuring and integration


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charges ($15.9 million in cost of services and $11.4 million in selling, general and administrative expenses), principally associated with workforce reductions .

For the nine months ended September 30, 2012, total operating costs and expenses were $209.7 million below the prior year level, primarily due to the impact of the 2011 Medi-Cal charge, transaction costs associated with the acquisitions of Athena and Celera in 2011 and, to a lesser extent, actions we have taken to reduce our cost structure. This decrease was partially offset by higher costs associated with employee compensation and benefits, costs incurred in connection with the succession of our prior CEO and an increase in operating expenses associated with the acquired operations of Athena, Celera and S.E.D. The decrease in total operating expenses as a percentage of net revenues compared to the prior year is principally due to the Medi-Cal charge recorded in 2011.

Results for the nine months ended September 30, 2012 included $70.2 million of pre-tax restructuring and integration charges ($28.6 million in cost of services and $41.6 million in selling, general and administrative expenses), primarily associated with workforce reductions and professional fees incurred in connection with further restructuring and integrating our business . In addition, $10.1million of pre-tax charges, associated with separation costs and accelerated vesting of certain equity awards in connection with the succession of our prior CEO, were recorded in selling, general and administrative expenses in 2012.

Results for the nine months ended September 30, 2011 included the Medi-Cal charge of $236 million recorded in connection with the California Lawsuit. In addition, results for the nine months ended September 30, 2011 included $46.7 million of pre-tax restructuring and integration charges ($24.9 million in cost of services and $21.8 million in selling, general and administrative expenses), principally associated with workforce reductions. Results for the nine months ended September 30, 2011 also included pre-tax transaction costs of $16.6 million associated with the acquisitions of Athena and Celera, primarily related to professional fees, which were recorded in selling, general and administrative expenses.

Also, year-over-year comparisons for both the three and nine months ended September 30, 2012 were unfavorably impacted by approximately $8.4 million and $9.5 million, respectively, associated with gains and losses on investments in our supplemental deferred compensation plans. Under our supplemental deferred compensation plans, employee compensation deferrals, together with Company matching contributions, are invested in a variety of investments held in trusts. Gains and losses associated with the investments are recorded in earnings within other income (expense), net. A corresponding and offsetting adjustment is also recorded to the deferred compensation obligation to reflect investment gains and losses earned by the employee. Such adjustments to the deferred compensation obligation are recorded in earnings principally within selling, general and administrative expenses and offset the amount of investment gains and losses recorded in other income (expense), net. Results for the three and nine months ended September 30, 2012 included an increase in operating costs of $2.5 million and $6.0 million, respectively, representing increases in the deferred compensation obligation to reflect investment gains earned by employees participating in our deferred compensation plans. Results for the three and nine months ended September 30, 2011 included a decrease in operating costs of $5.9 million and $3.5 million, respectively, representing decreases in the deferred compensation obligation to reflect investment losses incurred by employees participating in our deferred compensation plans.

Cost of Services

The increase in cost of services as a percentage of net revenues for the three months ended September 30, 2012 is primarily due to higher costs associated with restructuring and integration activities, compared to the prior year period. Higher costs associated with employee compensation and benefits were essentially offset by the impact of actions we have taken to reduce our cost structure.

The year over year decrease in cost of services as a percentage of revenues for the nine months ended September 30, 2012, primarily reflects the impact of actions we have taken to reduce our cost structure, and the impact of the acquired operations of Athena and Celera which serve to reduce the percentage. In addition, severe weather in 2011, which served to reduce revenues and increase costs as a percentage of revenues, contributed to higher cost of services as a percentage of revenues in 2011 compared to the current year period.


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Selling, General and Administrative Expenses

Selling, general and administrative expenses as a percentage of net revenues for the three months ended September 30, 2012 was essentially unchanged compared to the prior year period. Higher costs associated with restructuring and integration activities in 2012 compared to the prior year period, were essentially offset by the impact of actions we have taken to reduce our cost structure.

Selling, general and administrative expenses as a percentage of net revenues for the nine months ended September 30, 2012 was essentially unchanged compared to the prior year period. Higher costs associated with restructuring and integration activities in 2012, the impact of the acquired operations of Athena and Celera, and costs incurred in connection with the succession of our prior CEO served to increase the percentage compared to the prior year. These increases were essentially offset by the impact of actions we have taken to reduce our cost structure, and the favorable impact on the year over year comparisons of the severe weather in 2011, and the transaction costs associated with the Athena and Celera acquisitions that were incurred during the 2011.

For the three and nine months ended September 30, 2012, bad debt expense as a percentage of net revenues improved compared to the prior year periods, primarily as a result of continued improvement efforts in this area.

Amortization of Intangible Assets

The increase in amortization of intangible assets for the nine months ended September 30, 2012, compared to the prior year period, primarily reflects the impact of amortization of intangible assets acquired as part of the Athena, Celera and S.E.D. acquisitions.

Other Operating Expense, net

Other operating expense, net includes special charges, and miscellaneous income
and expense items related to operating activities. For the nine months ended
September 30, 2011, other operating expense, net included the Medi-Cal charge of
$236 million recorded in connection with the California Lawsuit.

Operating Income

                                 Three Months Ended September 30,                 Nine Months Ended September 30,
                                                             Increase                                        Increase
                               2012             2011        (Decrease)         2012             2011        (Decrease)
                                       (dollars in millions)
Operating income           $    308.7       $    322.1     $    (13.4 )    $    943.1       $    669.9     $     273.2
Operating income as a % of
net revenues                     16.7 %           16.9 %         (0.2 )%         16.6 %           11.9 %           4.7 %

The decrease in operating income as a percentage of net revenues for the three months ended September 30, 2012, compared to the prior year period, primarily reflects higher costs associated with restructuring and integration activities and lower revenues. Partially offsetting these items were actions we have taken to reduce our cost structure.

The impacts of the Medi-Cal charge and severe weather in the first quarter of 2011 served to decrease operating income as a percentage of net revenues in 2011 and are the principal drivers of the improved operating income as a percentage of net revenues for the nine months ended September 30, 2012. Also contributing to the improvement are actions we have taken to reduce our cost structure. Partially offsetting these improvements are higher costs associated with restructuring and integration activities, employee compensation and benefits, . . .

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