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DGX > SEC Filings for DGX > Form 10-Q on 25-Jul-2013All Recent SEC Filings

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Form 10-Q for QUEST DIAGNOSTICS INC


25-Jul-2013

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 information services ("DIS") providing insights that empower and enable patients, physicians, hospitals, integrated delivery networks, health plans, employers and others to make better healthcare decisions. Over 90% of our revenues are derived from DIS with the balance derived from risk assessment services, clinical trials testing, diagnostic products and healthcare information technology. Our business segment information is disclosed in Note 13 to the interim consolidated financial statements.

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 $600 million in annual run-rate cost savings versus 2011 by the time we exit 2014. We are continuing to seek additional opportunities to increase the savings from Invigorate, to as much as $1 billion over time, and where practical to accelerate the savings. 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 approximately 35% of the savings to come from laboratory operations and specimen acquisition by driving process standardization across all laboratory operations and by creating a new logistics operating platform; approximately 25% of the savings to come from procurement and supply chain by further automating and standardizing technology platforms with suppliers and by building global sourcing capabilities; approximately 25% of the savings from selling, general and administrative expenses, including information technology, by reducing management layers and increasing spans of control, centralizing and selective outsourcing of certain activities, and migrating to standard information technology systems and data bases; and approximately 15% of the savings from client support/billing by increasing the utilization of electronic billing, creating one standard billing system and partnering with payers to improve efficiency.

In connection with our Invigorate program, we launched a voluntary retirement program to certain eligible employees that qualified for the program. This program was essentially completed at the end of the first quarter of 2013. This program will contribute an estimated $40 million in annualized savings, and we have incurred approximately $49 million of pre-tax employee separation costs in connection with the voluntary separation program through June 30, 2013.

In October 2012, as part of Invigorate, we launched a major management restructuring aimed at driving operational excellence and restoring growth. We have completed the elimination of at least three layers from the organization, and have reduced approximately 450 management positions through the end of the second quarter of 2013, contributing about $80 million of the $600 million in expected savings associated with our Invigorate program. We expect to eliminate a total of approximately 500 management positions by the end of 2013. In the six months ended June 30, 2013, we recorded approximately $18.5 million of employee separation costs associated this management restructuring initiative, and are on-track to meet our expected savings in 2013.

As a result of our Invigorate program, we expect to deliver more than $250 million in realized savings in 2013 versus 2012. Furthermore, we continue to track well against our goal to deliver $600 million of run rate savings by the end of 2014.

Our high-level estimates of the pre-tax charges expected to be incurred through 2014 in connection with our Invigorate program remain unchanged. The total estimated pre-tax charges range from $170 million to $250 million and consist of $90 million to $135 million of employee separation costs; $30 million to $45 million of facility-related costs; $10 million to $20 million of asset impairment charges; and $40 million to $50 million of systems conversion and integration costs. Of the total estimated pre-tax charges expected to be incurred, we estimate that $160 million to $230 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. Through June 30, 2013, the cumulative charge recorded in connection with the Invigorate program totaled $135.5 million.


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For additional information on the Invigorate program and associated costs (see Note 4 to the Consolidated Financial Statements).

Divestiture of Business

In April 2013, we completed the sale of HemoCue, our diagnostic point-of-care testing business ("HemoCue"). As a
result of the sale, discontinued operations for the three and six months ended June 30, 2013 includes a gain of $13.3 million.

Sale of Future Royalty Rights

In July 2013, we completed the sale of our rights to royalties from commercialization of the drug candidate ibrutinib to Royalty Pharma, Inc. for $485 million in cash. We are entitled to these rights pursuant to a royalty agreement between Celera Corporation (which we acquired in May 2011) and Pharmacyclics, Inc.

Recent Acquisitions

Acquisition of Businesses from UMass Memorial Medical Center

On January 2, 2013, we completed the acquisition of the clinical outreach and anatomic pathology businesses of UMass Memorial Medical Center ("UMass"). This purchase is the first step in a series of transactions between the parties whereby the two organizations expect to eventually have a financial stake in a new entity that will perform diagnostic information testing services in a defined territory within the state of Massachusetts.

Acquisition of Advanced Toxicology Network

On May 15, 2013, we completed the acquisition of the toxicology and clinical laboratory business of Advanced Toxicology Network ("ATN") from Concentra, a subsidiary of Humana Inc.

Acquisition of Business from Dignity Health

On June 22, 2013, we completed the acquisition of certain lab-related clinical outreach service operations of Dignity Health ("Dignity"), a hospital system in California.

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 2012 Annual Report on Form 10-K.


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Results of Operations

Three and Six Months Ended June 30, 2013 Compared with Three and Six Months
Ended June 30, 2012

Continuing Operations
                                  Three Months Ended June 30,                 Six Months Ended June 30,
                                                         % Increase                                % Increase
                               2013           2012       (Decrease)       2013          2012       (Decrease)
                                              (dollars in millions, except per share data)
Net revenues               $   1,815.7     $ 1,878.4         (3.3 )%   $ 3,602.4     $ 3,787.0         (4.9 )%
Income from continuing
operations                       152.7         175.2        (12.8 )%       268.2         331.3        (19.0 )%
Earnings per diluted share $      0.99     $    1.09         (9.2 )%   $    1.71     $    2.06        (17.0 )%

Results for the three months ended June 30, 2013 include $18.8 million of pre-tax charges, or $0.07 per diluted 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 six months ended June 30, 2013 included $63.3 million of pre-tax charges, or $0.24 per diluted 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 three months ended June 30, 2012 were affected by certain items that impacted earnings per diluted share by $0.06. During the second quarter of 2012, we incurred costs of $12.3 million, or $0.05 per diluted share, primarily associated with professional fees and workforce reductions associated with further restructuring and integrating our business. Results for the quarter also included $3.0 million, or $0.01 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 six months ended June 30, 2012 were affected by certain items that impacted earnings per diluted share by $0.14. During the six months ended June 30, 2012, we incurred costs of $25.4 million, or $0.10 per diluted share, primarily associated with professional fees and workforce reductions associated with further restructuring and integrating our business. Results for the six months ended June 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.

Net Revenues

Net revenues for the three months ended June 30, 2013 were 3.3% below the prior year level. Net revenues decreased in the second quarter of 2013 due to lower healthcare utilization, which impacted many healthcare providers, as well as reduction in reimbursement.

DIS revenue, which accounted for over 90% of our consolidated net revenues, decreased by 3.6% for the three months ended June 30, 2013 compared to the prior year period. DIS volume, measured by the number of requisitions, increased 0.1% for the second quarter of 2013 compared to the prior year period. The acquisitions of UMass, ATN and Dignity contributed approximately 1.6% to the DIS volume growth in the quarter. The contribution from these acquisitions was essentially offset by a decrease in our underlying volumes of approximately 1.5% as compared to the prior year period. This compares to the first quarter of 2013 where our underlying volumes were down 2% as compared to the first quarter of 2012.

Revenue per requisition for the three months ended June 30, 2013 decreased 3.7% from the prior year level. This decrease is primarily associated with a Medicare fee schedule reduction, including pathology reimbursement reductions that went into effect at the beginning of the year and Medicare reductions related to sequestration, which were implemented at the beginning of the current quarter. Certain commercial fee schedule changes, all of which went into effect at the beginning of the year, also negatively impacted revenue per requisition in the quarter. Revenue per requisition was also negatively impacted by a decrease in higher priced anatomic pathology testing and an increase in lower priced drugs-of-abuse testing, which includes the impact of the ATN acquisition.

Net revenues for the six months ended June 30, 2013 were 4.9% below the prior year level. DIS revenue, which accounted for over 90% of our consolidated net revenues, decreased by 5.2% for the six months ended June 30, 2013 compared


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to the prior year period. DIS volume, measured by the number of requisitions, decreased 1.6% compared to the prior year period. The acquisitions of UMass, ATN and Dignity contributed approximately 1.2% to the DIS volume for the six months ended June 30, 2013. The contribution from these acquisitions was partially offset by fewer business days and weather during the current period, as compared to the prior year period. The underlying volume was about 2% below the prior year.

Revenue per requisition for the six months ended June 30, 2013 decreased 3.6% from the prior year level. This decrease is primarily associated with a Medicare fee schedule reduction, including pathology reimbursement reductions, as well as certain commercial fee schedule changes, all of which went into effect at the beginning of the year. Revenue per requisition was also negatively impacted by a decrease in higher priced anatomic pathology testing and an increase in lower priced drugs-of-abuse testing. We expect reimbursement pressures to adversely impact our underlying revenue per requisition by about 3% for the full year in 2013, as compared to 2012.

Our Diagnostic Solutions ("DS") business accounted for approximately 8% of our net revenues for the three and six months ended June 30, 2013 and 2012. For the three months ended June 30, 2013, combined revenues in these businesses increased by approximately 0.4%, compared to the prior year period. This compares to the first quarter of 2013, where combined revenues in these businesses were down approximately 2% as compared to the first quarter of 2012. For the six months ended June 30, 2013, combined revenues in these businesses decreased by approximately 1.0%, compared to the prior year period. The decrease in both periods was primarily due to a reduction in revenues within our clinical trials testing business.

Operating Costs and Expenses

                                                     Three Months Ended June 30,
                                                                                         Increase
                                       2013                      2012                   (Decrease)
                                             % Net                      % Net                    % Net
                                  $         Revenue          $         Revenue        $         Revenue
                                                        (dollars in millions)
Cost of services             $ 1,093.7        60.2  %   $ 1,101.9        58.7 %   $   (8.2 )       1.5  %
Selling, general and
administrative expenses
(SG&A)                           418.5        23.1          424.1        22.6         (5.6 )       0.5
Amortization of intangible
assets                            19.8         1.1           18.8         1.0          1.0         0.1
Other operating expense, net      (5.0 )      (0.3 )          0.2           -         (5.2 )      (0.3 )
Total operating costs and
expenses                     $ 1,527.0        84.1  %   $ 1,545.0        82.3 %   $  (18.0 )       1.8  %
Bad debt expense (included
in SG&A)                     $    67.5         3.7  %   $    66.5         3.5 %   $    1.0         0.2  %



                                                       Six Months Ended June 30,
                                                                                          Increase
                                       2013                       2012                   (Decrease)
                                             % Net                      % Net                     % Net
                                  $         Revenue          $         Revenue         $         Revenue
                                                         (dollars in millions)
Cost of services             $ 2,185.5        60.7  %   $ 2,211.1        58.4  %   $  (25.6 )       2.3  %
Selling, general and
administrative expenses
(SG&A)                           866.4        24.1          907.3        24.0         (40.9 )       0.1
Amortization of intangible
assets                            39.0         1.1           37.6         1.0           1.4         0.1
Other operating expense, net      (4.2 )      (0.2 )         (0.1 )      (0.1 )        (4.1 )      (0.1 )
Total operating costs and
expenses                     $ 3,086.7        85.7  %   $ 3,155.9        83.3  %   $  (69.2 )       2.4  %
Bad debt expense (included
in SG&A)                     $   139.4         3.9  %   $   147.2         3.9  %   $   (7.8 )         -  %

Total Operating Costs and Expenses

For the three months ended June 30, 2013, total operating costs and expenses were $18.0 million below the prior year level, primarily driven by actions we have taken to reduce our cost structure under our Invigorate program and lower testing volumes in our DIS business. The savings associated with Invigorate have served to mitigate some of the earnings impact from


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the year over year revenue decrease. These savings were partially offset by higher costs primarily associated with workforce reductions and professional fees incurred in connection with further restructuring and integrating our business. These costs totaled $18.8 million ($6.9 million in cost of services and $11.9 million in selling, general and administrative expenses).

Results for the three months ended June 30, 2012 included costs of $12.3 million, primarily associated with professional fees and workforce reductions incurred in connection with further restructuring and integrating our business ($4.6 million in cost of services and $7.7 million in selling, general and administrative expenses). In addition, $3.0 million 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.

For the six months ended June 30, 2013, total operating costs and expenses were $69.2 million below the prior year level, primarily driven by actions we have taken to reduce our cost structure under our Invigorate program and lower testing volumes in our DIS business. The savings associated with Invigorate have served to mitigate some of the earnings impact from the year over year revenue decrease. These savings were partially offset by higher costs primarily associated with workforce reductions and professional fees incurred in connection with further restructuring and integrating our business. These costs totaled $63.3 million ($24.3 million in cost of services and $39.0 million in selling, general and administrative expenses).

Results for the six months ended June 30, 2012 included costs of $25.4 million, primarily associated with professional fees and workforce reductions incurred in connection with further restructuring and integrating our business ($8.6 million in cost of services and $16.8 million in selling, general and administrative expenses). In addition, $10.1 million 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.

Cost of Services

The decrease in cost of services for the three and six months ended June 30, 2013 is primarily due to the impact of actions we have taken to reduce our cost structure under the Invigorate program and lower testing volumes in our DIS business. This was partially offset by higher costs associated with restructuring and integration activities in 2013, compared to both prior year periods. The decrease in net revenues was the primary factor for the increase in cost of services as a percentage of net revenues in 2013 compared to both prior year periods.

Selling, General and Administrative Expenses

Selling, general and administrative expenses for the three and six months ended June 30, 2013 decreased as a result of actions we have taken to reduce our cost structure under the Invigorate program as compared to the prior year periods.

Amortization of Intangible Assets

The increase in amortization of intangible assets for the three and six months ended June 30, 2013, compared to the prior year period, primarily reflects the impact of amortization of intangible assets acquired as part of the ATN, Dignity and UMass acquisitions.

Other Operating (Income) Expense, net

Other operating (income) expense, net includes miscellaneous income and expense
items related to operating activities. For both the three and six months ended
June 30, 2013, other operating (income) expense, net includes a gain of $5.7
million resulting from consideration received associated with certain
non-compete agreements.

Operating Income
                                   Three Months Ended June 30,               Six Months Ended June 30,
                                                          Increase                                Increase
                                2013          2012       (Decrease)      2013         2012       (Decrease)
                                                          (dollars in millions)
Operating income            $   288.7      $  333.4     $    (44.7 )  $  515.7     $  631.2     $   (115.5 )
Operating income as a % of
net revenues                     15.9 %        17.7 %         (1.8 )%     14.3 %       16.7 %         (2.4 )%


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The decrease in operating income as a percentage of net revenues for the three and six months ended June 30, 2013, compared to both prior year periods, is primarily a function of reduced revenues and higher costs associated with restructuring and integration activities, partially offset by savings realized from our Invigorate program.

Interest Expense, net
                                 Three Months Ended June 30,                Six Months Ended June 30,
                                                        Increase                                  Increase
                              2013          2012       (Decrease)       2013          2012       (Decrease)
                                    (dollars in millions)
Interest expense, net      $    39.9     $   41.8     $     (1.9 )   $    79.8     $   83.9     $     (4.1 )

Interest expense, net for the three and six months ended June 30, 2013 decreased, compared to prior year period, primarily due to lower average outstanding debt balances in 2013.

Other Income (Expense), net

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 months ended June 30, 2013 and 2012, other income (expense), net includes a gain of $0.3 million and a loss of $1.3 million, respectively, associated with investments held in trusts pursuant to our supplemental deferred compensation plans. For the six months ended June 30, 2013 and 2012, other income (expense), net includes gains of $3.6 million and $3.5 million, respectively, associated with investments held in trusts pursuant to our supplemental deferred compensation plans.

Income Tax Expense
                                  Three Months Ended June 30,                  Six Months Ended June 30,
                                                          Increase                                   Increase
                               2013           2012       (Decrease)        2013          2012       (Decrease)
                                                           (dollars in millions)
Income tax expense         $    94.5       $  113.7     $    (19.2 )    $   167.8     $  216.3     $    (48.5 )
Effective income tax rate       36.9 %         38.2 %         (1.3 )%        37.1 %       38.2 %         (1.1 )%

The decrease in the effective income tax rate for the three and six months ended June 30, 2013, compared to both prior year periods, is due primarily to certain tax credits reflected in the effective income tax rate for 2013.

Discontinued Operations

Discontinued operations for the three and six months ended June 30, 2013 include HemoCue, OralDNA, a salivary-diagnostics business ("OralDNA"), which was sold during the fourth quarter of 2012 and NID, a test kit manufacturing subsidiary. The results of operations for HemoCue, OralDNA and NID have been classified as discontinued operations for all periods presented. See Note 12 to the interim consolidated financial statements for further details.


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The following table summarizes our income from discontinued operations, net of taxes:

                                       Three Months Ended June 30,                     Six Months Ended June 30,
                                                               Increase                                        Increase
                                   2013           2012        (Decrease)           2013            2012       (Decrease)
                                          (dollars in millions)                          (dollars in millions)
Net revenues                   $     2.6       $    28.5     $     (25.9 )   $    27.6          $   56.2     $     (28.6 )
Income from discontinued
operations before taxes             21.1             1.6            19.5          22.1               4.2            17.9
Income tax (expense) benefit        (8.3 )           0.9            (9.2 )        11.0               1.3             9.7

Income from discontinued
operations, net of taxes       $    12.8       $     2.5     $      10.3     $    33.1          $    5.5     $      27.6

Discontinued operations, net of taxes, for the three and six months ended June 30, 2013 includes a gain of $13.3 million (including foreign currency translation adjustments, partially offset by income tax expense and transaction costs) associated with the sale of HemoCue. In addition, income from discontinued operations, net of taxes for the six months ended June 30, 2013, includes discrete tax benefits of $19.8 million associated with favorable resolution of certain tax contingencies related to our NID business.

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