How did Quest Diagnostics perform financially in 1998 compared with 1997?

Net revenues fell 4.6% to $1.459 billion because base clinical testing volume declined 7.2%, partly offset by a 2.5% rise in average revenue per requisition. Net income swung to $26.9 million ($0.89 diluted EPS) from a $22.3 million loss in 1997, which had included $48.7 million of restructuring charges and a $6.8 million bad debt charge. Improved cost structure and lower bad debt expense (6.1% of revenues versus 7.4% excluding the special charge in 1997) drove the improvement.

What is the SmithKline Beecham acquisition and how would it change Quest?

Quest agreed on February 9, 1999 to buy SmithKline Beecham's clinical laboratory business for about $1.3 billion, paid with $1.025 billion in cash and 12.6 million new Quest shares. The deal would make Quest the leading U.S. clinical lab, add a national footprint particularly strong in the Southeast and West, and create expected net cost savings above $100 million annually after three years. Debt would rise to about $1.4 billion, SmithKline Beecham would own about 29.5% of Quest, and management expects a negative effect on second-half 1999 profitability with accretion in 2000 before transaction charges. Closing requires stockholder approval, financing, and regulatory clearance; the HSR waiting period has already expired.

What are the main regulatory and legal risks facing Quest?

Quest faces an open federal investigation of Nichols Institute's former billing and marketing practices, several qui tam suits, indictments of four former Damon officers whom Quest must indemnify, and a private class action under federal RICO. Reserves for government and private claims total about $52.6 million, and Corning has agreed to indemnify most government monetary penalties for claims pending at December 31, 1996, though not private claims beyond the specified limits or defense costs. Quest is also operating under a five-year corporate integrity agreement with the OIG, and Medicare reimbursement reductions and utilization controls remain a headwind.

Does Quest pay dividends, and what constrains its capital allocation?

Quest has not paid common dividends in 1997 or 1998 and does not expect to in the foreseeable future. The bank credit facility prohibits cash dividends, and the indenture for its 10.75% senior subordinated notes restricts them based primarily on a percentage of earnings. The company suspended its share repurchase program after the SmithKline Beecham announcement, and the new acquisition financing is expected to carry similar covenants and restrictions.

DGX 10-K FY1998 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed March 31, 1999. Cited figures are marked; the original filing is the authoritative source.

Quest Diagnostics (DGX) reported modest recovery in its 1998 10-K: net revenues fell 4.6% to $1.459 billion^a (from $1.529 billion) on a 7.2% decline in base clinical testing volume, partly offset by a 2.5% increase in average revenue per requisition.

Profitability improved sharply as the company lapped prior-year charges: net income was $26.9 million^b ($0.89 diluted EPS) versus a net loss of $22.3 million in 1997, cost of services fell to 59.0% of revenues from 60.7%, bad debt expense dropped to 6.1% of revenues, and Adjusted EBITDA rose to $158.6 million (10.9% of revenues). Operating cash flow was $141.4 million, days sales outstanding improved to 58 from 63, and total debt was reduced to $465 million (current plus long-term), though it remains high relative to the company's size. The dominant event is the pending $1.3 billion acquisition of SmithKline Beecham's clinical laboratory business (about $1.025 billion cash plus 12.6 million shares), expected to close by July 1999.

If completed, SmithKline Beecham would own roughly 29.5% of Quest, debt would rise to about $1.4 billion^c, and Quest would become the largest U.S. clinical laboratory. Management guides to an adverse impact on second-half 1999 profitability and accretion in 2000 before transaction charges, and the deal depends on stockholder approval and financing for the cash portion.

Investors should weigh the improved earnings and cash generation against several risks: a regulatory overhang (a five-year corporate integrity agreement, ongoing Nichols Institute government investigations, qui tam suits, and reserves of $52.6 million^d, largely indemnified by Corning), declining Medicare reimbursement, pricing pressure from managed care capitation, Year 2000 exposure with estimated remaining costs of $40-60 million, and integration risk from the SmithKline Beecham transaction. The company paid no dividends and its credit agreement prohibits them.

02—Key points

Key Highlights

Net income of $26.9 million ($0.89 diluted EPS) in 1998, a turnaround from a $22.3 million net loss in 1997 that was driven largely by the absence of prior-year special charges.
Net revenues declined 4.6% to $1.459 billion, with base clinical testing volume down 7.2% partly offset by a 2.5% increase in average revenue per requisition.
Adjusted EBITDA rose to $158.6 million (10.9% of net revenues) from $153.8 million (10.1%), and cost of services improved to 59.0% of revenues from 60.7%.
Pending acquisition of SmithKline Beecham's clinical laboratory business for about $1.3 billion ($1.025 billion cash plus 12.6 million shares), expected to close by July 1999 and would make Quest the largest U.S. clinical lab provider; SmithKline Beecham would hold about 29.5% of shares.
Operating cash flow of $141.4 million and improved working capital efficiency (days sales outstanding down to 58 from 63); total debt reduced to about $465 million.
Ongoing regulatory exposure, including the Nichols Institute federal investigation, qui tam suits, and a five-year corporate integrity agreement, with aggregate reserves of $52.6 million and Corning indemnifying much of the government-claim exposure.
Year 2000 remediation costs estimated at $40-60 million going forward, with the company warning of potential payer and Medicare carrier disruption, plus Medicare fee-schedule pressure and managed care pricing pressure.

03—Questions

Frequently Asked Questions

How did Quest Diagnostics perform financially in 1998 compared with 1997?
Net revenues fell 4.6% to $1.459 billion because base clinical testing volume declined 7.2%, partly offset by a 2.5% rise in average revenue per requisition. Net income swung to $26.9 million ($0.89 diluted EPS) from a $22.3 million loss in 1997, which had included $48.7 million of restructuring charges and a $6.8 million bad debt charge. Improved cost structure and lower bad debt expense (6.1% of revenues versus 7.4% excluding the special charge in 1997) drove the improvement.
What is the SmithKline Beecham acquisition and how would it change Quest?
Quest agreed on February 9, 1999 to buy SmithKline Beecham's clinical laboratory business for about $1.3 billion, paid with $1.025 billion in cash and 12.6 million new Quest shares. The deal would make Quest the leading U.S. clinical lab, add a national footprint particularly strong in the Southeast and West, and create expected net cost savings above $100 million annually after three years. Debt would rise to about $1.4 billion, SmithKline Beecham would own about 29.5% of Quest, and management expects a negative effect on second-half 1999 profitability with accretion in 2000 before transaction charges. Closing requires stockholder approval, financing, and regulatory clearance; the HSR waiting period has already expired.
What are the main regulatory and legal risks facing Quest?
Quest faces an open federal investigation of Nichols Institute's former billing and marketing practices, several qui tam suits, indictments of four former Damon officers whom Quest must indemnify, and a private class action under federal RICO. Reserves for government and private claims total about $52.6 million, and Corning has agreed to indemnify most government monetary penalties for claims pending at December 31, 1996, though not private claims beyond the specified limits or defense costs. Quest is also operating under a five-year corporate integrity agreement with the OIG, and Medicare reimbursement reductions and utilization controls remain a headwind.
Does Quest pay dividends, and what constrains its capital allocation?
Quest has not paid common dividends in 1997 or 1998 and does not expect to in the foreseeable future. The bank credit facility prohibits cash dividends, and the indenture for its 10.75% senior subordinated notes restricts them based primarily on a percentage of earnings. The company suspended its share repurchase program after the SmithKline Beecham announcement, and the new acquisition financing is expected to carry similar covenants and restrictions.

04—Continue

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