<PAGE> 1
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER 000-21949
PACIFICARE HEALTH SYSTEMS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
<TABLE>
<S> <C>
DELAWARE 95-4591529
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER IDENTIFICATION NUMBER)
INCORPORATION OR ORGANIZATION)
</TABLE>
3120 LAKE CENTER DRIVE, SANTA ANA, CALIFORNIA 92704
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) (714) 825-5200
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 such 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 __
As of October 30, 1998, there were 14,830,961 shares of the Registrant's
Class A Common Stock, par value $0.01 per share, outstanding, and 30,682,765
shares of Class B Common Stock, par value $0.01 per share, outstanding.
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<PAGE> 2
PACIFICARE HEALTH SYSTEMS, INC.
FORM 10-Q INDEX
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Condensed Consolidated Balance Sheets as of
September 30, 1998 and December 31, 1997........... 1
Consolidated Statements of Operations for the
three months ended September 30, 1998 and 1997..... 2
Consolidated Statements of Operations for the nine
months ended September 30, 1998 and 1997........... 3
Consolidated Statements of Cash Flows for the nine
months ended September 30, 1998 and 1997........... 4
Notes to Condensed Consolidated Financial
Statements......................................... 6
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS................. 11
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.................... 20
SIGNATURES.................................................. 21
EXHIBITS
</TABLE>
<PAGE> 3
PART I: FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS
PACIFICARE HEALTH SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1998 1997
------------- ------------
(UNAUDITED)
(IN THOUSANDS,
EXCEPT PER SHARE DATA)
<S> <C> <C>
ASSETS
Current assets:
Cash and equivalents...................................... $ 181,504 $ 680,674
Marketable securities..................................... 994,397 864,708
Receivables, net.......................................... 283,429 301,345
Prepaid expenses and other current assets................. 19,091 32,194
Deferred income taxes..................................... 96,892 112,037
---------- ----------
Total current assets.............................. 1,575,313 1,990,958
---------- ----------
Property, plant and equipment, net.......................... 193,581 235,943
Marketable securities -- restricted......................... 153,982 145,989
Goodwill and intangible assets, net......................... 2,401,769 2,458,463
Other assets................................................ 23,070 36,605
---------- ----------
$4,347,715 $4,867,958
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Medical claims and benefits payable....................... $ 661,900 $ 715,600
Accounts payable and accrued liabilities.................. 562,186 429,524
Unearned premium revenue.................................. 36,931 491,808
Long-term debt due within one year........................ 149 154
---------- ----------
Total current liabilities......................... 1,261,166 1,637,086
---------- ----------
Long-term debt due after one year........................... 751,121 1,011,234
Deferred income taxes....................................... 102,756 102,793
Other liabilities........................................... 49,455 54,283
Minority interest........................................... 355 375
Shareholders' equity:
Preferred shares, par value $0.01 per share; 40,000 shares
authorized; 10,517 shares of Series A Convertible
Preferred Stock issued and outstanding at December 31,
1997................................................... -- 105
Class A common shares, par value $0.01 per share; 100,000
shares authorized; 14,873 and 14,794 shares issued at
September 30, 1998 and December 31, 1997,
respectively........................................... 149 148
Class B common shares, par value $0.01 per share; 100,000
shares authorized; 31,411 and 27,201 shares issued at
September 30, 1998 and December 31, 1997,
respectively........................................... 314 272
Additional paid-in capital................................ 1,618,227 1,599,229
Accumulated other comprehensive income.................... 17,496 9,993
Retained earnings......................................... 590,630 452,440
Treasury shares, at cost: Class A common shares - 42;
Class B common shares - 728............................ (43,954) --
---------- ----------
Total shareholders' equity........................ 2,182,862 2,062,187
---------- ----------
$4,347,715 $4,867,958
========== ==========
</TABLE>
See accompanying notes.
1
<PAGE> 4
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
SEPTEMBER 30,
-----------------------
1998 1997
---------- ----------
(IN THOUSANDS,
EXCEPT PER SHARE DATA)
<S> <C> <C>
Revenue:
Commercial premiums....................................... $ 969,575 $1,006,239
Government premiums (Medicare and Medicaid)............... 1,402,638 1,382,399
Other income.............................................. 28,684 12,717
---------- ----------
Total operating revenue........................... 2,400,897 2,401,355
---------- ----------
Expenses:
Health care services:
Commercial services....................................... 802,849 867,337
Government services....................................... 1,206,475 1,183,652
---------- ----------
Total health care services........................ 2,009,324 2,050,989
---------- ----------
Marketing, general and administrative expenses.............. 268,235 271,663
Amortization of goodwill and intangible assets.............. 19,543 21,295
Disposition charges......................................... 15,644 --
Office of Personnel Management charge....................... 3,776 --
---------- ----------
Operating income............................................ 84,375 57,408
Net investment income....................................... 29,193 22,196
Interest expense............................................ (13,828) (18,069)
---------- ----------
Income before income taxes.................................. 99,740 61,535
Provision for income taxes.................................. 46,509 30,767
---------- ----------
Net income.................................................. $ 53,231 $ 30,768
========== ==========
Preferred dividends......................................... -- (2,629)
---------- ----------
Net income available to common shareholders................. $ 53,231 $ 28,139
========== ==========
Basic earnings per share.................................... $ 1.17 $ 0.67
========== ==========
Diluted earnings per share.................................. $ 1.16 $ 0.67
========== ==========
</TABLE>
See accompanying notes.
2
<PAGE> 5
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
-----------------------
1998 1997
---------- ----------
(IN THOUSANDS,
EXCEPT PER SHARE DATA)
<S> <C> <C>
Revenue:
Commercial premiums....................................... $2,891,561 $2,759,127
Government premiums (Medicare and Medicaid)............... 4,205,669 3,831,597
Other income.............................................. 81,876 35,334
---------- ----------
Total operating revenue........................... 7,179,106 6,626,058
---------- ----------
Expenses:
Health care services:
Commercial services....................................... 2,405,952 2,367,428
Government services....................................... 3,626,931 3,280,934
---------- ----------
Total health care services........................ 6,032,883 5,648,362
---------- ----------
Marketing, general and administrative expenses.............. 826,212 753,090
Amortization of goodwill and intangible assets.............. 57,444 53,855
Disposition charges......................................... 15,644 --
Office of Personnel Management charge....................... 3,776 --
---------- ----------
Operating income............................................ 243,147 170,751
Net investment income....................................... 78,347 60,249
Interest expense............................................ (48,259) (46,483)
---------- ----------
Income before income taxes.................................. 273,235 184,517
Provision for income taxes.................................. 129,787 92,258
---------- ----------
Net income.................................................. $ 143,448 $ 92,259
========== ==========
Preferred dividends......................................... (5,258) (6,163)
---------- ----------
Net income available to common shareholders................. $ 138,190 $ 86,096
========== ==========
Basic earnings per share.................................... $ 3.20 $ 2.15
========== ==========
Diluted earnings per share.................................. $ 3.12 $ 2.11
========== ==========
</TABLE>
See accompanying notes.
3
<PAGE> 6
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------
1998 1997
-------- -----------
(IN THOUSANDS)
<S> <C> <C>
Operating activities:
Net income............................................. $143,448 $ 92,259
Adjustments to reconcile net income to net cash used in
operating activities:
Amortization of goodwill and intangible assets.... 57,444 53,855
Depreciation and amortization..................... 35,119 36,127
Disposition charges............................... 15,644 --
Deferred income taxes............................. 10,681 (2,399)
Loss on disposal of property, plant and
equipment....................................... 4,444 4,227
Office of Personnel Management charge............. 3,776 --
Provision for doubtful accounts................... 2,608 2,212
Other noncash items............................... (20) --
Changes in assets and liabilities, net of effects
from acquisitions:
Receivables.................................. 15,308 (17,152)
Prepaid expenses and other assets............ 26,638 7,085
Medical claims and benefits payable.......... (53,700) 4,460
Accounts payable and accrued liabilities..... 114,346 (96,614)
Unearned premium revenue..................... (454,877) (215,977)
-------- -----------
Net cash flows used in operating activities....... (79,141) (131,917)
-------- -----------
Investing activities:
(Purchase) sale of marketable securities............... (117,759) 38,743
Proceeds from the sale of property, plant and
equipment............................................. 31,318 --
Purchase of property, plant and equipment.............. (28,519) (48,201)
Purchase of marketable securities - restricted......... (7,993) (11,982)
Acquisitions, net of cash acquired..................... (750) (982,379)
-------- -----------
Net cash flows used in investing activities....... (123,703) (1,003,819)
-------- -----------
Financing activities:
Principal payments on long-term debt................... (290,117) (180,821)
Repurchase of common stock............................. (44,658) --
Proceeds from long-term borrowing, net of expenses..... 30,000 1,107,783
Proceeds from issuance of common and treasury stock.... 14,117 41,537
Cash dividends paid to preferred shareholders.......... (5,258) (6,163)
Redemption of preferred stock.......................... (410) --
Capitalization of Talbert.............................. -- (67,000)
Proceeds from sale of Talbert stock.................... -- 59,598
-------- -----------
Net cash flows (used in) provided by financing
activities...................................... (296,326) 954,934
-------- -----------
Net decrease in cash and equivalents........................ (499,170) (180,802)
Beginning cash and equivalents.............................. 680,674 367,748
-------- -----------
Ending cash and equivalents................................. $181,504 $ 186,946
======== ===========
</TABLE>
See accompanying notes.
4
<PAGE> 7
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
--------------------
1998 1997
------- ----------
(IN THOUSANDS)
<S> <C> <C>
Supplemental cash flow information:
Cash paid during the period for:
Income taxes........................................... $ 8,163 $ 109,768
Interest............................................... $44,737 $ 40,710
Supplemental schedule of noncash investing and financing
activities:
Tax benefit realized upon exercise of stock options.... $ 4,935 $ 17,488
Compensation awarded in Class B Common Stock........... $ 998 $ 721
Details of businesses acquired in purchase transactions:
Fair value of assets acquired............................. $ 750 $3,365,674
Liabilities assumed or created............................ -- (1,172,910)
Preferred and common consideration........................ -- (1,163,595)
------- ----------
Cash paid for acquisitions................................ 750 1,029,169
Cash acquired in acquisitions............................. -- (46,790)
------- ----------
Net cash paid for acquisitions............................ $ 750 $ 982,379
======= ==========
Details of accumulated other comprehensive income:
Change in marketable securities........................... $11,930 $ 6,581
Less change in deferred income taxes...................... (4,427) (1,102)
------- ----------
Change in shareholders' equity............................ $ 7,503 $ 5,479
======= ==========
</TABLE>
See accompanying notes.
5
<PAGE> 8
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1998
(UNAUDITED)
NOTE 1 - BASIS OF PRESENTATION
PacifiCare Health Systems, Inc. (the "Company" or "PacifiCare") is one of
the leading health care services companies in the United States, serving
approximately 3.6 million members in the commercial, Medicare and Medicaid lines
of business. Following the rules and regulations of the Securities and Exchange
Commission ("SEC"), PacifiCare has omitted footnote disclosures that would
substantially duplicate the disclosures contained in the annual audited
financial statements. These unaudited condensed consolidated financial
statements should be read together with the consolidated financial statements
and the notes included in PacifiCare's December 31, 1997 Annual Report on Form
10-K, filed with the SEC in March 1998.
The accompanying unaudited condensed consolidated financial statements
reflect all adjustments, consisting solely of normal recurring adjustments,
needed to present fairly the financial results for these interim periods. The
results of operations presented for the interim periods are not necessarily
indicative of the results for a full year.
NOTE 2 - ACQUISITIONS AND DISPOSITIONS
On September 30, 1998, PacifiCare sold the outstanding common stock of its
Utah HMO subsidiary to Elan Health Partners, LLC, a Utah limited liability
company. The Utah HMO will operate as Altius Health Plans. Under the terms of
the stock purchase agreement, PacifiCare guaranteed the buyer that the Utah HMO
would have a minimum net equity of $10 million based on the audited values of
the assets acquired and liabilities assumed on the closing date. On October 31,
1998, the Company sold its workers' compensation subsidiary to HIH America
Compensation & Liability Insurance Company. The Company recognized pretax
charges of approximately $15 million ($8 million or $0.18 diluted loss per
share, net of tax) for the disposition of its Utah HMO and workers' compensation
subsidiaries. The workers' compensation company will be excluded from the
Company's consolidated results of operations and financial position in the
fourth quarter.
In February 1997, PacifiCare acquired FHP International Corporation
("FHP"). Because this acquisition was accounted for as a purchase, total
consideration of approximately $2.2 billion was allocated to the assets acquired
and liabilities assumed based on estimates of their fair values. The fair values
of the assets acquired and liabilities assumed were $0.9 billion and $1.1
billion, respectively. A total of $2.4 billion, net of related deferred taxes,
representing the excess of the purchase price over the estimated fair values of
the net assets acquired, was allocated to goodwill and other acquired intangible
assets and is being amortized over a four to 40 year period.
In February 1997, PacifiCare sold the outstanding common stock of its
Florida subsidiary, at which time the buyer assumed the daily operations. The
sales price, which approximated net book value, totaled $9 million. The close of
the sale was completed in July 1997 when PacifiCare received regulatory approval
from the state of Florida.
The pro forma information below presents combined results of operations as
if the sales of the Utah and Florida subsidiaries and the FHP acquisition had
occurred at the beginning of 1997. This information reflects PacifiCare's actual
operating results before these transactions, plus adjustments for interest
expense, goodwill amortization and income taxes. No adjustment was made to give
effect to synergies that may be realized as a
6
<PAGE> 9
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1998
(UNAUDITED)
result of the FHP acquisition. Because the sale of the workers' compensation
subsidiary is not material to the Company's results of operations, it is not
included in the pro forma information below.
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------- -----------------------
1998 1997 1998 1997
---------- ---------- ---------- ----------
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
Total operating revenue....................... $2,354,055 $2,333,125 $7,025,582 $7,021,032
Pretax income................................. $ 120,238 $ 71,199 $ 308,353 $ 197,003
Net income.................................... $ 65,489 $ 36,736 $ 164,449 $ 96,865
Basic earnings per share...................... $ 1.43 $ 0.81 $ 3.69 $ 2.18
Diluted earnings per share.................... $ 1.42 $ 0.80 $ 3.57 $ 2.10
</TABLE>
NOTE 3 - LONG-TERM DEBT
PacifiCare has a $1.5 billion credit facility under which it had $650
million in borrowings outstanding as of September 30, 1998. The terms of this
facility require a mandatory step-down payment schedule that begins on January
1, 1999 and ends on January 1, 2002 if the principal balance exceeds certain
thresholds. Because the current balance is $650 million, no step-down payments
are required until the final maturity date on January 1, 2002. Interest under
the credit facility is variable and is presently based on the London Interbank
Offering Rate ("LIBOR") plus a spread, except for $250 million of the
outstanding balance that is covered by interest-rate swap agreements. The
average fixed interest rate PacifiCare pays on the existing swap agreements is
approximately six percent. The terms of the credit facility contain various
covenants usual for financing of this type, including a minimum net worth
requirement, a minimum fixed charge requirement, leverage ratios and limits on
the amount of treasury stock that may be purchased by the Company. At September
30, 1998, PacifiCare was in compliance with all such covenants. PacifiCare also
has $100 million in senior notes outstanding that were assumed in the FHP
acquisition. These notes carry an interest rate of seven percent, are payable
semiannually and mature on September 15, 2003.
NOTE 4 - SHAREHOLDERS' EQUITY
On May 22, 1998, PacifiCare announced the redemption of its 10,517,044
shares of Series A Preferred Stock. All but 15,604 shares of the Series A
Preferred Stock were converted into 3,929,503 shares of Class B Common Stock as
of the June 23, 1998 redemption date. The conversion ratio was one share of
Series A Preferred Stock to 0.37419548 of a share of Class B Common Stock. The
shares not converted were redeemed in cash for $25.77 per share, including
accrued and unpaid dividends of approximately $0.02 per share, or $0.4 million
in the aggregate. During the nine months ended September 30, 1998, PacifiCare
paid approximately $5 million in dividends to its preferred shareholders.
In January 1998, PacifiCare's board of directors approved a plan to
repurchase shares of the Company's outstanding common stock. PacifiCare has and
may continue to repurchase its outstanding common stock using cash flows from
operations and additional borrowings under the credit facility. The terms of the
credit facility permit PacifiCare to repurchase up to $500 million of its
outstanding common stock. Shares repurchased have been and will be reissued for
PacifiCare's employee benefit plans or for other corporate purposes. See
"Liquidity and Capital Resources."
NOTE 5 - CONTINGENCIES
OPM. In September 1998, a pretax charge of approximately $4 million ($2
million, or $0.04 diluted loss per share, net of tax) was recognized to increase
reserves in anticipation of negotiations relating to potential
7
<PAGE> 10
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1998
(UNAUDITED)
governmental claims for contracts with the United States Office of Personnel
Management ("OPM"). The Company's HMO subsidiaries have commercial contracts
with OPM to provide managed health care services to members under the Federal
Employees Health Benefit Program ("FEHBP") for federal employees, annuitants and
their dependents. In the normal course of business, OPM audits health plans with
which it contracts to, among other things, verify that the premiums calculated
and charged to OPM are established in compliance with the best price community
rating guidelines established by OPM. OPM typically audits plans once every five
or six years, and each audit covers the prior five or six year period. Depending
on the type of contract the Company has with OPM, OPM will audit one or more
health plans at the same time. While the government's initial on-site audits are
usually followed by a post-audit briefing in which the government indicates its
preliminary results, final resolution and settlement of the audits have
historically taken a minimum of three to five years. In connection with the sale
of its health plans in New Mexico, Illinois and Utah, the Company has agreed to
indemnify the buyers for potential OPM liabilities that relate to the years in
which the Company owned these plans.
In addition to claims made by the OPM auditors as part of the normal audit
process, OPM may also refer their results to the United States Department of
Justice ("DOJ") for potential legal action under the False Claims Act. The DOJ
has the authority to file a claim under the False Claims Act if it believes that
the health plan knowingly overcharged the government or otherwise submitted
false documentation or certifications. In False Claims Act actions, the
government may impose trebled damages and a civil penalty of not less than
$5,000 nor more than $10,000 for each separate alleged false claim. In November
1997, the Company was notified that the 1995 audit of the operations of the
Company's Oklahoma HMO subsidiary had been referred to the DOJ. The Company is
negotiating to settle this matter with the DOJ.
PacifiCare intends to negotiate with OPM and the DOJ on all matters to
attain a mutually satisfactory result. There can be no assurance that these
negotiations will be concluded satisfactorily, that additional audits will not
be referred to the DOJ, or that additional, possibly material, liability will
not be incurred. The Company believes that any ultimate liability in excess of
amounts accrued would not materially affect the Company's consolidated financial
position. However, such liability could have a material effect on results of
operations or cash flows of a future quarter if resolved unfavorably.
Legal Proceedings. As previously reported, a securities class action
lawsuit was brought on behalf of all purchasers of PacifiCare stock between
February 14, 1997 and November 24, 1997. The complaint accuses the Company and
certain of its officers and directors (collectively, the "defendants") of making
false and misleading statements about the cost savings and synergies resulting
from the FHP acquisition. Plaintiffs also claim the Company made fraudulent
earnings forecasts for 1997 and 1998, and misstated its financial results for
the first, second and third quarters of 1997. The complaint alleges violations
of certain provisions of the Securities Exchange Act of 1934 and Rule 10b-5
promulgated thereunder. On May 11, 1998, the defendants filed a motion to
dismiss the entire complaint under the Private Securities Litigation Reform Act
of 1995. No discovery has been taken and all discovery has been stayed pending
the resolution of defendants' motion to dismiss. The Company believes it has
good defenses to these claims and is contesting them vigorously.
The Company is also involved in legal actions in the normal course of
business, some of which seek monetary damages, including claims for punitive
damages which are not covered by insurance. After review, including consultation
with counsel, based on current information, management believes any ultimate
liability in excess of amounts accrued that would likely arise from these
actions (including the purported class actions) would not materially affect the
Company's consolidated financial position, results of operations or cash flows.
However, management's evaluation of the likely impact of these actions could
change in the future and an unfavorable outcome, depending upon the amount and
timing, could have a material adverse effect on the Company's results of
operations or cash flows of a future quarter.
8
<PAGE> 11
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1998
(UNAUDITED)
NOTE 6 - EARNINGS PER SHARE
The denominators for the calculation of basic and diluted earnings per
share for the periods indicated are determined as follows:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ ------------------
1998 1997 1998 1997
------- ------- ------- -------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Shares outstanding at the beginning of the period...... 45,794 41,886 41,995 31,301
Weighted average number of shares issued:
Conversion of Series A Preferred Stock............ -- -- 1,440 --
Treasury stock acquired, net of shares reissued... (156) -- (467) --
Exercise of stock options......................... 18 18 208 639
FHP acquisition................................... -- -- -- 8,095
------ ------ ------ ------
Denominator for basic earnings per share............... 45,656 41,904 43,176 40,035
Assumed conversion of Series A Preferred Stock......... -- 3,955 2,490 3,303
Employee stock options and other dilutive potential
common shares........................................ 375 321 354 459
------ ------ ------ ------
Denominator for diluted earnings per share............. 46,031 46,180 46,020 43,797
====== ====== ====== ======
</TABLE>
NOTE 7 - ADOPTION OF NEW ACCOUNTING STANDARDS
Comprehensive Income - As of January 1, 1998, the Company adopted Statement
of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive
Income." Comprehensive income represents PacifiCare's net income plus changes in
its equity, other than those changes resulting from investments by and
distributions to PacifiCare's shareholders. Such changes include unrealized
gains or losses on the Company's available-for-sale securities. PacifiCare's
comprehensive income totaled $62 million and $151 million for the three and nine
months ended September 30, 1998, respectively, and $36 million and $98 million
for the three and nine months ended September 30, 1997, respectively.
Internal-Use Software - In March 1998, the American Institute of Certified
Public Accountants issued Statement of Position ("SOP") No. 98-1, "Accounting
for the Costs of Computer Software Developed or Obtained for Internal Use." This
statement requires that certain internal and external costs associated with the
purchase or development of internal-use software be capitalized rather than
expensed. The Company's adoption of SOP No. 98-1 as of January 1, 1998 did not
have a material effect on results of operations for the three and nine months
ended September 30, 1998. Capitalized software costs are included in property,
plant and equipment and are being amortized using the straight-line method over
estimated useful lives ranging from three to five years.
NOTE 8 - FUTURE APPLICATION OF ACCOUNTING STANDARDS
Segment Reporting - SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information," establishes new standards for reporting
operating segments of publicly held companies in annual and interim financial
statements. Its guiding principle is the "management approach." This approach
requires companies to present segment information externally the same way
management uses financial data internally to make operating decisions and assess
performance. Under SFAS No. 131, public companies will report financial and
descriptive information about their operating segments. PacifiCare will adopt
SFAS No. 131 in 1998, with the first disclosure in its 1998 Annual Report on
Form 10-K.
9
<PAGE> 12
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1998
(UNAUDITED)
Derivatives - In June 1998, the Financial Accounting Standards Board issued
SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities."
This standard requires companies to record all derivatives on the balance sheet
as either assets or liabilities and measure those instruments at their fair
value. The manner in which companies are to record gains or losses resulting
from changes in the values of those derivatives depends on the use of the
derivative and whether it qualifies for hedge accounting. This standard is
effective for the Company's financial statements beginning January 1, 2000,
although early adoption is permitted. The Company believes that the adoption of
this statement will not have a material impact to the Company's financial
position or results of operations.
10
<PAGE> 13
PART I: FINANCIAL INFORMATION
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following table presents HMO membership data by state and by consumer
type as of the dates indicated. Due to the sale of the Utah HMO subsidiary on
September 30, 1998, Utah membership will not be included in the table after
October 1, 1998.
<TABLE>
<CAPTION>
AT SEPTEMBER 30, 1998 AT SEPTEMBER 30, 1997
------------------------------------ ------------------------------------
GOVERNMENT GOVERNMENT
(MEDICARE (MEDICARE
& &
MEMBERSHIP DATA COMMERCIAL MEDICAID) TOTAL COMMERCIAL MEDICAID) TOTAL
--------------- ---------- ----------- --------- ---------- ----------- ---------
<S> <C> <C> <C> <C> <C> <C>
Arizona........................ 105,900 87,800 193,700 107,000 88,700 195,700
California..................... 1,570,000 596,300 2,166,300 1,673,900 622,900 2,296,800
Colorado....................... 299,400 57,200 356,600 281,500 51,700 333,200
Guam........................... 39,500 -- 39,500 42,700 -- 42,700
Nevada......................... 43,900 25,000 68,900 40,700 23,900 64,600
Ohio........................... 45,400 15,400 60,800 54,300 12,200 66,500
Oklahoma....................... 97,600 26,800 124,400 110,300 26,100 136,400
Oregon......................... 116,200 39,200 155,400 117,600 40,900 158,500
Texas.......................... 135,000 67,300 202,300 131,400 69,300 200,700
Utah........................... 102,000 19,000 121,000 159,100 27,000 186,100
Washington..................... 96,600 59,800 156,400 95,600 56,900 152,500
--------- ------- --------- --------- --------- ---------
Total membership..... 2,651,500 993,800 3,645,300 2,814,100 1,019,600 3,833,700
========= ======= ========= ========= ========= =========
</TABLE>
<TABLE>
<CAPTION>
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30 SEPTEMBER 30
------------- -------------
OPERATING STATISTICS 1998 1997 1998 1997
-------------------- ---- ---- ---- ----
<S> <C> <C> <C> <C>
Medical care ratio (health care services as a percent of
premium revenue):
Consolidated........................................... 84.7% 85.9% 85.0% 85.7%
Commercial............................................. 82.8% 86.2% 83.2% 85.8%
Government (Medicare and Medicaid)..................... 86.0% 85.6% 86.2% 85.6%
Marketing, general and administrative expenses as a percent
of operating revenue...................................... 11.2% 11.3% 11.5% 11.4%
Operating income as a percent of operating revenue.......... 3.5% 2.4% 3.4% 2.6%
Effective tax rate.......................................... 46.6% 50.0% 47.5% 50.0%
</TABLE>
11
<PAGE> 14
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1998
COMPARED WITH THE
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1997
OVERVIEW
PacifiCare is one of the leading managed health care services companies in
the United States, with HMOs in 10 states and Guam serving approximately 3.6
million members in the commercial, Medicare, Medicaid and individual markets.
PacifiCare owns the nation's largest Medicare Risk program, Secure Horizons, and
provides specialty managed health care products and services through additional
subsidiaries.
Total operating revenue was flat for the three months ended September 30,
1998, compared to the same period in the prior year. Premiums declined one
percent with membership losses substantially offset by premium rate increases.
Total operating revenue increased eight percent for the nine months ended
September 30, 1998 compared to the same period in 1997, primarily because 1998
includes six more weeks of FHP results compared to 1997. The 1997 results
included the results of operations of FHP from February 14, 1997 (see Note 2 of
the Notes to Condensed Consolidated Financial Statements). Other income
increased 126 percent and 132 percent for the three and nine months ended
September 30, 1998, respectively, compared to the same periods in the prior
year, due primarily to increased revenues from the Company's Prescription
Solutions, Secure Horizons USA and PacifiCare Behavioral Health subsidiaries.
In July 1998, PacifiCare announced its intention to sell its Utah HMO and
workers' compensation subsidiaries. The Utah HMO subsidiary was sold on
September 30, 1998, and the sale of the workers' compensation subsidiary
occurred on October 31, 1998. See Note 2 of the Notes to Condensed Consolidated
Financial Statements.
RESULTS OF OPERATIONS
Total HMO membership decreased five percent to approximately 3.6 million
members at September 30, 1998, from approximately 3.8 million members at
September 30, 1997, with the majority of the decrease in California and Utah.
The membership declines are consistent with the Company's shift in strategic
focus from rapid growth to improved margin performance. The Company has
emphasized renewing commercial contracts with sufficient price increases to
improve gross margin. In addition, the Company has exited certain geographic
areas where commercial and government premiums are insufficient to support the
cost of health care in that area.
Commercial premiums decreased four percent, or $37 million for the three
months ended September 30, 1998, compared to the same period in the prior year.
The specialty product companies contributed $20 million of the decline due to
the exit of unprofitable indemnity and workers' compensation products.
Commercial HMO premium rate increases of approximately five percent increased
premiums by $38 million. Increased premium rates led to membership losses that
decreased premiums by $55 million, for a net commercial HMO premium decrease of
$17 million.
Commercial premiums for the nine months ended September 30, 1998 increased
five percent over the same period in the prior year due to a full nine months of
FHP results being included in 1998 compared to seven and one-half months in the
prior year. The inclusion of an additional six weeks of results in 1998 from the
FHP acquisition increased commercial premiums by $231 million. In addition,
premium rate increases of approximately three percent contributed to a six
percent membership decrease for the nine months ended September 30, 1998
compared to the same period in the prior year.
Government premiums increased $20 million and $374 million for the three
and nine months ended September 30, 1998, respectively, compared to the same
periods in the prior year. The inclusion of an additional six weeks of results
in 1998 from the FHP acquisition increased government premiums by $301 million
for the nine months ended September 30, 1998. Premium rate increases that
averaged approximately four percent increased premiums by $59 million and $167
million for the three and nine months ended September 30, 1998, respectively.
Membership disenrollments attributable to the Company's exit of
12
<PAGE> 15
certain rural geographic areas and its Medicaid lines of business in California
and Florida resulted in premium decreases of $39 million and $94 million for the
third quarter and year to date, respectively.
The consolidated medical care ratio (health care services as a percent of
premium revenue) decreased for the three and nine months ended September 30,
1998, compared to the same periods in the prior year. For the quarter, the
decrease was due to improved provider agreements and favorable commercial
pricing. Year to date, the improvements in the medical care ratio were partially
offset by increased provider insolvency reserves, principally recorded in the
second quarter for, but not limited to, the bankruptcy of FPA Medical
Management, Inc. ("FPA"), one of the Company's contracted health care providers.
In July 1998, FPA declared bankruptcy and the Company terminated all FPA
contracts. FPA served approximately 200,000 members in Arizona, California,
Nevada and Texas. The provider insolvency reserves include the estimated cost of
unpaid health care claims in certain markets that were covered by FPA capitation
and reserves for receivables due from FPA. The second quarter provider
insolvency reserves were partially offset by unrelated favorable provider
settlements because the Company periodically makes changes in provider
settlements as certain prior year contract issues are resolved. Provider
insolvency reserves recorded in the third quarter were not material.
The commercial medical care ratio decreased for the three and nine months
ended September 30, 1998 compared to the same periods in the prior year. The
decrease in the commercial medical care ratio was due to improved provider
agreements, a favorable premium pricing environment and improved performance
from the specialty product companies.
The government medical care ratio increased for the three and nine months
ended September 30, 1998, compared to the same periods in the prior year. The
third quarter increase was primarily due to higher prescription drug costs and a
shift to noncapitated provider contracts for Medicare members no longer under
FPA contracts. For the nine months ended September 30, 1998, net provider
reserves recognized in the second quarter, combined with higher prescription
drugs and higher costs for areas previously capitated under FPA contracts,
increased the government medical care ratio.
As a percentage of operating revenue, marketing, general and administrative
expenses for the three and nine months ended September 30, 1998 were comparable
to the same periods in the prior year. The Company continues to realize the
benefits of restructuring and a full year of synergies as a result of the FHP
acquisition.
The Company recognized pretax charges for the three and nine months ended
September 30, 1998 totaling $19 million ($10 million or $0.22 diluted loss per
share, net of tax). These charges included approximately $15 million ($8 million
or $0.18 diluted loss per share, net of tax) for the disposition of the
Company's Utah HMO and workers' compensation subsidiaries and approximately $4
million ($2 million, or $0.04 diluted loss per share, net of tax) for potential
OPM claims. See Notes 2 and 5 of the Notes to Condensed Consolidated Financial
Statements.
Net investment income increased approximately 32 percent and 30 percent for
the three and nine months ended September 30, 1998, respectively, compared to
the same periods in the prior year. These increases were primarily due to gains
on sales of marketable securities experienced throughout 1998 and more efficient
investment through account consolidation. Interest expense decreased
approximately 24 percent for the three months ended September 30, 1998, compared
to the same period in the prior year, primarily due to reductions in principal
amounts outstanding on the Company's credit facility. The four percent increase
in interest expense for the nine months ended September 30, 1998, compared to
the same period in the prior year, resulted from the borrowings used to finance
the FHP acquisition being outstanding for six weeks longer in 1998.
The effective income tax rates were approximately 46.6 and 47.5 percent for
the three and nine months ended September 30, 1998, respectively, compared to
50.0 percent for both periods in the prior year. This decrease was due to
nondeductible goodwill amortization comprising a smaller percentage of taxable
income than in the prior year.
13
<PAGE> 16
LIQUIDITY AND CAPITAL RESOURCES
The Company's consolidated cash, equivalents and marketable securities
decreased $369 million to $1.2 billion at September 30, 1998, from $1.5 billion
at December 31, 1997. The decrease primarily reflects the impact of timing
differences in the receipt of the January 1998 advance Medicare payment from
HCFA and the paydown of principal on long term debt. Cash flows provided by
operations, excluding the impact of the unearned revenue, primarily the advance
Medicare payment, were $376 million and were primarily attributable to changes
in liabilities. The increase in accounts payable and accrued liabilities was
primarily due to timing differences for income taxes and the increase in OPM and
disposition reserves. The decrease in medical claims and benefits payable
related to reduced specialty product company reserves due to the discontinuation
of unprofitable products, a significant reduction in the claims backlog and
continued renegotiation of provider contracts into capitated arrangements.
Net cash used in investing activities was $124 million and $1.0 billion for
the nine months ended September 30, 1998 and 1997, respectively. In 1998 cash
was used primarily to purchase marketable securities, and in 1997 cash was used
primarily to acquire FHP.
Net cash used in financing activities was $296 million for the nine months
ended September 30, 1998, while financing activities provided $955 million for
the nine months ended September 30, 1997. In January 1998, the Company's board
of directors approved a plan to repurchase shares of the Company's equity
instruments. During 1998, the Company borrowed $30 million under its credit
facility to repurchase shares of its common stock. As of September 30, 1998, the
Company had repurchased 784,000 shares of its Class A and Class B Common Stock
for an aggregate amount of $45 million (see Note 4 of the Notes to Condensed
Consolidated Financial Statements). To date, the Company has borrowed $1.2
billion under the credit facility to finance the acquisition of FHP and other
activities. The Company repaid $290 million and $181 million during the nine
months ended September 30, 1998 and 1997, respectively, of total borrowings. The
issuance of common and treasury stock provided cash in 1998 and 1997 of $14
million and $42 million, respectively. The Company paid approximately $5 million
and $6 million of preferred stock dividends in 1998 and 1997, respectively. In
the first quarter of 1997, the Company made capital contributions totaling $67
million to Talbert Medical Management Corporation, a former subsidiary of FHP.
In the second quarter of 1997, the Company received $60 million from the sale of
Talbert stock.
NEW ACCOUNTING PRONOUNCEMENTS
See Notes 7 and 8 of the Notes to Condensed Consolidated Financial
Statements for a discussion of new accounting standards and future application
of accounting standards.
DISCLOSURE REGARDING FORWARD LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a "safe
harbor" for forward looking statements to encourage companies to provide
prospective information about themselves without fear of litigation so long as
those statements are identified as forward looking and are accompanied by
meaningful cautionary statements identifying important factors that could cause
actual results to differ materially from those projected in the statements. The
statements contained in this section, and throughout the document, are based on
current expectations. These statements are forward looking and actual results
may differ materially from those projected in the forward looking statements,
which statements involve risks and uncertainties. In addition, past financial
performance is not necessarily a reliable indicator of future performance and
investors should not use historical performance to anticipate results or future
period trends. Shareholders are also directed to the other risks discussed in
other documents filed by the Company with the SEC.
FORWARD LOOKING INFORMATION UNDER THE PRIVATE SECURITIES LITIGATION ACT OF 1995
Membership and Premiums. The Company's membership for the year ended
December 31, 1998 is expected to decline in the commercial program from 1997. In
accordance with the Company's shift in strategic focus from rapid growth to
improved margin performance, the Company's emphasis is on renewing employer
contracts with sufficient price increases to improve gross margin. In addition
to pricing increases, the
14
<PAGE> 17
Company has or intends to exit certain geographical areas where the premiums are
insufficient to support the cost of health care in that area. Increased
competition and the disposition of its Utah subsidiary, which currently has
approximately 102,000 commercial members, will also contribute to the expected
decline. The trend is expected to reverse in 1999. The Company plans to
implement commercial price increases ranging from zero to 12 percent in all
markets in 1999. Despite price increases and excluding the effects of the
Company's dispositions, preliminary marketing efforts in the fourth quarter
indicate positive growth in 1999 commercial membership compared to 1998.
Government membership is expected to decrease in 1998 as compared to 1997,
partially due to the membership attrition experienced to date related to the
migration of FHP senior members into the Company's benefit structures and the
combined provider network. Membership losses are also expected in certain
geographical markets where health care costs outpace the Medicare reimbursement.
Additionally, the Utah disposition will result in a decrease of approximately
19,000 government members. By the end of 1999, government membership is expected
to be comparable to or slightly higher than 1998. The Company expects an
increase as it focuses on expanding its membership retention programs and
targeting group retiree members. The Company also expects increases as certain
competitors exit markets in which Secure Horizons will remain. This may be
partially offset by membership decreases as the Company anticipates exiting
certain rural markets. Based on information received from HCFA, the Company
anticipates Medicare premium rate increases averaging two percent beginning
January 1, 1999.
An unforeseen loss of profitable membership could have a material adverse
effect on the Company. Factors that could contribute to the loss of membership
include failure to obtain new customers or to retain existing customers, effect
of premium increases, reductions in work force by existing customers, adverse
publicity and news coverage, inability to carry out marketing and sales plans,
or the loss of key executives or key employees.
Health Care Provider Contracts. The Company's profitability depends, in
part, on its ability to maintain effective control over health care costs while
providing members with quality care. Because the majority of the Company's
Nevada members have been shifted to fee-for-service providers, obtaining
capitated arrangements with providers for that market will be important to
improve 1999 results of operations. Securing cost-effective contracts with
existing and new physician groups is more difficult due to increased
competition. The negotiation of provider contracts, generally as of January 1,
may be impacted by adverse state and federal legislation and regulation
discussed below. Failure to secure cost-effective contracts may result in a loss
in membership or a higher medical care ratio. The Company's inability to
contract with providers, loss of contracts with providers, inability of
providers to provide adequate care or insolvency of providers could materially
and adversely affect the Company. These contracting and insolvency risks
include, among others; a loss of membership; the occurrence of additional
expenses to meet the requirement to continue to arrange for health care and
other services for members; the inability to obtain reimbursement due the
Company from providers; the expenditure of additional funds to maintain adequate
provider networks; and the assertion of claims by third parties against the
Company. Based on current information, including claims information received
from FPA, the Company believes that its contingency plans and the financial
reserves it has established are adequate to cover the potential impact of the
FPA contract terminations and bankruptcy. The effect of these risks and the need
for additional provider reserves could have a material adverse effect on the
results of operations or cash flows of a future quarter. The Company believes,
however, that such reserves would not materially affect the Company's
consolidated financial position.
Commercial Medical Care Ratio. For the year ended December 31, 1998, the
commercial medical care ratio is expected to be lower than 1997. The Company
expects improvements as it continues to renegotiate provider contracts and
implement capitated contracts and price increases. Moreover, higher premium
rates offered during renewal periods should continue to result in the
elimination of some high medical care ratio business. Finally, the commercial
medical care ratio should improve as a result of the Utah disposition. In 1999
the Company expects the commercial medical care ratio to be consistent with or
improve slightly from the current year. Higher premium rates are expected for
1999 employer contract renewals. The Company also plans to continue to
renegotiate provider contracts and exit certain geographical areas where price
increases do not cover the cost of health care.
15
<PAGE> 18
Government Medical Care Ratio. For the year ended December 31, 1998 the
Company expects the government medical care ratio to be comparable to the ratio
experienced in the first nine months of 1998, but overall, anticipates that the
medical care ratio for the full year will be higher than the ratio reported for
the year ended December 31, 1997. The implementation of Medicare reform
provisions that curtail program spending and allow the entry of new forms of
competitor plans could increase competitive pressures (see Legislation and
Regulation below). The Company should also experience improvement in the
government medical care ratio with the exit of certain product lines and
geographic markets including the Utah disposition. The Company expects the
government medical care ratio in 1999 to remain flat or slightly increase from
1998. Any price increases and recontracting efforts are expected to be offset by
increases in capitation and non-capitated costs.
Medical Care Risk Factors. The commercial and government medical care ratio
expectations discussed above could be affected by various uncertainties,
including increases in medical and prescription drug costs that have been
escalating faster than premium increases in recent years, increases in
utilization and costs of medical services and the effect of actions by
competitors or groups of providers, termination of provider contracts or
renegotiations of such contracts at less cost-effective rates or terms of
payment.
Other Income. Compared to 1997, other income for 1998 is expected to
increase substantially due to improvements in the Company's Prescription
Solutions, PacifiCare Behavioral Health and Secure Horizons USA subsidiaries.
For the quarter ended December 31, 1998, other income is expected to be
comparable to or slightly less than the quarter ended September 30, 1998 as the
Company's Secure Horizons USA consulting agreement revenues from existing
customers decline. In 1999, the Company expects other income to be lower than
1998 because of the lower Secure Horizons USA revenues as well as the
discontinuation of certain rental income streams that will not recur in 1999.
Marketing, General and Administrative Expense. As a percentage of operating
revenue, marketing, general and administrative expenses are expected to be
slightly higher for the three months ended December 31, 1998 compared to the
three months ended September 30, 1998, due to increased marketing costs of open
enrollment. Marketing, general and administrative expenses as a percentage of
operating revenue in 1998 are expected to be comparable to or slightly lower
than 1997. The Company expects to experience additional costs related to
upgrading and converting information systems to maintain and enhance the
Company's competitive edge in information technology, some of which do not
qualify for capitalization. These additional costs are expected to be partially
offset as the Company realizes the benefits of restructuring and a full year of
synergies as a result of the FHP acquisition. In 1999, marketing, general and
administrative expenses as a percentage of operating revenue are expected to
decline because the Company expects to continue to realize additional synergies
as the effect of final conversion from FHP's legacy systems to PacifiCare's
systems for its California HMO, which was completed in June 1998, will be
realized. Marketing, general and administrative expenses could be adversely
impacted by the need for additional advertising, marketing, administrative, or
management information systems expenditures and the inability to carry out
marketing and sales plans.
Impairment of Long-Lived Assets. The Company assesses the recoverability of
its long-lived assets (including goodwill and intangibles) whenever adverse
events or changes in circumstances or the business climate indicate that
expected undiscounted future cash flows for individual business units may not be
sufficient to support the recorded asset. Throughout 1998, the Company has
continued to monitor its existing operations with no indication of material
impairment of existing assets. The Company believes that any future impairment
would not materially affect the Company's consolidated financial position.
However, the impairment charges could have a material adverse effect on the
results of operations or cash flows.
Year 2000. The Company has implemented a Year 2000 compliance program to
address all major computing information systems, including core application
systems, networks, desktop systems, infrastructure and critical information
supply chains. In addition to all major information systems, the Company is
seeking to verify that all date fields and calculations used in critical
business processes will be Year 2000 compliant.
When the program was first established in 1996, the Company focused on
existing systems and did not contemplate acquisitions of other companies. The
total estimated cost to make the Company's pre-FHP core
16
<PAGE> 19
legacy system Year 2000 compliant is $6 million, with the majority of this
expense already incurred. The Company expects this core legacy system to be Year
2000 compliant by the end of 1998.
With the February 1997 FHP acquisition, the original integration plan
required the Arizona, Colorado, Nevada and Ohio HMOs to shift to the Company's
legacy systems throughout 1998 and 1999 as the providers moved to capitation
arrangements. In the second quarter of 1998, it was determined that while some
providers in these markets had successfully been contracted under capitation
arrangements, these provider networks did not have sufficient infrastructure to
administer the claims under a fully delegated capitated arrangement. Therefore,
these HMOs would need to continue to administer claims on behalf of providers.
Because the FHP legacy systems function more robustly than the Company's legacy
systems for non-delegated delivery systems, the Company decided to maintain the
FHP legacy systems. The Company is in the process of finalizing a detailed
project plan for modifying the FHP legacy systems to be Year 2000 compliant in
phases during 1999. Based upon an outside consultant's recommendations and
internal analysis, the Company estimates that the total cost to make the FHP
legacy system Year 2000 compliant ranges from $5 to $8 million. The Company is
currently developing contingency plans in the event the former FHP system cannot
be made Year 2000 compliant on a timely basis. If the Company is not able to
correct all Year 2000 problems on a timely basis, there could be a material
adverse effect to the Company's financial position, results of operations or
cash flows.
The Company is also contacting business associates such as its third party
vendors, provider and hospital networks, business partners, contractors and
service providers, including HCFA, to assess their level of readiness. In some
cases, the Company is seeking reasonable assurances with respect to Year 2000
compliance. The Company's priority is to assess the readiness of its providers
with delegated responsibility and other third parties with which it
electronically exchanges data or interacts. Because the Company does not control
third parties' products, services or systems, the Company cannot ensure Year
2000 compliance by third parties. Business process contingency plans will be
developed by June 1999 for external sources that appear to be at risk. As part
of the contingency planning process, the Company will estimate the cost of
implementing its contingency plans.
If HCFA or certain other third parties experience significant failures or
erroneous applications, it could have a material adverse effect on the Company's
financial position, results of operations or cash flows. For example, HCFA, OPM
or commercial customers' failures could cause a delay in the Company's receipt
of payments from these customers, including a significant HCFA payment due in
January 2000.
The Company could also have difficulties processing Medicare and other
claims within required periods, collecting accurate claims and other data on
which it depends, or enrolling new members. In preparing contingency plans, the
Company intends to focus on developing risk reduction strategies. However, some
risks may be beyond the Company's control. Furthermore, marketing, general and
administrative expenses could be adversely impacted by Year 2000 compliance
expenditures.
Finally, the Company's Year 2000 steering committee formed during the
second quarter of 1998 has made progress toward its goals and internal awareness
of Year 2000 issues has increased. The committee has developed a common project
methodology for assessing Year 2000 readiness, developing and implementing plans
to remedy non-compliant systems, testing systems and developing business
contingency plans. Once the assessment process is completed, the committee will
establish priorities for solving the remaining problems and continue to work on
risk reduction strategies and contingency plans.
Office of Personnel Management Contingencies. The Company intends to
negotiate with OPM and DOJ on all claims to attain a mutually satisfactory
result. While there is no assurance that the negotiations will be concluded
satisfactorily or that additional liability will not be incurred, management
believes that any ultimate liability in excess of amounts accrued, which could
arise upon completion of the audits by OPM of the health plans, would not
materially affect the Company's consolidated financial position. However, such
liability could have a material adverse effect on results of operations or cash
flows of a future quarter if resolved unfavorably (see Note 5 of the Notes to
Condensed Consolidated Financial Statements).
Liquidity and Capital Resources. The terms of the Company's credit facility
require a mandatory step-down payment schedule beginning January 1999, with
final maturity on January 1, 2002 if the principal
17
<PAGE> 20
balance exceeds certain thresholds. Such terms would not require a reduction
below the current $650 million outstanding principal balance until the final
maturity date. The Company believes cash flows from operations, existing cash
equivalents, marketable securities and other financing sources will be
sufficient to meet the requirements of the credit facility and should provide
sufficient liquidity for operations in the foreseeable future.
Cash flows could be adversely affected because the Company is subject to
greater operating leverage due to its higher levels of indebtedness as a result
of the FHP acquisition. The Company may continue to repurchase shares of
outstanding stock, resulting in the reduction of cash and equivalents or in
additional borrowings on its credit facility. Additional borrowings on the
credit facility may make the Company subject to earlier mandatory reduction of
its outstanding balance. Additionally, should the credit facility be fully
drawn, the Company's ability to make a payment on, or repayment of, its future
obligations under the credit facility and $100 million of FHP senior notes
assumed by the Company will be significantly dependent upon the receipt of funds
from the Company's subsidiaries. These subsidiary payments represent fees for
management services rendered by the Company to the subsidiaries and cash
dividends by the subsidiaries to the Company. Nearly all of the subsidiaries are
subject to HMO regulations or insurance regulations and may be subject to
substantial supervision by one or more HMO or insurance regulators. Subsidiaries
subject to regulation must meet or exceed various fiscal standards imposed by
HMO or insurance regulations, which may from time to time impact the amount of
funds that may be paid by subsidiaries to the Company. Additionally, from time
to time, the Company advances funds, in the form of a loan or capital
contribution, to its subsidiaries to assist them in satisfying state financial
requirements. If a federal or state regulator has concerns about the financial
position of a subsidiary, as a result of costs being incurred by such
subsidiary, a regulator may impose additional financial requirements on the
subsidiary which may require additional funding from the Company.
Risk Based Capital Requirements. The National Association of Insurance
Commissioners adopted risk-based capital standards which, if implemented by the
states, would require new minimum capitalization limits for health care coverage
provided by insurance companies, HMOs and other risk-bearing health care
entities. Based on the states that have adopted the standards to date, the
risk-based capital legislation is not expected to have a material impact on the
consolidated financial position of the Company at December 31, 1998.
Furthermore, the Company believes that cash flows from operations or, if
necessary, borrowings under its credit facility, will be sufficient to fund the
additional risk-based capital requirements.
Legislation and Regulation. The Company's business is significantly
affected by federal and state legislation and regulation. Almost 60 percent of
the Company's revenue, and an even greater percentage of its profit, comes from
its government programs, the majority of which is Medicare risk business.
Changes in state and federal legislation or regulation could cause actual
results to differ materially from the expected results discussed throughout this
document. Changes which could have a material effect on the Company include
limitations on premium levels; increases in minimum capital and reserves and
other financial viability requirements; prohibition or limitation of capitated
arrangements or provider financial incentives; benefit mandates (including
mandatory length of stay and emergency room coverage, many of which became
effective in 1998); and limitations on the ability to manage care and
utilization of any willing provider and direct access laws. Legislation and
regulation could also include adverse actions of governmental payors, including
unilateral reduction of Medicare premiums payable; discontinuance of or
limitation on governmentally funded programs; recovery by governmental payors of
previously paid amounts; the inability to increase premiums or prospective or
retroactive reductions to premium rates for federal employees; and adverse
regulatory determinations.
On August 5, 1997, President Clinton signed into law the Balanced Budget
Act of 1997 (the "Balanced Budget Act"), which enacted numerous revisions to the
Medicare program. The law replaces the existing risk contract program with a
revised Medicare+Choice program (the "M+C Program"). On June 26, 1998, HCFA
published interim final regulations to implement the M+C Program. The new
regulations outline requirements for organizations participating in the M+C
Program and establish new or expanded standards for quality assurance,
beneficiary protection, coordinated open enrollment, M+C Program payments,
information disclosure and provider participation. While the new regulations
became effective on July 27, 1998, most
18
<PAGE> 21
provisions that affect the Company will not impact the Company until after
January 1, 1999 when the Company makes the transition to the M+C Program. The
Company is currently implementing processes to comply with the new M+C
regulations and is evaluating the operational and financial impact that the new
M+C Program will have on the Company. Compliance with and implementation of the
new M+C Program regulations will increase the Company's costs associated with
administering its Medicare business.
The Balanced Budget Act also revises the formula used by HCFA to calculate
payments to Medicare health plans by establishing minimum payment levels, annual
increases and limiting the overall rate of payment growth. Further, the Balanced
Budget Act requires HCFA to develop a risk adjusted payment methodology by March
1, 1999 and implement the methodology for payment periods beginning January 1,
2000. On September 8, 1998, HCFA announced a proposed risk adjusted payment
methodology and solicited public comments on the proposal. The proposed
methodology relies on hospital encounter data in order to establish a risk
premium attributable to individual enrollees. If the methodology is adopted as
proposed, it may have an adverse impact on the Company. The Company has provided
comments to the proposed methodology and is engaged in various efforts with HCFA
and others to modify the proposed methodology so that it does not create
incentives for increased inpatient utilization and does not penalize health
plans that have developed programs to reduce unnecessary hospitalizations.
However, there can be no assurance that the Company will be successful in its
efforts to obtain modification to the proposed methodology. The loss of Medicare
contracts or termination or modification of the HCFA risk-based Medicare program
could have a material adverse effect on the revenue, profitability and business
prospects of the Company.
Additionally, the Balanced Budget Act repeals the requirement that at least
half of a Medicare health plan's enrollment be drawn from commercial contracts
(the "50/50 Rule") beginning January 1, 1999, and gives the Department of Health
and Human Services broad authority to waive the 50/50 Rule for certain plans
beginning January 1, 1998. The Company believes that the repeal of the 50/50
Rule will allow it to develop Medicare risk programs in markets where it does
not have operations through expansion of the Secure Horizons programs and
affiliations between Secure Horizons USA, its Medicare risk management
subsidiary, and health plans or providers in such markets.
Legal Proceedings. As previously reported, a securities class action
lawsuit, Madruga et al. v. PacifiCare Health Systems, Inc., et al. (No.
SAVC-97-974 LHM, Central District of California) was brought on behalf of all
purchasers of PacifiCare stock between February 14, 1997 and November 24, 1997.
The complaint accuses the Company and certain of its officers and directors of
making false and misleading statements about the cost savings and synergies
resulting from the FHP acquisition. Plaintiffs also claim the Company made
fraudulent earnings forecasts for 1997 and 1998, and misstated its financial
results for the first, second and third quarters of 1997. The complaint alleges
violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934
and Rule 10b-5 promulgated thereunder. On May 11, 1998, the defendants filed a
motion to dismiss the entire complaint under the Private Securities Litigation
Reform Act of 1995. No discovery has been taken and all discovery has been
stayed pending the resolution of defendants' motion to dismiss. The Company
believes it has good defenses to these claims and is contesting them vigorously.
The Company is also involved in legal actions in the normal course of
business, some of which seek monetary damages, including claims for punitive
damages which are not covered by insurance. After review, including consultation
with counsel, based on current information, management believes any ultimate
liability in excess of amounts accrued that would likely arise from these
actions (including the purported class actions) would not materially affect the
Company's consolidated financial position, results of operations or cash flows.
However, management's evaluation of the likely impact of these actions could
change in the future and an unfavorable outcome, depending upon the amount and
timing, could have a material adverse effect on the Company's results of
operations or cash flows of a future quarter.
Other. Results may differ materially from those projected, forecast,
estimated and budgeted by the Company due to adverse results in ongoing audits
or in other reviews conducted by federal or state agencies or health care
purchasing cooperatives; adverse results in significant litigation matters; and
changes in interest rates causing changes in interest expense and net investment
income.
19
<PAGE> 22
PART II: OTHER INFORMATION
ITEM 1: LEGAL PROCEEDINGS
No changes.
ITEM 2: CHANGES IN SECURITIES
None.
ITEM 3: DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5: OTHER INFORMATION
None.
ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibit Index
Exhibit 10.1 Employment Agreement dated as of June 15, 1998, between
the Company and Robert B. Stearns.
Exhibit 27 Financial Data Schedule (filed electronically).
b) On October 7, 1998, the Company filed a Form 8-K announcing the
September 30, 1998 sale of its Utah subsidiary.
20
<PAGE> 23
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.
PACIFICARE HEALTH SYSTEMS, INC.
(Registrant)
<TABLE>
<S> <C> <C> <C>
Date: November 6, 1998 By: /s/ ALAN R. HOOPS
---------------------------------------- -----------------------------------
Alan R. Hoops
President,
Chief Executive Officer
and Director
Date: November 6, 1998 By: /s/ ROBERT B. STEARNS
---------------------------------------- -----------------------------------
Robert B. Stearns
Executive Vice President
and Chief Financial Officer
</TABLE>
21
<PAGE> 24
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
<C> <S>
10.1 Employment Agreement dated as of June 15, 1998, between the
Company and Robert B. Stearns.
27 Financial Data Schedule (filed electronically).
</TABLE>
<PAGE> 1
EXHIBIT 10.1
EMPLOYMENT AGREEMENT
This EMPLOYMENT AGREEMENT (this "Agreement") is made and entered into as
June 15, 1998, by and between PACIFICARE HEALTH SYSTEMS, INC., a Delaware
corporation (the "Company"), with its principal place of business located at
3120 Lake Center Drive, Santa Ana, California 92704 and Robert Stearns
("Executive"), residing at 1156 Beaver Tail, P.O. Box 6045, Carefree, Arizona
85377.
RECITALS
WHEREAS, the Company desires to employ Executive in the capacity of
Executive Vice President and Chief Financial Officer.
WHEREAS, the Company and Executive are entering into this Agreement to
establish the terms and conditions of the desired employment relationship.
NOW, THEREFORE, in consideration of the following covenants, conditions
and promises contained herein, and other good and valuable consideration, the
Company and Executive hereby agree as follows:
1. EMPLOYMENT
1.1 Executive's General Duties. The Company hereby employs Executive and
Executive hereby agrees to serve the Company in the capacity of Executive Vice
President and Chief Financial Officer of the Company, having such usual and
customary duties and authority as an officer of similar capacity in a
corporation of comparable size, holdings, and business as that of the Company.
Executive shall do and perform all services, acts, or things necessary
or advisable to manage and conduct the business of the Company and shall preside
over such other areas of corporate activity as specified from time to time by
the Board of Directors of the Company. During the term of this Agreement,
Executive shall perform such additional or different duties, and accept the
election or appointment to such other offices or positions as are mutually
agreed upon by Executive and the Company.
1.2 Devotion of Executive. During the term of this Agreement, Executive
shall devote his entire productive time, ability, and attention to the business
of the Company. Executive shall use his best efforts, skills, and abilities to
promote the general welfare and interests of the Company and to preserve,
maintain, and foster the Company's business and business relationships with all
persons and entities associated therewith, including, without limitation,
employer groups, medical service providers, shareholders, affiliates, officers,
employees, and banks and other financial institutions. The Company shall give
Executive a reasonable opportunity to perform his duties and shall neither
expect Executive to devote more time, nor assign more duties or functions to
Executive, than are customary and reasonable for an executive in Executive's
position.
-1-
<PAGE> 2
2. TERM AND TERMINATION
2.1 TERM. The term of Executive's employment under this Agreement shall
commence on June 15, 1998, and shall continue unless terminated as provided in
Section 2.2.
2.2 TERMINATION. This Agreement shall be terminated upon the occurrence
of any one of the following events:
a. The death of the Executive.
b. Executive becomes incapacitated or disabled, which incapacity
or disability prevents Executive from fully performing his duties to the
Company for a period in excess of 90 days and, after such 90-day period,
the Company and a physician, duly licensed and qualified in the
specialty of Executive's incapacity, decide in their reasonable
judgments, that such incapacity will be permanent or of such continued
duration as to prevent Executive from resuming the rendition of services
to the Company for at least an additional six-month period. For purposes
of this Agreement, Executive shall be deemed permanently disabled, and
this Agreement terminated upon the date Executive receives written
notice from the Company that such determination has been made.
c. Executive habitually neglects his duties to the Company or
engages in gross misconduct during the term of this Agreement. For the
purposes of this Agreement, "gross misconduct" shall mean Executive's
misappropriation of funds; securities fraud; insider trading;
unauthorized possession of corporate property; the sale, distribution,
possession or use of a controlled substance; or conviction of any
criminal offense (whether or not such criminal offense is committed in
connection with Executive's duties hereunder or in the course of his
employment with the Company). In such event, Executive's termination
shall be effective immediately upon receipt of written notice from the
Company.
d. Either party hereto may terminate this Agreement, with or
without cause, upon 90 days prior written notice to the other party.
Except for the circumstances described in Section 2.2(c) above,
Executive's termination shall be effective 90 days after receipt of such
written notice. Any termination of this Agreement in accordance with
this Section 2.2(d) shall not limit, restrict, or reduce, in any manner,
Executive's rights to the compensation and benefits available under
Section 3.2 and Section 4 below.
-2-
<PAGE> 3
2.3 EFFECT OF TERMINATION. No termination of this Agreement shall affect
or impair any rights or obligations of the parties respecting certain
compensation accruing prior thereto or continuing thereafter in accordance with
the terms set forth in Section 3.2 and Section 4.
3. COMPENSATION
3.1 COMPENSATION DURING THE TERM OF THIS AGREEMENT
a. As long as Executive satisfactorily performs all of his
obligations hereunder, the Company shall pay Executive an annual base
salary, as determined by the Compensation Committee of the Board of
Directors, payable in equal installments on the Company's regular
payroll dates. As of this date, Executive's annual base salary has been
set at $450,000. On an annual basis, the Company's compensation
committee shall review Executive's salary, but shall be under no
obligation to increase Executive's salary. Executive authorizes the
Company to take such deductions and withholdings from his salary as are
required by law, directed by Executive, or as reasonably directed by the
Company for its employees, which deductions shall include, without
limitation, withholding for federal and state income taxes and social
security.
b. Executive shall also receive a $125,000 sign-on bonus (the
"Sign-on Bonus"). If Executive voluntarily leaves the Company or
Executive is terminated pursuant to the provisions of 2.2(c) hereof
prior to June 15, 1999, Executive shall be required to repay an amount
equal to the Sign-on Bonus divided by a fraction the numerator of which
is the number of months remaining till June 15, 1999 and the denominator
is 12.
c. In addition, Executive shall receive a loan in the amount of
$125,000 which may be used only in connection with Executive's
relocation from Arizona to California (the "Loan"). Interest on the full
amount of the Loan will be determined based on the Internal Revenue
Service mandated rate. The entire principal amount of the Loan and any
accrued interest will be forgiven in its entirety if Executive remains
employed by the Company on or after June 14, 2003. If Executive
terminates employment with the Company prior to June 14, 2003, except as
otherwise provided herein, Executive will be responsible for repaying
the Loan or a portion thereof on the following basis:
1. If Executive's employment with the Company terminates
prior to one year from June 15, 1998, Executive will be required
to repay the full amount of the Loan plus accrued interest at the
applicable rate.
2. If Executive's employment with the Company terminates
at any time from one year from June 15, 1998 but prior to two
years from June 15, 1998, Executive will be required to repay
$100,000 of the Loan plus accrued interest at the applicable rate
on the amount to be repaid and $25,000 of the Loan plus the
accrued interest on this portion of the Loan will be forgiven by
the Company.
-3-
<PAGE> 4
3. If Executive's employment with the Company terminates
at any time from two years from June 15, 1998 but prior to three
years from June 15, 1998, Executive will be required to repay
$75,000 of the Loan plus accrued interest at the applicable rate
on the amount to be repaid and $50,000 of the Loan plus the
accrued interest on this portion of the Loan will be forgiven by
the Company.
4. If Executive's employment with the Company terminates
at any time from three years from June 15, 1998 but prior to four
years from June 15, 1998, Executive will be required to repay
$50,000 of the Loan plus accrued interest at the applicable rate
on the amount to be repaid and $75,000 of the Loan plus the
accrued interest on this portion of the Loan will be forgiven by
the Company.
5. If Executive's employment with the Company terminates
at any time from four years from June 15, 1998 but prior to five
years from the June 15, 1998, Executive will be required to repay
$25,000 of the Loan plus accrued interest at the applicable rate
on the amount to be repaid and $100,000 of the Loan plus the
accrued interest on this portion of the Loan will be forgiven by
the Company.
6. If Executive terminates employment with the Company at
any time after June 15, 2003, Executive shall not have to repay
any portion of the Loan or any accrued interest.
7. Executive will be responsible for any taxation incurred
by him resulting from forgiveness of any portion of the Loan or
accrued interest.
d. Executive shall be entitled to fully participate in all of the
employee benefit plans and programs available to other high-level
executives of the Company, including, without limitation, health,
dental, and life insurance benefits for Executive and Executive's
dependents, pension and profit sharing programs, and vacation and sick
leave benefits. However, the terms of this Agreement shall not restrict
the Company's right to change, amend, modify, or terminate any existing
benefit plan or program, or to change any insurance company or modify
any insurance policy adopted incident to such existing benefit plan and
program.
e. The Company shall provide Executive with a $850.00 per month
automobile allowance. The Company shall furnish Executive's automobile
with a cellular car telephone. Executive shall provide and maintain
automobile insurance for Executive's car including collision,
comprehensive liability, personal and property damage, and uninsured and
underinsured motorist coverage in amounts customarily obtained to cover
such contingencies in the State of California. Executive shall provide
proof of such coverage to the Company upon the Company's request.
-4-
<PAGE> 5
f. The Company shall pay for or reimburse Executive for all
reasonable travel, entertainment, and other business expenses incurred
or paid for by Executive in connection with the performance of his
services under this Agreement. The Company shall not be obligated to
make any such reimbursement unless Executive presents corresponding
expense statements or vouchers and such other supporting information as
the Company may from time to time reasonably request. The Company
reserves the right to place subsequent limitations or restrictions on
business expenses to be incurred or reimbursed.
g. Executive shall be entitled to participate fully in the
Company's 1996 Management Incentive Compensation Plan (the "MICP"), as
may be amended, modified, or replaced, in accordance with the terms and
conditions set forth herein and therein, provided, however, for the 1998
MICP performance cycle, any awards granted to Executive shall be
prorated according to the effective date of this Agreement.
h. Executive shall be entitled to participate in the 1996 Stock
Option Plan for Officers and Key Employees of PacifiCare Health Systems,
Inc. (the "1996 Stock Option Plan"), as such plan from time to time may
be amended, modified or replaced, in accordance with the terms and
conditions set forth herein and therein.
i. During the term of this Agreement, the Company shall insure
Executive under its general liability insurance for all conduct
committed in good faith while acting in the capacity of Executive Vice
President and Chief Financial Officer of the Company or in any other
capacity to which Executive may be appointed or elected.
j. In the event Executive is involuntarily terminated, without
cause, except in the case of death or incapacity or disability, the
Company shall provide outplacement services to Executive to assist
Executive in securing a position comparable to the one from which he was
terminated. The Company shall be obligated to provide those outplacement
services as customarily provided by companies of similar size and
holdings as those of the Company to executives with comparable
responsibility and longevity as Executive and for reasonable cost as
approved by the Company. The Company's provision of such outplacement
services shall not limit, restrict, or reduce, in any manner, any and
all other compensation to which Executive is entitled hereunder.
-5-
<PAGE> 6
k. As part of the compensation for services rendered under this
Agreement, Executive shall be entitled to participate in the Amended and
Restated PacifiCare Health Systems, Inc. Savings and Profit-Sharing
Plan, and the trust agreement implemented pursuant thereto, adopted as
of February 1998, as from time to time may be amended modified, or
replaced, in accordance with the terms and conditions set forth therein.
l. Executive shall be entitled to the benefits provided under the
Company's Statutory Restoration Plan, as such plan from time to time may
be amended, modified or replaced, in accordance with the terms set forth
herein and therein.
3.2 COMPENSATION FOLLOWING TERMINATION
a. In the event that this Agreement is terminated by reason of
Executive's death, Executive's estate or legal representative shall be
entitled to receive the following:
1. Payment of benefits under the life insurance policy
purchased by the Company on Executive's behalf, if any;
2. Payments of benefits under the MICP set forth in
Section 3.1(g), which will be deemed to have accrued as of the
date of Executive's death; and
3. Executive's legal representative shall be permitted to
exercise any vested and unexercised options under the 1996 Stock
Option Plan set forth in Section 3.1(h) and shall be permitted to
exercise any other vested and unexercised options granted under
any other existing stock option plans of the Company ("the
Existing Stock Option Plans") in accordance with their terms for
a period of one year following Executive's death. The 1996 Stock
Option Plan and the Existing Stock Option Plans shall together be
referred to herein as the "Stock Option Plans."
4. If Executive's death occurs while Executive is still
employed by the Company, but prior to his having completed five
years of employment with the Company, Executive's estate or legal
representative will not be required to repay any amount of the
Loan or any accrued, which, but for this provision Executive's
estate or legal representative would be required to repay under
the terms set forth in Section 3.1(c) above.
b. In the event that Executive is terminated because of an
incapacity or disability, the Company shall provide Executive with the
following:
1. Payment of benefits under the disability insurance
policy maintained by the Company on Executive's behalf, if any;
2. Payment of benefits under the MICP set forth in Section
3.1(g), which will be deemed to have accrued as of the effective
date of such termination;
-6-
<PAGE> 7
3. The right to exercise any vested and unexercised
options under the Stock Option Plans in accordance with the terms
stated therein; and
4. Payment of the automobile allowance as provided under
Section 3.1(e) for a period of 24 months following the effective
date of such termination.
5. If Executive is disabled or incapacitated while
Executive is still employed by the Company, but prior to his
having completed five years of employment with the Company,
Executive will not be required to repay any amount of the Loan or
any accrued interest, which, but for this provision, Executive
would be required to repay under the terms set forth in Section
3.1(c) above.
c. In the event this Agreement is terminated because of
Executive's habitual neglect or gross misconduct pursuant to Section
2.2(c) or because of Executive's voluntary termination, the Company
shall be relieved from any and all further or future obligations to
compensate Executive; provided, however, that Executive shall be able to
exercise any vested and unexercised awards under the Stock Option Plans
in accordance with the terms set forth therein. If this Agreement is
terminated pursuant to the provisions contained in this Section 3.2(c),
prior to Executive's completing five years of employment with the
Company, Executive shall be required to repay the Loan plus accrued
interest as set forth in Section 3.1(c) above.
d. In the event that the Company terminates Executive, for any
reason other than Executive's incapacity or disability or misconduct as
described in Sections 2.2(b) and 2.2(c), respectively, Executive shall
be entitled to the following severance compensation, on the condition
that Executive executes the Company's standard severance agreement
including a general release of the Company, including its owners,
partners, stockholders, directors, officers, employees, independent
contractors, agents, attorneys, representatives, predecessors,
successors and assigns, parents, subsidiaries, affiliated entities and
related entities:
1. Executive's then current annual salary under Section
3.1(a) for a period of 24 months following the effective date of
such termination;
2. Payment of benefits under the MICP set forth in Section
3.1(g), which will be deemed to have accrued as of the effective
date of such termination;
3. The right to exercise any vested and unexercised
options under the Stock Option Plans in accordance with their
terms within one year of the effective date of such termination;
-7-
<PAGE> 8
4. Notwithstanding the foregoing, in the event Executive
engages in employment with a competitor of the Company during the
24 month period in which Executive's salary continues pursuant to
Section 3.2(d)(1), the severance compensation available to
Executive under this Section 3.2(d) shall be reduced by the
amount of any and all gross earnings Executive earns while
engaged in employment with any such competitor or competitors.
For the purposes of this Section 3.2(d)(4), a "competitor of the
Company" shall include, without limitation, managed care
organizations, including a health maintenance organization,
competitive medical plan, preferred provider organization,
provider sponsored organization ("PSO"), or health or life
insurance company which owns a managed care organization, plan or
program. Executive agrees to provide immediate notice to Company
upon receipt of any gross earnings received by Executive from a
competitor of Company;
5. Payment of the automobile allowance as provided in
Section 3.1(e) for a period of 24 months following the effective
date of such termination; and
6. The Company shall provide to Executive the outplacement
services described in Section 3.1(j).
7. If Executive is terminated pursuant to the provisions
contained in this Section 3.2(d), prior to Executive's completing
five years of employment with the Company, Executive will not be
required to repay any amount of the Loan or any accrued interest
which, but for this provision, Executive would be required to
repay under the terms set forth in Section 3.1(c).
e. Notwithstanding anything which may be expressed in, or
inferred from the provisions of this Section 3.2 or Section 4.1, this
Agreement should not be construed to limit, restrict, or deny Executive
any benefits to which he otherwise may be entitled to under the MICP,
the Stock Option Plans, the Company's profit-sharing plan, non-qualified
deferred compensation plans or otherwise which arise from circumstances
not addressed in this Agreement.
4. TERMINATION AS A RESULT OF A CHANGE OF CONTROL OR FOR GOOD CAUSE
4.1 EXECUTIVE'S RIGHTS. In the event that, during the term of this
Agreement, the Company undergoes a "change of ownership or control," as that
term is defined in Section 4.3, and if within 24 months after the consummation
of such change either (1) Executive is involuntarily terminated, except as
-8-
<PAGE> 9
provided in Section 4.2, or (2) Executive voluntarily terminates his employment
for "good cause" as defined in Section 4.4, then Executive shall be entitled to
the following compensation:
a. Executive's then current annual salary under Section 3.1(a)
for a period of 24 months following the effective date of such
termination, subject to the conditions set forth in Section 3.2(d)
herein.
b. Payment of health insurance premiums under the Consolidated
Omnibus Budget Reconciliation Act of 1985, as amended, for Executive and
Executive's dependents for a period of 18 months following the effective
date of such termination;
c. Annual payment of benefits where applicable, under the MICP
set forth in Section 3.1(g), for a period of 24 months following the
effective date of such termination, at the percentage of target and
maximum specified for Executive in the records of the executive
compensation department of the Company's Human Resource's Department.
d. The right to exercise any and all granted and unexercised
stock options, under the Stock Option Plans in accordance with their
terms (whether or not such options are actually vested), as if all such
unexercised stock options were fully vested, within one year of the
effective date of such termination;
e. In the event of a change of control in the first six months of
employment which precludes eligibility for exercise of stock options
under the Premium Price & Officer and Key Employee Stock Option Plans,
PacifiCare will provide compensation to Executive to make him whole for
the loss of these options as of the date of the
change and control.
f. Payment of the automobile allowance as provided under Section
3.1(e) for a period of 24 months following the effective date of such
termination; and
g. The Company shall provide to Executive the outplacement
services described in Section 3.1(j).
h. If Executive's termination is a result of a Change of Control
or Executive voluntarily terminates for "good cause" and such
termination occurs prior to Executive having completed five years of
employment with the Company, Executive will not be required to repay any
amount of the Loan or any accrued interest which but for this provision,
Executive would be required to repay as set forth in Section 3.1(c).
4.2 LIMITATION OF BENEFITS. In the event that Executive is terminated
within 12 months after a change of ownership or control of the Company, and such
termination results from either Executive's incapacity or disability or habitual
neglect or gross misconduct, then, notwithstanding anything in this Section 4 to
the contrary, Executive shall receive only that compensation, if any, to which
he is entitled to under Sections 3.2(b) and 3.2(c), respectively.
-9-
<PAGE> 10
In no event shall the aggregate amount of all compensation which
Executive may receive pursuant to the provisions of this Section 4, including
without limitation, any salary, bonuses, stock options, employee benefits and
all other cash and in-kind compensation, exceed an amount (the "Maximum
Compensation Amount") which would give rise to an "excess parachute payment" as
determined by Section 280G of the Internal Revenue Code of 1986, as amended, and
any regulations promulgated thereunder. In the event that this Section 4 would
entitle Executive to sums in excess of the Maximum Compensation Amount, the
Company shall use its sound discretion, in good faith, to furnish Executive with
a post-termination compensation package which is substantially equal to the
Maximum Compensation Amount.
4.3 CHANGE OF CONTROL. As used in this Section 4, the term "change of
ownership or control" means and refers to:
a. any merger, consolidation, or sale of the Company such that
any individual, entity or group (within the meaning of Section 13(d)(3)
or 14(d)(2) of the Securities Exchange Act of 1934, as amended (the
"Exchange Act")) acquires beneficial ownership, within the meaning of
Rule 13d-3 of the Exchange Act, of 20 percent or more of the voting
common stock of the Company and the ownership interest of the voting
common stock owned by UniHealth is less than or equal to the ownership
interest of the voting common stock of such individual, entity or group;
b. any transaction in which the Company sells substantially
all of its material assets;
c. a dissolution or liquidation of the Company; or
d. the Company becomes a non-publicly held company.
4.4 GOOD CAUSE. As used in this Section 4, "good cause" for Executive to
terminate his employment shall be deemed to exist if Executive voluntarily
terminates his employment for any of the following reasons:
a. Without Executive's express prior written consent,
Executive:
1. is assigned duties materially inconsistent with
Executive's position, duties, responsibilities, or status with
the Company which substantially varies from that which existed
immediately prior to such change of ownership or control;
2. experiences a change in his reporting level, titles, or
business location (to a point that is more than 50 miles outside
of Orange County, California) which substantially varies from
that which existed immediately prior to the change of ownership
or control; or
-10-
<PAGE> 11
3. with respect to any position held immediately prior to
the change of ownership or control, is removed or fails to obtain
reelection, which removal or failure to reelect is not directly
related to Executive's incapacity or disability, habitual
neglect, gross misconduct or death;
b. Without Executive's express prior written consent, Executive's
salary is reduced below that which existed immediately prior to the
change of ownership or control and such change is not otherwise applied
to others in the Company with at least Executive's position or title;
c. Without Executive's express prior written consent, any
employee benefit, business expense reimbursement or allotment, incentive
bonus program, or any other manner or form of compensation available to
Executive immediately prior to the change of ownership or control is
reduced or eliminated and such change is not otherwise applied to others
in the Company with at least Executive's position or title;
d. The Company fails to obtain from any successor, before the
succession takes place, a written commitment obligating the successor to
perform this Agreement in accordance with all of its terms and
conditions; or
e. The Company or any successor thereto purports to terminate
Executive without first giving Executive prior written notice thereof
that specifies: (i) the exact provision of Section 2.2 relied upon; and
(ii) the facts and circumstances, in reasonable detail, serving as the
basis for Executive's termination.
5. NOTICES
All notices or other communications required or permitted to be made
hereunder shall be given in writing and sent by either personal delivery,
overnight delivery, or United States registered or certified mail, return
receipt requested, all of which shall be properly addressed with postal or
delivery charges prepaid, to the parties at their respective addresses set forth
below, or to such other addresses as either party may designate to the other in
accordance with this Section 5:
If to the Company: PacifiCare Health Systems, Inc.
3120 Lake Center Drive
Santa Ana, California 92704
Attn: President and
Chief Executive Officer
If to Executive: Mr. Robert Stearns
1156 Beaver Tail
P.O. Box 6045
Carefree, Arizona 85377
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<PAGE> 12
All notices sent by personal delivery shall be deemed given when actually
received. All notices sent by overnight delivery shall be deemed received on the
next business day. All other notices sent via United States mail shall be deemed
received no later than two business days after mailing. Any notice given by any
method not expressly authorized herein, shall nevertheless be effective if
actually received, and shall be deemed given upon actual receipt.
6. GENERAL PROVISIONS
6.1 ASSIGNABILITY. This Agreement shall inure to the benefit of, and
shall be binding upon the heirs, executors, administrators, successors, and
legal representatives of Executive and shall inure to the benefit of, and be
binding upon the Company and its successors and assigns. Executive shall not
assign, delegate, subdelegate, transfer, pledge, encumber, hypothecate, or
otherwise dispose of this Agreement, or any rights, obligations, or duties
hereunder, and any such attempted delegation or disposition shall be null and
void and without any force or effect; provided, however, that nothing contained
herein shall prevent Executive from designating beneficiaries for insurance,
death or retirement benefits.
6.2 ENTIRE AGREEMENT. This Agreement is a fully integrated document and
contains any and all promises, covenants, and agreements between the parties
hereto with respect to Executive's employment. This Agreement supersedes any and
all other, prior or contemporaneous, discussions, negotiations, representations,
warranties, covenants, conditions, and agreements, whether written or oral,
between the parties hereto. Except as expressed herein, the parties have not
exchanged any other representations, warranties, inducements, promises, or
agreements respecting Executive's employment with the Company.
6.3 SEVERABILITY. In the event any one or more of the provisions of this
Agreement shall be rendered by a court of competent jurisdiction to be invalid,
illegal, or unenforceable, in any respect, such invalidity, illegality, or
unenforceability shall not affect or impair the remainder of this Agreement
which shall remain in full force and effect and enforced accordingly, unless a
party demonstrates by a preponderance of the evidence that the invalidated
provision was an essential economic term of this Agreement.
6.4 AMENDMENT. This Agreement shall not be changed, amended, or
modified, nor shall any performance or condition hereunder be waived, in whole
or in part, except by written instrument signed by the party against whom
enforcement or waiver is sought. The waiver of any breach of any term or
condition of this Agreement shall not be deemed to constitute the waiver of any
other or subsequent breach of the same or any other term or condition of this
Agreement.
-12-
<PAGE> 13
6.5 GOVERNING LAW. This Agreement shall be governed by, enforced under,
and construed in accordance with the laws of the State of California.
IN WITNESS WHEREOF, the parties hereto have executed this Agreement as
of the date first written above.
The Company: PACIFICARE HEALTH SYSTEMS, INC.,
a Delaware corporation
/s/ Alan R. Hoops
-----------------------------------
By: Alan R. Hoops
Title: President and
Chief Executive Officer
Executive: /s/ Robert Stearns
-----------------------------------
Robert Stearns
-13-
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from PacifiCare
Health Systems, Inc.'s unaudited condensed consolidated balance sheet as of
September 30, 1998, and related unaudited consolidated statement of operations
for the nine months ended September 30, 1998, and is qualified in its entirety
by reference to such financial statements.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 181,504
<SECURITIES> 994,397
<RECEIVABLES> 294,163
<ALLOWANCES> 10,734
<INVENTORY> 0
<CURRENT-ASSETS> 1,575,313
<PP&E> 320,976
<DEPRECIATION> 127,395
<TOTAL-ASSETS> 4,347,715
<CURRENT-LIABILITIES> 1,261,166
<BONDS> 0
0
0
<COMMON> 463
<OTHER-SE> 2,182,399
<TOTAL-LIABILITY-AND-EQUITY> 4,347,715
<SALES> 0
<TOTAL-REVENUES> 7,179,106
<CGS> 0
<TOTAL-COSTS> 6,032,883
<OTHER-EXPENSES> 900,468
<LOSS-PROVISION> 2,608
<INTEREST-EXPENSE> 48,259
<INCOME-PRETAX> 273,235
<INCOME-TAX> 129,787
<INCOME-CONTINUING> 143,448
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 143,448
<EPS-PRIMARY> 3.20
<EPS-DILUTED> 3.12
</TABLE>
