<PAGE> 1
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
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 JUNE 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 INCORPORATION (IRS EMPLOYER IDENTIFICATION NUMBER)
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 July 31, 1998, there were 14,828,561 shares of the Registrant's Class
A Common Stock, par value $0.01 per share, outstanding, and 30,979,740 shares of
Class B Common Stock, par value $0.01 per share, outstanding.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE> 2
PACIFICARE HEALTH SYSTEMS, INC.
FORM 10-Q INDEX
<TABLE>
<CAPTION>
PAGE
----
<S> <C> <C>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of June 30, 1998 and
December 31, 1997................................................ 1
Consolidated Statements of Operations for the three months ended
June 30, 1998 and 1997........................................... 2
Consolidated Statements of Operations for the six months ended
June 30, 1998 and 1997........................................... 3
Consolidated Statements of Cash Flows for the six months ended
June 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 2. Changes in Securities....................................... 20
Item 4. Submission of Matters to a Vote of Security Holders......... 20
Item 5. Other Information........................................... 20
Item 6. Exhibits and Reports on Form 8-K............................ 21
SIGNATURES............................................................. 22
EXHIBITS
</TABLE>
i
<PAGE> 3
PART 1: FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS
PACIFICARE HEALTH SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1998 1997
----------- ------------
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER
SHARE DATA)
<S> <C> <C>
A S S E T S
CURRENT ASSETS:
CASH AND EQUIVALENTS...................................... $ 90,207 $ 680,674
MARKETABLE SECURITIES..................................... 931,171 864,708
RECEIVABLES, NET.......................................... 306,514 301,345
PREPAID EXPENSES AND OTHER CURRENT ASSETS................. 40,208 32,194
DEFERRED INCOME TAXES..................................... 107,511 112,037
---------- ----------
TOTAL CURRENT ASSETS.............................. 1,475,611 1,990,958
---------- ----------
PROPERTY, PLANT AND EQUIPMENT, NET.......................... 228,148 235,943
MARKETABLE SECURITIES -- RESTRICTED......................... 161,400 145,989
GOODWILL AND INTANGIBLE ASSETS, NET......................... 2,421,312 2,458,463
OTHER ASSETS................................................ 20,439 36,605
---------- ----------
$4,306,910 $4,867,958
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Medical claims and benefits payable....................... $ 664,600 $ 715,600
Accounts payable and accrued liabilities.................. 491,218 429,524
Unearned premium revenue.................................. 39,498 491,808
Long-term debt due within one year........................ 156 154
---------- ----------
Total current liabilities......................... 1,195,472 1,637,086
---------- ----------
Long-term debt due after one year........................... 811,153 1,011,234
Deferred income taxes....................................... 103,138 102,793
Other liabilities........................................... 58,449 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 at December 31,
1997.................................................. -- 105
Class A common shares, par value $0.01 per share;
100,000 shares authorized; 14,871 and 14,794 issued at
June 30, 1998 and December 31, 1997, respectively..... 149 148
Class B common shares, par value $0.01 per share;
100,000 shares authorized; 31,357 and 27,201 issued at
June 30, 1998 and December 31, 1997, respectively..... 313 272
Additional paid-in capital............................. 1,614,726 1,599,229
Accumulated other comprehensive income................. 8,390 9,993
Retained earnings...................................... 537,399 452,440
Treasury shares, at cost: Class A common shares -- 42;
Class B common shares - 392........................... (22,634) --
---------- ----------
Total shareholders' equity........................ 2,138,343 2,062,187
---------- ----------
$4,306,910 $4,867,958
========== ==========
</TABLE>
- ---------------
See accompanying notes.
1
<PAGE> 4
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
JUNE 30,
------------------------
1998 1997
---------- ----------
(IN THOUSANDS, EXCEPT
PER SHARE DATA)
<S> <C> <C>
Revenue:
Commercial premiums....................................... $ 961,088 $ 995,961
Government premiums (Medicare and Medicaid)............... 1,406,509 1,374,203
Other income.............................................. 28,662 10,936
---------- ----------
Total operating revenue........................... 2,396,259 2,381,100
---------- ----------
Expenses:
Health care services:
Commercial services....................................... 804,651 870,298
Government services....................................... 1,210,407 1,179,420
---------- ----------
Total health care services........................ 2,015,058 2,049,718
---------- ----------
Marketing, general and administrative expenses.............. 275,664 266,913
Amortization of goodwill and intangible assets.............. 19,265 22,241
---------- ----------
Operating income............................................ 86,272 42,228
Interest income............................................. 23,850 20,368
Interest expense............................................ (16,913) (18,695)
---------- ----------
Income before income taxes.................................. 93,209 43,901
Provision for income taxes.................................. 44,338 25,904
---------- ----------
Net income.................................................. $ 48,871 $ 17,997
========== ==========
Preferred dividends......................................... (2,630) (2,630)
---------- ----------
Net income available to common shareholders................. $ 46,241 $ 15,367
========== ==========
Basic earnings per share.................................... $ 1.10 $ 0.37
========== ==========
Diluted earnings per share.................................. $ 1.06 $ 0.37
========== ==========
</TABLE>
- ---------------
See accompanying notes.
2
<PAGE> 5
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
SIX MONTHS ENDED
JUNE 30,
------------------------
1998 1997
---------- ----------
(IN THOUSANDS, EXCEPT
PER SHARE DATA)
<S> <C> <C>
Revenue:
Commercial premiums....................................... $1,921,986 $1,752,888
Government premiums (Medicare and Medicaid)............... 2,803,031 2,449,198
Other income.............................................. 53,192 22,617
---------- ----------
Total operating revenue........................... 4,778,209 4,224,703
---------- ----------
Expenses:
Health care services:
Commercial services....................................... 1,603,103 1,500,091
Government services....................................... 2,420,456 2,097,282
---------- ----------
Total health care services........................ 4,023,559 3,597,373
---------- ----------
Marketing, general and administrative expenses.............. 557,977 481,427
Amortization of goodwill and intangible assets.............. 37,901 32,560
---------- ----------
Operating income............................................ 158,772 113,343
Interest income............................................. 49,154 38,053
Interest expense............................................ (34,431) (28,414)
---------- ----------
Income before income taxes.................................. 173,495 122,982
Provision for income taxes.................................. 83,278 61,491
---------- ----------
Net income.................................................. $ 90,217 $ 61,491
========== ==========
Preferred dividends......................................... (5,258) (3,534)
---------- ----------
Net income available to common shareholders................. $ 84,959 $ 57,957
========== ==========
Basic earnings per share.................................... $ 2.03 $ 1.48
========== ==========
Diluted earnings per share.................................. $ 1.96 $ 1.44
========== ==========
</TABLE>
- ---------------
See accompanying notes.
3
<PAGE> 6
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
SIX MONTHS ENDED
JUNE 30,
-----------------------
1998 1997
--------- ----------
(IN THOUSANDS)
<S> <C> <C>
Operating activities:
Net income................................................ $ 90,217 $ 61,491
Adjustments to reconcile net income to net cash used in
operating activities:
Amortization of goodwill and intangible assets......... 37,901 32,560
Depreciation and amortization.......................... 25,292 21,943
Deferred income taxes.................................. 6,058 1,080
Provision for doubtful accounts........................ 1,174 2,435
Loss on disposal of property, plant and equipment...... 679 6,205
Other noncash items.................................... (20) --
Changes in assets and liabilities, net of effects from
acquisitions:
Receivables....................................... (6,343) 46,770
Prepaid expenses and other assets................. 8,152 (6,453)
Medical claims and benefits payable............... (51,000) 5,138
Accounts payable and accrued liabilities.......... 70,581 (85,189)
Unearned premium revenue.......................... (452,310) (211,749)
--------- ----------
Net cash flows used in operating activities............ (269,619) (125,769)
--------- ----------
Investing activities:
(Purchase) sale of marketable securities.................. (69,253) 38,007
Purchase of property, plant and equipment................. (18,176) (28,584)
Purchase of marketable securities - restricted............ (15,411) (16,977)
Acquisitions, net of cash acquired........................ (750) (982,285)
--------- ----------
Net cash flows used in investing activities............ (103,590) (989,839)
--------- ----------
Financing activities:
Principal payments on long-term debt...................... (230,079) (150,240)
Proceeds from long-term borrowing, net of expenses........ 30,000 1,108,974
Repurchase of common stock................................ (23,338) --
Proceeds from issuance of common and treasury stock....... 11,827 38,723
Cash dividends paid to preferred shareholders............. (5,258) (3,534)
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............................................ (217,258) 986,521
--------- ----------
Net decrease in cash and equivalents........................ (590,467) (129,087)
Beginning cash and equivalents.............................. 680,674 367,748
--------- ----------
Ending cash and equivalents................................. $ 90,207 $ 238,661
========= ==========
</TABLE>
- ---------------
See accompanying notes.
4
<PAGE> 7
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(UNAUDITED)
<TABLE>
<CAPTION>
SIX MONTHS ENDED
JUNE 30,
-----------------------
1998 1997
--------- ----------
(IN THOUSANDS)
<S> <C> <C>
Supplemental cash flow information:
Cash paid during the period for:
Income taxes.............................................. $ 2,083 $ 77,316
Interest.................................................. $ 31,127 $ 20,356
Supplemental schedule of noncash investing and financing
activities:
Tax benefit realized upon exercise of stock options....... $ 4,133 $ 16,911
Compensation awarded in Class B Common Stock.............. $ 588 $ 721
Details of businesses acquired in purchase transactions:
Fair value of assets acquired............................. $ 750 $3,362,943
Liabilities assumed or created............................ -- (1,170,179)
Preferred and common consideration........................ -- (1,163,689)
--------- ----------
Cash paid for acquisitions................................ 750 1,029,075
Cash acquired in acquisitions............................. -- (46,790)
--------- ----------
Net cash paid for acquisitions............................ $ 750 $ 982,285
========= ==========
Details of accumulated other comprehensive income:
Change in marketable securities........................... $ (2,790) $ 640
Less change in deferred income taxes...................... 1,187 (222)
--------- ----------
Change in shareholders' equity............................ $ (1,603) $ 418
========= ==========
</TABLE>
- ---------------
See accompanying notes.
5
<PAGE> 8
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 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 3.7 million members in the commercial, Medicare and Medicaid lines
of business. The interim condensed consolidated financial statements included
herein have been prepared by the Company without audit, pursuant to the rules
and regulations of the Securities and Exchange Commission (the "SEC"). Certain
information and footnote disclosures, normally included in the financial
statements prepared in accordance with generally accepted accounting principles,
have been condensed or omitted pursuant to such SEC rules and regulations;
nevertheless, management of the Company believes that the disclosures herein are
adequate to make the information presented not misleading. It is suggested that
these condensed consolidated financial statements be read in conjunction with
the consolidated financial statements and notes thereto included in the
Company's December 31, 1997 Annual Report on Form 10-K, filed with the SEC in
March 1998.
In the opinion of management, all adjustments, consisting only of normal
recurring adjustments necessary to present fairly the consolidated financial
position of the Company with respect to the interim condensed consolidated
financial statements, and the consolidated results of its operations and its
cash flows for the interim periods then ended, have been included. The results
of operations for the interim periods are not necessarily indicative of the
results for the full year.
NOTE 2 -- ACQUISITIONS AND DISPOSITIONS
In February 1997, the Company acquired FHP International Corporation
("FHP"). The FHP acquisition was accounted for as a purchase; accordingly, 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, the Company 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 the Company received regulatory
approval from the state of Florida.
The pro forma information below presents combined results of operations as
if the FHP acquisition and the sale of the Company's Florida subsidiary had
occurred at the beginning of 1997. The pro forma information gives effect to
actual operating results prior to the acquisition and adjustments to interest
expense, goodwill amortization and income taxes. No adjustment was made to give
effect to synergies that may be realized as a result of the FHP acquisition.
<TABLE>
<CAPTION>
SIX MONTHS ENDED
JUNE 30, 1997
----------------
(UNAUDITED)
(IN THOUSANDS,
EXCEPT PER SHARE
AMOUNTS)
<S> <C>
Total operating revenue..................................... $4,777,583
Pretax income............................................... $ 114,564
Net income.................................................. $ 50,763
Basic earnings per share.................................... $ 1.10
Diluted earnings per share.................................. $ 1.10
</TABLE>
6
<PAGE> 9
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)
NOTE 3 -- LONG-TERM DEBT
The Company has a $1.5 billion credit facility under which it had $710
million in borrowings outstanding as of June 30, 1998. The terms of the credit
facility require mandatory step-down payments beginning on January 1, 1999 with
final maturity on January 1, 2002. Such terms would not require a reduction
below the current $710 million outstanding principal balance until the final
maturity date. Interest under the credit facility is presently based on the
London Interbank Offering Rate ("LIBOR") plus a spread, except for $350 million
of the outstanding balance which is covered by interest-rate swap agreements.
The average fixed interest rate paid by the Company 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 and leverage ratios.
Terms of the credit agreement also established the amount of treasury stock that
may be purchased by the Company. In December 1997, the Company renegotiated the
terms of its credit facility to increase the maximum amount permitted for
repurchases to $500 million. At June 30, 1998, the Company was in compliance
with all such covenants. In 1997, the Company assumed $100 million in senior
notes of FHP that carry an interest rate of seven percent, are payable
semiannually and mature on September 15, 2003.
NOTE 4 -- SHAREHOLDERS' EQUITY
On May 22, 1998, the Company 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 six months ended June 30, 1998, the Company paid
approximately $5 million in dividends to its preferred shareholders.
In January 1998, the Company's board of directors approved a plan to
repurchase shares of the Company's equity instruments. The Company has
repurchased its equity instruments using cash flows from operations and
additional borrowings under its credit facility. Shares repurchased have been
and will be reissued in connection with the Company's employee benefit plans or
for other corporate purposes. See "Liquidity and Capital Resources."
NOTE 5 -- CONTINGENCIES
OPM. The Company's HMO subsidiaries have commercial contracts with the
United States Office of Personnel Management ("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 the pending Utah sale, the
Company has agreed to indemnify the buyers for potential OPM liabilities that
relate to the years in which the Company owned these plans.
7
<PAGE> 10
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)
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 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 substantial monetary damages, including claims of
punitive damages that 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.
NOTE 6 -- EARNINGS PER SHARE
In 1997, the Financial Accounting Standards Board issued Statement No. 128
("SFAS 128"), "Earnings per Share." SFAS 128 replaces the calculation of primary
and fully diluted earnings per share with basic and diluted earnings per share.
Unlike primary earnings per share, basic earnings per share excludes any
dilutive effects of options and convertible securities. Diluted earnings per
share is very similar to the previously reported fully diluted earnings per
share. Earnings per share amounts reported for the three and six months ended
June 30, 1997 were restated to conform to the SFAS 128 requirements, and did not
vary materially
8
<PAGE> 11
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)
from amounts previously stated. The following table sets forth the computation
of the denominator for basic and diluted earnings per share for the periods
indicated:
<TABLE>
<CAPTION>
THREE MONTHS SIX MONTHS
ENDED ENDED
JUNE 30, JUNE 30,
--------------- ---------------
1998 1997 1998 1997
------ ------ ------ ------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Shares outstanding at the beginning of the period..... 41,720 41,710 41,995 31,301
Weighted average number of shares issued:
Conversion of Series A Preferred Stock.............. 348 -- 175 --
Treasury stock reissued (acquired), net............. 9 -- (405) --
Exercise of stock options........................... 68 59 150 501
FHP acquisition..................................... -- -- -- 7,283
------ ------ ------ ------
Denominator for basic earnings per share.............. 42,145 41,769 41,915 39,085
Assumed conversion of Series A Preferred Stock........ 3,582 3,955 3,755 2,972
Employee stock options and other dilutive potential
common shares....................................... 507 470 341 539
------ ------ ------ ------
Denominator for diluted earnings per share............ 46,234 46,194 46,011 42,596
====== ====== ====== ======
</TABLE>
NOTE 7 -- COMPREHENSIVE INCOME
As of January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 130 ("SFAS 130"), "Reporting Comprehensive Income."
SFAS 130 establishes new rules for the reporting and display of comprehensive
income and its components. Adoption of SFAS 130 had no impact on the Company's
net income or shareholders' equity for the three and six months ended June 30,
1998. SFAS 130 requires unrealized gains or losses on the Company's
available-for-sale securities to be included in other comprehensive income.
These amounts were reported separately in shareholders' equity prior to
adoption. Prior year financial statements have been conformed to the reporting
requirements of SFAS 130. Comprehensive income totaled $49 million and $89
million for the three and six months ended June 30, 1998, respectively, and $23
million and $62 million for the three and six months ended June 30, 1997,
respectively.
NOTE 8 -- 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 98-1 as of January 1, 1998 did not have a material
effect on the results of operations for the three and six months ended June 30,
1998. Capitalized software costs are included in property, plant and equipment
on the balance sheet and are being amortized using the straight-line method over
estimated useful lives ranging from three to five years.
NOTE 9 -- SUBSEQUENT EVENTS
On July 2, 1998 the Company announced it had entered into an agreement to
sell its workers' compensation subsidiary, Great States Insurance Company, to
HIH America Compensation & Liability Insurance Company. The sale, subject to
final regulatory approvals and customary closing conditions, is expected to
close by October 31, 1998.
9
<PAGE> 12
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)
On July 15, 1998 the Company announced that a Utah-based investment group
had signed a definitive agreement to purchase the Company's Utah HMO. Because
the sale is subject to regulatory approvals and other closing conditions, the
Company has not yet completed all of the analysis required to estimate the final
financial impact of the sale. The sale is expected to close by December 31, 1998
While the Company has not finalized its analysis of the pending sales, the
Company anticipates that the Utah and workers' compensation operations
dispositions will result in losses that range from $10 to $20 million and may
include restructuring expenses for severance, lease and contract terminations.
There can be no assurance that the dispositions will not result in additional
pretax charges. The Company believes that any disposition operating losses would
not materially affect the Company's consolidated financial position. However,
the disposition losses could have a material adverse effect on the results of
operations or cash flows of a future quarter.
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.
<TABLE>
<CAPTION>
AT JUNE 30, 1998 AT JUNE 30, 1997
------------------------------------ ------------------------------------
GOVERNMENT GOVERNMENT
(MEDICARE & (MEDICARE &
MEMBERSHIP DATA COMMERCIAL MEDICAID) TOTAL COMMERCIAL MEDICAID) TOTAL
--------------- ---------- ----------- --------- ---------- ----------- ---------
<S> <C> <C> <C> <C> <C> <C>
Arizona...................... 105,400 88,400 193,800 105,100 88,400 193,500
California................... 1,561,000 600,300 2,161,300 1,677,000 626,500 2,303,500
Colorado..................... 295,200 55,500 350,700 279,200 49,200 328,400
Guam......................... 40,400 -- 40,400 43,000 -- 43,000
Nevada....................... 43,700 24,700 68,400 39,600 23,600 63,200
Ohio......................... 46,800 15,000 61,800 53,900 10,600 64,500
Oklahoma..................... 100,700 26,700 127,400 111,800 25,600 137,400
Oregon....................... 116,200 38,700 154,900 118,200 40,500 158,700
Texas........................ 141,800 68,600 210,400 137,000 69,300 206,300
Utah......................... 113,300 22,200 135,500 159,800 31,100 190,900
Washington................... 95,600 59,500 155,100 96,300 55,000 151,300
--------- ------- --------- --------- --------- ---------
Total
membership(1).... 2,660,100 999,600 3,659,700 2,820,900 1,019,800 3,840,700
========= ======= ========= ========= ========= =========
</TABLE>
<TABLE>
<CAPTION>
THREE MONTHS SIX MONTHS
ENDED ENDED
JUNE 30 JUNE 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........................................... 85.1% 86.5% 85.2% 85.6%
Commercial............................................. 83.7% 87.4% 83.4% 85.6%
Government (Medicare and Medicaid)..................... 86.1% 85.8% 86.4% 85.6%
Marketing, general and administrative expenses as a percent
of operating revenue...................................... 11.5% 11.2% 11.7% 11.4%
Operating income as a percent of operating revenue.......... 3.6% 1.8% 3.3% 2.7%
Effective tax rate.......................................... 47.6% 59.0% 48.0% 50.0%
</TABLE>
- ---------------
(1) The membership table does not include the members of Illinois and New Mexico
at June 30, 1997 because these companies were classified as net assets held
for sale, and were subsequently sold during 1997. As of June 30, 1997,
Illinois had approximately 54,000 and 4,000 commercial and government
members, respectively; New Mexico had approximately 41,000 and 18,000
commercial and government members, respectively.
11
<PAGE> 14
THREE AND SIX MONTHS ENDED JUNE 30, 1998
COMPARED WITH THE
THREE AND SIX MONTHS ENDED JUNE 30, 1997
RESULTS OF OPERATIONS
For the three months ended June 30, 1998, total operating revenue increased
one percent compared to the same period in the prior year because of the
increase in other income. Premiums remained flat with membership losses being
substantially offset by premium rate increases. Total operating revenue
increased 13 percent for the six months ended June 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 the Condensed Consolidated
Financial Statements). Other income increased 162 percent and 135 percent for
the three and six months ended June 30, 1998, respectively, compared to the same
periods in the prior year, due primarily to increased revenue from the Company's
prescription drug benefit management, Secure Horizons USA and PacifiCare
Behavioral Health subsidiaries.
Total HMO membership decreased five percent to approximately 3.7 million
members at June 30, 1998, from approximately 3.8 million members at June 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 product performance. The Company has emphasized renewing
commercial contracts with sufficient premium 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 for the three months ended June
30, 1998, compared to the same period in the prior year. Premiums decreased by
$54 million for the quarter due to expected membership losses that related to
premium rate increases and the exit of certain geographic markets. Commercial
HMO premium rate increases in the second quarter offset these decreases by $39
million. Specialty product commercial premiums decreased $20 million due to the
exit of unprofitable indemnity and workers' compensation products. The 10
percent increase in commercial premiums for the six months ended June 30, 1998,
over the same period in the prior year, was due to a full six months of FHP
results being included in 1998 compared to four 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 six months ended June 30, 1998 compared to the same
period in the prior year.
Government premiums increased two percent and 14 percent for the three and
six months ended June 30, 1998, compared to the same periods in the prior year,
respectively. The inclusion of an additional six weeks of results in 1998 from
the FHP acquisition increased government premiums by $301 million. Premium rate
increases averaging approximately four percent contributed $56 million and $108
million to the three and six months ended June 30, 1998, respectively.
Membership losses decreased premiums by $24 million and $55 million for the
second quarter and year to date, respectively. Membership losses are
attributable to the Company's exit of certain rural geographic areas and its
Medicaid lines of business in California and Florida.
The medical care ratio (health care services as a percent of premium
revenue) decreased for the three and six months ended June 30, 1998, compared to
the same periods in the prior year. The improvement was due to the continued
renegotiation of provider contracts into capitated arrangements and improved
commercial pricing, partially offset by increased net provider reserves of $20
million. In the second quarter, the Company added approximately $35 million ($18
million or $0.39 diluted loss per share, net of tax) of provider insolvency
reserves for, but not limited to, the bankruptcy of FPA Medical Management, Inc.
("FPA"), one of the Company's contracted health care providers. These provider
insolvency reserves were partially offset by approximately $15 million ($8
million or $0.17 diluted loss per share, net of tax) of unrelated favorable
provider settlements. Excluding the $20 million in net provider reserves, the
second quarter and year to date consolidated medical care ratios would have been
84.3 and 84.7 percent, respectively.
12
<PAGE> 15
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 provider insolvency reserves were
partially offset by unrelated favorable provider settlements. The Company
periodically makes changes in provider settlement estimates and in the second
quarter, certain prior year contract issues were resolved.
The commercial medical care ratio decreased for the three and six months
ended June 30, 1998 compared to the same periods in the prior year. The
improvement in the commercial medical care ratio was due to the continued
renegotiation of provider contracts into capitated arrangements and an improved
premium pricing environment. In the second quarter, commercial provider
insolvency reserves of $10 million were offset by $8 million of unrelated
favorable provider settlements. The net increase in provider reserves of $2
million did not materially impact the commercial medical care ratio.
The government medical care ratio increased for the three and six months
ended June 30, 1998, compared to the same periods in the prior year primarily
due to the second quarter increase in net government provider reserves of $18
million. The Company added approximately $25 million of provider insolvency
reserves that were partially offset by $7 million of unrelated favorable
provider settlements in the second quarter. Excluding the $18 million in net
provider reserves, the second quarter and year to date government medical care
ratios would have been 84.7 and 85.7 percent, respectively. In the second
quarter, the Company realized higher pharmacy rebates and amortized Utah premium
deficiency reserves established in 1997. These factors contributed to a one
percent decrease in the second quarter government medical care ratio excluding
net provider reserves compared to the prior year. For the six months ended June
30, 1998, the government medical care ratio excluding net provider reserves was
comparable to the same period in the prior year.
As a percentage of operating revenue, marketing, general and administrative
expenses for both the three and six months ended June 30, 1998, increased from
the prior year primarily from the accelerated discretionary spending for
employee profit sharing plans and other overhead costs. Excluding these
accelerated expenses, the administrative ratios this year would have been
comparable to the ratios recorded in the same periods last year.
Interest income increased approximately 17 percent and 29 percent for the
three and six months ended June 30, 1998, respectively, compared to the same
periods in the prior year, primarily due to gains on sales of marketable
securities experienced in the first quarter and more efficient investment
through account consolidation. Interest expense decreased approximately 10
percent for the three months ended June 30, 1998, compared to the same period in
the prior year, primarily due to reductions in principal on the Company's credit
facility. The 21 percent increase in interest expense for the six months ended
June 30, 1998, compared to the same period in the prior year, was primarily due
to borrowings used to finance the FHP acquisition being outstanding for six
weeks longer in 1998.
The effective income tax rate was approximately 47.6 and 48.0 percent for
the three and six months ended June 30, 1998, respectively, compared to 59.0 and
50.0 percent for the same periods in the prior year, respectively. This decrease
is due to non-deductible goodwill amortization being a smaller percentage of
taxable income than in the prior year.
During the year ended December 31, 1997, the Company adopted the provisions
of Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per
Share." This statement requires a dual presentation of earnings per share, basic
and diluted, and restatement of prior years. Earnings per share amounts reported
for the three and six months ended June 30, 1997 were restated to conform to the
SFAS 128 requirements, and did not vary materially from amounts previously
stated.
LIQUIDITY AND CAPITAL RESOURCES
The Company's consolidated cash, equivalents and marketable securities
decreased $524 million to $1.0 billion at June 30, 1998, from $1.5 billion at
December 31,1997. The decrease primarily reflects the impact of timing
differences in receipt of HCFA premiums and the paydown of principal of
long-term debt.
13
<PAGE> 16
Cash flows provided by operations, excluding the impact of the January 1998
advance Medicare payment from HCFA, were $183 million and primarily attributable
to an increase in accounts payable and accrued liabilities, offset by a decrease
in medical claims and benefits payable. The increase in accounts payable and
accrued liabilities was primarily due to timing differences for income taxes.
The medical claims and benefits payable decrease related to a significant
reduction of the claims backlog, reduced specialty company reserves as
unprofitable products have been discontinued and continued renegotiation of
provider contracts into capitated arrangements.
Net cash used in investing activities was $104 million and $990 million for
the six months ended June 30, 1998 and 1997, respectively. Cash used in 1998 was
primarily attributable to the purchase of marketable securities and capital
expenditures. Cash used in 1997 was primarily attributable to the FHP
acquisition.
Net cash used in financing activities was $217 million for the six months
ended June 30, 1998. Financing activities provided $987 million for the six
months ended June 30, 1997. During 1998, net cash provided by financing
activities included $30 million in borrowings under the Company's credit
facility to finance the repurchase of common stock. In January 1998, the
Company's board of directors approved a plan to repurchase shares of the
Company's equity instruments. As of June 30, 1998, the Company had repurchased
shares of Class A and Class B Common Stock for an aggregate amount of $23
million (see Note 4 of the Notes to the Condensed Consolidated Financial
Statements). To date, the Company has borrowed $1.2 billion under the credit
facility to finance the FHP acquisition and other financing activities, and has
repaid $230 million and $150 million for the six months ended June 30, 1998 and
1997, respectively, of such borrowings. The issuance of common and treasury
stock provided cash in 1998 and 1997 of $12 million and $39 million,
respectively. The Company paid approximately $5 million and $4 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
The Financial Accounting Standards Board ("FASB") has issued the following
pronouncements regarding disclosure that the Company will adopt in 1998.
SFAS No. 129, "Disclosure of Information about Capital Structure,"
consolidates the existing guidance relating to an entity's capital structure.
The required capital structure disclosures include liquidation preferences of
preferred stock, information about the pertinent rights and privileges of the
outstanding equity securities and the redemption amounts of all issues of
capital stock that are redeemable at fixed or determinable prices on fixed or
determinable dates.
SFAS No. 131, "Disclosures about Segments of an Enterprise and Related
Information," significantly changes the way public companies report segment
information in annual financial statements and also requires those companies to
report selected segment information in interim financial reports. Under SFAS
131, public companies will report financial and descriptive information about
their operating segments. Operating segments are revenue-producing components of
the enterprise for which separate financial information is produced internally
and are subject to evaluation by the chief operating decision maker in deciding
how to allocate resources to segments.
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
14
<PAGE> 17
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 commercial membership for the year
ended December 31, 1998 is expected to decline from 1997. In accordance with the
Company's shift in strategic focus from one of rapid growth to improved margin
performance, the Company's emphasis is on renewing employer contracts with
sufficient price increases to improve gross margin. Specifically, the Company
has implemented commercial price increases in all markets ranging from zero to
over 10 percent which may continue to result in net membership attrition. Price
increases on a consolidated Company basis for commercial membership are expected
to increase by an average of three percent in 1998. In addition to pricing
increases, the 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 pending disposition of its Utah subsidiary, which
currently has approximately 113,000 commercial members, will also contribute to
the expected decline.
Government membership is expected to remain flat or decrease slightly in
1998 compared to 1997, including 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 expected
from the exit of certain geographical markets where health care costs outpace
Medicare reimbursement. Finally, failure to reassign members, who were
previously served by FPA into cost-effective alternative provider networks, may
result in membership attrition. Additionally, if the Utah disposition is
completed, government membership will decrease by approximately 22,000 members.
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 retention of former members who are being reassigned from FPA to other
providers, the sale of certain managed care operations, 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 were served by FPA, shifting these members into cost-effective
alternative provider networks will be important to improved results of
operations for that market. 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;
incurring 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 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. The commercial medical care ratio is
expected to remain relatively consistent for the three months ended September
30, 1998 compared to the three months ended June 30, 1998. For the remainder of
1998, the Company expects the commercial medical care ratio to increase from the
15
<PAGE> 18
ratio experienced in the first six months of 1998, but overall, anticipates that
the medical care ratio for the full year will be lower than that for the year
ended December 31, 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 commercial medical care ratio
business. During 1998, the Company will continue to concentrate its efforts on
renegotiations with providers. Successful renegotiation of these contracts
should reduce the commercial medical care ratio from the prior year. Finally,
the commercial medical care ratio should improve if the Utah disposition is
completed.
Government Medical Care Ratio. For the three months ended September 30,
1998, the medical care ratio for the government programs is expected to be
relatively flat or slightly lower than the three months ended June 30, 1998. The
government medical care ratio is anticipated to be comparable or slightly
decrease as the need for additional net provider reserves is expected to
decrease in the third quarter. For the year ended December 31, 1998, the
government medical care ratio is expected to be slightly higher than the prior
year. 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 pending Utah
disposition.
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 which 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. For the quarter ended September 30, 1998, other income is
expected to be comparable or slightly less than the quarter ended June 30, 1998
as pharmacy funding from mail service co-payments typically decreases in the
third quarter. Compared to 1997, other income is expected to increase
substantially from the Company's prescription drug benefit management, Secure
Horizons USA and PacifiCare Behavioral Health subsidiaries.
Marketing, General and Administrative Support. As a percentage of operating
revenue, marketing, general and administrative expenses are expected to be
comparable for the three months ended September 30, 1998 compared to the three
months ended June 30, 1998. 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. 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.
Future Dispositions. In addition to the announced pending disposition of
Utah and the Company's workers' compensation operations, other dispositions
could be announced as the Company continues to evaluate whether certain
subsidiaries or products fit within its core business strategy. The Company
anticipates that the Utah and workers' compensation operations dispositions will
result in losses that range from $10 to $20 million and may include
restructuring expenses for severance, lease and contract terminations. There can
be no assurance that the dispositions will not result in additional pretax
charges. The Company believes, however, that any disposition operating losses
would not materially affect the Company's consolidated financial position.
However, the disposition losses could have a material adverse effect on the
results of operations or cash flows of a future quarter.
Impairment of Long-Lived Assets. The Company assesses the recoverability of
its long-lived assets (including goodwill and intangibles) on an annual basis or
whenever adverse events or changes in circumstances or the business climate
indicate that expected undiscounted future cash flows for individual
16
<PAGE> 19
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 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. The total estimated cost
to make the Company's existing legacy system Year 2000 compliant is $6 million,
with the majority already incurred. The Company expects its legacy systems to be
Year 2000 compliant by the end of the year.
With the February 1997 FHP acquisition, the original integration plan
required the Arizona, Colorado, Nevada, Ohio and Utah 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, the 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 all
claims on behalf of the 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. A detailed project plan
is being developed to ensure that FHP legacy systems are Year 2000 compliant.
The testing is expected to be completed by June 1999. The Company is currently
quantifying the costs of making the FHP legacy system Year 2000 compliant and is
also developing contingency plans in the event this legacy system cannot timely
be made Year 2000 compliant. If the Company is not able to timely correct all
Year 2000 problems, 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 and to
seek reasonable assurances with respect to Year 2000 compliance. Because the
Company has no control over third parties' products or services, 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. These contingency plans will include edit checks within
internal Company systems prior to interfacing with non-compliant third parties
to prevent Year 2000 issues. 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.
Finally, a Year 2000 steering committee was formed in the second quarter
to:
- raise compliance awareness;
- provide a common project methodology for all activities;
- establish priorities based on risk and liability;
- develop business process contingency plans; and
- develop risk reduction strategies in the areas of business disruption,
financial loss, Company image and regulatory compliance.
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
17
<PAGE> 20
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 mandatory step-down payments beginning January 1, 1999 with final
maturity on January 1, 2002. Such terms would not require a reduction below the
current $710 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 result in the Company being 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 federal or 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.
Legislation and Regulation. The Company's success is significantly impacted
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. Actual
results may differ materially from expected results discussed throughout this
document because of adverse state and federal legislation and regulation. This
includes 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
are 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 and recovery by governmental payors
of previously paid amounts; the inability to increase premiums or prospective or
retroactive reductions to premium rates for federal employees; adverse
regulatory determinations resulting in care or limitations of licensure, and
certification or contracts with governmental payors; and consolidation of
operations.
On August 5, 1997, President Clinton signed into law the Balanced Budget
Act of 1997 (the "1997 Budget Act"), which enacted numerous revisions to the
Medicare program. The law replaces the risk contract program with a new
Medicare+Choice program (the "M+C Program"), which is intended to increase
Medicare enrollment in private health plans. On June 26, 1998, HCFA published
interim final regulations to implement the M+C Program. The new regulations
outline participation requirements for the M+C Program by M+C organizations,
including HMOs, preferred provider organizations, point-of-service plans,
provider sponsored organizations and fee-for-service plans, and establish new or
expanded standards for quality assurance, beneficiary protection, coordinated
open enrollment, M+C payments and provider participation. While the new
regulations became effective on July 27, 1998, most provisions that affect the
Company will not impact the Company until January 1, 1999 when the Company makes
the transition from Medicare risk to the M+C Program. The Company is currently
evaluating the operational and financial impact that the new M+C
18
<PAGE> 21
Program will have on the Company. While the Company believes that compliance
with and implementation of the new M+C Program regulations will have an
operational and financial impact on the Company, it is too early for the Company
to assess the nature of the impact.
The 1997 Budget Act also revises the formula used by HCFA to calculate
payments to Medicare health plans by establishing minimum payment levels and
annual increases and limiting the overall rate of payment growth. Further, the
law enacts new requirements for risk adjustment, information disclosure, quality
measurement and improvement and beneficiary enrollment, among other provisions.
The Company believes that any slowdown in the rate of premium growth may be
offset by the effect of this new legislation encouraging managed health care for
Medicare beneficiaries. 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 1997 Budget Act, among other things, 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 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 which 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 an increase in interest expense.
19
<PAGE> 22
PART II. OTHER INFORMATION
ITEM 1: LEGAL PROCEEDINGS
No changes.
ITEM 2: CHANGES IN SECURITIES
On May 22, 1998, the Company 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 shares not converted were redeemed in
cash for $25.77 per share, or approximately $0.4 million in the aggregate. The
conversion ratio was one share of Series A Preferred Stock to .37419548 of a
share of Class B Common Stock.
ITEM 3: DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company held its Annual Meeting of Shareholders on June 25, 1998. The
following is a brief description of each matter voted upon at the meeting and a
statement of the number of votes cast for, withheld or against, and the number
of abstentions with respect to each matter. Both proposals were approved by the
shareholders.
(a) The shareholders approved the election of the nominees to the
Company's board of directors.
<TABLE>
<CAPTION>
VOTES
----------------------
WITHHELD
DIRECTOR FOR AUTHORITY
-------- ---------- ---------
<S> <C> <C>
Jack R. Anderson........................................ 12,659,469 43,045
Terry O. Hartshorn...................................... 12,685,129 17,385
Warren E. Pinckert II................................... 12,685,269 17,245
Jean Bixby Smith........................................ 12,686,172 16,342
</TABLE>
(b) The shareholders approved the Amended 1997 Premium Priced Stock
Option Plan.
<TABLE>
<CAPTION>
VOTES
- ----------------------------------------------------------------------------
FOR AGAINST ABSTAINED
--- ------- ---------
<S> <C> <C>
10,382,500 1,719,005 22,005
</TABLE>
ITEM 5: OTHER INFORMATION
Effective June 25, 1998, the Company announced the resignation of Steve
Lindstrom, Regional Vice President, Desert Region and President and CEO of
PacifiCare of Arizona, Inc.
On June 25, 1998, the Company announced the appointment of Rick Badger as
Regional Vice President, Desert Region and President and CEO of PacifiCare of
Arizona, Inc.
On July 2, 1998, the Company announced the appointment of Robert B. Stearns
as Executive Vice President and Chief Financial Officer.
Pursuant to recent changes in the proxy rules, unless a stockholder who
wishes to bring a matter before the Company's 1999 annual meeting of
stockholders notifies the Company of such matter before April 14, 1999,
management will have the discretionary authority to vote all shares for which it
has proxies with respect to such matter.
20
<PAGE> 23
ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibit Index
Exhibit 27 Financial Data Schedule (filed electronically).
b) On June 4, 1998, the Company filed a Form 8-K in connection with
its shelf registration of $250 million of 10-year Senior Notes.
21
<PAGE> 24
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: August 13, 1998 By: /s/ ALAN R. HOOPS
------------------------------------------------------------
Alan R. Hoops
President,
Chief Executive Officer
and Director
Date: August 13, 1998 By: /s/ MARY C. LANGSDORF
------------------------------------------------------------
Mary C. Langsdorf
Vice President
and Corporate Controller
</TABLE>
22
<PAGE> 25
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
<C> <S>
27 Financial Data Schedule (filed electronically).
</TABLE>
<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 JUNE
30, 1998, AND RELATED UNAUDITED CONSOLIDATED STATEMENT OF OPERATIONS FOR THE SIX
MONTHS ENDED JUNE 30, 1998, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO
SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> JUN-30-1998
<CASH> 90,207
<SECURITIES> 931,171
<RECEIVABLES> 329,020
<ALLOWANCES> 22,506
<INVENTORY> 0
<CURRENT-ASSETS> 1,475,611
<PP&E> 381,064
<DEPRECIATION> 152,916
<TOTAL-ASSETS> 4,306,910
<CURRENT-LIABILITIES> 1,195,472
<BONDS> 0
0
0
<COMMON> 462
<OTHER-SE> 2,137,881
<TOTAL-LIABILITY-AND-EQUITY> 4,306,910
<SALES> 0
<TOTAL-REVENUES> 4,778,209
<CGS> 0
<TOTAL-COSTS> 4,023,559
<OTHER-EXPENSES> 594,704
<LOSS-PROVISION> 1,174
<INTEREST-EXPENSE> 34,431
<INCOME-PRETAX> 173,495
<INCOME-TAX> 83,278
<INCOME-CONTINUING> 90,217
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 90,217
<EPS-PRIMARY> 2.03
<EPS-DILUTED> 1.96
</TABLE>
