<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, 1999
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
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
</TABLE>
3120 LAKE CENTER DRIVE, SANTA ANA, CALIFORNIA 92704
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
(714) 825-5200
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
------------------------
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 [ ]
The number of shares of common stock outstanding at October 29, 1999 was
approximately 43,571,000.
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<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 September 30,
1999 and December 31, 1998.................................. 1
Condensed Consolidated Statements of Operations for the
three months ended September 30, 1999 and 1998.............. 2
Condensed Consolidated Statements of Operations for the nine
months ended September 30, 1999 and 1998.................... 3
Condensed Consolidated Statements of Cash Flows for the nine
months ended September 30, 1999 and 1998.................... 4
Notes to Condensed Consolidated Financial Statements........ 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 15
Item 3. Quantitative and Qualitative Disclosures About Market
Risk........................................................ 29
PART II. OTHER INFORMATION
Item 1. Legal Proceedings........................................... 30
Item 5. Other Information........................................... 30
Item 6. Exhibits and Reports On Form 8-K............................ 30
Signatures........................................................... 31
Exhibits
</TABLE>
<PAGE> 3
PART I: FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS
PACIFICARE HEALTH SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
ASSETS
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1999 1998
------------- ------------
(UNAUDITED)
<S> <C> <C>
Current assets:
Cash and equivalents...................................... $ 176,593 $ 724,636
Marketable securities..................................... 1,023,279 875,553
Receivables, net.......................................... 302,470 275,955
Prepaid expenses and other current assets................. 38,733 24,979
Deferred income taxes..................................... 115,259 132,452
---------- ----------
Total current assets.............................. 1,656,334 2,033,575
---------- ----------
Property, plant and equipment at cost, net.................. 175,954 178,520
Marketable securities-restricted............................ 87,020 82,660
Goodwill and intangible assets, net......................... 2,260,830 2,313,266
Other assets................................................ 22,878 22,923
---------- ----------
$4,203,016 $4,630,944
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Medical claims and benefits payable....................... $ 743,500 $ 645,300
Accounts payable and accrued liabilities.................. 407,055 464,170
Unearned premium revenue.................................. 55,124 509,859
Long-term debt due within one year........................ -- 87
---------- ----------
Total current liabilities......................... 1,205,679 1,619,416
---------- ----------
Long-term debt due after one year........................... 625,000 650,006
Deferred income taxes....................................... 119,057 112,056
Other liabilities........................................... 14,892 11,015
Minority interest........................................... 333 355
Stockholders' equity:
Common stock, $0.01 par value; 200,000 shares authorized;
issued 46,803 shares in 1999 and 46,386 shares in
1998................................................... 468 464
Additional paid-in capital................................ 1,597,497 1,624,619
Accumulated other comprehensive (loss) income............. (19,503) 7,359
Retained earnings......................................... 861,750 649,608
Treasury stock, at cost; 3,231 shares in 1999 and 770
shares in 1998......................................... (202,157) (43,954)
---------- ----------
Total stockholders' equity........................ 2,238,055 2,238,096
---------- ----------
$4,203,016 $4,630,944
========== ==========
</TABLE>
See accompanying notes.
1
<PAGE> 4
PACIFICARE HEALTH SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
SEPTEMBER 30,
------------------------
1999 1998
---------- ----------
<S> <C> <C>
Revenue:
Government premiums (Medicare and Medicaid)................. $1,479,811 $1,402,638
Commercial premiums....................................... 1,007,721 969,575
Other income.............................................. 30,385 28,684
---------- ----------
Total operating revenue........................... 2,517,917 2,400,897
---------- ----------
Expenses:
Health care services:
Government services....................................... 1,292,320 1,206,475
Commercial services....................................... 815,378 802,849
---------- ----------
Total health care services........................ 2,107,698 2,009,324
---------- ----------
Marketing, general and administrative expenses.............. 280,867 268,235
Amortization of goodwill and intangible assets.............. 18,849 19,543
Impairment, disposition, restructuring and other (credits)
charges................................................... (2,233) 15,644
Office of Personnel Management charges...................... -- 3,776
---------- ----------
Operating income............................................ 112,736 84,375
Net investment income....................................... 20,304 29,193
Interest expense............................................ (9,742) (13,828)
---------- ----------
Income before income taxes.................................. 123,298 99,740
Provision for income taxes.................................. 54,041 46,509
---------- ----------
Net income.................................................. $ 69,257 $ 53,231
========== ==========
Basic earnings per share.................................... $ 1.54 $ 1.17
========== ==========
Diluted earnings per share.................................. $ 1.54 $ 1.16
========== ==========
</TABLE>
See accompanying notes.
2
<PAGE> 5
PACIFICARE HEALTH SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
------------------------
1999 1998
---------- ----------
<S> <C> <C>
Revenue:
Government premiums (Medicare and Medicaid)................. $4,370,090 $4,205,669
Commercial premiums....................................... 2,967,821 2,891,561
Other income.............................................. 86,662 81,876
---------- ----------
Total operating revenue........................... 7,424,573 7,179,106
---------- ----------
Expenses:
Health care services:
Government services....................................... 3,813,213 3,626,931
Commercial services....................................... 2,411,868 2,405,952
---------- ----------
Total health care services........................ 6,225,081 6,032,883
---------- ----------
Marketing, general and administrative expenses.............. 809,079 826,212
Amortization of goodwill and intangible assets.............. 56,717 57,444
Impairment, disposition, restructuring and other (credits)
charges................................................... (2,233) 15,644
Office of Personnel Management charges...................... -- 3,776
---------- ----------
Operating income............................................ 335,929 243,147
Net investment income....................................... 60,747 78,347
Interest expense............................................ (29,547) (48,259)
---------- ----------
Income before income taxes.................................. 367,129 273,235
Provision for income taxes.................................. 154,987 129,787
---------- ----------
Net income.................................................. $ 212,142 $ 143,448
========== ==========
Preferred dividends......................................... -- (5,258)
---------- ----------
Net income available to common stockholders................. $ 212,142 $ 138,190
========== ==========
Basic earnings per share.................................... $ 4.67 $ 3.20
========== ==========
Diluted earnings per share.................................. $ 4.64 $ 3.12
========== ==========
</TABLE>
See accompanying notes.
3
<PAGE> 6
PACIFICARE HEALTH SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------
1999 1998
--------- ---------
<S> <C> <C>
Operating activities:
Net income.................................................. $ 212,142 $ 143,448
Adjustments to reconcile net income to net cash provided
by (used in) operating activities:
Amortization of goodwill and intangible assets......... 56,717 57,444
Deferred income taxes.................................. 38,803 10,681
Depreciation and amortization.......................... 31,011 35,119
Loss on disposal of property, plant and equipment and
other................................................. 6,406 4,444
Impairment, disposition, restructuring and other
(credits) charges..................................... (2,233) 15,644
Office of Personnel Management charges................. -- 3,776
Provision for doubtful accounts........................ 294 2,608
Other noncash items.................................... (22) (20)
Changes in assets and liabilities, net of effects from
acquisitions and dispositions:
Receivables, net..................................... (26,809) 15,308
Prepaid expenses and other assets.................... (13,709) 26,638
Medical claims and benefits payable.................. 106,955 (53,700)
Accounts payable and accrued liabilities............. (33,291) 114,346
Unearned premium revenue............................. (454,735) (454,877)
--------- ---------
Net cash flows used in operating activities....... (78,471) (79,141)
--------- ---------
Investing activities:
Purchase of marketable securities, net.................... (189,197) (117,759)
Purchase of property, plant and equipment................. (48,049) (28,519)
Acquisitions.............................................. (18,581) (750)
Proceeds from the sale of property, plant and equipment... 13,198 31,318
Purchase of marketable securities-restricted.............. (4,360) (7,993)
--------- ---------
Net cash flows used in investing activities....... (246,989) (123,703)
--------- ---------
Financing activities:
Common stock repurchases.................................. (158,203) (44,658)
Principal payments on long-term debt...................... (75,093) (290,117)
Common stock reclassification payments to UniHealth and
others................................................. (61,881) --
Proceeds from borrowings of long-term debt................ 50,000 30,000
Proceeds from issuance of common and treasury stock....... 22,594 14,117
Preferred dividends paid.................................. -- (5,258)
Redemption of preferred stock............................. -- (410)
--------- ---------
Net cash flows used in financing activities....... (222,583) (296,326)
--------- ---------
Net decrease in cash and equivalents........................ (548,043) (499,170)
Beginning cash and equivalents.............................. 724,636 680,674
--------- ---------
Ending cash and equivalents................................. $ 176,593 $ 181,504
========= =========
</TABLE>
See accompanying notes.
4
<PAGE> 7
PACIFICARE HEALTH SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
-------------------
1999 1998
-------- -------
<S> <C> <C>
Supplemental cash flow information:
Cash paid during the year for:
Income taxes, net of refunds........................... $156,367 $ 8,163
Interest............................................... $ 28,935 $44,737
Supplemental schedule of noncash investing and financing
activities:
Tax benefit associated with exercise of stock options..... $ 4,943 $ 4,935
Stock-based compensation.................................. $ 7,226 $ 998
Details of accumulated other comprehensive income:
Change in marketable securities........................... $(41,471) $11,930
Less change in deferred income taxes...................... 14,609 (4,427)
-------- -------
Change in stockholders' equity............................ $(26,862) $ 7,503
======== =======
Details of businesses acquired in purchase transactions:
Fair value of assets acquired............................. $ 18,581 $ 750
Liabilities assumed or created............................ -- --
-------- -------
Cash paid for fair value of assets acquired............... $ 18,581 $ 750
======== =======
</TABLE>
See accompanying notes.
5
<PAGE> 8
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1999
(UNAUDITED)
1. BASIS OF PRESENTATION
PacifiCare Health Systems, Inc. is one of the leading health care services
companies in the United States, serving approximately 3.7 million members in the
Medicare and commercial lines of business. Following the rules and regulations
of the Securities and Exchange Commission ("SEC"), we have omitted footnote
disclosures that would substantially duplicate the disclosures contained in the
annual audited financial statements. The accompanying unaudited condensed
consolidated financial statements should be read together with the consolidated
financial statements and the notes included in our December 31, 1998 Annual
Report on Form 10-K/A, filed with the SEC in April 1999.
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 consolidated
results of operations presented for the interim periods are not necessarily
indicative of the results for a full year.
2. ACQUISITIONS AND DISPOSITIONS
Acquisitions. In September 1999, we acquired ANTERO Health Plans in Colorado for
a purchase price of $14 million. This acquisition added approximately 32,000
commercial members and 4,000 Medicare members to our Colorado health maintenance
organization ("HMO"). In February 1999, we acquired approximately 15,000
commercial members in Texas for $4 million.
Dispositions. On September 30, 1998, we sold our Utah HMO subsidiary. We
guaranteed the buyer that the Utah HMO would have a minimum net equity of $10
million, based on the values of the Utah HMO's assets and liabilities as of
September 30, 1998. We also extended a $700,000 subordinated loan to the Utah
HMO to increase its statutory net equity. We sold all of the issued and
outstanding shares of capital stock of the Utah HMO to the buyer for no other
consideration. As of September 30, 1998, the Utah HMO served approximately
102,000 commercial and 19,000 government members. On October 31, 1998, we sold
our workers' compensation subsidiary for $17 million. We recognized pretax
charges (credits) for these dispositions in the third quarter of 1998 and 1999.
See Note 5 "Impairment, Disposition, Restructuring, Office of Personnel
Management and Other (Credits) Charges."
Pro Forma Financial Statements. The pro forma information below presents our
consolidated results of operations as if the sale of the Utah HMO occurred on
January 1, 1998. This information reflects our actual consolidated operating
results before this transaction plus an adjustment for income taxes. Because the
purchases of the Texas and Colorado membership and the sale of the workers'
compensation subsidiary were not material to our consolidated results of
operations, these transactions were not included in the pro forma information
below.
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 1998 SEPTEMBER 30, 1998
------------------ ------------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C>
Total operating revenue.......................... $2,354,055 $7,025,582
Pretax income.................................... $ 118,143 $ 302,108
Net income....................................... $ 64,236 $ 160,714
Basic earnings per share......................... $ 1.41 $ 3.60
Diluted earnings per share....................... $ 1.40 $ 3.49
</TABLE>
6
<PAGE> 9
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
(UNAUDITED)
3. LONG-TERM DEBT
Beginning January 1, 1999, and continuing through the January 1, 2002 final
maturity date, the amount available for borrowing under our credit facility
declines incrementally every six months. Borrowings available to us at September
30, 1999 were $1.3 billion. The facility requires mandatory step-down payments
if the principal balance exceeds certain thresholds. Because our $525 million
balance at September 30, 1999 was less than any of these thresholds, no payments
are required until the final maturity date.
Interest under the credit facility is variable and is presently based on the
London Interbank Offered Rate ("LIBOR") plus a spread, except for $100 million
of the outstanding balance that is covered by interest-rate swap agreements. The
average fixed interest rate we pay on the existing swap agreements is
approximately five percent. The terms of the credit facility contain various
covenants, usual for financings of this type, including a minimum net worth
requirement, a minimum fixed charge requirement, leverage ratios and limits on
the amount of treasury stock we may purchase. At September 30, 1999, we were in
compliance with all such covenants. We also have $100 million in senior notes
outstanding that we assumed when we acquired FHP. These notes carry an interest
rate of seven percent, are payable semiannually and mature on September 15,
2003.
4. STOCKHOLDERS' EQUITY
Treasury Stock. In October 1999, our board of directors approved a stock
repurchase program that allows us to repurchase up to 12 million shares of our
outstanding common stock, including any UniHealth shares repurchased (see
"UniHealth Stock Repurchase Agreement" below). This repurchase program
supersedes the stock repurchase program approved in January 1998. Under that
program, through September 30, 1999, we repurchased approximately 3.2 million
shares for a total of $203 million. We will repurchase our outstanding common
stock using cash flows from operations and additional borrowings under the
credit facility. To purchase the maximum number of shares authorized, we will
have to negotiate changes to our existing credit facility or obtain alternative
financing. Our existing credit facility permits repurchases of up to $500
million of our securities, including the $203 million spent to date. We are
currently evaluating our options, but may fund the program through a combination
of cash flow and long and short term debt. We have reissued, and will continue
to reissue these shares for our employee benefit plans or for other corporate
purposes.
Reclassification of Common Stock. At our June 24, 1999 annual meeting, our Class
A and Class B common stockholders, including UniHealth Foundation ("UniHealth"),
a non-profit public benefit corporation and our largest stockholder, approved an
amended and restated certificate of incorporation. The amended and restated
certificate combined and reclassified our Class A and Class B common stock into
a single class of voting common stock. The reclassified common stock has the
same rights, powers and limitations as the previously existing Class A common
stock. The reclassification of the Class A and Class B common stock had no
impact on the total number of our issued and outstanding shares of common stock.
Prior to the combination and reclassification of our Class A and Class B common
stock, UniHealth owned approximately 40 percent of our Class A common stock and
approximately one percent of our Class B common stock. After the transaction,
UniHealth owned approximately 13.5 percent of our outstanding common stock. In
consideration for UniHealth's vote in favor of the amended and restated
certificate of incorporation, and in consideration of the agreements and
covenants contained in the stock purchase agreement discussed below, we paid
UniHealth $60 million on June 24, 1999, when our stockholders approved the
amended and restated certificate of incorporation. We also incurred $2 million
of expenses related to the reclassification of our common stock and the
registration of the shares held by UniHealth. These amounts were recorded as a
reduction of stockholders' equity.
7
<PAGE> 10
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
(UNAUDITED)
UniHealth Stock Repurchase Agreement. In May 1999, we entered into a stock
purchase agreement with UniHealth to repurchase up to 5.9 million shares of our
common stock held by UniHealth. The purchase price for the shares equals the
average closing price of the stock for the 30 trading days preceding the
scheduled purchase dates. We are not required to buy if the stock price is
greater than $120 per share and UniHealth is not required to sell if the stock
price is less than $75 per share. Depending on the average stock price, we may
repurchase UniHealth shares on the following dates and in the following
installments:
<TABLE>
<CAPTION>
AGGREGATE
REPURCHASE
PER SHARE PRICE RANGE
----------- --------------
APPROXIMATE PURCHASE DATE SHARES LOW HIGH LOW HIGH
------------------------- --------- --- ---- ----- -----
(IN MILLIONS)
<S> <C> <C> <C> <C> <C>
August 9, 1999(1).......................... 1,000,000 $70 $120 $ 70 $120
November 15, 1999.......................... 1,000,000 $75 $120 75 120
February 15, 2000.......................... 750,000 $75 $120 56 90
May 15, 2000............................... 750,000 $75 $120 56 90
August 15, 2000............................ 750,000 $75 $120 56 90
November 15, 2000.......................... 750,000 $75 $120 56 90
February 15, 2001.......................... 909,500 $75 $120 68 109
--------- ---- ----
Repurchase shares........................ 5,909,500 $437 $709
========= ==== ====
</TABLE>
- ---------------
(1) We did not purchase the August 1999 installment because the average stock
price, as defined above, was less than $70 per share and UniHealth did not
elect to sell the shares for the average stock price. For any unpurchased
installments, we have no further obligation to buy, and UniHealth has no
further obligation to sell us the shares. We do, however, have a right of
first refusal to purchase the installments should UniHealth decide to sell.
Our credit facility contains limits on the amount of stock we may repurchase.
Because of these limits, we will have to negotiate changes to our existing
credit facility or obtain alternative financing. See "Treasury Stock" above.
Preferred Stock Redemption. In May 1998, we announced the redemption of 10.5
million shares of our Series A preferred stock. Substantially all of the
preferred shares were converted into 3.9 million shares of common stock as of
the June 23, 1998 redemption date. For the nine months ended September 30, 1998,
we paid approximately $5 million in dividends to our preferred stockholders.
8
<PAGE> 11
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
(UNAUDITED)
5. IMPAIRMENT, DISPOSITION, RESTRUCTURING, OFFICE OF PERSONNEL MANAGEMENT
("OPM") AND OTHER (CREDITS) CHARGES
We recognized pretax (credits) charges in the third quarter of 1999 and 1998 as
follows:
<TABLE>
<CAPTION>
PRETAX (CREDITS) NET OF DILUTED LOSS
CHARGES TAX AMOUNT (EARNINGS) PER SHARE
---------------- ---------- --------------------
(IN MILLIONS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C>
1999
Ohio HMO goodwill impairment.......... $ 14.1 $ 11.3 $ 0.25
Utah HMO changes in estimates......... (10.7) (6.3) (0.14)
Other disposition changes in
estimates........................... (5.6) (3.3) (0.07)
------ ------ ------
$ (2.2) $ 1.7 $ 0.04
====== ====== ======
1998
Sale of Utah HMO and workers'
compensation subsidiaries........... $ 15.6 $ 8.2 $ 0.18
OPM charges........................... 3.8 2.0 0.04
------ ------ ------
$ 19.4 $ 10.2 $ 0.22
====== ====== ======
</TABLE>
1999. We recognized pretax credits of $2 million (after tax charges of $2
million or $0.04 diluted loss per share) as detailed below.
- - Ohio HMO Goodwill Impairment. We recognized $14 million of Ohio HMO goodwill
impairment charges ($11 million or $0.25 diluted loss per share, net of tax).
Third quarter operating losses, provider contract terminations and a lower
membership base do not support the recoverability of goodwill. The majority of
the impairment is not deductible for income tax purposes.
- - Utah HMO Changes in Estimates. We recognized $11 million of disposition
credits ($6 million or $0.14 diluted earnings per share, net of tax). When we
sold our Utah HMO, we retained responsibility for all medical claims and
benefits payable for services rendered through September 30, 1998. Payments
made through September 30, 1999, plus our current estimate of claims incurred
but not reported, were $7 million less than original reserves existing at
disposition. In addition, $4 million of severance, legal, and receivable
reserves were settled for amounts less than originally estimated.
- - Other Disposition Changes in Estimates. We recognized $6 million of other
disposition credits for changes in estimates ($3 million or $0.07 diluted
earnings per share, net of tax). We have or expect to successfully settle
certain contingencies related to other dispositions from 1996 to 1998.
Contingencies include pending and threatened litigation as well as
indemnifications made to the buyers of sold subsidiaries.
1998. Pretax charges of $19 million ($10 million or $0.22 diluted loss per
share, net of tax) were recorded in 1998 as follows:
- - Dispositions. We recognized $15 million of disposition charges ($8 million or
$0.18 diluted loss per share, net of tax) for the sales of our Utah HMO and
workers' compensation subsidiaries. See Note 2 "Acquisitions and
Dispositions." These charges included transferring $10 million of net assets
to the buyer for no proceeds, in addition to severance, legal and other
disposition reserves.
- - 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
governmental claims for contracts with OPM. See Note 6 "Commitments and
Contingencies."
9
<PAGE> 12
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
(UNAUDITED)
6. COMMITMENTS AND CONTINGENCIES
Provider Instability and Insolvency. Provider insolvency charges include
write-offs of certain uncollectable receivables from our providers and the
estimated cost of unpaid health care claims normally covered by our capitation
payments. Depending on state laws, we may be held liable for unpaid health care
claims that were contractually the responsibility of the capitated provider. The
balance of our provider insolvency reserves was $33 million at September 30,
1999 and $58 million at December 31, 1998. The net year-to-date decrease in
provider insolvency reserves was attributable to $22 million in payments,
primarily to Nevada providers, and other net changes in estimates totaling $3
million. For the first nine months of 1998, provider insolvency costs totaled
$61 million and were related primarily to the bankruptcy of FPA Medical
Management, Inc.
The California Department of Corporations ("DOC") entered into a settlement with
Alabama-based Caremark Rx, Inc. (formerly MedPartners, Inc. "Caremark")
regarding its California subsidiary, MedPartners Network ("MPN"). MPN was a
provider organization licensed by the DOC that arranged health care services for
HMO members through arrangements between HMOs and health care providers, such as
hospitals and physician groups. MPN was one of our significant provider networks
in California. In March 1999, California regulators seized MPN and appointed a
conservator to oversee MPN. The conservator placed MPN in bankruptcy. In June
1999, the State of California, the DOC, MPN and Caremark entered into an
Operations and Settlement Agreement to ensure continuing patient care and to
resolve certain claims by and against MPN and Caremark. Under this agreement,
Caremark agreed to fund MPN's liabilities to its contracted and non-contracted
providers in California. As part of the agreement, and subject to certain
conditions that have not yet been fulfilled, effective June 1, 1999, we agreed
to assume financial responsibility for institutional services that were
previously the responsibility of MPN. The agreement requires the institutional
providers to offer the same terms to us as MPN had through the earlier of the
termination of the provider's contract or December 31, 1999. In addition, our
intent is to participate in the agreement, which may require us to waive or
subordinate certain claims against MPN in exchange for waivers of claims against
us in connection with services provided by MPN or its affiliates in California.
We, along with other HMOs, are participating in discussions about making a loan
or loans to Caremark. Recent discussions involve a total loan by all the HMOs in
the amount of $12 million, with approximately $3 million contributed by us. No
final commitment to loan funds to Caremark has been made. MPN has ceased doing
business and all of MPN's affiliated medical groups in California have recently
been sold.
The majority of our insolvency reserves relate to specific providers. However,
our reserves also include estimates for potentially insolvent providers, where
conditions indicate claims are not being paid or have slowed considerably. Based
on information currently available, we believe that any liability in excess of
amounts accrued would not materially affect our consolidated financial position.
However, our evaluation of the likely impact of claims asserted against us could
change in the future and an unfavorable outcome, depending on the amount and
timing, could have a material effect on our results of operations or cash flows
for a future quarter.
OPM. Our HMO subsidiaries have commercial contracts with OPM to provide managed
health care services to federal employees, annuitants and their dependents under
the Federal Employee Health Benefits Program ("FEHBP"). Rather than negotiating
rates with the HMO, OPM requires HMOs to provide the FEHBP with rates comparable
to the rates charged to the two employer groups with enrollment closest in size
to the FEHBP in the applicable state after adjusting for differences in
benefits, enrollment demographics, and coordination of costs with Medicare. OPM
further requires that the HMO certify each year that its rates meet these
requirements. Approximately every three to five years, OPM's Office of Inspector
General audits each HMO to verify that the premiums charged are calculated and
charged in compliance with these rating regulations and guidelines. Each audit
encompasses a period of up to six years. Following the government's
10
<PAGE> 13
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
(UNAUDITED)
initial on-site audit, OPM will provide the HMO with a post-audit briefing
indicating its preliminary results. Because these are actuarial calculations,
interpretations of the rating regulations and audit findings often raise complex
issues. The final resolution and settlement of audits have historically taken
more than three years and as many as seven years to resolve.
During the audit process, OPM may refer its findings to the United States
Department of Justice ("DOJ") if it believes that the health plan knowingly
overcharged the government or otherwise submitted false documentation or
certifications in violation of the False Claims Act. Under the False Claims Act,
an action can be considered knowingly committed if the government contractor
acted with actual knowledge, or with reckless disregard or deliberate ignorance
of the government's rules and regulations. If the government were to win a False
Claims Act lawsuit against an HMO, the government could obtain trebled damages,
a civil penalty of not less than $5,000 nor more than $10,000 for each separate
alleged false claim, and the government could permanently disqualify the HMO
from participating in all federal government programs. In November 1997, we were
notified that the 1990 through 1995 audit of the operations of our Oklahoma HMO
subsidiary had been referred to the DOJ. In the third quarter of 1998 we
recorded an additional reserve of approximately $4 million ($2 million, or $0.04
diluted loss per share, net of tax) for potential OPM claims bringing the
September 30, 1998 balance for the 1990 - 1995 audits to $17 million. In January
1999, we preliminarily agreed to settle the 1990 - 1995 Oklahoma OPM audits for
$9 million. As a result of this settlement and other changes in estimate, we
recognized a pretax OPM credit of $8 million ($4 million or $0.10 diluted income
per share, net of tax) in the fourth quarter of 1998, bringing the December 31,
1998 reserve balance for the 1990 - 1995 audits down to $9 million. In June
1999, we paid $9 million to the DOJ as final settlement for the 1990 - 1995
Oklahoma OPM audits.
In August 1999, we were notified that the 1995 audit of TakeCare, Inc. covering
contract years 1990 through 1994 had been referred to the DOJ under the False
Claims Act. TakeCare, Inc. was a California HMO that we acquired in 1997 as part
of the FHP acquisition. We do not agree with the government's interpretations of
the applicable rules and guidelines or its method of calculating amounts owed,
and we deny any intentional wrongdoing or any action that would violate the
False Claims Act. We are negotiating to settle this matter amicably with the
DOJ.
In July 1999, we received a request from the OPM Office of Inspector General
requesting documentation regarding all of the contracts between OPM and any of
the HMOs owned by FHP that related to the contract years 1990 through 1997. The
majority of these contract years have already been audited, but are not yet
settled. We are complying with OPM's request.
In addition to the HMOs currently owned, we have also agreed to indemnify the
buyers of our previously owned HMOs in New Mexico, Illinois and Utah for
potential OPM liabilities that relate to years prior to the sale. To address all
of these potential liabilities, we have established reserves based upon internal
estimates of liability and preliminary findings by the auditors for all OPM
audits not yet settled.
We intend to negotiate with OPM on any existing or future unresolved matters to
attain a mutually satisfactory result. There can be no assurance that any
ongoing and future negotiations will be concluded satisfactorily, that
additional audits will not be referred to the DOJ, or that additional, possibly
material, liabilities will not be incurred. We believe that any ultimate
liability, including any lost investment income, in excess of amounts accrued
would not materially affect our 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.
In late 1997, we established a formal corporate compliance program to
specifically address potential issues that may arise from the FEHBP rating
process, to work with OPM to understand its interpretation of the rules
11
<PAGE> 14
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
(UNAUDITED)
and guidelines prior to completion of the rating process, to standardize the
FEHBP rating process among all of our HMOs, and to help reduce the likelihood
that future government audits will result in any significant findings. Based
upon the limited number of audits that have been conducted for contract years
1998 and later, we believe that this program has been effective.
Legal Proceedings. On November 2, 1999, Jose Cruz, on behalf of himself and all
others similarly situated, filed a purported class action complaint against
PacifiCare Health Systems, Inc., PacifiCare of California, Inc., and FHP
International Corporation in San Francisco Superior Court. The complaint alleges
causes of action for injunctive relief and restitution under California Business
and Professions Code sections 17200 and 17500 and violations of the consumer
legal remedies act. The complaint alleges, in essence, that we made false or
fraudulent representations relating to the quality and nature of medical care
provided to members under our plans. The complaint seeks unspecified damages,
declaratory and injunctive relief. We will defend these charges vigorously.
In 1997, we were served with several purported class action suits alleging
violations of federal securities laws by PacifiCare and certain of our officers
and directors. The complaints related to the period from the date of the FHP
acquisition through our November 1997 announcement that earnings for the fourth
quarter of 1997 would be lower than expected. These complaints primarily alleged
that we previously omitted and/or misrepresented material facts with respect to
our costs, earnings and profits. These cases have been dismissed by the courts.
Two of these cases, brought on behalf of former FHP shareholders, were dismissed
but are now on appeal. Another one of these cases, brought on behalf of our
shareholders, was dismissed but plaintiffs were given until November 11, 1999 to
file an amended complaint. If an amended complaint is filed, we plan to make a
second motion to dismiss. We believe we have good defenses to the claims in
these suits and are contesting them vigorously.
We are also involved in legal actions in the normal course of business, some of
which seek monetary damages, including claims of punitive damages that are not
covered by insurance. Based on current information and review with our lawyers,
management believes any ultimate liability that may arise from these actions
(including the purported class actions), would not materially affect our
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 effect on our results of operations or cash flows for a
future quarter.
12
<PAGE> 15
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
(UNAUDITED)
7. EARNINGS PER SHARE
We calculated the denominators for the computation of basic and diluted earnings
per share as follows:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ ------------------
1999 1998 1999 1998
------- ------- ------- -------
(AMOUNTS IN THOUSANDS)
<S> <C> <C> <C> <C>
Shares outstanding at the beginning of the period........ 46,032 45,794 45,616 41,995
Weighted average number of shares issued:
Treasury stock acquired, net of shares issued.......... (1,098) (156) (370) (467)
Stock options exercised................................ -- 18 229 208
Conversion of Series A preferred stock................. -- -- -- 1,440
------ ------ ------ ------
Denominator for basic earnings per share................. 44,934 45,656 45,475 43,176
Employee stock options and other dilutive potential
common shares(1)....................................... 143 375 257 354
Assumed conversion of Series A preferred stock........... -- -- -- 2,490
------ ------ ------ ------
Denominator for diluted earnings per share............... 45,077 46,031 45,732 46,020
====== ====== ====== ======
</TABLE>
- ---------------
(1) Certain options to purchase common stock were not included in the
calculation of diluted earnings per share because their exercise prices were
greater than the average market price of our common stock for the periods
presented. For the quarters ended September 30, 1999 and 1998, these
weighted options outstanding totaled 6.4 million and 3.3 million,
respectively (with exercise prices ranging from $61.75 to $114.00 per
share). For the nine months ended September 30, 1999 and 1998, these
weighted options outstanding totaled 4.4 million and 3.3 million,
respectively (with exercise prices ranging from $71.59 to $114.00 per
share).
8. COMPREHENSIVE INCOME
Comprehensive income represents our net income plus changes in equity, other
than those changes resulting from investments by, and distributions to our
stockholders. Such changes include unrealized gains or losses on our
available-for-sale securities. Our comprehensive income totaled $63 million for
the three months ended September 30, 1999 and $185 million for the nine months
ended September 30, 1999. Comprehensive income totaled $62 million for the three
months ended September 30, 1998 and $151 million for the nine months ended
September 30, 1998.
9. FUTURE APPLICATION OF ACCOUNTING STANDARDS
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 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 our
consolidated financial statements beginning January 1, 2001, although early
adoption is permitted. Based on current derivatives held, we believe that the
adoption of this statement will not have a material impact to our consolidated
financial position or results of operations.
13
<PAGE> 16
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
(UNAUDITED)
10. SUBSEQUENT EVENTS
On November 4, 1999, we announced that Jeffrey M. Folick is stepping down as
President and will act as Executive Vice President overseeing our specialty
product companies. Alan R. Hoops will assume the role of President while
remaining Chief Executive Officer and member of our board of directors. David A.
Reed, who has served as a board member for seven years, will lead the board as
chairman.
In November 1999, we entered into a definitive agreement to purchase Harris
Texas Methodist Health Plan, Inc. and Harris Methodist Health Insurance Company,
Inc., a health plan and insurance company in Texas with approximately 300,000
members. In addition to acquiring Harris' membership, we have established a
long-term agreement with a hospital delivery system in North Texas. We plan to
close the transaction in the first quarter of 2000, after regulatory approval
and completion of normal closing conditions.
We signed transition agreements with QualMed Plans for Health of Colorado, Inc.
in September 1999, and with QualMed Washington Health Plans, Inc. in October
1999, each a subsidiary of Foundation Health Systems, Inc. The agreements
provide replacement care coverage for up to 140,000 commercial members in 2000.
QualMed employer clients and their employees will be able to select PacifiCare
coverage in early 2000. We expect that only a portion of these members will
enroll with PacifiCare. We will pay a per member price based on retained
membership.
14
<PAGE> 17
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RESULTS OF OPERATIONS
Overview. PacifiCare sells HMO and HMO-related products primarily to members in
two groups: the Secure Horizons program for Medicare beneficiaries and the
commercial programs for members of employer groups and individuals. Our
specialty managed care HMOs and HMO-related products and services supplement our
commercial and Secure Horizons programs. These include pharmacy benefit
management, life and health insurance, behavioral health services, dental and
vision services and Medicare+Choice management services.
Events significant to our business in 1999 include the following:
- - We made two in-market acquisitions during the year. See Note 2 of the Notes to
Condensed Consolidated Financial Statements.
- - In October 1999, our board of directors authorized us to repurchase up to 12
million shares of our approximately 43.6 million shares of outstanding common
stock, including any UniHealth shares repurchased. This repurchase program
supersedes our former repurchase program originally approved in January 1998.
See Note 4 of the Notes to Condensed Consolidated Financial Statements.
- - In June 1999, we submitted our year 2000 proposed Secure Horizons benefit plan
changes to HCFA for their approval. These changes include exiting Secure
Horizons operations in 12 counties in Ohio, Washington, Oregon and California
effective January 1, 2000. This will affect approximately 15,700 Secure
Horizons members, or less than two percent of our 1,011,600 members. In
addition, we plan to increase our members' monthly premiums and copayments or
reduce benefits where the government provides insufficient reimbursement. See
"Forward Looking Information."
- - At our June 24, 1999 annual meeting, our Class A and Class B common
stockholders approved an amended and restated certificate of incorporation,
which combined and reclassified PacifiCare's Class A and Class B common stock
into a single class of voting common stock. We paid UniHealth $60 million when
our stockholders approved the amended and restated certificate of
incorporation on June 24, 1999. This payment was recorded as a reduction of
stockholders' equity. See Note 4 of the Notes to Condensed Consolidated
Financial Statements.
- - In May 1999, we entered into a stock purchase agreement with UniHealth to
repurchase up to 5.9 million shares of our common stock held by UniHealth. See
Note 4 of the Notes to Condensed Consolidated Financial Statements.
- - The California Department of Corporations ("DOC") entered into a settlement
with Alabama-based Caremark Rx, Inc. (formerly MedPartners, Inc.) regarding
its California subsidiary, MedPartners Network ("MPN"). See Note 6 of the
Notes to Condensed Consolidated Financial Statements and "Consolidated Medical
Care Ratio and Provider Reserves" below.
15
<PAGE> 18
1999 COMPARED WITH 1998
The following information includes both the Medicare and Medicaid lines of
business as part of the government program for the 1998 period presented.
Membership. Total membership increased slightly to approximately 3.7 million
members at September 30, 1999 from approximately 3.6 million members at
September 30, 1998.
<TABLE>
<CAPTION>
AT SEPTEMBER 30, 1999 AT SEPTEMBER 30, 1998
----------------------------------- -----------------------------------
MEMBERSHIP DATA GOVERNMENT COMMERCIAL TOTAL GOVERNMENT COMMERCIAL TOTAL
--------------- ---------- ---------- --------- ---------- ---------- ---------
<S> <C> <C> <C> <C> <C> <C>
Arizona........................ 82,800 102,900 185,700 87,800 105,900 193,700
California..................... 616,800 1,710,000 2,326,800 596,300 1,570,000 2,166,300
Colorado....................... 76,100 319,300 395,400 57,200 299,400 356,600
Guam........................... -- 40,400 40,400 -- 39,500 39,500
Nevada......................... 25,400 34,500 59,900 25,000 43,900 68,900
Ohio........................... 19,600 42,900 62,500 15,400 45,400 60,800
Oklahoma....................... 28,800 86,700 115,500 26,800 97,600 124,400
Oregon......................... 37,800 115,900 153,700 39,200 116,200 155,400
Texas.......................... 59,900 121,100 181,000 67,300 135,000 202,300
Utah(1)........................ -- -- -- 19,000 102,000 121,000
Washington..................... 64,400 74,900 139,300 59,800 96,600 156,400
--------- --------- --------- ------- --------- ---------
Total membership..... 1,011,600 2,648,600 3,660,200 993,800 2,651,500 3,645,300
========= ========= ========= ======= ========= =========
</TABLE>
- ---------------
(1) At September 30, 1998, Utah had approximately 7,800 Medicaid members.
Government membership increased approximately two percent at September 30, 1999
compared to the same period in the prior year due to:
- - The positive results of retention programs implemented during 1998 in
California; and
- - Competitor exits in markets in which Secure Horizons will remain; partially
offset by
- - Membership decreases resulting from the sale of our Utah HMO and our exit from
certain rural markets in California and Colorado.
Commercial membership decreased slightly at September 30, 1999 compared to the
same period in the prior year due to:
- - The sale of our Utah HMO; and
- - Our continued focus on renewing commercial contracts with sufficient price
increases to improve gross margin, primarily in Washington and Texas;
partially offset by
- - Membership increases in California primarily due to improved sales efforts,
and in Colorado as a result of the acquisition of ANTERO Health Plans.
16
<PAGE> 19
Government Premiums. Government premiums increased six percent or $77 million
for the three months and four percent or $164 million for the nine months ended
September 30, 1999 compared to the same periods in the prior year as follows:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 1999 SEPTEMBER 30, 1999
------------------ ------------------
(AMOUNTS IN MILLIONS)
<S> <C> <C>
Premium rate increases that averaged
approximately four percent for the three months
and three percent for the nine months ended
September 30, 1999............................. $ 54 $139
Net membership increases (excluding Utah),
primarily in California and including the
Colorado and Texas acquisitions.................. 38 74
Premium and membership losses resulting from the
disposition of the Utah HMO.................... (15) (49)
---- ----
Increase over prior year......................... $ 77 $164
==== ====
</TABLE>
Government premium rate increases were higher than the published Health Care
Financing Administration ("HCFA") rate increase due to changes in membership
mix, higher retiree supplemental premiums and the exit of the Utah Medicaid
business.
Commercial Premiums. Commercial premiums increased four percent or $38 million
for the three months and three percent or $76 million for the nine months ended
September 30, 1999 compared to the same periods in the prior year as follows:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 1999 SEPTEMBER 30, 1999
------------------ ------------------
(AMOUNTS IN MILLIONS)
<S> <C> <C>
Premium rate increases that averaged
approximately six percent for both the three
and nine months ended September 30, 1999....... $52 $166
Net membership increases (excluding Utah)
primarily in California and including the
Colorado and Texas acquisitions.................. 21 32
Premium and membership losses resulting from the
disposition of the Utah HMO.................... (31) (100)
Discontinued indemnity and workers' compensation
products....................................... (4) (22)
--- ----
Increase over prior year......................... $38 $ 76
=== ====
</TABLE>
Other Income. Other income increased for the three and nine months ended
September 30, 1999 compared to the same periods in the prior year. The increase
was primarily due to increased mail-service revenues from our pharmacy benefit
management company, where we, rather than the network retail pharmacies, collect
the member copayments.
Consolidated Medical Care Ratio and Provider Reserves. The consolidated medical
care ratio (health care services as a percentage of premium revenue) was
comparable for the three months ended and declined slightly for the nine months
ended September 30, 1999, compared to the same periods in the prior year.
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
------------------ ------------------
1999 1998 1999 1998
----- ----- ----- -----
<S> <C> <C> <C> <C>
Medical care ratio:
Consolidated................................ 84.7% 84.7% 84.8% 85.0%
Government................................ 87.3% 86.0% 87.3% 86.2%
Commercial................................ 80.9% 82.8% 81.3% 83.2%
</TABLE>
17
<PAGE> 20
The improved consolidated medical care ratio performance for the nine months
ended September 30, 1999, as compared to the same period in the prior year, was
primarily related to lower 1999 provider reserves compared to 1998. Provider
reserves included in health care costs for the nine months ended September 30,
1998 were as follows:
<TABLE>
<CAPTION>
QUARTER GOVERNMENT COMMERCIAL TOTAL
------- ---------- ---------- -----
(AMOUNTS IN MILLIONS)
<S> <C> <C> <C>
First................................................. $ 3 $ 3 $ 6
Second................................................ 25 10 35
Third................................................. 14 6 20
--- --- ---
Total................................................. $42 $19 $61
=== === ===
</TABLE>
Provider charges include the write-off of uncollectable receivables from
providers and the estimated cost of unpaid health care claims covered by our
capitation payment. Depending on state law, we may be liable for unpaid health
care claims that were the responsibility of the capitated provider. Excluding
1998 net provider reserves, the increase in the 1999 consolidated medical care
ratio for the three and nine months ended September 30, 1999 compared to 1998
was primarily due to higher physician costs and increased pharmacy costs due to
benefit enhancements for Secure Horizons members.
Government Medical Care Ratio. The government medical care ratio increased for
the three and nine months ended September 30, 1999 compared to the prior year
due to:
- Higher physician costs; and
- Increased pharmacy utilization as a result of pharmacy benefit
enhancements and higher prescription drug costs; partially offset by
- Premium rate increases; and
- Reduced hospital expenses, primarily because current year provider
reserves were significantly less than in 1998.
Commercial Medical Care Ratio. The commercial medical care ratio includes the
specialty HMOs and indemnity insurance results. The commercial medical care
ratio for the three and nine months ended September 30, 1999 decreased compared
to the prior year due to:
- A favorable premium pricing environment;
- The sale of our Utah HMO and workers' compensation subsidiaries; and
- Reduced hospital costs.
Marketing, General and Administrative Expenses. Marketing, general and
administrative expenses as a percentage of operating revenue for the third
quarter of 1999 were comparable to the third quarter of 1998. For the nine
months ended September 30, 1999 compared to 1998, marketing, general and
administrative expenses as a percentage of operating revenue decreased because
of:
- The Utah HMO disposition;
- The introduction of new technologies;
- The improved efficiencies of our regional customer service operations;
and
- The realization of a full year of synergies from the FHP acquisition.
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
------------------ ------------------
1999 1998 1999 1998
----- ----- ----- -----
<S> <C> <C> <C> <C>
Marketing, general and administrative
expenses as a percentage of operating
revenue................................... 11.2% 11.2% 10.9% 11.5%
</TABLE>
18
<PAGE> 21
Impairment, Disposition, Restructuring, and Other (Credits) Charges. We
recognized impairment, disposition, restructuring and other pretax credits for
the three and nine months ended September 30, 1999 totaling $2 million (after
tax charges of $2 million or $0.04 diluted loss per share). The after tax and
per share amounts were losses because the goodwill impairment is not deductible
for income tax purposes. See Note 5 of the Notes to Condensed Consolidated
Financial Statements.
Operating Income. Factors contributing to the increase in operating income are
discussed above.
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
------------------- ------------------
1999 1998 1999 1998
----- ----- ----- -----
<S> <C> <C> <C> <C>
Operating income as a percentage of
operating revenue......................... 4.5% 3.5% 4.5% 3.4%
</TABLE>
Net Investment Income. Net investment income decreased approximately 30 percent
for the three months ended and approximately 22 percent for the nine months
ended September 30, 1999 compared to the same periods in the prior year due to
the following:
- Fewer realized gains on sales of marketable securities in the current
year;
- Lower interest rates;
- The shift of more portfolio holdings to tax-exempt investments; and
- Lower invested balances.
Interest Expense. Interest expense decreased approximately 30 percent for the
three months ended and approximately 39 percent for the nine months ended
September 30, 1999 compared to the same periods in the prior year due to the
continued repayment and lower overall average interest rates paid on our credit
facility.
Provision for Income Taxes. The effective income tax rate was 43.8 percent for
the three months ended and 42.2 percent for the nine months ended September 30,
1999, compared with 46.6 percent for the three months ended and 47.5 percent for
the nine months ended September 30, 1998. The rate declined significantly
because:
- Nondeductible goodwill amortization was a smaller percentage of pretax
income;
- We benefited from certain tax strategies, in particular the legal
reorganization of PacifiCare and its subsidiaries;
- The 1998 effective tax rate included an increase related to the
dispositions of the Utah HMO and workers' compensation subsidiaries; and
- 1999 investment strategies to date have resulted in an increase in
tax-exempt earnings.
Diluted Earnings Per Share. For the three months ended September 30, 1999, net
income was $69 million or $1.54 diluted earnings per share, compared to net
income of $53 million or $1.16 diluted earnings per share for the same period in
the prior year. For the nine months ended September 30, 1999, net income was
$212 million or $4.64 diluted earnings per share. For the nine months ended
September 30, 1998, net income
19
<PAGE> 22
was $143 million or $3.12 diluted earnings per share. The increases in diluted
earnings per share from the prior periods were as follows:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
------------------ -----------------
<S> <C> <C>
Diluted earnings per share -- September 30, 1998......... $ 1.16 $ 3.12
Impairment, disposition, restructuring, Office of
Personnel Management and other charges................... 0.22 0.22
------ ------
Diluted earnings per share before impairment,
disposition, restructuring, Office of Personnel
Management and other charges........................... 1.38 3.34
Improved operations:
Commercial gross margin performance.................... 0.32 0.89
Government gross margin performance.................... (0.11) (0.28)
Marketing, general and administrative expenses......... (0.16) 0.22
Other income performance............................... 0.02 0.06
Amortization of goodwill and intangible assets......... 0.01 0.01
------ ------
Total improved operations...................... 0.08 0.90
Net investment income and interest expense............... (0.06) 0.02
Income tax rate decrease................................. 0.15 0.40
Accretive impact of treasury stock purchases............. 0.03 0.02
------ ------
Diluted earnings per share before impairment,
disposition, restructuring and other charges........... 1.58 4.68
Impairment, disposition, restructuring, and other
charges................................................ (0.04) (0.04)
------ ------
Diluted earnings per share -- September 30, 1999......... $ 1.54 $ 4.64
====== ======
</TABLE>
LIQUIDITY AND CAPITAL RESOURCES
Operating Cash Flows. PacifiCare's consolidated cash, equivalents and marketable
securities decreased to $1.2 billion at September 30, 1999 from $1.6 billion at
December 31, 1998. The combined decrease in cash, equivalents and marketable
securities occurred because the January 1999 Medicare payment from HCFA was
prepaid in December 1998, while the October 1999 HCFA payment was paid in
October 1999. Cash flows from operations, excluding the impact of deferred
revenue, were $376 million at September 30, 1999 and 1998.
Investing Activities. For the nine months ended September 30, 1999, we used $247
million of cash for investing activities, compared to $124 million used for the
nine months ended September 30, 1998. We purchased more marketable securities in
1999, resulting in the majority of the net increase over the prior year.
Financing Activities. For the nine months ended September 30, 1999, we used $223
million of cash for financing activities compared to $296 million used for the
same period of the prior year. The decrease was primarily related to fewer
credit facility payments. The changes were as follows:
- We repurchased 2.5 million shares of our common stock in 1999 for $158
million and 0.8 million shares of our common stock in 1998 for $45
million under our stock repurchase program;
- We paid $75 million on our credit facility in the first nine months of
1999 and $290 million for the same period of 1998;
- In consideration for UniHealth's vote for the reclassification of our
stock and in consideration for the agreements and covenants contained in
the stock purchase agreement between PacifiCare and UniHealth, we paid
UniHealth $60 million on June 24, 1999, when our stockholders approved
the amended and restated certificate of incorporation. We incurred $2
million of expenses related to the reclassification of our common stock
and the registration of the shares held by UniHealth. See Note 4 of the
Notes to Condensed Consolidated Financial Statements;
- - We borrowed under the credit facility to repurchase shares of our outstanding
common stock. Year-to-date borrowings were $50 million in 1999 and $30 million
in 1998;
20
<PAGE> 23
- - We received cash for the issuance of common stock of $22 million for the nine
months ended September 30, 1999 and $14 million for the nine months ended
September 30, 1998; and
- - We paid $5 million in preferred stock dividends in 1998.
OTHER BALANCE SHEET CHANGE EXPLANATIONS
Receivables, Net. Receivables, net increased $27 million from December 31, 1998,
primarily due to increases in premium and provider receivables. Premium
receivable increases related to increased membership and October 1999 HCFA
premiums received related to prior periods. In addition, we administer claims
payments for some of our capitated providers. For this service we hold back, or
withhold, a percentage of capitation payments due to the providers. At September
30, 1999, claims paid on behalf of providers exceeded capitation withheld.
Goodwill and Intangible Assets, Net. Goodwill and intangible assets decreased
$52 million from 1998 as follows:
- - $57 million of goodwill and intangible amortization expense;
- - $14 million for the impairment of the Ohio HMO's goodwill; partially offset by
- - $19 million primarily for the acquisition of approximately 15,000 commercial
members in Texas and approximately 36,000 commercial and Medicare members in
Colorado.
Medical Claims and Benefits Payable. Medical claims and benefits payable
increased $98 million from December 31, 1998 as follows:
- - $65 million increase in claims incurred but not yet reported for increased
membership and utilization under shared-risk arrangements;
- - $36 million increase primarily due to increased amounts withheld from
capitation for claims administered on behalf of providers;
- - $22 million increase in provider capitation and incentive liabilities;
partially offset by
- - $25 million net decrease in provider insolvency reserves, consisting of $22
million in payments, primarily to Nevada providers, and other net changes in
estimates totaling $3 million.
Accounts Payable and Accrued Liabilities. Accounts payable and accrued
liabilities decreased $57 million from December 31, 1998 primarily due to income
taxes payable. The decrease was attributable to estimated tax payments,
partially offset by the income tax provision on 1999 income.
Material Commitments. See Note 4 of the Notes to Condensed Consolidated
Financial Statements for a discussion of our agreement to purchase shares of our
common stock held by UniHealth.
New Accounting Pronouncements. See Note 9 of the Notes to Condensed Consolidated
Financial Statements for a discussion of future application of accounting
standards.
Three Months Ended September 30, 1999 Compared With Three Months Ended June 30,
1999
The following presents our results of operations for the three months ended
September 30, 1999 in comparison to the results of operations for the three
months ended June 30, 1999. We are presenting this information to assist in the
understanding of our discussions about our operating trends. This includes our
outlook on future performance and the risks affecting our future performance
discussed below in Forward Looking Information under the Private Securities
Litigation Act of 1995.
21
<PAGE> 24
Membership. Total membership increased slightly at September 30, 1999 from June
30, 1999.
<TABLE>
<CAPTION>
AT SEPTEMBER 30, 1999 AT JUNE 30, 1999
----------------------------------- -----------------------------------
MEMBERSHIP DATA GOVERNMENT COMMERCIAL TOTAL GOVERNMENT COMMERCIAL TOTAL
--------------- ---------- ---------- --------- ---------- ---------- ---------
<S> <C> <C> <C> <C> <C> <C>
Arizona........................ 82,800 102,900 185,700 81,200 100,300 181,500
California..................... 616,800 1,710,000 2,326,800 613,900 1,665,200 2,279,100
Colorado....................... 76,100 319,300 395,400 67,300 292,200 359,500
Guam........................... -- 40,400 40,400 -- 42,100 42,100
Nevada......................... 25,400 34,500 59,900 22,600 36,200 58,800
Ohio........................... 19,600 42,900 62,500 19,800 42,700 62,500
Oklahoma....................... 28,800 86,700 115,500 27,700 84,500 112,200
Oregon......................... 37,800 115,900 153,700 38,600 115,300 153,900
Texas.......................... 59,900 121,100 181,000 60,000 126,700 186,700
Washington..................... 64,400 74,900 139,300 64,900 76,200 141,100
--------- --------- --------- ------- --------- ---------
Total membership..... 1,011,600 2,648,600 3,660,200 996,000 2,581,400 3,577,400
========= ========= ========= ======= ========= =========
</TABLE>
Government membership increased approximately two percent at September 30, 1999
from June 30, 1999 mainly due to competitor exits in markets in which Secure
Horizons will remain.
Commercial membership increased approximately three percent at September 30,
1999 from June 30, 1999, primarily a result of improved sales efforts in
California and Colorado and the acquisition of approximately 32,000 commercial
members in Colorado.
Government Premiums. Government premiums increased approximately two percent or
$35 million for the three months ended September 30, 1999 compared to the three
months ended June 30, 1999. The increase was primarily due to $21 million of
premium rate increases.
Commercial Premiums. Commercial premiums increased approximately three percent
or $25 million for the three months ended September 30, 1999 compared to the
three months ended June 30, 1999. The increase was due to $14 million of premium
rate increases and $12 million of membership increases partially offset by a
slight decrease in the specialty product companies due to increased utilization
in the indemnity product line.
Other Income. Other income increased for the three months ended September 30,
1999 compared to the three months ended June 30, 1999 primarily due to increased
mail-service revenues from our pharmacy benefit management company, where we,
rather than the network retail pharmacies, collect the member copayments.
Consolidated Medical Care Ratio. The consolidated medical care ratio decreased
for the three months ended September 30, 1999 compared to the three months ended
June 30, 1999.
<TABLE>
<CAPTION>
THREE MONTHS ENDED THREE MONTHS ENDED
SEPTEMBER 30, 1999 JUNE 30, 1999
------------------ ------------------
<S> <C> <C>
Medical care ratio:
Consolidated............................ 84.7% 85.0%
Government............................ 87.3% 87.5%
Commercial............................ 80.9% 81.4%
</TABLE>
Government Medical Care Ratio. The government medical care ratio decreased for
the three months ended September 30, 1999 compared to the three months ended
June 30, 1999. Higher third quarter premiums per member and lower pharmacy costs
contributed to the improved medical care ratio and more than offset higher
physician costs.
22
<PAGE> 25
Commercial Medical Care Ratio. The commercial medical care ratio includes the
specialty HMOs and indemnity insurance results. The commercial medical care
ratio decreased for the three months ended September 30, 1999 compared to the
three months ended June 30, 1999 due to:
- - A favorable premium pricing environment;
- - Termination of unprofitable individual and small group membership; and
- - Decreased hospital costs; partially offset by
- - Increased physician costs.
Marketing, General and Administrative Expenses. Marketing, general and
administrative expenses as a percentage of operating revenue were 11.2 percent
for the three months ended September 30, 1999 compared to 10.8 percent for the
three months ended June 30, 1999. Marketing, general and administrative expenses
as a percentage of operating revenue increased due to training and development
programs and consulting expenses associated with our reorganization and
strategic planning process.
Operating Income. Operating income as a percentage of operating revenue was 4.5
percent for the three months ended September 30, 1999 and was 4.4 percent for
the three months ended June 30, 1999. The sequential changes are discussed above
and are detailed in earnings (loss) per share below.
Net Investment Income and Interest Expense. Net investment income for the three
months ended September 30, 1999 was comparable to net investment income for the
three months ended June 30, 1999. Interest expense increased two percent for the
three months ended September 30, 1999 compared to the three months ended June
30, 1999 due to the higher average balance outstanding on the credit facility
during the current quarter because of additional borrowings to fund the
repurchase of our stock.
Provision for Income Taxes. The effective income tax rate was 43.8 percent for
the three months ended September 30, 1999 compared with 41.4 percent for the
three months ended June 30, 1999. The sequential increase was primarily due to
the nondeductible Ohio HMO goodwill impairment charges. See Note 5 of the Notes
to Condensed Consolidated Financial Statements.
Diluted Earnings Per Share. For the three months ended September 30, 1999, net
income was $69 million or $1.54 diluted earnings per share compared to net
income of $69 million or $1.49 diluted earning per share for the three months
ended June 30, 1999. The change was due to the following:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
------------------
<S> <C>
Diluted earnings per share -- June 30, 1999................ $ 1.49
Improved operations:
Government gross margin performance...................... 0.08
Commercial gross margin performance...................... 0.12
Other income performance................................. 0.04
Marketing, general and administrative expenses........... (0.18)
------
Total improved operations........................ 0.06
Net investment income and interest expense................. (0.01)
Accretive impact of treasury stock purchases............... 0.04
------
Diluted earnings per share before impairment, disposition,
restructuring and other charges.......................... 1.58
Impairment, disposition, restructuring and other charges... (0.04)
------
Diluted earnings per share -- September 30, 1999........... $ 1.54
======
</TABLE>
FORWARD LOOKING INFORMATION UNDER THE PRIVATE SECURITIES LITIGATION ACT OF 1995
The Private Securities Litigation Reform Act of 1995 provides a "safe harbor"
for forward looking statements. The Act was designed to encourage companies to
provide prospective information about themselves without fear of litigation. The
prospective information must be identified as forward looking and must be
accompanied
23
<PAGE> 26
by meaningful cautionary statements identifying important factors that could
cause actual results to differ materially from those projected in the
statements. The statements about our plans, strategies, intentions, expectations
and prospects contained throughout the document are based on current
expectations. These statements are forward looking and actual results may differ
materially from those predicted as of the date of this report in the forward
looking statements, which 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. Stockholders are also directed to the other
risks discussed in other documents filed by PacifiCare with the Securities and
Exchange Commission.
Membership. We expect government membership to increase two to four percent by
December 31, 1999 compared to December 31, 1998. We continue to expand our
membership retention programs and target group retiree members in our existing
markets. We also continue to focus our marketing efforts on growing membership
as our competitors exit markets in which Secure Horizons will remain. These
increases will be partially offset by our exit from certain rural markets and
our exit from Dayton, Ohio.
We expect commercial membership for the year ended December 31, 1999 to increase
three to four percent compared to December 31, 1998. The majority of the growth
will be in California and Colorado where we continue to focus our marketing
efforts on membership renewal and national accounts.
In 2000, we expect membership to increase primarily as a result of in-market
acquisitions, including those we have already announced.
Premiums. We expect premium rate increases of three percent for Medicare and six
percent for commercial for the nine months ended September 30, 1999 to be
sustained for the remainder of 1999. Our emphasis continues to be on renewing
commercial employer contracts with price increases sufficient to maintain or
improve margin performance.
Commercial HMO premium rate increases for 2000 will range from four to eight
percent. Effective January 1, 2000, we expect to receive a weighted average
premium increase of 3.5 percent from the Health Care Financing Administration.
In addition, we plan to increase Secure Horizons member paid supplemental
premiums for approximately 45 percent of our Secure Horizons members.
Membership and Premium Risk Factors. An unforeseen loss of profitable membership
or a change in premium expectations could negatively affect our financial
position, results of operations and cash flows. Factors that could contribute to
the loss of membership or lower premiums include:
- - Our failure to obtain new customers or retain existing customers;
- - The effect of premium increases, benefit changes and member paid supplemental
premiums and copayments;
- - Our exit from certain markets;
- - Reductions in work force by existing customers;
- - Negative publicity and news coverage;
- - Inability of our marketing and sales plans to attract new customers; and
- - Our loss of key executives or key employees.
Other Income. In 1999, we expect other income to be comparable to or slightly
higher than 1998. In 2000, we expect other income to grow modestly, primarily
related to increased pharmacy mail-service revenues.
Health Care Costs. Our profitability depends, in part, on our ability to control
health care costs while providing quality care. Our primary focus is securing
cost-effective physician, hospital and other health care provider contracts to
maintain our qualified and stable network of providers in each geographic area
we serve. Through September 30, 1999, consolidated medical and hospital costs
were trending between two and four percent higher. Other costs, the majority of
which is prescription drugs, were trending between 12 and 14 percent higher.
These health care cost trends are expected to continue into 2000 with slight
increases. These
24
<PAGE> 27
increases are reflected in our premium rate increase expectations. About 75 to
80 percent of our membership are under capitated hospital arrangements, a
decrease from 85 percent at the end of 1998. This shift has resulted in higher
health care costs. Some of the medical and hospital increases will be in the
form of increased capitation rates, designed to improve the network stability of
our capitated providers.
Prescription drug cost increases are driven by drug utilization, cost per
prescription and new pharmacy products. We use prescription drug formularies as
a way of controlling health care costs. Formularies are lists of physician
recommended drugs in different therapeutic classes that have been reviewed for
safety, efficacy and value. These lists help ensure that members get the right
prescription at the right time in the right dose, avoiding potential adverse
effects. Formularies also ensure that the price is right; if two medications
have the same effect, the less expensive option (often a generic alternative) is
recommended. Medically necessary drugs not included in the formulary can be
obtained through our authorization process. We continue to conduct member and
physician education programs to provide information on the appropriate use of
generic drugs, over the counter drugs and antibiotics. Many of our medical
groups share the financial risk for prescription drugs to find the most
effective and cost-efficient treatments for our members. Prescription drug
benefit changes for Secure Horizons members have been implemented in almost all
our geographic areas for 2000 as a way of controlling this health care cost
component.
We continue to evaluate the financial stability of our providers, focusing on
providers with significant membership in key geographic areas and providers that
have been identified as a poor risk. We are also seeking to improve provider
stability by taking steps to minimize insolvency risk. This includes developing
contingency plans to shift membership to other providers, supplementing
utilization management review personnel of the provider group and reviewing
operational and financial plans to increase financial stability. We believe our
September 30, 1999 provider insolvency reserves are adequate. These reserves are
intended to pay for September 1999 and prior health care services that may not
be paid by insolvent or unstable providers.
Government Medical Care Ratio. We expect the 1999 government medical care ratio
to increase from 86.5 percent in 1998. Higher provider costs (both capitated and
shared risk) and pharmacy costs will increase the 1999 medical care ratio. These
will be partially offset by premium rate increases, improvements in hospital
utilization management and our exit of rural markets in certain states plus the
disposition of our Utah HMO. Because we intend to pass a majority of 2000
premium increases to providers to offset increasing health care costs, the
government medical care ratio for next year is expected to be comparable to or
slightly higher than 1999.
Commercial Medical Care Ratio. We expect the 1999 commercial medical care ratio
improvements made to date to continue for the remainder of the year. Higher
provider costs (both capitated and shared risk) and pharmacy costs will increase
the 2000 medical care ratio. These will be partially offset by premium rate
increases and improvements in hospital utilization management.
Medical Care Ratio Risk Factors. Increases in the government and/or commercial
medical care ratio could have an adverse effect on our profitability.
Uncertainties that could have a negative impact on our medical care ratio
include:
- - Medical and prescription drug costs that rise faster than premium increases;
- - Increases in utilization and costs of medical and hospital services;
- - The effect of federal and/or state legislation on our ability to secure
cost-effective contracts with providers;
- - The effect of actions by competitors or groups of providers;
- - Termination of provider contracts, provider insolvency or renegotiation of
such contracts at less favorable rates or terms of payment;
- - Legislation that gives physicians collective bargaining power;
- - The September 1999 announcement of drug benefit changes effective January 1,
2000 that could result in increased pharmacy utilization during the fourth
quarter of 1999; and
25
<PAGE> 28
- - The mix of our capitated and non-capitated provider contracts.
We have and may continue to incur additional health care costs. The effect of
these risks and the need for additional provider insolvency reserves could have
a material effect on our results of operations or cash flows. We believe,
however, that such reserves would not materially affect our consolidated
financial position.
Marketing, General and Administrative Support. In 1999, we expect marketing,
general and administrative expenses as a percentage of operating revenue to
remain comparable to or slightly decrease from the 1998 rate of 11.4 percent
because we expect to realize continued efficiencies from the FHP acquisition and
new technologies that are implemented. The California HMO's final conversion
from FHP information systems to PacifiCare systems was completed in June 1998,
so 1999 will be the first full year of integrated operations. In 2000, we expect
marketing, general and administrative expenses as a percentage of operating
revenue to be comparable to or increase slightly compared to 1999.
Marketing, General and Administration Risk Factors. The following factors could
have an adverse impact on marketing, general and administrative expenses:
- - The need for additional advertising, marketing, administrative or management
information systems expenditures;
- - The inability of marketing and sales plans to attract new customers;
- - The need for increased claims administration for capitated providers;
- - Integration costs for Harris that exceed expectation; and
- - The need for investments in medical management resources and technology.
Future Dispositions and Impairments. Dispositions could be announced as we
continue to evaluate whether certain subsidiaries or products fit within our
core business strategy. We review long-lived assets for impairment when events
or changes in business conditions indicate that their full carrying value may
not be recovered. We consider assets to be impaired and write them down to fair
value if we determine that the realizable value of long-lived assets such as
property and equipment, real estate and goodwill, is less than the value carried
on the consolidated financial statements. There can be no assurances that the
dispositions and impairments will not result in additional pretax charges. We
believe that any disposition or impairment operating losses would not materially
affect our consolidated financial position. However, the disposition or
impairment losses could have a material effect on the results of operations or
cash flows of a future period.
Effective Tax Rate. We expect the 1999 effective tax rate to be comparable to
the rate for the nine months ended September 30, 1999. We expect the 2000
effective tax rate to be approximately 41 to 42 percent. Although we are not
expecting additional nondeductible goodwill impairments (which increased the
1999 year-to-date effective tax rate from 41.4 percent at June 30 to 42.2
percent at September 30) we are expecting less tax-exempt investment income.
There can be no assurance that pretax income will increase as projected or that
future business decisions will not impact the current effective tax rate.
Year 2000. We have tested and certified as Year 2000 compliant all of our
internal systems and components. PacifiCare 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, we have
verified that all date fields and calculations used in critical business
processes will be Year 2000 compliant. Under the program we have also addressed
our external Year 2000 related risks which arise from the Year 2000 readiness of
third parties with whom we maintain ongoing relationships.
The Year 2000 compliance program included the following phases for our internal
systems, which are listed in logical order, but were addressed concurrently as
appropriate:
- - Awareness and Communication. We have undertaken an ongoing company-wide
communication and education effort to ensure that there is a clear
understanding of the Year 2000 problem and associated risks.
26
<PAGE> 29
- - Inventory and Assessment. We have completed a company-wide inventory of all
internal computer information systems and their components, including
infrastructure equipment and hardware, software applications and information
supply chains. Through the inventory, we have assessed the business risks and
Year 2000 compliance status of each system component. For components that were
not Year 2000 compliant, a preliminary remediation plan was developed that
included the Year 2000 remediation, action required and the time and resources
needed to accomplish it. We established priorities based on the relative
business critical function of each system component.
- - Remediation, Testing, and Certification. We have tested each computer
information system and component for Year 2000 compliance, using industry
standards. If actual test results were acceptable, we certified the tested
system or component as Year 2000 compliant. If the test identified any issues,
we took steps to correct the system or component and then retest the corrected
system or component as necessary to achieve certified compliance.
- - Implementation and Close. A final review has been completed and we have
confirmed that the remediated systems and components have met all Year 2000
compliance objectives.
When our Year 2000 compliance program was first established in 1996, we focused
on existing systems and did not contemplate acquisitions of other companies.
These core computing programs became Year 2000 compliant in 1998. Prior to 1999
the total cost to make our pre-FHP core computing information systems Year 2000
compliant was approximately $6 million. Amounts spent during the third quarter
of 1999 were insignificant.
With the February 1997 FHP acquisition, we originally expected the Arizona,
Colorado, Nevada and Ohio HMOs to shift to our pre-FHP core computing
information systems throughout 1998 and 1999 as providers moved to delegated
capitation arrangements. In the second quarter of 1998, we determined that while
we had successfully moved some of these providers to capitation arrangements,
the provider networks did not have sufficient infrastructure to administer the
claims under a fully delegated capitated arrangement. We concluded that our HMOs
in these states will need to continue to administer claims on behalf of
providers. Because the claims-based FHP core systems function more effectively
than our core computing systems for claims administration on behalf of
non-delegated delivery systems, we decided to maintain the FHP systems. As a
result, the scope of our Year 2000 compliance activities was expanded to include
the FHP computer system. We have successfully modified the FHP systems to be
Year 2000 compliant at the end of September 1999. Through September 30, 1999,
our 1999 costs for remedying the FHP systems have been approximately $3 million.
Prior to 1999, our costs incurred were approximately $3 million.
We have also contacted our third party vendors, provider and hospital networks,
business partners, contractors, and service providers, including HCFA, to assess
their Year 2000 level of readiness. In some cases, we sought reasonable
assurances with respect to Year 2000 compliance. Our priority was to assess the
readiness of our providers with delegated responsibility and other third parties
with which we electronically exchange data or interact. Because we do not
control the products, services, or systems of our providers, vendors or
customers, we cannot ensure their Year 2000 compliance. We have developed
business process contingency plans for critical third party sources that appear
to be at risk. These plans, which vary by third party entity, include
contingencies for replacement, outsourcing, or manual processing.
If HCFA or certain other third parties experience significant failures or
erroneous applications, it could have a material effect on our financial
position, results of operations, cash flows, and business prospects. For
example, if HCFA, OPM, or our commercial customers experience system failures,
this could cause a delay in our receipt of payments from these customers,
including a significant HCFA payment due in January 2000. Therefore, we have
developed a cash contingency plan that includes using available cash and lines
of credit to cover any significant shortfalls in cash receipts.
We also could have difficulties processing Medicare and other claims within
required periods, collecting accurate claims and other data on which we depend,
or enrolling new members. Further, our marketing, general and administrative
expenses could increase due to Year 2000 compliance expenditures. Because some
risks are beyond our control, we have developed business contingency plans to
mitigate these risks. These
27
<PAGE> 30
business contingency plans were developed for each critical business function
and cover contingencies such as the loss of a facility, loss of system(s), or
loss of a key vendor. We may also have members who are concerned about
prescription drug availability in light of the "millennium bug." This could lead
to over ordering of drugs and result in increased pharmacy utilization in the
fourth quarter of 1999.
Office of Personnel Management Contingencies. We intend to negotiate with OPM on
any existing or future unresolved matters to attain a mutually satisfactory
result. There can be no assurance that any ongoing and future negotiations will
be concluded satisfactorily, that additional audits will not be referred to the
Department of Justice, or that additional, possibly material, liability will not
be incurred. We believe that any ultimate liability in excess of amounts accrued
would not materially affect our 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.
Liquidity and Capital Resources. As of September 30, 1999, we had a $1.3 billion
credit facility under which we had $525 million in borrowings outstanding.
Additional borrowings or amendments to our credit facility may be necessary if
HCFA and OPM are unable to remit funds as a result of year 2000 compliance
issues.
Currently the terms of our credit facility permit us to repurchase up to $500
million of our outstanding common stock. To repurchase the maximum number of
shares authorized, we will need to negotiate changes to our existing credit
facility or obtain alternative financing. We are evaluating our options, but may
fund repurchases through a combination of cash flow and long and short term
debt.
Should the credit facility be drawn, we could be subject to earlier mandatory
reductions of the outstanding balance. Our ability to repay amounts owed under
the credit facility and other long-term debt will also depend on cash receipts
from our subsidiaries' restricted cash reserves. These subsidiary receipts
represent cash dividends by the subsidiaries to us. 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 capital standards
imposed by HMO or insurance regulations, which may from time to time impact the
amount of funds the subsidiaries can pay to us. Additionally, from time to time,
we advance funds in the form of a loan or capital contribution to our
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, a regulator may impose additional financial
requirements on the subsidiary, which may require additional funding from us. We
believe that cash flows from operations, existing cash equivalents, marketable
securities and other financing sources will be sufficient to meet the
requirements of the credit facility, our business and the UniHealth transaction.
Risk-Based Capital Requirements. The National Association of Insurance
Commissioners has proposed that states adopt risk-based capital standards that,
if implemented, would require new minimum capitalization limits for health care
coverage provided by HMOs and other risk-bearing health care entities. To date,
Colorado and Washington are the only states where we have HMO operations that
have adopted these standards. We do not expect this legislation to have a
material impact on our consolidated financial position in the near future if
other states where we operate HMOs adopt these standards. We believe that cash
flows from operations will be sufficient to fund any additional 1999 risk-based
capital requirements. Furthermore, borrowings under the credit facility could be
used for risk based capital requirements, if necessary.
Legislation and Regulation. Changes in state and federal legislation may
negatively impact our financial and operating results. These changes may
increase our medical care ratios, decrease our membership or otherwise adversely
affect our revenues and our profitability. As of September 30, 1999,
approximately 59 percent of our revenue came from our Medicare business. Changes
that could affect us materially include:
- - Limitations on premium levels;
- - Increases in minimum capital, reserves, and other financial viability
requirements;
- - Prohibition or limitation of capitated arrangements or provider financial
incentives;
- - New benefit mandates including mental health parity which becomes effective
July 1, 2000;
28
<PAGE> 31
- - Limitations on the ability to manage care and utilization due to willing
provider and direct access laws;
- - Adoption on the federal and/or state level of legislation that holds HMOs
liable for malpractice; and
- - A provision of the Patient's Bill of Rights that allows individuals to sue
their health plans in State Courts.
Legislation and regulation could also include adverse actions of governmental
payors, including reduced Medicare premiums; 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 actions.
Other. Results may differ materially from those projected, forecast, estimated
and budgeted by us 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.
1999 Diluted Earnings Per Share. The full year 1999 expectations are expected to
remain on track with our previously stated guidance that 1999 diluted EPS will
grow 40 to 45 percent from the $4.40 diluted EPS reported for 1998. Our 1999
expectations exclude new acquisitions or dispositions and changes to health care
cost trends resulting from member fears of the "millennium bug."
2000 Diluted Earnings Per Share. Our goal is to increase 2000 diluted EPS
approximately 15 percent from 1999 reported diluted EPS through a combination of
improved performance, acquisitions, divestitures and share repurchases.
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The principal objective of our asset/liability management activities is to
maximize net investment income, while managing levels of interest rate risk and
facilitating our funding needs. Our net investment income and interest expense
are subject to the risk of interest rate fluctuations. To mitigate the impact of
fluctuations in interest rates, we manage the structure of the maturity of debt
investments and derivatives. We use derivative financial instruments, primarily
interest rate swaps, with maturities that correlate to balance sheet financial
instruments. This results in a modification of existing interest rates to levels
deemed appropriate based on our current economic outlook.
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<PAGE> 32
PART II: OTHER INFORMATION
ITEM 1: LEGAL PROCEEDINGS
See Note 6 of the Notes to Condensed Consolidated Financial Statements.
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
President and Chief Operating Officer, Jeffrey M. Folick, announced that he
intends to transition into a less active role with PacifiCare. He will act as
Executive Vice President and will oversee our specialty product companies until
a permanent leader is named. Alan R. Hoops, Chairman and Chief Executive
Officer, will assume the role of President and also continue as Chief Executive
Officer and board member. David A. Reed, who has served as a director of
PacifiCare for seven years and participates on our Audit Committee, will lead
the board of directors as chairman.
ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibit Index
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
15 Letter re: Unaudited Interim Financial Information
20 Independent Accountants' Review Report
27 Financial Data Schedule (filed electronically)
99 Press release, dated November 4, 1999
</TABLE>
(b) Reports on Form 8-K
On September 17, 1999, we filed a Form 8-K in connection with the resignation of
Robert B. Stearns as Executive Vice President and Chief Financial Officer, and
also in connection with certain organizational and leadership changes.
30
<PAGE> 33
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)
Date: November 11, 1999 By: /s/ ALAN R. HOOPS
------------------------------------
Alan R. Hoops
President and Chief Executive
Officer
Date: November 11, 1999 By: /s/ MARY C. LANGSDORF
------------------------------------
Mary C. Langsdorf
Senior Vice President, Corporate
Controller
and Interim Chief Financial Officer
31
<PAGE> 34
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
15 Letter re: Unaudited Interim Financial Information
20 Independent Accountants' Review Report
27 Financial Data Schedule (filed electronically)
99 Press release, dated November 4, 1999
</TABLE>
<PAGE> 1
EXHIBIT 15
LETTER RE: UNAUDITED INTERIM FINANCIAL INFORMATION
The Board of Directors
PacifiCare Health Systems, Inc.
We are aware of the incorporation by reference in the Registration Statement
(Form S-8 number 333-21713) and related Prospectus pertaining to the 1996 Stock
Option Plan for Officers and Key Employees and the related Prospectus pertaining
to the 1996 Non-Officer Directors Stock Option Plan of PacifiCare Health
Systems, Inc. and in the Registration Statement (Form S-8 number 333-48377) and
related Prospectus pertaining to the 1997 Premium Priced Stock Option Plan and
the related Prospectus pertaining to the Amendment and Restatement of the
PacifiCare Health Systems, Inc. Savings and Profit-Sharing Plan of PacifiCare
Health Systems, Inc. of our report dated October 25, 1999 (except for Notes 6
and 10 as to which the date is November 5, 1999) relating to the unaudited
condensed consolidated interim financial statements of PacifiCare Health
Systems, Inc. that are included in its Form 10-Q for the quarters ended
September 30, 1999 and 1998.
ERNST & YOUNG LLP
Los Angeles, California
November 9, 1999
<PAGE> 1
EXHIBIT 20
INDEPENDENT ACCOUNTANTS' REVIEW REPORT
The Board of Directors
PacifiCare Health Systems, Inc.
We have reviewed the accompanying condensed consolidated balance sheets of
PacifiCare Health Systems, Inc. as of September 30, 1999, and the related
condensed consolidated statements of operations for the three and nine-month
periods ended September 30, 1999 and 1998, and the condensed consolidated
statements of cash flows for the nine-month periods ended September 30, 1999 and
1998. These financial statements are the responsibility of the Company's
management.
We conducted our reviews in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures to
financial data, and making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an audit conducted in
accordance with generally accepted auditing standards, which will be performed
for the full year with the objective of expressing an opinion regarding the
financial statements taken as a whole. Accordingly, we do not express such an
opinion.
Based on our reviews, we are not aware of any material modifications that should
be made to the accompanying condensed consolidated financial statements for them
to be in conformity with generally accepted accounting principles.
We have previously audited, in accordance with generally accepted auditing
standards, the consolidated balance sheet of PacifiCare Health Systems, Inc. as
of December 31, 1998, and the related consolidated statements of operations,
shareholders' equity, and cash flows for the year then ended [not presented
herein] and in our report dated February 9, 1999, we expressed an unqualified
opinion on those consolidated financial statements. In our opinion, the
information set forth in the accompanying condensed consolidated balance sheet
as of December 31, 1998, is fairly stated, in all material respects, in relation
to the consolidated balance sheet from which it has been derived.
ERNST & YOUNG LLP
Los Angeles, California
October 25, 1999,
Except for Notes 6 and 10, as to which the date is
November 5, 1999
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from PacifiCare
Health Systems, Inc.'s condensed consolidated balance sheets as of September 30,
1999 and related consolidated statements of operations for the six months ended
September 30, 1999 and is qualified in its entirety by reference to such
financial statements.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> SEP-30-1999
<CASH> 176,593
<SECURITIES> 1,023,279
<RECEIVABLES> 313,434
<ALLOWANCES> 10,964
<INVENTORY> 0
<CURRENT-ASSETS> 1,656,334
<PP&E> 306,551
<DEPRECIATION> 130,597
<TOTAL-ASSETS> 4,203,016
<CURRENT-LIABILITIES> 1,205,679
<BONDS> 0
0
0
<COMMON> 468
<OTHER-SE> 2,237,587
<TOTAL-LIABILITY-AND-EQUITY> 4,203,016
<SALES> 0
<TOTAL-REVENUES> 7,424,573
<CGS> 0
<TOTAL-COSTS> 6,225,081
<OTHER-EXPENSES> 863,269
<LOSS-PROVISION> 294
<INTEREST-EXPENSE> 29,547
<INCOME-PRETAX> 367,129
<INCOME-TAX> 154,987
<INCOME-CONTINUING> 212,142
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 212,142
<EPS-BASIC> 4.67
<EPS-DILUTED> 4.64
</TABLE>
<PAGE> 1
EXHIBIT 99.1
PacifiCare(R)
Health Systems
3120 W. Lake Center Drive
Santa Ana, California 92704
Tel. (714) 825-5200
News Release
- --------------------------------------------------------------------------------
CONTACT: David K. Erickson Lisa Boyette
Investor Relations Media Relations
(714) 825-5491 (714) 825-5121
FOR IMMEDIATE RELEASE
- ---------------------
PACIFICARE HEALTH SYSTEMS ANNOUNCES INCREASE
IN SHARE REPURCHASE AUTHORIZATION
Jeff Folick Announces Intention to Transition Into Less Active Role
Alan Hoops Assumes Role of President, In Addition to
Chief Executive Officer and Director
SANTA ANA, Calif., November 4, 1999 - PacifiCare Health Systems, Inc.,
(Nasdaq: PHSY) today announced that its board of directors has authorized the
repurchase of up to 12 million shares of its 43.5 million outstanding shares of
common stock, in addition to the 2.46 million shares repurchased to date. The
authorization includes any repurchases to be made under the terms of the
Company's previously announced agreement with UniHealth. It is anticipated that
the repurchase of the shares will be funded through a combination of cash from
operations, bank debt and/or other debt financing.
"Share repurchases are absolutely irresistible for us, given our
current stock price and views on our strong growth prospects," said Alan Hoops,
president and chief executive officer. "Our strong cash flows will enable us to
purchase shares while maintaining adequate levels of capital reserves and a
reasonable debt-to-capital ratio." Hoops confirmed that PacifiCare continues to
expect to reach its previously stated goal of 1999 earnings per share growth in
the 40 to 45 percent range.
Additionally, President and Chief Operating Officer Jeff Folick
announced that he intends to transition into a less active role with the
Company. Folick will act as executive vice president and oversee the Specialty
Services division until a permanent leader of this division is named.
Commensurate with Folick's announcement, Hoops will resume the role of
president and also continue as chief executive officer and board member. David
A. Reed, who has served as a director of the Company for seven years and
participates on its Audit Committee, will lead the board as chairman based on
his 40 years of extensive experience in the health delivery and health plan
industries. He is a past chairman of the board of the American Hospital
Association and the Health Plan of America.
Reed stressed, "Since PacifiCare was founded, two things have always
been constant. One is that we can count on Alan to make tremendous contributions
to the growth of this company. The second is that to ensure proper checks and
balances between the board and management, PacifiCare's president has not
simultaneously served as chairman of the board. Given Alan's invaluable and
extensive experience, we believe there is no one better than Alan to return to a
more hands-on role of running the Company as its president and chief executive
officer."
<PAGE> 2
Hoops stated, "As one of the founders of PacifiCare, I'm deeply
committed to continuing our track record of growth. With the highest degree of
enthusiasm, I will again devote my attention to the president's active daily
role in our strong range of operations, in addition to my duties as chief
executive officer. As stated when we released third quarter earnings last week,
our confidence in and outlook on the future is very positive."
Consistent with the board's purpose of increasing shareholder value, it
has named directors David Reed, Jack Anderson, David Carpenter and Terry
Hartshorn, the Company's former chairman, to its new executive committee whose
primary focus is to explore value increasing strategies. The executive committee
worked with Warburg Dillon Read LLC, the company's financial advisor, to
facilitate the increase in PacifiCare's share repurchase authorization announced
today.
PacifiCare Health Systems is one of the nation's leading managed health
care services companies. Primary operations include managed care products for
Medicare beneficiaries and employer groups in nine states and Guam serving
approximately 3.7 million members. Other specialty products and operations
include behavioral health services, life and health insurance, dental and vision
services, pharmacy benefit management and Medicare+Choice management services.
More information on PacifiCare Health Systems can be obtained at
www.pacificare.com.
Cautionary Statement:
- ---------------------
The statements contained in this release that are not historical facts are
forward-looking statements, including those relating to expectations regarding
cash flows, capital reserves and debt levels. Important factors that could cause
results to differ materially from management's expectations include failure to
continue current cost control and pricing strategies or to implement planned
changes; the availability of internally generated cash to fund common stock
repurchases; the ability to successfully amend the existing credit facility and
more generally, an unexpected increase in competition; an unfavorable pricing
environment; the inability to achieve expected efficiencies in operations or
effectively control health care costs; computer conversion and Year 2000
problems; and new regulations or laws relating to capitation, benefit mandates,
service, utilization management, provider contracts and similar matters.
Additional information on factors that could potentially affect our financial
and other results may be found in our documents filed with the Securities and
Exchange Commission.
###
