<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 MARCH 31, 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)
DELAWARE 95-4591529
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
3120 LAKE CENTER DRIVE, SANTA ANA, CALIFORNIA 92704
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) (714) 825-5200
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
--- ---
The number of shares of Class A Common Stock and Class B Common Stock
outstanding at April 30, 1999 was approximately 14,800,000 and 30,800,000,
respectively.
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<PAGE> 2
PACIFICARE HEALTH SYSTEMS, INC.
FORM 10-Q INDEX
<TABLE>
<CAPTION>
PAGE
<S> <C>
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Condensed Consolidated Balance Sheets as of March 31, 1999 and December 31, 1998.......................... 1
Condensed Consolidated Statements of Operations for the three months ended March 31, 1999 and 1998........ 2
Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 1999 and 1998........ 3
Notes to Condensed Consolidated Financial Statements...................................................... 5
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS................. 9
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK............................................ 19
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K...................................................................... 20
SIGNATURES..................................................................................................... 21
EXHIBITS....................................................................................................... 22
</TABLE>
<PAGE> 3
PART I: FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS
PACIFICARE HEALTH SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
MARCH 31, DECEMBER 31,
1999 1998
----------- -----------
(UNAUDITED)
(IN THOUSANDS, EXCEPT
PER SHARE DATA)
<S> <C> <C>
ASSETS
Current assets:
Cash and equivalents ............................................. $ 247,587 $ 724,636
Marketable securities ............................................ 901,299 875,553
Receivables, net ................................................. 322,932 275,955
Prepaid expenses and other current assets ........................ 28,845 24,979
Deferred income taxes ............................................ 137,839 132,452
----------- -----------
Total current assets .......................................... 1,638,502 2,033,575
----------- -----------
Property, plant and equipment at cost, net .......................... 175,257 178,520
Marketable securities-restricted .................................... 85,695 82,660
Goodwill and intangible assets, net ................................. 2,298,287 2,313,266
Other assets ........................................................ 22,298 22,923
----------- -----------
$ 4,220,039 $ 4,630,944
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Medical claims and benefits payable .............................. $ 671,000 $ 645,300
Accounts payable and accrued liabilities ......................... 466,086 464,170
Unearned premium revenue ......................................... 62,961 509,859
Long-term debt due within one year ............................... 57 87
----------- -----------
Total current liabilities ..................................... 1,200,104 1,619,416
----------- -----------
Long-term debt due after one year ................................... 575,004 650,006
Deferred income taxes ............................................... 118,664 112,056
Other liabilities ................................................... 11,427 11,015
Minority interest ................................................... 333 355
Shareholders' equity:
Capital stock, $0.01 par value per share:
Common stock:
Class A, 100,000 shares authorized, voting: issued 14,880
shares in 1999 and 1998 .................................... 149 149
Class B, 100,000 shares authorized, non-voting: issued 31,555
shares in 1999 and 31,506 shares in 1998 ................... 315 315
Additional paid-in capital ....................................... 1,633,257 1,624,619
Accumulated other comprehensive income ........................... 1,148 7,359
Retained earnings ................................................ 723,592 649,608
Treasury shares, at cost: Class A common, 42 shares and Class B
common, 728 shares .......................................... (43,954) (43,954)
----------- -----------
Total shareholders' equity .................................... 2,314,507 2,238,096
----------- -----------
$ 4,220,039 $ 4,630,944
=========== ===========
</TABLE>
See accompanying notes.
1
<PAGE> 4
PACIFICARE HEALTH SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
-----------------------------
1999 1998
----------- -----------
(IN THOUSANDS, EXCEPT
PER SHARE DATA)
<S> <C> <C>
Revenue:
Government premiums (Medicare and Medicaid) $ 1,445,456 $ 1,396,522
Commercial premiums ....................... 977,433 960,898
Other income .............................. 29,020 24,530
----------- -----------
Total operating revenue ................ 2,451,909 2,381,950
----------- -----------
Expenses:
Health care services:
Government services ....................... 1,257,131 1,210,049
Commercial services ....................... 796,789 798,452
----------- -----------
Total health care services ............. 2,053,920 2,008,501
----------- -----------
Marketing, general and administrative expenses 262,584 282,313
Amortization of goodwill and intangible assets 19,059 18,636
----------- -----------
Operating income ............................. 116,346 72,500
Net investment income ........................ 20,201 25,304
Interest expense ............................. (10,293) (17,518)
----------- -----------
Income before income taxes ................... 126,254 80,286
Provision for income taxes ................... 52,270 38,940
----------- -----------
Net income ................................... $ 73,984 $ 41,346
=========== ===========
Preferred dividends .......................... -- (2,629)
----------- -----------
Net income available to common shareholders .. $ 73,984 $ 38,717
=========== ===========
Basic earnings per share ..................... $ 1.62 $ 0.93
=========== ===========
Diluted earnings per share ................... $ 1.61 $ 0.90
=========== ===========
</TABLE>
See accompanying notes.
2
<PAGE> 5
PACIFICARE HEALTH SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
-------------------------
1999 1998
--------- ---------
(IN THOUSANDS)
<S> <C> <C>
Operating activities:
Net income ................................................. $ 73,984 $ 41,346
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Amortization of goodwill and intangible assets ............. 19,059 18,636
Depreciation and amortization .............................. 9,971 12,627
Deferred income taxes ...................................... 5,092 2,368
Loss on disposal of property, plant and equipment and other 2,159 --
Provision for doubtful accounts ............................ (106) 136
Other noncash items ........................................ (22) (22)
Changes in assets and liabilities, net of effects from
acquisitions and dispositions:
Receivables, net ........................................ (46,871) (25,134)
Prepaid expenses and other assets ....................... (3,241) 1,325
Medical claims and benefits payable ..................... 25,700 (6,900)
Accounts payable and accrued liabilities ................ 4,167 33,017
Unearned premium revenue ................................ (446,898) (448,774)
--------- ---------
Net cash flows used in operating activities ........ (357,006) (371,375)
--------- ---------
Investing activities:
Purchase of marketable securities, net ..................... (35,828) (65,456)
Purchase of property, plant and equipment .................. (11,803) (5,827)
Purchase of marketable securities-restricted ............... (3,035) (11,607)
Proceeds from the sale of property, plant and equipment .... 2,936 --
Acquisitions, net of cash acquired ......................... -- (750)
--------- ---------
Net cash flows used in investing activities ............. (47,730) (83,640)
--------- ---------
Financing activities:
Principal payments on long-term debt ....................... (75,032) (41)
Proceeds from borrowings of long-term debt ................. -- 30,000
Repurchase of common stock ................................. -- (23,338)
Proceeds from issuance of common and treasury stock ........ 2,719 6,042
Preferred dividends paid ................................... -- (2,629)
--------- ---------
Net cash flows (used in) provided by financing activities (72,313) 10,034
--------- ---------
Net decrease in cash and equivalents .......................... (477,049) (444,981)
Beginning cash and equivalents ................................ 724,636 680,674
--------- ---------
Ending cash and equivalents ................................... $ 247,587 $ 235,693
========= =========
</TABLE>
See accompanying notes.
Table continued on next page.
3
<PAGE> 6
PACIFICARE HEALTH SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
-----------------------
1999 1998
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Supplemental cash flow information:
Cash paid during the year for:
Income taxes, net of refunds ................................. $ 41,628 $ 360
Interest ..................................................... $ 11,346 $ 16,086
Supplemental schedule of noncash investing and financing activities:
Tax benefit associated with exercise of stock options .......... $ 376 $ 2,216
Stock-based compensation ....................................... $ 5,543 $ 32
Details of accumulated other comprehensive income:
Change in marketable securities ................................. $(10,082) $ (3,512)
Less change in deferred income taxes ............................ 3,871 1,351
-------- --------
Change in shareholders' equity .................................. $ (6,211) $ (2,161)
======== ========
Details of businesses acquired in purchase transactions:
Fair value of assets acquired ................................... $ 4,080 $ 750
Liabilities assumed or created .................................. (4,080) --
-------- --------
Cash paid for fair value of assets acquired ........................ $ -- $ 750
======== ========
</TABLE>
See accompanying notes.
Table continued from previous page.
4
<PAGE> 7
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 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 3.6 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 February 1999, we acquired approximately 15,000 commercial
members in Texas for a $4.1 million purchase price. In February 1997 we acquired
FHP International Corporation ("FHP"). See the 1997 Form 10-K for additional
information.
DISPOSITIONS. On September 30, 1998, we sold our Utah health maintenance
organization ("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 of approximately $15 million ($8 million or $0.18
diluted loss per share, net of tax) for these dispositions.
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
purchase of the Texas 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
MARCH 31, 1998
------------------
(UNAUDITED)
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C>
Total operating revenue.................................. $2,327,778
Pretax income............................................ $87,629
Net income............................................... $45,738
Basic earnings per share................................. $1.03
Diluted earnings per share............................... $1.00
</TABLE>
3. LONG-TERM DEBT
We have a $1.5 billion credit facility under which we had $475 million in
borrowings outstanding as of March 31, 1999. The terms of this facility require
a mandatory step-down payment schedule if the principal balance exceeds certain
thresholds. Because the March 31, 1999 balance of $475 million was below the
threshold, no step-down payments are required until the final maturity date on
January 1, 2002. Interest under the credit facility is variable and is presently
based on the London Interbank Offering Rate ("LIBOR") plus a spread, except for
$350 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 six percent. The terms of the credit facility
contain various covenants, usual for financing of this type, including a minimum
net worth requirement, a minimum fixed charge requirement, leverage ratios and
limits on the amount
5
<PAGE> 8
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
(UNAUDITED)
of treasury stock we may purchase. At March 31, 1999, we were in compliance with
all such covenants. We also have $100 million in senior notes outstanding that
were assumed when we acquired FHP. These notes carry an interest rate of seven
percent, are payable semiannually and mature on September 15, 2003.
4. SHAREHOLDERS' EQUITY
In January 1998, our board of directors approved a plan to repurchase shares of
our outstanding common stock. To date we have repurchased 784,000 shares of our
Class A and B common stock, totaling $45 million. We have repurchased, and may
continue to repurchase our outstanding common stock using cash flows from
operations and additional borrowings under the credit facility. The terms of the
credit facility permit us to repurchase up to $500 million of our outstanding
common stock. Shares repurchased have been, and will be reissued for our
employee benefit plans or for other corporate purposes. See Note 9 of the Notes
to Condensed Consolidated Financial Statements.
In May 1998, we announced the redemption of our 10,517,044 shares of Series A
preferred stock. Substantially all of the preferred shares were converted into
3,929,503 shares of Class B common stock as of the June 23, 1998 redemption
date. During 1998, we paid approximately $5 million in dividends to our
preferred shareholders.
5. COMMITMENTS AND CONTINGENCIES
PROVIDER INSTABILITY AND INSOLVENCY. Provider insolvency reserves include
write-offs of certain providers' uncollectable receivables 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 reserve was $49 million at March 31, 1999 and
$58 million at December 31, 1998. The net decrease in provider insolvency
reserves consisted of $16 million in payments, primarily to Nevada providers,
offset by an increase of $7 million in additional provider insolvency reserves.
Provider insolvency costs totaled $7 million in the first quarter of 1999 and $6
million in the first quarter of 1998.
The majority of our insolvency reserves relate to specific providers, namely FPA
Medical Management, Inc. and MedPartners Provider Network ("MPN"). However, our
estimates also include reserves 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 the United States
Office of Personnel Management ("OPM") to provide managed health care services
to federal employees, annuitants and their dependents under the Federal Employee
Health Benefits Program ("FEHBP"). In the normal course of business, OPM audits
health plans with which it contracts mainly to verify that the premiums
calculated and charged to OPM are established in compliance with the best price
community rating guidelines established by OPM. OPM typically audits plans once
every five or six years, and each audit covers the prior five or six year
period. While the government's initial on-site audits are usually followed by a
post-audit briefing in which the government indicates its preliminary results,
final resolution and settlement of the audits have historically taken a minimum
of three to five years. In connection with the sales of our health plans in New
Mexico, Illinois and Utah, we have agreed to indemnify the buyers for potential
OPM liabilities that relate to the years in which we owned these plans.
In addition to claims made by the OPM auditors as part of the normal audit
process, OPM may also refer their results to the United States Department of
Justice ("DOJ") for potential legal action under the False Claims Act. The DOJ
has the authority to file a claim under the False Claims Act if it believes that
the health plan knowingly overcharged the government or otherwise submitted
false documentation or certifications. In False Claims Act actions, the
government may impose trebled damages and a civil penalty of not less than
$5,000 nor more than $10,000 for each separate alleged false claim. In November
1997, 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
6
<PAGE> 9
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
(UNAUDITED)
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.
We intend to negotiate with OPM on all unresolved matters to attain a mutually
satisfactory result. There can be no assurance that these negotiations will be
concluded satisfactorily, that additional audits will not be referred to the
DOJ, or that additional, possibly material, liability will not be incurred. 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.
LEGAL PROCEEDINGS. In 1997, we were served with several purported class action
suits alleging violations of federal securities laws by PacifiCare and by
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. We have filed a
motion to dismiss the entire complaint. No discovery has been taken, and all
discovery has been stayed pending the resolution of our 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 which 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.
6. EARNINGS PER SHARE
We calculated the denominators for the computation of basic and diluted earnings
per share as follows:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
--------------------
1999 1998
------- -------
(AMOUNTS IN THOUSANDS)
<S> <C> <C>
Shares outstanding at the beginning of the period ............... 45,616 41,995
Weighted average number of shares issued:
Stock options exercised ...................................... 16 58
Treasury stock acquired, net of shares issued ................ -- (370)
------- -------
Denominator for basic earnings per share ........................ 45,632 41,683
Employee stock options and other dilutive potential common shares 298 250
Assumed conversion of Series A preferred stock .................. -- 3,955
------- -------
Denominator for diluted earnings per share ...................... 45,930 45,888
======= =======
</TABLE>
7. COMPREHENSIVE INCOME
Comprehensive income represents PacifiCare's net income plus changes in its
equity, other than those changes resulting from investments by, and
distributions to PacifiCare's shareholders. Such changes include unrealized
gains or losses on our available-for-sale securities. PacifiCare's comprehensive
income totaled $68 million for the three months ended March 31, 1999 and $39
million for the three months ended March 31, 1998.
7
<PAGE> 10
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
(UNAUDITED)
8. 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, 2000, 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.
9. SUBSEQUENT EVENTS
At our next annual meeting, we will ask the holders of the Class A common stock
and the Class B common stock to approve an amended and restated certificate of
incorporation. If approved, the amended and restated certificate would combine
and reclassify PacifiCare's Class A and Class B common stock into a single class
of voting common stock. As of March 31, 1999, UniHealth Foundation
("UniHealth"), a non-profit public benefit corporation, owned approximately 40
percent of PacifiCare's outstanding shares of Class A common stock and
approximately one percent of our Class B common stock. UniHealth has agreed to
vote affirmatively for the amended and restated certificate subject to certain
conditions. On May 4, 1999, we entered into a stock purchase agreement with
UniHealth to repurchase the 5.9 million shares of Class A common stock currently
held by UniHealth. The UniHealth shares will be purchased in a series of
installments including one million share installments each in the third and
fourth quarters of 1999. The purchase price for the UniHealth shares will equal
the average fair value of the stock for the 30 trading days preceding a
scheduled purchase date. PacifiCare is 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 ($70 on the initial purchase date). In
consideration for the agreements and covenants contained in the stock purchase
agreement between us and UniHealth, including repurchasing the UniHealth shares
and the vote in favor of the amended and restated certificate, we have agreed to
pay UniHealth $60 million upon stockholder approval of the amended and restated
certificate of incorporation. This payment will be made immediately following
stockholder approval and will be recorded as a reduction of shareholders'
equity.
8
<PAGE> 11
PART I: FINANCIAL INFORMATION
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following table presents HMO membership data by state and by consumer type
as of the dates indicated.
<TABLE>
<CAPTION>
AT MARCH 31, 1999 AT MARCH 31, 1998
--------------------------------------- ---------------------------------------
Membership Data Government Commercial Total Government Commercial Total
- --------------- ---------- ---------- --------- ---------- ---------- ---------
<S> <C> <C> <C> <C> <C> <C>
Arizona ........... 83,300 103,500 186,800 88,700 111,100 199,800
California ........ 611,200 1,657,000 2,268,200 605,900 1,578,000 2,183,900
Colorado .......... 65,400 292,700 358,100 53,400 293,800 347,200
Guam .............. -- 41,500 41,500 -- 42,600 42,600
Nevada ............ 22,300 40,200 62,500 24,400 44,200 68,600
Ohio .............. 18,900 43,900 62,800 14,000 48,700 62,700
Oklahoma .......... 27,300 87,600 114,900 26,500 101,500 128,000
Oregon ............ 38,500 114,000 152,500 38,200 114,100 152,300
Texas ............. 60,700 134,500 195,200 68,500 138,600 207,100
Utah (1) .......... -- -- -- 23,100 120,300 143,400
Washington ........ 64,000 78,800 142,800 57,600 95,300 152,900
--------- --------- --------- --------- --------- ---------
Total membership 991,600 2,593,700 3,585,300 1,000,300 2,688,200 3,688,500
========= ========= ========= ========= ========= =========
</TABLE>
(1) At March 31, 1998, Utah had approximately 10,500 Medicaid members.
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31
--------------------
1999 1998
---- ----
<S> <C> <C>
OPERATING STATISTICS
- --------------------
Medical care ratio (health care services as a
percentage of premium revenue):
Consolidated............................................ 84.8% 85.2%
Government.............................................. 87.0% 86.6%
Commercial ............................................. 81.5% 83.1%
Marketing, general and administrative expenses as a
percent of operating revenue.............................. 10.7% 11.9%
Operating income as a percent of operating revenue ........ 4.7% 3.0%
Effective tax rate......................................... 41.4% 48.5%
</TABLE>
9
<PAGE> 12
THREE MONTHS ENDED MARCH 31, 1999
COMPARED WITH THE
THREE MONTHS ENDED MARCH 31, 1998
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 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:
o The California Department of Corporations ("DOC") proposed settlement
with Alabama-based MedPartners Inc. regarding its California
subsidiary, MPN. MPN is a provider organization licensed by the DOC
which arranges health care services to HMO members through arrangements
between HMOs and health care providers, such as hospitals and physician
groups. In March 1999, California regulators seized MPN and appointed a
conservator to oversee MPN. The conservator placed MPN in bankruptcy.
Under a proposed settlement, MedPartners, Inc. will agree to fund MPN's
liabilities to its contracted and non-contracted providers in
California. In addition, certain HMOs and hospitals, including
PacifiCare, will loan MedPartners, Inc. up to $25 million. PacifiCare's
loan will be approximately $10 million. MPN is one of PacifiCare's
significant provider networks in California, covering approximately
380,000 members, or 12 percent of our total membership in California.
See "Provider Insolvency Reserves," and "Liquidity and Capital
Resources" below.
o A decision to seek stockholder approval for an amendment to our
certificate of incorporation to reclassify and combine our Class A and
Class B common stock into a single class of voting common stock. In
addition, we agreed to repurchase approximately 5.9 million shares of
our stock held by UniHealth. The amendment to our certificate of
incorporation is expected to be approved at our 1999 Annual Stockholder
Meeting. See Note 9 of the Notes to Condensed Consolidated Financial
Statements and "Forward Looking Information."
The information below includes both the Medicare and Medicaid lines of business
as part of the government program for the 1998 period presented.
MEMBERSHIP. Total membership decreased three percent to approximately 3.6
million members at March 31, 1999 from approximately 3.7 million members at
March 31, 1998, with the majority of the decrease resulting from the disposition
of Utah. Commercial membership decreased approximately four percent at
March 31, 1999 as compared to the same period in the prior year due to:
o Membership decreases resulting from the disposition of Utah; offset by
o Membership increases primarily in California due to increased sales
efforts.
Government membership decreased approximately one percent at March 31, 1999 as
compared to the same period in the prior year due to:
o Membership decreases resulting from the disposition of Utah; offset by
o Membership increases due primarily to competitor exits in markets in
which Secure Horizons will remain.
GOVERNMENT PREMIUMS. Government premiums increased four percent or $49 million
for the three months ended March 31, 1999 as compared to the same period in the
prior year due to:
o Increases of $52 million from premium rate increases that averaged
approximately three percent;
o Increases of $14 million from net membership increases (excluding
Utah), due to competitors' exits in markets in which Secure Horizons
will remain; offset by
o Decreases of $17 million from membership losses resulting from the
disposition of Utah.
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.
10
<PAGE> 13
COMMERCIAL PREMIUMS. Commercial premiums increased two percent or $17
million for the three months ended March 31, 1999 as compared to the same period
in the prior year. The net increase was a result of:
o Increases of $62 million from premium rate increases that averaged
approximately seven percent;
o Increases of $3 million from net membership increases (excluding Utah),
primarily in California; offset by
o Decreases of $36 million from membership losses resulting from the
disposition of Utah; and
o Decreases of $12 million primarily from discontinued indemnity and
workers' compensation products.
OTHER INCOME. Other income increased 18 percent for the three months ended
March 31, 1999 compared to the same period in the prior year, primarily due to
higher mail order distribution revenues from Prescription Solutions.
CONSOLIDATED MEDICAL CARE RATIO AND PROVIDER INSOLVENCY RESERVES. The
consolidated medical care ratio (health care services as a percentage of premium
revenue) declined for the three months ended March 31, 1999, compared to the
same period in the prior year. The decrease was due to improved commercial
pricing. Provider insolvency costs for the three months ended March 31, 1999
were comparable to the costs for the same period in the prior year. Provider
insolvency reserves include the write-offs of the providers' uncollectable
receivables and 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.
GOVERNMENT MEDICAL CARE RATIO. The government medical care ratio for the three
months ended March 31, 1999 increased compared to the prior year. This increase
was primarily due to increases in capitation and pharmacy benefit enhancements
for Secure Horizons members. These increases were partially offset by premium
rate increases, decreases in non-capitated provider costs and improvements in
pharmaceutical contracting and utilization management.
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 months ended March 31, 1999 decreased due to the following:
o A favorable premium pricing environment;
o Sale of our Utah HMO and workers' compensation subsidiaries;
o Improved provider contracts; and
o Improved specialty product performance.
MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES. As a percentage of operating
revenue, marketing, general and administrative expenses decreased compared to
the prior year because of:
o The Utah disposition;
o The introduction of new technologies;
o The consolidation of our regional customer service operations; and
o The realization of a full year of synergies from the FHP acquisition.
In 1998, we completed the consolidation of our regional customer service centers
from 17 centers to five larger centers. We also implemented a claims imaging
system which has improved our claims turnaround time and reduced claims
processing costs. Marketing, general and administrative expenses for the quarter
ended March 31, 1999 were comparable to the quarter ended December 31, 1998.
NET INVESTMENT INCOME. Net investment income decreased approximately 20 percent
for the three months ended March 31, 1999 compared to the same period in the
prior year due to fewer realized gains on sales of marketable securities and
declining interest rates.
INTEREST EXPENSE. Interest expense decreased approximately 41 percent for the
three months ended March 31, 1999 compared to the same period in the prior year
due to continued repayment of our credit facility and declining interest rates.
PROVISION FOR INCOME TAXES. The effective income tax rate was 41.4 percent for
the three months ended March 31, 1999, compared with 48.5 percent for the same
period in the prior year. The rate declined significantly because:
o Nondeductible goodwill amortization was a smaller percentage of pretax
income;
o We benefited from certain tax strategies, in particular the legal
reorganization of the Company and its subsidiaries;
11
<PAGE> 14
o The 1998 effective tax rate included an increase related to the
dispositions of Utah and the workers' compensation subsidiaries; and
o 1999 investment strategies to date have resulted in an increase in
tax-exempt earnings.
DILUTED EARNINGS PER SHARE. For the three months ended March 31, 1999, net
income was $74 million or $1.61 diluted earnings per share. For the three months
ended March 31, 1998, net income was $41 million or $.90 diluted earnings per
share. The increase in income was due to:
<TABLE>
<S> <C>
Diluted earnings per share - March 31, 1998 $0.90
Improved operations:
MG&A decreases .25
Commercial performance .23
Other income performance, primarily pharmacy .06
Government performance .02
-----
Total improved operations 0.56
-----
Interest income and expense, net 0.03
Income tax rate decrease 0.12
-----
Diluted earnings per share - March 31, 1999 $1.61
=====
</TABLE>
LIQUIDITY AND CAPITAL RESOURCES
OPERATING CASH FLOWS. PacifiCare's consolidated cash, equivalents and marketable
securities decreased to $1.1 billion at March 31, 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 and the April 1999 HCFA payment was paid in April 1999.
Cash flows from operations, excluding the impact of deferred revenue, were $90
million at March 31, 1999 and $77 million at March 31, 1998, and were primarily
attributable to improvements in net income.
INVESTING ACTIVITIES. Net cash used in investing activities was $48 million at
March 31, 1999 and $84 million at March 31, 1998. The decreases were mainly
attributable to a decrease in purchases of marketable securities.
FINANCING ACTIVITIES. Financing activities used $72 million of cash in the
quarter ended March 31, 1999, primarily because we paid $75 million on our
credit facility during the quarter. Net cash provided by financing activities
was $10 million for the three months ended March 31, 1998. Since the inception
of the repurchase program through March 31, 1999, we had repurchased 784,000
shares of our Class A and Class B common stock for $45 million. During 1998, we
borrowed $30 million under the credit facility to repurchase shares of our
outstanding common stock, and as of March 31, 1998, we had repurchased 448,000
shares of our Class A and Class B common stock for an aggregate amount of $23
million. Cash received for the issuance of common stock provided $3 million in
1999 and $6 million in 1998. We paid approximately $3 million of preferred stock
dividends in 1998. See Note 9 of the Notes to Condensed Consolidated Financial
Statements.
OTHER BALANCE SHEET CHANGE EXPLANATIONS
RECEIVABLES, NET. Receivables, net increased by $47 million from
December 31,1998 as follows:
o $21 million increase in provider receivables;
o $17 million increase in premium receivables; and
o $9 million net increase in trade and other receivables.
We administer claims payments for some of our capitated providers. Claims paid
in the first quarter exceeded capitation withheld, increasing provider
receivables. Provider receivables created in the first quarter will be recovered
through capitation withhold adjustments throughout the year.
Premium receivables increased $10 million for open enrollment, $4 million for
FEHBP members and $3 million for Medicare premiums. Open enrollment increases
are typical in the first quarter as membership information is gathered and
reconciled. OPM will be paying a portion of the 1999 FEHBP premiums in a lump
sum payment in the third quarter. Amounts earned for FEHBP members but not yet
collected will continue to increase in the second quarter. We receive and
12
<PAGE> 15
reimburse retroactive Secure Horizons premiums as membership changes. At
March 31, 1999, our retroactive premiums collected in April 1999 increased
compared to December 31, 1998 because of membership growth. Trade and other
receivables increased primarily due to higher rebate receivables as a result of
higher prescription drug utilization.
GOODWILL AND INTANGIBLE ASSETS, NET. Goodwill and intangible assets decreased by
$15 million from 1998 as follows:
o $19 million of goodwill and intangible amortization expense; offset by
o $4 million increase related to the acquisition of approximately 15,000
commercial members in Texas.
MEDICAL CLAIMS AND BENEFITS PAYABLE. Medical claims and benefits payable
increased by $26 million from December 31, 1998 as follows:
o $21 million increase in claims payable, both our risk and claims
administered on behalf of providers;
o $20 million increase in provider capitation and incentive liabilities;
offset by
o $9 million net decrease in provider insolvency reserves, consisting of
$7 million in additional provisions and $16 million in payments,
primarily to Nevada providers; and
o $6 million decrease in claims incurred but not yet reported, primarily
due to Nevada providers shifting to capitated contracts on January 1,
1999.
The increase in claims payable was primarily due to increased monies withheld
for claims administered on behalf of providers primarily in California, Colorado
and Nevada. These increases were partially offset by decreases due to contract
changes. The increase in provider capitation and incentive liabilities was
primarily caused by higher capitation liabilities due to membership
retroactivity and premium increases from open enrollment. These increases were
partially offset by decreases due to incentive payments to providers.
MATERIAL COMMITMENTS. On May 4, 1999, we committed to repurchase approximately
5.9 million of our shares of common stock from UniHealth in installments during
1999 through February 2001. In addition, we committed to pay UniHealth $60
million upon receipt of stockholder approval of the amended and restated
certificate of incorporation. If the stockholders approve the amended
certificate, then we expect to repurchase up to 2,000,000 shares during 1999 at
a price equal to the average closing price for the 30 trading days preceding the
repurchase. We expect to use internally generated funds for the $60 million
payment and the initial stock purchase.
NEW ACCOUNTING PRONOUNCEMENTs. See Note 8 of the Notes to Condensed Consolidated
Financial Statements for a discussion of future application of accounting
standards.
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 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.
DILUTED EARNINGS PER SHARE. We estimate that 1999 diluted earnings per share
will be 40 to 45 percent greater than 1998 diluted earnings per share of $4.40.
The drivers of this growth are discussed below.
MEMBERSHIP. We expect government membership to increase three to four percent by
December 31, 1999 compared to December 31, 1998. We plan to expand our
membership retention programs and target group retiree members in our existing
markets. We also expect membership increases as competitors exit markets in
which Secure Horizons will remain. These increases will be partially offset by
our exit from certain rural markets.
We expect commercial membership for the year ended December 31, 1999 to increase
two to four percent compared to 1998. The majority of the growth will be in
California where we plan to focus our marketing efforts on membership renewal
and national accounts.
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<PAGE> 16
MEMBERSHIP RISK FACTORS. An unforeseen loss of profitable membership could have
an effect on our financial position, results of operations and cash flows.
Factors that could contribute to the loss of membership include:
o Failure to obtain new customers or retain existing customers;
o The effect of premium increases and benefit changes;
o Reductions in work force by existing customers;
o Negative publicity and news coverage;
o Inability of marketing and sales plans to attract new customers; or
o The loss of key executives or key employees.
PREMIUMS. For 1999, we expect premium increases in both the commercial and
Medicare lines of business. We expect a HCFA premium rate increase of between
three and four percent in January 2000. Additionally, our emphasis continues to
be on renewing commercial employer contracts with price increases sufficient to
maintain or improve margin performance. The price increases in our commercial
product line are expected to range from zero to 12 percent depending upon
employer size, benefit design, geographic market and other factors. While we
expect to increase commercial premiums without experiencing significant
membership losses, we could experience membership losses as a result.
OTHER INCOME. In 1999, we expect other income to be higher than 1998 because of
higher revenues from Prescription Solutions.
HEALTH CARE PROVIDER CONTRACTS. Our profitability depends, in part, on our
ability to control health care costs while providing quality care. The
profitability and the success of our business strategy also depends on our
ability to attract and retain a network of qualified health care providers in
each geographic area we serve. To that end, we expect to make increased
capitation payments to various providers during the latter half of the year.
Maintaining capitated arrangements with solvent providers, especially in the
Nevada market, will be important to improving 1999 results of operations.
Securing cost-effective contracts with existing and new physician groups has
become more difficult due to increased competition. Failure to secure
cost-effective contracts may result in a loss in membership or a higher medical
care ratio. Additionally, the negotiation of provider contracts may be impacted
by unfavorable state and federal legislation and regulation discussed below. Our
inability to contract with providers, loss of contracts with providers,
inability of providers to provide adequate care, or insolvency of providers
could materially affect us. Based on current information, we believe that our
contingency plans are adequate to cover the potential impact of contract
terminations.
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 our
performance in 1999 by taking steps to minimize our risk associated with
providers. We believe that the March 31, 1999 provider insolvency reserves are
adequate to cover the cost of health care services rendered through March 1999
that may not be paid by insolvent or unstable providers. We believe our
contingency plans for shifting the membership or assisting the provider to
obtain and maintain stability are adequate to cover the risk. We have and may
continue to incur additional costs as a result of entering into new contracts.
The effect of these risks and the need for additional provider 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.
GOVERNMENT MEDICAL CARE RATIO. We expect the 1999 government medical care ratio
to increase 60 to 100 basis points from 1998. Changes in premium mix, increases
in capitation for contracts not yet renegotiated and higher pharmacy costs, due
primarily to benefit enhancements, will increase the medical care ratio. These
will be partially offset by premium rate increases, recontracting efforts in
Nevada and California, improvements in pharmaceutical contracting and
utilization management and our exit of rural markets in certain states plus the
disposition of Utah.
COMMERCIAL MEDICAL CARE RATIO. In 1999, we expect the commercial medical care
ratio to improve from 1998. We expect improvements as we continue to implement
premium increases, renegotiate provider contracts and implement capitated
contracts. Moreover, higher premium rates offered during the summer renewal
period should continue to result in the elimination of some high medical care
ratio business. Improvements may be partially offset by increases in capitation,
pharmacy drug costs and provider payments that we expect to pay in the latter
part of the year.
MEDICAL CARE RATIO RISK FACTORS. The government and commercial medical care
ratio expectations discussed above could be affected by various uncertainties,
including:
o Medical and prescription drug costs that are rising faster than premium
increases;
14
<PAGE> 17
o Increases in utilization and costs of medical services;
o The effect of actions by competitors or groups of providers; or
o Termination of provider contracts, provider insolvency or renegotiation
of such contracts at less cost-effective rates or terms of payment.
MARKETING, GENERAL AND ADMINISTRATIVE SUPPORT. In 1999, marketing, general and
administrative expenses as a percentage of operating revenue are expected to
decline because we expect to realize continued efficiencies from the FHP
acquisition and new technologies that are implemented. California'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. The
need for additional advertising, marketing, administrative, or management
information systems expenditures, and the inability of marketing and sales plans
to attract new customers, could impact marketing, general and administrative
expenses.
IMPAIRMENT OF LONG-LIVED ASSETS. As circumstances warrant, we determine whether
the realizable value of long-lived assets such as property and equipment, real
estate and goodwill, are less than the value carried on the consolidated
financial statements. We believe that any impairment of such long-lived assets
would not materially affect our consolidated financial position. However,
impairment charges, if material, could have an effect on our results of
operations or cash flows of a future period.
EFFECTIVE TAX RATE. The 1998 effective tax rate was 47.5 percent. We expect the
1999 effective tax rate to be between 41 and 42 percent because:
o Nondeductible goodwill amortization is expected to be a smaller
percentage of pretax income. As a result, the effective tax rate will
decrease by approximately one to two percent.
o A full year's benefit of certain tax strategies, in particular the
legal reorganization of the Company and its subsidiaries, will be
realized in 1999. These tax strategies are expected to reduce the
effective tax rate by two to three percent.
o The 1998 effective tax rate included a more than one percent increase
related to the dispositions of Utah and the workers' compensation
subsidiary. This is not expected to reoccur.
o 1999 investment strategies to date have resulted in an increase in
tax-exempt earnings, which are expected to decrease the effective tax
rate on a year to date basis by approximately one percent.
There can be no assurance that these tax strategies will be successful, that
pretax income will increase as projected or that future business decisions will
not impact the current effective tax rate.
YEAR 2000. PacifiCare has implemented a Year 2000 compliance program to address
all major computing information systems, including core application systems,
networks, desktop systems, infrastructure, and critical information supply
chains. In addition to all major information systems, we are verifying that all
date fields and calculations used in critical business processes will be Year
2000 compliant. Under the program we are also addressing 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 includes the following phases for our internal
systems, which are listed in logical order, but are being addressed concurrently
as appropriate:
o 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.
o 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 are not Year 2000 compliant, a
preliminary remediation plan has been developed that includes the Year
2000 remediation, action required and the time and resources needed to
accomplish it. We have established priorities based on the relative
business critical function of each system component.
o Remediation, Testing, and Certification. We are in the process of
testing each computer information system and component for Year 2000
compliance, using industry standards. If actual test results are
acceptable, we certify the tested system or component as Year 2000
compliant. If the test identifies any issues, we take steps to correct
the system or component and then retest the corrected system or
component as necessary to achieve certified compliance. To date, we
have tested and certified as Year 2000 compliant 95 percent of our
internal systems and components other than the FHP core system
described below. We expect to complete testing of all internal systems
(except the FHP core systems) by June 30, 1999.
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<PAGE> 18
o Implementation and Close. There will be a final review and confirmation
that the remediated systems and components have met all Year 2000
compliance objectives.
The program incorporates a regular reporting process, which helps us to monitor
and measure our progress toward Year 2000 compliance against defined goals.
Through this reporting process we can focus resources on any Year 2000 issue as
necessary.
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 first quarter
of 1999 are 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 a detailed project plan for modifying the FHP
systems to be Year 2000 compliant in phases during 1999. Based upon an outside
consultant's recommendations and internal analysis, we estimate that the total
cost to make the FHP systems Year 2000 compliant ranges from $5 to $9 million.
Through March 31, 1999, our costs for remedying the FHP systems have been
approximately $1 million. Prior to 1999, our costs incurred were approximately
$2 million.
We are also contacting 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 are seeking reasonable
assurances with respect to Year 2000 compliance. Our priority is 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 anticipate developing
business process contingency plans by June 1999 for external sources that appear
to be at risk.
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 are
developing a cash receipts contingency plan.
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. In preparing contingency plans, we are developing risk
reduction strategies. However, some risks may be beyond our control. Further,
our marketing, general and administrative expenses could increase due to Year
2000 compliance expenditures.
OFFICE OF PERSONNEL MANAGEMENT CONTINGENCIES. OPM generally audits health plans
which it contracts with every five or six years. We currently have several
audits with OPM that are in various stages. We intend to negotiate with OPM and
DOJ on all unresolved matters to attain a mutually satisfactory result. We
cannot assure that the negotiations will conclude satisfactorily, or that there
will not be additional liability upon completion of the audits. However, we
believe that any ultimate liability in excess of amounts already set aside would
not materially affect our consolidated financial position. The liability, if
material, could have an effect on results of operations or cash flows of a
future quarter.
LIQUIDITY AND CAPITAL RESOURCES. Additional borrowings on our credit facility
may be necessary if:
o We pay UniHealth $60 million in consideration for their affirmative
vote on the reclassification, their agreement to allow PacifiCare to
purchase its shares and the other agreements contained in the stock
purchase agreement;
o We repurchase additional shares of outstanding stock, including the
repurchase of approximately 5.9 million shares held by UniHealth;
o HCFA and OPM are unable to remit funds as a result of Year 2000
compliance issues; and
o We have additional risk-based capital requirements.
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<PAGE> 19
Subject to approval of the transaction, PacifiCare will repurchase UniHealth
shares on the following dates and in the following installments:
<TABLE>
<CAPTION>
AGGREGATE
PER SHARE REPURCHASE PRICE
------------ ----------------
APPROXIMATE PURCHASE DATE SHARES LOW HIGH LOW HIGH
- ------------------------- ------ --- ---- --- ----
(IN MILLIONS)
<S> <C> <C> <C> <C> <C>
August, 1999 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
One time payment 60 60
--------- ---- ----
Total payment range 5,909,500 $497 $769
========= ==== ====
</TABLE>
We have a $1.5 billion credit facility under which we had $475 million in
borrowings outstanding as of March 31, 1999. The terms of our credit facility
permit us to repurchase up to $500 million of our outstanding common stock.
Depending on the repurchase prices of the UniHealth shares and other repurchases
of our common stock, PacifiCare may need to obtain an amendment under the credit
facility. If an amendment cannot be obtained, PacifiCare would be required to
negotiate a new credit facility.
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,
Washington is the only state where we have HMO operations that has 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. Further, we believe that cash flows from
operations or, if necessary, borrowings under our credit facility, will be
sufficient to fund any additional risk-based capital requirements.
LEGISLATION AND REGULATION. Federal and state legislation and regulation
significantly affect us. Almost 59 percent of our revenue, and an even greater
percentage of our profit, comes from our government programs, the majority of
which is Medicare business. Changes in state and federal legislation or
regulation could cause actual results to differ materially from the expected
results discussed throughout this document. Changes that could effect us
materially include:
o Limitations on premium levels;
o Increases in minimum capital and reserves and other financial viability
requirements;
o Prohibition or limitation of capitated arrangements or provider
financial incentives;
o Benefit mandates (including mandatory length of stay and emergency room
coverage, many of which become effective in 1999);
o Limitations on the ability to manage care and utilization of any
willing provider and direct access laws; and
o Adoption on the federal and/or state level of legislation that holds
HMOs liable for malpractice.
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<PAGE> 20
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.
18
<PAGE> 21
PART I: FINANCIAL INFORMATION
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.
19
<PAGE> 22
PART II: OTHER INFORMATION
ITEM 1: LEGAL PROCEEDINGS
No changes.
ITEM 2: CHANGES IN SECURITIES
None.
ITEM 3: DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5: OTHER INFORMATION
None.
ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibit Index
Exhibit 15 Letter re: Unaudited Interim Financial Information
Exhibit 20 Independent Accountants' Review Report
Exhibit 27 Financial Data Schedule (filed electronically)
b) We did not file any reports on Form 8-K during the quarter ended
March 31, 1999.
20
<PAGE> 23
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
PACIFICARE HEALTH SYSTEMS, INC.
(Registrant)
Date: May 7, 1999 By: /s/ ALAN R. HOOPS
--------------- -------------------------------
Alan R. Hoops
Chairman of the Board and
Chief Executive Officer
Date: May 7, 1999 By: /s/ ROBERT B. STEARNS
--------------- ----------------------------------
Robert B. Stearns
Executive Vice President
and Chief Financial Officer
21
<PAGE> 24
EXHIBIT INDEX
Exhibit 15 Letter re: Unaudited Interim Financial Information
Exhibit 20 Independent Accountants' Review Report
Exhibit 27 Financial Data Schedule (filed electronically)
<PAGE> 1
EXHIBIT 15
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 May 3, 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 March
31, 1999 and 1998.
ERNST & YOUNG LLP
Los Angeles, California
May 3, 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 and the
related condensed consolidated statements of operations and cash flows of
PacifiCare Health Systems, Inc. (the "Company") as of March 31, 1999 and 1998,
and for the three-month periods then ended. 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
May 3, 1999
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from PacifiCare
Health Systems, Inc.'s consolidated balance sheets as of March 31, 1999 and
related consolidated statements of operations for the three months ended March
31, 1999 and is qualified in its entirety by reference to such financial
statements.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> MAR-31-1999
<CASH> 247,587
<SECURITIES> 901,299
<RECEIVABLES> 329,834
<ALLOWANCES> 6,902
<INVENTORY> 0
<CURRENT-ASSETS> 1,638,502
<PP&E> 292,208
<DEPRECIATION> 116,951
<TOTAL-ASSETS> 4,220,039
<CURRENT-LIABILITIES> 1,200,104
<BONDS> 0
0
0
<COMMON> 464
<OTHER-SE> 2,314,043
<TOTAL-LIABILITY-AND-EQUITY> 4,220,039
<SALES> 0
<TOTAL-REVENUES> 2,451,909
<CGS> 0
<TOTAL-COSTS> 2,053,920
<OTHER-EXPENSES> 281,749
<LOSS-PROVISION> (106)
<INTEREST-EXPENSE> 10,293
<INCOME-PRETAX> 126,254
<INCOME-TAX> 52,270
<INCOME-CONTINUING> 73,984
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 73,984
<EPS-PRIMARY> 1.62
<EPS-DILUTED> 1.61
</TABLE>
