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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K/A
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended September 30, 1996
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 0-14181
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PACIFICARE HEALTH SYSTEMS, INC.
(Exact name of registrant as specified in its Charter)
Delaware 33-0064895
(State or other jurisdiction of (IRS Employer Identification Number)
incorporation or organization)
5995 Plaza Drive, Cypress, California 90630-5028
(Address of principal executive offices, including zip code)
(Registrant's telephone number, including area code) (714) 952-1121
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant
to Section 12(g) of the Act: Class A Common Stock, par value $0.01
Class B Common Stock, par value $0.01
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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 ___
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K [ ].
The aggregate market value of voting stock held by non-affiliates of the
Registrant on December 31, 1996, was approximately $388,248,000.
The number of shares of Class A Common Stock and Class B Common Stock
outstanding at December 31, 1996, was 12,379,658 and 18,921,555, respectively.
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PART I
ITEM 1. BUSINESS
PacifiCare-Registered Trademark- Health Systems, Inc. (the "Company" or
"PacifiCare") is one of the nation's leading managed health care services
companies, serving approximately 2,031,000 HMO members in its commercial,
Medicare and Medicaid product lines as of September 30, 1996. The Company is
also a leader in the management, development and marketing of diversified health
maintenance organization ("HMO") products and related services. The Company
operates HMOs in California, Florida, Oklahoma, Oregon, Texas and Washington,
which as of September 30, 1996 had a combined commercial HMO membership of
approximately 1,434,000 members. Through internal growth and strategic
acquisitions, the Company believes it has built a strong competitive position in
California and has expanded operations into new and existing geographic markets.
The Company, through its Secure Horizons-Registered Trademark- programs,
operates the largest and one of the fastest growing Medicare risk programs in
the United States (as measured by membership and membership growth,
respectively) with approximately 554,000 members enrolled as of September 30,
1996. The Company believes that its Secure Horizons programs are attractive to
Medicare beneficiaries because they provide a more comprehensive package of
benefits than those available under traditional Medicare and they substantially
reduce the member's administrative responsibilities.
The Company's commercial and government (Medicare and Medicaid) members are
provided some or all of the following health care services: primary and
specialty physician care, hospital care, laboratory and radiology services,
prescription drugs, dental and vision care, skilled nursing care, physical
therapy and psychological counseling. The Company also offers certain specialty
products and services to group purchasers and to other managed care
organizations and their beneficiaries, including pharmacy benefit management,
life and health insurance, behavioral health services, dental and vision
services and Medicare risk management services.
The Company believes that its ability to offer a comprehensive range of
products and services, combined with its long-term relationships with health
care providers will enable the Company to respond effectively to the changing
needs of the health care marketplace. The Company anticipates that it will
continue to be among the nation's leading managed health care services
companies.
RECENT DEVELOPMENTS
On August 5, 1996, the Company announced that it had entered into a
definitive agreement and plan of reorganization with FHP International
Corporation, the Fountain Valley-based health care services company ("FHP"), in
which the Company will acquire FHP for a total purchase price of approximately
$2.1 billion (the "FHP Transaction"). FHP is a diversified health care services
company which, through its HMO subsidiaries, serves approximately 1.9 million
members in 11 states and Guam. FHP reported revenues of $4.2 billion and net
income of $44.2 million for the fiscal year ended June 30, 1996. FHP also
operates a health indemnity insurer, a workers' compensation insurer and a
national preferred provider organization. FHP operates one of the largest
providers of health care services for Medicare beneficiaries in the United
States. As a result of the FHP Transaction, the Company and FHP will become
wholly-owned subsidiaries of N-T Holdings, Inc., a corporation formed to effect
the FHP Transaction ("PacifiCare Holding"). The FHP Transaction will result in
the current operations of the Company in California, Florida, Oklahoma, Oregon,
Texas and Washington being expanded to include operations in Arizona, Colorado,
Illinois, Indiana, Kentucky, New Mexico, Nevada, Ohio, Utah and Guam.
Terms of the FHP Transaction call for holders of FHP common stock to
receive a package of consideration equal, at the time of signing, to
approximately $35 per share of FHP common stock of which $17.50 per FHP share of
common stock will be paid in cash. Holders of FHP common stock will also
receive a total of 2,350,000 shares of Class A Common Stock, par value $0.01 per
share, of PacifiCare Holding (the "PacifiCare Holding Class A Common Stock")
with the remaining consideration to be paid in shares of PacifiCare Holding
Class B Common Stock, par value $0.01 per share (the "PacifiCare Holding Class B
Common Stock"). Holders of FHP preferred stock will receive either: $14.113 in
cash and one-half share of PacifiCare Holding preferred stock, assuming approval
of an amendment to the FHP Restated Certificate of Incorporation (or an
irrevocable election by the holder of FHP preferred stock is made); or if the
amendment is not approved (or an irrevocable election by the holder of FHP
preferred stock is not made) (a) $25.00 in cash, (b) a mix of cash, PacifiCare
Holding Class A and Class B
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Common Stock determined by a formula described in the agreement and plan of
reorganization, or (c) the consideration that would have been received had the
FHP preferred stock been converted into FHP common stock immediately prior to
the consummation of the FHP Transaction.
The FHP Transaction is subject to various federal and state regulatory
approvals, approval of both the Company's and FHP's shareholders and other
customary closing conditions and is expected to close in February 1997. The FHP
Transaction and any similar acquisitions could affect the Company's ability to
integrate and manage its overall business effectively. In addition, the FHP
Transaction is key to the Company's business strategy as it offers significant
synergies creating a combined company that would be better able to respond to
the needs of consumers and customers, the increased competitiveness of the
health care industry and the opportunities that changes in the health care
industry might bring. See "Business Strategy." There can be no assurance that
the Company will be able to successfully integrate the administrative,
management and service operations of FHP's and PacifiCare's subsidiaries, that
such integration will occur in a timely or efficient manner, if at all, or that
the uncertainty associated with such integration will not result in the loss of
providers, employers, members or key employees. The failure to achieve such
integration in a timely or efficient manner could materially and adversely
affect the Company.
To focus on the challenges which may arise as a result of the FHP
Transaction, the Company intends to dispose of various business operations.
These include the potential sale of its Florida operations and certain specialty
products and services.
PacifiCare of Florida ("PCFL") was established in 1994 through the
acquisition of two health plans which resulted in more than $62.1 million of
goodwill recognized in purchase accounting. As of September 30, 1996, PCFL had
approximately 41,000 members in small group, individual and Medicaid health
plans. The business strategy for PCFL profitability was based on the launching
of the Company's Secure Horizons program in Florida. In response to the FHP
Transaction and the considerable amount of resources which will be needed to
integrate FHP's operations with those of the Company, assuming the FHP
Transaction is consummated, the Company decided to explore options with respect
to PCFL's operations, including a possible sale. Accordingly, the Company
withdrew its HCFA application in September 1996. Consequently, the Company
recognized a $58.7 million ($34.1 million or $1.08 per share, net of tax)
impairment of PCFL goodwill and other intangible assets in the fourth quarter of
fiscal year 1996 (See Note 11 of the Notes to the Consolidated Financial
Statements). The Company expects to continue operations in Florida until a sale
is consummated or the Company makes alternative arrangements. A comprehensive
plan to dispose of PCFL's business may involve a restructuring charge in future
periods.
THE MANAGED CARE INDUSTRY
In response to the rapid increases in health care costs, employers,
insurers, government entities and health care providers have sought alternative
health care delivery systems, such as HMOs, that provide better controls on
rising costs without sacrificing quality. HMOs provide members with access to
quality health care, while employing a business strategy and management systems
designed to encourage more cost-effective use of health care delivery systems.
To accomplish these objectives, the following basic HMO models have
evolved: the staff model, the group model, the network model and the IPA model.
These models are distinguishable by the HMO's relationship with its physician
providers and the capital investment required by the HMO to support its
operations. Under the staff model, the HMO employs physicians and, ordinarily,
provides the facility in which the physicians see patients. Under the staff
model, physicians receive a salary (and sometimes a bonus) based on the
performance of the HMO. Under the group model, the HMO contracts with one large
multi-specialty medical group, which receives a monthly fixed fee for each HMO
member (capitation), regardless of the medical services provided to each member.
Under the network model, the HMO contracts with many physician groups generally
though capitation. Finally, under an individual practice association ("IPA")
model, the HMO contracts with independent physicians who are broadly dispersed
throughout a community and who see patients in their own offices in exchange for
a monthly capitation or a discounted fee for service. The Company primarily
operates network model HMOs and, to a lesser extent, IPA and group model HMOs.
To enhance cost and quality control, the Company may, in certain instances,
expand its current involvement with health care providers by making investments
in their operations or in health care facilities.
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OPERATIONS, PRODUCTS AND SERVICES
HMO OPERATIONS
The Company's total membership has grown from approximately 726,000 members
at September 30, 1991 to approximately 2,031,000 members at September 30, 1996,
a 23 percent compound annual growth rate. The Company's membership at September
30, 1996 by state and program is as follows:
GOVERNMENT
(MEDICARE & PERCENT
COMMERCIAL MEDICAID) TOTAL OF TOTAL
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California 962,409 411,492 1,373,901 67.6%
Florida 38,455 2,627 41,082 2.0%
Oklahoma 117,279 22,636 139,915 6.9%
Oregon 112,736 45,433 158,169 7.8%
Texas 113,063 60,692 173,755 8.6%
Washington 90,533 53,351 143,884 7.1%
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Total Membership 1,434,475 596,231 2,030,706 100.0%
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COMMERCIAL PROGRAMS
The Company's commercial membership has grown from approximately 567,000
members at September 30, 1991 to approximately 1,434,000 members at September
30, 1996, a 20 percent compound annual growth rate. The Company offers a
comprehensive range of products, including HMOs, Preferred Provider Organization
("PPO") and Point of Service ("POS") plans, which combine the features of an HMO
(a defined provider network providing care to members with reduced deductibles
and co-payments) with the features of a traditional indemnity insurance product
(the option to use any physician, with higher deductibles and co-payments). The
Company has historically focused on the larger employer market, but has recently
entered the smaller employer and individual markets. The Company believes that
these markets have lower HMO penetration levels than the larger employer market
and represent significant growth opportunities.
For the commercial employer market, the Company offers a range of benefit
plan designs that vary in the amount of member co-payments. The Company
believes that nominal co-payments are useful in helping contain the costs of
health care without providing a barrier to members seeking needed health care
services. For an additional premium, the Company offers employers specialty
managed care products and services, including dental and vision care and
behavioral health care services. These optional services are generally provided
through subcontracting or referral relationships with other health care
providers.
The Company's 25 largest employer groups as of September 30, 1996 accounted
for approximately 31 percent of the total commercial membership, with the
largest employer group accounting for approximately 5 percent of total
commercial membership. The Company's five largest employer groups, in the
aggregate, accounted for approximately 16 percent of its commercial revenue for
the fiscal year ended September 30, 1996.
SECURE HORIZONS PROGRAMS
The Company offers health care services to Medicare beneficiaries through
its Secure Horizons programs. The Secure Horizons programs represent the
largest and one of the fastest growing Medicare risk programs in the United
States (as measured by membership and membership growth, respectively). Secure
Horizons membership has grown from approximately 159,000 members at September
30, 1991 to approximately 554,000 members at September 30, 1996, a 28 percent
compound annual growth rate. The Company believes the Medicare market continues
to offer significant growth opportunities since only approximately 10 percent of
the country's Medicare beneficiaries are enrolled in Medicare risk HMO programs
such as those offered by the Company. The Company will seek to continue its
growth in the Medicare risk arena by entering into new geographic markets with
its Secure Horizons programs.
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The Company has been offering Secure Horizons since 1985, pursuant to
annual contracts ("Medicare risk contracts") with the Health Care Financing
Administration ("HCFA"). These Medicare risk contracts entitle the Company to a
fixed fee-per-member premium, which is based upon the average cost of providing
traditional fee-for-service Medicare benefits to the Medicare population in each
county. The risk contracts are subject to periodic unilateral revisions by HCFA
based upon updated demographic information relating to the Medicare population
and the cost of providing health care in a particular geographic area. The
Company's Medicare risk contracts are automatically renewed every 12 months
unless the Company or HCFA elects to terminate them. HCFA may unilaterally
terminate the Company's Medicare risk contracts if the Company fails to continue
to meet compliance and eligibility standards. Termination of the Company's
Medicare risk contracts could have a material adverse effect on the Company.
The Company, however, has no reason to believe that such termination will occur.
The Company believes that its Secure Horizons programs are attractive to
Medicare beneficiaries because they provide a more comprehensive range of
benefits than the benefits offered under traditional Medicare and because these
programs substantially reduce the beneficiaries' administrative
responsibilities. Each Secure Horizons member enrolls individually and may
disenroll by providing 30 days' notice. The Company believes that its Secure
Horizons programs have one of the lowest disenrollment rates among Medicare risk
plans.
Because the average use of health care services by Medicare beneficiaries
greatly exceeds the use of services by those who are under the age of 65, the
Company's Medicare risk plans generate substantially larger per member revenue
than the Company's commercial plans. Premium revenue for each Secure Horizons
member is usually more than three times that of a commercial member reflecting
in part, the higher medical and administrative cost of serving a Medicare
member. As a result, although membership in the Secure Horizons programs
represented only approximately 27 percent of the Company's membership at
September 30, 1996, it accounted for 57 percent of the consolidated premium
revenue for the fiscal year ended September 30, 1996 and an even larger
percentage of the Company's operating profit. The Secure Horizons programs are
subject to certain risks relative to commercial programs, such as higher
comparative medical costs, higher levels of utilization, government and
regulatory reporting requirements, the possibility of reduced or insufficient
government reimbursement in the future and higher marketing and advertising
costs associated with selling to individuals rather than to groups.
The Company's Secure Horizons programs are not permitted, under federal
regulations, to account for more than one-half of the Company's total HMO
members in each of the Company's non-contiguous geographic state markets. This
limitation may constrain the rate of growth or expansion of the Company's Secure
Horizons programs in markets where the Company is able to add Medicare members
at a faster rate than commercial members.
In response to the needs of employers to provide cost-effective health care
coverage to their retired employees who may or may not be currently entitled to
Medicare, the Company developed the Secure Horizons retiree product. This
product takes advantage of the Company's expertise in providing health care to
seniors. The provider networks are similar to the ones offered to the Company's
Secure Horizons enrollees, and the premium is based on the revenue requirements
needed to provide services to Secure Horizons enrollees. Moreover, the retiree
product provides the Company with access to individuals who, once familiar with
the Company's services and delivery system, may enroll in Secure Horizons
programs when they become entitled to Medicare benefits.
MEDICAID HMO PROGRAMS
Since 1993, the Company has arranged for health care services to Medicaid
beneficiaries through certain of its HMO subsidiaries pursuant to annual
contracts with the Department of Health and Human Services ("HHS"). Medicaid is
a joint federal and state program designed to provide health care coverage for
the indigent. The Company's Medicaid programs generally operate similarly to
the Company's Secure Horizons programs with the Company receiving a capitated
payment for each Medicaid member from HHS similar to payments received by the
Company from HCFA in connection with its Secure Horizons programs. Currently,
the Company arranges for the provision of health care services to Medicaid
beneficiaries in California, Florida, Oregon and Washington. The Company
expects to de-emphasize its Medicaid programs in all markets in fiscal year
1997, and accordingly, expects to have little, if any, Medicaid membership by
fiscal year end. The Company does not believe this will materially affect the
Company's consolidated financial position, results of operations or cash flows.
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SPECIALTY MANAGED CARE PRODUCTS AND SERVICES
In addition to its HMO operations, the Company provides a range of
specialty managed care products and services. These products and services are
offered to HMOs, insurers, employers, governmental entities, providers and PPOs
through the following affiliated operations:
PRESCRIPTION SOLUTIONS-Registered Trademark- was established in May 1993 to
offer pharmacy benefit management services. Clients of Prescription Solutions
have access to a pharmacy provider network that features independent and chain
pharmacies, as well as a variety of cost and quality management capabilities.
In January 1995, Prescription Solutions acquired Preferred Solutions, a San
Jose-based pharmacy benefit management company. The acquisition of Preferred
Solutions enables Prescription Solutions to provide fully integrated services,
including mail order distribution, an extensive network of retail pharmacies,
claims processing and sophisticated drug utilization reporting. In addition,
the Company believes the acquisition of Preferred Solutions makes Prescription
Solutions one of the industry's 10 largest pharmacy benefit management companies
covering more than 3.5 million lives.
PACIFICARE LIFE AND HEALTH INSURANCE COMPANY-SM- ("PLHIC") offers employer
groups managed health care insurance products which have been integrated with
the Company's existing HMO products to form multi-option health benefits
programs. PLHIC is a life and health insurance company licensed to operate in
the District of Columbia and 37 states, including California, Florida, Oklahoma,
Oregon, Texas and Washington.
PACIFICARE BEHAVIORAL HEALTH OF CALIFORNIA, INC. is a licensed specialized
health care service plan which provides behavioral health care services,
including chemical dependency benefit programs, in California directly to
corporate customers and indirectly through the Company's California HMO to its
commercial members. Outside of California, PacifiCare Behavioral Health, Inc.
contracts with various HMOs, insurers and employers to manage their respective
mental health and chemical dependency benefit programs.
CALIFORNIA DENTAL HEALTH PLAN, INC. ("CDHP") is a licensed specialized
health care service plan which provides prepaid dental and optometric benefits
for individuals, including members of PacifiCare's California commercial and
Secure Horizons programs and employer groups. CDHP continues to market
independently of the Company's California HMO and to provide dental and vision
benefits to its members.
BUSINESS STRATEGY
The Company's business strategy is to solidify its position as one of the
leading managed health care services companies by: marketing a broader range of
managed care products and services; capitalizing on its experience in developing
long-term relationships with health care providers; expanding its Secure
Horizons Medicare programs and selectively expanding into new markets to further
its Medicare risk growth. Growth in new markets has resulted from the Company
building membership through expansion of its existing HMOs into additional
geographic markets within the same state and through acquisitions. The Company
continually evaluates opportunities to expand its business and considers whether
to invest or cease offering the products of certain of its businesses. The
opportunities may include acquisitions or dispositions of specialty managed care
services programs or of insurance and health plan operations. In response to
the evolving health care industry and to advance its business strategy, the
Company announced on August 5, 1996 its proposed acquisition of FHP. See
"Recent Developments."
HEALTH CARE PROVIDER RELATIONSHIPS
The Company's HMOs contract with more than 555 physician groups,
representing over 44,000 primary care and specialist physicians, and 533
hospitals to arrange for a comprehensive range of health care services for their
members. The profitability of the Company and the success of its long-range
business plans depends upon its ability to attract and retain qualified health
care providers. Contracts with health care providers are commonly negotiated on
an annual basis. Generally, there is no requirement that the provider continue
its relationship with the Company upon expiration of the annual period. The
Company has, however, entered into a number of provider service contracts with
terms up to 10 years.
The Company's ability to expand is dependent, in part, on competitive
premium pricing and its ability to secure cost effective contracts with
additional physicians or to ensure that existing physician groups expand their
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operations to accommodate the Company's new HMO membership. Achieving such
objectives with respect to competitive premium pricing and physician contracts
is becoming more difficult due to increasing competition. In addition, increased
competition in the health care industry has resulted in the consolidation of
health care providers, resulting in larger provider groups being created and
fewer groups with which the Company can contract. Further, the financial
viability of the resulting provider groups may be adversely affected by
consolidation, rendering them unable to adequately service HMO members and meet
contractual obligations. Inability to contract, loss of contracts with
providers or inability to service members could materially and adversely affect
the Company.
HEALTH CARE COSTS
The Company manages health care costs primarily by entering into
contractual arrangements with health care providers to pay a fixed monthly fee,
or capitation payment, for each HMO member regardless of the services provided
to each member. The primary care physician or group influences medical
utilization and cost control in the Company's HMOs through referrals,
hospitalization and other services and is responsible for any related payments
to those referred providers. The Company's HMOs share the risk of certain
health care costs not covered by capitation arrangements and provide additional
incentives to the physicians or groups for appropriate utilization of hospital
inpatient, outpatient surgery and emergency room services. The Company may also
make incentive payments to providers based on performance relative to budgeted
targets. For the fiscal year ended September 30, 1996, the percentage of total
health care services expense representing medical and hospital capitation
increased to 72 percent from the prior fiscal year's 68 percent. In the
commercial programs, 79 percent of medical costs and 63 percent of hospital
costs were paid in capitation while in the government programs, 94 percent of
medical costs and 78 percent of hospital costs were capitated in fiscal year
1996.
The Company also operates a utilization review system, under which routine
hospital admissions and lengths of stay are reviewed by utilization review
committees comprised of several physicians at each physician group. The
committees approve non-emergency hospitalizations in advance. After admission,
the committees, together with the Company's medical services utilization staff,
carefully monitor the member's continued stay. The Company, through its medical
services department, becomes actively involved in the utilization review of
longer, more costly hospitalizations and emergencies. This department also
becomes involved in the field to monitor catastrophic cases in an effort to
provide members appropriate medical care and suggest treatment options that may
be more appropriate and cost-effective than a long-term hospital stay.
The Company's profitability is dependent, in large part, on its ability to
maintain effective control over health care costs while providing members with
quality care. Factors such as health care reform, levels of utilization of
health care services, new technologies, hospital costs, pharmaceutical costs,
major epidemics, and numerous other external influences may affect the ability
of HMOs to control health care costs. Trends in health care prices and
utilization have a substantial effect on the Company's financial results.
Historically, increases in health care prices and utilization have caused health
care costs to rise faster than general inflation. Recently, these increases have
moderated, but there can be no assurance that health care prices or utilization
will not again increase at a more rapid pace. The Company believes that its
methods of physician reimbursement and utilization review encourage efficient
utilization of health care services by its providers. Nonetheless, if health
care costs do begin to increase more rapidly, there can be no assurance that the
Company will be able to meet its goal of maintaining price increases at least
sufficient to cover increases in health care costs. Competitive pressures,
demands from providers and customers, applicable regulations or other factors
could materially and adversely affect the Company's ability to limit the impact
of health care cost increases by reducing the amounts paid to providers or by
increasing prices.
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QUALITY ASSURANCE
The Company believes that providing access to high quality health care
services is an essential ingredient for success. To achieve this goal, the
Company has established a peer review procedure at each HMO, which is
implemented by a Quality Assurance Committee chaired by the HMO's Medical
Director and comprised of physicians and representatives of the physician groups
at each HMO. When a new physician or physician group is considered by one of
the Company's HMOs as a potential provider, the Quality Assurance Committee of
the HMO evaluates, among other things, the quality of the physician or group's
medical facilities, medical records, laboratory and x-ray licenses and the
capacity to handle membership demands. Once selected, a physician or group is
periodically reviewed to monitor whether members are receiving quality medical
care.
The Company evaluates the quality and appropriateness of medical care
provided to its HMO members by performing medical care evaluation and member
satisfaction studies, by reviewing the utilization of certain services and by
responding to member and physician questions and complaints. These evaluations
are based on statistical information compiled by the Company concerning the
utilization of various health care services and on-site reviews of medical
records at the medical groups. Another measure of quality is the reporting of
Health Plan Employer Data Information Sets ("HEDIS") which the Company has been
reporting since June 1994. HEDIS is useful to purchasers of managed health care
services to measure individual health plan quality and service.
The National Committee for Quality Assurance (the "NCQA") is an
independent, non-profit organization that reviews and accredits HMOs. NCQA
performs site reviews of standards established for quality assurance,
utilization management, credentialing process, commitment to members' rights and
preventative health services. HMOs that comply with NCQA's review requirements
and quality standards receive NCQA accreditation. In fiscal year 1995, the
Company's California and Florida HMOs have received one year accreditation. The
California HMO has recently completed its 1996 site review and is awaiting
approval of re-accreditation. The Company's HMOs in Oklahoma, Oregon and Texas
have applied for NCQA accreditation and are scheduled for NCQA site reviews.
RISK MANAGEMENT
In addition to the Company's cost control systems, the use of underwriting
criteria is an integral part of its risk management efforts. Underwriting is
the process by which a health plan assesses the risk of enrolling employer
groups (or individuals) and establishes appropriate or necessary premium rates.
The setting of premium rates directly affects a health plan's profitability and
marketing success. Underwriting techniques are not employed for the Secure
Horizons programs because of regulations which require the Company to accept
nearly all Medicare entitled applicants.
The Company shifts part of the risk of catastrophic losses by maintaining
reinsurance coverage for hospital costs incurred in the treatment of
catastrophic illnesses of its members. The Company also maintains general
liability, property and medical malpractice insurance coverage in amounts that
the Company believes are adequate. The Company requires contracting physicians,
physician groups and hospitals to maintain individual malpractice insurance
coverage.
MARKETING
Commercial marketing is a two-step process in which the Company first
markets to employer groups and then provides information directly to employees
once the employer has selected the HMO. The Company solicits new employer
groups of various sizes through direct, personal selling efforts and through
contacts with insurance brokers and consultants. Many employer groups under
contract with the Company are represented by insurance brokers and consultants
who work with the employer to recommend or design employee benefits packages.
Brokers are paid on a commission basis by the Company over the life of the
contract, while consultants generally are paid by the employer. The Company has
also developed a marketing strategy to strengthen and increase its market share
by increasing penetration in existing employer groups and by increasing access
to new populations through expansion of its delivery network. This strategy
includes a telemarketing program, research and product development, corporate
communications, public relations and marketing services. A significant portion
of the Company's commercial membership growth comes from existing employer
groups.
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During "open enrollment" periods when employees are permitted to change
health care programs, the Company utilizes various techniques to attract
commercial members, including work site presentations, direct mail, medical
group tours and local advertising. Marketing efforts are also supported by an
advertising program that includes television, radio, billboard and print media.
The Company markets the Secure Horizons programs to Medicare beneficiaries
through direct mail, telemarketing, television, radio and cooperative
advertising with participating medical groups. The Company anticipates further
growth opportunities in the Medicare risk program based on the Company's current
marketing strategies and the growing senior population in the United States.
MANAGEMENT INFORMATION SYSTEMS
The Company uses computer-based management information systems for various
purposes, including underwriting, billing, claims processing, utilization
management, marketing and sales tracking, financial and management accounting,
reporting, medical cost and utilization trending, planning and analysis. These
systems also support member, group and provider service functions, including on-
line access to membership verification, claims and referral status and
information regarding hospital admissions and lengths of stay. In addition,
these systems support extensive analyses of cost and outcome data. The
Company's computer information systems which support its managed care operations
and specialty managed products are continually being enhanced and upgraded. The
Company is dependent upon the operations of these systems for electronic claims
receipt, utilization management authorization processing, claims adjudication
and payment, eligibility verification, bill processing and general corporate
accounting. Simplification, integration and expansion of the systems servicing
the Company's business is an important component of controlling administrative
expenses.
COMPETITION
The health care industry is highly competitive, both nationally and in the
Company's various markets. The Company has many competitors, including
insurance carriers, other HMOs, employer self-funded programs and PPOs, many of
which have substantially larger enrollments or greater financial resources than
the Company. The Company also faces competition from hospitals, health care
facilities and other health care providers who have combined and formed their
own networks to contract directly with employer groups and other prospective
customers for the delivery of health care services. California, the largest
market in which the Company competes, is served by a large number of HMOs and is
one of the most heavily penetrated markets by HMOs in the United States.
Competition for members in the Company's markets has resulted in an increase in
benefits and price competition. In such an increasingly competitive
environment, the Company believes that a comprehensive range of products and
services, along with a strong provider network, must be provided to remain
competitive. Other factors which the Company believes generally help it in
regard to competitors are the strength of its underwriting and pricing practices
and staff, its significant market position in certain geographic areas, its
financial strength, its experience and its generally favorable marketplace
reputation. Increased competition could result in a decline in revenue or in
price reductions, which could materially and adversely affect the Company.
GOVERNMENT REGULATION
One of the most significant federal laws affecting the Company is the
Federal Health Maintenance Organization Act of 1973 (the "HMO Act") and the
regulations promulgated thereunder by the Secretary of HHS. Among other things,
the HMO Act requires federally qualified HMOs to offer a comprehensive benefit
program and to have quality assurance and educational programs for both the
health care professionals utilized by the HMO and its members. Only HMOs that
continue to meet federal criteria may retain their qualified status. HCFA
requires periodic financial reports from qualified HMOs and imposes net equity,
net profitability (or a plan to achieve a net operating profit within available
financial resources), reserve and cash flow requirements. The Company's HMO
operations, except for its Washington HMO and portions of its California and
Oklahoma HMO service areas, are federally qualified. Lack of federal
qualification does not substantially impact the operations of the Company's HMO
subsidiaries or their ability to offer the Company's Medicare risk program.
The Company's Secure Horizons programs are subject to regulation by HCFA
and various state agencies. HCFA requires that an HMO be federally qualified or
meet similar requirements as a competitive medical plan in order to be eligible
for Medicare risk contracts. HCFA has the right to audit HMOs operating under
Medicare
9
<PAGE>
contracts to determine the quality of care being rendered and the degree of
compliance with HCFA's contracts and regulations. HCFA may unilaterally
terminate the Company's Medicare risk contracts if the Company fails to continue
to meet compliance and eligibility standards. Termination of the Company's risk
contracts would materially and adversely affect the Company.
As a result of HCFA's regulations governing the Company's Medicare risk
programs, the "medical loss ratio" (health care expenses as a percentage of
premium revenue), as determined prospectively through formulas established by
HCFA for the Company's Medicare risk contracts in a particular region, is not
allowed to be less than the medical loss ratio for the Company's non-Medicare
risk contracts in such regions. If the Company were to fall out of compliance
with these regulations, it would have to provide additional benefits, reduce the
supplemental premiums charged to its Medicare members or accept a lower payment
from HCFA to increase the medical loss ratio for the Medicare risk contracts to
the level of the medical loss ratio for the non-Medicare contracts. This
regulation could materially and adversely affect the Company.
Secure Horizons' premiums are determined through formulas established by
HCFA for the Company's Medicare risk contracts in a particular region. If these
premiums are reduced or if premium rate increases in a particular region are
lower than the rate of increase in health care service expenses of Secure
Horizons members in such region, the Company's operations, profitability or
business prospects could be affected. The Company has mitigated this risk by
paying approximately 78 percent of the health care service expenses of the
Secure Horizons programs for the fiscal year ended September 30, 1996 on a
capitated basis. The Company believes that any slowdown in the rate of premium
growth may be offset by the effect of proposals encouraging managed health care
for Medicare beneficiaries. The loss of Medicare contracts or termination or
modification of the HCFA risk-based Medicare program could have a material
adverse effect on the revenue, profitability and business prospects of the
Company.
In the normal course of business, the governmental agencies with which
PacifiCare contracts periodically review the premiums paid to the Company under
these programs to detect whether any excess premiums have been paid. If such
agencies discover, in connection with any such review, that excess premiums were
paid to the Company, adjustments to current or future premiums would be made.
If such adjustments were significant, they could materially and adversely affect
the profitability, operations or business prospects of the Company.
PacifiCare's HMOs have commercial contracts with the United States Office
of Personnel Management ("OPM") to provide managed health care services to
employees under the Federal Employees Health Benefits Program ("FEHBP"). OPM,
as a normal course of business, audits health plans with which it contracts to,
among other things, verify that premiums charged under OPM contracts are
established in compliance with community rating and other requirements under the
FEHBP. OPM audits for multiple periods are in various stages of completion for
several of PacifiCare's HMO subsidiaries. PacifiCare incurred a pre-tax charge
of $25 million (See Note 11 of the Notes to the Consolidated Financial
Statements) to its results of operations for the three and nine months ended
June 30, 1996 to increase reserves in anticipation of negotiations relating to
potential governmental claims for contracts with OPM. PacifiCare intends to
negotiate with OPM on all matters to attain a mutually satisfactory result.
There can be no assurance, however, that these negotiations will be concluded
satisfactorily or that additional, possibly material, liability will not be
incurred. The Company believes that any ultimate liability in excess of amounts
accrued as a result of the audits by OPM would not materially affect the
Company's consolidated financial position, results of operations or cash flows,
however, such liability could be material to net income of a future quarter.
The Company's HMOs are subject to state regulations which require periodic
financial reports from HMOs licensed to operate in their state and, in certain
cases, impose minimum equity, capital, deposit and/or reserve requirements.
Certain federal and/or state regulatory agencies also require the Company's HMOs
to maintain restricted cash reserves represented by interest-bearing instruments
which are held by trustees or state regulatory agencies. These requirements,
which limit the ability of the Company's subsidiaries to transfer funds to the
Company, may limit the ability of the Company to pay dividends. From time to
time, the Company advances funds, in the form of a loan, to its subsidiaries to
assist them in satisfying federal or state financial requirements.
California legislation requires all HMOs and insurers which offer small
group coverage to accept all small employers who apply for coverage and to
guarantee coverage to their employees seeking coverage regardless of their
health status. The legislation also requires renewal of these small group
employer plans, limits rate renewal increases, mandates community rating and
prohibits exclusions for pre-existing conditions except for the first six
10
<PAGE>
months after enrollment. Compliance with this legislation has required the
Company to make certain changes to its small group products in California.
The Company has two insurance subsidiaries, one domiciled in Indiana and
licensed in 37 states and the District of Columbia and one domiciled in Arizona.
The Company's insurance subsidiaries are subject to regulation in each state in
which they are licensed. Regulatory authorities exercise extensive supervisory
power over insurance companies. The Company's insurance subsidiaries are
required to file periodic statutory financial statements in each jurisdiction in
which they are licensed. Additionally, such subsidiaries are periodically
examined by the insurance departments of the jurisdiction in which they are
licensed to do business.
Certain of the Company's HMOs and each of the Company's insurance
subsidiaries are subject to regulation under state insurance holding company
regulations. Such insurance holding company laws and regulations generally
require registration with the appropriate state department of insurance and the
filing of certain reports describing capital structure, ownership, financial
condition, certain intercompany transactions and general business operations.
Various notice and reporting requirements generally apply to transactions
between companies within an insurance holding company system, depending on the
size and nature of the transactions. Certain state insurance holding company
laws and regulations require prior regulatory approval or, in certain
circumstances, prior notice of certain material intercompany transfers of assets
as well as certain transactions between the regulated companies, their parent
holding companies and affiliates, and acquisitions.
In 1996, HCFA promulgated regulations ("physician incentive regulations")
enforcing Sections 4204(a) and 4731 of the Omnibus Budget Reconciliation Act of
1990 ("OBRA 90"). OBRA 90 and the physician incentive regulations prohibit HMOs
with Medicare risk contracts from knowingly making incentive payments to
physicians as an inducement to reduce or limit medically necessary services to
Medicare beneficiaries. Under the physician incentive regulations, HMOs must,
among other things, disclose to HCFA their physician compensation plan in such
detail as to allow HCFA to determine compliance with the regulations, and
provide stop-loss insurance to a physician or physician group, if the HMO places
the physician at "substantial financial risk" for services provided to Medicare
beneficiaries. Revision of the physician incentive regulations in several
specific areas is currently under serious consideration by HCFA. However, HCFA
continues to require plans to show a good faith effort to meet these regulations
by January 1997. The Company is taking steps to come in compliance with the
physician incentive regulations.
On August 20, 1996, President Clinton signed into law the "Health Insurance
Portability and Accountability Act of 1996," which takes effect beginning
January 1997. The Act requires certain guaranteed issuance and renewability of
health coverage for individuals and small groups, limits preexisting condition
exclusions and provides for a demonstration project for medical savings
accounts. In addition, more recent federal legislation, which will become
effective beginning January 1998, requires health plans to provide parity for
mental health benefits and at least 48 hour inpatient coverage for mothers and
their newborns. The Company is analyzing the impact these acts will have on its
operations.
Government regulation of health care coverage products and services is a
changing area of law that varies from jurisdiction to jurisdiction. Changes in
applicable laws and regulations are continually being considered and the
interpretation of existing laws and rules may also change from time to time.
Regulatory agencies generally have broad discretion in promulgating regulations
and in interpreting and enforcing laws and rules. While the Company is unable
to predict what regulatory changes may occur or the impact on the Company of any
particular change, the Company's operations and financial results could be
negatively affected by regulatory revisions. Although the Company believes that
it would benefit from legislative proposals encouraging the use of managed
health care, there can be no assurance that the enactment of any of such reforms
would not materially and adversely affect the Company's financial position,
results of operations, cash flows or business prospects. The continued
consideration and enactment of "anti-managed care" laws and regulations, such as
"any willing provider" laws and limits on utilization management, by federal and
state bodies may make it more difficult for the Company to control medical costs
and could adversely affect financial results. Although the Company intends to
maintain its HMOs' federal qualifications, state licenses and Medicare
contracts, there can be no assurance that it can do so.
11
<PAGE>
STOCK MARKET
The market prices of the Company's Class A and Class B Common Stock and the
share prices of the publicly traded shares of the Company's competitors have
shown significant volatility and sensitivity to many factors, including
legislative or regulatory actions, health care cost trends, premium pricing
trends, levels of competition, earning and membership reports of industry
participants, and acquisition activity. There can be no assurances regarding
the stability of the various share prices of the Company at any time or the
impact of these or any other factors on the share prices of the Company. See
Item 5 - "Market for the Company's Common Stock and Quarterly Information."
TRADEMARKS
The federally registered service marks PacifiCare-Registered Trademark- and
SecureHorizons-Registered Trademark- are owned by the Company and are material
to its business.
EMPLOYEES
As of September 30, 1996, the Company had 4,957 full and part-time
employees. None of the Company's employees are presently covered by a
collective bargaining agreement and the Company has not experienced any work
stoppage since its organization. The Company considers its relations with its
employees to be good.
ITEM 2. PROPERTIES
As of September 30, 1996 the Company had leases, in the aggregate, for
approximately 1,177,000 square feet of office space for its corporate
headquarters, executive offices, regional offices and subsidiary operations in
California, Florida, Oklahoma, Oregon, Texas and Washington. Of this aggregate
amount, the Company had leases for its corporate headquarters and executive
offices of approximately 105,000 square feet in Cypress, California. The
Company also had leases, in the aggregate, for approximately 110,000 square feet
for computer operations and administrative and warehouse purposes in California.
The Company owns an office building of approximately 200,000 square feet on
approximately 9.2 acres of land in Cypress, California which serves as the
executive and administrative offices of its California HMO operation.
Additionally, the Company owns a child care facility and an office building
totaling approximately 30,000 square feet on 2.4 acres of land in Cypress and
Tustin, California.
The Company considers its facilities to be in good working condition, well
maintained and adequate for its present needs.
ITEM 3. LEGAL PROCEEDINGS
The Company is involved in legal actions in the normal course of business,
some of which seek substantial monetary damages, including claims of punitive
damages which are not covered by insurance. After review, including
consultation with counsel, management believes any ultimate liability in excess
of amounts accrued which could arise from the actions would not materially
affect the Company's consolidated financial position, results of operations or
cash flows.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of security holders during the three
months ended September 30, 1996.
12
<PAGE>
PART II
ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND QUARTERLY INFORMATION
The Class A Common Stock, par value $0.01 per share (the "Class A Common
Stock"), and the Class B Common Stock, par value $0.01 per share (the "Class B
Common Stock"), are traded on the over-the-counter market and are quoted on the
Nasdaq National Market under the symbols PHSYA and PHSYB, respectively. The
following tables set forth, for the indicated periods, the high and low reported
sale prices per share of the Class A and Class B Common Stock as furnished by
Nasdaq.
CLASS A CLASS B
COMMON STOCK COMMON STOCK
------------------------ ------------------------
HIGH LOW HIGH LOW
------------------------ ------------------------
1995
First Quarter 79 60 3/4 74 3/4 60 1/2
Second Quarter 76 1/4 61 77 62
Third Quarter 75 1/8 44 1/2 76 1/4 44
Fourth Quarter 68 1/2 49 3/4 71 48 1/2
1996
First Quarter 89 3/8 64 1/2 91 66 1/4
Second Quarter 98 3/4 75 1/4 99 1/2 78 1/2
Third Quarter 83 3/4 63 7/8 86 3/4 65 1/4
Fourth Quarter 84 3/4 59 5/8 91 59 3/4
The Company has never paid any cash dividends on its common stock and
presently anticipates for the foreseeable future that no cash dividends on its
common stock will be declared and that all of its earnings will be retained for
development of the Company's business. Any dividends will depend upon future
earnings, the financial condition of the Company and regulatory requirements.
If the Company were to decide to make dividend payments, the Company could only
make dividend payments in shares of its Common Stock pursuant to the
restrictions on dividend payments which exist in the new credit facility
established with Bank of America (See Note 13 of the Notes to the Consolidated
Financial Statements).
As of September 30, 1996 there were approximately 222 and 196 shareholders
of record of the Company's Class A Common Stock and Class B Common Stock,
respectively. These numbers do not include individual participants in security
position listings. Based on available information, the Company believes there
are at least 15,000 beneficial holders of its Class A and Class B Common Stock.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial and operating data are derived from the
audited financial statements of the Company and its subsidiaries. The selected
financial and operating data should be read in conjunction with "Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations" and also with "Item 8. Financial Statements and Supplementary
Data."
13
<PAGE>
INCOME STATEMENT DATA
<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30
(in thousands, except per share data) 1996(1) 1995 1994 1993 1992
- ----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Operating revenue $ 4,637,305 $ 3,731,022 $ 2,893,252 $ 2,221,073 $ 1,686,314
- ----------------------------------------------------------------------------------------------------------------------------------
Expenses:
Health care services 3,872,747 3,077,135 2,374,258 1,850,469 1,393,645
Other operating expenses 585,081 505,644 398,064 283,360 232,120
Impairment, disposition and restructuring charges 75,840 - - - -
Office of Personnel Management charge 25,000 - - - -
- ----------------------------------------------------------------------------------------------------------------------------------
Operating income 78,637 148,243 120,930 87,244 60,549
Interest income, net 44,143 33,857 24,538 21,083 14,303
- ----------------------------------------------------------------------------------------------------------------------------------
Income before income taxes and cumulative
effect of a change in accounting principle 122,780 182,100 145,468 108,327 74,852
Provision for income taxes 50,827 74,005 60,875 45,631 31,262
- ----------------------------------------------------------------------------------------------------------------------------------
Income before cumulative effect of a change
in accounting principle 71,953 108,095 84,593 62,696 43,590
Cumulative effect on prior years of a change
in accounting principle - - 5,658 - -
- ----------------------------------------------------------------------------------------------------------------------------------
Net Income $ 71,953 $ 108,095 $ 90,251 $ 62,696 $ 43,590
- ----------------------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------------------
Earnings per share $ 2.27 $ 3.62 $ 3.22(2) $ 2.25 $ 1.78
- ----------------------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------------------
OPERATING STATISTICS
YEARS ENDED SEPTEMBER 30 1996(1) 1995 1994 1993 1992
- ----------------------------------------------------------------------------------------------------------------------------------
Medical loss ratio (health care services as a
percent of premium revenue)
Consolidated 84.4% 83.6% 83.1% 84.1% 83.2%
Commercial 83.1% 82.5% 80.5% 82.5% 80.2%
Government 85.4% 84.3% 85.2% 85.6% 86.6%
Marketing, general and administrative expenses
as a percent of operating revenue 12.4% 13.4% 13.6% 12.6% 13.6%
Operating income(1) 1.7% 4.0% 4.2% 3.9% 3.6%
Effective tax rate 41.4% 40.6% 41.8% 42.1% 41.8%
Return on average shareholders' equity(1) 9.3% 18.9% 24.6% 24.2% 29.2%
- ----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
(1) The fiscal year 1996 results include $100.8 million of pretax charges
($62.0 million or $1.96 per share, net of tax) for the impairment of long-
lived assets, potential government claims, dispositions and certain
restructuring charges (See Note 11 of the Notes to the Consolidated
Financial Statements). Operating income as a percentage of operating
revenue before pretax charges for fiscal year 1996 was 3.9%. Return on
average shareholders' equity before pretax charges for fiscal year 1996 was
17.2%.
(2) Earnings per share before cumulative effect of a change in accounting
principle for the year ended September 30, 1994 was $3.02 per share. The
cumulative effect of a change in accounting principle for the fiscal year
ended September 30, 1994 was $.20 per share.
14
<PAGE>
FINANCIAL STATEMENT CHANGE STATISTICS
<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30 1996(1) 1995 1994(2) 1993 1992
- ------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Operating revenue 24.3% 29.0% 30.3% 31.7% 35.7%
Net income (33.4)% 19.8% 44.0% 43.8% 69.6%
Earnings per share (37.3)% 12.4% 43.1% 26.4% 61.8%
Total assets (6.2)% 25.3% 59.4% 39.3% 54.5%
Total shareholders' equity 12.5% 77.1% 29.5% 60.5% 99.5%
- ------------------------------------------------------------------------------------------------------------------------
MEMBERSHIP DATA
(owned and managed)
SEPTEMBER 30 1996 1995 1994 1993 1992
- ------------------------------------------------------------------------------------------------------------------------
Commercial 1,434,475 1,216,140 949,124 806,918 742,104
Government (Medicare & Medicaid) 596,231 540,992 409,095 290,149 214,110
- ------------------------------------------------------------------------------------------------------------------------
Total membership 2,030,706 1,757,132 1,358,219 1,097,067 956,214
- ------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------
Percent change in membership 15.6% 29.4% 23.8% 14.7% 31.6%
- ------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET DATA
(in thousands)
SEPTEMBER 30 1996 1995 1994 1993 1992
- ------------------------------------------------------------------------------------------------------------------------
Cash and equivalents and marketable
securities $ 700,093 $ 811,525 $ 710,608 $ 437,231 $ 272,135
Total assets $ 1,299,462 $ 1,385,372 $ 1,105,548 $ 693,646 $ 498,082
Medical claims and benefits payable $ 268,000 $ 288,400 $ 302,900 $ 255,000 $ 208,000
Long-term debt, excluding current
maturities $ 5,183 $ 11,949 $ 101,137 $ 21,821 $ 18,488
Shareholders' equity $ 823,224 $ 732,024 $ 413,358 $ 319,294 $ 198,884
- ------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------
</TABLE>
(1) The fiscal year 1996 results include $100.8 million of pretax charges
($62.0 million or $1.96 per share, net of tax) for the impairment of long-
lived assets, potential government claims, dispositions and certain
restructuring charges (See Note 11 of the Notes to the Consolidated
Financial Statements). Before these charges, the fiscal year 1996
increases in net income and earnings per share were 23.9 percent and 16.9
percent, respectively.
(2) The fiscal year 1994 results reflect the cumulative effect on prior fiscal
years of a change in accounting principle. The fiscal year 1994 changes in
net income and earnings per share before cumulative effect of a change in
accounting principle are 34.9 percent and 34.2 percent, respectively.
15
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
FISCAL YEAR 1996 COMPARED WITH FISCAL YEAR 1995
Total operating revenue increased $906 million to $4.6 billion for the
fiscal year ended September 30, 1996 from $3.7 billion for the same period in
the prior fiscal year. Enrollment gains in both the government (Medicare and
Medicaid) and commercial programs, offset slightly by decreases in commercial
premium rates, provided an increase in total operating revenue of $787 million.
The remaining operating revenue increase was contributed by the incremental
operations of acquisitions described in Note 5 of the Notes to Consolidated
Financial Statements and the Company's specialty managed care products and
services.
Commercial premiums increased $355 million or 23 percent to $1.9 billion
for the fiscal year ended September 30, 1996 from $1.5 billion in 1995.
Commercial HMO membership increased by 218,000 to 1,434,000 due to continued
growth in all markets except Florida. Commercial HMO membership growth provided
$281 million of the increase, more than offsetting average premium rate
decreases of 1.2 percent, primarily in California. The effects of acquisitions
described above and the commercial specialty managed care products and services
provided the remainder of the increase in commercial premiums.
Government premiums rose $550 million or 25 percent to $2.7 billion for
the fiscal year ended September 30, 1996 from $2.2 billion in 1995. Enrollment
gains, predominantly in the Secure Horizons programs, accounted for $430 million
or 78 percent of the increase. The remainder of the premium increase is
attributable to incremental acquisitions and premium rate increases averaging
4.2 percent.
Total health care services expense as a percent of premium revenue (the
"medical loss ratio"; See Item 6. Selected Financial Data, page 14) for the
fiscal year ended September 30, 1996 increased to 84.4 percent from 83.6 percent
in 1995. The commercial medical loss ratio increased to 83.1 percent from 82.5
percent while the government medical loss ratio increased to 85.4 percent from
84.3 percent. The Company controls health care costs through contractual
arrangements which capitate providers. Capitation pays providers a fixed
monthly fee for each HMO member regardless of the services provided to each
member. During the fiscal year, the Company continued its contracting strategy
of shifting providers from traditional fee-for-service delivery systems to
capitation and risk-sharing arrangements. Accordingly, the percentage of total
health care services expense for the fiscal year ended September 30, 1996
representing medical and hospital capitation was 72 percent, an increase from
the prior fiscal year's 68 percent.
The increase in the commercial medical loss ratio for the fiscal year ended
September 30, 1996 is primarily attributable to increased PPO and indemnity
costs of the Company's specialty managed care products and services combined
with higher physician and prescription drug costs in the Company's HMOs.
Exclusive of the Company's PPO and indemnity products, the commercial medical
loss ratio decreased slightly through improved contracting arrangements. Many
of the Company's newer markets experienced more membership growth than the
Company as a whole. However, with provider networks less sophisticated in
managed care, these newer markets contributed to a higher medical loss ratio.
The more mature commercial markets experienced slightly improved medical loss
ratios from fiscal year 1995. In the commercial program, 62 percent of all
health care services expense was capitated with 79 percent of all medical costs
and 63 percent of all hospital costs capitated in fiscal year 1996. In the
prior fiscal year, total commercial health care services expense was 58 percent
capitated, a capitation combination of 78 percent of medical costs and 52
percent of hospital costs.
The increase in the medical loss ratio for the government programs reflects
increased physician and hospital costs on a per member basis due to higher
membership growth in areas with higher provider costs combined with lower member
supplemental premiums and enhanced benefits to enrollees. These increased costs
are partially offset by January 1, 1996 HCFA premium rate increases. In the
government program, 78 percent of all health care services expense was capitated
with 94 percent of medical costs and 78 percent of hospital costs capitated in
fiscal year 1996. In the prior fiscal year, total government health care
services expense was 75 percent capitated, a capitation combination of 93
percent of medical costs and 72 percent of hospital costs.
16
<PAGE>
Marketing, general and administrative expenses increased $78.0 million to
$576 million for the fiscal year ended September 30, 1996 from $498 million for
fiscal year 1995. However, as a percentage of operating revenue, marketing,
general and administrative expenses decreased to 12.4 percent from 13.4 percent.
The decrease is primarily attributable to the Company's reduction of performance
based employee incentives due to current fiscal year operating results not
meeting anticipated fiscal year 1996 targets. Additionally, the Company is
realizing the benefit derived from prior investments in the Company's
infrastructure which have proven adequate to support the growth in membership.
The Company recognized pretax charges for the fiscal year ended September
30, 1996 totaling $100.8 million ($62.0 million or $1.96 loss per share, net of
tax). Included was a fourth quarter charge for the impairment of goodwill
associated with the potential disposition of its Florida operations, in addition
to third quarter reserves associated with potential government claims with OPM
for multiple contract years, the disposition of Pasteur Delivery Systems ("PDS")
and certain restructuring charges (See Note 11 of the Notes to the Consolidated
Financial Statements).
In the fourth quarter of fiscal year 1996, the Company recognized a $58.7
million ($34.1 million or $1.08 per share, net of tax) impairment of goodwill
related to the potential disposition of its Florida operations. The business
strategy for PCFL profitability was based on the launching of the Company's
Secure Horizons program in Florida. In response to the FHP Transaction and the
considerable amount of resources which will be needed to integrate FHP's
operations with those of the Company, assuming the FHP Transaction is
consummated, the Company decided to explore options with respect to PCFL's
operations, including a possible sale. Accordingly, the Company withdrew its
HCFA application in September 1996. Consequently, the Company recognized an
impairment of the PCFL goodwill and other intangible assets. The Company
expects to continue operations in Florida until a sale is consummated or the
Company makes alternative arrangements. A comprehensive plan to dispose of
PCFL's business may involve a restructuring charge in future periods.
In the third quarter, the Company recorded pretax charges of $42.1 million
($27.9 million or $0.88 per share, net of tax). Of the total, $25.0 million
($14.9 million or $0.47 per share, net of tax) was associated with a reserve
charge for the Company's commercial contracts with OPM to provide managed health
care services to approximately 64,000 members under the Federal Employees Health
Benefits Program for Federal employees, annuitants and their dependents; $9.3
million ($8.3 million or $0.26 per share, net of tax) resulted from a pretax
loss associated with the sale of the PDS staff-model clinics; and $7.8 million
($4.7 million or $0.15 per share, net of tax) related to a plan for the
discontinuation of certain specialty health care products and services and the
restructuring of regional operations.
Net interest income increased by approximately $10.0 million compared to
the prior fiscal year primarily due to increased cash available for investment
purposes at higher interest rates than fiscal year 1995 and lower interest
expense associated with decreased debt service.
The consolidated effective income tax rate for the fiscal year ended
September 30, 1996 was 41.4 percent compared to 40.6 percent for the same period
in fiscal year 1995. The increase is attributable to the charges for the
disposition of PDS and goodwill impairment described in Note 11 of the Notes to
the Consolidated Financial Statements, some of which are not deductible for
income tax purposes.
Income exclusive of the impairment, disposition, restructuring and OPM
charges described above was $134 million or a 24 percent increase over fiscal
year 1995. Earnings per share before impairment, disposition, restructuring and
OPM charges, increased 17 percent or $0.61 to $4.23 for the fiscal year ended
September 30, 1996. The increases reflect membership growth in both the
commercial and government programs and lower marketing, general and
administrative costs, partially offset by increases in health care service
expenses.
Net income decreased 33 percent to $72.0 million for the fiscal year ended
September 30, 1996 compared to $108 million in the same period in fiscal year
1995. Earnings per share of $2.27 were 37 percent lower than the prior fiscal
year's earnings per share of $3.62.
FISCAL YEAR 1995 COMPARED WITH FISCAL YEAR 1994
Total operating revenue increased 29 percent or $838 million to $3.7
billion for the fiscal year ended September 30, 1995 from $2.9 billion for the
same period in the prior fiscal year. Enrollment gains in both the government
and commercial programs, offset slightly by decreases in commercial premium
rates, provided an increase in total operating revenue of $659 million.
Approximately $149 million of the increase in total operating revenue
17
<PAGE>
represents the incremental operations of acquisitions described in Note 5 of the
Notes to Consolidated Financial Statements. The remaining $30 million was
contributed by the Company's specialty managed care products and services and
its joint venture medical groups.
Commercial premiums increased $275 million or 22 percent to $1.5 billion
for the fiscal year ended September 30, 1995 from $1.2 billion in fiscal year
1994. Commercial HMO membership increased by 267,000 or 28 percent to 1,216,000
due to continued growth in California, Oregon, Texas and Washington. The
increase in membership includes the effects of acquisitions in California and
Washington of 67,000 and 33,000 members, respectively. Commercial HMO
membership growth provided $177 million of the increase, more than offsetting
average premium rate decreases of two percent, primarily in California. The
effects of acquisitions described above and the commercial specialty managed
care products and services and joint venture medical groups provided the
remainder of the increase in commercial premiums.
Government premiums rose $553 million or 34 percent to $2.2 billion for
the fiscal year ended September 30, 1995 from $1.6 billion in fiscal year 1994.
Enrollment gains, predominantly in the Secure Horizons programs, accounted for
$492 million or 89 percent of the increase. The remainder of the premium
increase was attributable to incremental acquisitions and premium rate increases
averaging one percent.
The medical loss ratio for the fiscal year ended September 30, 1995,
increased to 83.6 percent from 83.1 percent in fiscal year 1994. The commercial
medical loss ratio increased to 82.5 percent from 80.5 percent while the
government medical loss ratio decreased to 84.3 percent from 85.2 percent. The
increase in the commercial medical loss ratio has been driven by the Company's
entry into new markets, through acquisitions and internal development, with
principally traditional fee-for-service delivery systems. The decrease in the
government medical loss ratio is primarily related to more cost effective
physician and hospital contracts.
For the fiscal year ended September 30, 1995, the Company made net positive
reserve adjustments totaling $12 million. These net positive reserve
adjustments have historically been made in the third quarter and result
primarily from the periodic reconciliation of amounts reserved for physician and
hospital incentive programs. For the fiscal year ended September 30, 1995,
however, net positive reserve adjustments were made in insignificant amounts
throughout the year. For the fiscal year ended September 30, 1994, net positive
reserve adjustments of $9 million were made in the third quarter.
Marketing, general and administrative expenses increased $104 million or 26
percent to $498 million for the fiscal year ended September 30, 1995 from $395
million for fiscal year 1994. As a percentage of operating revenue, marketing,
general and administrative expenses decreased to 13.4 percent from 13.6 percent.
The decrease was primarily attributable to increased operating revenue and
efficiencies due to process improvements which have offset infrastructure
investments in new markets.
For the fiscal year ended September 30, 1995, earnings per share increased
20 percent to $3.62 compared to $3.02 for fiscal year 1994 before the cumulative
effect of a change in accounting principle. The increase is primarily related
to membership growth derived substantially from the government programs,
predominantly Secure Horizons. Increases in health care service expenses were
partially offset by decreases in marketing, general and administrative expenses.
The results for the fiscal years ended September 30, 1995 and 1994 included
approximately $0.24 and $0.18, respectively, related to the net positive reserve
adjustments previously described. Earnings per share for the fiscal year ended
September 30, 1994 were $3.22 which included approximately $0.20 due to changes
in income tax accounting principles (see Note 2m of the Notes to Consolidated
Financial Statements).
LIQUIDITY AND CAPITAL RESOURCES
The Company's consolidated cash and cash equivalents decreased by $136
million to $143 million at September 30, 1996 from $279 million one year ago.
The decrease reflects the impact of timing differences in receipt of HCFA
premiums. The Company's September 30, 1995 cash balances included the early
receipt of approximately $184 million of premiums from HCFA for Medicare
services to be provided to Secure Horizons members in October 1995. The
Company's cash balances at September 30, 1996 did not include any early receipt
of HCFA premiums. The major source of cash during the fiscal year ended
September 30, 1996 was $111 million from operations (excluding the effect of
timing differences in receipt of HCFA premiums). The Company's use of cash
during fiscal year 1996 included $22.7 million for capital expenditures, $8.6
million for debt payments, and $5.4 million for acquisitions. The
18
<PAGE>
Company anticipates that the level of capital expenditures will increase in
fiscal year 1997 in connection with the Company's increased investment in the
updating and enhancing of its management information systems.
The Company's working capital at September 30, 1996 was $464 million, an
increase of $143 million from September 30, 1995. The increase in receivables
is primarily attributable to increased provider and government receivables as
well as growth in membership. Medical claims and benefits payable decreased
from September 30, 1995, reflecting shifting membership to capitated
arrangements.
In October 1996, the Company established a $1.5 billion revolving credit
facility with Bank of America National Trust and Savings Association and a
syndicate of banks (the "Credit Facility") to finance the cash portion of the
FHP Transaction or for other corporate purposes (See Note 13 of the Notes to the
Consolidated Financial Statements).
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 to encourage companies to provide
prospective information about themselves without fear of litigation so long as
those statements are identified as forward looking and are accompanied by
meaningful cautionary statements identifying important factors that could cause
actual results to differ materially from those projected in the statements. The
statements contained in this section, and throughout the document, are based on
current expectations. These statements are forward looking and actual results
may differ materially from those projected in the forward looking statements,
which statements involve risks and uncertainties. In addition, past financial
performance is not necessarily a reliable indicator of future performance and
investors should not use historical performance to anticipate results or future
period trends. Shareholders are also directed to the other risks discussed in
other documents filed by the Company with the Securities and Exchange Commission
("SEC")..
The following forward looking statements, except where specifically noted,
exclude the potential impact of the integration of FHP into the Company
subsequent to the FHP Transaction (See Note 13 of the Notes to the Consolidated
Financial Statements, and "Recent Developments" and "Business Strategy"). The
impact of FHP has been excluded because the Company believes that it has
insufficient information to make any projections and that disclosure of any
potential impact would be premature.
INDUSTRY COMPETITION AND CONSOLIDATION. The Company's business strategy is
to solidify its position as one of the leading managed health care services
companies. The pending FHP Transaction is key to this strategy as it offers
significant synergies creating a combined company that would be better able to
respond to the needs of consumers and customers, the increased competitiveness
of the health care industry and the opportunities that changes in the health
care industry might bring. While the Company believes that the acquisition will
be successfully completed, the regulatory approvals required, including
antitrust and various state approvals, as well as shareholder approval required
from voting stockholders of both entities may not be obtained. For additional
information regarding the FHP Transaction, please refer to the Registration
Statement on Form S-4 of PacifiCare Holding filed with the SEC on November 18,
1996. Increased competition could result in a decline in revenue or in price
reductions. Factors which could influence increased competition include larger
competitors being created through consolidation, intensification of price
competition and the formation of new products by new and existing competitors,
especially with respect to Medicare products.
MEMBERSHIP GROWTH. Excluding the effects of the FHP Transaction, the
Company's membership growth is expected to continue in fiscal year 1997 in both
the commercial and government programs but decline from the overall 16 percent
growth experienced in fiscal year 1996 as competition continues to increase and
the Company shifts its emphasis from rapid growth to improved margin performance
in fiscal year 1997. The rate of membership growth is also expected to decline
in fiscal year 1997 with approximately 41,000 of expected membership losses with
the Company's exit from the Florida market and additional losses as the Company
exits the Medicaid business in all markets. If the FHP Transaction is
successfully completed, membership growth is expected to double solely as a
result of the combination of the two companies. Had the business combination
been closed as of September 30, 1996, total membership would have been
approximately 3,923,000, an increase of 93 percent. Commercial and government
membership would have been 2,921,000 and 1,002,000, respectively. An unforeseen
loss of membership could have a material adverse effect on the Company. Factors
which could contribute to the loss of membership include without limitation,
failure to obtain new customers or to retain existing customers, reductions in
workforce by existing customers, adverse publicity and news coverage, inability
to carry out marketing and sales plans, loss or
19
<PAGE>
retirement of key executives or key employees or denial of accreditation by
independent quality accrediting agencies.
HEALTH CARE PROVIDER CONTRACTS. The Company's profitability depends, in
part, on its ability to maintain effective control over health care costs while
providing members with quality care. Securing cost effective contracts with
existing and new physician groups is more difficult due to increased
competition. The negotiation of provider contracts, generally as of January 1,
may be impacted by adverse state and federal legislation and regulation
discussed below. Factors which could impact the Company's ability to secure
contracts with providers include the inability to renegotiate contracts or
entering into contracts with less cost-effective rates or terms of payment and
factors affecting increased competition as discussed above.
COMMERCIAL MEDICAL LOSS RATIO. The fiscal year 1997 commercial medical
loss ratio is expected to decrease as compared to fiscal year 1996. The Company
expects commercial premium rates to increase slightly from September 30, 1996 as
competitive pressures ease and the Company pursues its strategic focus on
product performance, primarily in California, resulting in premium rate
stabilization or increases for its HMO and PPO indemnity products. The Company
continues to work with certain large employer groups and other purchasers of
commercial health care services which continue to demand minimal premium rate
increases or reductions in premium rates while limiting the number of choices
offered to employees. Increased provider experience in the newer markets,
combined with continual renegotiation of current contracts in all markets,
should begin to slightly decrease health care costs, improving the commercial
medical loss ratio. Additionally, the anticipated divestiture of PCFL, the
recent PDS disposition and restructuring plans (See Note 11 of the Notes to the
Consolidated Financial Statements), should contribute to a further decrease in
the commercial medical loss ratio.
GOVERNMENT MEDICAL LOSS RATIO. In September 1996, the Company was advised
by HCFA that effective January 1997, its HMOs will receive a weighted average
premium rate increase of approximately 6.1 percent. The Company expects to
receive these rates barring any adverse federal legislation change. The fiscal
year 1997 medical loss ratio for the government programs is expected to be
comparable or slightly higher than the fiscal year 1996 rate as HCFA rate
increases are offset by enhanced benefits to enrollees.
The commercial and government medical loss ratio expectations discussed
above could be affected by various uncertainties, including, without limitation:
increases in medical costs, including increases in utilization and costs of
medical services and the effect of actions by competitors or groups of
providers; termination of provider contracts or renegotiation thereof at less
cost-effective rates or terms of payment. In addition, price increases in
pharmaceuticals, which have been escalating faster than premium increases in
recent years, as well as price increases for durable medical equipment and other
covered items plus other factors, as discussed below, could also effect
expectations.
MARKETING, GENERAL AND ADMINISTRATIVE SUPPORT INVESTMENTS. Marketing,
general and administrative expenses as a percentage of operating revenue in
fiscal year 1997 are expected to be slightly higher than fiscal year 1996. The
Company plans to increase its investment in medical management to improve its
medical loss ratios and expects increased investments in information services to
maintain and enhance its current competitive advantage in information
technology. In addition, employee incentives will be realigned with fiscal year
1997 targets. Marketing, general and administrative expenses as a percentage of
operating revenue for fiscal year 1997 are expected to increase from fiscal year
1996 levels as the Company continues to invest in the combined infrastructure
and the consolidation of the Company's regional customer service centers.
Marketing, general and administrative expenses could be adversely impacted by
the need for additional advertising, marketing, administrative, or management
information systems expenditures and the inability to carry out marketing and
sales plans. The Company anticipates that the FHP Transaction will yield
increased operating income partly resulting from a combination of reductions in
marketing, general and administrative expenses. There can be no assurances that
the anticipated benefits and synergies may be obtained if the FHP Transaction is
consummated. The ability of PacifiCare to realize the anticipated benefits and
synergies is subject to the following additional uncertainties, among others:
the ability to integrate the Company's and FHP's management and information
systems, on a timely basis, if at all; the ability to eliminate duplicative
functions while maintaining acceptable performance levels; and the possibility
that the integration of FHP will result in the loss of providers, employers,
members or key employees of PacifiCare, FHP or their subsidiaries.
OFFICE OF PERSONNEL MANAGEMENT CONTINGENCIES. The Company intends to
negotiate with OPM on all matters to attain a mutually satisfactory result.
While there is no assurance that the negotiations will be concluded
satisfactorily or that additional liability will not be incurred, management
believes that any ultimate liability in excess of amounts accrued which could
arise upon completion of the audits by OPM of the health plans would not
materially affect the
20
<PAGE>
Company's consolidated financial position, results of operations or cash flows,
however could be material to net income of a future quarter if resolved
unfavorably.
LIQUIDITY AND CAPITAL RESOURCES. The Company believes that the cash flows
from operations, the Credit Facility, existing cash and equivalents and
marketable securities and other financing sources will be sufficient for the
foreseeable future. However, cash flows could be adversely affected by changes
in interest rates causing an increase in interest expense and the fact that
PacifiCare will be subject to greater operating leverage due to its higher
levels of indebtedness if the FHP Transaction is consummated. Additionally,
should the Credit Facility be fully drawn to fund the FHP Transaction or other
business purpose, the Company's ability to make a payment on, or repayment of,
its future obligations under the Credit Facility will be significantly dependent
upon the receipt of funds from the Company's subsidiaries. These subsidiary
payments represent fees for management services rendered by the Company to the
subsidiaries and cash dividends by the subsidiaries to the Company. Nearly all
of the subsidiaries are subject to HMO regulations or insurance regulations and
may be subject to substantial supervision by one or more HMO or insurance
regulators. Subsidiaries subject to regulation must meet or exceed various
fiscal standards imposed by HMO or insurance regulations. These fiscal
standards may, from time to time, impact the amount of funds paid by
subsidiaries to the Company.
LEGISLATION AND REGULATION. The Company's success is significantly impacted
by federal and state legislation and regulation. Actual results may differ
materially from expected results discussed throughout this document because of
adverse state and federal legislation and regulation. This includes limitations
on premium levels, increases in minimum capital and reserves and other financial
viability requirements, prohibition or limitation of capitated arrangements or
provider financial incentives, benefit mandates (including mandatory length of
stay and emergency room coverage) and limitations on the ability to manage care
and utilization of any willing provider or pharmacy laws. It also includes
adverse actions of governmental payors, including unilateral reduction of
Medicare and Medicaid premiums payable; discontinuance of or limitation on
governmentally-funded programs and recovery by governmental payors of previously
paid amounts; the inability to increase premiums or prospective or retroactive
reductions to premium rates for federal employees notwithstanding increases in
medical costs due to competition, government regulation or other factors;
adverse regulatory determinations resulting in loss or limitations of licensure,
certification or contracts with governmental payors; and increase by regulatory
authorities of minimum capital, reserve and other financial viability
requirements.
OTHER. Results may differ materially from those projected, forecast,
estimated and budgeted by the Company due to adverse results in ongoing audits
or in other reviews conducted by federal or state agencies or health care
purchasing cooperatives; adverse results in significant litigation matters; and
changes in interest rates causing an increase in interest expense.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
PAGE
Consolidated Balance Sheets. . . . . . . . . . . . . . . .22
Consolidated Statements of Income. . . . . . . . . . . . .23
Consolidated Statements of Shareholders' Equity. . . . . .24
Consolidated Statements of Cash Flows. . . . . . . . . . .25
Notes to Consolidated Financial Statements . . . . . . . .27
Report of Ernst & Young LLP Independent Auditors . . . . .39
Quarterly Information for Fiscal
Years 1996 and 1995 (Unaudited). . . . . . . . . . . . .40
21
<PAGE>
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
SEPTEMBER 30
(in thousands, except per share data) 1996 1995
- ---------------------------------------------------------------------------------------------------------
<S> <C> <C>
ASSETS
Current assets:
Cash and equivalents $ 142,818 $ 279,145
Marketable securities 557,275 532,380
Receivables, net 169,545 112,408
Prepaid expenses 8,274 9,469
Deferred income taxes 56,295 28,207
- ---------------------------------------------------------------------------------------------------------
Total current assets 934,207 961,609
- ---------------------------------------------------------------------------------------------------------
Property, plant and equipment at cost, net of accumulated
depreciation and amortization 93,816 99,276
Marketable securities - restricted 32,406 23,108
Goodwill and intangible assets 228,834 295,794
Other assets 10,199 5,585
- ---------------------------------------------------------------------------------------------------------
$ 1,299,462 $ 1,385,372
- ---------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Medical claims and benefits payable:
Medical claims payable $ 177,600 $ 192,800
Incentives payable to participating medical groups 74,000 80,600
Future life and annuity policy benefits 16,400 15,000
- ---------------------------------------------------------------------------------------------------------
Total medical claims and benefits payable 268,000 288,400
- ---------------------------------------------------------------------------------------------------------
Accounts payable 31,082 21,699
Accrued liabilities 92,945 74,685
Accrued compensation and employee benefits 46,930 45,415
Income taxes payable 1,325 7,404
Unearned premium revenue 24,059 195,413
Long-term debt due within one year 6,323 7,978
- ---------------------------------------------------------------------------------------------------------
Total current liabilities 470,664 640,994
- ---------------------------------------------------------------------------------------------------------
Long-term debt due after one year 5,183 11,949
Minority interest 391 405
Commitments and contingencies
Shareholders' equity:
Preferred shares, par value $1.00 per share; 20,000
shares authorized; none issued - -
Class A common shares, par value $0.01 per share;
100,000 shares authorized; 12,380 and 12,331 shares
issued in 1996 and 1995, respectively 124 123
Class B common shares, par value $0.01 per share;
100,000 shares authorized; 18,912 and 18,551 shares
issued in 1996 and 1995, respectively 189 186
Additional paid-in capital 370,442 347,548
Unrealized gains on available-for-sale securities, net of taxes 1,293 4,944
Retained earnings 451,176 379,223
- ---------------------------------------------------------------------------------------------------------
Total shareholders' equity 823,224 732,024
- ---------------------------------------------------------------------------------------------------------
$ 1,299,462 $ 1,385,372
- ---------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------
</TABLE>
See accompanying notes.
22
<PAGE>
CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30
(in thousands, except per share data) 1996 1995 1994
- ------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Revenue:
Commercial premiums $ 1,866,830 $ 1,512,080 $ 1,237,411
Government premiums (Medicare and Medicaid) 2,720,698 2,170,885 1,618,145
Other income 49,777 48,057 37,696
- ------------------------------------------------------------------------------------------------------------------
Total operating revenue 4,637,305 3,731,022 2,893,252
Expenses:
Health care services:
Medical services 1,844,516 1,453,289 1,127,785
Hospital services 1,595,510 1,264,002 968,605
Other services 432,721 359,844 277,868
- ------------------------------------------------------------------------------------------------------------------
Total health care services 3,872,747 3,077,135 2,374,258
Marketing, general and administrative expenses 575,928 498,445 394,620
Impairment, disposition and restructuring charges 75,840 - -
Office of Personnel Management charge 25,000 - -
Amortization of goodwill and intangible assets 9,153 7,199 3,444
- ------------------------------------------------------------------------------------------------------------------
Operating income 78,637 148,243 120,930
Interest income 46,237 39,406 28,588
Interest expense (2,094) (5,549) (4,050)
- ------------------------------------------------------------------------------------------------------------------
Income before income taxes and cumulative effect
of a change in accounting principle 122,780 182,100 145,468
Provision for income taxes 50,827 74,005 60,875
- ------------------------------------------------------------------------------------------------------------------
Income before cumulative effect of a change in
accounting principle 71,953 108,095 84,593
Cumulative effect on prior years of a change in
accounting principle - - 5,658
- ------------------------------------------------------------------------------------------------------------------
Net income $ 71,953 $ 108,095 $ 90,251
- ------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------
Weighted average common shares and equivalents
outstanding used to calculate earnings per share 31,671 29,864 28,004
- ------------------------------------------------------------------------------------------------------------------
Earnings per share:
Before cumulative effect of a change in accounting principle $ 2.27 $ 3.62 $ 3.02
Cumulative effect on prior years of a change in
accounting principle - - .20
- ------------------------------------------------------------------------------------------------------------------
Earnings per share $ 2.27 $ 3.62 $ 3.22
- ------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------
</TABLE>
See accompanying notes.
23
<PAGE>
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30, 1996, 1995 AND 1994
CLASS A COMMON SHARES CLASS B COMMON SHARES
------------------------ ------------------------
(in thousands) OUTSTANDING AMOUNT OUTSTANDING AMOUNT
- -----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Balances at September 30, 1993 12,133 $ 121 15,123 $ 151
- -----------------------------------------------------------------------------------------------------------------------------
Issuance of common stock upon exercise of stock options 105 1 181 2
Issuance of common stock under incentive plan - - 21 -
Tax benefit realized upon exercise of stock options - - - -
Purchase and retirement of common stock - - (35) -
Net income - - - -
- -----------------------------------------------------------------------------------------------------------------------------
Balances at September 30, 1994 12,238 122 15,290 153
- -----------------------------------------------------------------------------------------------------------------------------
Issuance of 3,000 shares of common stock in connection
with public offering - - 3,000 30
Issuance of common stock upon exercise of stock options 93 1 245 3
Issuance of common stock under incentive plan - - 16 -
Tax benefit realized upon exercise of stock options - - - -
Cumulative effect of a change in accounting principle,
net of taxes of $2,474 - - - -
Change in unrealized gains (losses), net of taxes of $5,516 - - - -
Net income - - - -
- -----------------------------------------------------------------------------------------------------------------------------
Balances at September 30, 1995 12,331 123 18,551 186
- -----------------------------------------------------------------------------------------------------------------------------
Issuance of common stock upon exercise of stock options 49 1 347 3
Issuance of common stock under incentive plan - - 14 -
Tax benefit realized upon exercise of stock options - - - -
Change in unrealized gains (losses), net of taxes of $2,304 - - - -
Net income - - - -
- -----------------------------------------------------------------------------------------------------------------------------
Balances at September 30, 1996 12,380 $ 124 18,912 $ 189
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
YEARS ENDED SEPTEMBER 30, 1996, 1995 AND 1994 UNREALIZED
GAINS (LOSSES)
ADDITIONAL ON AVAILABLE
PAID-IN FOR SALE RETAINED
(in thousands) CAPITAL SECURITIES EARNINGS TOTAL
- -----------------------------------------------------------------------------------------------------------------------------
Balances at September 30, 1993 $ 138,145 $ - $ 180,877 $ 319,294
- -----------------------------------------------------------------------------------------------------------------------------
Issuance of common stock upon exercise of stock options 2,323 - - 2,326
Issuance of common stock under incentive plan 849 - - 849
Tax benefit realized upon exercise of stock options 1,715 - - 1,715
Purchase and retirement of common stock (1,077) - - (1,077)
Net income - - 90,251 90,251
- -----------------------------------------------------------------------------------------------------------------------------
Balances at September 30, 1994 141,955 - 271,128 413,358
- -----------------------------------------------------------------------------------------------------------------------------
Issuance of 3,000 shares of common stock in connection
with public offering 197,602 - - 197,632
Issuance of common stock upon exercise of stock options 3,284 - - 3,288
Issuance of common stock under incentive plan 1,024 - - 1,024
Tax benefit realized upon exercise of stock options 3,683 - - 3,683
Cumulative effect of a change in accounting principle,
net of taxes of $2,474 - (3,808) - (3,808)
Change in unrealized gains (losses), net of taxes of $5,516 - 8,752 - 8,752
Net income - - 108,095 108,095
- -----------------------------------------------------------------------------------------------------------------------------
Balances at September 30, 1995 347,548 4,944 379,223 732,024
- -----------------------------------------------------------------------------------------------------------------------------
Issuance of common stock upon exercise of stock options 13,338 - - 13,342
Issuance of common stock under incentive plan 1,172 - - 1,172
Tax benefit realized upon exercise of stock options 8,384 - - 8,384
Change in unrealized gains (losses), net of taxes of $2,304 - (3,651) - (3,651)
Net income - - 71,953 71,953
- -----------------------------------------------------------------------------------------------------------------------------
Balances at September 30, 1996 $ 370,442 $ 1,293 $ 451,176 $ 823,224
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
</TABLE>
See accompanying notes.
24
<PAGE>
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30
(in thousands) 1996 1995 1994
- ----------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Operating activities:
Net income $ 71,953 $ 108,095 $ 90,251
Adjustments to reconcile net income to net cash (used in)
provided by operating activities:
Impairment, disposition and restructuring charges 75,840 - -
Deferred income taxes (25,783) (2,834) (9,411)
Office of Personnel Management charge 25,000 - -
Depreciation and amortization 22,949 21,436 17,913
Amortization of goodwill and intangible assets 9,153 7,199 3,444
Provision for doubtful accounts 999 530 532
Loss on disposal of property, plant and equipment and other 750 2,147 687
Cumulative effect of a change in accounting principle - - (5,658)
Changes in assets and liabilities, net of effects from
acquisitions:
Accounts receivable (55,971) (27,458) (15,607)
Prepaid expenses and other assets (5,038) (2,489) 9,774
Medical claims and benefits payable (21,261) (19,093) 29,043
Accounts payable (13,629) (153) (5,819)
Accrued liabilities 18,766 27,575 8,336
Accrued compensation and employee benefits 1,515 7,678 9,249
Income taxes payable (6,079) 656 2,372
Unearned premium revenue (172,156) 23,934 153,387
- ----------------------------------------------------------------------------------------------------------------
Net cash flows (used in) provided by operating activities (72,992) 147,223 288,493
- ----------------------------------------------------------------------------------------------------------------
Investing activities:
Acquisitions, net of cash acquired (5,403) (134,971) (69,589)
Purchase of property, plant and equipment (22,728) (25,035) (24,979)
Purchase of marketable securities (30,623) (6,395) (113,415)
(Purchase) sale of marketable securities - restricted (9,298) (7,114) 450
Proceeds from sale of property, plant and equipment - 3,056 -
- ----------------------------------------------------------------------------------------------------------------
Net cash flows used in investing activities (68,052) (170,459) (207,533)
- ----------------------------------------------------------------------------------------------------------------
Financing activities:
Proceeds from issuance of common stock 13,342 200,920 2,326
Principal payments on long-term debt (8,625) (174,483) (5,212)
Proceeds from borrowings of long-term debt - 83,335 82,350
Purchase and retirement of common stock - - (1,077)
- ----------------------------------------------------------------------------------------------------------------
Net cash flows provided by financing activities 4,717 109,772 78,387
- ----------------------------------------------------------------------------------------------------------------
Net (decrease) increase in cash and equivalents (136,327) 86,536 159,347
Beginning cash and equivalents 279,145 192,609 33,262
- ----------------------------------------------------------------------------------------------------------------
Ending cash and equivalents $ 142,818 $ 279,145 $ 192,609
- ----------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------
</TABLE>
See accompanying notes.
25
<PAGE>
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30
(in thousands) 1996 1995 1994
- ------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Supplemental cash flow information
Cash paid during the year for:
Income taxes $ 74,092 $ 61,166 $ 66,510
Interest $ 1,230 $ 2,685 $ 2,466
- ------------------------------------------------------------------------------------------------------------
Supplemental schedule of noncash investing and financing
activities:
Tax benefit realized upon exercise of stock options $ 8,384 $ 3,683 $ 1,715
Compensation awarded in Class B Common Stock $ 1,172 $ 1,024 $ 849
Leases capitalized $ 183 $ 392 $ 4,063
Capitalized leases terminated $ - $ - $ 1
- ------------------------------------------------------------------------------------------------------------
Details of unrealized gains on marketable securities:
Increase (decrease) in marketable securities $ (5,955) $ 7,986 $ -
Less decrease (increase) in deferred income tax assets 2,304 (3,042) $ -
- ------------------------------------------------------------------------------------------------------------
Increase (decrease) in shareholders' equity $ (3,651) $ 4,944 $ -
- ------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------
Details of businesses acquired in purchase transactions:
Fair value of assets acquired $ 9,906 $ 152,456 $ 130,323
Less liabilities assumed or created, including
notes to sellers 3,023 15,909 42,587
- ------------------------------------------------------------------------------------------------------------
Cash paid for acquisitions 6,883 136,547 87,736
Cash acquired in acquisitions 1,480 1,576 18,147
- ------------------------------------------------------------------------------------------------------------
Net cash paid for acquisitions $ 5,403 $ 134,971 $ 69,589
- ------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------
</TABLE>
See accompanying notes.
26
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. THE REPORTING ENTITY
a) ORGANIZATION AND OPERATIONS. PacifiCare Health Systems, Inc. (the
"Company") owns and operates federally qualified health maintenance
organizations ("HMOs"), which arrange health care services principally for a
predetermined, prepaid periodic fee to enrolled subscriber groups through
independent health care organizations under contract. The Company also offers
certain specialty products and services to group purchasers and to other
managed care organizations and their beneficiaries, including pharmacy benefit
management, life and health insurance, behavioral health services, dental and
vision services and Medicare risk management services. UniHealth, a California
non-profit public benefit corporation ("UniHealth"), owned approximately 48
percent and 2 percent of the Company's outstanding shares of Class A Common
Stock, par value $0.01 per share (the "Class A Common Stock") and Class B
Common Stock, par value $0.01 per share (the "Class B Common Stock"),
respectively, at September 30, 1996.
b) BASIS OF PRESENTATION. The accompanying consolidated financial
statements include the accounts of the Company and all significant subsidiaries
which are more than 50 percent owned and controlled. All significant
intercompany transactions and balances have been eliminated in consolidation.
2. SIGNIFICANT ACCOUNTING POLICIES
a) CASH AND EQUIVALENTS. Cash and equivalents are defined as cash, money
market funds and certificates of deposit with a maturity, on acquisition date,
of three months or less.
b) MARKETABLE Securities. The Company has determined that all marketable
securities (which are comprised of municipal bonds, corporate notes, commercial
paper and U.S. Treasury securities) held at September 30, 1996 and 1995, except
marketable securities-restricted, are designated available for sale.
Accordingly, such securities are carried at fair value and unrealized gains or
losses, net of applicable income taxes, are recorded in shareholders' equity.
These marketable securities are available for use in current operations and,
accordingly, such securities are classified as current assets without regard to
the securities' contractual maturity dates. As of October 1, 1994, the Company
adopted Statement of Financial Accounting Standards ("SFAS") No. 115,
"Accounting for Certain Investments in Debt and Equity Securities" which
decreased marketable securities by $6.3 million, decreased shareholders' equity
by $3.8 million and increased deferred tax assets by $2.5 million.
The Company is required by state regulatory agencies to set aside funds
for the protection of their plan members in accordance with the laws of the
various states in which they operate. Such funds are included in marketable
securities-restricted (which are comprised of U.S. government securities and
certificates of deposit held by trustees or state regulatory agencies). The
Company determined that all marketable securities-restricted are held-to-
maturity since the Company has the intent and ability to hold the securities to
maturity. Held-to-maturity securities continue to be stated at amortized cost,
adjusted for amortization of premiums and accretion of discounts to maturity,
and are classified as noncurrent assets.
c) CONCENTRATIONS OF CREDIT RISK. Financial instruments which
potentially subject the Company to concentrations of credit risk consist
primarily of investments in marketable securities and commercial premiums
receivable. The Company's short-term investments in marketable securities are
managed by professional investment managers within guidelines established by
the Company's Board of Directors, which, as a matter of policy, limit the
amounts which may be invested in any one issuer. Concentrations of credit risk
with respect to commercial premiums receivable are limited due to the large
number of employer groups comprising the Company's customer base. In
management's opinion, the Company had no significant concentrations of credit
risk at September 30, 1996.
d) FAIR VALUE OF FINANCIAL INSTRUMENTS. The Company's consolidated
balance sheets include the following financial instruments: cash and cash
equivalents, trade accounts and notes receivable, trade accounts payable and
long-term obligations. The Company considers the carrying amounts of current
assets and liabilities in the consolidated financial statements to approximate
the fair value for these financial instruments because of the
27
<PAGE>
relatively short period of time between origination of the instruments and
their expected realization. The Company considers that the carrying value of
all long-term obligations approximates the fair value of such obligations.
e) PROPERTY, PLANT AND EQUIPMENT. Property, plant and equipment are
recorded at cost; replacements and major improvements are capitalized, while
repairs and maintenance are charged to expense as incurred. Upon sale or
retirement of property, plant and equipment, the costs and related accumulated
depreciation are eliminated from the accounts. Any resulting gains and losses
are included in the determination of net income. Property, plant and equipment
including assets under capital leases are depreciated using the straight-line
method for financial reporting purposes over estimated useful lives ranging
from five to twenty-five years. Leasehold improvements are amortized using the
straight-line method over the term of the lease or ten years, whichever is
shorter.
f) GOODWILL AND INTANGIBLE ASSETS. Goodwill and intangible assets
represent principally the unamortized excess of the cost of acquiring
subsidiary companies over the fair values of such companies' net tangible
assets at the dates of acquisition. Goodwill and intangible assets are
amortized on a straight-line basis over periods not exceeding forty years. As
of September 30, 1996 and 1995, accumulated amortization totaled $25.2 million
and $16.0 million, respectively.
g) ACCOUNTING FOR IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED
ASSETS TO BE DISPOSED OF. The Company periodically reviews its long-lived
assets for impairment based on discounted future cash flows analyses. In the
fourth quarter of fiscal year 1996, the Company determined that certain
intangibles, primarily goodwill, were no longer recoverable from future
operations (See Note 11 - Impairment, Disposition, Restructuring and OPM
Charges).
In March 1995, SFAS No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed Of," was issued. The statement
requires impairment losses to be recorded on long-lived assets used in
operations when indicators of impairment are present and the undiscounted cash
flows estimated to be generated by those assets are less than the assets'
carrying amount. The statement also addresses the accounting for long-lived
assets that are expected to be disposed of. The Company will adopt SFAS No.
121 on October 1, 1996 and, based on current accounting policies, does not
believe the effect of the adoption will be material.
h) SOFTWARE COSTS. Direct costs associated with the development of
computer software are expensed as incurred. These costs totaled $12.5 million,
$12.1 million and $9.6 million for the fiscal years ended September 30, 1996,
1995 and 1994, respectively.
i) PREMIUMS AND REVENUE RECOGNITION. Prepaid health care premiums from
the Company's HMOs' enrolled groups are reported as revenue in the month in
which enrollees are entitled to receive health care. Premiums received prior
to such period are recorded as unearned premium revenue. Funds received under
the federal Medicare programs accounted for approximately 57 percent of the
Company's premium revenue for each of the fiscal years ended September 30,
1996, 1995 and 1994.
j) HEALTH CARE SERVICES. The Company's HMOs arrange for comprehensive
health care services to their members principally through capitation, a fixed
monthly payment made without regard to the frequency, extent or nature of the
health care services actually furnished. Benefits are provided to enrolled
members generally through the Company's contractual relationships with
physician groups and hospitals. The Company's contracted providers may, in
turn, contract with specialists or referral providers for specific services and
are responsible for any related payments to those referral providers.
The Company's HMOs have various programs that provide incentives to
participating medical groups through the use of risk-sharing agreements and
other programs. Payments are made to medical groups based on their performance
in controlling health care costs while providing quality health care. Expenses
related to these programs, which are based in part on estimates, are recorded
in the period in which the related services are dispensed.
The cost of health care provided is accrued in the period it is dispensed
to the enrolled members, based in part on estimates for hospital services and
other health care costs which have been incurred but not yet reported. The
Company has also recorded reserves, based in part on estimates, to indemnify
its members against potential referral
28
<PAGE>
claims related to insolvent medical groups. The Company's HMOs have stop-loss
insurance to cover unusually high costs of care when incurred beyond a
predetermined annual amount per enrollee.
k) UTILIZATION REVIEW AND CASE MANAGEMENT SERVICES. The Company's HMOs
conduct utilization review and case management programs to ensure that their
providers deliver a consistent quality of care to members. The utilization
review program essentially provides patients with second opinions, while the
case management program assigns nurses to complicated, high-risk or chronic
cases to evaluate and recommend treatment options to the patient and provider.
Exclusive of costs related to the Company's behavioral health product, the
HMOs' costs associated with providing these medical services are recorded in
marketing, general and administrative expenses and totaled $11.5 million, $10.4
million and $7.4 million for the fiscal years ended September 30, 1996, 1995
and 1994, respectively.
l) ACCOUNTING FOR STOCK-BASED COMPENSATION. In October 1995, SFAS No.
123, "Accounting for Stock-Based Compensation," was issued which provides an
alternative to Accounting Principles Board ("APB") Opinion No. 25, "Accounting
for Stock Issued to Employees." SFAS No. 123 encourages, but does not require,
recognition of compensation expense for grants of stock, stock options and
other equity instruments to employees based on the fair value. SFAS No. 123
also allows companies to continue to measure compensation cost using the
intrinsic value method of accounting prescribed by APB Opinion No. 25. While
recognition for employee stock-based compensation is not mandatory, SFAS No.
123 requires companies that choose not to adopt the new fair value accounting
rules to disclose pro forma net income and earnings per share under the new
method. The Company intends to continue with the intrinsic value based method
prescribed by APB Opinion No. 25 and make proforma disclosures of net income
and earnings per share, as if the fair value based method of accounting defined
in SFAS No. 123 had been applied beginning on October 1, 1996.
m) TAXES BASED ON PREMIUMS AND INCOME. Certain states in which the
Company does business require the remittance of excise, per capita or premium
taxes based upon a specified rate for enrolled members or a percentage of
billed premiums. Such taxes may be levied in lieu of a state income tax.
These amounts are recorded in marketing, general and administrative expenses
and totaled $6.0 million, $4.3 million and $4.0 million for the fiscal years
ended September 30, 1996, 1995 and 1994.
As of October 1, 1993, the Company adopted SFAS No. 109, "Accounting for
Income Taxes" and recorded a benefit for the cumulative effect prior to October
1, 1993 of the change in accounting principle of $5.7 million or approximately
$0.20 per share.
n) EARNINGS PER SHARE. Earnings per share are computed on the weighted
average number of common shares outstanding each year. Outstanding stock
options are common stock equivalents and are included in earnings per share
computations.
o) USE OF ESTIMATES IN PREPARATION OF FINANCIAL STATEMENTS. The
preparation of consolidated financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from these estimates. Principal
areas requiring the use of estimates include: determination of allowances for
doubtful accounts receivable, medical claims payable, professional and general
liability, reserves relating to the Office of Personnel Management ("OPM")
contract and certain other reserves (See Note 11 - "Impairment, Disposition,
Restructuring and OPM Charges").
29
<PAGE>
3. MARKETABLE SECURITIES
The following table summarizes marketable securities as of September 30,
1996:
<TABLE>
<CAPTION>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED
(amounts in thousands) COST GAINS LOSSES FAIR VALUE
- -------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Marketable securities:
U.S. Government and agency $ 165,789 $ 988 $ (827) $ 165,950
State, municipal and state and local agency 205,321 2,986 (207) 208,100
Corporate debt and other securities 184,134 662 (1,571) 183,225
- ------------------------------------------------------------------------------------------------------------------------------
Total marketable securities 555,244 4,636 (2,605) 557,275
- ------------------------------------------------------------------------------------------------------------------------------
Marketable securities - restricted:
U.S. Government and agency 15,842 - - 15,842
Municipal and local agency 8,020 - - 8,020
Corporate debt and other securities 8,544 - - 8,544
- ------------------------------------------------------------------------------------------------------------------------------
Total marketable securities - restricted 32,406 - - 32,406
- ------------------------------------------------------------------------------------------------------------------------------
Total marketable securities $ 587,650 $ 4,636 $ (2,605) $ 589,681
- ------------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------------
</TABLE>
The following table summarizes marketable securities as of September 30,
1995:
<TABLE>
<CAPTION>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED
(amounts in thousands) COST GAINS LOSSES FAIR VALUE
- -------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Marketable securities:
U.S. Government and agency $ 120,756 $ 3,396 $ (63) $ 124,089
State, municipal and state and local agency 224,704 4,594 (237) 229,061
Corporate debt and other securities 178,934 1,498 (1,202) 179,230
- ------------------------------------------------------------------------------------------------------------------------------
Total marketable securities 524,394 9,488 (1,502) 532,380
- ------------------------------------------------------------------------------------------------------------------------------
Marketable securities - restricted:
U.S. Government and agency 5,595 11 - 5,606
Corporate debt and other securities 17,513 - - 17,513
- ------------------------------------------------------------------------------------------------------------------------------
Total marketable securities - restricted 23,108 11 - 23,119
- ------------------------------------------------------------------------------------------------------------------------------
Total marketable securities $ 547,502 $ 9,499 $ (1,502) $ 555,499
- ------------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------------
</TABLE>
30
<PAGE>
As of September 30, 1996, the contractual maturities of the Company's
marketable securities were as follows:
<TABLE>
<CAPTION>
MARKETABLE SECURITIES MARKETABLE SECURITIES -
RESTRICTED
---------------------------------------------------------------
AMORTIZED AMORTIZED
(amounts in thousands) COST FAIR VALUE COST FAIR VALUE
- -------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Due in one year or less $ 124,696 $ 124,779 $ 18,225 $ 18,225
Due after one year through five years 202,751 202,807 8,986 8,986
Due after five years through ten years 187,348 189,300 4,733 4,733
Due after ten years 40,449 40,389 462 462
- -------------------------------------------------------------------------------------------------------------
$ 555,244 $ 557,275 $ 32,406 32,406
- -------------------------------------------------------------------------------------------------------------
- -------------------------------------------------------------------------------------------------------------
</TABLE>
During the fiscal years ended September 30, 1996 and 1995, proceeds from
sales and maturities of marketable securities were $1.4 billion and $2.7
billion, resulting in gross realized gains of $3.9 million and $6.0 million and
realized losses of $1.8 million and $6.8 million, respectively. Realized gains
and losses are included in interest income under the specific identification
method.
4. PROPERTY, PLANT AND EQUIPMENT
The following table summarizes the components of property, plant and
equipment:
SEPTEMBER 30
(in thousands) 1996 1995
- -------------------------------------------------------------------------------
Land $ 12,060 $ 12,060
Buildings and improvements 32,797 33,994
Furniture, fixtures and equipment 107,594 91,304
Leasehold improvements 15,793 15,620
Capital leases 17,480 18,357
Construction in progress 363 1,082
- ------------------------------------------------------------------------------
186,087 172,417
Less accumulated depreciation and amortization 92,271 73,141
- ------------------------------------------------------------------------------
Net property, plant and equipment $ 93,816 $ 99,276
- ------------------------------------------------------------------------------
- ------------------------------------------------------------------------------
5. ACQUISITIONS
The Company completed several acquisitions (the "Acquisitions") in the
fiscal years ended September 30, 1996 and 1995. In January 1996, the Company
acquired Psychology Systems, Inc., a California-based managed care behavioral
health and employee assistance program company with approximately 275,000
covered lives. During fiscal year 1995, the Company made the following
acquisitions: (i) Preferred Solutions, a San Jose-based pharmacy benefit
management company, in January 1995; (ii) ValuCare, a Fresno, California-based
HMO with approximately 67,000 members in March 1995; and (iii) the membership
of Pacific Health Plans, a Washington-based HMO, with approximately 33,000
members in March 1995.
The total purchase price for the Acquisitions, including contingent
purchase payments, is expected to be approximately $131 million. Based on the
fair values of the assets and liabilities of the acquired companies, the
preliminary estimate of excess purchase price is approximately $126 million. A
final allocation of purchase price will be determined when appraisals and other
studies are completed and contingent purchase payments are determined. The
Acquisitions have been accounted for as purchases and the operating results of
each completed acquisition are included in the consolidated financial
statements from the date of purchase. Amortization of excess purchase price is
made over a period not to exceed forty years. Proforma results of operations
have not been presented because the effects of these acquisitions were not
significant.
31
<PAGE>
6. LONG-TERM DEBT
Long-term debt consists of the following components:
SEPTEMBER 30
(in thousands) 1996 1995
- -------------------------------------------------------------------------------
8.80% privately placed senior debt, due in annual
installments of $3,750 through November 1997 $ 7,500 $ 11,250
Capitalized lease obligations 2,280 5,655
Other long-term debt 1,726 3,022
- ------------------------------------------------------------------------------
11,506 19,927
Less amounts due within one year 6,323 7,978
- ------------------------------------------------------------------------------
Long-term debt due after one year $ 5,183 $ 11,949
- ------------------------------------------------------------------------------
- ------------------------------------------------------------------------------
In November 1994, the Company established a $250.0 million revolving line
of credit with Bank of America National Trust and Saving Association and a
syndicate of banks (the "B of A Credit Line"). At that time, the Company
borrowed $82.3 million under the B of A Credit Line to pay the balance owed
under a syndicated $130.0 million credit line with The Chase Manhattan Bank.
The amount outstanding under the B of A Credit Line was repaid in March 1995
from the proceeds of the sale of the Company's Class B Common Stock (See Note 7
- - "Shareholders' Equity"). At September 30, 1996, the Company did not owe any
amounts under the B of A Credit Line.
In October 1996, the Company established a new credit facility with Bank
of America National Trust and Savings Association, as agent (See Note 13 -
"Proposed FHP Merger"), in the aggregate amount of $1.5 billion. Subsequent to
establishing this new credit facility, the B of A Credit Line was terminated.
As of September 30, 1996, the maturities of long-term debt for the years
following 1996 are as follows:
YEARS ENDING SEPTEMBER 30
(in thousands)
- ------------------------------------------------------------------------------
1997 $ 6,323
1998 3,953
1999 85
2000 76
2001 40
Thereafter 1,029
- ------------------------------------------------------------------------------
$ 11,506
- ------------------------------------------------------------------------------
- ------------------------------------------------------------------------------
Capitalized leases relate to equipment included in the accompanying
consolidated balance sheets at a cost of $17.5 million and $18.4 million at
September 30, 1996 and 1995, respectively. Accumulated amortization related to
this equipment totaled $15.4 million and $12.8 million at September 30, 1996
and 1995, respectively. These leases require future payments including
interest totaling $2.4 million at September 30, 1996 through the end of the
lease terms.
7. SHAREHOLDERS' EQUITY
In March 1996, the shareholders of the Company approved an amendment (the
"Amendment") to the Company's Certificate of Incorporation, as amended (the
"Certificate of Incorporation"), to increase the total number of authorized
shares of stock which the Company has the authority to issue to 220,000,000.
The Amendment increased the number of shares of the Class A Common Stock, which
the Company is authorized to issue from 30,000,000 to 100,000,000, increased
the number of shares of the Class B Common Stock which the Company is
authorized to issue from 60,000,000 to 100,000,000 and increased the total
number of shares of preferred stock, par value $1.00 per share (the "Preferred
Stock"), which the Company is authorized to issue from 10,000,000 to
20,000,000. Holders of the Class A Common Stock have one vote per share while
holders of the Class B Common Stock have no voting rights other than as
required by Delaware law. Holders of the Class A
32
<PAGE>
Common Stock and Class B Common Stock are entitled to equal amounts per share
of cash distributions and stock dividends, if any, upon liquidation of the
Company and consideration in a merger or consolidation of the Company.
As of March 29, 1995, the Company completed a public offering of 5,175,000
shares of its Class B Common Stock of which 3,000,000 shares were issued and
sold by the Company and 2,175,000 shares were sold by UniHealth. The sale of
4,500,000 shares of the Class B Common Stock closed on March 23, 1995 with the
sale of the additional 675,000 shares of the Class B Common Stock occurring on
March 29, 1995 pursuant to the exercise of the underwriters' over-allotment
option.
The Company received net proceeds of approximately $197.6 million from the
sale of the 3,000,000 shares of Class B Common Stock after deducting
underwriting discounts and commissions and expenses of the offering payable by
the Company. The Company did not receive any of the proceeds from the sale of
shares of Class B Common Stock by UniHealth. The Company used approximately
$186.0 million of the net proceeds to repay the amount outstanding under its B
of A Credit Line and to replenish working capital used to pay for certain of
the Acquisitions (see Note 5 - "Acquisitions").
In December 1994, the Company completed a public offering of 90,000 shares
of its Class B Common Stock to certain physician groups which currently
contract with the Company. Each group has entered into an irrevocable
obligation to purchase a fixed number of shares of the Class B Common Stock
over a five year period beginning May 1, 1996 at $64.88 per share. As of
September 30, 1996, 14,000 shares had been purchased and 20,000 shares
forfeited.
8. TRANSACTIONS WITH RELATED PARTIES
The Company purchased health care services from hospitals owned and
managed by UniHealth totaling $73.9 million, $70.6 million and $61.5 million
for the fiscal years ended September 30, 1996, 1995 and 1994, respectively.
UniHealth purchased health care coverage from the Company in the amounts of
$6.5 million, $12.0 million and $10.0 million for the fiscal years ended
September 30, 1996, 1995 and 1994, respectively.
Joseph S. Konowiecki, the Secretary and General Counsel of the Company, is
the sole shareholder of Joseph S. Konowiecki, Inc., a California professional
corporation, which is a partner of the law firm of Konowiecki & Rank. The
Company purchased legal services from Konowiecki & Rank in the amounts of $4.0
million, $3.2 million and $3.1 million for the fiscal years ended September
30, 1996, 1995 and 1994, respectively.
33
<PAGE>
9. INCOME TAXES
Deferred income taxes reflect the net effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components
of the Company's deferred tax assets and liabilities are as follows:
SEPTEMBER 30
(IN THOUSANDS) 1996 1995
- ------------------------------------------------------------------------------
Deferred tax assets:
Future benefit from goodwill impairment $ 22,637 $ -
Accrued health care costs 14,477 15,147
Accrued compensation 11,025 8,682
Accrued expenses 5,107 4,761
Other assets 2,550 485
Depreciation 2,137 693
State franchise taxes 1,779 3,121
Capital leases - 708
- ------------------------------------------------------------------------------
59,712 33,597
Deferred tax liabilities:
Prepaid expenses (1,451) (1,445)
Unrealized gains on marketable securities (738) (3,042)
Capital leases (726) -
Other liabilities (502) (903)
- ------------------------------------------------------------------------------
Net deferred tax assets $ 56,295 $ 28,207
- ------------------------------------------------------------------------------
- ------------------------------------------------------------------------------
The provision for income taxes for the fiscal years ended September 30,
1996, 1995 and 1994, consists of the following components:
YEARS ENDED SEPTEMBER 30
(in thousands) 1996 1995 1994
- ------------------------------------------------------------------------------
Current:
Federal $ 62,781 $ 62,912 $ 58,036
State 13,829 13,927 12,250
- ------------------------------------------------------------------------------
Total current 76,610 76,839 70,286
Deferred:
Federal (22,172) (2,444) (9,349)
State (3,611) (390) (62)
- ------------------------------------------------------------------------------
Total deferred (25,783) (2,834) (9,411)
- ------------------------------------------------------------------------------
Provision for income taxes $ 50,827 $ 74,005 $ 60,875
- ------------------------------------------------------------------------------
- ------------------------------------------------------------------------------
34
<PAGE>
The following table summarizes significant differences between the
provision for income taxes and the amount computed by applying the statutory
federal income tax rate to income before income taxes:
YEARS ENDED SEPTEMBER 30
(in thousands) 1996 1995 1994
- ------------------------------------------------------------------------------
Computed expected provision 35.0% 35.0% 35.0%
State taxes, net of federal benefit 4.4 4.9 5.4
Tax exempt interest (3.6) (2.2) (1.9)
Future benefit from goodwill impairment 1.8 - -
Amortization of intangibles 1.5 1.1 0.7
Other, net 2.3 1.8 2.6
- ------------------------------------------------------------------------------
Provision for income taxes 41.4% 40.6% 41.8%
- ------------------------------------------------------------------------------
- ------------------------------------------------------------------------------
The Company and its subsidiaries file a consolidated Federal income tax
return. The Company also files a combined California franchise tax return with
its subsidiaries.
10. EMPLOYEE BENEFIT PLANS
a) Savings and Profit-Sharing Plan. The Company has an employee profit-
sharing plan (the "Plan") covering substantially all full-time employees, which
provides for annual contributions by the Company of two percent of the annual
compensation of employees and additional amounts determined by the Board of
Directors which are generally based upon a percentage of pretax income.
Employees may defer up to twelve percent of their annual compensation under the
Plan, with the Company matching one-half of the deferred amount, up to a
maximum of three percent of annual compensation. Amounts charged to expense
applicable to the Plan were $13.7 million, $14.3 million and $10.3 million for
the fiscal years ended September 30, 1996, 1995 and 1994, respectively.
b) Stock Option Plans. The Company has granted stock options for
employees and directors under various plans including the Stock Option Plan for
Executive and Key Employees, as amended (the "1985 Plan"), the Second Amended
and Restated 1989 Stock Option Plan for Officers and Key Employees, as amended
(the "1989 Employee Plan"), the 1989 Non-Officer Directors Stock Option Plan
(the "1989 Director Plan") and the amended 1992 Non-Officer Directors Stock
Option Plan (the "1992 Director Plan").
Grants under the 1985 Plan and 1989 Director Plan were suspended. The
total number of shares of common stock which may be granted as incentive stock
options, non-qualified stock options ("NQSOs"), stock appreciation rights
("SARs") and stock payments under the 1989 Employee Plan as of September 30,
1996 is approximately 980,400. Options may be granted for a term of up to ten
years at a price not less than 100 percent of the fair market value of the
common stock at the time of grant.
The 1992 Director Plan provides for a maximum of 140,000 shares of Class B
Common Stock issuable upon the exercise of NQSOs granted to eligible non-
officer Directors of the Company. Non-officer Directors of the Company who are
not eligible to receive options under the 1989 Employee Plan are eligible to
receive NQSOs under the 1992 Director Plan. The Company's Board of Directors
has amended the 1992 Directors Plan, subject to shareholder approval, to:
increase the number of shares available under the plan; increase the number of
shares underlying the NQSOs automatically granted to eligible directors of the
Company each year; and provide for the automatic grant of NQSOs to each
eligible director of the Company upon being elected the Company's Board of
Directors.
35
<PAGE>
The following table summarizes the activity in NQSOs under the 1985 Plan,
the 1989 Employee Plan, the 1989 Director Plan and the 1992 Director Plan for
the fiscal years ended September 30, 1996 and 1995:
<TABLE>
<CAPTION>
NON-QUALIFIED STOCK OPTIONS
- -------------------------------------------------------------------------------------------------------------
YEARS ENDED SEPTEMBER 30, CLASS A CLASS B
1996 AND 1995 STOCK EXERCISE PRICE STOCK EXERCISE PRICE
- -------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
OUTSTANDING AT SEPTEMBER 30, 1994 451,284 $ 1.63 - $ 19.75 1,304,839 $ 1.63 - $53.75
Granted - $ - - $ - 743,700 $ 65.56 - $66.75
Exercised 93,375 $ 1.63 - $ 19.75 245,233 $ 1.63 - $53.75
Canceled 825 $ 17.25 - $ 19.75 110,995 $ 17.25 - $66.75
- -------------------------------------------------------------------------------------------------------------
OUTSTANDING AT SEPTEMBER 30, 1995 357,084 $ 1.63 - $ 19.75 1,692,311 $ 1.63 - $66.75
Granted $ - $ 402,150 $ 69.50 - $87.00
Exercised 48,250 $ 1.63 - $ 17.25 333,168 $ 1.63 - $66.75
Canceled $ - $ 114,172 $ 37.38 - $69.50
- -------------------------------------------------------------------------------------------------------------
OUTSTANDING AT SEPTEMBER 30, 1996 308,834 $ 1.63 - $ 19.75 1,647,121 $ 1.63 - $87.00
- -------------------------------------------------------------------------------------------------------------
- -------------------------------------------------------------------------------------------------------------
</TABLE>
At September 30, 1996, approximately 1,955,955 shares were reserved for
issuance upon the exercise of outstanding options. As of that date, options
were exercisable for 308,834 shares of Class A Common Stock at exercise prices
of $1.63 - $19.75 per share and 434,411 shares of Class B Common Stock at
exercise prices of $1.63 - $66.75. No SARs have been awarded under the 1989
Employee Plan.
c) Performance Incentive Programs. The Company has a long-term
performance incentive program, under which all executive officers of the
Company and certain officers and key employees of the Company and its
subsidiaries are eligible to participate. Incentive compensation is based on
the achievement of objectives established by the Compensation Committee (the
"Committee") of the Board of Directors and approved by the shareholders of the
Company. For fiscal years ended September 30, 1996, 1995 and 1994, the
incentive compensation expense for this program was $3.6 million, $3.0 million
and $2.5 million, respectively.
The Company also has an annual incentive compensation program. All
executive officers of the Company or any subsidiary of the Company are eligible
to participate and any officer or full-time employee of the Company or any
subsidiary of the Company, determined by the Committee to have a direct,
significant and measurable impact on the attainment of the Company's or
subsidiary's annual growth and profitability objectives is eligible to
participate. Amounts charged to expense for the annual compensation program
were $5.1 million, $2.7 million and $7.0 million for the fiscal years ended
September 30, 1996, 1995 and 1994, respectively.
11. IMPAIRMENT, DISPOSITION, RESTRUCTURING AND OPM CHARGES
Pretax impairment, disposition, restructuring and OPM charges were
recorded for the fiscal year ended September 30, 1996 totaling $100.8 million
($62.0 million or $1.96 per share, net of tax) for the following:
a) Impairment of Goodwill Charge. In the fourth quarter the Company
recognized a charge for the impairment of goodwill associated with its Florida
operations. PacifiCare of Florida ("PCFL") was established in 1994 through the
acquisition of two health plans which resulted in more than $62.1 million of
goodwill recognized in purchase accounting. As of September 30, 1996, PCFL had
approximately 41,000 members in small group, individual and Medicaid health
plans. The business strategy for PCFL profitability was based on the launching
of the Company's Secure Horizons program in Florida. In response to the FHP
Transaction (See "Proposed FHP Merger") and the considerable amount of
resources which will be needed to integrate FHP's operations with those of the
Company, assuming the FHP Transaction is consummated , the Company decided to
explore options with respect to PCFL's operations, including a possible sale.
Accordingly, the Company withdrew its HCFA application in September 1996.
Consequently, the Company recognized a $58.7 million ($34.1 million or $1.08
per share, net of tax) impairment of PCFL goodwill and other intangible assets.
The Company expects to continue operations in Florida until a sale is
consummated or the Company makes alternative arrangements. A comprehensive
plan to dispose of PCFL's business may involve a restructuring charge in future
periods.
b) Disposition Charge. Effective June 1, 1996, PCFL and its Pasteur
Delivery Systems ("PDS") affiliates sold the assets of the PDS staff-model
medical clinics to PrimeCare of Florida, Inc. ("PrimeCare"). The transaction
36
<PAGE>
resulted in a pretax loss of $9.3 million ($8.3 million or $0.26 loss per
share, net of tax), primarily attributable to the write off of goodwill and
certain other assets, the majority of which is not deductible for income tax
purposes. PrimeCare assumed the daily operations of the PDS clinics on June
1, 1996, delivering primary and specialty health care services to certain
members under capitated contracts with PCFL.
c) Restructuring Charge. The Company recorded a pretax restructuring
charge of $7.8 million ($4.7 million, or $0.15 loss per share, net of tax) for
the three and nine months ended June 30, 1996. In June 1996, management
approved a plan relating to the discontinuation of certain specialty health
care products and services that do not meet the Company's strategic and
economic return objectives and the restructuring of regional operations,
including a reduction in workforce and the completion of regional customer
service centers. The restructuring plan was announced to all affected employees
prior to June 30, 1996. The expected costs encompass employee separation,
($3.8 million loss, pretax), asset write-offs ($2.5 million loss, pretax) and
certain other costs ($1.5 million loss, pretax). These restructuring activities
should be substantially completed by March 31, 1997.
d) OPM Charge. The results for the fiscal year ended September 30, 1996
include a pretax charge of $25.0 million ($14.9 million, or $0.47 loss per
share, net of tax) for an increase of reserves in anticipation of negotiations
relating to potential governmental claims for contracts with the United States
Office of Personnel Management ("OPM"). The Company's HMO subsidiaries have
commercial contracts with OPM to provide managed health care services to
approximately 64,000 members under the Federal Employees Health Benefits
Program ("FEHBP") for Federal employees, annuitants and their dependents. OPM,
as a normal course of business, audits health plans with which it contracts to,
among other things, verify that premiums charged under OPM contracts are
established in compliance with community rating and other requirements under
the FEHBP. OPM audits for multiple periods are in various stages of completion
for several of the Company's HMO subsidiaries.
The Company intends to negotiate with OPM on all matters to attain a
mutually satisfactory result. While there is no assurance that the negotiations
will be concluded satisfactorily or that additional liability will not be
incurred, management believes that any ultimate liability in excess of amounts
accrued which could arise upon completion of the audits by OPM of the health
plans, would not materially affect the Company's consolidated financial
position, results of operations or cash flows, however, such liability could
be material to net income of a future quarter.
12. COMMITMENTS AND CONTINGENCIES
a) LEASE COMMITMENTS. The Company leases office space and equipment
under various non-cancelable operating leases. Rental expense for the fiscal
years ended September 30, 1996, 1995 and 1994 totaled $29.1 million, $18.3
million and $10.2 million, respectively. Future minimum lease payments under
operating leases at September 30, 1996 are as follows:
YEARS ENDING SEPTEMBER 30
(in thousands)
- ------------------------------------------------------------------------------
1997 $ 24,245
1998 16,887
1999 9,089
2000 4,256
2001 2,536
Thereafter 1,538
- ------------------------------------------------------------------------------
$ 58,551
- ------------------------------------------------------------------------------
- ------------------------------------------------------------------------------
b) EMPLOYMENT AGREEMENTS. The Company has entered into employment
agreements with the President of the Company and certain other executive
officers. The agreements contain provisions that would entitle each to receive
severance benefits which are payable if employment is terminated for various
reasons, including termination following a change of ownership or control of
the Company as defined by the agreements. The maximum contingent liability for
severance payments that the Company would be required to make under the
employment agreements (excluding amounts which may be payable under incentive
plans and the value of certain benefits) would be approximately $7.1 million at
September 30, 1996.
37
<PAGE>
c) LITIGATION. The Company is involved in legal actions in the normal
course of business, some of which seek substantial monetary damages, including
claims for punitive damages which are not covered by insurance. Additionally,
the Company's programs, including services provided to government employees, in
the normal course of its business, are subject to retrospective audits by the
respective regulating agencies. After review, including consultation with
counsel, management believes any ultimate liability in excess of amounts
accrued which could arise from the actions would not materially affect the
Company's consolidated financial position, results of operations or cash flows.
13. PROPOSED FHP MERGER
On August 5, 1996, the Company announced that it had entered into a
definitive agreement and plan of reorganization with FHP International
Corporation, the Fountain Valley-based health care services company("FHP"), in
which the Company will acquire FHP for a total purchase price expected to be
approximately $2.1 billion (the "FHP Transaction"). FHP is a diversified
health care services company which, through its HMO subsidiaries, serves
approximately 1.9 million members in 11 states and Guam. FHP reported revenues
of $4.2 billion and net income of $44.2 million for the fiscal year ended June
30, 1996. FHP also operates a health indemnity insurer, a workers'
compensation insurer, and a national preferred provider organization. FHP
operates one of the largest providers of health care services for Medicare
beneficiaries in the United States. As a result of the FHP Transaction, the
Company and FHP will become wholly-owned subsidiaries of N-T Holdings, Inc., a
corporation formed to effect the FHP Transaction ("PacifiCare Holding"). In
addition, the FHP Transaction will result in the current operations of the
Company in California, Florida, Oklahoma, Oregon, Texas and Washington being
expanded to include operations in Arizona, Colorado, Illinois, Indiana,
Kentucky, New Mexico, Nevada, Ohio, Utah and Guam. The FHP Transaction will be
accounted for as a purchase and is designed to qualify as a tax-free exchange
for the stock portion.
Terms of the FHP Transaction call for holders of FHP common stock to receive
a package of consideration equal, at the time of signing, to approximately $35
per share of FHP common stock of which $17.50 per FHP share of common stock
will be paid in cash. Holders of FHP common stock will also receive a total of
2,350,000 shares of Class A Common Stock, par value $0.01 per share, of
PacifiCare Holding (the "PacifiCare Holding Class A Common Stock") with the
remaining consideration to be paid in shares of PacifiCare Holding Class B
Common Stock, par value $0.01 per share (the "PacifiCare Holding Class B Common
Stock"). Holders of FHP preferred stock will receive either: $14.113 in cash
and one half of one share of PacifiCare Holding preferred stock, assuming
approval of an amendment to the FHP Restated Certificate of Incorporation (or
an irrevocable election by the holder of FHP is made); or if the amendment is
not approved (or an irrevocable election by the holder of FHP preferred stock
is not made) (a) $25.00 in cash, (b) a mix of cash, PacifiCare Holding Class A
and Class B Common Stock determined by a formula described in the agreement and
plan of reorganization, or (c) the consideration that would have been received
had the FHP preferred stock been converted into FHP common stock immediately
prior to the consummation of the FHP Transaction.
In October 1996, PacifiCare Holding entered into a credit agreement, dated
as of October 31, 1996 (the "Credit Agreement") with Bank of America as Agent,
and a syndicate of financial institutions (collectively, the "Banks") whereby
the Banks are obligated to provide a five-year unsecured, revolving credit
facility in an aggregate amount of $1.5 billion (the "Credit Facility"). The
Company and FHP will provide guarantees under the Credit Facility. PacifiCare
Holding may borrow the full amount of the Credit Facility to fund the cash
portion of the consideration being paid to FHP shareholders and to pay a
portion of the fees and expenses incurred in the connection with the FHP
transaction. Thereafter, the Credit Facility will remain available for general
corporate purposes. Interest on the borrowing under the Credit Facility will
be based on any of the London Interbank Offering Rate, a base rate or
competitive bid. Funding under the Credit Facility is subject to the
satisfaction of a variety of customary borrowing conditions.
The FHP Transaction is subject to various federal and state regulatory
approvals, approval of the Company's and FHP's shareholders and other customary
conditions and is expected to close in February 1997. For additional
information regarding the proposed transaction, please refer to the
Registration Statement on Form S-4 filed with the Securities and Exchange
Commission on November 18, 1996.
38
<PAGE>
REPORT OF ERNST & YOUNG LLP INDEPENDENT AUDITORS
The Board of Directors and Shareholders
PacifiCare Health Systems, Inc.
We have audited the accompanying consolidated balance sheets of PacifiCare
Health Systems, Inc. as of September 30, 1996 and 1995, and the related
consolidated statements of income, shareholders' equity and cash flows for each
of the three years in the period ended September 30, 1996. Our audits also
included the financial statement schedule listed in the Index at Item 14(a)(2).
These financial statements and schedule are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of PacifiCare Health Systems, Inc. at September 30, 1996 and 1995, and the
consolidated results of its operations and its cash flows for each of the three
years in the period ended September 30, 1996 in conformity with generally
accepted accounting principles. Also in our opinion, the related financial
statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.
ERNST & YOUNG LLP
Los Angeles, California
November 18, 1996
39
<PAGE>
QUARTERLY INFORMATION FOR FISCAL YEARS 1996 AND 1995 (UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
-----------------------------------------------------------------
<S> <C> <C> <C> <C>
(in thousands, except per share amounts) DEC. 31 MARCH 31 JUNE 30(2) SEPT. 30(3)
- ---------------------------------------------------------------------------------------------------------------
YEAR ENDED SEPTEMBER 30, 1996
- ---------------------------------------------------------------------------------------------------------------
Operating revenue $ 1,064,324 $ 1,157,170 $ 1,194,718 $ 1,221,093
Operating expenses 1,029,240 1,115,205 1,185,689 1,228,534
Interest income, net 11,749 11,383 9,880 11,131
- ---------------------------------------------------------------------------------------------------------------
Income before income taxes 46,833 53,348 18,909 3,690
Provision for income taxes 18,854 21,479 10,331 163
- ---------------------------------------------------------------------------------------------------------------
Net income $ 27,979 $ 31,869 $ 8,578 $ 3,527
- ---------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------
Earnings per share $ 0.88 $ 1.01 $ 0.27 $ 0.11
- ---------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------
Membership(1) 1,816 1,959 1,996 2,031
- ---------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------
YEAR ENDED SEPTEMBER 30, 1995
- ---------------------------------------------------------------------------------------------------------------
Operating revenue $ 821,614 $ 912,766 $ 981,236 $ 1,015,406
Operating expenses 790,748 875,318 941,650 975,063
Interest income, net 3,217 8,594 11,281 10,765
- ---------------------------------------------------------------------------------------------------------------
Income before income taxes 34,083 46,042 50,867 51,108
Provision for income taxes 14,026 18,683 20,619 20,677
- ---------------------------------------------------------------------------------------------------------------
Net income $ 20,057 $ 27,359 $ 30,248 $ 30,431
- ---------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------
Earnings per share $ 0.71 $ 0.96 $ 0.97 $ 0.98
- ---------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------
Membership(1) 1,405 1,526 1,682 1,757
- ---------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------
</TABLE>
(1) Membership as of quarter-end.
(2) The June 30, 1996 results include $42.1 million of pretax charges ($27.9
million or $0.88 loss per share, net of tax) for potential government
claims, the disposition of Pasteur Delivery Systems and certain
restructuring charges
(3) The September 30, 1996 results include $58.7 million of pretax charges
($34.1 million or $1.08 per share, net of tax) for the impairment of
goodwill of the Florida operations.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS AND ACCOUNTING AND
FINANCIAL DISCLOSURE
There have been no changes in the Registrant's independent auditors or
disagreements with such auditors on accounting principles or practices or
financial statement disclosure within the last two years.
40
<PAGE>
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The Directors and Executive Officers of the Company are as follows:
<TABLE>
<CAPTION>
NAME AGE POSITION
---- --- --------
<S> <C> <C>
Terry O. Hartshorn........... 51 Chairman of the Board
Alan R. Hoops................ 49 Director, President and Chief Executive Officer
David R. Carpenter........... 57 Director
Gary L. Leary................ 61 Director
Warren E. Pinckert II........ 53 Director
David A. Reed................ 63 Director
Lloyd E. Ross................ 55 Director
Jean Bixby Smith............. 58 Director
Jeffrey Folick............... 49 Executive Vice President and Chief Operating Officer
Wayne Lowell................. 41 Executive Vice President, Chief Administrative Officer
and Chief Financial Officer
Joseph S. Konowiecki......... 43 General Counsel and Secretary
Patrick Feyen................ 40 Regional Vice President of the Southwest,
President, PacifiCare of Oklahoma, Inc. and
President, PacifiCare of Texas, Inc.
Jon Wampler.................. 45 Regional Vice President of the West and
President, PacifiCare of California
Ronald Davis................. 37 Senior Vice President, Operations
Mitchell Goodstein........... 44 Senior Vice President, Health Care Economics
Wanda Lee.................... 55 Senior Vice President, Corporate Human Resources
Linda Lyons, M.D............. 47 Senior Vice President, Health Services
Craig Schub.................. 41 Senior Vice President, Marketing and
President, Secure Horizons USA, Inc.
James Williams............... 50 Senior Vice President and Chief Information Officer
Mary Langsdorf............... 36 Vice President and Corporate Controller
</TABLE>
Terry O. Hartshorn has been a Director of the Company since 1985 and
Chairman of the Board of Directors since April 1993. Mr. Hartshorn served in
various capacities for the Company, including President and Chief Executive
Officer from 1976 to April 1993, and Secretary and a Director from 1977 to
1981. Mr. Hartshorn served as President and Chief Executive Officer of
UniHealth from April 1993 to December 1996; he resigned from those positions
effective January 1, 1997. Mr. Hartshorn has served as a Director of Apria
HealthCare Group Inc., a provider of home health care products and services
since 1991, and also as a Director of Emcare Holdings Inc., a provider of
emergency department services, since November 1994. Mr. Hartshorn is a member
of the Executive and Nominating Committees of the Company.
Alan R. Hoops has been a Director of the Company since 1994. Mr. Hoops
has been President and Chief Executive Officer of the Company since April 1993.
For the Company, Mr. Hoops has served as Executive Vice President and Chief
Operating Officer from 1986 to April 1993, as Secretary from 1982 to April
1993, as Senior Vice President from 1985 to 1986 and as Vice President,
Marketing and Planning from 1977 to 1985. Mr. Hoops is a member of the
Executive and Nominating Committees of the Company.
David R. Carpenter has been a Director of the Company since 1989. Mr.
Carpenter has been President of the Darcy Company, an actuarial and insurance
consulting company, since 1995. Mr. Carpenter served as Executive Vice
President of Transamerica Corporation from 1993 through 1995, Group Vice
President of Transamerica Corporation from 1990 through 1993, Chairman from
1985 through 1995 and Chief Executive Officer from 1984 through 1995 of
Transamerica Occidental Life Insurance Company. Mr. Carpenter has also been
Chairman of the UniHealth Board of Directors since 1994, an Ex-Officio Member
of the Compensation Committee of UniHealth since 1994 and serves as Chairman of
its Executive and Nominating Committees and Governance Subcommittee.
41
<PAGE>
Mr. Carpenter is Chairman of the Company's Compensation and Nominating
Committees and is a member of its Executive Committee. Mr. Carpenter has
served as a Director of H.F. Ahmanson & Company, parent of Home Savings of
America, since 1995.
Gary L. Leary has been a Director of the Company since 1989. Mr. Leary
has been Executive Vice President of UniHealth since April 1992, General
Counsel of UniHealth since 1988, Director and member of the Executive Committee
of UniHealth since 1988, and Secretary of the UniHealth Board of Directors
since November 1994. Mr. Leary has served as Corporate Counsel to UniHealth
and its predecessor since 1977.
Warren E. Pinckert II has been a Director of the Company since 1985. Mr.
Pinckert has been President, Chief Executive Officer and a Director of
Cholestech Corporation, a medical device manufacturing firm, since June 1993.
At Cholestech Corporation Mr. Pinckert served as Executive Vice President,
Operations from 1991 to June 1993, Vice President of Finance and Business
Development from 1989 to 1991, and Secretary from 1989 to June 1993. Mr.
Pinckert is a member of the Compensation, Executive and Special Committees of
the Company and is Chairman of its Audit/Finance Committee. Mr. Pinckert is a
certified public accountant.
David A. Reed has been a Director of the Company since 1992. Mr. Reed
currently is the President of DAR Consulting Group and serves as a special
advisor to the Health Care Practice Group of Deloitte & Touche LLP. Mr. Reed
served as President and Chief Executive Officer of St. Joseph Health System, a
nonprofit public benefit corporation, which owns and operates hospitals and
other health care service entities, from 1990 through December 1994. Mr. Reed
is a former chairman and speaker of the House of Delegates of the American
Hospital Association. Mr. Reed is a member of the Audit/Finance and Special
Committees of the Company. Mr. Reed recently has been elected to the Board of
Directors of Invitro International, a developer and distributor of in vitro
bioassay systems.
Lloyd E. Ross has been a Director of the Company since 1985. Mr. Ross has
been President and Chief Executive Officer of SMI Construction, Inc., a
commercial and industrial building company, since 1976 and has been Vice
President, Division Manager of ARB, Inc., a construction company, since
February 1996. Mr. Ross is a member of the Audit/Finance, Compensation and
Special Committees of the Company.
Jean Bixby Smith has been a Director of the Company since 1995. Ms. Smith
has been President of Bixby Land Company since January 1984 and President of
Alamitos Land Company since March 1991, both of which are engaged in the
development and management of commercial and industrial real estate. Ms. Smith
has also been a Director of UniHealth since 1988.
Jeffrey Folick has been an Executive Vice President and Chief Operating
Officer of the Company since December 1994. Between July 1992 and December
1994, Mr. Folick served in various capacities for the Company, including
Regional Vice President of the West, President of PacifiCare of California
("PCC") and Chief Operating Officer of PCC. Prior to joining PCC in July 1992,
Mr. Folick served as President of Secure Horizons from January 1991 to July
1992 and Vice President, Secure Horizons from December 1989 to December 1990.
Wayne Lowell has been Chief Administrative Officer of the Company since
December 1994, an Executive Vice President of the Company since April 1993 and
Chief Financial Officer of the Company since November 1986. Mr. Lowell served
as Senior Vice President of the Company from March 1992 to April 1993 and as
Treasurer of the Company from 1986 to April 1993. Mr. Lowell is a certified
public accountant.
Joseph S. Konowiecki has been General Counsel of the Company since October
1989 and Secretary of the Company since April 1993. Mr. Konowiecki served as
Assistant Secretary from 1989 to April 1993. Mr. Konowiecki has been a partner
of Konowiecki & Rank, a law partnership including a professional corporation,
or its predecessor, since 1980 and has over eighteen years of practice in
business, corporate and health care law.
Patrick Feyen has been Regional Vice President of the Southwest, President
and Chief Executive Officer of PacifiCare of Oklahoma, Inc. ("PCOK") and
President and Chief Executive Officer of PacifiCare of Texas, Inc. ("PCTX")
since December 1994. Mr. Feyen served as Regional Vice President of the
Northwest from September 1994 to December 1994 and President and Chief
Executive Officer of PacifiCare of Oregon, Inc. ("PCOR") from 1993 to December
1994. Mr. Feyen served as Vice President, Finance and Chief Financial Officer
of PCOR from 1991 to 1993. Prior to joining PCOR, Mr. Feyen served as Vice
President, Finance and Controller from 1990 to
42
<PAGE>
1992 and Senior Administrator, Operations from 1989 to 1990 of Michigan Health
Care Corporation, a provider of medical care and mental health services in
Detroit.
Jon Wampler has been Regional Vice President of the West and President of
PCC since December 1994. Mr. Wampler served as Regional Vice President of the
Southwest and President of PCOK from September 1994 to December 1994 and served
as President of PCTX from August 1990 to December 1994. Prior to joining the
Company, Mr. Wampler served as Executive Director of Humana Health Care Plan of
Colorado, Inc. from July 1988 to August 1990.
Ronald Davis has been Senior Vice President, Operations since June 1995.
Mr. Davis served as Senior Vice President, Operations of PCC from January 1993
to June 1995 and Vice President, Operations of PCC from November 1991 to
December 1992. From October 1989 to November 1991, Mr. Davis was Senior Vice
President, Operations and Controller of Health Plan of America, a federally
qualified health maintenance organization based in southern California, which
was merged into PCC in December 1991.
Mitchell Goodstein has been Senior Vice President, Health Care Economics
since September 1996. Mr. Goodstein served as Regional Vice President of the
Southeast and President of PacifiCare of Florida, Inc. from September 1995 to
September 1996. Prior to joining the Company, Mr. Goodstein served as Chief
Executive Officer of HMO California, a licensed health care service plan, from
June 1992 to August 1995. From July 1986 to June 1992, he was a principal of
Tillinghast, a Towers Perrin Company, which provides consulting services to
managed care entities.
Wanda Lee has been Senior Vice President, Corporate Human Resources of the
Company since March 1993. From 1989 to March 1993, Ms. Lee was Vice President
of Human Resources of FHP, Inc., a southern California-based managed care
organization.
Linda Lyons, M.D. has been Senior Vice President, Health Services since
June 1996. Prior to joining the Company, Dr. Lyons served in various
capacities for SCRIPPS Clinic Medical Group, including as Senior Vice
President, Managed Care Operations, from January 1986 to June 1996.
Craig Schub has been Senior Vice President, Marketing since June 1996 and
President of Secure Horizons USA, Inc. since April 1993. Mr. Schub served as
Senior Vice President, Government Programs from December 1994 to June 1996,
Senior Vice President of PCC, Secure Horizons of California from 1992 to 1993,
Vice President of PCC, Secure Horizons of Northern California from 1991 to 1992
and Director of Corporate Planning from 1990 to 1991.
James Williams has been Senior Vice President and Chief Information
Officer since June 1993. Prior to joining the Company, Mr. Williams served as
Senior Vice President, Information Services of Sanwa Bank California from
August 1992 to May 1993 and Senior Vice President, Retail Systems Department of
Security Pacific Automation Company from May 1988 through August 1992.
Mary Langsdorf has been Vice President and Corporate Controller since
February 1996. Ms. Langsdorf served as Vice President, Finance from October
1995 to February 1996, Director of Finance from October 1989 to October 1995
and Corporate Accounting Manager from October 1988 to October 1989.
Each Executive Officer of the Company is elected or appointed by the Board
of Directors of the Company and holds office until his successor is elected, or
until the earlier of his death, resignation or removal.
The information given in this Form 10-K concerning the Directors is based
upon statements made or confirmed to the Company by or on behalf of such
Directors, except to the extent that such information appears in its records.
43
<PAGE>
SECTION 16(a) - BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934, as amended (the
"Exchange Act") requires the Company's Officers and Directors, and persons who
own more than 10 percent of a registered class of the Company's equity
securities to file reports of ownership on Forms 3, 4 and 5 with the Securities
and Exchange Commission (the "SEC"). Officers, Directors and greater than 10
percent shareholders are required by SEC regulation to furnish the Company with
copies of all Forms 3, 4 and 5 they file.
Based solely on the Company's review of the copies of such forms it has
received and written representations from certain reporting persons that they
were not required to file Form 5 for specified fiscal years, the Company
believes that all of its Executive Officers, Directors and greater than 10
percent beneficial owners complied with all filing requirements applicable to
them with respect to transactions during fiscal year 1996, except for Mary
Langsdorf who did not file her initial report on a timely basis, Jeffrey Folick
who did not file a report for one transaction on a timely basis and Lloyd Ross
who did not file one report for four transactions on a timely basis.
44
<PAGE>
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth for the fiscal years ended September 30,
1996, 1995 and 1994, the compensation for services in all capacities to the
Company of those persons who were during the fiscal year ended September 30,
1996: (i) the chief executive officer; and (ii) the other most highly
compensated executive officers of the Company (collectively, the "Named
Executive Officers").
<TABLE>
<CAPTION>
SUMMARY COMPENSATION TABLE
--------------------------
ANNUAL COMPENSATION LONG-TERM COMPENSATION
------------------- ----------------------------
SECURITIES
NAME AND UNDERLYING LTPIP ALL OTHER
PRINCIPAL POSITION YEAR SALARY BONUS(1) OPTIONS PAYOUTS(2) COMPENSATION(3)
------------------ ---- ------ -------- ------- ---------- ---------------
<S> <C> <C> <C> <C> <C> <C>
Alan Hoops, 1996 $660,888 $400,000 30,000 $161,760 $116,454
President and CEO 1995 $578,384 $350,000 30,000 $393,120 $ 85,059
1994 $442,803 $405,000 65,000 $334,200 $ 56,728
Jeffrey Folick 1996 $466,124 $190,350 25,000 $165,898 $ 87,136
Exec. Vice President 1995 $330,444 $269,121 90,000 $238,815 $ 69,413
and COO 1994 $264,904 $165,000 94,000 $138,000 $ 36,156
Wayne Lowell 1996 $323,371 $130,000 15,000 $ 64,960 $ 37,229
Exec. Vice President 1995 $300,390 $144,900 50,000 $168,758 $ 37,137
CAO and CFO 1994 $243,079 $162,925 37,000 $155,213 $ 31,729
Jon Wampler 1996 $323,087 $137,638 11,200 $133,740 $ 91,227 (4)
Regional Vice President, West 1995 $268,537 $166,045 45,000 $107,000 $372,070 (5)
President, PCC 1994 $182,526 $126,000 24,000 $ 66,267 $ 29,162
Craig Schub 1996 $251,428 $ 57,377 10,000 $ 59,715 $135,343 (6)
Sr. Vice Pres., Marketing 1995 $207,501 $ 79,350 45,000 $ 86,862 $ 30,156
Pres., Secure Horizons USA, Inc. 1994 $178,519 $ 85,200 9,000 $ 15,180 $ 39,728 (7)
Roger Taylor, M.D. (8) 1996 $228,394 $ 0 0 $ 40,890 $103,863 (9)
Exec. Vice President 1995 $299,864 $128,241 5,000 $129,092 $ 38,485
and CMO 1994 $268,896 $181,212 37,000 $132,084 $120,588 (10)
</TABLE>
(1) The amounts shown in this column include payments made pursuant to the
Amended Management Incentive Compensation Plan, as amended, of the Company (the
"MICP") and include amounts awarded and accrued during the fiscal year in which
they were earned but paid in the following fiscal year.
(2) Includes amounts awarded and accrued during the fiscal year in which
they were earned but paid in the following fiscal year. Please refer to
"Long-Term Performance Incentive Plan Awards in Last Fiscal Year."
In fiscal years 1996, 1995 and 1994, 40 percent of the payments made under
the Amended Long-Term Performance Incentive Plan, as amended (the "LTPIP"), were
paid out in stock and 60 percent of the payments made under the LTPIP were paid
out in cash, with the exception of Dr. Taylor who was paid 100 percent in cash.
For the Named Executive Officers the cash portion equaled: $97,105, $235,950
and $200,553 for Mr. Hoops; $99,568, $143,319 and $82,846 for Mr. Folick;
$38,997, $101,288 and $93,165 for Mr. Lowell; $80,307, $64,269 and $39,765 for
Mr. Wampler; $35,846, $52,175 and $9,108 for Mr. Schub; and $40,890, $77,538 and
$79,270 for Dr. Taylor for fiscal years 1996, 1995 and 1994, respectively. For
the Named Executive Officers, the stock portion equaled: 772, 1,817 and 2,113
shares of Class B Common Stock for Mr. Hoops; 792, 1,104 and 872 shares of Class
B Common Stock for Mr. Folick; 310, 780 and 981 shares of Class B Common Stock
for Mr. Lowell; 638, 494 and 419 shares of Class B Common Stock for Mr. Wampler;
285, 401 and 96 shares of Class B Common Stock for Mr. Schub; and 0, 596 and 835
shares of Class B Common Stock for Dr. Taylor for fiscal years 1996, 1995 and
1994, respectively. For each Named Executive Officer, the shares of Class B
Common Stock were valued at $83.75 per share (the fair market value
45
<PAGE>
of the Class B Common Stock at the time the payment was awarded) for payments
made in fiscal year 1995 and at $63.25 per share (the fair market value of
the Class B Common Stock at the time of payment) for payments made in fiscal
year 1994.
(3) Amounts in this column include contributions by the Company to the
PacifiCare Health Systems, Inc. Savings and Profit Sharing Plan (the "Profit
Sharing Plan"). All employees of the Company who have completed 12 months of
continuous service and have worked at least 1,000 hours are eligible to
participate in the Profit Sharing Plan. The Company contributed the following
amounts for each employee:
(a) An amount equal to two percent of their annual salary up to a
specified maximum amount. For the Named Executive Officers, this amount
equaled: $3,000, $3,000 and $3,000 for Mr. Hoops; $3,000, $3,263 and $5,484
for Mr. Folick; $3,000, $3,557 and $4,564 for Mr. Lowell; $3,000, $4,161
and $5,107 for Mr. Wampler; $3,000, $4,400 and $5,053 for Mr. Schub; and
$3,000, $3,280 and $3,000 for Dr. Taylor for fiscal years 1996, 1995 and
1994, respectively.
(b) An amount equal to one half of the compensation deferred by each
employee up to three percent of the employee's annual compensation up to a
specified amount. For the Named Executive Officers, this amount equaled:
$4,500, $4,620 and $4,500 for Mr. Hoops; $4,500, $6,514 and $4,096 for Mr.
Folick; $4,500, $5,575 and $4,500 for Mr. Lowell; $4,500, $6,788 and $4,649
for Mr. Wampler; $4,500, $4,853 and $4,996 for Mr. Schub; and $4,500,
$5,055 and $4,500 for Dr. Taylor for fiscal years 1996, 1995 and 1994,
respectively.
(c) A discretionary amount, determined solely at the discretion of
the Board of Directors, from the Company's current or accumulated earnings
which is generally based upon a percentage of pretax income. This amount
equaled $5,291, $4,771 and $4,440 for each of Messrs. Hoops, Folick, Lowell
and Dr. Taylor for fiscal years 1996, 1995 and 1994, respectively; and
$5,291, $4,891 and $4,440 for Messrs. Wampler and Schub for fiscal years
1996, 1995 and 1994, respectively.
(d) Includes amounts contributed by the Company pursuant to the
Statutory Restoration Plan of the Company (the "Statutory Restoration
Plan"). For the Named Executive Officers, this amount equaled: $60,668,
$32,824 and $44,506 for Mr. Hoops; $40,399, $24,729 and $21,854 for Mr.
Folick; $24,072, $22,691 and $17,943 for Mr. Lowell; $21,306, $19,101 and
$14,678 for Mr. Wampler; $13,204, $8,361 and $8,123 for Mr. Schub; and
$16,737, $24,511 and $14,848 for Dr. Taylor for fiscal years 1996, 1995 and
1994, respectively. The Statutory Restoration Plan allows participants to
defer the portion of their pay that otherwise would be limited by the
Company's Profit Sharing Plan and to receive excess matching contributions,
profit-sharing contributions and discretionary contributions in the same
percentages as those provided by the Profit Sharing Plan. Senior Vice
Presidents and above are eligible to participate in the Statutory
Restoration Plan.
(e) An amount equal to premiums paid by the Company for term life
insurance for all employees. For the Named Executive Officers this amount
equaled: $582 for Messrs. Hoops, Folick and Dr. Taylor, $366 for Messrs.
Lowell and Schub and $392 for Mr. Wampler for fiscal year 1996. The amount
includes additional insurance premiums paid by the Company equal to:
$38,979 for Mr. Hoops; $11,028 for Mr. Wampler; $7,192 for Mr. Schub for
fiscal years 1996 and 1995; and $29,839 and $29,419 for Mr. Folick for
fiscal years 1996 and 1995, respectively.
(f) Includes amounts paid by the Company for personal financial
services. For the Named Executive Officers this amount equaled: $3,433 for
Mr. Hoops; $3,525 for Mr. Folick; $2,978 for Mr. Wampler; and $1,790 for
Mr. Schub for fiscal year 1996.
(4) Amount includes $42,732 paid in moving expenses to Mr. Wampler.
(5) Amount includes $285,802 paid in moving expenses and $40,000 paid as a
sign-on bonus to Mr. Wampler.
(6) Amount includes $100,000 in debt forgiveness for Mr. Schub.
(7) Amount includes $16,834 paid as a sign-on bonus to Mr. Schub.
46
<PAGE>
(8) Dr. Taylor resigned as an Executive Vice President and Chief Medical
Officer of the Company effective as of June 28, 1996.
(9) Amount includes $73,753 paid in severance benefits to Dr. Taylor.
(10) Amount includes $97,952 paid in moving expenses to Dr. Taylor.
OPTION GRANTS IN LAST FISCAL YEAR
The following table sets forth for the fiscal year ended September 30,
1996, the stock options granted to the Company's Named Executive Officers
pursuant to the Second Amended and Restated 1989 Stock Option Plan for Officers
and Key Employees of PacifiCare Health Systems, Inc., as amended (the "1989
Employee Plan").
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS POTENTIAL REALIZABLE VALUE AT
----------------------------------------------------------- ASSUMED ANNUAL RATES
NUMBER OF % OF TOTAL OPTIONS OF STOCK PRICE APPRECIATION
SECURITIES GRANTED TO EXERCISE OR FOR OPTION TERM
UNDERLYING EMPLOYEES BASE PRICE EXPIRATION -------------------------------------
NAME(1) OPTIONS(2) IN FISCAL YEAR PER SHARE(3) DATE 5% 10%
------- ---------- -------------- ------------ ---- ------------------ ------------------
<S> <C> <C> <C> <C> <C> <C>
Alan Hoops
Class B (4) 30,000 7.5% $ 69.50 10/11/05 $ 1,311,245 $ 3,322,953
Jeffrey Folick
Class B (4) 25,000 6.2% $ 69.50 10/11/05 $ 1,092,704 $ 2,769,128
Wayne Lowell
Class B (4) 15,000 3.7% $ 69.50 10/11/05 $ 655,623 $ 1,661,477
Jon Wampler
Class B (4) 11,200 2.8% $ 69.50 10/11/05 $ 489,532 $ 1,240,569
Craig Schub
Class B (4) 10,000 2.5% $ 69.50 10/11/05 $ 437,082 $ 1,107,651
</TABLE>
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------
Change in total market value of Company at assumed annual rates
of stock price appreciation for 10 years (5) 5% 10%
- -------------------------------------------- ---------- ----------
<S> <C> <C>
Class A, 12,379,658 shares outstanding, $98.75 per share $ 768,818,164 $1,948,336,176
Class B, 18,911,833 shares outstanding, $99.50 per share $1,183,408,241 $2,998,988,829
- -------------------------------------------------------------------------------------------------------------------
</TABLE>
(1) Dr. Taylor resigned as an Executive Vice President and Chief Medical
Officer of the Company effective June 28, 1996. No stock options were
granted to Dr. Taylor in fiscal year 1996.
(2) Only non-qualified stock options ("NQSOs") were granted in fiscal year
1996 pursuant to the 1989 Employee Plan. No incentive stock options or stock
appreciation rights were granted in fiscal year 1996. The date of grant for the
NQSOs was October 10, 1995. NQSOs which have been held for six months and which
are not already exercisable and not expired shall upon a "Change of Control"
automatically become exercisable. A Change of Control is defined as the
occurrence of any of the following: (i) a business combination effectuated
through the merger or consolidation of the Company with or into another entity
where the Company is not the Surviving Organization (as defined herein); (ii)
any business combination effectuated through the merger or consolidation of the
Company with or into another entity where the Company is the Surviving
Organization and such business combination occurred with an entity whose market
capitalization prior to the transaction was greater than 50 percent of the
Company's market capitalization prior to the transaction; (iii) the sale in a
transaction or series of transactions of all or substantially all of the
Company's assets; (iv) any "person" or "group" (within the meaning of Sections
13(d)and 14(d) of the Exchange Act) other than UniHealth, acquires beneficial
ownership (within the meaning of Rule 13d-3 of the Exchange Act), directly or
indirectly, of 20 percent or more of the voting common stock of the Company and
the beneficial ownership of the voting common stock of the Company owned by
UniHealth at that date is less than or equal to the beneficial ownership
interest of voting
47
<PAGE>
securities attributable to such other person or group; (v) a dissolution or
liquidation of the Company; or (vi) the Company ceases to be subject to the
reporting requirements of the Exchange Act as a result of a "going private
transaction" (within the meaning of the Exchange Act). For purposes hereof,
"Surviving Organization" shall mean any entity where the majority of the members
of such entity's board of directors are persons who were members of the
Company's board of directors prior to the merger, consolidation or other
business combination and the senior management of the surviving entity includes
all of the individuals who were the Company's executive management (the
Company's chief executive officer and those individuals who report directly to
the Company's chief executive officer) prior to the merger, consolidation or
other business combination and such individuals are in at least comparable
positions with such entity. While the acquisition of FHP International
Corporation ("FHP") by the Company constitutes a Change of Control under the
1989 Employee Plan, the Company has requested that the Named Executive Officers
waive this acceleration provision. In exchange for this waiver, the Company
will grant each Named Executive Officer additional options to purchase shares
of Class B Common Stock equal to approximately the number of options for which
a waiver is obtained.
(3) The exercise price may be paid in cash, in shares of the Company's
common stock valued at fair market value on the date of exercise or pursuant to
a cashless exercise procedure under which the optionee provides irrevocable
instructions to a brokerage firm to sell the purchased shares and to remit to
the Company, out of the sale proceeds, an amount equal to the exercise price
plus all applicable withholding taxes.
(4) The NQSOs granted to the Named Executive Officers become exercisable
in four cumulative installments of 25 percent of the shares on the first
anniversary of the date of grant and in subsequent installments of 25 percent on
each anniversary of the date of grant.
(5) The dollar amounts in this table are the result of calculations at the
five and 10 percent rates used to determine the potential realizable value of
the stock options in the above table and therefore are not intended to forecast
possible future appreciation, if any, of the Company's stock prices. No
assurances can be given that the stock prices will appreciate at these rates or
experience any appreciation at all.
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR
AND FISCAL YEAR END OPTION VALUES
The following table sets forth information with respect to the Named
Executive Officers concerning the exercise of options during fiscal year 1996
and unexercised options held as of the end of fiscal year 1996.
<TABLE>
<CAPTION>
NUMBER OF SECURITIES
SHARES UNDERLYING UNEXERCISED VALUE OF UNEXERCISED IN-THE-
ACQUIRED OPTIONS AT FY-END (#) MONEY OPTIONS AT FY-END ($)
ON VALUE ------------------------------- --------------------------------
EXERCISE REALIZED EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
-------- -------- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C>
Alan Hoops
Class A........... 0 $ 0 72,000 0 $ 5,801,000 $ 0
Class B........... 20,000 $ 1,882,500 81,750 101,250 $ 4,779,625 $ 3,446,250
Jeffrey Folick
Class A........... 0 $ 0 3,000 0 $ 216,625 $ 0
Class B........... 11,104 $ 466,508 50,646 154,000 $ 1,604,298 $ 4,261,500
Wayne Lowell
Class A........... 0 $ 0 14,500 0 $ 1,125,000 $ 0
Class B........... 10,600 $ 540,913 16,750 81,350 $ 559,500 $ 2,435,475
Jon Wampler
Class A........... 0 $ 0 7,250 0 $ 517,875 $ 0
Class B........... 11,250 $ 348,750 17,550 62,650 $ 898,100 $ 1,734,988
Craig Schub
Class A........... 2,000 $ 124,250 0 0 $ 0 $ 0
Class B........... 6,400 $ 385,650 13,750 49,050 $ 264,688 $ 1,154,863
Roger Taylor
Class A........... 0 $ 0 0 0 $ 0 $ 0
Class B........... 92,000 $ 3,730,717 0 0 $ 0 $ 0
</TABLE>
48
<PAGE>
LONG-TERM PERFORMANCE INCENTIVE PLAN
AWARDS IN LAST FISCAL YEAR
The following table sets forth the LTPIP Awards for the fiscal year ended
September 30, 1996 for the Company's Named Executive Officers:
ESTIMATED FUTURE PAYOUTS UNDER
PERFORMANCE OR NON-STOCK PRICE-BASED PLANS (2)
OTHER PERIOD UNTIL -------------------------------------
NAME (1) MATURATION OR PAYOUT THRESHOLD TARGET MAXIMUM
-------- -------------------- --------- ------ -------
Alan Hoops....... January 1999 $0 $327,690 $655,380
Jeffrey Folick... January 1999 $0 $207,427 $414,853
Wayne Lowell..... January 1999 $0 $125,504 $251,008
Jon Wampler...... January 1999 $0 $125,504 $251,008
Craig Schub...... January 1999 $0 $ 70,340 $140,679
(1) Dr. Taylor resigned as an Executive Vice President and Chief Medical
Officer of the Company effective June 28, 1996. No LTPIP Awards were
established for Dr. Taylor.
(2) Incentive compensation under the LTPIP is based on the achievement of
performance objectives established by the Compensation Committee of the Board
of Directors (the "Committee") and approved by the shareholders of the Company,
measured over a three year performance period. The performance objective for
this performance period is based on increases in earnings per share. Prior to
the commencement of services for this performance period, the Committee
established, in writing, minimum targets for earnings per share which must be
achieved, maximum targets above which no additional awards will be earned and
the formula for computing each participant's award if such target is achieved.
Payouts under the LTPIP are based on the average three-year annual base salary
for the calendar year of the Named Executive Officer for the performance cycle
with certain assumptions regarding increases in base salary per calendar year
over the performance cycle being made. Please refer to the "Summary
Compensation Table" for payouts under the LTPIP for fiscal year 1996. Payments
made under the LTPIP will be made in a cash portion and a stock portion. It is
anticipated that the cash portion will equal 60 percent of the LTPIP award and
the stock portion will equal 40 percent of the LTPIP award. The stock portion
will be valued at the fair market value of the stock at the time the LTPIP award
is made.
EMPLOYMENT AGREEMENTS
The Company has entered into employment agreements with the Named Executive
Officers. Each agreement continues until the death, disability, misconduct or
written notice of termination by either the Company or the Named Executive
Officer. The agreements provide that each Named Executive Officer is entitled
to his base salary, participation in all employee benefit programs,
reimbursement for business expenses and participation in the MICP, LTPIP and the
1989 Employee Plan of the Company. The agreements also contain provisions that
entitle each of the Named Executive Officers to receive severance benefits which
are payable if the officer's employment with the Company is terminated for
various reasons, including death, disability and termination following a change
of ownership or control of the Company. Under the employment agreements for Mr.
Hoops and Mr. Folick, a change of ownership or control would result from: (i)
any merger, consolidation or sale such that any individual, entity or group
(within the meaning of Section 13(d)(3) or 14(d)(2) of the Exchange Act)
acquires beneficial ownership, within the meaning of Rule 13d-3 of the Exchange
Act, of 20 percent or more of the voting common stock of the Company and the
ownership interest of the voting common stock owned by UniHealth is less than or
equal to the ownership interest of the voting common stock of such individual,
entity or group; (ii) any transaction in which the Company sells substantially
all of its material assets; (iii) a dissolution or liquidation of the Company;
or (iv) the Company becomes a non-publicly held company. Under Mr. Lowell's
employment agreement, a change of ownership or control would result from any
merger, consolidation or sale of the Company, which reduces the voting interest
of UniHealth below 51 percent, any transaction in which the Company sells
substantially all of its material assets or the Company becoming non-publicly
held.
In the event one of the officers is terminated by the Company (other than
for incapacity, disability, habitual neglect or gross misconduct) within 24
months of a change in ownership or control, the employment agreements provide
for payment of base salary and certain benefits for 36 months in the case of Mr.
Hoops, 24 months in the case of Messrs.
49
<PAGE>
Folick, Schub and Wampler and 12 months in the case of Mr. Lowell, and payment
of benefits under the Company's MICP and the LTPIP which will be deemed to have
accrued to the termination date. The contingent liability for severance
payments that the Company would be required to make under the employment
agreements (excluding amounts which may be payable under incentive plans and the
value of certain benefits) would be $2,005,200 to Mr. Hoops, $954,400 to Mr.
Folick, $332,200 to Mr. Lowell, $659,600 to Mr. Wampler and $519,616 to Mr.
Schub.
COMPENSATION OF DIRECTORS
CASH COMPENSATION
Pursuant to the PacifiCare Health Systems, Inc. Amended Non-Employee
Director Compensation and Retirement Plan (the "Compensation and Retirement
Plan"), directors who are not full-time employees of the Company or UniHealth
receive, as compensation for their services, an annual retainer of $25,000,
$1,200 for each Board of Directors meeting attended, $1,000 for each Board
Committee meeting attended and $500 for meetings held by telephone, except for a
non-employee Chairperson of the Board or Chairperson of Committees who will
receive double the amount paid for actual attendance at meetings. During fiscal
year 1996, Terry Hartshorn, the Chairman of the Board of Directors, received an
annual base salary of $90,062 as compensation for his services. Effective
January 1, 1997, Mr. Hartshorn's employment agreement with the Company was
terminated and the Company will compensate Mr. Hartshorn pursuant to the terms
of the Compensation and Retirement Plan in his position as Chairman of the
Board. Mr. Hartshorn receives and will continue to receive benefits under the
Company's benefit plans, including the MICP and the LTPIP, similar to those
which other executive officers of the Company are entitled. The Chairman of the
Board and the Company's Directors are all entitled to reimbursement of expenses
incurred in attending Board of Directors and Board Committee meetings.
RETIREMENT BENEFITS
Through fiscal year 1996, retirement benefits were also provided to
eligible Directors under the Compensation and Retirement Plan. Upon retirement,
each Director, who is not a full-time employee of the Company or UniHealth, was
entitled to receive an annual amount equal to the average annual retainer for
the preceding three-year period for the number of years of service accumulated
by such Director at the time of retirement, provided five years of service as a
Director have been completed. The retirement benefits under the Compensation
and Retirement Plan have been terminated. All directors who had accumulated
retirement benefits under the Compensation and Retirement Plan were paid such
accumulated amounts at their present value.
STOCK OPTION PLAN
The Directors Plan
In fiscal year 1996, eligible Directors were granted NQSOs pursuant to the
Amended 1992 Non-Officer Directors Stock Option Plan of PacifiCare Health
Systems, Inc. (the "1992 Directors Plan"). Non-officer Directors of the
Company, who were not eligible to receive awards under the 1989 Employee Plan,
were eligible to receive NQSOs under the 1992 Directors Plan. The Company's
Class B Common Stock are the shares of stock subject to the 1992 Directors Plan
and no more than 140,000 shares of Class B Common Stock are subject to NQSOs
granted under the 1992 Directors Plan. If a NQSO granted under the 1992
Directors Plan expires or is terminated or canceled, the shares of Class B
Common Stock subject to NQSOs shall be added to the shares of Class B Common
Stock otherwise available for issuance pursuant to NQSOs granted under the 1992
Directors Plan. The 1992 Directors Plan provides for adjustments in the number
and kind of shares subject to said plan, and to outstanding NQSOs in the event
of a reorganization, merger, consolidation, recapitalization, reclassification,
stock split, stock dividend or combination of shares, extraordinary cash or
non-cash dividends declared on outstanding shares of Class B Common Stock or
other similar transactions. In addition, NQSOs granted under the 1992 Directors
Plan, which have been held for six months and which are not already exercisable
and not expired upon a "Change of Control" (as defined in the 1989 Employee
Plan) automatically become exercisable. The Second Amended 1992 Non-Officer
Directors Stock Option Plan of PacifiCare Health Systems, Inc. (the "1992
Amended Plan") has been approved by the Company's shareholders and its board of
directors. The 1992 Amended Plan has terms similar to the 1992 Directors Plan
but also provides for: (i) an increase in the number of shares of the Company's
Class B Common Stock available for option grants under the Amended Plan; (ii) an
increase in the number of shares of the Company's Class B Common Stock
underlying the
50
<PAGE>
options automatically granted to eligible directors each year; and (iii) the
grant of options to purchase shares of the Company's Class B Common Stock to
eligible directors upon being elected to the Company's board of directors.
Six Directors of the Company were eligible to participate in the 1992
Directors Plan during fiscal year 1996. Eligible Directors are automatically
granted NQSOs to purchase 2,000 shares of Class B Common Stock on December 31 of
each year; provided that, during the twelve month period preceding December 31,
the optionee Director served on the Board of Directors and was not eligible to
receive awards under the 1989 Employee Plan. All NQSOs granted pursuant to the
1992 Directors Plan are subject to the terms of the 1992 Directors Plan,
including the acceleration provision upon a Change of Control.
The per share exercise price of the shares of Class B Common Stock subject
to any NQSO granted under the 1992 Directors Plan is 100 percent of the fair
market value of the shares on the date of grant. NQSOs granted under the 1992
Directors Plan vest in four cumulative installments of 25 percent of the shares
of Class B Common Stock covered by each NQSO beginning on the first anniversary
of the date of the grant.
NQSOs granted under the 1992 Directors Plan may not be exercised after the
earlier of: (i) the expiration of ten years and one day from the date the NQSO
was granted; (ii) the expiration of eight months from the time the optionee
voluntarily or involuntarily ceases to serve as a Director of the Company; (iii)
the expiration of one year from the date Optionee ceases to serve as a Director
of the Company by reason of disability or death; or (iv) on the effective date
of (a) the liquidation or dissolution of the Company, or (b) a Change of
Control event.
Messrs. Carpenter, Leary, Pinckert, Reed and Ross, and Ms. Smith were each
automatically granted NQSQs to purchase 2,000 shares of Class B Common Stock
pursuant to the 1992 Directors Plan during fiscal year 1996.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
The following table sets forth the names of those shareholders known to the
Company to be the beneficial owners (as defined under the Exchange Act) of more
than five percent of the Company's outstanding shares of Class A Common Stock as
of December 31, 1996.
<TABLE>
<CAPTION>
NAME AND ADDRESS AMOUNT AND NATURE OF PERCENT
TITLE OF CLASS OF BENEFICIAL OWNER BENEFICIAL OWNERSHIP (1) OF CLASS
-------------- ------------------- ------------------------ --------
<S> <C> <C> <C>
Class A Common Stock UniHealth 5,910,000 47.7%
3400 Riverside Drive
Burbank, CA 91505
Massachusetts Financial Services 813,580 (2) 6.6%
500 Boylston Street
Boston, MA 02115
The Capital Group Companies, Inc. 630,000 (3) 5.1%
333 South Hope Street
Los Angeles, CA 90071
</TABLE>
(1) Information with respect to beneficial ownership is based on
information furnished to the Company by each person in this table and is
reported in accordance with the beneficial ownership rules of the Securities and
Exchange Commission (the "Commission").
(2) Number of shares beneficially owned by Massachusetts Financial
Services, a registered investment advisor, as of September 30, 1996, according
to a Schedule 13F filed with the Commission. Massachusetts Financial Services
may
51
<PAGE>
be deemed a beneficial owner of shares of the Company's Class A Common Stock
under Rule 13d-3 of the Exchange Act as a result of its discretionary authority
to dispose of the shares on behalf of its clients.
(3) Number of shares beneficially owned by The Capital Group Companies,
Inc., a registered investment advisor ("Capital Groups"), as of September 30,
1996, according to a Schedule 13F filed with the Commission. Capital Groups may
be deemed a beneficial owner of shares of the Company's Class A Common Stock
under Rule 13d-3 of the Exchange Act as a result of its discretionary authority
to dispose of the shares on behalf of its clients.
SECURITY OWNERSHIP OF MANAGEMENT
The following table sets forth the number of shares of the Company's
Common Stock, which are beneficially owned as of December 31, 1996, by: (1)
each of the Directors of the Company; (2) the Named Executive Officers (as
defined herein); and (3) all Executive Officers (as defined in Section 3b-7
of the Exchange Act) and Directors of the Company as a group.
<TABLE>
<CAPTION>
AMOUNT AND NATURE OF BENEFICIAL
OWNERSHIP (1)
---------------------------------------------------------------
CLASS A CLASS B
COMMON STOCK (2) COMMON STOCK (3)
------------------------------ ------------------------------
NUMBER PERCENT NUMBER PERCENT
NAME OF BENEFICIAL OWNER OF SHARES OF CLASS OF SHARES OF CLASS
- ------------------------ ----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Terry O. Hartshorn . . . . . . . . . . 212,000 1.7% 164,683 *
Alan R. Hoops. . . . . . . . . . . . . 190,000 1.5% 192,947 1.0%
David R. Carpenter . . . . . . . . . . 6,900 * 11,900 *
Gary L. Leary. . . . . . . . . . . . . 6,900 * 11,900 *
Warren E. Pinckert II. . . . . . . . . 10,500 * 7,216 *
David A. Reed. . . . . . . . . . . . . 300 * 3,200 *
Lloyd E. Ross. . . . . . . . . . . . . 1,500 * 5,900 *
Jean Bixby Smith . . . . . . . . . . . 230 * 925 *
Jeffrey Folick . . . . . . . . . . . . 4,000 * 76,500 *
Wayne Lowell . . . . . . . . . . . . . 18,800 * 36,602 *
Craig Schub. . . . . . . . . . . . . . 0 * 27,428 *
Jon Wampler. . . . . . . . . . . . . . 7,250 * 31,794 *
Roger Taylor, M.D. (4) . . . . . . . . 0 * 1,431 *
All Executive Officers and Directors
as a group (21 persons). . . . . . . 488,880 3.9% 668,857 3.5%
- ----------------------------
</TABLE>
* Less than 1 percent of class.
(1) Information with respect to the beneficial ownership is based on
information furnished to the Company by each person in this table. Each
shareholder included in the table has sole voting and dispositive power with
respect to the shares of Common Stock shown to be beneficially owned by the
shareholder. Most of the shareholders included in this table reside in states
having community property laws under which the spouse of the shareholder, in
whose name the securities are registered, may be entitled to share in the
management of their community property, which may include the right to vote or
dispose of the shares of Common Stock.
(2) Includes stock options of Class A Common Stock exercisable within 60
days for the following named individuals and group, and number of shares: Mr.
Hartshorn, 89,000 shares; Mr. Hoops, 72,000 shares; Mr. Carpenter, 6,900 shares;
Mr. Leary, 6,900 shares; Mr. Pinckert, 10,184 shares; Mr. Reed, 0 shares; Mr.
Ross, 1,500 shares; Ms. Smith, 0 shares; Mr. Folick, 3,000 shares; Mr. Lowell,
14,500 shares; Mr. Schub, 0 shares; Mr. Wampler, 7,250 shares; and all Executive
Officers and Directors as a group (21 persons), 241,234 shares.
(3) Includes options of Class B Common Stock exercisable within 60 days
for the following named individuals and group, and number of shares: Mr.
Hartshorn, 80,000 shares; Mr. Hoops, 99,250 shares; Mr. Carpenter, 11,900
shares; Mr. Leary, 11,900 shares; Mr. Pinckert, 6,900 shares; Mr. Reed, 3,000
shares; Mr. Ross, 5,900 shares;
52
<PAGE>
Ms. Smith, 500 shares; Mr. Folick, 72,146 shares; Mr. Lowell, 33,850 shares; Mr.
Schub, 26,800 shares; Mr. Wampler, 31,300 shares; and all Executive Officers and
Directors as a group (21 persons), 476,354 shares.
(4) Dr. Taylor resigned as an Executive Vice President and Chief Medical
Officer of the Company effective as of June 28, 1996.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The Company purchased health care services from hospitals owned and managed
by UniHealth totaling $73.9 million, $70.6 million and $61.5 million for the
fiscal years ended September 30, 1996, 1995 and 1994, respectively. UniHealth
purchased health care coverage from the Company in the amounts of $6.5 million,
$12.0 million and $10.0 million for the fiscal years ended September 30, 1996,
1995 and 1994, respectively.
Joseph S. Konowiecki, the Secretary and General Counsel of the
Company, is the sole shareholder of Joseph S. Konowiecki, Inc., a California
professional corporation, which is a partner of the law firm of Konowiecki &
Rank. The Company purchased legal services from Konowiecki & Rank in the
amounts of $4.0 million, $3.2 million and $3.1 million for the fiscal years
ended September 30, 1996, 1995 and 1994, respectively.
53
<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 10-K
The following documents are filed as part of this report. Consolidated
financial statements and notes thereto are included in Part II, Item 8 of this
Report:
PAGE REFERENCE
--------------
(a)1. Financial Statements:
Consolidated Balance Sheets as of September 30, 1996
and 1995. . . . . . . . . . . . . . . . . . . . . . . . . . .22
Consolidated Statements of Income for the fiscal
years ended September 30, 1996, 1995 and 1994 . . . . . . . .23
Consolidated Statements of Shareholders' Equity for
the fiscal years ended September 30, 1996,
1995 and 1994 . . . . . . . . . . . . . . . . . . . . . . . .24
Consolidated Statements of Cash Flows for the fiscal
years ended September 30, 1996, 1995 and 1994 . . . . . . . .25
Notes to Consolidated Financial Statements. . . . . . . . . . .27
Report of Ernst & Young LLP Independent Auditors. . . . . . . .39
Quarterly Information for Fiscal Years 1996
and 1995 (Unaudited). . . . . . . . . . . . . . . . . . . . .40
2. Financial Statement Schedule:
Schedule II - Valuation and Qualifying Accounts . . . . . . .58
All other schedules have been omitted since the required information
is notpresent or is not present in amounts sufficient to require
submission of theschedule, or because information required is included
in the Financial Statements and related notes.
3. Exhibits:
3.1 Certificate of Incorporation and amendments thereto [incorporated by
reference to Exhibit 3.1 to the Company's Registration Statement on
Form S-2 (File No. 33-31541)].
3.2 Amendment to the Certificate of Incorporation [incorporated by
reference to Exhibit 3.1 to the Company's Form 10-Q for the quarter
ended December 31, 1995].
3.3 Amendment to the Certificate of Incorporation [incorporated by
reference to Exhibit 3.1 to the Company's Form 10-Q for the quarter
ended March 31, 1994].
3.4 Bylaws of the Company [incorporated by reference to Exhibit 3.4 to the
Company's Form 10-K for the fiscal year ended September 30, 1994].
3.5 First Amendment to the Bylaws of the Company [incorporated by
reference to Exhibit 3.5 to the Company's Form 10-K for the fiscal
year ended September 30, 1994].
4.1 Specimen of the Company's Class A Common Shares [incorporated by
reference to Exhibit 1 to the Company's Form 8, dated May 20, 1992].
4.2 Specimen of the Company's Class B Common Shares [incorporated by
reference to Exhibit 1 to the Company's Registration Statement on
Form 8-A, dated May 20, 1992].
54
<PAGE>
10.1 Employment Agreement, dated as of April 1, 1993, between the Company
and Terry Hartshorn [incorporated by reference to Exhibit 10.2 to the
Company's Form 10-Q for the quarter ended March 31, 1994].1
10.2 Employment Agreement, dated December 1, 1994, between the Company and
Alan Hoops [incorporated by reference to Exhibit 10.2 to the Company's
Form 10-Q for the quarter ended December 31, 1994].1
10.3 Employment Agreement, dated December 12, 1994, between the Company and
Jeffrey Folick [incorporated by reference to Exhibit 10.3 to the
Company's Form 10-Q for the quarter ended December 31, 1994].1
10.4 Employment Agreement, dated February 22, 1990, between the Company and
Wayne Lowell, as amended June 5, 1992 [incorporated by reference to
Exhibit 28.3 to the Company's Registration Statement on Form S-3 (File
No. 33-52438)].1
10.5 Form of contract for the period January 1, 1993 through December 31,
1993 between PacifiCare of California and the Department of Health and
Human Services [incorporated by reference to Exhibit 10.3 to the
Company's Registration Statement on Form S-3 (File No. 33-72012)].
10.6 Management Consulting Agreement, dated as of October 1, 1991, between
the Company and UniHealth [incorporated by reference to Exhibit 28.6
to the Company's Registration Statement on Form S-3 (File No.
33-52438)].
10.7 Second Amended and Restated 1989 Stock Option Plan for Officers and
Key Employees, as amended [incorporated by reference to Exhibit A to
the Company's Proxy Statement, dated January 26, 1992].1
10.8 First Amendment, dated as of November 20, 1995, to the Second Amended
and Restated 1989 Stock Option Plan for Officers and Key Employees of
PacifiCare Health Systems, Inc. [incorporated by reference to the
Company's Form 10-Q for the quarter ended March 31, 1996].1
10.9 Amended 1992 Non-Officer Directors Stock Option Plan of PacifiCare
Health Systems, Incorporate [incorporated by reference to Exhibit 10.1
to the Company's Form 10-Q for the quarter ended December 31, 1995].1
10.10 Second Amended and Restated 1992 Non-Officer Directors Stock Option
Plan of PacifiCare Health Systems, Inc. [incorporated by reference to
the Exhibit 99.08 to the Registration Statement on Form S-4 of N-T
Holdings, Inc. (File No. 333-16271)]1
10.11 PacifiCare Health Systems, Inc., Second Amended Non-Employee Director
Compensation and Retirement Plan. 1
10.12 Amended Long-Term Performance Incentive Plan, as amended [incorporated
by reference to Exhibit 10.4 to the Company's Form 10-Q for the
quarter ended March 31, 1994].1
10.13 Amended Management Incentive Compensation Plan, as amended
[incorporated by reference to Exhibit 10.5 to the Company's Form 10-Q
for the quarter ended March 31, 1994].1
55
<PAGE>
10.14 Credit Agreement, dated as of October 31, 1996, among N-T Holdings,
Inc., the several financial institutions from time to time party to
the Credit Agreement, The Bank of New York, The Bank of Nova Scotia,
Banque Nationale de Paris, Dai-Ichi Kangyo Bank, Ltd., The Industrial
Bank of Japan Limited, RaboBank Nederland, Sanwa Bank of California,
The Sumitomo Bank, Limited and Wells Fargo Bank, N.A., as co-agents,
The Chase Manhattan Bank and CitiCorp USA, Inc., as managing agents,
and Bank of America National Trust and Savings Association, as agent
for the Banks [incorporated by reference to Exhibit 10.01 to the
Registration Statement on Form S-4 of N-T Holdings, Inc. (File No.
333-16271)].
10.15 Contribution and Indemnification Agreement, dated March 16, 1995
between the Company and UniHealth [incorporated by reference to
Exhibit 10.01 to the Company's Registration Statement on Form S-3
(File No. 33-57783)].
10.16 The PacifiCare Health Systems, Inc. Statutory Restoration Plan
[incorporated by reference to the Company's Form 10-K for the fiscal
year ended September 30, 1995].1
10.17 Amended and Restated Agreement and Plan of Reorganization, dated as of
November 11, 1996, among PacifiCare Health Systems, Inc., N-T
Holdings, Inc., Neptune Merger Corp., Tree Acquisition Corp. and FHP
International Corp. [incorporated by reference to Exhibit 2.01 to the
Registration Statement on Form S-4 of N-T Holdings, Inc. (File No.
333-16271)].
11A Computation of Earnings Per Share - Primary
11B Computation of Earnings Per Share - Fully Diluted
21 List of Subsidiaries
23 Consent of Ernst & Young LLP Independent Auditors
27 Financial Data Schedules
1 Management contract or compensatory plan or arrangement required
to be filed as an exhibit to this Form 10-K pursuant to
Item 14(c) of Form 10-K.
(b) Reports on Form 8-K:
The Company's current report on Form 8-K filed on September 23, 1996.
56
<PAGE>
SIGNATURES
Pursuant to the requirements of the Section 13 or 15(d) 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.
Date: January 17, 1997 By /s/ ALAN HOOPS
---------------------------------------------------
Alan Hoops, President
and Chief Executive Officer
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS
REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE
REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED.
SIGNATURE TITLE DATE
/s/ TERRY HARTSHORN Chairman of the Board January 17, 1997
- ----------------------------
Terry Hartshorn
President,
Chief Executive Officer,
and Director
/s/ ALAN HOOPS (Principal Executive Officer) January 17, 1997
- ----------------------------
Alan Hoops
Executive Vice President,
Chief Administrative Officer
and Chief Financial Officer
/s/ WAYNE LOWELL (Principal Financial Officer) January 17, 1997
- ----------------------------
Wayne Lowell
Vice President and
Corporate Controller
/s/ MARY C. LANGSDORF (Principal Accounting Officer) January 17, 1997
- ----------------------------
Mary C. Langsdorf
/s/ JEAN BIXBY SMITH Director January 17, 1997
- ----------------------------
Jean Bixby Smith
/s/ DAVID R. CARPENTER Director January 17, 1997
- ----------------------------
David R. Carpenter
/s/ GARY L. LEARY Director January 17, 1997
- ----------------------------
Gary L. Leary
/s/WARREN E. PINCKERT II Director January 17, 1997
- ----------------------------
Warren E. Pinckert II
/s/ DAVID A. REED Director January 17, 1997
- ----------------------------
David A. Reed
/s/ LLOYD ROSS Director January 17, 1997
- ----------------------------
Lloyd Ross
57
<PAGE>
PACIFICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
(amounts in thousands)
<TABLE>
<CAPTION>
ADDITIONS
-----------------------------
BALANCE AT CHARGED TO CHARGED TO BALANCE AT
BEGINNING COSTS AND OTHER DEDUCTIONS/ END OF
DESCRIPTION OF PERIOD EXPENSES ACCOUNTS WRITE-OFFS PERIOD
- --------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Allowance for
Doubtful Accounts
Year ended
September 30, 1996 $ 690 $ 999 $ (85) $ 714 $ 890
-------------------------------------------------------------------------
-------------------------------------------------------------------------
Year ended
September 30, 1995 $ 558 $ 530 $ 1,498 $ 1,896 $ 690
-------------------------------------------------------------------------
-------------------------------------------------------------------------
Year ended
September 30, 1994 $ 1,155 $ 532 $ 263 $ 1,392 $ 558
-------------------------------------------------------------------------
-------------------------------------------------------------------------
</TABLE>
58
<PAGE>
Exhibit 11A
PACIFICARE HEALTH SYSTEMS, INC.
COMPUTATION OF EARNINGS PER SHARE OF COMMON STOCK - PRIMARY
(dollars and shares in thousands, except per share amounts)
<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30
--------------------------------------------
1996 1995 1994
--------------------------------------------
<S> <C> <C> <C>
Shares outstanding at the beginning of the year 30,882 27,528 27,256
Weighted average number of shares issued during
the period in connection with a public offering,
compensation awarded in stock and exercise of stock options 209 1,750 155
Shares repurchased (weighted) - - (33)
Dilutive shares issuable, net of shares assumed to have
been purchased (at the average market price) for treasury
with assumed proceeds from contingent exercise of stock
options and registered equity purchase contracts 580 586 626
----------------------------------------
Total primary shares 31,671 29,864 28,004
----------------------------------------
----------------------------------------
Income before cumulative effect of a change in
accounting principle $ 71,953 $ 108,095 $ 84,593
Cumulative effect on prior years of a change in
accounting principle - - 5,658
----------------------------------------
Net income $ 71,953 $ 108,095 $ 90,251
----------------------------------------
----------------------------------------
Primary earnings per share:
Before cumulative effect of a change in
accounting principle $ 2.27 $ 3.62 $ 3.02
Cumulative effect on prior years of a change in
accounting principle - - 0.20
----------------------------------------
Earnings per share - primary $ 2.27 $ 3.62 $ 3.22
----------------------------------------
----------------------------------------
</TABLE>
<PAGE>
Exhibit 11B
PACIFICARE HEALTH SYSTEMS, INC.
COMPUTATION OF EARNINGS PER SHARE OF COMMON STOCK - FULLY DILUTED
(dollars and shares in thousands, except per share amounts)
<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30
--------------------------------------------
1996 1995 1994
--------------------------------------------
<S> <C> <C> <C>
Shares outstanding at the beginning of the year 30,882 27,528 27,256
Weighted average number of shares issued during the
period in connection with a public offering, compensation
awarded in stock and exercise of stock options 209 1,750 155
Shares repurchased (weighted) - - (33)
Dilutive shares issuable, net of shares assumed to have been
purchased (at the higher of average or ending market
price) for treasury with assumed proceeds from contingent
exercise of stock options and registered equity purchase
contracts 632 612 766
--------------------------------------------
Total fully diluted shares 31,723 29,890 28,144
--------------------------------------------
--------------------------------------------
Income before cumulative effect of a change in
accounting principle $ 71,953 $ 108,095 $ 84,593
Cumulative effect on prior years of a change in
accounting principle - - 5,658
--------------------------------------------
Net income $ 71,953 $ 108,095 $ 90,251
--------------------------------------------
--------------------------------------------
Fully diluted earnings per share:
Earnings before cumulative effect of a change in
accounting principle $ 2.27 $ 3.62 $ 3.00
Cumulative effect on prior years of a change in
accounting principle - - 0.20
--------------------------------------------
Earnings per share - fully diluted $ 2.27 $ 3.62 $ 3.20
--------------------------------------------
--------------------------------------------
</TABLE>
<PAGE>
Exhibit 21
PACIFICARE HEALTH SYSTEMS, INC.
LIST OF SUBSIDIARIES
NAME OF SUBSIDIARY STATE OF INCORPORATION
------------------ ----------------------
California Dental Health Plan California
Clinica Pasteur, Inc. Florida
COMPREMIER, Inc. California
Covantage, Inc. Delaware
CRM Insurance Services, Inc. California
Dental Plan Administrators California
Interstate Medical Equipment, Inc. Florida
Oregon Health Management Company California
PacifiCare Administrative Services, Inc. California
PacifiCare Administrative Services of Florida, Inc. Florida
PacifiCare Behavioral Health, Inc. Delaware
PacifiCare Behavioral Health of California, Inc. Delaware
PacifiCare Benefit Administrators, Inc. Washington
PacifiCare Life and Health Insurance Company Indiana
PacifiCare Life Insurance Company Arizona
PacifiCare Military Health Systems, Inc. Delaware
PacifiCare of California California
PacifiCare of Florida, Inc. Florida
PacifiCare of Oklahoma, Inc. Oklahoma
PacifiCare of Oregon, Inc. Oregon
PacifiCare of Texas, Inc. Texas
PacifiCare of Washington, Inc. Washington
PacifiCare Pharmacy Centers, Inc. California
PacifiCare Ventures, Inc. California
PacifiCare Wellness Company California
PacifiClinic, P.C. Oregon
PC-CWD Vista Associates California
Pasteur Delivery Systems, Inc. Florida
Pasteur Systems, Inc. Florida
Secure Horizons USA, Inc. California
<PAGE>
Exhibit 23
CONSENT OF ERNST & YOUNG LLP INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statement
(S-8 number 33-82204) and related Prospectus pertaining to the Amended and
Restated 1989 Stock Option Plan for Officers and Key Employees, as amended, and
in the Registration Statement (S-8 number 48543) and related Prospectus
pertaining to the 1992 Non-Officer Directors Stock Option Plan, of PacifiCare
Health Systems, Inc. of our report dated November 18, 1996 with respect to the
consolidated financial statements and schedule of PacifiCare Health Systems,
Inc. included in this Annual Report (Form 10-K) for the year ended September 30,
1996.
ERNST & YOUNG LLP
Los Angeles, California
January 13, 1997
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> SEP-30-1996
<PERIOD-START> OCT-01-1995
<PERIOD-END> SEP-30-1996
<CASH> 142,818
<SECURITIES> 557,275
<RECEIVABLES> 170,435
<ALLOWANCES> 890
<INVENTORY> 0
<CURRENT-ASSETS> 934,207
<PP&E> 186,087
<DEPRECIATION> 92,271
<TOTAL-ASSETS> 1,299,462
<CURRENT-LIABILITIES> 470,664
<BONDS> 5,183
0
0
<COMMON> 313
<OTHER-SE> 822,911
<TOTAL-LIABILITY-AND-EQUITY> 1,299,462
<SALES> 0
<TOTAL-REVENUES> 4,637,305
<CGS> 0
<TOTAL-COSTS> 3,872,747
<OTHER-EXPENSES> 685,921
<LOSS-PROVISION> 999
<INTEREST-EXPENSE> 2,094
<INCOME-PRETAX> 122,780
<INCOME-TAX> 50,827
<INCOME-CONTINUING> 71,953
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 71,953
<EPS-PRIMARY> 2.27
<EPS-DILUTED> 2.27
</TABLE>
