<PAGE> 1
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
---------------------
FORM 10-Q
<TABLE>
<C> <S>
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934.
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934.
FOR THE TRANSITION PERIOD FROM ____________ TO ____________
</TABLE>
COMMISSION FILE NUMBER 0-22585
HEALTHCARE RECOVERIES, INC.
(Exact Name of Registrant as Specified in its Charter)
<TABLE>
<S> <C>
DELAWARE 61-1141758
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
1400 WATTERSON TOWER, LOUISVILLE, KENTUCKY 40218
(Address of Principal Executive Offices) (Zip Code)
</TABLE>
(502) 454-1340
Registrant's Telephone Number, Including Area Code
Indicate by check whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days YES [X] NO [ ]
As of August 14, 1998, 11,499,247 shares of the registrant's Common Stock,
$0.001 par value (the only class of Common Stock), were outstanding.
- --------------------------------------------------------------------------------
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<PAGE> 2
HEALTHCARE RECOVERIES, INC.
FORM 10-Q
JUNE 30,1998
INDEX
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
PART I: FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed Balance Sheets as of June 30, 1998 and December
31, 1997............................................... 3
Condensed Statements of Operations for the three and six
months ended June 30, 1998 and
1997................................................... 4
Condensed Statements of Cash Flows for the six months
ended June 30, 1998 and 1997........................... 5
Notes to Condensed Financial Statements................... 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations....................... 8
Item 3. Quantitative and Qualitative Disclosures About
Market Risk............................................... 13
PART II: OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security
Holders................................................... 14
Item 6. Exhibits and Reports on Form 8-K.................... 14
Signatures.................................................. 15
</TABLE>
THIS FORM 10-Q AND OTHER STATEMENTS ISSUED OR MADE FROM TIME TO TIME BY
HEALTHCARE RECOVERIES, INC. OR ITS REPRESENTATIVES CONTAIN STATEMENTS WHICH MAY
CONSTITUTE "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING OF THE SECURITIES ACT
OF 1933, AS AMENDED, AND THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED BY THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995, 15 U.S.C.A. SECTIONS 77Z-2 AND
78U-5 (SUPP. 1996). THOSE STATEMENTS INCLUDE STATEMENTS REGARDING THE INTENT,
BELIEF OR CURRENT EXPECTATIONS OF HEALTHCARE RECOVERIES, INC. AND MEMBERS OF ITS
MANAGEMENT TEAM, AS WELL AS THE ASSUMPTIONS ON WHICH SUCH STATEMENTS ARE BASED.
PROSPECTIVE INVESTORS ARE CAUTIONED THAT ANY SUCH FORWARD-LOOKING STATEMENTS ARE
NOT GUARANTEES OF FUTURE PERFORMANCE AND INVOLVE RISKS AND UNCERTAINTIES, AND
THAT ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE CONTEMPLATED BY SUCH
FORWARD-LOOKING STATEMENTS. IMPORTANT FACTORS CURRENTLY KNOWN TO MANAGEMENT THAT
COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE IN FORWARD-LOOKING
STATEMENTS ARE SET FORTH IN THE SAFE HARBOR COMPLIANCE STATEMENT FOR
FORWARD-LOOKING STATEMENTS INCLUDED AS EXHIBIT 99.1 TO THIS FORM 10-Q, AND ARE
HEREBY INCORPORATED BY REFERENCE HEREIN. HEALTHCARE RECOVERIES, INC. UNDERTAKES
NO OBLIGATION TO UPDATE OR REVIEW FORWARD-LOOKING STATEMENTS TO REFLECT CHANGES
IN ASSUMPTIONS, THE OCCURRENCE OF UNANTICIPATED EVENTS OR CHANGES TO FUTURE
OPERATING RESULTS OVER TIME.
2
<PAGE> 3
PART I
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)
HEALTHCARE RECOVERIES, INC.
CONDENSED BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS)
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1998 1997
-------- ------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents................................. $ 23,916 $ 24,674
Restricted cash........................................... 17,072 14,207
Accounts receivable, less allowance for doubtful accounts
of $265 -- June 30, 1998 and $251 -- December 31,
1997................................................... 2,718 2,507
Other current assets...................................... 1,098 676
-------- --------
Total current assets.............................. 44,804 42,064
-------- --------
Property and equipment, at cost:
Furniture and fixtures.................................... 2,375 2,177
Office equipment.......................................... 1,589 1,471
Computer equipment........................................ 7,012 5,066
Leasehold improvements.................................... 803 649
-------- --------
11,779 9,363
Accumulated depreciation and amortization................. (5,880) (4,920)
-------- --------
5,899 4,443
Other assets................................................ 1,850 1,663
-------- --------
Total assets...................................... $ 52,553 $ 48,170
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable.................................... $ 696 $ 986
Accrued expenses.......................................... 4,612 4,770
Funds due clients......................................... 13,354 11,643
Income taxes payable...................................... 392 1,754
-------- --------
Total current liabilities......................... 19,054 19,153
Other liabilities........................................... 1,370 1,152
-------- --------
Total liabilities................................. 20,424 20,305
-------- --------
Contingencies
Stockholders' equity:
Preferred stock, $.001 par value, 2,000,000 shares
authorized, no shares issued or outstanding............ -- --
Common stock, $.001 par value, 20,000,000 shares
authorized, 11,470,000 shares issued and outstanding... 11 11
Capital in excess of par value............................ 22,001 22,001
Retained earnings......................................... 10,117 5,853
-------- --------
Total stockholders' equity........................ 32,129 27,865
-------- --------
Total liabilities and stockholders' equity........ $ 52,553 $ 48,170
======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements
3
<PAGE> 4
HEALTHCARE RECOVERIES, INC.
CONDENSED STATEMENTS OF OPERATIONS
(UNAUDITED)
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 1998 AND 1997
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------ ------------------
1998 1997 1998 1997
-------- ------- -------- -------
<S> <C> <C> <C> <C>
Revenues.............................................. $ 12,025 $ 9,324 $ 23,221 $18,240
Cost of services...................................... 5,612 4,359 10,871 8,685
-------- ------- -------- -------
Gross profit................................ 6,413 4,965 12,350 9,555
Support expenses...................................... 2,524 2,213 4,764 4,305
Depreciation and amortization......................... 580 237 1,089 482
Non-recurring compensation charge..................... -- 2,848 -- 2,848
-------- ------- -------- -------
Operating income (loss)..................... 3,309 (333) 6,497 1,920
Interest income....................................... 395 215 815 329
-------- ------- -------- -------
Income (loss) before income taxes........... 3,704 (118) 7,312 2,249
Provision for income taxes............................ 1,533 1,146 3,048 2,137
-------- ------- -------- -------
Net income (loss)..................................... $ 2,171 $(1,264) $ 4,264 $ 112
======== ======= ======== =======
Earnings (loss) per common share (basic and
diluted)............................................ $ 0.19 $ (0.12) $ 0.37 $ 0.01
======== ======= ======== =======
</TABLE>
The accompanying notes are an integral part of these financial statements
4
<PAGE> 5
HEALTHCARE RECOVERIES, INC.
CONDENSED STATEMENTS OF CASH FLOWS
(UNAUDITED)
FOR THE SIX MONTHS ENDED JUNE 30, 1998 AND 1997
(IN THOUSANDS)
<TABLE>
<CAPTION>
SIX MONTHS ENDED
JUNE 30,
-----------------
1998 1997
------- -------
<S> <C> <C>
Cash flows from operations:
Net income.................................................. $ 4,264 $ 112
Adjustment to reconcile net income to net cash provided by
operations:
Non-recurring compensation charge......................... -- 2,848
Depreciation and amortization............................. 1,089 482
Deferred income taxes..................................... 35 (612)
Changes in operating assets and liabilities:
Restricted cash........................................ (2,865) 4,851
Accounts receivable.................................... (211) (77)
Other current assets................................... (457) (627)
Other assets........................................... (316) (970)
Trade accounts payable................................. (290) 345
Accrued expenses....................................... (158) 610
Funds due clients...................................... 1,711 (3,966)
Income taxes payable................................... (1,362) 513
Other liabilities...................................... 218 454
------- -------
Net cash provided by operations................... 1,658 3,963
------- -------
Cash flows from investing activities:
Purchases of property and equipment....................... (2,416) (375)
------- -------
Net cash used in investing activities............. (2,416) (375)
------- -------
Cash flows from financing activities:
Issuance of common stock.................................. -- 19,194
Distributions to Medaphis Corporation..................... -- (2,253)
------- -------
Net cash provided by financing activities......... -- 16,941
------- -------
Net (decrease) increase in cash and cash equivalents........ (758) 20,529
Cash and cash equivalents, beginning of period.............. 24,674 53
------- -------
Cash and cash equivalents, end of period.................... $23,916 $20,582
======= =======
</TABLE>
The accompanying notes are an integral part of these financial statements
5
<PAGE> 6
HEALTHCARE RECOVERIES, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION
Healthcare Recoveries, Inc. (the "Company") was incorporated on June 30,
1988 under the laws of the State of Delaware. The Company's services comprise
the complete outsourcing of the identification, investigation and recovery of
accident-related medical benefits incurred by its clients for which other
persons or entities have primary responsibility. The rights of the Company's
clients to recover the value of these medical benefits, arising by law or
contract, are known generally as the right of subrogation and are generally paid
from the proceeds of liability or workers' compensation insurance.
The Company operated as an independent entity until August 28, 1995 when
the Company was merged with and into a subsidiary of Medaphis Corporation
("Medaphis") in a transaction accounted for as a pooling of interests (the
"Merger"). Prior to the Merger, the Company's redeemable convertible preferred
stock was converted to common stock. As of the effective time of the Merger,
each share of the then issued and outstanding Company common stock was exchanged
for Medaphis common stock. Employee stock options of the Company outstanding at
the effective time of the Merger were also substituted with similar options on
common stock. Subsequent to the Merger, Medaphis recapitalized the Company
effectively canceling all but 100 shares of common stock used as collateral for
Medaphis' bank debt, and made the Company a guarantor for Medaphis' bank debt.
On May 21, 1997, the Company completed its initial public offering (the
"Offering") of 9,800,000 shares of common stock, excluding 200,000 shares
granted by the Company to certain members of the Company's executive management
upon consummation of the Offering. All the shares were sold by Medaphis. As a
result, the Company received no proceeds from the sale of shares in the
Offering. On June 9, 1997, the Company sold 1,470,000 shares of common stock to
the underwriters of the Offering under an over-allotment option, resulting in
proceeds to the Company of approximately $19.2 million.
The accompanying financial statements are presented in a condensed format
and consequently do not include all of the disclosures normally required by
generally accepted accounting principles or those normally made in the Company's
annual financial statements. Accordingly, for further information, the reader of
this Form 10-Q may wish to refer to the Company's audited financial statements
as of and for the year ended December 31, 1997, contained in the Company's Form
10-K, filed on March 31, 1998 (file no. 0-22585).
The financial information has been prepared in accordance with the
Company's customary accounting practices and has not been audited. In the
opinion of management, the information presented reflects all adjustments
necessary for a fair presentation of interim results. All such adjustments are
of a normal and recurring nature.
2. CONTINGENCIES
The Company is engaged in the business of identifying and recovering
subrogation and related claims of its clients, many of which arise in the
context of personal injury lawsuits. As such, the Company operates in a
litigation-intensive environment. The Company has from time to time been, and in
the future expects to be, named as a party in litigation incidental to its
business operations. To date, the Company has not been involved in any
litigation which has had a material adverse effect upon the Company, but there
can be no assurance that pending litigation or future litigation will not have a
material adverse effect on the Company's business, results of operations or
financial condition.
3. EARNINGS PER COMMON AND COMMON EQUIVALENT SHARE
In February 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per
Share." SFAS 128 specifies the computation,
6
<PAGE> 7
HEALTHCARE RECOVERIES, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
presentation, and disclosure requirements for earnings per share and requires
presentation of both basic and fully diluted earnings per share for both interim
and annual periods ended after December 15, 1997.
The table below sets forth a reconciliation of the numerators and
denominators of the basic and diluted earnings (loss) per common share
calculations (dollars and shares in thousands, except per share results):
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------- -----------------
1998 1997 1998 1997
-------- -------- ------- -------
<S> <C> <C> <C> <C>
Weighted average number of common shares
outstanding................................... 11,470 10,243 11,470 10,023
Add: Dilutive stock options..................... 112 -- 136 20
------- ------- ------- -------
Number of common and common equivalent shares
outstanding................................... 11,582 10,243 11,606 10,043
======= ======= ======= =======
Net earnings (loss) for basic and diluted
earnings (loss) per share..................... $ 2,171 $(1,264) $ 4,264 $ 112
Earnings (loss) per share:
Basic......................................... $ 0.19 $ (0.12) $ 0.37 $ 0.01
======= ======= ======= =======
Diluted....................................... $ 0.19 $ (0.12) $ 0.37 $ 0.01
======= ======= ======= =======
</TABLE>
For the three and six month periods ended June 30, 1998, options to
purchase 314,600 and 181,050 shares, respectively, were not included in the
computation of earnings per common share -- assuming dilution because the
options' exercise prices exceeded the average price of the common shares during
the respective periods. For the quarter ended June 30, 1997, options to purchase
27,000 shares were not included in the computation of earnings per common
share -- assuming dilution because inclusion of these options would be
anti-dilutive due to the net loss for the period.
4. CHANGES IN ACCOUNTING STANDARDS
The Company adopted SFAS No. 130, "Reporting Comprehensive Income," and
SFAS No. 131, "Disclosure about Segments of an Enterprise and Related
Information," on January 1, 1998. Based on the Company's current operations,
these new standards, which are primarily disclosure oriented, did not have a
material impact on the presentation of the Company's financial condition,
results of operations or cash flows. Comprehensive income of the Company for the
three and six months ended June 30, 1998 and 1997 is the same as net income
presented in the accompanying condensed statements of income.
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued Statement of Position ("SOP")
98-1, "Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use." SOP 98-1 requires capitalization of internal and external costs
incurred to develop or obtain computer software for internal use. The Company
elected adoption of SOP 98-1 as of January 1, 1998. For the three and six months
ended June 30, 1998, the Company capitalized $100,000 and $269,000,
respectively, of certain software development costs associated with the upgrade
of the SubroSystem. These costs were capitalized in conjunction with the
requirements under SOP 98-1.
7
<PAGE> 8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Healthcare Recoveries, Inc. (hereinafter referred to as "HRI" or the
"Company") provides insurance subrogation and related recovery services to the
private healthcare payor industry. HRI's services comprise the complete
outsourcing of the identification, investigation and recovery of
accident-related medical benefits incurred by its clients for which other
persons or entities have primary responsibility. The rights of HRI's clients to
recover the value of these medical benefits, arising by law or contract, are
known generally as the right of subrogation and are generally paid from the
proceeds of liability or workers' compensation insurance.
For a typical new client, it takes three to six months from the contract
signing (when the lives are "sold") to complete the construction of electronic
data interfaces necessary for the Company to begin service; at this point, the
new client is considered "installed." During the installation period, the
Company must also hire and train qualified staff necessary to provide
contractual services. After installation, HRI receives data from the client from
which it creates an inventory of backlog.
"Backlog" is the total dollar amount of potentially recoverable claims that
the Company is pursuing on behalf of its clients at a given point in time. These
claims are gross figures, prior to estimates of claim settlement and rejection.
Backlog increases when the Company opens new files of potentially recoverable
claims and decreases when files of claims are recovered or, after further
investigation, determined to be non-recoverable. Historically, subrogation
recoveries (the amount actually recovered for its clients prior to the Company's
fee) have been produced from the backlog in a generally predictable cycle,
because any group of potential recoveries that has been sufficiently large in
number to display statistically significant characteristics and that originate
from a defined time period, tended to produce recovery results that have been
comparable to other groups having similar characteristics. Although some
recoveries will be made during the first year of service, the average time to
make a recovery is 18 to 24 months, with substantially all recoveries made by
the sixth year. Backlog for a client will range in age from newly identified
potential recoveries (which will be identified each year) to potential
recoveries that are in the late stages of the recovery process. As a result of
this cycle, approximately six years from the date of installation, the client's
annual amounts of subrogation recoveries as a percent of the client's backlog
will be generally constant, except for variations due to the number of installed
lives for the client.
The Company is paid a contingency fee from the amount of recoveries it
makes from backlog on behalf of its clients. The Company's revenues are a
function of subrogation recoveries and effective fee rates. Effective fee rates
vary depending on the mix between recovery services provided and client fee
schedules. The fee schedules for each client are separately negotiated and
reflect the Company's standard fee rates, the services to be provided and
anticipated volume of services. The Company grants volume discounts and
negotiates a lower fee when it assumes backlog from a client because the client
will have already completed some of the recovery work. Since the Company records
expenses as costs are incurred and records revenues only when a file is settled,
there is a significant lag between recording expense and revenue recognition.
The Company's expenses are determined primarily by the number of employees
directly engaged in recovery activities (cost of services) and by the number of
employees engaged in a variety of support activities (support expenses).
Recovery-related employees must be hired and trained in advance of the
realization of recoveries and revenues and, during times of rapid growth,
installed lives and cost of service will grow more rapidly than revenue. The
number of employees accounted for in support expenses generally grows less
rapidly than revenue due to economies of scale.
8
<PAGE> 9
RESULTS OF OPERATIONS
The following tables present certain key operating indicators for the
Company for the periods indicated:
KEY OPERATING INDICATORS
(IN MILLIONS, EXCEPT FOR PERCENTAGES AND EMPLOYEES)
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------- -----------------
1998 1997 1998 1997
------- ------- ------ ------
<S> <C> <C> <C> <C>
Cumulative lives sold, beginning of
period.................................... 38.8 30.9 38.5 29.5
Lives from existing client growth......... (2.6) 0.9 (3.1) 0.9
Lives added from contracts with existing
clients................................ 0.2 1.0 0.9 2.3
Lives added from contracts with new
clients................................ 1.9 1.5 2.0 1.6
------ ------ ------ ------
Cumulative lives sold, end of period........ 38.3(1) 34.3 38.3(1) 34.3
====== ====== ====== ======
Lives installed............................. 35.7(1) 32.7 35.7(1) 32.7
Backlog(2).................................. $737.3 $599.6 $737.3 $599.6
Subrogation recoveries...................... $ 43.7 $ 34.1 $ 84.8 $ 67.8
Throughput(3)............................... 6.1% 5.8% 12.1% 12.0%
Effective fee rate.......................... 27.5% 27.3% 27.4% 26.9%
Subrogation revenues........................ $ 12.0 $ 9.3 $ 23.2 $ 18.2
Employees:
Direct operations......................... 404 326 404 326
Support................................... 98 78 98 78
------ ------ ------ ------
Total employees................... 502 404 502 404
====== ====== ====== ======
</TABLE>
- ---------------
(1) The decline in lives sold and installed is mainly attributable to the loss
of 2.0 million Oxford Health Plans' lives that were previously reported last
quarter and 600,000 lives from Healthsource, which was acquired by CIGNA.
See "Concentration of Clients."
(2) Backlog represents the total dollar amount of potentially recoverable claims
that the Company was pursuing on behalf of its clients as of June 30, 1997
and 1998.
(3) Throughput equals recoveries for the period divided by the average of
backlog at the beginning and end of the period presented.
The following table presents, for the periods indicated, certain items in
the statements of operations as a percentage of revenue:
STATEMENTS OF OPERATIONS AS A PERCENTAGE OF REVENUES
<TABLE>
<CAPTION>
THREE MONTHS SIX MONTHS
ENDED ENDED
JUNE 30, JUNE 30,
------------- -------------
1998 1997 1998 1997
----- ----- ----- -----
<S> <C> <C> <C> <C>
Revenues.............................................. 100.0% 100.0% 100.0% 100.0%
Cost of services...................................... 46.7 46.8 46.8 47.6
Support expenses...................................... 21.0 23.7 20.5 23.6
Depreciation and amortization......................... 4.8 2.5 4.7 2.6
Operating income (loss)............................... 27.5 (3.6) 28.0 10.5
Income (loss) before income taxes..................... 30.8 (1.3) 31.5 12.3
Net income (loss)..................................... 18.1 (13.6) 18.4 0.6
</TABLE>
Three and six months ended June 30, 1998 compared to three and six months
ended June 30, 1997
Revenues. Revenues increased 29.0% to $12.0 million in the three months
ended June 30, 1998 as compared with $9.3 million in the three months ended June
30, 1997, and increased 27.3% to $23.2 million in
9
<PAGE> 10
the six months ended June 30, 1998 as compared with $18.2 million in the
comparable period in 1997. Growth in subrogation revenues occurred primarily
because of the growth in subrogation recoveries from $34.1 million for the three
months ended June 30, 1997 to $43.7 million for the three months ended June 30,
1998, a 28.2% increase, and from $67.8 million for the six months ended June 30,
1997 to $84.8 million for the comparable period in 1998, a 25.1% increase.
The increase in subrogation recoveries was due primarily to growth in
backlog, attributable to a 9.2% increase in the number of lives installed.
Backlog increased 23.0% to $737.3 million at June 30, 1998 from $599.6 million
at June 30, 1997. The Company obtained subrogation recoveries at a throughput
rate of 6.1% of backlog for the three months ended June 30, 1998 and 5.8% for
the same period in 1997.
Cost of Services. Cost of services for the second quarter of 1998 was $5.6
million, an increase of 28.7% from $4.4 million in the three months ended June
30, 1997, and was $10.9 million for the six months ended June 30, 1998, an
increase of 25.2% from $8.7 million for the comparable period in 1997. The
increase in cost of services for the three and six months ended June 30, 1998
resulted from installing additional lives, which requires increased processing
activities, and correspondingly led to increased staffing and investigation
cost. As a percentage of subrogation revenues, cost of services for the three
months ended June 30, 1998 was 46.7%; a decrease from 46.8% in the three months
ended June 30, 1997, and for the six months ended June 30, 1998 was 46.8%, a
decrease from 47.6% for the comparable period in 1997. The decline in cost of
services as a percentage of subrogation revenues for the three and six months
ended June 30, 1998 was a result of productivity improvements.
Support Expenses. Support expenses increased 14.0%, to $2.5 million, for
the three months ended June 30, 1998, from $2.2 million for the comparable
period in 1997, and 10.7%, to $4.8 million, for the six months ended June 30,
1998 from $4.3 million in 1997, due to hiring of additional support staff.
Support expenses decreased as a percentage of revenues from 23.7% for the three
months ended June 30, 1997 to 21.0% for the three months ended June 30, 1998,
and from 23.6% for the six months ended June 30, 1997 to 20.5% for the
comparable period in 1998. The decline in support expenses as a percentage of
subrogation revenues resulted from improved economies of scale in the support
functions and capitalization of $100,000 and $269,000, respectively, of certain
software development costs associated with the upgrade of the SubroSystem for
the three and six months ended June 30, 1998, respectively. These costs were
capitalized in conjunction with the requirements under SOP 98-1
Compensation Charge. In connection with the divestiture of the Company by
Medaphis in May 1997, the Company incurred a one-time $2.8 million non-cash,
non-recurring compensation charge from the issuance by the Company of 200,000
shares of common stock to the Company's management as a bonus for the successful
completion of the sale of the Company by Medaphis. These shares represented 2%
of the 10,000,000 shares of common stock outstanding after the initial public
offering that closed on May 28, 1997 and 1.7% of the 11,470,000 shares of common
stock outstanding after the sale of 1,470,000 newly issued shares upon exercise
of the underwriters' over-allotment option.
Depreciation and Amortization. Depreciation and amortization expenses
increased 144.7%, to $580,000 for the three months ended June 30, 1998 from
$237,000 for the comparable period in 1997, and increased 125.9% to $1,089,000
for the six months ended June 30, 1998 from $482,000 in the comparable period in
1997, due mainly to the expenditures related to the upgrade of the SubroSystem.
Interest Income. Net interest income totaled $395,000 and $215,000 for the
three months ended June 30, 1998 and 1997, respectively, and $815,000 and
$329,000 for the six months ended June 30, 1998 and 1997, respectively. The
increase in interest income was a result of interest income earned on $19.2
million of proceeds from the issuance by the Company of 1,470,000 shares of
common stock as of June 9, 1997 upon the exercise of the underwriters'
over-allotment option.
Tax. Provisions for income taxes were 41.4% for the three month ended June
30, 1998 and 42.0% of pre-tax income, excluding the non-cash non-recurring
compensation charge, for the three months ended June 30, 1997, and 41.7% and
42.0% for the six months ended June 30, 1998 and 1997, respectively. The
decrease in tax rate is mainly due to tax exempt interest income from certain
investments. The effective tax
10
<PAGE> 11
rates exceeded the U.S. statutory tax rate as a consequence of state and local
taxes and non-deductible expenses.
Net Income. Recurring net income for the three months ended June 30, 1998
increased $587,000, or 37.1%, to $2.2 million, or $0.19 per share, from $1.6
million, or $0.15 per share, in the comparable period of 1997, and for the six
months ended June 30, 1998 increased $1.3 million, or 44.1%, to $4.3 million, or
$0.37 per share, from $3.0 million, or $0.29 per share, in the comparable period
in 1997. In each case, recurring net income excludes a $2.8 million non-cash,
non-recurring compensation charge in the second quarter of 1997. Net income as
reported for the three months ended June 30, 1998 was $2.2 million, or $0.19 per
share, compared to a net loss of $1.3 million, or $0.12 per share, for the same
period in 1997. Net income as reported for the six months ended June 30, 1998
was $4.3 million, or $0.37 per share, compared to $112,000, or $0.01 per share,
for the six months ended June 30, 1997.
LIQUIDITY AND CAPITAL RESOURCES
The Company's statements of cash flows for the six months ended June 30,
1998 and 1997 are summarized below:
<TABLE>
<CAPTION>
SIX MONTHS ENDED
JUNE 30,
-------------------
1998 1997
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Net cash provided by operations............................. $ 1,658 $ 3,963
Net cash used in investing activities....................... (2,416) (375)
Net cash provided by financing activities................... -- 16,941
-------- --------
Net (decrease) increase in cash and cash equivalents........ $ (758) $ 20,529
======== ========
</TABLE>
The Company had working capital of $25.8 million at June 30, 1998,
including cash and cash equivalents of $23.9 million, compared with working
capital of $22.9 million at December 31, 1997.
Net cash provided by operations decreased $2.3 million for the six months
ended June 30, 1998 compared to the six months ended June 30, 1997, primarily as
a result of timing of recurring cash receipts and disbursements related to
accrued expenses and subrogation recoveries.
Net cash used in investing activities primarily reflects the Company's
capital expenditures for ongoing facility expansion and system enhancements,
including computer hardware, to meet the requirements of the Company's growing
revenue base.
The Company spent $2.4 million in capital expenditures during the six
months ended June 30, 1998 for facility expansion, computer hardware and the
planned upgrade of the SubroSystem. Over the next 12 to 18 months, the Company
anticipates total expenditures for such upgrade of approximately $1.9 million,
of which $1.6 million to be spent on hardware and third-party software will be
capitalized.
Net cash provided by financing activities for the six months ended June 30,
1997 reflected the over-allotment offset by the Company's ongoing distributions
to Medaphis prior to the sale of the Company by Medaphis.
In February 1998, the Company entered into a new $50 million senior secured
revolving credit facility (the "Credit Facility") with a group of lenders.
Principal amounts outstanding under the Credit Facility mature on January 31,
2001 and bear interest at the Company's option, at either: (i) the Prime Rate
plus the applicable margin in effect or (ii) the Eurodollar Rate plus the
applicable margin in effect. The applicable margin is determined in accordance
with a Pricing Grid based on the Company's ratio of consolidated total
indebtedness to consolidated earnings before interest, taxes, depreciation and
amortization. The agreement contains usual and customary covenants including,
but not limited to financial tests for interest coverage, net worth levels and
leverage. The obligations under the Credit Facility are backed by substantially
all of the Company's assets subject to certain permitted exceptions. The
agreement also contains a material adverse
11
<PAGE> 12
change clause. As of June 30, 1998 the Company was in compliance with the
covenants and there were no outstanding draws under the Credit Facility.
By contract, with respect to its standard recovery services, the Company
disburses recoveries to its clients on or before the 15th day of the month
following the month in which recoveries are made. At June 30, 1998 and December
31, 1997, the Company reported on its balance sheet, as a current asset,
restricted cash of $17.1 million and $14.2 million respectively, representing
subrogation recoveries effected by HRI for its clients and as a current
liability, funds due clients of $13.4 million and $11.6 million, respectively,
representing recoveries to be distributed to clients, net of the fee earned on
such recoveries.
The Company believes that its available cash resources, together with the
borrowings available under the Credit Facility, will be sufficient to meet its
current operating requirements and internal development initiatives.
EXTERNAL FACTORS
The business of recovering subrogation and related claims for healthcare
payors is subject to a wide variety of external factors. Prominent among these
are factors that would materially change the healthcare payment, fault-based
liability or workers' compensation systems. Because the Company's profitability
depends in large measure upon obtaining and using claims data, and the
availability of property and casualty and workers' compensation coverages as
sources of recovery, changes in laws that would limit or bar either the access
to or use of claims data or the ability of healthcare payors to recover
subrogation and related claims represent an ongoing risk to the Company.
Moreover, because the Company's revenues derive from the recovery of the
costs of medical treatment of accidents, material changes in such costs will
tend to affect the Company's revenue or its rate of revenue growth. The
healthcare industry, and particularly the business of healthcare payors, is
subject to various external factors that may have the effect of significantly
altering the costs of healthcare. The Company is unable to predict which of
these factors, if any, could have a potentially material impact on healthcare
payors and through them, the healthcare subrogation recovery industry.
CONCENTRATION OF CLIENTS
The Company's clients includes national and regional healthcare payors,
large third-party administrators or self-insured corporations. The Company's
three largest clients represented 31%, 9% and 9% of the Company's revenues in
1997 and 25%, 9% and 8% for the six months ended June 30, 1998. The loss of one
or more of these accounts could have a material adverse effect on the Company's
business, results of operations and financial condition. The Company's revenues
are earned under written contracts with its clients that provide for contingency
fees from recoveries under a variety of pricing regimes. These contracts are
generally terminable on 60 to 180 days' notice by either party. However, the
Company's contracts provide that in the event of termination, the Company is
generally entitled to complete the recovery process on the backlog for that
client. During the six months ended June 30, 1998, HRI covered approximately
38.3 million lives, a decrease of 200,000 lives from December 31, 1997. This
decline resulted from the previously reported loss of 2.0 million lives from
Oxford Health Plans and of 600,000 lives from Healthsource, which was acquired
by CIGNA. The Healthsource contract was terminated by CIGNA, who is not an HRI
client, in order to consolidate vendors. Compared to last year, lives sold at
the end of the current quarter increased 4.0 million, or 12%, over the end of
the same quarter a year ago. Consistent with these changes in lives sold,
installed lives grew by 3.0 million over the end of the comparable quarter last
year, a 9% increase, but decreased by 900,000, or 2%, over the end of the prior
quarter.
YEAR 2000 COMPUTER ISSUES
The year 2000 presents a problem for computer systems (software and
hardware) that were not designed to handle any dates beyond the year 1999. The
problem is pervasive and complex because virtually every
12
<PAGE> 13
computer operation will be affected in some way by the rollover of the last two
digits of the year to "00." In consequence, any such software and hardware will
need to be modified some time prior to January 1, 1999 in order to remain
functional. Computer systems that do not properly handle this rollover could
generate erroneous data or fail to function.
The Company has initiated a company-wide program to identify and address
the modifications to or replacements of computer code (including data received
from clients), hardware and office equipment, the testing, and the
implementation procedures necessary to achieve year 2000 readiness ("Y2K
Readiness" or descriptively, "Y2K Ready"). As a result of this program, 9
different areas or functions within the Company have been surveyed in order
first, to identify software and hardware that are not presently Y2K Ready, and
second, to establish a schedule for remediation or replacement of the items of
software and hardware that are not Y2K Ready.
The Company has completed its identification of the elements of its
software and hardware that are not Y2K Ready. Included among these elements are
certain fields contained in SubroSystem, the Company's on-line subrogation
system. The first date of failure for all of these items of software and
hardware, including SubroSystem, is January 1, 2000. The completion date for
replacement or remediation of all elements of Company software and hardware that
are not Y2K Ready, including SubroSystem, is June 30, 1999. To date, the costs
of the Company's efforts to achieve Y2K Readiness have not been material, and
the Company believes that the future costs to complete its program to become Y2K
Ready will not be material.
Management believes that the greatest risk posed to the Company's Y2K
Readiness lies in the possible failure of its clients and other members of the
healthcare payor industry to achieve Y2K Readiness. The Company relies on its
clients to provide electronic claims data, through electronic data interfaces,
as the source of information from which the Company identifies potentially
recoverable claims. If clients are unable to provide such data because they are
not Y2K Ready, the Company could suffer a slow-down in its recovery efforts,
impairing its ability to make the recoveries from which it derives its revenue.
Moreover, to the extent that payors which are potential clients fail to achieve
Y2K Readiness, HRI's ability to sell to and to install such payors may also be
impaired. With respect to current clients, HRI has undertaken a survey of each
client's state of Y2K Readiness. The Company has not, to date, received its
clients' responses to this survey, and is therefore unable to form an opinion as
to the present level of this risk. Furthermore, the Company is unaware of any
survey speaking to the Y2K Readiness of the healthcare payor industry at-large,
and is thus unable to assess the magnitude of this risk with respect to
potential clients.
The Company's contingency planning calls for, among other things, early
identification of alternative means of obtaining electronic claims data should
the existing electronic data interfaces with clients fail. However, the Company
does not at present have a developed contingency plan for dealing with clients
that, because of a failure to achieve Y2K Readiness, are unable to process
healthcare claims electronically. This contingency planning will occur on an as
needed, client-specific basis, as part of the client assessment process
described above.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Inapplicable
13
<PAGE> 14
PART II
OTHER INFORMATION
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company held its Annual Meeting of Stockholders on May 4, 1998. Of the
11,470,000 shares of common stock outstanding and entitled to vote at this
meeting, 9,377,595 were represented at the meeting in person or by proxy. The
following matters were voted upon.
(a) The following members were elected to the Board of Directors to
hold office for a three year term:
<TABLE>
<CAPTION>
NOMINEE SHARE VOTED FOR SHARES WITHHELD TERM
------- --------------- --------------- ----
<S> <C> <C> <C>
John H. Newman........................... 9,377,240 355 2001
Chris B. Van Arsdel...................... 9,377,240 355 2001
</TABLE>
The Company's other directors continuing after the Annual Meeting are
as follows:
William C. Ballard, Jr.
Jill L. Force
Patrick B. McGinnis
Elaine J. Robinson
(b) The ratification of the appointment of Coopers & Lybrand LLP as
independent public accountants of the Company to serve for 1998. The result
of the vote was 9,377,240 shares favor, 200 shares opposed and 155 shares
withheld. Accordingly, the appointment of PricewaterhouseCoopers LLP was
ratified.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
<TABLE>
<S> <C> <C>
3.1 -- Amended and Restated Certificate of Incorporation of the
Registrant (incorporated by reference to Exhibit 3.1 of
Registrant's Amendment No. 2 to Registration Statement on
Form S-1, File No. 333-23287).
3.2 -- Amended and Restated Bylaws of the Registrant (incorporated
by reference to Exhibit 3.2 of Registrant's Amendment No. 2
to Registration Statement on Form S-1, File No. 333-23287).
27.1 -- Financial Data Schedule (for SEC use only)
99.1 -- Healthcare Recoveries, Inc. Private Securities Litigation
Reform Act of 1995 Safe Harbor Compliance Statement for
Forward-Looking Statements.
</TABLE>
(b) Reports on Form 8-K
The Company did not file any Current Reports on Form 8-K during the quarter
ended June 30, 1998.
14
<PAGE> 15
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HEALTHCARE RECOVERIES, INC.
Date: August 14, 1998 /s/ PATRICK B. MCGINNIS
--------------------------------------
Patrick B. McGinnis
Chairman, President and
Chief Executive Officer
Date: August 14, 1998 /s/ DOUGLAS R. SHARPS
--------------------------------------
Douglas R. Sharps
Executive Vice President -- Finance
and
Administration, and Chief Financial
Officer
(Principal Financial and Chief
Accounting Officer)
15
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
FINANCIAL STATEMENTS OF HEALTHCARE RECOVERIES, INC. FOR THE SIX MONTHS ENDED
JUNE 30, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL
STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> JUN-30-1998
<CASH> 23,916
<SECURITIES> 0
<RECEIVABLES> 2,983
<ALLOWANCES> 265
<INVENTORY> 0
<CURRENT-ASSETS> 44,804
<PP&E> 11,779
<DEPRECIATION> 5,880
<TOTAL-ASSETS> 52,553
<CURRENT-LIABILITIES> 19,054
<BONDS> 0
0
0
<COMMON> 11
<OTHER-SE> 32,118
<TOTAL-LIABILITY-AND-EQUITY> 52,553
<SALES> 23,221
<TOTAL-REVENUES> 23,221
<CGS> 10,871
<TOTAL-COSTS> 10,871
<OTHER-EXPENSES> 5,853
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 64
<INCOME-PRETAX> 7,312
<INCOME-TAX> 3,048
<INCOME-CONTINUING> 4,264
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 4,264
<EPS-PRIMARY> .19
<EPS-DILUTED> .19
</TABLE>
<PAGE> 1
EXHIBIT 99.1
HEALTHCARE RECOVERIES, INC.
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
SAFE HARBOR COMPLIANCE STATEMENT
FOR FORWARD-LOOKING STATEMENTS
------------------------------
In passing the Private Securities Litigation Reform Act of 1995 ("the
Reform Act") 15 U.S.C.A. Section 77z-2 and 78u-5 (Supp. 1996), Congress
encouraged public companies to make "forward-looking statements" by creating a
safe harbor to protect companies from securities law liability in connection
with forward looking statements. Healthcare Recoveries, Inc. ("HRI" or the
"Company") intends to qualify both its written and oral forward-looking
statements for protection under the Reform Act and any other similar safe harbor
provisions.
"Forward-looking statements" are defined by the Reform Act. Generally,
forward-looking statements include expressed expectations of future events and
the assumptions on which the expressed expectations are based. All
forward-looking statements are inherently uncertain as they are based on various
expectations and assumptions concerning future events and they are subject to
numerous known and unknown risks and uncertainties which could cause actual
events or results to differ materially from those projected. Due to those
uncertainties and risks, the investment community is urged not to place undue
reliance on written or oral forward-looking statements of HRI. The Company
undertakes no obligation to update or revise this Safe Harbor Compliance
Statement for Forward-Looking Statements (the "Safe Harbor Statement") to
reflect future developments. In addition, HRI undertakes no obligation to update
or revise forward-looking statements to reflect changed assumptions, the
occurrence of unanticipated events or changes to future operating results over
time.
HRI provides the following risk factor disclosure in connection with
its continuing effort to qualify its written and oral forward-looking statements
for the safe harbor protection of the Reform Act and any other similar safe
harbor provisions. Important factors currently known to management that could
cause actual results to differ materially from those in forward-looking
statements include the following:
REGULATORY AND POLITICAL RISKS
General. From time to time, legislation is introduced in Congress and
in various state legislatures that would materially affect the Company's
business. The most significant legislation, law and regulation, for clarity, may
be grouped in three categories: (1) legislation that would substantially limit
the ability of healthcare insurers to recover from third-parties
accident-related medical benefits incurred by injured insureds ("Health
Insurance Primacy Law"), (2) legislation that would substantially limit the
Company's ability to receive and utilize individual claim information from
healthcare insurers ("Confidentiality Laws") and (3) other federal and state
laws. The following identify specific risks in those three categories:
Health Insurance Primacy Laws:
Auto Choice Reform Act of 1997. On April 22, 1997, Senators McConnell,
Grams, Moynihan, Lieberman and Gorton introduced the Auto Choice Reform Act of
1997. Under this Act, in those states not opting out of its provisions,
individual drivers may choose to be covered by an auto insurance system in which
healthcare insurers, with some exceptions, would be made primarily responsible
for healthcare costs incurred by those injured in automobile accidents.
Consequently, even if the insured's injuries were caused by the negligence of
another driver, the healthcare insurer would have no rights of recovery against
the negligent party or that party's liability insurer. Revenue generated from
recoveries against automobile liability insurers represented approximately 60%
of the Company's 1997 revenues. Similar legislation was introduced, but not
enacted in the previous session of Congress. On June 24, 1997, similar
legislation was introduced in the House of Representatives by Representatives
Armey, Moran, Saxton, Cox and McIntosh. Should this or similar legislation be
enacted it would have a material adverse effect on the Company's business,
results of operations and financial condition.
The proposed legislation asserts that (i) the costs of operating a
motor vehicle are excessive due to legal and administrative costs associated
with the processing of claims under the fault-based liability system and (ii)
the costly fault-based liability insurance system often fails to provide
compensation commensurate with loss and takes too long to pay benefits.
<PAGE> 2
Even if the Auto Choice Reform Act is ultimately abandoned, these
policy reasons may result in future legislation designed to significantly alter
the fault-based liability system used in most states, eliminate recovery rights
of healthcare insurers and adversely affect the Company's business.
Clinton Administration Healthcare Proposals. In 1993, as part of its
healthcare reform proposals, the Clinton Administration proposed to require in
effect that an injured insured's healthcare insurance provider be primarily
liable for the insured's healthcare costs, for both injuries caused by a
third-party and work related injuries. Although these proposals were never
enacted into law, had they or similar rules been enacted into law, the Company's
services would have been rendered largely unnecessary and the Company's
business, results of operations and financial condition would have been
materially adversely affected. Although the Clinton Administration has abandoned
its healthcare reform proposal, there can be no guarantee that a future
administration or Congress will not propose or enact such a provision or other
regulatory scheme that would diminish or eliminate the value of the Company's
services.
Certain No Fault Insurance Systems. Certain states have adopted versions of
automobile "no fault" insurance systems in which the injured party's health
insurance carrier or provider is primarily responsible for healthcare related
expenses (and not the responsible party and his or her insurer or the injured
insured's automobile liability insurer). In 1996, California voters rejected a
no-fault automobile insurance measure, Proposition 200, which would have
required drivers with bodily injuries to be compensated by their own healthcare
insurers. Although Proposition 200 was rejected by the voters, there can be no
assurance that similar measures will not again be presented in a ballot
initiative or as legislation in the future. Growth in the number of states
adopting similar systems could significantly reduce the amounts otherwise
recoverable by the Company in connection with automobile injuries in such
states.
Confidentiality Laws:
Confidentiality Provisions of the Health Insurance Portability and
Accountability Act of 1996. Section 262 of the Health Insurance Portability and
Accountability Act of 1996 (42 U.S.C. s.s. 1177) prohibits any person from
knowingly obtaining or disclosing individually identifiable health information
relating to an individual in violation of the standards relating to the
electronic transmission of healthcare information established by the Secretary
of the Department of Health and Human Services. In September 1997, the Secretary
submitted recommendations to Congress to implement these standards. If Congress
does not enact health information privacy legislation by August, 1999, the
Secretary will be required to issue final regulations on the subject. The
Secretary's recommendations set forth general principals, but do not propose
specific legislation. Several bills pertaining to privacy of individually
identifiable health information have been introduced in this Congress. In
addition, the Secretary recently has issued three proposed rules that outline
security standards for healthcare information specific to an individual that is
maintained or transmitted electronically, including standards for electronic
signatures; electronic transaction standards; a standard employer identification
number and requirements concerning its implementation; and a standard healthcare
provider identifier and requirements concerning its implementation. The
provisions of future legislation or regulations could impair or prevent the
acquisition and use by the Company of claims and insurance information necessary
to process recovery claims on behalf of its clients. In addition to federal law,
state laws and regulations governing privacy of insurance records and related
matters may significantly affect the Company's business. State efforts to
restrict the use of such records, which clients currently provide to the
Company, could impair the Company's business, results of operations and
financial condition.
Other Federal and State Laws:
Changes in the regulation of insurance and debt collection could also
affect the Company's business. Similarly, changes in law that would bar
healthcare subrogation or impair an injured party's ability to collect insured
damages (that is, an injured person would be prevented from recovering from the
wrongdoer damages for accident-related medical benefits covered by health
insurance) could similarly adversely affect the Company's business. Existing
debt collection laws also may be amended or interpreted in a manner that could
adversely affect the Company's business. Additionally, although the Company does
not believe that it engages in the unauthorized practice of law, changes in the
law or a judicial or administrative decision defining some of the Company's
activities as the practice of law, could have a material adverse effect on the
Company's business.
Certain Legal Doctrines
With respect to recoverable claims, the rights of subrogation and
reimbursement may be limited in some cases by (i) the "made whole doctrine,"
which may limit the healthcare provider's ability to recover when the
settlement damage award received by the injured party is inadequate to cover
the injured party's damages and (ii) the "common fund doctrine," which permits
plaintiff's attorneys to determine their compensation, based on the entire
amounts covered by a damage award and may, in some cases, proportionally
diminish the amount recoverable by HRI on behalf of the healthcare payor of
that damage award.
-2-
<PAGE> 3
DEPENDENCE ON LARGE CLIENTS
The Company's clients includes national and regional healthcare payors,
large third-party administrators or self-insured corporations. The Company's
three largest clients represented 31%, 9% and 9% of the Company's revenues in
1997 and 25%, 9% and 8% for the six months ended June 30, 1998. The loss of one
or more of these accounts could have a material adverse effect on the Company's
business, results of operations and financial condition. The Company's revenues
are earned under written contracts with its clients that provide for contingency
fees from recoveries under a variety of pricing regimes. These contracts are
generally terminable on 60 to 180 days' notice by either party. However, the
Company's contracts provide that in the event of termination, the Company is
generally entitled to complete the recovery process on the backlog for that
client. During the six months ended June 30, 1998, HRI covered approximately
38.3 million lives, a decrease of 200,000 lives from December 31, 1997. This
decline resulted from the previously reported loss of 2.0 million lives from
Oxford Health Plans and of 600,000 lives from Healthsource, which was acquired
by CIGNA. The Healthsource contract was terminated by CIGNA, who is not an HRI
client, in order to consolidate vendors. Compared to last year, lives sold at
the end of the current quarter increased 4.0 million, or 12%, over the end of
the same quarter a year ago. Consistent with these changes in lives sold,
installed lives grew by 3.0 million over the end of the comparable quarter last
year, a 9% increase, but decreased by 900,000, or 2%, over the end of the prior
quarter.
LENGTHY REVENUE CYCLE AND FLUCTUATION IN OPERATING RESULTS
The Company's operating results may fluctuate from time to time as a
result of a number of factors, including additions of new clients, cancellation
of client contracts, postponement of client decisions to enter into contracts,
delays in transmission of clients' claims data, changes in prices offered to new
clients, timing of acquisitions, introduction of new services or introduction of
new technologies to the Company's business processes. HRI expends substantial
time, effort and funds to install lives and generate active files. As a result,
HRI incurs expenses related to its revenue in advance of the time such revenue
is received which can result in fluctuations in operating results.
In particular, the volume and timing of receipt of clients' claims data
received during a fiscal quarter are difficult to forecast. The Company's
clients continuously update and modify their claims and medical encounter
processing systems, and such changes often create delays in or errors to the
transmission of claims data. Furthermore, the Company's expense levels are based
in part on expectations of future receipt of claims data and the Company has
been significantly increasing and intends to continue to increase operating
expenditures and working capital balances as it expands its operations.
Specifically, material increases in new clients and lives installed, and
consequently client claims data received, will cause the Company to increase its
operating capacity well in advance of its expectation to earn revenues from such
new clients. Operating results in any particular quarter which do not meet the
expectations of securities analysts could cause volatility in the price of the
Company's Common Stock.
LITIGATION
The Company is engaged in the business of identifying and recovering
subrogation and related claims of its clients, many of which arise in the
context of personal injury lawsuits. As such, the Company operates in a
litigation-intensive environment. The Company has, from time to time, been, and
in the future expects to be, named as a party in litigation incidental to its
business operations. To date, the Company has not been involved in any
litigation which has had a material adverse effect upon the Company, but there
can be no assurance that pending litigation or future litigation will not have a
material adverse effect on the Company's business, results of operations and
financial condition.
The Company is also party to a putative class action lawsuit that seeks
monetary damages from the Company on the basis that the Company recovered from
responsible parties the "reasonable value" of medical treatment provided by
medical providers rather than the amounts actually paid by certain healthcare
payors, in circumstances where such healthcare payors had a discounted
fee-for-service ("DFS") arrangement, capitation arrangement or other payment
arrangement that did not involve solely fee-for-service arrangements with the
medical providers. Under a typical capitation arrangement a medical provider is
paid a flat periodic fee for each patient referred by a healthcare payor and the
medical provider contractually bears the risk of the amount of services needed
by the potential patient group. Thus, there is no specific amount paid by the
healthcare payor for any service rendered by the medical provider. In addition
to monetary damages, the class action lawsuit seeks injunctive relief preventing
the Company from pursuing recoveries in excess of the amounts actually paid by
its clients regardless of the payment mechanism. Although it is the Company's
current policy not to seek recovery of the "reasonable value" of medical
treatment in DFS arrangements, the Company does collect the "reasonable value"
of medical treatment under capitation and certain other payment arrangements.
The Company's clients determine such "reasonable value" according to their
internal procedures. If this lawsuit or another lawsuit seeking relief under
similar
-3-
<PAGE> 4
theories were to be successful, it could have a material adverse effect on the
Company's business, results of operations and financial condition.
COMPETITION
HRI competes primarily with the internal recovery departments of
potential customers and other subrogation recovery service vendors. To the
Company's knowledge, there are three smaller, but significant, independent
providers of subrogation recovery services in addition to HRI. All three
independent competitors preceded HRI's entry into the recovery industry, and no
major competitors have entered the market since that time. HRI believes that it
has competitive advantages in the bulk of its market, including process
expertise, capital requirements necessitated by the unusually long revenue cycle
in the recovery industry, a qualified and productive employee base possessing
appropriate industry expertise, and an information processing system designed to
aid investigators and examiners engaged in the recovery process. However, there
are participants in the healthcare insurance and transaction processing
industries that possess sufficient capital, and managerial and technical
expertise to develop competitive services.
DEPENDENCE ON KEY PERSONNEL
The Company's success depends to a significant degree upon the
continued contributions of members of the Company's senior management and other
key sales, marketing, computer systems and operations personnel, and the loss of
any such persons could have a materially adverse effect on the business of the
Company. The Company's success also depends upon its ability to attract and
retain highly qualified and skilled managerial, sales, marketing and computer
software development and operations personnel, the competition for whom is
intense. There can be no assurance that the Company will be successful in hiring
or retaining the requisite personnel, which could have a material adverse effect
on the Company's business, results of operations and financial condition. The
Company does not maintain key man insurance. The Company has employment
agreements with Patrick B. McGinnis, Chairman and Chief Executive Officer, Debra
M. Murphy, Executive Vice President - Operations, Douglas R. Sharps, Executive
Vice President - Finance and Administration.
PROSPECTIVE UPGRADE OF INFORMATION MANAGEMENT SYSTEM AND LOSS OF PROPRIETARY
TECHNOLOGY
The SubroSystem and its Upgrade. Although the SubroSystem, a key
feature of HRI's recovery process, historically served the Company's operational
and management information needs, HRI developed a 3-step plan (the "System
Upgrade") under which it would, over a 24-month to 36-month period, (i) migrate
the SubroSystem from an MS-DOS based environment to a Windows NT operating
environment, (ii) adopt a new database system, and (iii) adopt an
object-oriented programming language, such as C++. The System Upgrade includes a
detailed process for the comprehensive testing of all key elements prior to
implementation of each step. The Company expects that it will spend
approximately $4.4 million on the System Upgrade, of which $4.0 million spent on
hardware and third-party software will be capitalized. HRI's policy is to
expense software development costs as incurred.
There can be no assurance that the implementation of the System Upgrade
(or any part of it) will be successful, that it will be within budget, or that
the implementation of the System Upgrade (or any part of it) will not have an
adverse effect on the Company's business, results of operations or financial
condition. Furthermore, because the SubroSystem is proprietary,
industry-specific software, the absence of complete and detailed written
documentation with respect to the SubroSystem's functioning and code structure
make the Company dependent on existing staff, who are skilled in its operations
and some of whom participated in its design.
Dependence on Proprietary Software Applications. The Company's success
depends, in part, upon its proprietary technology, specifically the integrated
software programs comprising the SubroSystem. Although certain elements of the
SubroSystem are protected by federal copyright law, such protection neither
confers a monopoly on the use of subrogation recovery software systems nor
prevents competitors from developing similar systems. The SubroSystem, like all
other software programs, may be subject to a variety of replication techniques
(for example, reverse engineering, logic tracing, disassembly and decompilation)
that would produce a functionally similar software system not covered by the
Company's registered copyright. Therefore, there can be no assurance that the
Company's registered copyright on the SubroSystem will
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preclude or deter circumvention by current or future competitors, with the
effect that the Company might lose any advantage conferred by the SubroSystem.
CONSOLIDATION AMONG HEALTHCARE PAYORS: PRESSURE ON MARGINS
Consolidation among healthcare payors could increase their bargaining
strength as the number of lives insured or otherwise covered by such healthcare
payors grows, which may place downward pressure on the Company's historic
margins and may create additional competition from such healthcare payors in the
form of better equipped in-house recovery departments. Additionally, existing
clients have been and may in the future be lost through acquisition by
non-client healthcare payors.
LIMITATION ON DIVIDENDS
From August 28, 1995, the date Medaphis Corporation ("Medaphis")
acquired HRI, until May 1997 when Medaphis sold HRI in an initial public
offering (the "Offering"), the Company paid dividends to Medaphis totaling $13.6
million. Following the Offering, however, the Company has retained earnings to
finance the growth and development of its business and does not anticipate
paying cash dividends on its common stock in the foreseeable future. The
Company's credit facility limits its ability to pay dividends on its common
stock.
ABILITY TO MANAGE GROWTH IN SUBROGATION BUSINESS
The Company recently has experienced significant growth in both its
revenues and the number of its employees. This growth has resulted in an
increase in responsibilities placed upon the Company's management and has placed
added pressures an the Company's operating systems. The Company expects to
expand its management, systems development and support, marketing, sales and
customer services and to upgrade the SubroSystem, which could place a strain on
the Company's operations. Furthermore, the initial expenses associated with the
addition of new clients may be incurred prior to the recognition of any revenues
from such new clients. There can be no assurance that the Company will
successfully manage its expanding operations or implement its growth strategy;
and if the Company's management is unable to manage growth effectively, the
Company's business, operating results and financial condition could be adversely
affected.
ABILITY TO EXECUTE GROWTH STRATEGY
In addition to growing its existing subrogation recovery business, HRI
intends to extend its business model and capabilities, through external and
internal development, to other service industries. Although HRI does not, at
present, engage in any line of business other than subrogation recovery, it
believes that future development opportunities are likely to be characterized
by: outsourcing services that produce predictable and recurring revenue streams;
competitive advantages from processes, automation and the provision of
knowledge-rich services; development-stage niche markets; value-based pricing;
and a focus on (non-exclusive) healthcare information services.
There can be no assurance that the Company will be successful in the
internal development or acquisition of new lines of business or that it will be
able to successfully manage new lines of business which it may develop or
acquire, and if the Company's management is unable either to execute this growth
strategy or to manage the resulting growth, the Company's business, operating
results and financial condition could be adversely affected.
CERTAIN ANTI-TAKEOVER PROVISIONS
Certain provisions of the Amended and Restated Certificate of
Incorporation and Bylaws of the Company may be deemed to have the effect of
making difficult an acquisition of control of the Company in a transaction not
approved by the Company's Board of Directors. These provisions include the
ability of the Company's board of directors to issue shares of preferred stock
in one or more series without further authorization of the Company's
stockholders. Accordingly, the Company's Board of Directors is empowered,
without stockholder approval, to issue preferred stock with dividend,
liquidation, conversion, voting or other rights which could adversely affect the
voting power or other rights of the holders of Common Stock. In the event of
such issuance, the preferred stock could also be utilized, under certain
circumstances, as a method of discouraging delaying or preventing a change in
control of the Company. Although the Company has no current intention to issue
any shares of its preferred stock, there can be no assurance that the Company
will not do so in the future. These provisions may also have the effect of
discouraging a third-party from making a tender offer or otherwise attempting to
obtain control of the Company even though such a transaction might be
economically beneficial to the Company and its stockholders. Furthermore, the
Company is subject to the anti-takeover provisions of Section 203 of the
Delaware General Corporation Law which prohibits the Company from engaging in a
"business combination" with an "interested stockholder" for a period of three
years after the time of the transaction in which the person first becomes an
"interested stockholder," unless the business combination is approved in a
prescribed manner. The application of Section 203 could have the effect of
delaying or preventing a change of control of the Company. Certain other
provisions of the Company's Amended and
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Restated Certificate of Incorporation and Bylaws may have the effect of delaying
or preventing changes of control or management of the Company, which could
adversely affect the market price of the Common Stock. Among these are
provisions (i) requiring a classified board of directors, (ii) prohibiting
action by written consent of the stockholders, (iii) limiting the person able
to, and the procedures for, calling a special meeting of the stockholders and
(iv) requiring certain supermajority stockholder votes to amend certain of the
foregoing provisions.
PROFESSIONAL LIABILITY AND INDEMNITY OBLIGATIONS TO CLIENTS
From time to time, the Company may be subject to claims from its
clients that it failed to provide services in accordance with its contract or
that its recovery activities have harmed the client. To date, no client has
terminated its contract with the Company based upon the failure to provide
services, nor has any client asserted that the Company has in any way damaged
its business. The Company has agreed to indemnify and hold certain of its
clients harmless from negligent acts or omissions of the Company in the
performance of recovery services. Although the Company maintains, and intends to
continue maintaining, insurance covering these types of risks, there can be no
assurance that such insurance will be an adequate amount or will be available at
reasonable costs in the future.
STOCK PRICE VOLATILITY
The Company believes that a variety of factors could cause the price of
the Common Stock to fluctuate, perhaps substantially, including: announcements
of developments related to the Company's business; changes in financial
estimates by securities analysts; and developments in the Company's
relationships with its customers, distributors and suppliers. In addition, in
recent years the stock prices of companies have experienced extreme price
fluctuations which have often been unrelated to the operating performance of
such companies. Similar fluctuations may adversely affect the market price of
the Common Stock in the future.
YEAR 2000 COMPUTER ISSUES
The year 2000 presents a problem for computer systems (software and
hardware) that were not designed to handle any dates beyond the year 1999. The
problem is pervasive and complex because virtually every computer operation
will be affected in some way by the rollover of the last two digits of the year
to "00." In consequence, any such software and hardware will need to be
modified some time prior to January 1, 1999 in order to remain functional.
Computer systems that do not properly handle this rollover could generate
erroneous data or fail to function.
The Company has initiated a company-wide program to identify and
address the modifications to or replacements of computer code (including data
received from clients), hardware and office equipment, the testing, and the
implementation procedures necessary to achieve year 2000 readiness ("Y2K
Readiness" or descriptively, "Y2K Ready"). As a result of this program, 9
different areas or functions within the Company have been surveyed in order
first, to identify software and hardware that are not presently Y2K Ready, and
second, to establish a schedule for remediation or replacement of the items of
software and hardware that are not Y2K Ready.
The Company has completed its identification of the elements of its
software and hardware that are not Y2K Ready. Included among these elements
are certain fields contained in SubroSystem, the Company's online subrogation
system. The first date of failure for all of these items of software and
hardware, including SubroSystem, is January 1, 2000. The completion date for
replacement or remediation of all elements of Company software and hardware that
are not Y2K Ready, including SubroSystem, is June 30, 1999. To date, the costs
of the Company's efforts to achieve Y2K Readiness have not been material, and
the Company believes that the future costs to complete its program to become Y2K
Ready will not be material.
Management believes that the greatest risk posed to the Company's Y2K
Readiness lies in the possible failure of its clients and other members of the
healthcare payor industry to achieve Y2K Readiness. The Company relies on its
clients to provide electronic claims data, through electronic data interfaces,
as the source of information from which the Company identifies potentially
recoverable claims. If clients are unable to provide such data because they are
not Y2K Ready, the Company could suffer a slow-down in its recovery efforts,
impairing its ability to make the recoveries from which it derives its revenue.
Moreover, to the extent that payors which are potential clients fail to achieve
Y2K Readiness, HRI's ability to sell to and to install such payors may also be
impaired. With respect to current clients, HRI has undertaken a survey of each
client's state of Y2K Readiness. The Company has not, to date, received its
clients' responses to this survey, and is therefore unable to form an opinion
as to the present level of this risk. Furthermore, the Company is unaware of
any survey speaking to the Y2K Readiness of the healthcare payor industry
at-large, and is thus unable to assess the magnitude of this risk with respect
to potential clients.
The Company's contingency planning calls for, among other things, early
identification of alternative means of obtaining electronic claims data should
the existing electronic data interfaces with clients fail. However, the Company
does not at present have a developed contingency plan for dealing with clients
that, because of a failure to achieve Y2K Readiness, are unable to process
healthcare claims electronically. This contingency planning will occur on an as
needed, client-specific basis, as part of the client assessment process
described above.
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