<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
(X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1996
------------------------------
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transaction period from ____________ to ____________
Commission File Number 1-10540
-------------
FOUNDATION HEALTH CORPORATION
-------------------------------------------------------
(Exact name of registrant as specified in its charter)
Delaware 68-0014772
- ------------------------------------------ --------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification
incorporation or organization) No.)
3400 Data Drive, Rancho Cordova, CA 95670
- ------------------------------------- --------
(Address of principal executive offices) (Zip Code)
(916) 631-5000
- -------------------------------------------------------------------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
---------- -----------
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of November 15 , 1996:
Common Stock, $0.01 Par Value 58,752,016
- ----------------------------- -----------------------------
Class Number of Shares
1
<PAGE>
FOUNDATION HEALTH CORPORATION
INDEX TO FORM 10-Q
PAGE
Part I - Financial Information
Item 1 - Financial Statements
Condensed Consolidated Balance Sheets -
September 30, 1996 and June 30, 1996 3
Condensed Consolidated Statements of Operations for the Quarters
Ended September 30, 1996 and 1995 4
Condensed Consolidated Statements of Cash Flows for the Quarters
Ended September 30, 1996 and 1995 5
Notes to Condensed Consolidated Financial Statements 6 - 8
Item 2 - Management's Discussion and Analysis of Financial
Condition and Results of Operations 9 - 16
Part II - Other Information
Item 1 - Legal Proceedings 17
Item 6 - Exhibits and Reports on Form 8-K 18
Signature 19
Index to Exhibits 20
2
<PAGE>
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
FOUNDATION HEALTH CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
September 30, June 30,
-------------- --------------
1996 1996
-------------- --------------
(Restated)
<S> <C> <C>
ASSETS
Cash and cash equivalents $ 168,697 $ 226,156
Investments 812,748 714,914
Amounts receivable under government contracts 200,484 182,062
Reinsurance receivable 102,033 94,662
Premium and patient receivables, net 154,376 139,499
Property and equipment, net 260,058 257,564
Goodwill and other intangible assets, net 400,839 402,015
Deferred income taxes 40,685 45,487
Net assets of discontinued operations 27,989
Other assets 327,082 275,294
-------------- --------------
$2,494,991 $2,337,653
-------------- --------------
-------------- --------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Reserves for claims, losses and loss adjustment expenses $ 942,175 $ 883,911
Notes payable and capital leases 391,644 309,136
Amounts payable under government contracts 46,507 52,948
Accrued dividends to policyholders 3,726 9,726
Net liabilities of discontinued operations 1,483
Other liabilities 204,939 213,523
-------------- --------------
1,588,991 1,470,727
-------------- --------------
Stockholders' Equity:
Common stock and additional paid-in capital 537,520 533,855
Retained earnings 375,229 343,026
Unrealized holding gains and losses, net of taxes (3,702) (6,908)
Common stock held in treasury, at cost (3,047) (3,047)
-------------- --------------
906,000 866,926
-------------- --------------
$2,494,991 $2,337,653
-------------- --------------
-------------- --------------
</TABLE>
See Notes to Condensed Consolidated Financial Statements
3
<PAGE>
FOUNDATION HEALTH CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
(UNAUDITED)
<TABLE>
<CAPTION>
Quarter Ended September 30,
------------------------------
1996 1995
-------------- ------------
(Restated)
<S> <C> <C>
Revenues:
Commercial premiums $ 566,912 $ 459,575
Government contracts 248,001 81,019
Specialty services revenue 184,922 157,702
Patient service revenue, net 13,371 11,645
Investment and other income 18,851 14,112
-------------- ------------
1,032,057 724,053
-------------- ------------
Expenses:
Commercial health care services 475,700 367,398
Government contracts health care services 180,927 45,257
Specialty services costs 162,945 138,623
Patient service costs 12,889 9,080
Selling, general and administrative 131,467 88,288
Amortization and depreciation 14,553 11,340
Interest expense 5,690 3,788
-------------- ------------
984,171 663,774
-------------- ------------
Income from continuing operations before income taxes 47,886 60,279
Provision for income taxes 15,683 20,495
-------------- ------------
Income from continuing operations 32,203 39,784
Discontinued operations:
Loss, net of taxes - (16,088)
-------------- ------------
Net income $ 32,203 $ 23,696
-------------- ------------
-------------- ------------
Earnings (loss) per share:
Continuing operations $ 0.55 $ 0.69
Discontinued operations - (0.28)
-------------- ------------
Net earnings $ 0.55 $ 0.41
-------------- ------------
-------------- ------------
Weighted average common and common
stock equivalent shares outstanding 59,077,144 57,427,162
-------------- ------------
-------------- ------------
</TABLE>
See Notes to Condensed Consolidated Financial Statements
4
<PAGE>
FOUNDATION HEALTH CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
Quarter Ended September 30,
------------------------------
1996 1995
------------- --------------
(Restated)
<S> <C> <C>
Net cash provided by (used for) operating activities $ (12,139) $ 33,114
------------- --------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of property and equipment (10,735) (22,752)
Purchases of available for sale investments (171,344) (111,315)
Sales/maturities of available for sale investments 77,712 135,138
Purchases of held to maturity investments (1,567) (2,508)
Maturities of held to maturity investments 4,050 8,559
Increase in other assets (23,392) (4,578)
Acquisition of businesses, net of cash acquired (6,034)
------------- --------------
Net cash used for investing activities (125,276) (3,490)
------------- --------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of notes payable 80,107 40,016
Principal payments on notes payable and capital leases (1,132) (2,319)
Proceeds and tax benefits from issuance of common stock
and exercise of stock options 1,482 2,025
Stock repurchase and other merger related adjustments (501) (17,557)
------------- --------------
Net cash provided by financing activities 79,956 22,165
------------- --------------
Net (decrease) increase in cash and cash equivalents (57,459) 51,789
Cash and cash equivalents, beginning of quarter 226,156 203,210
------------- --------------
Cash and cash equivalents, end of quarter $ 168,697 $ 254,999
------------- --------------
------------- --------------
SUPPLEMENTAL CASH FLOW DISCLOSURE:
Interest paid $ 2,607 $ 993
------------- --------------
------------- --------------
Income taxes paid $ 3,825 $ 1,678
------------- --------------
------------- --------------
Noncash investing and financing activities:
Unrealized holding gains (losses) $ 3,206 $ 1,732
------------- --------------
------------- --------------
Acquisition of businesses:
Assets acquired $ $ 7,074
Liabilities assumed (854)
------------- --------------
Cash paid - 6,220
Less cash acquired (186)
------------- --------------
Net cash paid $ - $ 6,034
------------- --------------
------------- --------------
</TABLE>
See Notes to Condensed Consolidated Financial Statements
5
<PAGE>
FOUNDATION HEALTH CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1 - BASIS OF PRESENTATION
In the opinion of management, the accompanying unaudited condensed consolidated
financial statements include all adjustments necessary for a fair presentation
of the consolidated financial position of Foundation Health Corporation (the
"Company") and the consolidated results of its operations and its cash flows for
the interim periods presented. Although the Company believes that the
disclosures in these financial statements are adequate to make the information
presented not misleading, certain information and footnote disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted pursuant to the rules and
regulations of the Securities and Exchange Commission ("SEC"). For further
information refer to the consolidated financial statements and notes thereto in
the Company's Annual Report on Form 10-K/A for the year ended June 30, 1996.
Results of operations for the interim periods are not necessarily indicative of
results to be expected for the full year.
As discussed in Note 5, prior year financial statements have been restated to
include the operations of the Company's affiliated, physician-owned Medical
Practices, which were discontinued, along with the Company's physician practice
management subsidiary, in the third quarter of fiscal year 1996. Additionally,
certain reclassifications have been made to prior period financial statements to
conform to current period presentation.
NOTE 2- INVESTMENTS
Investments comprised the following (in thousands):
September 30, 1996 June 30, 1996
------------------ -------------
Available for sale $ 783,421 $ 683,023
Held to maturity 29,327 31,891
------------ -----------
Total investments $ 812,748 $ 714,914
------------ -----------
------------ -----------
For purposes of calculating realized gains and losses on sales of investments
available for sale, the amortized cost of each investment sold is used.
6
<PAGE>
NOTE 3- CAPITAL STOCK
The Company has a stock repurchase program to acquire from time to time up to
5.7 million shares of the Company's common stock in the open market. As of
September 30, 1996 the Company had repurchased a total of 1,795,500 shares
pursuant to this program. No shares were repurchased during the quarter ended
September 30, 1996. Effective September 30, 1996, the stock repurchase program
was canceled.
NOTE 4- RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In October 1995, the Financial Accounting Standards Board issued Statement No.
123, "Accounting for Stock-Based Compensation". The new standard defines a fair
value method of accounting for stock options and other equity instruments, such
as stock purchase plans. Under this method, compensation cost is measured on
the fair value of the stock award when granted and is recognized as expense over
the service period, which is usually the vesting period. This standard is
effective for the Company beginning in fiscal 1997, and requires measurement of
awards made on or after December 15, 1995. The new standard permits companies to
continue to account for equity transactions with employees under existing
accounting rules, but requires disclosure in a note to the financial statements
of the pro forma net income and earnings per share as if the Company had applied
the new method of accounting. The Company intends to follow the disclosure
requirements for its employee stock plans. The new standard will also require
that all stock-based transactions with non-employees be measured in accordance
with the fair value method and recorded as expense. The Company does not expect
that implementation of this standard will have a material impact on its results
of operations during fiscal 1997.
In March 1995, the Financial Accounting Standards Board issued Statement No.
121, "Accounting for the Impairment of Long-lived Assets and for Long-lived
Assets to be Disposed of" ("SFAS No. 121"). The Statement requires that long-
lived assets and certain identifiable intangibles to be held and used by an
entity be reviewed for impairment whenever events or changes in circumstances
indicate that the carrying amount of an asset may not be recoverable. The
Statement also requires that long-lived assets and certain identifiable
intangibles to be disposed of be reported at the lower of carrying amounts or
fair value less cost to sell. This Statement is effective for the Company
beginning in fiscal 1997. Adoption of SFAS No. 121 is not expected to have a
material effect on the Company's consolidated financial statements.
NOTE 5 - RESTATEMENT
Subsequent to the issuance of its financial statements for the year ended
June 30, 1996, the Company reconsidered, in light of recent industry
developments, its prior accounting treatment for its affiliated
physician-owned Medical Practices and determined that certain adjustments to
consolidate those Medical Practices were required to be made to the
previously reported amounts as of June 30, 1996 and for the quarter ended
September 30, 1995. The operations of the affiliated physician-owned Medical
Practices along with the Company's physician practice management subsidiary
are being treated as discontinued operations as they previously represented a
segment of the Company's business that is in the process of being sold.
7
<PAGE>
A summary of the effects of the restatement in the determination of loss from
discontinued operations for the quarters ended September 30, 1996 and 1995 is as
follows (dollars in thousands):
Quarter Ended September 30,
-------------------------------
1996 1995
----------------- ------------
Revenues $ 40,020 $ 30,303
Expenses 59,329 46,627
--------- ---------
Net loss before income taxes (19,309) (16,324)
Benefit (provision) for income taxes 657 (236)
Deferral of losses from measurement date 19,966 -
--------- ---------
Net loss from discontinued operations $ - $(16,088)
--------- ---------
--------- ---------
NOTE 6- SUBSEQUENT EVENT
On October 1, 1996, the Company entered into an Agreement and Plan of Merger
with Health Systems International, Inc. ("HSI"). Under the definitive
agreement approved by both companies' boards of directors, the Company will
merge into a wholly-owned subsidiary of HSI with the Company surviving the
merger as a wholly-owned subsidiary of HSI. HSI will change its name to
Foundation Health Systems, Inc. Completion of the transaction, which will be
a tax-free combination and accounted for as a pooling-of-interests, is
subject to stockholder and regulatory approval as well as other customary
conditions and is expected to be completed in January 1997. The Company's
stockholders will receive 1.3 shares of HSI Class A common stock for each
share of Company common stock owned (the "exchange ratio"). Holders of
Company options will receive substitute HSI options based on the same
exchange ratio.
8
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
GENERAL
Foundation Health Corporation (the "Company") is an integrated managed care
organization which administers the delivery of managed health care services.
Through its subsidiaries, the Company offers group, Medicaid, individual and
Medicare health maintenance organization ("HMO") and preferred provider
organization ("PPO") plans; government sponsored managed care plans; and managed
care products related to workers' compensation insurance, administration and
cost-containment, behavioral health, dental, vision and pharmaceutical products
and services.
Commercial HMO and PPO operations are characterized by the assumption of
underwriting risk in return for premium revenue. Government contracts consist
of contractual services to state and federal government programs such as CHAMPUS
and Medicaid in which the Company receives revenues for administrative and
management services and, under most of the contracts, also accepts financial
responsibility for health care costs. Specialty services consists both of
operations in which the Company assumes underwriting risk in return for premium
revenue, including managed care workers' compensation insurance and behavioral
health, dental and vision HMO products, and operations in which the Company
provides administrative services only, including certain of the behavioral
health and pharmacy benefits management programs, workers' compensation third
party administration and bill review services and administrative-only products
and services.
In fiscal year 1995, the Company was awarded two contracts to establish
managed care programs for up to 227,000 eligible CHAMPUS beneficiaries in
Washington and Oregon (the "Washington/Oregon Contract") and up to 590,000
eligible CHAMPUS beneficiaries in Oklahoma and most of Arkansas, Louisiana
and Texas (the "Region 6 Contract"). Implementation of the Washington/Oregon
Contract commenced in September 1994 and the delivery of health care services
commenced in March 1995. Implementation of the Region 6 Contract commenced in
April 1995 and the delivery of health care services commenced in November
1995. Each of these contracts has a five year term. In August 1995, the
Company was awarded a contract to establish a managed care program for up to
720,000 eligible CHAMPUS beneficiaries in California and Hawaii (the
"California/Hawaii Contract"). Implementation of the contract commenced in
September 1995 with the provision of health care services beginning in April
1996. The contract has a term of up to five years. In October 1995, the
Company's California HMO was awarded four Medicaid contracts, and is
subcontractor under two other contracts, in California to deliver managed
care to up to 616,000 Medicaid beneficiaries. Implementation of these
programs commenced in fiscal year 1996 with delivery of health care services
currently anticipated to commence during the second half of fiscal year 1997.
9
<PAGE>
CONSOLIDATED OPERATING RESULTS
The Company achieved significant increases in revenues for the quarter ended
September 30, 1996 over the same period in fiscal year 1995. The growth in
revenues was primarily driven by commercial enrollment gains from the Company's
individual, Medicare risk and Medicaid products, increases in specialty services
revenue from its behavioral health and pharmacy subsidiaries and delivery of
healthcare services under the California/Hawaii and Region 6 Contracts.
The Company's selling, general and administrative ("SG&A") expenses in the
quarter ended September 30, 1996 increased as compared to the same period in the
prior year due primarily to the new government contracts and increased
commercial enrollment in existing service areas and geographic expansion. The
SG&A ratio for the quarter ended September 30, 1996 increased as compared to the
same period in the prior fiscal year due to the continued competitive premium
pricing pressure offset by the Company's continued cost containment efforts and
the transition of certain government contracts between the implementation and
health care delivery phase.
The Company's net income before income taxes for the quarter ended September 30,
1996 decreased compared to the results for the same period in the prior year due
to higher medical loss ratios at the Company's Gem Insurance Company insured PPO
subsidiary, increased operations in Medicaid business which has a higher medical
loss ratio than other commercial operations and continued competitive premium
pricing pressure.
The Company's ability to expand its business is dependent, in part, on
competitive premium pricing and its ability to secure cost-effective contracts
with providers. Achieving these objectives is becoming increasingly difficult
due to the competitive environment. In addition, the Company's profitability is
dependent, in part, on its ability to maintain effective control over health
care costs while providing members with quality care. Factors such as health
care reform, integration of acquired companies, regulatory changes, utilization,
new technologies, hospital costs, major epidemics and numerous other external
influences may affect the Company's operating results. Accordingly, past
financial performance is not necessarily a reliable indicator of future
performance, and investors should not use historical records to anticipate
results or future period trends.
LINE OF BUSINESS REPORTING
The Company currently operates in a single industry segment, managed health
care. The Company's continuing operations are in three primary lines of
business (i) commercial (ii) government contracts; and (iii) specialty
services. Previously, the Company operated in another segment, physician
practice management and Medical Practices, which were discontinued during the
third quarter of fiscal year 1996. For the quarters ended September 30, 1996
and 1995, discontinued operations had total revenues of $40.0 million and
$30.3 million; operating losses of $20.0 million and $16.1 million; and per
share losses of nil and $0.28, respectively. Operating losses since the
measurement date are being deferred because of an anticipated gain on the
contractual sale which is scheduled to close in the second quarter of fiscal
1997.
10
<PAGE>
The following table presents financial information reflecting the Company's
continuing operations by its three primary lines of business: (i) commercial
operations; (ii) government contracts; and (iii) specialty services.
11
<PAGE>
FOUNDATION HEALTH CORPORATION
LINE OF BUSINESS FINANCIAL INFORMATION
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<TABLE>
<CAPTION>
Quarter Ended
Quarter Ended September 30, 1996 September 30, 1995
------------------------------------------ ---------------------------
Percent Percent Percent
Amount or of Total Increase Amount or of Total
Percent Revenue (Decrease) Percent Revenue
------------- ------------ ----------- ------------- ----------
(Restated)
<S> <C> <C> <C> <C> <C>
Revenues:
Commercial premiums $ 566,912 54.9 % 23.4 % $ 459,575 63.5 %
Government contracts 248,001 24.0 206.1 81,019 11.2
Specialty services revenue 184,922 17.9 17.3 157,702 21.8
Patient service revenue, net 13,371 1.3 14.8 11,645 1.6
Investment and other income 18,851 1.8 33.6 14,112 1.9
------------- ------------ ------------ ----------
1,032,057 100.0 42.5 724,053 100.0
------------- ------------ ------------ ----------
Expenses:
Commercial health care services 475,700 46.1 29.5 367,398 50.7
Government contracts health care services 180,927 17.5 299.8 45,257 6.3
Specialty services costs 162,945 15.8 17.5 138,623 19.1
Patient service costs 12,889 1.2 41.9 9,080 1.3
Selling, general and administrative ("SG&A") 131,467 12.7 48.9 88,288 12.2
Amortization and depreciation 14,553 1.5 28.3 11,340 1.6
Interest expense 5,690 0.6 50.2 3,788 0.5
------------- ------------ ------------ ----------
984,171 95.4 48.3 663,774 91.7
------------- ------------ ------------ ----------
Income from continuing operations before income taxes 47,886 4.6 (20.6) 60,279 8.3
Provision for income taxes 15,683 1.5 (23.5) 20,495 2.8
------------- ------------ ------------ ----------
Income from continuing operations $ 32,203 3.1 % (19.1) $ 39,784 5.5 %
------------- ------------ ------------ ----------
------------- ------------ ------------ ----------
Earnings per share from continuing operations $ 0.55 (21.0) $ 0.69
------------- ------------
------------- ------------
Weighted average common and common
stock equivalent shares outstanding 59,077,144 2.9 57,427,162
------------- ------------
------------- ------------
Operating ratios:
Commercial loss ratio 83.9 % 79.9 %
Government contracts ratio 73.0 55.9
Specialty services ratio 88.1 87.9
Patient service ratio 96.4 78.0
SG&A to total revenues 12.7 12.2
Effective tax rate 32.8 34.0
Enrollment (in thousands):
Commercial:
Group and individual 1,201 15.3 1,042
Medicare risk 88 17.3 75
Medicaid 249 126.4 110
------------- ------------ ------------
1,538 25.3 1,227
------------- ------------ ------------
Government
CHAMPUS PPO and indemnity 1,048 342.2 237
CHAMPUS HMO 481 381.0 100
------------- ------------ ------------
1,529 353.7 337
------------- ------------ ------------
Combined 3,067 96.1 % 1,564
------------- ------------ ------------
------------- ------------ ------------
</TABLE>
12
<PAGE>
COMMERCIAL OPERATIONS
Revenues generated by the Company's commercial operations increased in the
quarter ended September 30, 1996 over the quarter ended September 30, 1995 due
in part to a 25.3% increase in enrollment from existing lines of business and
geographic expansion offset by reductions in commercial premium revenue per
member due to competitive pricing pressures.
The Company expects continued pressure from employer groups and government
agencies to reduce premiums. Health care costs on a per member basis increased
for the quarter ended September 30, 1996 as compared to the quarter ended
September 30, 1995. The commercial loss ratio also increased from 79.9% for the
quarter ended September 30, 1995 to 83.9% for the quarter ended September 30,
1996. The increase in the ratio was due to higher than anticipated medical costs
in the Company's California HMO operations for non-capitated hospital services,
increased medical costs in the Company's Gem Insurance Company insured PPO
subsidiary, increased Medicaid business and competitive premium pressures. The
Company believes that the pressures on margins will continue, which may
adversely affect the commercial loss ratio; however, the Company will seek to
mitigate any increase in the loss ratio by the continued focus on medical cost
management efforts. In addition, as the Company's Medicaid and Medicare risk
business increases, the loss ratio may increase as historically these products
have a higher loss ratio than the Company's other HMO and indemnity insurance
business. Subsequent actual claims experience could require reserves for prior
periods to be increased or decreased which would impact the Company's earnings
in future periods.
GOVERNMENT CONTRACTS
Government contracts revenue increased in the quarter ended September 30, 1996
over the quarter ended September 30, 1995 primarily due to the delivery of
health care services under the California/Hawaii and Region 6 Contracts offset
in part by the decrease in revenue due to expiration of the Base Realignment and
Closure ("BRAC") Contract.
The government contracts ratio increased during the quarter ended September 30,
1996 compared to the quarter ended September 30, 1995. This was due primarily
to several of the contracts being in the implementation period during the
quarter ended September 30, 1995. Comparability of the government contracts
ratio between periods is dependent on the mix of the contracts that are in the
implementation phase versus contracts that are in the health care delivery
phase. Administrative expenses relating to both phases are recorded as part of
SG&A. Once the delivery of health care services begins the expenses related to
health care services are recorded as government contracts health care services.
SPECIALTY SERVICES
Specialty services revenues increased in the quarter ended September 30, 1996
over the same period in the prior year due to increases in the operations of its
workers' compensation and behavioral health subsidiaries.
The Company's workers' compensation subsidiaries (collectively referred to as
the "workers' compensation companies") entered into a quota share reinsurance
agreement ("quota share") with a nonrelated reinsurance company, effective
July 1, 1996. The workers' compensation companies previously utilized a
quota share agreement from January 1990 through June 1994. Under the current
quota share treaty, the percentage of premiums, losses and allocated loss
adjustment expenses incurred ceded to the reinsurer is 30% for the period of
July 1, 1996 to December 31, 1996. For business written in calendar year
1997, the ceding
13
<PAGE>
rate is 7.5% for the first six months of 1997, and 3.75% for the second half of
the year. In addition, a ceding commission is earned based on actual loss
experience reported in the subject period.
Net premiums earned before quota share reinsurance increased by 44.9% for the
quarter ended September 30, 1996 to $154.1 million from $106.4 million for the
quarter ended September 30, 1995. The growth in premiums is due primarily to
national expansion through the Company's multi-state insurance workers'
compensation subsidiary, Business Insurance Company. Due to the premiums ceded
under the quota share agreement, the growth in net premiums earned in the
current quarter is 2.9%. Net investment income increased by 42.5% compared to
the comparable quarter last year. The growth in investment income is due to an
increase in investable assets from operational cash flow, as well as capital
contributions to the workers' compensation companies of $75 million in May 1996
and $55 million in August 1996.
Four ratios are traditionally used to measure underwriting performance of
workers' compensation companies: the loss and loss adjustment expense ratio, the
underwriting expense ratio and the policyholder dividend ratio, which when added
together constitute the combined ratio. A combined ratio of greater than 100%
reflects an underwriting loss, while a combined ratio of less than 100%
indicates an underwriting profit.
The following sets forth the workers' compensation companies underwriting
experience as measured by its combined ratio and its components for the quarters
ended September 30, 1996 and 1995:
The loss and allocated loss adjustment expense ratio for the current quarter
increased to 74.0% from 65.7% for the comparable quarter in 1995. The increase
in ratio is due to all of the California workers' compensation net premiums
earned during the current quarter from policies issued under the state's
competitive premium rating system, while premiums earned during the September
1995 quarter included policies issued in 1994 prior to the start of California's
competitive rating law in January 1995. In addition, the September 1995 quarter
included decreases to prior accident year loss reserve estimates, which reduced
the overall loss ratio for the calendar quarter.
The underwriting expense ratio decreased in the current quarter by 4.3
percentage points to 17.5%, primarily due to business ceded under the quota
share treaty effective July 1, 1996. The Company did not have a quota share
treaty in effect during the comparable quarter in 1995. The ceding commission
earned for business placed with the reinsurer generates a ceding commission. In
addition, overall average commissions incurred has decreased, as a greater
percentage of premiums earned is now related to policies issued outside of
California, where the average commission incurred is approximately 3 percentage
points less than California.
The policyholder dividend ratio for the current quarter is a benefit of 5.5% of
net premiums earned, as the liability for accrued policyholder dividends was
reduced by $6.0 million. Since July 1993, California workers' compensation
premium rates have been reduced substantially. Mandated premium rate reductions
totaling approximately 36% occurred from mid 1993 to late 1994. In 1996, the
California State Legislature passed AB1913. This legislation may require
insurance carriers in California to return premiums earned to policyholders due
to experience modification revisions in situation where claims reported by other
insurance companies were
14
<PAGE>
closed significantly below the original claim costs estimated at the time of the
original unit statistical filing. The above premium reductions apply to all
policies issued in California. As a result of the passage of this legislation,
the industry is faced with the possibility of additional policyholder
litigation, as legal challenges may require the return of premiums to
policyholders.
To offset the effect of these revenue reductions not contemplated at the time
these premiums were written, the Company reduced its accrual for dividends to
policyholders during the quarter. In addition, due to the start of competitive
rating in California effective January 1, 1995, the percentage of new policies
issued on a participating basis has decreased dramatically. As fewer policies
are issued on a participating basis, and the impact of reduced premium rates
accrue to the benefit of the policyholder at the inception of the policy, rather
than after a policy's expiration through policyholder dividends, a reduction in
the accrual for dividends to policyholders was made during the current quarter.
Revenues generated by the behavioral health subsidiaries totaled
approximately $28 million for the quarter ended September 30, 1996 compared
to approximately $9 million for the quarter ended September 30, 1995
primarily due to the operations of Managed Health Network, Inc. which was
acquired during the third quarter of fiscal 1996.
The specialty services ratio for the quarter ended September 30, 1996
increased slightly as compared with the quarter ended September 30, 1995 as a
result of the increase in the workers' compensation loss and allocated loss
adjustment expense ratio described above.
LIQUIDITY AND CAPITAL RESOURCES
Cash used by operating activities was $12.1 million for the quarter ended
September 30, 1996 as compared to cash provided by operating activities of
$33.1 million for the comparable period in fiscal year 1995 due to timing of
the accrual for and payment of operating payables and to a lesser extent to
timing of the receipt or payment of amounts under government contracts.
Offsetting this net use of cash is an increase in claims reserves on
specialty services companies attributed to growth of the workers'
compensation business. The Company's cash and investments increased from
$941.1 million at June 30, 1996 to $981.4 million at September 30, 1996. The
Company invests its cash in investment grade securities.
During fiscal year 1997, the Company expects capital expenditures to
approximate $85.8 million, primarily consisting of $78.2 million for the
purchase of computer hardware and software systems; $4.1 million for the
purchase of furniture and equipment; and $3.5 million for other requirements.
Other assets increased over the amount at June 30, 1996 and is primarily due
to increases in pharmacy rebates, prepaid expenses, trade receivables,
provider receivables and the cash surrender value of life
insurance policies related to the non-qualified defined benefit pension
plans. Other liabilities decreased over the amount at June 30, 1996 due to
the timing of cash receipts for certain government premiums, payment of
fiscal 1996 employee bonuses during the quarter ended September 30, 1996
offset by income tax accruals and payroll accruals.
During December 1996, the Company expects to close its previously announced sale
to FPA Medical Management, Inc. (FPA) of its affiliated, physician-owned Medical
Practices and its physician management subsidiary. Upon closing, the Company
will receive approximately $200 million in cash, FPA common stock and notes and
anticipates recording a gain on the sale.
15
<PAGE>
In December 1994, the Company established a $300 million unsecured revolving
credit agreement with Citicorp USA, Inc. as Administrative Agent for the lenders
thereto (the "Credit Agreement"). As of November 18, 1996, the Company has
borrowed $285 million on the Credit Agreement.
Certain of the Company's subsidiaries must comply with minimum capital and
surplus requirements under applicable state HMO and insurance laws and
regulations, and must have adequate reserves for claims incurred but not yet
reported and claims payments. Certain subsidiaries must maintain ratios of
current assets to current liabilities of 1:1 pursuant to certain government
contracts. The Company believes it is in compliance with these contractual and
regulatory requirements in all material respects.
Certain of the Company's HMO and insurance subsidiaries are required to
maintain reserves to cover their estimated ultimate liability for expenses
with respect to reported and unreported claims incurred. These reserves are
estimates of future costs based on various assumptions. Establishment of
appropriate reserves is an inherently uncertain process, and there can be no
certainty that currently established reserves will prove adequate in light of
subsequent actual experience, which in the past has resulted and in the
future could result in loss reserves being too high or too low. The accuracy
of these estimates may be affected by external forces such as changes in the
rate of inflation, the regulatory environment, the judicial administration of
claims, medical costs and other factors. Future loss development or
governmental regulators could require reserves for prior periods to be
increased, which would adversely impact earnings in future periods. In light
of present facts and current legal interpretations, management believes that
adequate provisions have been made for claims and loss reserves.
Management of the Company continually evaluates opportunities to expand the
Company's commercial, government, insurance and specialty services operations;
however, the Company currently has no material commitments for future use of its
current or expected levels of available cash resources except as described
above. The Company's expansion options may include additional acquisitions and
internal development of new products and programs.
On October 1, 1996, the Company entered into an Agreement and Plan of Merger
with Health Systems International, Inc. ("HSI"). Under the definitive
agreement approved by both companies' boards of directors, the Company will
merge into a wholly-owned subsidiary of HSI with the Company surviving the
merger as a wholly-owned subsidiary of HSI. HSI will change its name to
Foundation Health Systems, Inc. Completion of the transaction, which will be
a tax-free combination and accounted for as a pooling-of-interests, is
subject to stockholder and regulatory approval as well as other customary
conditions and is expected to be completed in January 1997. The Company's
stockholders will receive 1.3 shares of HSI Class A common stock for each
share of Company common stock owned (the "exchange ratio"). Holders of
Company options will receive substitute HSI options based on the same
exchange ratio.
16
<PAGE>
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In the ordinary course of its business, the Company is a party to claims and
legal actions by enrollees, providers and others. The Company's operations are
subject to extensive state and federal regulation. Such regulation is subject
to change, and the impact of potential changes on the Company's business cannot
be determined. There can be no assurance that the Company will be able to obtain
or maintain any necessary governmental approvals to continue to implement its
business strategy of product growth and geographic expansion.
Where the Company provides services under government contracts, the respective
federal and state agencies posses significant powers to review, audit and
control the contractual relationship.
The results of government audits, investigations or lawsuits, which may continue
past the termination of such contracts, may result in reimbursement to the
government of amounts previously paid, the imposition of significant penalties
or limitation of marketing under, or cessation of participation in, these
programs.
On October 16, 1996, an alleged stockholder of the Company filed suit in the
Superior Court in Sacramento, California against the Company and individual
members of the Companies' Board. The plaintiff, who purports to represent a
class of all the Company's stockholders, alleges that the consideration which
the Company's stockholders would receive pursuant to the merger with HSI
(referred to as "the Merger") is inadequate and that the directors of the
Company have therefore breached their fiduciary duties to the Company's
stockholders. The complaint alleges that the Merger consideration is below
the fair or intrinsic value of the Company and that the defendants have not
considered other potential purchasers of the Company or explored other
strategic alternatives to maximize stockholder value. The suit seeks an
injunction against the Merger, rescission of the Merger if consummated,
unspecified damages, attorney's fees and other relief. The Company believes,
based in part upon discussions with its outside legal counsel, that the suit
is without merit and intends to defend the suit vigorously.
Two complaints, as previously disclosed, filed under seal against the Company
and certain of its subsidiaries, have been resolved with no material adverse
effect on the Company's financial results. The government informed the Company
that it has declined to intervene in one such filed complaint and in the other
action, the government and the Company have resolved the matter.
See "Government Regulation" and "Legal Proceedings" in the Company's Annual
Report on Form 10-K/A for the fiscal year ended June 30, 1996, which are
incorporated herein by reference, for a further description of audits,
investigations, claims and legal proceedings to which the Company and certain of
its subsidiaries are subject.
After consulting with legal counsel, the Company believes that any liability
that may ultimately be incurred as a result of the claims, legal actions,
investigations or audits described above will not have a material adverse effect
on the consolidated financial position or results of operations of the Company.
17
<PAGE>
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
11 - Earnings Per Share Computation
(b) Reports on Form 8-K
There were no reports on Form 8-K filed by Foundation Health Corporation
during the quarter ended September 30, 1996.
18
<PAGE>
SIGNATURE
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.
FOUNDATION HEALTH CORPORATION
Dated: November 18, 1996 By: /S/ JEFFREY L. ELDER
----------------------------
JEFFREY L. ELDER
SENIOR VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER
19
<PAGE>
FOUNDATION HEALTH CORPORATION
INDEX TO EXHIBITS
EXHIBIT NO. PAGE
11 Earnings Per Share Computation 21
20
<PAGE>
FOUNDATION HEALTH CORPORATION
EXHIBIT 11
EARNINGS PER SHARE COMPUTATION
UTILIZING THE TREASURY STOCK METHOD
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)
(unaudited)
<TABLE>
<CAPTION>
PRIMARY
QUARTER ENDED SEPTEMBER 30,
--------------------------------
1996 1995
------------ ------------
(Restated)
<S> <C> <C>
Proceeds upon exercise of options outstanding $ 31,563 $ 73,168
------------ ------------
------------ ------------
Average market price of common stock $ 30.26 $ 33.25
------------ ------------
------------ ------------
Weighted average common shares outstanding 58,921,099 57,018,779
Issued shares - exercise of options 1,199,032 2,608,786
Shares assumed to be repurchased with proceeds from exercise (1,042,987) (2,200,403)
------------ ------------
Weighted average shares outstanding (A) 59,077,144 57,427,162
------------ ------------
------------ ------------
Income from continuing operations (B) $ 32,203 $ 39,784
------------ ------------
------------ ------------
Loss from discontinued operations (C) $ - $ (16,088)
------------ ------------
------------ ------------
Net income (D) $ 32,203 $ 23,696
------------ ------------
------------ ------------
Earnings (loss) per share:
Continuing operations (B/A) $ 0.55 $ 0.69
Discontinued operations (C/A) $ - $ (0.28)
------------ ------------
Net earnings (D/A) $ 0.55 $ 0.41
------------ ------------
------------ ------------
FULLY DILUTED
QUARTER ENDED SEPTEMBER 30,
--------------------------------
1996 1995
------------ ------------
(Restated)
Proceeds upon exercise of options outstanding $ 53,228 $ 91,816
------------ ------------
------------ ------------
Greater of average or end of period market price of common stock $ 33.88 $ 38.13
------------ ------------
------------ ------------
Weighted average common shares outstanding 58,921,099 57,098,070
Issued shares - exercise of options 1,829,150 3,015,213
Shares assumed to be repurchased with proceeds from exercise (1,571,313) (2,408,283)
------------ ------------
Weighted average shares outstanding (A) 59,178,936 57,705,000
------------ ------------
------------ ------------
Income from continuing operations (B) $ 32,203 $ 39,784
------------ ------------
------------ ------------
Loss from discontinued operations (C) $ - $ (16,088)
------------ ------------
------------ ------------
Net income (D) $ 32,203 $ 23,696
------------ ------------
------------ ------------
Earnings (loss) per share:
Continuing operations (B/A) $ 0.54 $ 0.69
Discontinued operations (C/A) $ - $ (0.28)
------------ ------------
Net earnings (D/A) $ 0.54 $ 0.41
------------ ------------
------------ ------------
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE FORM 10Q
FILED BY FOUNDATION HEALTH CORPORATION FOR THE QUARTER ENDED SEPTEMBER 30, 1996
AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> JUN-30-1997
<PERIOD-START> JUL-01-1996
<PERIOD-END> SEP-30-1996
<CASH> 168,697
<SECURITIES> 812,748
<RECEIVABLES> 456,893
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 0
<PP&E> 260,058<F1>
<DEPRECIATION> 0
<TOTAL-ASSETS> 2,494,991
<CURRENT-LIABILITIES> 0
<BONDS> 391,644
0
0
<COMMON> 537,520
<OTHER-SE> 368,480
<TOTAL-LIABILITY-AND-EQUITY> 2,494,991
<SALES> 1,013,206
<TOTAL-REVENUES> 1,032,057
<CGS> 0
<TOTAL-COSTS> 978,481
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 5,690
<INCOME-PRETAX> 47,886
<INCOME-TAX> 15,683
<INCOME-CONTINUING> 32,203
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 32,203
<EPS-PRIMARY> .55
<EPS-DILUTED> 0
<FN>
<F1>NET PPE
</FN>
</TABLE>
