<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[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 transition period from _________ to __________
COMMISSION FILE: 0-26818
AHI HEALTHCARE SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 95-4556968
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
12620 ERICKSON AVENUE, SUITE A, DOWNEY, CA 90241
(Address of principal executive offices) (Zip Code)
(310) 803-5333
(Registrant's telephone number, including area code)
- -------------------------------------------------------------------------------
(Former name, former address and former fiscal year, if changed since last
report.)
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 the latest practicable date.
14,523,041 SHARES OF COMMON STOCK, $0.01 PAR VALUE,
AS OF OCTOBER 31, 1996
<PAGE> 2
CONTENTS
AHI HEALTHCARE SYSTEMS, INC.
<TABLE>
<CAPTION>
Page #
------
<S> <C>
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 1996 (Unaudited) and
December 31, 1995. 3
Consolidated Statements of Operations for the Third Quarter and
Nine Months ended September 30, 1996 and 1995 (Unaudited). 4
Consolidated Statements of Cash Flows for the Nine Months ended
September 30, 1996 and 1995 (Unaudited). 5
Notes to Consolidated Financial Statements
(Unaudited)--September 30, 1996. 7
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations. 8
PART II OTHER INFORMATION
Item 1. Legal Proceedings 16
Item 6. Exhibits and Reports on Form 8-K 16
SIGNATURES 17
Exhibit Index 18
</TABLE>
2
<PAGE> 3
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
AHI HEALTHCARE SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
September 30 December 31
1996 1995
------------ -----------
(Unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 17,176,000 $31,608,000
Accounts receivable, net of allowances 13,797,000 12,639,000
Due from related parties 159,000 177,000
Prepaid expenses 558,000 880,000
Recoverable and deferred income taxes 2,294,000 1,908,000
Total current assets 33,984,000 47,212,000
Equipment and property improvements, at cost 9,881,000 6,906,000
Less: accumulated depreciation and amortization (4,328,000) (3,412,000)
------------ -----------
5,553,000 3,494,000
Deposits and other assets 339,000 422,000
Goodwill and other intangible assets, net 26,079,000 25,128,000
------------ -----------
Total assets $ 65,955,000 $76,256,000
============ ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accrued medical claims $ 19,455,000 $15,442,000
Accounts payable and accrued expenses 14,051,000 11,526,000
Notes payable, current portion 2,496,000 3,364,000
Unsecured notes payable to stockholders - 333,000
------------ -----------
Total current liabilities 36,002,000 30,665,000
Notes payable, less current portion 1,094,000 1,203,000
Contingencies
Stockholders' equity:
8% Cumulative convertible voting preferred stock, $0.01 par
value, 25,000,000 shares authorized, none issued - -
Common stock, $0.01 par value, 75,000,000 shares authorized,
14,523,000 shares issued and outstanding at September 30,
and December 31, 1995 145,000 145,000
Additional paid-in capital 47,753,000 47,753,000
Accumulated deficit (18,574,000) (2,999,000)
Unamortized deferred compensation expense (50,000) (61,000)
Due from stockholder (415,000) (450,000)
------------ -----------
28,859,000 44,388,000
------------ -----------
Total liabilities and stockholders' equity $ 65,955,000 $76,256,000
============ ===========
</TABLE>
See accompanying notes.
3
<PAGE> 4
AHI HEALTHCARE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
<TABLE>
<CAPTION>
Third Quarter Ended Nine Months Ended
September 30 September 30
1996 1995 1996 1995
----------- ----------- ------------ -----------
<S> <C> <C> <C> <C>
Total operating revenue $29,991,000 $29,866,000 $ 89,202,000 $84,307,000
Cost of medical services 28,351,000 22,967,000 77,388,000 66,158,000
----------- ----------- ------------ -----------
Gross margin 1,640,000 6,899,000 11,814,000 18,149,000
Operating expenses:
Medical network 2,587,000 1,757,000 7,111,000 4,736,000
General and administrative 5,610,000 3,056,000 16,389,000 8,122,000
Depreciation and amortization 718,000 572,000 1,959,000 1,552,000
Network development 579,000 2,089,000 3,259,000 6,460,000
----------- ----------- ------------ -----------
9,494,000 7,474,000 28,718,000 20,870,000
----------- ----------- ------------ -----------
Loss from operations (7,854,000) (575,000) (16,904,000) (2,721,000)
Interest income 267,000 4,000 955,000 50,000
Interest expense (36,000) (199,000) (123,000) (434,000)
----------- ----------- ------------ -----------
Net interest income (expense) 231,000 (195,000) 832,000 (384,000)
----------- ----------- ------------ -----------
Loss before income tax benefit (7,623,000) (770,000) (16,072,000) (3,105,000)
Income tax benefit - - 497,000 1,219,000
----------- ----------- ------------ -----------
Net loss $(7,623,000) $ (770,000) $(15,575,000) $(1,886,000)
=========== =========== ============ ===========
Net loss per share $ (0.52) $ (0.07) $ (1.07) $ (0.17)
=========== =========== ============ ===========
Pro forma net loss $(7,623,000) $ (770,000) $(15,575,000) $(2,148,000)
=========== =========== ============ ===========
Pro forma net loss per share $ (0.5) $ (0.07) $ (1.07) $ (0.20)
=========== =========== ============ ===========
Weighted average shares
outstanding 14,523,000 10,923,000 14,523,000 10,909,000
</TABLE>
See accompanying notes.
4
<PAGE> 5
AHI HEALTHCARE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
<TABLE>
<CAPTION>
Nine Months Ended
September 30
1996 1995
------------ -----------
<S> <C> <C>
OPERATING ACTIVITIES
Net loss $(15,575,000) $(1,886,000)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation and amortization 1,959,000 1,552,000
Amortization of deferred compensation expense and other 11,000 5,000
Changes in operating assets and liabilities:
Accounts receivable (1,058,000) (3,356,000)
Due from related parties 18,000 (40,000)
Prepaid expenses 322,000 (1,154,000)
Recoverable and deferred income taxes (386,000) (1,362,000)
Deposits and other assets 83,000 1,000
Accrued medical claims 3,163,000 (2,326,000)
Accounts payable and accrued expenses 1,608,000 3,664,000
Income taxes payable - (810,000)
------------ -----------
Net cash used in operating activities (9,855,000) (5,712,000)
INVESTING ACTIVITIES
Purchases of equipment and property improvements (2,975,000) (1,722,000)
Acquisitions of affiliates, net of cash acquired - (2,764,000)
------------ -----------
Net cash used in investing activities (2,975,000) (4,486,000)
FINANCING ACTIVITIES
Cash received on note receivable from stockholder 35,000 -
Proceeds from issuance of notes payable and Bank Facility
Principal payments of notes payable (1,637,000) (2,669,000)
Issuance of common stock - 7,000
------------ -----------
Net cash provided by (used in) financing activities (1,602,000) 10,298,000
------------ -----------
Increase (decrease) in cash and cash equivalents (14,432,000) 100,000
Cash and cash equivalents at beginning of period 31,608,000 655,000
------------ -----------
Cash and cash equivalents at end of period $ 17,176,000 $ 755,000
============ ===========
</TABLE>
5
<PAGE> 6
AHI HEALTHCARE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (CONTINUED)
<TABLE>
<CAPTION>
Nine Months Ended
September 30
1996 1995
---------- -----------
<S> <C> <C>
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND
FINANCING ACTIVITIES:
Stockholder note receivable issued in connection with
stock issuance $ - $ 450,000
DETAILS OF BUSINESSES ACQUIRED IN PURCHASE TRANSACTIONS:
Fair value of assets acquired $2,053,000 $17,196,000
Less:
Issuance of promissory notes 327,000 70,000
Other liabilities assumed 1,726,000 13,413,000
---------- -----------
Cash paid for acquisitions - (3,713,000)
Cash of acquired businesses - 949,000
---------- -----------
Net cash paid $ - $(2,764,000)
========== ===========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Interest paid $ 123,000 $ 434,000
Income taxes paid 166,000 953,000
</TABLE>
See accompanying notes.
6
<PAGE> 7
AHI HEALTHCARE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements of AHI
Healthcare Systems, Inc. (the "Company") have been prepared in accordance with
generally accepted accounting principles for interim financial information and
with the instructions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, they do not include all information and footnotes required by
generally accepted accounting principles for complete financial statements. In
the opinion of management, all adjustments (consisting of normal recurring
adjustments) considered necessary for a fair presentation have been included.
All significant intercompany balances and transactions have been eliminated.
Operating results for the third quarter and nine months ended September 30,
1996 are not necessarily indicative of the results that may be expected for the
year ended December 31, 1996. For further information, refer to the
consolidated financial statements and footnotes thereto included in the
Company's Annual Report on Form 10-K for the year ended December 31, 1995.
2. INCOME TAXES
The Company and all of its affiliated physician networks
("Affiliates") (except Health Services Alliance of Northern California, Inc.,
formerly known as Camino Real Medical Group, Inc., which is a C-corporation)
operated as Subchapter S corporations through December 31, 1993. Effective
January 1, 1994, the Company elected to operate as a C-corporation, while its
Affiliates continued to elect S-corporation status through December 31, 1994.
Effective January 1, 1995, all except two of the Affiliates, and effective
January 1, 1996, all except one of the Affiliates, elected C-corporation
status.
3. CONTINGENCIES
The Company and its Affiliates are subject to certain legal actions
arising in the ordinary course of business, generally related to professional
liability, employment-related issues and other business-related claims. In the
opinion of management, such actions are either adequately insured or will not
have a material adverse effect on the Company's financial position or results
of operations.
The Company is a defendant in a class action securities lawsuit, which
asserts that the Company, among other things, artificially inflated the price
of its common stock by misleading securities analysts and by failing to
disclose in its initial public offering prospectus alleged difficulties it was
having with the acquisition of Lakewood Health Plan, Inc. and with two of the
Company's contracts with FHP, Inc. The Company intends to vigorously defend
this lawsuit. The Company believes that it is adequately insured and does not
expect that the outcome of this lawsuit will have a material adverse effect on
the financial condition or results of operations of the Company.
4. SUBSEQUENT EVENT
On November 8, 1996, the Company entered into an Agreement and Plan of
Merger ("Merger Agreement") with FPA Medical Management, Inc. ("FPA") of San
Diego, California. Under the terms of the Merger Agreement, which has been
approved by the Board of Directors of each company, each outstanding share of
the Company's common stock would be exchanged for $8.75 worth of shares of
FPA's common stock, subject to adjustment in the event that the average value
of FPA's common stock during a defined period immediately prior to the merger
is less than $14.38 or equal to or greater than $22.38 per share. Based on the
closing price of FPA's common stock on November 8, 1996, FPA expects to issue
approximately 6.1 million shares of its common stock for 100% of the
outstanding common stock of the Company. The transaction will be accounted for
as a pooling-of-interests. The merger is subject to regulatory and stockholder
approvals and certain conditions precedent and is expected to be completed in
early 1997. However, because of these conditions precedent, there can be no
assurance in this regard. FPA is a national healthcare management service
organization that organizes and manages primary care physician networks to
contract with health maintenance organizations and other prepaid health
insurance plans to provide physician and related healthcare services.
7
<PAGE> 8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
OVERVIEW
The Company's physician networks contract directly with managed care
payors to deliver covered medical benefits and to coordinate all inpatient and
outpatient care for enrollees. Generally, each physician network receives a
prepaid monthly fee ("capitation payment") from the payor for each enrollee who
selects a primary care physician contracting with the physician network as the
enrollee's primary care provider. In addition, such contracts typically
provide for incentive payments to be paid by the payor to the physician network
to encourage the effective utilization of hospital and other medical services
("shared risk pools"). All such medical revenue is in turn assigned to the
Company pursuant to an administrative, nonmedical management agreement between
the physician network and the Company, but excludes amounts that may not be
assigned under applicable law.
For the nine months ended September 30, 1996, approximately 97% of the
Company's total operating revenue related to contracts under which the
Company's physician networks received a capitation payment for each covered
life in exchange for the responsibility for the provision of specific medical
services to assigned enrollees and bonuses under shared risk pools. Payors are
increasingly overseeing the provision of and the prices charged for medical
services with the goal of reducing costs and lowering reimbursement. The
Company's success therefore depends in large part on the effective management
of health care costs, including controlling utilization of specialty care
physicians, other ancillary providers, inpatient services and services from
third-party providers at competitive prices. Any adjustment downward in
capitation payments or shared risk pools caused by the increasing efforts by
payors to reduce their costs could have a material adverse effect on the
Company's operating results.
The physician networks contract with health care providers to deliver
medical services. The cost of medical services provided by the physician
networks consists of payments to affiliated primary care, specialty care and
ancillary providers. Compensation to such health care providers varies,
typically according to the type of provider. Primary care physicians are
generally compensated on a capitated basis, receiving a fixed monthly fee for
each enrollee selecting such physician, or on a discounted fee-for-service
basis when enrollment is low. Specialist and ancillary providers are typically
compensated on a discounted fee-for-service basis. Two of the Company's
affiliated networks include medical groups owned by the Company. The
associated medical and non-medical costs of operating these owned medical
groups are also included in cost of medical services.
Medical network operating expenses consist primarily of salary-related
expenses for the provision of medical management services to the physician
networks. The majority of costs associated with medical management services
fluctuate commensurate with enrollment and the number of contracted providers.
These costs consist primarily of claims administration, eligibility management,
quality and utilization management, physician credentialing and other costs
associated with the Company's National Service Center.
Network development expenses include direct and indirect costs
associated with the strategic planning, corporate organization, provider and
payor contracting and relationship building activities that are required to
develop and market a locally integrated managed health care system. Direct
costs include incremental costs of Company personnel physically located in new
markets prior to commencement of operations and certain incremental
administrative costs such as legal, travel and facility expenses. Indirect
costs consist of an allocation of expenses associated with existing executive
and corporate development staff engaged early in the network development
process to conduct market research and assess the operational and strategic
opportunities available in the market. The Company defines a network as being
"in development" once direct, incremental network development costs have been
incurred. Networks are considered operational once network physicians begin
accepting enrollees into the network.
8
<PAGE> 9
The Company has also entered into new markets by acquiring existing
physician networks. In such acquisitions, the Company or an affiliate has
principally purchased the physician and payor contracts that the network holds;
it generally does not purchase the assets or the practices of the independent
physicians who contract with the network. These contracts represent
significantly all of the assets of the physician network and, accordingly,
result in the recording of goodwill on the Company's balance sheet. In
addition to the consideration paid in the acquisition, all direct costs
associated with these acquisitions are capitalized. In August 1994, the
Company acquired Camino Real Medical Group (which has been renamed Health
Service Alliance of Northern California) in Northern California (which had
approximately 28,000 prepaid covered lives at the date of acquisition) and in
February 1995, the Company acquired The Healthcare Partnership in Houston,
Texas (which had approximately 40,600 prepaid covered lives at the date of
acquisition). In March 1996, the Company acquired Private Physician Group at
Stanford in Northern California (which had approximately 2,900 prepaid covered
lives at the date of acquisition). Although the Company continues to pursue
acquisitions and other opportunities, there can be no assurance that the
Company will be able to capitalize successfully on such opportunities or that
such opportunities will be available to the Company in the future.
The Company's acquisition and development strategy has had, and will
continue to have, significant revenue and cost implications. This is due to a
number of factors, including market conditions outside of the Company's base
Southern California market requiring more administrative costs, costs of
building infrastructure and the inherently delayed timing of revenue increases
and cost decreases after developing networks or acquiring networks with higher
medical costs.
The Company's operating results are subject to quarter-to-quarter
fluctuations. Quarterly results may be affected by the timing and amount of
costs associated with the Company's development and acquisition of physician
networks (as discussed above), by adverse trends in professional and
hospital-based medical costs, and by other operational or external factors,
including the movement of enrollees, particularly during periods of open
enrollment for HMOs. Quarterly results may be affected by significant
differences between actual and estimated amounts receivable or payable related
to payor shared risk pool arrangements and provider "incurred but not reported"
claims ("IBNR"), which are adjusted periodically as settlements are made in the
case of shared risk pools or as actual claims are paid in the case of IBNR.
The Company has noted a recent industry trend of increasing health care costs,
particularly in fee-for-service arrangements and hospital-based medical costs.
The Company has also made acquisitions of underperforming companies with
significantly higher costs of medical services as a percentage of revenue, and
there can be no assurance that the Company's acquisitions, including future
acquisitions, will not adversely affect the Company's results of operations or
cause significant quarterly fluctuations and/or adjustments.
Quarterly results have in the past been subject to fluctuations and,
as a result, the operating results for any quarter are not necessarily
indicative of results for any future period. The Company expects to report a
net loss through at least the fourth quarter of 1996.
On July 2, 1996, pursuant to discussions with the California
Department of Corporations ("DOC"), the regulatory body for managed care plans
in the State of California, the Company, through a wholly-owned subsidiary,
filed an application for restricted licensure as a Knox-Keene health care
service plan for its California operations. The restricted license, if granted,
would allow for the direct receipt of capitation payments for hospital and
medical professional services, but would not allow the marketing of a health
care service plan to employers and subscribers. The Company may be required to
restructure its California business operations (which, if such license is not
granted, could result in a reduction of revenue) and/or incur additional
administrative costs in the future to meet applicable regulatory requirements,
including the tangible net equity requirements pursuant to DOC regulations,
which could restrict the Company's ability to transfer funds and pay dividends.
Although the Company does not expect the licensure process to have a material
impact on its operations, there can be no assurance that the DOC will not
impose requirements adverse to the Company's business.
9
<PAGE> 10
OTHER OPERATING DATA
The following table sets forth certain operating data as of September
30, 1996 and 1995.
<TABLE>
<CAPTION>
September 30
1996 1995
------- -------
<S> <C> <C>
Affiliated physicians:
Primary care 2,445 1,571
Specialists 5,811 3,149
------- -------
Total 8,256 4,720
======= =======
Number of physician networks:
Operational 50 24
In development 44 68
------- -------
Total 94 92
======= =======
Number of payor contracts 250 187
Prepaid covered lives by product type:
Commercial 160,849 146,797
Senior 20,840 23,523
Medicaid 18,997 6,858
------- -------
Total 200,686 177,178
======= =======
Prepaid covered lives by region:
California 121,623 131,359
Texas 72,556 45,819
Southeast 6,507 -
------- -------
Total 200,686 177,178
======= =======
</TABLE>
10
<PAGE> 11
RESULTS OF OPERATIONS
The following table sets forth consolidated statements of operations
data expressed as a percentage of total operating revenue for the third quarter
and nine months ended September 30, 1996 and 1995.
<TABLE>
<CAPTION>
Quarter Ended Nine Months Ended
September 30 September 30
1996 1995 1996 1995
------ ------ ------ ------
(% of total operating revenue)
<S> <C> <C> <C> <C>
Total operating revenue 100.0 100.0 100.0 100.0
Cost of medical services 94.5 76.9 86.8 78.5
------ ------ ------ ------
Gross margin 5.5 23.1 13.2 21.5
Operating expenses:
Medical network 8.6 5.9 8.0 5.6
General and administrative 18.7 10.2 18.4 9.6
Depreciation and amortization 2.4 1.9 2.2 1.8
Network development 2.0 7.0 3.6 7.7
------ ------ ------ ------
31.7 25.0 32.2 24.7
------ ------ ------ ------
Loss from operations (26.2) (1.9) (19.0) (3.2)
Interest income 0.9 0.0 1.1 0.0
Interest expense (0.1) (0.7) (0.1) (0.5)
------ ------ ------ ------
Net interest income (expense) 0.8 (0.7) 1.0 (0.5)
------ ------ ------ ------
Loss before income taxes (25.4) (2.6) (18.0) (3.7)
Income tax benefit 0.0 0.0 0.5 1.5
------ ------ ------ ------
Net loss (25.4) (2.6) (17.5) (2.2)
====== ====== ====== ======
Pro forma net loss (1) (25.4) (2.6) (17.5) (2.5)
====== ====== ====== ======
</TABLE>
___________
(1) Pro forma net loss has been determined assuming the Company and its
affiliated physician networks had been taxed as C-corporations for all
periods presented.
THIRD QUARTER ENDED SEPTEMBER 30, 1996 COMPARED TO THE THIRD QUARTER ENDED
SEPTEMBER 30, 1995
Total operating revenue increased 0.4% to $30.0 million for the third
quarter of 1996 from $29.9 million for the third quarter of 1995. Revenues
under the Company's capitated arrangements increased due to an 8.5% increase in
the average number of covered lives. Average covered lives increased 15,042 to
191,666 for the third quarter of 1996 from 176,624 for the third quarter of
1995. Of this increase, 12,102 average covered lives, or 6.8%, were a result
of increased enrollment in existing networks and acquired networks since
acquisition, and 2,940 average covered lives, or 1.7%, were in an acquired
network at the date of acquisition. Total covered lives at September 30, 1996
increased 13.3% to 200,686 from 177,178 at September 30, 1995. This increase
in capitation revenue was offset by a reduction in risk share revenue due to
higher than expected hospital-based costs under certain of the Company's payor
contracts. Because of the Company's recent experience with higher than
expected hospital-based costs under certain payor contracts, the Company
11
<PAGE> 12
recorded less risk share revenue in the third quarter of 1996 compared with the
same period of 1995 and may record less revenue under shared risk arrangements
in the future.
Cost of medical services increased 23.4% to $28.4 million for the
third quarter of 1996 from $23.0 million for the third quarter of 1995. As a
percentage of total operating revenue, cost of medical services increased 17.6%
to 94.5% for the third quarter of 1996 from 76.9% for the third quarter of
1995. The increase in this percentage was principally due to the
aforementioned reduction in revenue relating to certain of the Company's risk
share arrangements, as well as an increase in medical costs of approximately $3
million due to a revision of claims reserves reflecting continuing recent
experience in physician claims payment patterns. The Company, and, in general,
the managed care industry has recently experienced an increase in medical
costs. There can be no assurance that this recent trend in increasing medical
costs will not continue in the future and, if it does, such trend could have a
material adverse effect on the Company's operating results in the future.
Medical network operating expenses increased 47.2% to $2.6 million for
the third quarter of 1996 from $1.8 million for the third quarter of 1995. As
a percentage of total operating revenue, medical network operating expenses
increased 2.7% to 8.6% in the third quarter of 1996 from 5.9% in the third
quarter of 1995. The Company is experiencing higher claims administration and
medical management costs as it expands outside of its base Southern California
market. This is primarily related to different billing patterns of physicians
in other regions of the country due to a greater percentage of primary care and
specialty physicians being reimbursed on a fee-for-service versus capitated
basis prior to achieving critical mass. Affiliated primary care and specialty
physicians totaled 8,256 and 4,720 at September 30, 1996 and 1995,
respectively. In addition, the increase in these percentages also was the
result of higher costs associated with increased claims payment volumes during
the third quarter of 1996 compared to the same quarter of 1995. The Company
is also continuing the process of implementing new technologies in the areas of
utilization management and claims administration with the goal of making these
processes more efficient. In the near term, however, these new technologies
have caused additional costs to be incurred while these new technologies are
phased into the Company's operations. There can be no assurance that the
Company's investment in new technologies will result in future operating
efficiencies.
General and administrative expenses increased 83.6% to $5.6 million
for the third quarter of 1996 from $3.1 million in the third quarter of 1995.
As a percentage of total operating revenue, general and administrative expenses
increased 8.5% to 18.7% for the third quarter of 1996 from 10.2% for the third
quarter of 1995. The increase in these expenses as a percentage of total
operating revenue reflects higher costs relating to newly operational markets
before economies of scale are achieved and additional investments in
infrastructure in anticipation of the Company's future growth. Operational
networks totaled 50 at September 30, 1996 compared with 24 at September 30,
1995. Until and if critical mass is achieved in these newly operational
markets, such increases will result in an increase in overall general and
administrative expenses as a percentage of revenue. In addition, general and
administrative expenses also increased due to regulatory compliance and other
costs associated with being a public company.
Depreciation and amortization increased 25.5% to $718,000 for the
third quarter of 1996 from $572,000 for the third quarter of 1995. The
increase in these expenses was primarily due to additional depreciation related
to recent equipment purchases and amortization of technology installation
costs.
Network development expenses decreased 72.3% to $579,000 for the
quarter ended September 30, 1996 from $2.1 million for the same quarter of
1995. The decreases in these expenses reflect the Company's emphasis on
bringing previously developmental networks into operation. Networks in
development decreased to 44 at September 30, 1996 compared to 68 at September
30, 1995.
Net interest income was $231,000 for the third quarter of 1996
compared with net interest expense of $195,000 for the third quarter of 1995.
The Company realized net interest income in the third quarter of 1996 primarily
due to interest earned on the remaining net proceeds from its initial public
offering.
12
<PAGE> 13
NINE MONTHS ENDED SEPTEMBER 30, 1996 COMPARED TO THE NINE MONTHS ENDED
SEPTEMBER 30, 1995
Total operating revenue increased 5.8% to $89.2 million for the first
nine months of 1996 from $84.3 million for the first nine months of 1995. The
increase in total operating revenue was primarily due to an increase in
capitation revenue. Average covered lives increased 24,625, or 15.2%, to
186,545 in the first nine months of 1996 compared to 161,920 in the
corresponding period of 1995. Of this increase, 17,828 average covered lives,
or 11.0%, were a result of increased enrollment in existing networks and
acquired networks since acquisition, and 6,797 average covered lives, or 4.2%,
were in acquired networks at the dates of acquisition. This increase in
capitation revenue was offset by a reduction in risk share revenue of
approximately $2 million due to higher than expected hospital-based costs under
certain of the Company's payor contracts. Because of the Company's recent
experience with higher than expected hospital-based costs under certain payor
contracts, the Company recorded less risk share revenue in the first nine
months of 1996 compared to the corresponding period of 1995 and may record less
revenue under shared risk arrangements in the future.
Cost of medical services increased 17.0% to $77.4 million for the
first nine months of 1996 from $66.2 million for the first nine months of 1995.
As a percentage of total operating revenue, cost of medical services increased
8.3% to 86.8% for the first nine months of 1996 from 78.5% for the
corresponding period of 1995. The increase in this percentage was principally
due to the aforementioned reduction in revenue relating to certain of the
Company's risk share arrangements, as well as an increase in medical costs of
$3 million due to revisions of claims reserves reflecting recent experience in
physician claims payment patterns. The Company, and, in general, the managed
care industry recently has experienced an increase in medical costs. There can
be no assurance that this recent trend in increasing medical costs will not
continue, and if it does, such trend could have a material adverse effect on
the Company's operating results in the future.
Medical network operating expenses increased 50.1% to $7.1 million for
the nine months ended September 30, 1996 from $4.7 million for the
corresponding period of 1995. As a percentage of total operating revenue,
medical network operating expenses increased 2.4% to 8.0% in the first nine
months of 1996 from 5.6% in the corresponding period of 1995. The Company is
experiencing higher claims administration and medical management costs as it
expands outside of its base Southern California market. This is primarily
related to different billing patterns of physicians in other regions of the
country due to a higher percentage of primary care and specialty physicians
being reimbursed on a fee-for- service versus capitated basis prior to
achieving critical mass. Affiliated primary care and specialty physicians
totaled 8,256 and 4,720 at September 30, 1996 and 1995, respectively. In
addition, the Company is continuing the process of implementing new
technologies in the areas of utilization management and claims administration
with the goal of making these processes more efficient. In the near term,
however, these new technologies have caused additional costs to be incurred
while these new technologies are phased into the Company's operations. There
can be no assurance that the Company's investment in new technologies will
result in future operating efficiencies.
General and administrative expenses increased 102% to $16.4 million
for the first nine months of 1996 from $8.1 million in the first nine months of
1995. As a percentage of total operating revenue, general and administrative
expenses increased 8.8% to 18.4% for the nine months ended September 30, 1996
from 9.6% for the corresponding period of 1995. The increase in these expenses
as a percentage of total operating revenue reflects higher costs relating to
newly operational markets before economies of scale are achieved and additional
investments in infrastructure in anticipation of the Company's future growth.
Operational networks totaled 50 at September 30, 1996 compared to 24 at
September 30, 1995. Until and if critical mass is achieved in these newly
operational markets, such increases will result in an increase in overall
general and administrative expenses as a percentage of revenue. In addition,
general and administrative expenses also increased due to regulatory compliance
and other costs associated with being a public company.
Depreciation and amortization increased 26.2% to $2.0 million for the
nine months of 1996 from $1.6 million for the same period of 1995. The
increase in these expenses was primarily due to additional depreciation related
to recent equipment purchases.
13
<PAGE> 14
Network development expenses decreased 49.6% to $3.3 million for the
first nine months of 1996 from $6.5 million for the corresponding period of
1995. The decrease in these expenses reflects the Company's emphasis on
bringing previously developmental networks into operation. Networks in
development decreased to 44 at September 30, 1996 compared to 68 at September
30, 1995.
Net interest income was $832,000 for the first nine months of 1996
compared with net interest expense of $384,000 for the corresponding period of
1995. The Company realized net interest income in the first nine months of
1996 primarily due to interest earned on the remaining net proceeds from its
initial public offering.
LIQUIDITY AND CAPITAL RESOURCES
The Company requires capital primarily to develop and acquire
physician networks and to fund working capital. Capitation arrangements
positively impact the Company's cash flow because the physician networks
receive capitation revenue prior to incurring costs associated with services
provided under payor agreements. Partially offsetting this, the Company's
shared risk pool arrangements negatively impact cash flow due to the fact that
settlements in connection with these arrangements are typically not collected
until at least 150 days following the end of the period in which they were
accrued. Since inception through the date the Company entered into the Bank
Facility (as defined), the Company financed its operations primarily through
internally generated funds.
For the nine months ended September 30, 1996, the Company used $9.9
million in its operating activities. The use of cash in operating activities
resulted primarily from (i) a net loss of $15.6 million, offset by $2.0 million
of depreciation and amortization, (ii) a $1.1 million increase in accounts
receivable and (iii) a $386,000 increase in recoverable and deferred income
taxes, offset by (iv) a $1.8 million increase in accrued medical claims, (v) a
$1.6 million increase in accounts payable and accrued expenses, and (vi) a
$423,000 decrease in prepaid expenses and other assets. For the first nine
months of 1996, the Company's investing activities included $3.0 million of cash
used for equipment purchases and technology implementation costs and its
financing activities included $1.6 million of cash used for principal payments
of notes payable.
The Company has a two-year revolving line of credit bank facility (the
"Bank Facility"), with a maximum borrowing limit of $15.0 million. As of
September 30, 1996, the Company had $13.0 million available under the Bank
Facility (represented by the total Bank Facility less a $2.0 million letter of
credit securing a promissory note issued in connection with an acquisition).
Interest is payable on borrowings under the Bank Facility at the bank's prime
rate plus 0.25% per annum or, at the Company's option, LIBOR plus 2.50%.
Borrowings under the Bank Facility are secured by the Company's accounts
receivable and certain equipment and, effective June 1996, are secured by an
amount of qualifying investments equal to the borrowing limit plus interest.
The Bank Facility contains certain restrictions on the Company's ability to
engage in certain actions.
At September 30, 1995 and from October 31, 1995 through December 31,
1995, the Company was in default on its cash flow coverage ratio and obtained
waivers from the Bank Facility lenders on August 21, 1995 and February 20,
1996, respectively, extending to all periods through March 30, 1996.
Effective March 31, 1996, the Bank Facility was amended to revise the
definitions of cash flow and debt in the computation of the cash flow coverage
and debt coverage ratios. Effective June 30, 1996, the Bank Facility was again
amended, deleting the cash flow coverage and debt coverage ratio covenants. As
of October 31, 1996, the Company borrowed $3.8 million under the Bank Facility
to fund the aforementioned $2.0 million note payment for an acquisition and to
fund cash used by the Company's operating and investing activities.
On July 2, 1996, pursuant to discussions with the California
Department of Corporations, the Company, through a wholly-owned subsidiary,
filed an application for restricted licensure as a Knox-Keene health care
service plan for its California operations. Pursuant to tangible net equity
requirements under regulations governing the Company's license application, the
Company will be required to maintain cash reserves, initially expected to be at
least $6 million. The restricted licensure, if granted, is expected in early
1997.
14
<PAGE> 15
Because of the Knox-Keene licensure cash reserve requirements (if
such license is granted), continued cash flow used in its operating activities
and future capital equipment requirements and technology implementation costs,
the Company believes that existing cash balances and amounts available under
the Bank Facility will not be sufficient to finance its operations through the
next twelve months. If the Company is unable to consummate its planned merger
with FPA (see Note 4 to the Unaudited Condensed Financial Statements) or is
unable to decrease its operating losses, the Company may find it necessary to
dispose of certain assets or undertake other actions as may be deemed
appropriate.
INFORMATION REGARDING FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains statements which, to the
extent that they are not recitations of historical fact, constitute
"forward-looking statements" within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Exchange
Act of 1934, as amended. The forward-looking statements in this document are
intended to be subject to the safe harbor protection provided by Sections 27A
and 21E. All forward-looking statements involve risks and uncertainties.
Although the Company believes that its expectations are based upon reasonable
assumptions within the bounds of its knowledge of its business and operations,
there can be no assurance that actual results will not materially differ from
its expectations. Factors which could cause actual results to differ from
expectations include, among other things, the difficulty in increasing and
managing growth in covered lives, controlling and estimating health care costs,
estimating revenue from shared-risk arrangements, as well as the possible
negative effects of the health care regulatory environment and the effects of
competition. For other risk factors which may cause actual results to
materially differ from expectations and underlying assumptions, refer to the
Registration Statement on Form S-1 (including the section entitled "Risk
Factors") and periodic reports, including the Annual Report on Form 10-K for
the year ended December 31, 1995, filed by the Company with the Securities and
Exchange Commission.
15
<PAGE> 16
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
The Company and its Affiliates are subject to certain legal actions
arising in the ordinary course of business, generally related to professional
liability, employment-related issues and other business-related claims. In the
opinion of management, such actions are either adequately insured or will not
have a material adverse effect on the Company's financial position, operating
results or working capital.
The Company is a defendant in a class action securities lawsuit
entitled In re AHI Healthcare Systems, Inc. Securities Litigation filed in the
United States District Court for the Central District of California, Western
Division. The plaintiffs initially filed three separate suits against the
Company, certain of its officers and directors and its securities underwriters
on December 20, 1995. Pursuant to an order of the Court, the plaintiffs filed
a Consolidated Amended Class Action Complaint on February 26, 1996. The suit
asserts that the Company, among other things, artificially inflated the price
of its common stock by misleading securities analysts and by failing to
disclose in its initial public offering prospectus (the "Prospectus") alleged
difficulties with the acquisition of Lakewood Health Plan, Inc. and with two of
the Company's payor contracts with FHP, Inc. The plaintiffs seek unspecified
damages on behalf of the stockholders who purchased the Company's common stock
between September 28, 1995 and December 19, 1995.
The Court certified a class of plaintiffs on April 29, 1996. On June
25, 1996, the Court certified two subclasses: one comprised of persons who
purchased the Company's common stock on September 28, 1995 in the Company's
initial public offering, and the second comprised of persons who purchased the
Company's common stock in the Nasdaq Stock Market between September 29, 1995
and December 19, 1995. In addition, on April 11, 1996, the Company filed a
Motion for Partial Summary Judgment seeking dismissal of all of the plaintiffs'
claims based on alleged material misrepresentations or omissions in the
Prospectus. This motion will not be heard until at least December 1996.
The Company intends to vigorously defend this lawsuit. The Company
believes that it is adequately insured and does not expect that the outcome of
this lawsuit will have a material adverse effect on the financial condition or
results of operations of the Company.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits
<TABLE>
<CAPTION>
Exhibit No. Description
----------- -----------
<S> <C>
10.3 First Amendment to Employment Agreement dated as of August 2, 1996
between the Company and H.R. Brereton Barlow
27 Financial Data Schedule.
</TABLE>
(b) Reports on Form 8-K
None.
16
<PAGE> 17
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.
AHI HEALTHCARE SYSTEMS, INC.
Date: November 13, 1996 /s/ LEONARDO A. BEREZOVSKY, M.D.
------------------------------------
Chairman of the Board and Chief
Executive Officer
(Principal Executive Officer)
Date: November 13, 1996 /s/ H.R. BRERETON BARLOW
-----------------------------------
Chief Financial Officer and
Senior Vice President
(Principal Financial Officer and
Principal Accounting Officer)
17
<PAGE> 18
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------ -----------
<S> <C>
10.3 First Amendment to Employment Agreement dated as of August 2, 1996
between the Company and H.R. Brereton Barlow
27 Financial Data Schedule
</TABLE>
18
<PAGE> 1
Exhibit 10.3
FIRST AMENDMENT
TO
EMPLOYMENT AGREEMENT
THIS FIRST AMENDMENT TO EMPLOYMENT AGREEMENT (the "Amendment") is
entered into as of August 2, 1996 by and between AHI HEALTHCARE SYSTEMS, INC.,
a Delaware corporation (the "Company") and H.R. Brereton Barlow (the
"Employee").
RECITALS
A. The Company desires to encourage the continuity of its
management and secure for its benefit the skills of individuals who provide
unique value to its operations;
B. The Company recognizes that Employee possesses certain skills
and expertise which give him peculiar value to the Company, the loss of which
cannot be reasonably or adequately replaced;
C. As a result of the foregoing, the Company and the Employee
entered into an Employment Agreement as of June 24, 1995 (the "Employment
Agreement").
D. In recognition of the need to further reward the Employee and
retain his skills for the benefit of the Company, the Company now desires to
amend the Employment Agreement as set forth hereinbelow.
In consideration of the promises set forth herein and other good and
valuable consideration, receipt whereof is hereby acknowledged by the parties
hereto, the parties agree as follows:
1. In the event that during the term of the Employment Agreement
there occurs a Change of Control as defined in Article 1.6 of the Employment
Agreement, the Company agrees that in addition to those payments Employee shall
be entitled to receive pursuant to such Article 1.6 or otherwise under the
Employment Agreement, Employee shall receive a sum equal to $80,000 times the
sum of each $1.00 per share of consideration received by the
sellers/transferors of the controlling interest in the Company in excess of
$6.00 per share (the "Selling Bonus"); provided, however, Employee shall not be
entitled to the Selling Bonus if he is terminated or voluntarily terminates, in
each case as described in the Employment Agreement, prior to consummation of
such sale or transfer.
2. Notwithstanding the foregoing, or any other provision of this
Amendment, in no event shall the total amount payable to Employee pursuant to
paragraph 1, hereunder, include any amount that reasonably could be
characterized as an "excess parachute payment," as defined in Section 280G of
the Internal Revenue Code (or such successor provisions thereto as may be
applicable) if such would not be allowed as a deduction to the Company by
reason of Section 280G or the regulations promulgated thereunder.
<PAGE> 2
3. Further, notwithstanding anything contained in this Amendment,
the payment of the Selling Bonus to the Employee shall be subject to and
conditioned upon all of the terms and conditions of Article 1.6 of the
Employment Agreement.
4. The validity, interpretation and construction of this
Amendment and all other matters related to this Amendment shall be interpreted
and governed by the laws of the State of California.
IN WITNESS WHEREOF, the parties hereto have executed this Amendment,
as of the date first above written, by their duly authorized representative.
COMPANY
AHI Healthcare Systems, Inc.,
a Delaware corporation
By: /s/ Leonardo A. Bereazovsky
--------------------------------
Title: Chairman and Chief Executive Officer
------------------------------------
EMPLOYEE
/s/ H.R. BRERETON BARLOW
-----------------------------------
H.R. Brereton Barlow
2
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-END> SEP-30-1996
<CASH> 17,176
<SECURITIES> 0
<RECEIVABLES> 13,797
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 33,984
<PP&E> 9,881
<DEPRECIATION> (4,328)
<TOTAL-ASSETS> 65,955
<CURRENT-LIABILITIES> 36,002
<BONDS> 0
0
0
<COMMON> 145
<OTHER-SE> 28,714
<TOTAL-LIABILITY-AND-EQUITY> 65,955
<SALES> 89,202
<TOTAL-REVENUES> 89,202
<CGS> 77,388
<TOTAL-COSTS> 28,718
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 123
<INCOME-PRETAX> (16,072)
<INCOME-TAX> (497)
<INCOME-CONTINUING> (15,575)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (15,575)
<EPS-PRIMARY> (1.07)
<EPS-DILUTED> (1.07)
</TABLE>
