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UNITED STATES

FORM 10-Q

Commission File Number 000-21949

PACIFICARE HEALTH SYSTEMS, INC.

5995 Plaza Drive, Cypress, California 90630-5028

(Registrant’s Telephone Number, Including Area Code) (714) 952-1121

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 o

There were approximately 35,529,000 shares of common stock outstanding on July 31, 2002.

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PACIFICARE HEALTH SYSTEMS, INC.

FORM 10-Q

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PART I. FINANCIAL INFORMATION

PACIFICARE HEALTH SYSTEMS, INC.

See accompanying notes.

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PACIFICARE HEALTH SYSTEMS, INC.

See accompanying notes.

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PACIFICARE HEALTH SYSTEMS, INC.

See accompanying notes.

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PACIFICARE HEALTH SYSTEMS, INC.

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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

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PACIFICARE HEALTH SYSTEMS, INC.

1. Basis of Presentation

PacifiCare Health Systems, Inc. is one of the nation’s largest health care services companies, offering managed care and other health insurance products to employer groups and Medicare beneficiaries in eight Western states and Guam. Following the rules and regulations of the Securities and Exchange Commission, or SEC, we have omitted footnote disclosures that would substantially duplicate the disclosures contained in the annual audited financial statements. The accompanying unaudited condensed consolidated financial statements should be read together with the consolidated financial statements and the notes included in our December 31, 2001 Annual Report on Form 10-K, filed with the SEC in March 2002.

The accompanying unaudited condensed consolidated financial statements reflect all adjustments, consisting solely of normal recurring adjustments, needed to present fairly the financial results for these interim periods in accordance with generally accepted accounting principles, or GAAP. The consolidated results of operations presented for the interim periods are not necessarily indicative of the results for a full year.

Reclassifications. We reclassified certain prior year amounts in the accompanying condensed consolidated financial statements to conform to the 2002 presentation.

2. Long-Term Debt and Other Commitments

The following table shows the amounts outstanding under our 10 3/4% senior notes, senior credit facility, FHP senior notes and other long-term debt as of June 30, 2002:

(1)	Amounts in parentheses indicate reductions in our borrowing availability under our revolving credit facility; amounts without parentheses indicate increases in our borrowing availability under our revolving credit facility.

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10 3/4% Senior Notes. In May 2002, we sold $500 million in aggregate principal amount of 10 3/4% senior notes due 2009 in a private placement. The 10 3/4% senior notes were issued at 99.389%, for a discount of $3 million that will be amortized over the term of the notes. We used a portion of the net proceeds from the 10 3/4% senior notes to repay $369 million in indebtedness under our senior credit facility, including $315 million under our term loan facility and $54 million under our revolving credit facility. Additionally, we used $85 million of the net proceeds to fund a restricted cash collateral account that has been and will be used, subject to our being in compliance with the senior credit facility, to repurchase or repay the FHP senior notes prior to or on their stated maturity date. As of June 30, 2002, we had used $41 million of the restricted cash collateral account to purchase and permanently retire FHP senior notes. We also used $22 million of the net proceeds as a deposit against outstanding letters of credit under our senior credit facility. In connection with the offering of the 10 3/4% senior notes, we incurred approximately $20 million in fees that will be amortized over the term of the notes.

We may redeem the 10 3/4% senior notes at any time on or after June 1, 2006 at an initial redemption price equal to 105.375% of their principal amount plus accrued and unpaid interest. The redemption price will thereafter decline annually. We also have the option before June 1, 2005 to redeem up to $175 million in aggregate principal amount of the 10 3/4% senior notes at a redemption price of 110.750% of their principal amount plus accrued and unpaid interest using the proceeds from sales of certain kinds of our capital stock. Additionally, at any time on or prior to June 1, 2006, we may redeem the 10 3/4% senior notes upon a change of control, as defined in the indenture for the notes, at 100% of their principal amount plus accrued and unpaid interest and a “make-whole” premium.

Certain of our domestic, unregulated subsidiaries fully and unconditionally guarantee the 10 3/4% senior notes. Certain of our other domestic, unregulated subsidiaries are currently restricted from guaranteeing the 10 3/4% senior notes by the terms of the FHP senior notes, but will fully and unconditionally guarantee the 10 3/4% senior notes once we permanently repay the FHP senior notes. See Note 10, “Financial Guarantees.”

Senior Credit Facility. In April 2002, we executed an amendment with our lenders to extend the maturity date of our senior credit facility to January 3, 2005. The extension of the maturity date to January 3, 2005 was conditioned on the reduction of the senior credit facility by $250 million on or prior to January 2, 2003, and we satisfied this condition following the closing of the offering of the 10 3/4% senior notes. Since December 31, 2001, we have repaid indebtedness under the senior credit facility as follows:

	•	In January 2002, we repaid $25 million under the term loan facility with proceeds from a sale of property to International Business Machines Corporation, or IBM, in connection with our information technology, or IT, outsourcing arrangement,
	•	In April 2002, we repaid $32 million under the term loan facility in connection with amending our senior credit facility,
	•	In May 2002, we repaid $4 million under the term loan facility and $1 million under the revolving credit facility with proceeds from a draw down on our equity commitment arrangement,
	•	In May 2002, we repaid $315 million under the term loan facility and $54 million under the revolving credit facility with proceeds from the offering of the 10 3/4% senior notes,
	•	In June 2002, we repaid $10 million under the term loan facility with proceeds from a sale of property, and
	•	In June 2002, we repaid $20 million under the term loan facility that was scheduled to be repaid on or before July 2, 2002 under the terms of the senior credit facility.

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As of July 2, 2002, the senior credit facility began amortizing at a rate of $25 million per quarter. Each quarterly amortization payment includes a $20 million cash payment on the term loan facility and a $5 million reduction in borrowing capacity under the revolving credit facility. As of June 30, 2002, we had $50 million in borrowing capacity available under the revolving credit facility.

The interest rates per annum applicable to amounts outstanding under the term loan facility and revolving credit facility were increased in connection with the amendment of our senior credit facility and are, at our option, either the administrative agent’s publicly announced “prime rate” (or, if greater, the Federal Funds Rate plus 0.5%) plus a margin of 4% per annum, or the rate of Eurodollar borrowings for the applicable interest period plus a margin of 5% per annum. Based on our outstanding balance under the credit facility as of June 30, 2002, our average overall interest rate, excluding the facility fee, was 5.7% per annum. In connection with the restructuring of our long-term debt, we recorded a write off of unamortized senior credit facility fees, and paid advisory fees totaling $18 million ($12 million or $0.32 diluted loss per share, net of tax) in the second quarter of 2002.

The terms of the senior credit facility contain various covenants usual for financings of this type, including a minimum net worth requirement, a minimum fixed-charge coverage requirement and a maximum debt to earnings before interest, taxes, depreciation and amortization, or EBITDA, requirement. At June 30, 2002, we were in compliance with all of these covenants. On January 23, 2002 we negotiated an amendment to our senior credit facility to exclude our restructuring charge for the fourth quarter of 2001 from all provisions of the senior credit facility. Our domestic, unregulated subsidiaries provide guarantees and have granted security interests to the lenders in substantially all of their personal property to secure our obligations under the senior credit facility. We have also pledged the equity of certain of our subsidiaries to the lenders under the senior credit facility.

FHP Senior Notes. We have $44 million in senior notes outstanding that we assumed when we acquired FHP International Corporation, or FHP, in 1997. These notes mature on September 15, 2003, and bear interest at 7% payable semiannually. As described above, $85 million of the net proceeds from the 10 3/4% senior notes offering was used to fund a restricted cash collateral account that has been and will be used, subject to our being in compliance with the senior credit facility, to repurchase or repay the FHP senior notes prior to or on their stated maturity date. As of June 30, 2002, we had used $41 million of the restricted cash collateral account to purchase and permanently retire FHP senior notes. Additionally, in May 2002, we retired $3 million of the FHP senior notes by exchanging approximately 0.1 million shares of our common stock for those FHP senior notes. We reissued treasury stock to provide the common stock used in the exchange. The FHP notes share in the collateral securing our obligations under our senior credit facility.

Information Technology Outsourcing Contracts. In December 2001, we entered into a 10-year contract to outsource our IT operations to IBM. Under the contract, IBM is the coordinator of our IT outsourcing arrangement, and will provide IT services and day-to-day management of our IT infrastructure, including data center operations, support services and information distribution. In January 2002, we entered into a 10-year contract to outsource our IT software applications maintenance and enhancement services to Keane, Inc., or Keane. Our total cash obligations for base fees under these contracts over the 10-year terms will be $1.3 billion. The contracts also provide for variable fees, based on services provided above certain contractual baselines. Additionally, in the event of contract termination, we would be responsible to pay termination fees to IBM and Keane. These termination fees decline as each successive year of the contract term is completed. In connection with these outsourcing agreements, we transitioned approximately 550 employee positions to IBM and Keane in March 2002.

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In connection with the IBM outsourcing contract, we sold IBM computer equipment with a net book value of $42 million in December 2001. The consideration we received from IBM for the sale included $25 million in cash, and a note receivable for the $17 million balance. We will collect the note receivable, which bears interest at approximately 7% per annum, in the form of credits against our future base fee payments from 2002 through 2005. We used the $25 million we received from IBM to repay indebtedness under the term loan facility of our senior credit facility in January 2002.

3. Stockholders’ Equity

Minority Interest. In the first quarter of 2001, we purchased all outstanding stock of SeniorCo, Inc. from minority stockholders for $9 million. Of this amount, $6 million was paid to Compaq Computer Corporation, as a return on their original investment of $8 million. No operating results were allocated to minority stockholders in 2001.

Acqua Wellington Arrangement. In December 2001, we entered into an equity commitment arrangement with Acqua Wellington North American Equities Fund Ltd., or Acqua Wellington, an institutional investor, for the purchase by Acqua Wellington of up to 6.9 million shares or $150 million of our common stock. We have the ability to call the equity commitment for an 18-month period beginning December 26, 2001, the effective date of our registration statement relating to the equity commitment, at a price per share equal to the daily volume weighted average price of our common stock on each of the 18 consecutive trading days in a draw down period that the weighted average price is above the threshold price we determine for the applicable draw down, less a discount ranging from 3.2% to 4.7% that is based on the threshold price. We have the sole discretion to present up to 15 draw down notices to Acqua Wellington. Each draw down notice sets the threshold price and the dollar value of shares Acqua Wellington may be obligated to purchase during a draw down period. The threshold price we choose cannot be less than $11.00 per share. The threshold price we select determines the maximum dollar value of shares and the discount to the market price based upon a predetermined schedule.

In April 2002, we made a draw down under our equity commitment arrangement with Acqua Wellington. As a result of this draw down, we sold 420,720 shares to Acqua Wellington for an average price of $21.39 per share. The total proceeds from the draw down were approximately $9 million.

Treasury Stock. As of June 30, 2002, we held approximately 11.9 million shares of treasury stock totaling $614 million. These shares were purchased pursuant to an October 1999 repurchase program that allowed us to repurchase up to 12 million shares of our common stock including shares purchased from prior repurchase programs. During the six months ended June 30, 2002, we reissued approximately 0.3 million shares of treasury stock in connection with our employee benefit plans. In May 2002, we reissued 0.1 million shares of treasury stock for the early retirement of FHP senior notes. See Note 2, “Long-Term Debt and Other Commitments.” In May 2002, we also reissued 0.4 million shares of treasury stock in connection with our draw down of the Acqua Wellington equity commitment arrangement as discussed above. We have reissued, and will continue to reissue treasury stock in connection with our employee benefit plans and future draw downs, if any, under the Acqua Wellington equity commitment arrangement, or for other corporate purposes.

4. Net Investment Income

We continually monitor our investment portfolio to determine whether any declines in the value of our investments are other than temporary. Since 2000, we have invested amounts totaling $11 million in MedUnite, Inc., or MedUnite, an independent, development state company conceived and financed by several of the nation’s largest health care payors. MedUnite was organized to provide claims submission

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and payment, referral, eligibility and other Internet provider connectivity services. As expected, MedUnite has experienced losses and negative cash flows since its inception. We had not adjusted the carrying value of this investment based upon valuations prepared by qualified independent third parties as recently as December 2001. Those valuations were based upon financial and operational information contained in MedUnite’s business plan. We account for our investment in MedUnite under the cost method.

Since that time, MedUnite has not met its business plan or its most recent forecast for 2002, and will require additional capital to meet its objectives. Current market conditions make it difficult predict whether new capital can be raised upon terms acceptable to its shareholders. As a result, we determined that the MedUnite investment had a decline in value that was other than temporary. Therefore, we wrote down the entire $11 million investment in MedUnite in the second quarter of 2002. Additionally, we wrote down certain telecommunications investments to market value resulting in a charge of approximately $2 million. In total, we recorded a charge of $13 million ($8 million, or $0.22 diluted loss per share, net of tax) for other than temporary impairments to the value of these investments which is included in net investment income. In addition to the impairment of these investments, year-to-date realized losses on our portfolio more than offset realized gains. Finally, we experienced lower pretax rates of return on our portfolio as a result of lower investable balances and interest rates that have been declining since 2001.

We may make additional investments in MedUnite in the future. If we make additional investments in the near term, such investments, depending on the facts and circumstances at that time, would likely be expensed when made.

5. Goodwill and Intangible Assets

Goodwill. When we acquire a business, we allocate the excess of the purchase price over the fair value of the net assets acquired to goodwill and identified intangible assets. Prior to 2002, we amortized goodwill and intangible assets evenly over periods ranging from three to 40 years.

In July 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards (SFAS) No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets, effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill is no longer amortized, but is subject to impairment tests on an annual basis or more frequently if impairment indicators exist. The tests for measuring goodwill impairment under SFAS No. 142 are more stringent than the previous tests required by SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of. Under SFAS No. 121, we applied an undiscounted cash flow model to assess the fair value of our reporting units, which did not result in the recognition of goodwill impairment in 2001.

Under the guidance of SFAS No. 142, we used a discounted cash flow methodology to assess the fair values of our reporting units as of January 1, 2002. For reporting units with book equity values that exceeded the fair values, we performed a hypothetical purchase price allocation. Impairment was measured by comparing the goodwill derived from the hypothetical purchase price allocation to the carrying value of the goodwill balance. As a result, we recognized $897 million (net of $32 million of deferred tax liability reversals) of goodwill impairment as the cumulative effect of a change in accounting principle during the three months ended March 31, 2002. No goodwill impairment indicators existed for the three months ended June 30, 2002, and as a result impairment testing was not required. The following table reflects

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consolidated results adjusted as though the adoption of the SFAS No. 142 non-amortization of goodwill provisions occurred as of the beginning of the three and six months ended June 30, 2001:

Under the new rules, other intangible assets will continue to be amortized over their useful lives. Future intangible asset amortization will be $22 million in 2003, $21 million in 2004, $17 million in 2005, $15 million in 2006 and $15 million in 2007. Balances of identified intangible assets, by major class, were as follows for the periods indicated: