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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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)     Yes x     No o

There were approximately 37,558,000 shares of common stock outstanding on July 31, 2003.

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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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See accompanying notes.

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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

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See accompanying notes.

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PACIFICARE HEALTH SYSTEMS, INC.

PacifiCare Health Systems, Inc. offers managed care and other health insurance products to employer groups and Medicare beneficiaries in eight Western states and Guam. Our commercial and senior medical plans are designed to deliver quality health care and customer service to members cost-effectively. These programs include health maintenance organizations, or HMOs, preferred provider organizations, or PPOs, and Medicare Supplement products. We also offer a variety of specialty managed care products and services that employees can purchase as a supplement to our basic commercial and senior plans or as stand-alone products. These products include pharmacy benefit management, or PBM, services, behavioral health services, group life and health insurance, dental and vision benefit plans.

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 our 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, 2002 Annual Report on Form 10-K, filed with the SEC in March 2003.

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. The consolidated results of operations presented for the interim periods are not necessarily indicative of the results for a full year.

Premium revenues are earned from products where we bear insured risk. Non-premium revenues are earned from all other sources, including revenues from our PBM mail service business, administrative fees and other revenue. Commencing with the first quarter of 2003, we reformatted our statement of operations to show total revenues (premium revenues and non-premium revenues) and health care services and other expenses by the following categories: commercial, senior and specialty and other. These changes are summarized below:

	•	For our behavioral health and dental and vision subsidiaries, we previously included premium revenues in the commercial revenue line and non-premium revenues in the other income line. In 2003, all revenues (premium and non-premium) derived from our specialty companies (behavioral health, dental and vision and PBM) are now reported in the specialty and other revenues line.
	•	All health care services and other expenses for our specialty companies were previously included within commercial health care costs. In 2003, all health care services and other expenses for our specialty companies are now reported in the specialty and other health care services expenses line.
	•	Non-premium revenues earned by, and non-premium related fees charged by, our health plans or subsidiaries were previously included in the other income line. In 2003, these amounts are now included in the commercial, senior or specialty revenue and health care services and other expenses lines, as appropriate.

We reclassified certain prior year amounts in the accompanying condensed consolidated financial statements to conform to the reformatted 2003 presentation. The reclassifications and changes in presentation do not have any effect on our total consolidated revenues or health care services and other expenses for 2002.

All intercompany transactions and accounts are eliminated in consolidation.

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Prior to 2003, we accounted for our stock-based employee and director compensation plans under the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Stock-based employee and director compensation cost was not reflected in the net loss for the three and six months ended June 30, 2002, because all options granted under our plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2003, we adopted the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, on a prospective basis for all employee and director awards granted, modified or settled on or after January 1, 2003, as provided by FASB Statement No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure. Awards typically vest over four years. The cost related to stock-based employee and director compensation included in the determination of net income for 2003 is less than that which would have been recognized if the fair value based method had been applied to all awards granted, modified or settled since October 1, 1995. The following table illustrates the effect on net income (loss) and earnings (loss) per share as if the fair value method had been applied to all outstanding and unvested awards in each period.

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The following table illustrates the components of our stock-based compensation expense for the three and six months ended June 30, 2003 and 2002:

(1)

The recognition and measurement of restricted stock is the same under APB Opinion No. 25 and FASB Statement No. 123. The related expenses for the fair value of restricted stock for the three and six months ended June 30, 2003 and 2002 were charged to selling, general and administrative expenses and are included in the net income (loss), as reported amounts in the pro forma net income (loss) table above. See Note 4, “Stockholders’ Equity.”

Convertible Subordinated Debentures. We have $135 million in aggregate principal amount of 3% convertible subordinated debentures due in 2032. The debentures are convertible into common stock under certain conditions, including satisfaction of a market price condition for our common stock, satisfaction of a trading price condition relating to the debentures, upon notice of redemption, or upon specified corporate transactions. Each $1,000 of the debentures is convertible into 23.8095 shares of our common stock. The market price condition for conversion of the debentures is satisfied if the closing sale price of our common stock exceeds 110% of the conversion price (which is calculated at $46.20 per share) for the debentures for at least 20 trading days in the 30 consecutive trading days ending on the last trading day of any fiscal quarter. In the event that the market price condition is satisfied during any fiscal quarter, the debentures are convertible, at the option of the holder, during the following fiscal quarter. The market price condition is evaluated each quarter to determine whether the debentures will be convertible (at the option of the holder) during the following fiscal quarter. The market price condition was not satisfied during our fiscal quarter ended June 30, 2003 and the debentures are not currently convertible based on satisfaction of the market price condition.

Beginning in October 2007, we may redeem for cash all or any portion of the debentures, at a purchase price of 100% of the principal amount plus accrued interest, upon not less than 30 nor more than 60 days written notice to the holders. Beginning in October 2007, and in successive 5-year increments, our holders may require us to repurchase the debentures for cash at a repurchase price of 100% of the principal amount plus accrued interest. Our payment obligations under the debentures are subordinated to our senior indebtedness, and effectively subordinated to all indebtedness and other liabilities of our subsidiaries.

10 3/4% Senior Notes. We have $500 million in aggregate principal amount of 10 3/4% senior notes due in 2009. The 10 3/4% senior notes were issued in May 2002 at 99.389% of the aggregate principal amount representing a discount of $3 million that is being 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

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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 “FHP Senior Notes” below and Note 10, “Financial Guarantees.”

In April 2003, we entered into an interest rate swap on $300 million of our 10 3/4% senior notes for the purpose of hedging the fair value of our indebtedness. This fair value hedge is accounted for using the short-cut method under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, whereby the hedge is reported in our balance sheets at fair value, and the carrying value of the long-term debt is adjusted for an offsetting amount representing changes in fair value attributable to the hedged risk. Changes in the fair value of the hedge and the long-term debt are reflected in our statements of operations. Under the terms of the agreement, we make interest payments based on the three-month London Interbank Offered Rate (LIBOR) plus 692 basis points and receive interest payments based on the 10 3/4% fixed rate. The three-month LIBOR rate we use to determine our interest payments under the swap agreement was first established on June 2, 2003 and resets every three months thereafter, until expiration in June 2009.

Senior Credit Facility. In June 2003, we replaced our senior credit facility with a new syndicated facility with JPMorgan Chase Bank serving as the Administrative Agent. The new facility consists of a $150 million term loan, which matures on June 3, 2008, and a $150 million revolving line of credit, which matures on June 3, 2006. We used the proceeds from the term loan to repay the $131 million outstanding under the prior facility. The remaining $19 million was used to pay fees and expenses relating to the new facility and for general corporate purposes. As of June 30, 2003, we had $150 million outstanding on the term loan and no balance outstanding on the revolving line of credit. We borrowed and repaid $3 million under the revolving line of credit in June 2003.

The new senior credit facility provides for interest rates per annum applicable to term loan borrowings that are, at our option, either JPMorgan Chase Bank’s prime rate (or, if greater, the Federal Funds Rate plus 0.5%), which we refer to as the alternate base rate, plus a margin of 2.5% per annum, or the LIBOR for the applicable interest period plus a margin of 3.5% per annum. All our borrowings under the term loan are currently LIBOR borrowings. The interest rates per annum under the new senior credit facility applicable to revolving credit borrowings are, at our option, either the alternate base rate plus a margin spread of between 1.5% to 2.75% per annum, or the LIBOR for the applicable interest period plus a margin spread of between 2.5% to 3.75% per annum, with the amount of the margin for any borrowing being determined based on current credit ratings for the debt under the new senior credit facility. Our current margins for revolving credit borrowings are 2.25% per annum for alternate base rate borrowings and 3.25% per annum for LIBOR borrowings.

The terms of the new senior credit facility contain various covenants customary for financings of this type which place restrictions on our and/or our subsidiaries’ ability to incur debt, pay dividends, create liens, make investments, optionally repay, redeem or repurchase our securities, and enter into mergers, dispositions and transactions with affiliates. The new senior credit facility also requires us to meet various financial ratios, including a minimum net worth requirement, a minimum fixed-charge coverage

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requirement and a maximum leverage ratio. At June 30, 2003, we were in compliance with all of these covenants. Certain of our domestic, unregulated subsidiaries provide guarantees and have granted security interests to the lenders in substantially all of their personal property in order to secure our obligations under the senior credit facility. We have also pledged the equity of certain of our subsidiaries to the lenders.

FHP Senior Notes. We had $43 million in senior notes outstanding as of June 30, 2003 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. In connection with our 10 3/4% senior notes offering in 2002, $85 million of the net proceeds 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, 2003, we had used $42 million of the restricted cash collateral account to purchase and permanently retire FHP senior notes. The FHP senior notes share in the collateral for our obligations under our senior credit facility.

Database Financing Agreements. As of June 30, 2003, we had $9 million outstanding under various financing agreements related to the purchase of database licenses, financial accounting system software and related maintenance in connection with the implementation of our information technology, or IT, initiatives. Payments under the financing agreements are due quarterly through July 2005. The interest imputed on the payment plan agreement ranges from 4% to 5.3%.

Letters of Credit. Letters of credit are purchased guarantees that assure our performance or payment to third parties in connection with professional liability insurance policies, lease commitments and other potential obligations. Letters of credit commitments totaled $18 million and $9 million at June 30, 2003 and 2002, respectively. As of June 30, 2003, our letters of credit commitments were backed by funds deposited in restricted cash accounts.

Information Technology Outsourcing Contracts. In December 2001, we entered into a 10-year contract to outsource our IT operations to International Business Machines Corporation, or IBM. Under the contract, IBM is the coordinator of our IT outsourcing arrangement, and provides 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. However, because we have the ability to reduce services from the vendors under the contracts, our ultimate cash commitment may be less than the stated contract amounts. 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.

Restricted Stock Awards. We granted 24,400 and 15,000 shares of restricted common stock as part of an employee recruitment, recognition and retention program during the three months ended June 30, 2003 and 2002, respectively. For the six months ended June 30, 2003 and 2002, we granted 718,400 and 15,000 shares in connection with the same program, respectively. Restrictions on these shares will expire and related charges are being amortized as earned over the vesting period, not to exceed four years. A total of 8,900 shares were forfeited during the six months ended June 30, 2003. No shares were forfeited during the six months ended June 30, 2002.

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All shares of restricted stock were issued from our 1996 Officer and Key Employee Stock Option Plan, as amended. The amount of unearned compensation recorded is based on the market value of the shares on the date of issuance and is included as a separate component of stockholders’ equity. Related expenses (charged to selling, general and administrative expenses) were $1.4 million and $.2 million for the three months ended June 30, 2003 and 2002, respectively. For the six months ended June 30, 2003 and 2002, the related expenses were $2.6 million and $.3 million, respectively.

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. This equity commitment arrangement expired in June 2003.

Treasury Stock. As of June 30, 2003, we held approximately 12 million shares of treasury stock. During the six months ended June 30, 2003, we reissued approximately 48,000 shares of treasury stock in connection with our employee benefit plans. Due to changes in our employee benefit plans in February 2003, no shares of treasury stock were issued for the three months ended June 30, 2003.

In the first quarter of 2002, 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 upon adopting SFAS No. 142, Goodwill and Other Intangible Assets. 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. 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. No goodwill impairment indicators existed for the six months ended June 30, 2003 and, as a result, impairment testing was not required.

Other intangible assets will continue to be amortized over their useful lives. Under current accounting rules and based on our current intangible assets, our 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. The following table sets forth balances of identified intangible assets, by major class, for the periods indicated:

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6.	Impairment, Disposition, Restructuring, Office of Personnel Management (“OPM”) and Other (Credits) Charges

We did not recognize any credits or charges during the six months ended June 30, 2003. For the six months ended June 30, 2002 we recognized net pretax (credits) charges as follows:

OPM. During the first quarter of 2002, we recognized OPM credits of $13 million, representing a reduction to the net liability we had established in prior periods as a result of settlements with the OPM, the U.S. Department of Justice, or DOJ, and a private individual to settle disputes and a private lawsuit under the False Claims Act regarding alleged premium overcharges to the government for the period 1990 through 1997, primarily related to contracts held by FHP health plans prior to our acquisition of FHP in 1997.

Write Off of Unamortized Senior Credit Facility Fees. During the second quarter of 2002, we recognized other charges of $18 million for the write off of unamortized senior credit facility fees in connection with our repayment of a significant portion of our senior credit facility, and for advisory fees paid in connection with the restructuring of our long-term debt.

Restructuring Charge. In December 2001, we recognized a restructuring charge of $60 million. Of the $60 million charge, approximately $34 million represented a liability for cash payments, of which approximately $22 million was paid during the fourth quarter of 2001 and during the year ended December 31, 2002. The remaining severance and separation benefits will be paid throughout 2003. Approximately $20 million of the restructuring charge was for severance and related employee benefits for 1,450 employees whose positions were eliminated. As of June 30, 2003, approximately 1,240 employees have left the company and 200 employees, whose positions were eliminated, accepted other positions within the company. The remaining employees are expected to be terminated by December 2003. During the six months ended June 30, 2003, there were no changes to the December 2001 restructuring charge estimate and we made severance payments totaling approximately $2 million to terminated employees.

The restructuring charge also included approximately $27 million related to the outsourcing of our IT production and $13 million related to lease terminations.

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The following table presents the activity through June 30, 2003, on the restructuring charge we took in 2001: