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FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
{X} QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2004
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 number 0-15846
First Health Group Corp.
(Exact name of registrant as specified in its charter)
Delaware 36-3307583
------------------------------- ------------------------------------
(State or other jurisdiction of (IRS Employer Identification Number)
incorporation or organization)
3200 Highland Avenue, Downers Grove, Illinois 60515
---------------------------------------------------
(Address of principal executive offices, Zip Code)
(630) 737-7900
------------------------------------------------
(Registrant's phone 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 by check mark whether the registrant is an accelerated filer (as
defined by Rule 12b-2 of the Exchange Act).
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.
The number of shares of Common Stock, par value $.01 per share, outstanding
on November 1, 2004, was 91,903,467.
First Health Group Corp. and Subsidiaries
INDEX
Part I. Financial Information
Page Number
-----------
Item 1. Financial Statements (Unaudited)
Consolidated Balance Sheets - Assets at September 30, 2004
and December 31, 2003 ................................... 3
Consolidated Balance Sheets - Liabilities and Stockholders'
Equity at September 30, 2004 and December 31, 2003....... 4
Consolidated Statements of Operations for the three months
ended September 30, 2004 and 2003 ....................... 5
Consolidated Statements of Operations for the nine months
ended September 30, 2004 and 2003 ....................... 6
Consolidated Statements of Comprehensive Income for the
three and nine months ended September 30, 2004 and 2003.. 7
Consolidated Statements of Cash Flows for the nine months
ended September 30, 2004 and 2003 ....................... 8-9
Notes to Consolidated Financial Statements ................ 10-15
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ............. 16-26
Item 3. Quantitative and Qualitative Disclosures About
Market Risk ..................................... 27
Item 4. Controls and Procedures ........................... 27
Part II. Other Information
Item 1. Legal Proceedings ................................. 28
Item 2. Unregistered Sales of Equity Securities
and Use of Proceeds ............................. 28
Item 5. Other Information ................................. 28
Item 6. Exhibits ......................................... 28-29
Signatures....................................................... 30
PART 1. Financial Information
First Health Group Corp. and Subsidiaries
CONSOLIDATED BALANCE SHEETS
(in millions) (Unaudited)
-----------------------------------------------------------------------------
ASSETS September 30, December 31,
2004 2003
-------- --------
Current Assets:
Cash and cash equivalents .................... $ 27.7 $ 8.0
Short-term investments ....................... 7.1 2.0
Accounts receivable, less allowances for
doubtful accounts of $17.5
and $21.1 respectively..................... 105.7 102.9
Deferred income taxes ........................ 23.1 26.8
Other current assets ......................... 47.2 37.4
-------- --------
Total current assets ......................... 210.8 177.1
Long-Term Investments:
Marketable securities ........................ 58.2 63.0
Other......................................... 70.8 66.7
-------- --------
129.0 129.7
-------- --------
Property and Equipment:
Land, buildings and improvements ............. 106.5 103.1
Computer equipment and software .............. 336.4 281.5
Office furniture and equipment ............... 43.3 37.9
-------- --------
486.2 422.5
Less accumulated depreciation and
amortization............................... (239.0) (186.6)
-------- --------
Net property and equipment ................... 247.2 235.9
-------- --------
Goodwill........................................ 328.8 324.3
Intangible assets, less accumulated amortization
of $15.2 and $9.3, respectively ........... 79.2 82.6
Reinsurance recoverable......................... 24.2 24.3
Other Assets.................................... 2.9 3.5
-------- --------
Total Assets $ 1,022.1 $ 977.4
======== ========
See Notes to Consolidated Financial Statements
First Health Group Corp. and Subsidiaries
CONSOLIDATED BALANCE SHEETS
(in millions) (Unaudited)
-----------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
September 30, December 31,
2004 2003
-------- --------
Current Liabilities:
Accounts payable ............................. $ 85.3 $ 73.2
Accrued expenses ............................. 38.5 47.8
Claims reserves .............................. 23.4 23.8
Income taxes payable ......................... 25.4 8.1
-------- --------
Total current liabilities .................... 172.6 152.9
Long-Term Debt.................................. 195.0 270.0
Claims Reserves - Noncurrent.................... 24.2 24.3
Deferred Taxes.................................. 128.2 126.5
Other Noncurrent Liabilities.................... 23.8 25.2
-------- --------
Total liabilities ............................ 543.8 598.9
-------- --------
Commitments and Contingencies................... -- --
Stockholders' Equity:
Common stock ................................. 1.4 1.4
Additional paid-in capital ................... 347.4 335.5
Retained earnings ............................ 758.5 672.0
Accumulated other comprehensive loss ......... (0.3) (1.7)
Treasury stock, at cost ...................... (628.7) (628.7)
-------- --------
Total stockholders' equity ................... 478.3 378.5
-------- --------
Total Liabilities and Stockholders' Equity ..... $ 1,022.1 $ 977.4
======== ========
See Notes to Consolidated Financial Statements
First Health Group Corp. and Subsidiaries
CONSOLIDATED STATEMENTS OF OPERATIONS
(in millions except per share amounts) (Unaudited)
-----------------------------------------------------------------------------
Three Months Ended
September 30,
---------------------------
2004 2003
-------- --------
Revenues......................................... $ 218.4 $ 219.7
-------- --------
Operating expenses:
Cost of services .............................. 104.2 98.7
Selling and marketing ......................... 24.4 23.2
General and administrative .................... 18.9 16.0
Health care benefits .......................... 6.3 4.4
Merger-related expenses ....................... 1.3 --
Depreciation and amortization ................. 19.8 15.6
-------- --------
174.9 157.9
-------- --------
Income from operations........................... 43.5 61.8
Other (income) expense:
Interest expense .............................. 1.6 1.2
Interest income ............................... (1.4) (1.6)
-------- --------
Income before income taxes....................... 43.3 62.2
Income taxes..................................... (15.7) (21.5)
-------- --------
Net income....................................... $ 27.6 $ 40.7
======== ========
Weighted average shares outstanding - basic...... 91.8 94.7
======== ========
Net income per common share - basic ............. $ .30 $ .43
======== ========
Weighted average shares outstanding - diluted.... 92.8 97.0
======== ========
Net income per common share - diluted ........... $ .30 $ .42
======== ========
See Notes to Consolidated Financial Statements
First Health Group Corp. and Subsidiaries
CONSOLIDATED STATEMENTS OF OPERATIONS
(in millions except per share amounts) (Unaudited)
-----------------------------------------------------------------------------
Nine Months Ended
September 30,
---------------------------
2004 2003
-------- --------
Revenues......................................... $ 657.3 $ 652.1
-------- --------
Operating expenses:
Cost of services .............................. 315.5 295.0
Selling and marketing ......................... 66.1 65.6
General and administrative .................... 57.8 46.6
Health care benefits .......................... 19.9 14.0
Merger-related expenses ....................... 1.3 --
Depreciation and amortization ................. 57.7 46.3
-------- --------
518.3 467.5
-------- --------
Income from operations........................... 139.0 184.6
Nonoperating expense (income):
Interest expense .............................. 5.1 3.9
Interest income ............................... (4.3) (4.3)
-------- --------
Income before income taxes....................... 138.2 185.0
Income taxes..................................... (51.7) (70.3)
-------- --------
Net income....................................... $ 86.5 $ 114.7
======== ========
Weighted average shares outstanding - basic 91.5 95.7
======== ========
Net income per common share - basic.............. $ .94 $ 1.20
======== ========
Weighted average shares outstanding - diluted.... 92.9 98.2
======== ========
Net income per common share - diluted ........... $ .93 $ 1.17
======== ========
See Notes to Consolidated Financial Statements
First Health Group Corp. and Subsidiaries
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in millions) (Unaudited)
-----------------------------------------------------------------------------
Three Months Ended
September 30,
---------------------------
2004 2003
-------- --------
Net income....................................... $ 27.6 $ 40.7
-------- --------
Unrealized gains (losses) on securities,
before tax..................................... 1.5 (0.7)
Unrealized gains on limited partnership
derivatives.................................... 3.1 --
-------- --------
Other comprehensive income (loss), before tax.... 4.6 (0.7)
Income tax (expense) benefit related to items
of other comprehensive income.................. (1.7) 0.2
-------- --------
Other comprehensive income (loss)................ 2.9 (0.5)
-------- --------
Comprehensive income............................. $ 30.5 $ 40.2
======== ========
Nine Months Ended
September 30,
---------------------------
2004 2003
-------- --------
Net income....................................... $ 86.5 $ 114.7
-------- --------
Unrealized gains (losses) on securities,
before tax..................................... (0.4) 0.3
Unrealized gains on limited partnership
derivatives.................................... 2.7 --
-------- --------
Other comprehensive income, before tax........... 2.3 0.3
Income tax expense related to items of other
comprehensive income........................... (0.9) (0.2)
-------- --------
Other comprehensive income....................... 1.4 0.1
-------- --------
Comprehensive income............................. $ 87.9 $ 114.8
======== ========
See Notes to Consolidated Financial Statements
First Health Group Corp. and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions) (Unaudited)
-----------------------------------------------------------------------------
Nine Months Ended
September 30,
---------------------------
2004 2003
-------- --------
Cash flows from operating activities:
Net Income .................................... $ 86.5 $ 114.7
-------- --------
Adjustments to Reconcile Net Income to Net Cash
Provided by Operating Activities:
Depreciation and amortization ............... 57.7 46.3
Change in allowance for uncollectible
receivables ............................... (3.8) (1.5)
Provision for deferred income taxes ......... 4.5 --
Tax benefits from stock options exercised.... 2.0 8.0
Income from limited partnership ............. (2.5) (2.1)
Other, net .................................. 0.2 0.2
Changes in Assets and Liabilities (net of
effects of acquired businesses):
Accounts receivable ......................... 3.0 (16.8)
Other current assets ........................ (9.9) (7.5)
Reinsurance recoverable ..................... 0.1 1.4
Accounts payable and accrued expenses........ (0.1) 5.0
Claims reserves ............................. (0.5) 0.2
Income taxes payable ........................ 17.3 13.9
Noncurrent assets and liabilities ........... (0.7) (1.2)
-------- --------
Net cash provided by operating activities ..... 153.8 160.6
-------- --------
Cash flows from investing activities:
Purchases of investments ...................... (29.2) (37.1)
Sales of investments .......................... 29.5 34.4
Acquisition of business, net of cash acquired.. (7.2) (3.0)
Purchase of property and equipment ............ (62.0) (56.0)
-------- --------
Net cash used in investing activities.......... (68.9) (61.7)
-------- --------
Cash flows from financing activities:
Purchase of treasury stock .................... -- (149.8)
Proceeds from issuance of long-term debt....... 50.0 145.0
Repayment of long-term debt ................... (125.0) (110.0)
Proceeds from issuance of common stock......... 9.8 19.7
Stock option loan repayments .................. -- 0.3
-------- --------
Net cash used in financing activities.......... (65.2) (94.8)
-------- --------
Net increase in cash and cash equivalents........ 19.7 4.1
Cash and cash equivalents, beginning of period... 8.0 20.9
-------- --------
Cash and cash equivalents, end of period ........ $ 27.7 $ 25.0
======== ========
First Health Group Corp. and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions) (Unaudited)
-----------------------------------------------------------------------------
Nine Months Ended
September 30,
---------------------------
2004 2003
-------- --------
Supplemental cash flow data:
Stock options exercised in exchange
for common stock............................... $ -- $ 0.5
Health care benefits paid........................ (22.1) (12.4)
Interest paid.................................... (5.0) (3.5)
Interest income received......................... 2.0 2.2
Income taxes paid, net........................... (27.9) (48.3)
Acquisition of businesses:
Fair value of assets acquired,
net of cash acquired......................... $ 3.1 $ (0.5)
Goodwill ...................................... 4.5 3.8
Intangible Assets ............................. 2.5 --
Fair value of liabilities assumed ............. (2.9) (0.3)
-------- --------
$ 7.2 $ 3.0
======== ========
See Notes to Consolidated Financial Statements
First Health Group Corp. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
-----------------------------------------------------------------------------
1. The unaudited financial statements herein have been prepared by the
Company pursuant to the rules and regulations of the Securities and
Exchange Commission. The accompanying interim financial statements have
been prepared under the presumption that users of the interim financial
information have either read or have access to the audited financial
statements for the latest fiscal year ended December 31, 2003.
Accordingly, footnote disclosures which would substantially duplicate
the disclosures contained in the December 31, 2003 audited financial
statements have been omitted from these interim financial statements.
Certain information and footnote disclosures normally included in
financial statements prepared in accordance with accounting principles
generally accepted in the United States of America have been condensed
or omitted pursuant to such rules and regulations. In our opinion, the
accompanying unaudited consolidated financial statements contain all
adjustments necessary for a fair presentation. Although the Company
believes that the disclosures are adequate to make the information
presented not misleading, it is suggested that these interim financial
statements be read in conjunction with the financial statements and the
notes thereto included in the Company's latest Annual Report on Form
10-K.
2. On October 31, 2003, the Company completed the acquisition of all of
the outstanding shares of capital stock of Health Net Employer
Services, Inc. ("Employer Services"), from Health Net, Inc. for
approximately $79 million. Health Net Employer Services, Inc. has been
renamed First Health Employer Services, Inc. The acquisition was
financed with borrowings under the Company's credit facility. The
allocation of the purchase price is expected to be completed in the
fourth quarter of 2004.
Purchase price has been allocated, on a preliminary basis, as follows
(in millions):
Fair value of tangible assets acquired $ 17.1
Goodwill 43.5
Intangible assets 29.5
Liabilities assumed (8.0)
Liability for restructuring and integration costs (2.9)
------
$ 79.2
======
On October 31, 2003, the Company completed the acquisition of PPO
Oklahoma for an initial purchase price of approximately $10 million,
subject to certain purchase price considerations. The acquisition was
financed with borrowings under the Company's credit facility. The
Company paid an additional $1 million in the third quarter of 2004
based on those purchase price considerations and increased goodwill.
Additional purchase price may be recorded in the fourth quarter of 2004
when the contingent purchase provisions are resolved.
Purchase price has been allocated, on a preliminary basis, as follows
(in millions):
Fair value of tangible assets acquired $ 0.6
Goodwill 7.6
Intangible assets 3.7
Liabilities assumed (0.2)
Liability for restructuring and integration costs (0.3)
------
$ 11.4
======
On April 7, 2004, the Company completed the acquisition of COMP Medical
for a purchase price of approximately $6 million, subject to certain
purchase price considerations depending on future performance. COMP
Medical has been renamed First Health Priority Services, Inc. ("FHPS").
The acquisition was funded with cash from operating activities.
Additional goodwill may be recognized as the annual contingent purchase
provisions are resolved.
Purchase price has been allocated, on a preliminary basis, as follows
(in millions):
Fair value of tangible assets acquired $ 3.2
Goodwill 3.5
Intangible assets 2.5
Liabilities assumed (2.8)
Liability for restructuring and integration costs (0.1)
------
$ 6.3
======
3. Acquired Intangible Assets
As of As of
September 30, 2004 December 31, 2003
--------------------- -----------------------
Gross Gross
Carrying Accumulated Carrying Accumulated
(in millions) Amount Amortization Amount Amortization
------------- ------ ------------ ------ ------------
Amortized intangible
assets:
Customer contracts $ 80.7 $ 13.6 $ 78.2 $ 8.3
and relationships
Provider Contracts 13.7 1.6 13.7 1.0
----- ----- ----- -----
Total $ 94.4 $ 15.2 $ 91.9 $ 9.3
===== ===== ===== =====
Customer contracts and relationships represent added value to the
Company's business for existing long-term contracts and long-term
business relationships. Provider contracts represent additions to the
First Health[R] Network that the Company has acquired. The aggregate
amortization expense recorded during the nine months ended September
30, 2004 and 2003, respectively, was $5.9 million and $3.1 million. The
estimated amortization expense for each of the years ending December
31, 2004 through 2007 is approximately $7.4 million. The estimated
amortization expense for the year ending December 31, 2008 is
approximately $6.9 million.
The changes in the carrying amount of goodwill for the nine months
ended September 30, 2004 and the twelve months ended December 31, 2003
are as follows:
(in millions) 2004 2003
------ ------
Balance, January 1 $ 324.3 $ 279.4
Goodwill acquired 3.5 50.0
Other changes 1.0 (5.1)
------ ------
Ending balance $ 328.8 $ 324.3
====== ======
The goodwill acquired in 2004 represents the goodwill from the FHPS
acquisition. The other goodwill adjustments in 2004 represent payments
for purchase price consideration related to the acquisition of PPO
Oklahoma. The goodwill acquired in 2003 represents goodwill from the
Employer Services and PPO Oklahoma acquisitions. The other goodwill
adjustments in 2003 represented finalization of the allocation of the
purchase price related to prior acquisitions.
4. Effective January 1, 2003, the Company adopted Statement of Financial
Accounting Standards No. 148 ("SFAS 148"), "Accounting for Stock-Based
Compensation - Transition and Disclosure," which amends SFAS No. 123
("SFAS 123"), "Accounting for Stock Based Compensation." The Company
accounts for these plans under the recognition and measurement
principles of APB Opinion No. 25, "Accounting for Stock Issued to
Employees" and related Interpretations. No stock-based employee
compensation cost is reflected in net income (other than compensation
cost for consultants), as all options granted under these plans had an
exercise price at least equal to the market value of the underlying
common stock on the date of grant. As permitted by SFAS 123, and
amended by SFAS 148, the Company follows only the disclosure
requirements of SFAS 123 and SFAS 148. The following table illustrates
the effect on net income and earnings per share if the Company had
applied the fair value recognition provisions to all outstanding and
unvested awards in each period:
Three Months Ended Nine Months Ended
(in millions except EPS) September 30, September 30,
------------------------ -------------- --------------
2004 2003 2004 2003
------ ------ ------ ------
Net income, as reported $ 27.6 $ 40.7 $ 86.5 $ 114.7
Add: Stock-based employee
compensation expense included
in reported net income, net
of related tax effects 0.1 0.1 0.1 0.1
Deduct: Total stock-based employee
compensation expense determined
under fair value based method
for all awards, net of related
tax effects (2.6) (3.1) (8.6) (10.3)
------ ------ ------ ------
Pro forma net income $ 25.1 $ 37.7 $ 78.0 $ 104.5
====== ====== ====== ======
Earnings per share:
Basic, as reported $ .30 $ .43 $ .94 $ 1.20
Basic, pro forma $ .27 $ .40 $ .85 $ 1.09
Diluted, as reported $ .30 $ .42 $ .93 $ 1.17
Diluted, pro forma $ .27 $ .39 $ .84 $ 1.06
5. Accounts receivable valuation allowances for client-specific items were
$39.4 million and $36.5 million as of September 30, 2004 and December
31, 2003, respectively. These valuation allowances for matters such as
performance guarantees and claim, eligibility and data adjustments,
are netted against the gross accounts receivable balance in the
consolidated balance sheets. The Company's largest client, Mail
Handlers Benefit Plan ("MHBP" or the "Plan"), generated revenue of
approximately $51.3 million and $152.9 million (23% of total revenue)
during the three and nine months ended September 30, 2004,
respectively, compared to $63.2 million and $169.3 million in revenues
(29% and 26% of total revenues, respectively) during the comparable
periods of 2003. As previously reported, the Company recorded $8
million of revenue in third quarter of 2003 related to the internal
reconciliation of 2002 MHBP claims and the Company recorded $3 million
of revenue in the second quarter of 2004 related to the internal
reconciliation of 2003 MHBP claims.
6. Allowances for doubtful accounts were $17.5 million and $21.1 million
as of September 30, 2004 and December 31, 2003, respectively. The
allowances for doubtful accounts are established based on historical
experience and current economic circumstances and are adjusted monthly
based upon updated information.
7. The Company's investments in marketable securities, which are
classified as available for sale, had a net unrealized loss in market
value of $0.3 million, net of deferred income taxes, for the nine month
period ended September 30, 2004. The accumulated net unrealized loss as
of September 30, 2004, included as a component of stockholders' equity,
was $0.2 million, net of deferred income taxes. The Company has eight
separate investments in a limited liability company that invests in
equipment that is leased to third parties. The total investment as of
September 30, 2004 and December 31, 2003 was $62.6 million and $59.0
million, respectively, and is accounted for using the equity method.
The Company's proportionate share of the partnership's income was $2.5
million and $2.1 million for the nine months ended September 30, 2004
and 2003, respectively, and is included in interest income. The total
investment recorded at September 30, 2004 and December 31, 2003 is net
of an unrealized loss on interest rate swaps of $0.5 million (net of
$0.2 million in related taxes) and $2.2 million (net of $1.3 million in
related taxes), respectively, which is recorded in accumulated other
comprehensive income. A member of the Company's Board of Directors is
associated with a group that owns approximately 90% of this
partnership. The Company has between a 20% and 25% interest in the
limited partners share of each individual tranche of the partnership
(approximately 10% of the total partnership). The partnership had $1.3
billion in total assets as of September 30, 2004.
8. In 2003 the Company's Board of Directors approved the repurchase of up
to 5 million shares of the Company's outstanding common stock. The
Board had previously approved the repurchase of up to 10 million shares
of common stock. Purchases may be made from time to time, depending on
market conditions and other relevant factors. The Company did not
repurchase any shares during the nine months ended September 30, 2004.
During the nine months ended September 30, 2003, the Company
repurchased 6.2 million shares (1.0 million shares in the third
quarter) on the open market for approximately $153.3 million ($27.8
million in the third quarter). The actual cash paid of $149.8 million
excludes $3.4 million for trades dated in September that were settled
in the first 3 days of October. As of September 30, 2004, approximately
6.1 million shares remain available for repurchase under the Company's
current repurchase authorization. The Company has agreed that it will
not repurchase any common stock prior to the closing of its proposed
Merger (See Note 13).
9. Weighted average shares outstanding for the diluted earnings per share
calculation increased by 1.0 million and 1.4 million and by 2.3 million
and 2.5 million for the three and nine months ended September 30, 2004
and 2003, respectively, due to the effect of stock options outstanding.
Diluted net income per share was the same as basic net income per share
for the three months ended September 30, 2004. Diluted net income per
share was $.01 less than basic net income per share for the three
months ended September 30, 2003, due to the effect of stock options
outstanding. Diluted net income per share was $.01 less than basic net
income per share for the nine months ended September 30, 2004 and $.03
less than basic net income per share for the nine months ended
September 30, 2003, due to the effect of stock options outstanding.
10. Effective January 1, 2003, the Company adopted Statement of Financial
Accounting Standards No. 146 ("SFAS 146"), "Accounting for Costs
Associated with Exit or Disposal Activities", which requires companies
to recognize costs associated with exit or disposal activities when
they are incurred rather than at the date of a commitment to an exit or
disposal plan. Examples of costs covered by the standard include lease
termination costs and certain employee severance costs that are
associated with a restructuring, discontinued operation, or other exit
or disposal activity. During the quarter ended March 31, 2004, the
Company initiated a plan to terminate approximately 200 employees for a
total cost of $1.4 million in termination benefits. The plan was
completed in the third quarter of 2004. Substantially all of the
termination costs were incurred in the first quarter of 2004. This
termination plan was solely for the Commercial segment of the Company.
11. A purported class action lawsuit was filed on October 20, 2004 against
Coventry Health Care, Inc. ("Coventry"), the Company and the Company's
Board of Directors in the Circuit Court of Cook County, Illinois
following the announcement that the Company had entered into the Merger
Agreement with Coventry (See Note 13). The plaintiff in this litigation
alleges, among other things, that the Company and its Board of
Directors breached their fiduciary duties by entering into the Merger
Agreement with Coventry and seeks to represent a class consisting of
all of the Company's stockholders who were allegedly harmed by such
action. The plaintiff seeks to enjoin the consummation of the Merger
Agreement, the imposition of a constructive trust in favor of the
plaintiff, and an award of attorneys' and experts' fees. The Company
believes the plaintiff's allegations are without merit and intends to
vigorously defend this litigation.
The Company and its subsidiaries are also subject to various claims
arising in the ordinary course of business and are parties to various
legal proceedings that constitute litigation incidental to the business
of the Company and its subsidiaries. The Company does not believe that
the outcome of such matters will have a material effect on the
Company's financial position, results of operations or cash flows.
The provisions of the contract with the Plan's sponsor, the National
Postal Mail Handlers Union, require that the Company fund any deficits
in the Plan after the Plan's reserves have been fully utilized. As of
September 30, 2004, the Plan has approximately $378 million in reserves
to cover Plan expenses, which may exceed the premiums charged and
collected from the Plan participants by the Plan sponsor. The Plan had
approximately $346 million in such reserves as of December 31, 2003.
There are no known Plan deficits as of September 30, 2004.
FASB Interpretation No. 45, "Guarantees, Including Indirect Guarantees
of Indebtedness to Others," requires the Company to disclose certain
guarantees, including contractual indemnifications, it has assumed. The
Company generally declines to provide indemnification to its customers.
In limited circumstances, to secure long-term customer contracts at
favorable rates, the Company may negotiate risk allocation through
mutual indemnification provisions that, in the Company's judgment,
appropriately allocate risk relative to the value of the customer.
Management believes that any liability under these indemnification
provisions would not be material.
12. The Company operates in two segments: Commercial and Public Sector. In
the Commercial segment, the Company often bundles its products and
services to offer a comprehensive health benefits solution to the
customer centered around the First Health [R] Network. In the Public
Sector segment, the Company offers products and services more
specialized to the needs of the individual customer as public sector
health programs move toward more efficient utilization of health
services. The Company has one executive management team that reviews
and approves all strategic and resource allocations for each of the two
segments. Discreet financial information is available for each of the
two segments and is reviewed regularly by the chief operating decision
maker.
The Company calculates income from operations and net income for each
segment consistent with the accounting policies for the consolidated
financial statements. Interest expense for the Company's credit
facility is charged primarily to the Commercial segment. The Commercial
segment also includes the Company's treasury, legal, tax and other
similar corporate functions. Income taxes are computed using the
consolidated income tax rate of the Company.
Summarized segment financial information for the three and nine months
ended September 30 is as follows:
Three months ended September 30,
--------------------------------
2004 2003
-------------------------------- --------------------------------
Public Public
(in millions) Commercial Sector Consolidated Commercial Sector Consolidated
------------- ---------- ------ ------------ ---------- ------ ------------
Revenue $173.4 $ 45.0 $ 218.4 $177.0 $ 42.7 $219.7
Net income 25.8 1.8 27.6 39.4 1.3 40.7
Total assets $974.4 $ 47.7 $1,022.1 $847.6 $ 39.8 $887.4
Nine months ended September 30,
-------------------------------
2004 2003
-------------------------------- --------------------------------
Public Public
(in millions) Commercial Sector Consolidated Commercial Sector Consolidated
------------- ---------- ------ ------------ ---------- ------ ------------
Revenue $530.4 $126.9 $ 657.3 $525.6 $126.5 $652.1
Net income 84.1 2.4 86.5 110.1 4.6 114.7
Total assets $974.4 $ 47.7 $1,022.1 $847.6 $ 39.8 $887.4
Included in the Commercial segment for the three and nine months ended
September 30, 2004, is $0.8 million, net of related taxes, of expenses
related to the Company's proposed merger (see Note 13).
13. On October 14, 2004, the Company announced that it had entered into an
Agreement and Plan of Merger, dated October 13, 2004 (the "Merger
Agreement"), with Coventry pursuant to which the Company will merge
with and into a wholly owned subsidiary of Coventry (the "Merger").
Pursuant to the Merger Agreement, at the effective time of the Merger,
each outstanding share of Company common stock will be converted
(except for shares held in the treasury of the Company or owned by a
stockholder who properly demands appraisal rights) into and represent
the right to receive 0.1791 shares of Coventry common stock and $9.375
in cash. The Merger Agreement has been approved by the Company's Board
of Directors and the Merger is expected to close in the first quarter
of 2005, subject to the approval of the Company stockholders,
regulatory approvals and other customary conditions.
First Health Group Corp. and Subsidiaries
Item 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
(Unaudited)
-----------------------------------------------------------------------------
Forward-Looking Information
---------------------------
This Management's Discussion and Analysis of Financial Condition and
Results of Operations may include certain 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, including
(without limitation) statements with respect to anticipated future operating
and financial performance, growth and acquisition opportunities and other
similar forecasts and statements of expectation. Words such as "expects",
"anticipates", "intends", "plans", "believes", "seeks", "estimates", "could"
and "should" and variations of these words and similar expressions, are
intended to identify these forward-looking statements. Forward-looking
statements made by the Company and its management are based on estimates,
projections, beliefs and assumptions of management at the time of such
statements and are not guarantees of future performance. The Company
disclaims any obligation to update or revise any forward-looking statement
based on the occurrence of future events, the receipt of new information or
otherwise.
Actual future performance, outcomes and results may differ materially
from those expressed in forward-looking statements made by the Company and
its management as a result of a number of risks, uncertainties and
assumptions. Representative examples of these factors include (without
limitation) the effect of the Merger Agreement with Coventry (defined
below); general industry and economic conditions; interest rate trends; cost
of capital and capital requirements; competition from other managed care
companies; customer contract cancellations; the ability to expand certain
areas of the Company's business; shifts in customer demands; changes in
operating expenses, including employee wages, benefits and medical
inflation; governmental and public policy changes and the continued
availability of financing in the amounts and on the terms necessary to
support the Company's future business. In addition, if the Company does not
continue to successfully implement new contracts and programs and control
health care benefit expenses, or if the Company does not successfully
integrate its recent acquisitions; then the Company may not achieve its
anticipated 2004 financial results.
Significant Developments
------------------------
Overview
--------
The following information concerning significant business developments is
important to understanding the comparability of the 2004 and 2003 financial
results.
Merger Agreement
----------------
On October 14, 2004, the Company announced that it had entered into an
Agreement and plan of Merger, dated October 13, 2004 (the "Merger
Agreement"), with Coventry Health Care, Inc. ("Coventry"), pursuant to which
the Company will merge with and into a wholly owned subsidiary of Coventry
(the "Merger").
Pursuant to the Merger Agreement, at the effective time of the Merger,
each outstanding share of Company common stock will be converted (except for
shares held in the treasury of the Company or owned by a stockholder who
properly demands appraisal rights) into and represent the right to receive
0.1791 shares of Coventry common stock and $9.375 in cash. The Merger
Agreement has been approved by the Company's Board of Directors and the
Merger is expected to close in the first quarter of 2005, subject to the
approval of the Company stockholders, regulatory approvals and other
customary conditions.
In conjunction with this Merger, the Company recorded $0.8 million in
merger-related expenses, net of related taxes, during the quarter ended
September 30, 2004. These expenses reduced earnings per share for the three
and nine months ended September 30, 2004 by approximately $.01.
The Merger is subject to approval by the Company's stockholders, but
there is no assurance that the Merger will be successfully completed. In the
event that the Merger is not successfully completed, the Company may be
subject to a number of material risks, including the following:
* failure to complete the Merger may seriously harm investors'
and analysts' perception of our underlying business and
prospects which could seriously harm our stock price;
* the Company may be required to pay Coventry a termination fee
of up to $59.7 million if the Merger Agreement is terminated
under specified circumstances;
* the price of the Company common stock may decline to the
extent that the current market price for the common stock
reflects a market assumption that the proposed Merger will be
completed;
* costs related to the proposed Merger, such as legal,
accounting, financial advisory and financial printing fees
must be paid by the Company, even if the Merger is not
completed; and
* the Merger has diverted management attention and resources
In addition, in the event that the Merger is not completed and the Board
of Directors of the Company determines to seek another merger or business
combination, it may not be able to find a partner willing to pay an
equivalent or more attractive price than that which would have been paid in
the proposed merger with Coventry.
Mail Handlers Benefit Plan
--------------------------
The Mail Handlers Benefit Plan ("MHBP" or the "Plan") is part of the
Company's Federal Employee Health Benefit Plan ("FEHBP") sector and the
Company's largest customer. Revenue was $51.3 million and $152.9 million
(approximately 23 % of total Company revenue) during the three and nine
months ended September 30, 2004, respectively, as compared to $63.2 million
and $169.3 million during the comparable periods of 2003 (29% and 26% of
total revenue, respectively). Adjustments to revenue are recorded on a
client specific and aggregated basis based on empirical data in each period
and may be subject to further adjustments in subsequent periods. The Company
previously disclosed that second quarter 2004 revenue includes $3 million
related to its internal claims reconciliation process for 2003 claims and
2003 revenue in the third quarter includes $8 million related to the
reconciliation of 2002 MHBP claims.
The adjustments resulted primarily from factors that the Company has
historically used in its internal claims reconciliation process. The
internal reconciliation process involves reconciling fees and savings
associated with each medical claim, the eligibility of each Plan member, the
allowability of each claim in relation to the Plan definition and the
coordination of benefits with other insurers. In addition, the MHBP may
include an audit performed by a governmental agency within each five year
period after a fiscal year end. This retrospective review of claims data may
result in changes to previous estimates made for eligibility, coordination
of benefits and other Plan provisions. See the "Critical Accounting
Policies" section for a further description of revenue adjustments.
The provisions of the contract with the Plan's sponsor, the National
Postal Mail Handlers Union, require that the Company fund any deficits in
the Plan after the Plan's reserves have been fully utilized. As of September
30, 2004, the Plan has approximately $378 million in reserves to cover Plan
expenses that may exceed the premiums charged and collected from the Plan
participants by the Plan sponsor. The Plan had approximately $358 million
and $346 million in such reserves as of September 30, 2003 and December 31,
2003, respectively. There are no known Plan deficits as of September 30,
2004.
Acquisitions
------------
On October 31, 2003, the Company completed the acquisition of all of the
outstanding shares of capital stock of Health Net Employer Services, Inc.
("Employer Services") from Health Net, Inc. for approximately $79 million.
The purchase also included Health Net Plus Managed Care Services, Inc. and
Health Net CompAmerica, Inc. Employer Services is a workers' compensation
managed care company based in Irvine, California. The acquisition was
financed with borrowings under the Company's credit facility. Health Net
Employer Services, Inc. has been renamed First Health Employer Services,
Inc.
On October 31, 2003, the Company also completed the acquisition of PPO
Oklahoma for a purchase price of approximately $10 million, subject to
certain purchase price considerations. The Company paid an additional $1
million in the third quarter of 2004 as part of the purchase price
considerations and increased goodwill. PPO Oklahoma operates almost
exclusively in the state of Oklahoma. The acquisition was financed with
borrowings under the Company's credit facility.
On April 7, 2004, the Company completed the acquisition of COMP Medical,
a workers' compensation company headquartered in Woodland Hills, California
that specializes in appointment setting for chronic pain management,
diagnostic imaging and electrodiagnostic procedures, as well as Medicare
set-aside allocations. The purchase price was approximately $6 million,
subject to additional purchase price considerations depending on future
performance, and was paid with cash from operating activities. COMP Medical
has been renamed First Health Priority Services, Inc. ("FHPS").
Termination Plan
----------------
During the quarter ended March 31, 2004, the Company initiated a plan to
terminate approximately 200 employees at an estimated cost of $1.4 million
in termination benefits. The Company recorded and paid substantially all of
these costs during the first quarter of 2004.
Results of Operations
---------------------
The Company's revenues consist primarily of fees for cost management
services provided on a predetermined contractual basis or on a percentage-
of-savings basis. Revenues also include insurance premium revenue from the
Company's insurance company operations.
The following table sets forth information with respect to the sources of
the Company's revenues for the three and nine months ended September 30,
2004 and 2003, respectively:
Sources of Revenue
($ in millions)
Three Months Ended September 30,
--------------------------------
2004 % 2003 %
------ ---- ------ ----
Commercial Revenue:
Group Health:
PPO plus Administration
Services $ 80.3 37% $ 97.1 44%
PPO 32.1 15 36.4 17
Premiums 9.7 4 4.4 2
------ ---- ------ ----
Total Group Health 122.1 56 137.9 63
------ ---- ------ ----
Workers' Compensation:
PPO plus Administration
Services 32.1 15 23.1 11
PPO 19.2 8 16.0 7
------ ---- ------ ----
Total Workers' Compensation 51.3 23 39.1 18
------ ---- ------ ----
Total Commercial Revenue 173.4 79 177.0 81
------ ---- ------ ----
Public Sector Revenue 45.0 21 42.7 19
------ ---- ------ ----
Total Revenue $ 218.4 100% $ 219.7 100%
====== ==== ====== ====
($ in millions)
Nine Months Ended September 30,
--------------------------------
2004 % 2003 %
------ ---- ------ ----
Commercial Revenue:
Group Health:
PPO plus Administration
Services $ 244.5 37% $ 277.1 43%
PPO 99.9 15 116.2 18
Premiums 28.2 5 12.8 2
------ ---- ------ ----
Total Group Health 372.6 57 406.1 63
------ ---- ------ ----
Workers' Compensation:
PPO plus Administration
Services 95.9 15 73.3 11
PPO 61.9 9 46.2 7
------ ---- ------ ----
Total Workers' Compensation 157.8 24 119.5 18
------ ---- ------ ----
Total Commercial Revenue 530.4 81 525.6 81
------ ---- ------ ----
Public Sector Revenue 126.9 19 126.5 19
------ ---- ------ ----
Total Revenue $ 657.3 100% $ 652.1 100%
====== ==== ====== ====
Supplemental Revenue Information
The following table sets forth supplemental information by revenue
sector:
($ in millions)
Three Months Ended September 30,
--------------------------------
2004 % 2003 %
------ ---- ------ ----
Commercial Revenue:
Group Health:
FEHBP $ 58.0 27% $ 71.9 33%
Corporate 39.4 18 47.8 22
Insurers/TPA 24.7 11 18.2 8
------ ---- ------ ----
Total Group Health 122.1 56 137.9 63
------ ---- ------ ----
Workers' Compensation 51.3 23 39.1 18
------ ---- ------ ----
Total Commercial 173.4 79 177.0 81
------ ---- ------ ----
Public Sector 45.0 21 42.7 19
------ ---- ------ ----
Total Revenue $ 218.4 100% $ 219.7 100%
====== ==== ====== ====
($ in millions)
Nine Months Ended September 30,
--------------------------------
2004 % 2003 %
------ ---- ------ ----
Commercial Revenue:
Group Health:
FEHBP $ 173.9 27% $ 193.7 30%
Corporate 123.8 19 150.9 23
Insurers/TPA 74.9 11 61.5 10
------ ---- ------ ----
Total Group Health 372.6 57 406.1 63
------ ---- ------ ----
Workers' Compensation 157.8 24 119.5 18
------ ---- ------ ----
Total Commercial 530.4 81 525.6 81
------ ---- ------ ----
Public Sector 126.9 19 126.5 19
------ ---- ------ ----
Total Revenue $ 657.3 100% $ 652.1 100%
====== ==== ====== ====
This supplemental revenue data provides information about the mix of
clients within the Company's revenue sectors. In addition to the
supplemental information above, the Company has generated approximately 38 %
and 39% of total Company revenues on a percentage-of-savings basis for the
three and nine months ended September 30, 2004, respectively, compared to
41% and 40% for the comparable periods of 2003.
Total revenue for the three and nine months ended September 30, 2004
decreased $1.4 million (0.6%) and increased $5.1 million (0.8%) from the
comparable periods of 2003. The components of the Company's quarterly
revenue are as follows:
Group Health revenue of $122.1 million and $372.6 million for the three
and nine months ended September 30, 2004 decreased $15.9 million (11.5%) and
$33.6 million (8.3%) from the comparable periods of 2003. Group Health
revenue represents revenue from the corporate, FEHBP, small group carrier
and third party administrator payors. Group Health PPO plus Administration
Services revenue for the three and nine months ended September 30, 2004
decreased $16.8 million (17.3%) and $32.6 million (11.8%) from the
comparable periods of 2003 due in part to increased price competition, less
new business and higher client attrition than expected. Group Health PPO
revenue for the three and nine months ended September 30, 2004 decreased
$4.3 million (11.9%) and $16.3 million (14.1%) from the comparable periods
of 2003 due primarily to clients taking advantage of a wider array of the
Company's services (which is reported under PPO plus Administration
Services). Premium revenue for the three and nine months ended September 30,
2004 increased $5.3 million (119.3%) and $15.4 million (120.8%) from the
comparable periods of 2003 as a result of new client activity, particularly
due to the New England Financial ("NEF") block of small group, multi-sited
business the Company assumed in the fourth quarter of 2003. The Company
ceded 80% of the premiums and related policy benefits to a highly-rated
insurance carrier.
Group Health revenue is further broken down into the FEHBP, Corporate and
Insurers/TPA sectors. FEHBP sector revenue for the three and nine months
ended September 30, 2004 decreased $13.9 million (19.4%) and $19.8 million
(10.2%) from the comparable periods of 2003. This decrease is due primarily
to the MHBP which experienced an approximate 10% decrease in enrollment,
lower participant utilization and a change in the mix of plan options. The
Company previously disclosed it had recorded $8 million of revenue in the
third quarter of 2003 as part of its retrospective review of claims data
related to 2002 MHBP business. The Company also previously disclosed it had
recorded $3 million of revenue in the second quarter of 2004 as part of its
retrospective review of claims data related to 2003 MHBP business. FEHBP
sector revenue increased $0.8 million (1.4%) from the second quarter of 2004
due primarily to billable open season activity for MHBP. Corporate sector
revenue for the three and nine months ended September 30, 2004 decreased
$8.4 million (17.7%) and $27.2 million (18.0%) from the comparable periods
of 2003. This decrease is due to client attrition, less new business than
anticipated and increased price competition in the sector. Corporate sector
revenue decreased $1.0 million (2.5%) from the second quarter of 2004 due
primarily to price competition. Insurers/TPA sector revenue for the three
and nine months ended September 30, 2004 increased $6.5 million (35.7%) and
$13.4 million (21.8%) from the comparable periods of 2003 due primarily to
new business with insurers, principally the NEF business discussed earlier.
Insurers/TPA sector revenue was comparable to the second quarter of 2004.
Workers' Compensation revenue of $51.3 million and $157.8 million for the
three and nine months ended September 30, 2004 increased $12.2 million
(31.2%) and $38.3 million (32.0%) from the comparable periods of 2003. This
increase is due to $12.5 million and $43.5 million in revenues earned as a
result of the Employer Services and FHPS acquisitions for the three and nine
months ended September 30, 2004, respectively. Workers' Compensation revenue
decreased $4.2 million (7.5%) from the second quarter of 2004 due primarily
to less new business and revenue delays as several large workers'
compensation clients made changes to their processes and systems related to
recent regulatory reforms in California.
Public Sector revenue of $45.0 million and $126.9 million for the three
and nine months ended September 30, 2004 increased $2.3 million (5.3%) and
$0.4 million (0.3%) from the comparable periods of 2003. Public Sector
revenue represents fees associated with pharmacy benefit management, fiscal
agent services and health care management from clients within the public
sector. This increase in revenue is due primarily to new pharmacy contracts.
Public Sector revenue in the third quarter of 2003 had been favorably
impacted by $9.0 million of non-recurring implementations (for HIPAA support
and other systems implementations) compared to $0.3 million of such revenue
in the third quarter of 2004. Absent the non-recurring business, the 2004
quarterly revenue would have increased $11.0 million or 32.7% from the
comparable quarter of 2003. Public Sector revenue increased $2.3 million
(5.5%) from the second quarter of 2004 due to new pharmacy contracts.
Cost of services increased $5.6 million (5.6%) and $20.6 million (7.0%)
for the three and nine months ended September 30, 2004 from the comparable
periods in 2003 due primarily to costs associated with the Employer
Services, PPO Oklahoma and FHPS acquisitions partially offset by savings
associated with improved efficiency and staff reductions. Cost of services
decreased $0.7 million (0.6%) from the second quarter of 2004 consistent
with the Company's cost savings initiatives. Cost of services consists
primarily of salaries and related costs for personnel involved in claims
administration, PPO administration, development and expansion, utilization
management programs, fee schedule and other cost management and
administrative services offered by the Company. To a lesser extent, cost of
services includes telephone expenses, facility expenses and information
processing costs. As a percentage of revenue, cost of services increased to
47.7% and 48.0% for the three and nine months ended September 30, 2004,
respectively, from 44.9% and 45.2% in the comparable periods of 2003, and
increased slightly from 47.5% in the second quarter of 2004. The increase as
a percentage of revenue from each comparable period in 2003 is due primarily
to the costs associated with the various acquisitions as well as a trend
toward providing more administrative services that are more cost-intensive.
The increase from the second quarter of 2004 is due primarily to expenses
related to open enrollment as well as lower workers' compensation revenues
previously discussed.
Selling and marketing costs for the three and nine months ended September
30, 2004 increased $1.1 million (4.9%) and $0.5 million (0.7%) from the
comparable periods in 2003 primarily due to costs associated with the
Company's MHBP enrollment campaign. Selling and marketing costs increased
$3.5 million (17.0%) from the second quarter of 2004 also due primarily to
costs associated with the MBHP enrollment campaign. The majority of the
2004 enrollment costs were incurred in the third quarter of 2004 while the
2003 expenses were incurred more ratably over the year.
General and administrative costs for the three and nine months ended
September 30, 2004 increased $3.0 million (18.6%) and $11.1 million (23.9%)
from the comparable periods in 2003 due primarily to increases in
professional liability insurance and other professional fees associated with
cost savings initiatives incurred in the first half of 2004. General and
administrative costs decreased slightly from the second quarter of 2004 due
primarily to less 401K expenses due to forfeitures.
Health care benefits represent medical losses incurred by insureds of the
Company's insurance entities. Health care benefits increased $1.8 million
(41.0%) and $5.9 million (41.8%) for the three and nine months ended
September 30, 2004 from the comparable periods of 2003. This increase was
due primarily to new business, particularly the NEF business discussed
above. Health care benefits decreased $1.0 million (13.2%) from the second
quarter of 2004 due primarily to improved experience in the Company's stop
loss business. The loss ratio (health care benefits as a percent of premium
revenue) was 65% and 71% for the three and nine months ended September 30,
2004 compared to 101% and 110% for the comparable periods of 2003. The
decrease in the loss ratio from 2003 is due primarily to improved experience
in the Company's stop loss business and the NEF small group business.
Management reviews the book of business in detail on a monthly basis to
minimize the loss ratio. Stop-loss insurance is related to the PPO and
claims administration businesses and is used as a way to attract additional
PPO business, which is the Company's most profitable product.
Depreciation and amortization expenses increased $4.1 million (26.2%) and
$11.3 million (24.5%) for the three and nine months ended September 30, 2004
from the comparable periods in 2003 due primarily to increased software
investments made over the course of the past few years, and, to a lesser
extent, amortization of intangible assets related to the various
acquisitions the Company has made. Depreciation expense is expected to
continue to grow primarily as a result of continuing investments the Company
is making in its infrastructure.
Income from operations of $43.5 million and $139.0 million for the three
and nine months ended September 30, 2004 decreased $18.3 million (29.7%) and
$45.6 million (24.7%) from the comparable periods of 2003. Income from
operations decreased $5.6 million (11.4%) from the second quarter of 2004.
These results include $1.3 million of pre-tax, merger-related expenses
recorded in the quarter ended September 30, 2004. Operating margin (income
from operations as a percentage of revenue) was 19.9% in the third quarter
of 2004, 28.1% in the third quarter of 2003 and 22.2% in the second quarter
of 2004. The decrease in income from operations and operating margins from
2003 is due to a change in the mix of revenue to lower-margin administrative
services business as well as expenses the Company incurred in the first half
of 2004 associated with cost savings initiatives. The decrease in income
from operations and operating margins from the second quarter of 2004 is due
primarily to the decrease in Workers' Compensation revenue.
Interest income for the three and nine months ended September 30, 2004 is
comparable to prior periods as the Company has repaid $75 million of debt
rather than increasing its investments.
Interest expense for the three and nine months ended September 30, 2004
increased $0.5 million (38.3%) and $1.3 million (32.9%) from the comparable
periods in 2003. Interest expense has increased as the outstanding debt
increased from $155 million at September 30, 2003 to $195 million at
September 30, 2004 and the effective borrowing rate has risen. The effective
marginal interest rate on September 30, 2004 was approximately 2.7% per
annum.
The Company's effective tax rate was 36% and 37.4% for the three and nine
months ended September 30, 2004, respectively, compared to 34.5% and 38%
for the same periods in 2003. The Company recorded $0.8 million in
additional tax credits in the third quarter of 2004 that reduced its annual
effective tax rate from 38%.
Diluted net income per common share for the three and nine months ended
September 30, 2004 decreased 28.6% to $.30 per share and 20.5% to $.93,
respectively, per share from the comparable periods of 2003. The decrease in
net income per common share was due primarily to the change in revenue mix
and the expenses associated with cost savings initiatives discussed above.
For the three and nine months ended September 30, 2004, diluted common
shares outstanding decreased 4.4% and 5.4%, respectively, from the
comparable periods of 2003.
Segment Information
-------------------
The Company reports its financial results under two segments: the
Commercial segment, where the Company provides its health benefit services
to Commercial customers in the Group Health and Workers' Compensation
markets, and the Public Sector segment, where the Company services are
provided to customers within state and local governments. The Commercial
Group Health market represents payors from the FEHBP, corporate and third
party administrators/insurers sectors. Management believes this presentation
reflects how the Company markets and sells its products and services. In the
Commercial sector, the Company often bundles its products and services to
offer a comprehensive health benefits solution, and it does not sell
administrative services (claims administration, bill review, pharmacy
benefit management, clinical management) on a stand-alone basis without PPO
network services. In the Public Sector, the Company offers products and
services more specialized to the needs of the individual customer as public
sector health programs move toward more efficient utilization of health
services. The Commercial sector includes the $1.3 million in pre-tax merger-
related expenses recorded in the third quarter of 2004.
Three months ended Nine months ended
September 30, September 30,
Commercial ----------------- ------------------
($ in millions) 2004 2003 2004 2003
---------------------- ------ ------ ------ ------
Revenues $ 173.4 $ 177.0 $ 530.4 $ 525.6
Operating expenses 132.8 117.1 395.3 348.4
------ ------ ------ ------
Income from operations 40.6 59.9 135.1 177.2
------ ------ ------ ------
Operating margin 23.5% 33.9% 25.5% 33.7%
Interest income (1.4) (1.6) (4.3) (4.3)
Interest expense 1.6 1.2 5.1 3.9
------ ------ ------ ------
Income before income taxes 40.4 60.3 134.3 177.6
Income taxes (14.6) (20.9) (50.2) (67.5)
------ ------ ------ ------
Net income $ 25.8 $ 39.4 $ 84.1 $ 110.1
====== ====== ====== ======
The decline in income from operations and net income for the Commercial
segment is due to a number of factors including: increased price competition
(particularly in the Corporate sector); new business in the lower margin
third party administrator/insurance sector; lower PPO savings in the FEHBP
sector; and the costs incurred associated with savings initiatives. The
Commercial segment has also experienced less new business in its Workers'
Compensation revenue, and some clients had system conversion problems
inherent in their businesses, partially due to regulatory reforms in
California.
Three months ended Nine months ended
September 30, September 30,
Public Sector ----------------- ------------------
($ in millions) 2004 2003 2004 2003
---------------------- ------ ------ ------ ------
Revenues $ 45.0 $ 42.7 $ 126.9 $ 126.5
Operating expenses 42.1 40.8 123.0 119.1
------ ------ ------ ------
Income from operations 2.9 1.9 3.9 7.4
------ ------ ------ ------
Operating margin 6.2% 4.3% 3.0% 5.8%
Interest expense -- -- -- --
------ ------ ------ ------
Income before income taxes 2.9 1.9 3.9 7.4
Income taxes (1.1) (0.6) (1.5) (2.8)
------ ------ ------ ------
Net income $ 1.8 $ 1.3 $ 2.4 $ 4.6
====== ====== ====== ======
The decline in income from operations and net income in the Public Sector
segment is due primarily to the decline in non-recurring HIPAA support and
other systems implementations discussed earlier. The revenue and
profitability is expected to increase going forward in 2004, as the pharmacy
benefit management ("PBM") business grows and efficiency initiatives are put
in place to help control costs. The Company has won 14 of its last 16
contract bids for PBM services within the Public Sector. PBM business is
higher-margin business and now represents more than half of the Public
Sector revenue.
Liquidity and Capital Resources
-------------------------------
The Company had $38.2 million in working capital on September 30, 2004
compared with working capital of $24.1 million at December 31, 2003. Total
cash and investments amounted to $163.8 million at September 30, 2004
compared to $139.7 million at December 31, 2003.
Cash flow from operations for the nine months ended September 30, 2004
decreased $6.8 million from 2003 due to lower net income, partially offset
by positive cash flow effects for the timing of collections of accounts
receivable and the timing of payment of the Company's tax-related
liabilities. Accounts receivable collection efforts in 2004 provided $3.0
million of cash in 2004 versus a use of $16.8 million of cash in 2003. Cash
collected from the exercise of stock options has declined from prior years.
The Company's most significant uses of cash continue to be for payment of
operating expenses, income taxes and capital expenditures. Management
currently expects that capital expenditures for 2004 will be approximately
8% of revenues or $75 million, slightly below the 10% average capital
investment of the past several years.
The Company's outstanding debt at September 30, 2004 decreased to $195
million from $270 million at December 31, 2003 as the Company used cash
generated from operations to pay down debt.
The following table summarizes the contractual obligations the Company has
outstanding as of September 30, 2004:
(in millions) Payments due by period
----------------------
Less than 1-3 3-5 Over 5
Contractual Obligations Total 1 year years years years
----------------------- ----- ------ ----- ----- -----
Long-term debt $195.0 $ -- $195.0 $ - $ -
Operating leases 52.0 14.3 20.6 12.8 4.3
Purchase obligations 0.5 0.5 - - -
----- ----- ----- ----- -----
Total $247.5 $14.8 $215.6 $ 12.8 $ 4.3
===== ===== ===== ===== =====
The purchase obligation is a commitment to a limited partnership
investment. The Company has no capital lease obligations, off-balance sheet
financing arrangements or other contractual obligations as of September 30,
2004. The long-term debt obligation excludes any related interest expense
and fees.
The Company believes that its working capital, long-term investments,
credit facility and cash generated from future operations will be sufficient
to fund the Company's anticipated operations and expansion plans.
In accordance with FASB Interpretation No. 45 ("FIN 45"), "Guarantees,
Including Indirect Guarantees of Indebtedness to Others", the Company is
required to disclose certain guarantees, including contractual
indemnifications, it has assumed. The Company generally declines to provide
indemnification to its customers. In limited circumstances, to secure long-
term customer contracts at favorable rates, the Company may negotiate risk
allocation through mutual indemnification provisions that, in the Company's
judgment, appropriately allocate risk relative to the value of the customer.
As of September 30, 2004 management believes that any liability under these
indemnification provisions would not be material.
2004 Outlook
------------
The Company expects full year 2004 earnings to be in the range of $1.25
to $1.28 per share excluding the costs and expenses related to the proposed
transaction with Coventry and professional fees for settlement of tax-
related services previously negotiated on a contingent fee basis. The costs
for these two issues are expected to aggregate to approximately $.10 per
share in 2004. Additionally, this guidance excludes any amounts for the
Merger Agreement's provision for settlement of the Company's outstanding
stock options, which cannot be estimated at this time. The earnings guidance
is reduced from prior quarters primarily due to less new business and
revenue delays in the Workers' Compensation sector. Although the recent
regulatory reforms in California have lead to delays in 2004 revenue,
management believes these reforms will have a significant positive effect on
revenue in 2005.
Critical Accounting Policies
----------------------------
The consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America and
include amounts based on management's prudent judgments and estimates.
Management believes that any reasonable deviation from these judgments and
estimates would not have a material impact on the Company's financial
position or results of operations. To the extent that the estimates used
differ from actual results, adjustments to the statement of operations and
the balance sheet would be necessary. Some of the more significant estimates
include the recognition of revenue, allowance for doubtful accounts and
insurance claim reserves. The Company uses the following techniques to
determine estimates:
Revenue recognition - Significant estimates used in recognizing revenue
relate to performance guarantees, other client-specific claim, eligibility
and other data adjustments. Adjustments to PPO savings, and, therefore, PPO
revenues, occur due to client corrections of member eligibility data as
originally submitted or due to certain clients' inability to resubmit claims
adjustments to the Company's repricing system. In addition, the Company
performs a claims reconciliation process which varies client-by-client and,
in some cases, such as with the MHBP, is performed a number of months after
year-end. The claims reconciliation process is affected by a number of items
including: size of enrollment; volume of claims data; a client's
technological infrastructure; structure of the benefit plan(s); and the
specific terms of the client contract. MHBP is the Company's largest client
and presents a complex combination of these items above which results in a
lengthy reconciliation process. The Company records adjustments in the
current accounting period; further adjustments may be made in future periods
based on new information that becomes available in such future periods. In
some cases, such as with the MHBP, the adjustment process is also subject to
an external audit performed by a governmental agency. The use of such
estimates and the claims reconciliation process enables the Company to
report PPO fee revenue more accurately as information becomes available to
support entitlement to fees, net of actual adjustments. Revenue adjustments
are estimated on a client-specific and aggregated basis using actual,
historical adjustment data. Valuation allowances recorded for such matters
were $39.4 million at September 30, 2004 and $36.5 million at December 31,
2003. Total adjustments to revenue amounted to a reduction of less than 1%
of total Company revenue for the nine months ended September 30, 2004 and an
addition to revenues of less than 1% for the nine months ended September 30,
2003.
Allowance for doubtful accounts - The Company provides reserves for
uncollectible revenue due to client collectibility issues as an allowance
for doubtful accounts. The primary reasons for nonpayment of these accounts
receivable are client bankruptcy, insolvency or disputes over eligibility.
The methodology for calculating the allowance for doubtful accounts includes
an assessment of specific receivables that are aged and an assessment of the
aging of the total receivable pool. Substantially all of the Public Sector
revenue is received from state and local governments. The Company's
experience with recovering receivables related to Public Sector revenue is
impacted primarily by contract disputes, changes in administrative personnel
and the timing of fiscal appropriations relative to the billing of our
services. The reserving methodology for Public Sector receivables provides
for a longer collection period compared to Commercial receivables. The
Company evaluates the recoverability of Public Sector receivables based on
the aging of receivables, with additional consideration given to clients
with known fiscal appropriations issues. The allowance for doubtful accounts
totaled $17.5 million at September 30, 2004 and $21.1 million at December
31, 2003.
Insurance claim reserves - Claims reserves are developed based on medical
claims payment history adjusted for specific benefit plan elements (such as
deductibles) and expected savings generated by utilization of The First
Health [R] Network. Based upon this process, management believes that the
insurance claims reserves are appropriate; however, actual claims incurred
and actual settlement values of claims may differ from the original
estimates requiring adjustments to the reserves.
New Accounting Pronouncements
-----------------------------
In March 2004, the FASB Task Force reached a consensus on Issue No. 03-1
("Issue 03-1"), "The Meaning of Other-Than-Temporary Impairment and its
Application to Certain Investments." Issue 03-1 provides guidance for
determining when an investment is other-than-temporarily impaired. In
September 2004, the FASB voted to defer the effective date of certain
paragraphs in Issue 03-1 pending the issuance of a final FASB position
relating to guidance on implementation of Issue 03-01. The Company adopted
the disclosure provisions of Issue 03-1 in 2003. The amount of any other-
than-temporary impairment that may need to be recognized upon adoption of
Issue 03-1 will be dependent on market conditions and management's intent
and ability at the time of the impairment evaluation to hold the underwater
investments until a forecasted recovery in fair value up to (or beyond)
adjusted cost.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
----------------------------------------------------------
The Company's market risk exposure as of September 30, 2004 was
consistent with the types of market risk and amount of exposure presented in
its 2003 Annual Report on Form 10-K.
Item 4. Controls and Procedures
-----------------------
The Company maintains disclosure controls and procedures that are
designed to ensure that information required to be disclosed in the
Company's Exchange Act reports is recorded, processed, summarized and
reported within the time periods specified in the Securities and Exchange
Commission's rules and forms and that such information is accumulated and
communicated to the Company's management, including its Chief Executive
Officer and Chief Financial Officer, as appropriate, to allow for timely
decisions regarding required disclosure. In designing and evaluating the
disclosure controls and procedures, management recognizes that any controls
and procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives, and
management is required to apply its judgment in evaluating the cost-benefit
relationship of possible controls and procedures.
As of September 30, 2004, the end of the quarter covered by this
report, management carried out an evaluation, with the participation of the
Company's Chief Executive Officer and Chief Financial Officer, of the
effectiveness of the design and operation of the Company's disclosure
controls and procedures. Based on the foregoing, the Company's Chief
Executive Officer and Chief Financial Officer concluded that the Company's
disclosure controls and procedures were effective at the reasonable
assurance level as of September 30, 2004.
There has been no change in the Company's internal controls over
financial reporting during the Company's most recent fiscal quarter that has
materially affected, or is reasonably likely to materially affect, the
Company's internal controls over financial reporting.
PART II
Item 1. Legal Proceedings
-----------------
A purported class action lawsuit was filed on October 20, 2004 against
Coventry, the Company and the Company's Board of Directors in the Circuit
Court of Cook County, Illinois following the announcement that the Company
had entered into the Merger Agreement with Coventry. The plaintiff in this
litigation alleges, among other things, that the Company and its Board of
Directors breached their fiduciary duties by entering into the Merger
Agreement with Coventry and seeks to represent a class consisting of all of
the Company's stockholders who were allegedly harmed by such action. The
plaintiff seeks to enjoin the consummation of the Merger Agreement, the
imposition of a constructive trust in favor of the plaintiff, and an award
of attorneys' and experts' fees. The Company believes the plaintiff's
allegations are without merit and intends to vigorously defend this
litigation.
The Company and its subsidiaries are also subject to various claims
arising in the ordinary course of business and are parties to various legal
proceedings that constitute litigation incidental to the business of the
Company and its subsidiaries. The Company does not believe that the outcome
of such matters will have a material effect on the Company's financial
position or results of operations.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
-----------------------------------------------------------
The following table summarizes any purchases of the Company common stock
made by or on behalf of the Company for the quarter ended September 30,
2004.
Total # of Maximum # of
shares purchased shares that
as part of may yet be
Total # Average publicly purchased
of shares price paid announced under the
Period purchased per share programs programs
------ --------- --------- -------- ---------
July 1 - July 31 -- -- -- 6,109,841
Aug 1 - Aug 31 -- -- -- 6,109,841
Sept 1 - Sept 30 -- -- -- 6,109,841
--------- --------- -------- ---------
Total -- -- -- 6,109,841
========= ========= ======== =========
Item 5. Other Information
-----------------
There has been no material change to the procedures by which security
holders may recommend nominees to the Company's Board of Directors.
Item 6. Exhibits
--------
(a) Exhibit 3 - Amendment to Restated Certificate of Incorporation
as Filed with the Securities and Exchange Commission
on March 30, 1991.
(b) Exhibit 10.1 - Change in control severance agreement by and between
Edward Wristen and the Company dated August 17, 2004.
(c) Exhibit 10.2 - Change in control severance agreement by and between
Joseph Whitters and the Company dated August 16, 2004.
(d) Exhibit 10.3 - Form of change in control severance agreement by
and between the Company and the following executive
officers: Alton L. Dickerson, Patrick Dills, Susan T.
Smith and Susan Oberling dated August 16, 2004.
(e) Exhibit 10.4 - Change in control severance agreement by and between
Thomas Mastri and the Company dated August 16, 2004.
(f) Exhibit 11 - Computation of Basic Earnings Per Common Share and
Diluted Earnings Per Common Share
(g) Exhibit 31.1 - Certification of Chief Executive Officer pursuant
to Rule pursuant 13a - 14(a) and Rule 15d - 14(a),
promulgated under the Securities Exchange Act of
1934, as amended.
(h) Exhibit 31.2 - Certification of Chief Financial Officer pursuant
to Rule pursuant 13a - 14(a) and Rule 15d - 14(a),
promulgated under the Securities Exchange Act of
1934, as amended.
(i) Exhibit 32.1 - Certification of Chief Executive Officer pursuant
to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes - Oxley Act of 2002.
(j) Exhibit 32.2 - Certification of Chief Financial Officer pursuant
to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes - Oxley Act of 2002.
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.
First Health Group Corp.
Dated: November 5, 2004 /s/Edward L. Wristen
-------------------------------------
Edward L. Wristen
President and Chief Executive Officer
Dated: November 5, 2004 /s/William R. McManaman
-------------------------------------
William R. McManaman
Senior Vice President,
Chief Financial Officer
(Principal Financial Officer)