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AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON MARCH 26, 1999
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
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 0-22585
HEALTHCARE RECOVERIES, INC.
(Exact Name of Registrant as Specified in its Charter)
DELAWARE 61-1141758
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
1400 WATTERSON TOWER
LOUISVILLE, KENTUCKY 40218
(Address of principal executive offices) (Zip Code)
(502) 454-1340
(Registrant's Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act
NAME OF EACH EXCHANGE
TITLE OF EACH CLASS ON WHICH REGISTERED
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None
Securities registered pursuant to Section 12(g) of the Act:
TITLE OF CLASS
Common Stock, par value $.001 per share
(including rights attached thereto)
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 if disclosure of delinquent filers pursuant to Item
405 of regulation S-K is not contained herein, and will not be contained, to be
the best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendments to this Form 10-K. [ ]
As of March 23, 1999, 11,502,987 shares of the registrant's Common Stock,
$0.001 par value were outstanding. The aggregate market value of Registrant's
Common Stock held by non-affiliates of the Registrant as of March 23, 1999 was
approximately $51,763,442 (based on the last sale price of a share of Common
Stock as of March 23, 1999 ($4.50)), as reported by The Nasdaq National Market.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for the Annual Meeting of Stockholders to
be held on May 3, 1999 are incorporated herein by reference in Part III.
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TABLE OF CONTENTS
ITEM: PAGE
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PART I
1. Business.................................................... 1
2. Properties.................................................. 9
3. Legal Proceedings........................................... 9
4. Submission of Matters to a Vote of Security Holders......... 10
Supplementary Item. Certain Risk Factors.................... 10
PART II
5. Market for the Registrant's Common Equity and Related
Stockholder Matters......................................... 10
6. Selected Financial Data..................................... 11
7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 12
7A. Quantitative and Qualitative Market Risk Disclosures........ 20
8. Financial Statements and Supplementary Data................. 20
9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 37
PART III
10. Directors and Executive Officers of the Registrant.......... 37
11. Executive Compensation...................................... 37
12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 37
13. Certain Relationships and Related Transactions.............. 37
PART IV
14. Exhibits, Financial Statement Schedules and Reports on Form
8-K......................................................... 37
THIS FORM 10-K AND OTHER STATEMENTS ISSUED OR MADE FROM TIME TO TIME BY
HEALTHCARE RECOVERIES, INC. OR ITS REPRESENTATIVES CONTAIN STATEMENTS WHICH MAY
CONSTITUTE "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING OF THE SECURITIES ACT
OF 1933, AS AMENDED, AND THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED BY THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995, 15 U.S.C.A. SECTIONS 77Z-2 AND
78U-5 (SUPP. 1996). THOSE STATEMENTS INCLUDE STATEMENTS REGARDING THE INTENT,
BELIEF OR CURRENT EXPECTATIONS OF HEALTHCARE RECOVERIES, INC. AND MEMBERS OF ITS
MANAGEMENT TEAM, AS WELL AS THE ASSUMPTIONS ON WHICH SUCH STATEMENTS ARE BASED.
PROSPECTIVE INVESTORS ARE CAUTIONED THAT ANY SUCH FORWARD-LOOKING STATEMENTS ARE
NOT GUARANTEES OF FUTURE PERFORMANCE AND INVOLVE RISKS AND UNCERTAINTIES, AND
THAT ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE CONTEMPLATED BY SUCH
FORWARD-LOOKING STATEMENTS. IMPORTANT FACTORS CURRENTLY KNOWN TO MANAGEMENT THAT
COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE IN FORWARD-LOOKING
STATEMENTS ARE SET FORTH IN THE SAFE HARBOR COMPLIANCE STATEMENT FOR
FORWARD-LOOKING STATEMENTS INCLUDED AS EXHIBIT 99.1 TO THIS FORM 10-K, AND ARE
HEREBY INCORPORATED BY REFERENCE. HEALTHCARE RECOVERIES, INC. UNDERTAKES NO
OBLIGATION TO UPDATE OR REVISE FORWARD-LOOKING STATEMENTS TO REFLECT CHANGED
ASSUMPTIONS, THE OCCURRENCE OF UNANTICIPATED EVENTS OR CHANGES TO FUTURE
OPERATING RESULTS OVER TIME.
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PART I
ITEM 1. BUSINESS
GENERAL
Healthcare Recoveries, Inc. (the "Company" or "HCRI"), a Delaware
corporation, believes it is the leading independent provider of health insurance
subrogation and related recovery services for private healthcare payors in the
United States, based on the Company's experience and assessment of its market.
HCRI recovers a portion of the value of accident-related healthcare benefits
provided by its clients to insureds when third parties are primarily responsible
for providing such healthcare benefits. The Company offers its services on a
nationwide basis to health maintenance organizations, indemnity health insurers,
self-funded employee health plans, companies that provide claims administration
services to self-funded plans (referred to as "third-party administrators"),
Blue Cross and Blue Shield organizations and provider organized health plans.
Current clients include UnitedHealth Group, Humana Inc., Kaiser Permanente,
NYLCare, The Principal Financial Group, Group Health, Inc. and Prudential
Healthcare. The Company had 40.5 million lives under contract from its clientele
at December 31, 1998, a 5 percent increase from December 31, 1997.
ORGANIZATIONAL STRUCTURE
HCRI was incorporated on June 30, 1988 under the laws of the State of
Delaware. The Company was co-founded by its present Chief Executive Officer and
was initially funded by two venture capital investors. The Company operated as
an independent entity until August 28, 1995, when Medaphis Corporation
("Medaphis"), a Delaware corporation, acquired the Company for approximately
$79.1 million in a stock-for-stock exchange accounted for as a pooling of
interests. Medaphis sold the Company in an initial public offering in May 1997.
The Company is now publicly held and is traded on The Nasdaq National Market
under the symbol "HCRI".
For information concerning business acquisitions effected by HCRI in the
first quarter of 1999. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Recent Developments."
STRATEGY
HCRI intends to pursue a two-fold growth strategy. First, with respect to
its existing subrogation recovery business, HCRI will focus on (i) servicing its
existing client base, (ii) selling and installing those additional lives covered
by contracts with existing clients and (iii) selling and installing new clients
and cross-selling other provided services. HCRI will continue to explore
opportunities to acquire competitors and to expand its client base to include
public sector healthcare payors. Two recent acquisitions have increased the
breadth of services provided by HCRI. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations -- Recent Developments."
Under the second aspect of its growth strategy, HCRI intends to extend its
systems-driven, process-oriented approach, through acquisitions and internal
development, to outsourcing opportunities in other service industries. The
defining characteristics of HCRI's business model are (i) the ability to
automate clerical and administrative tasks, using sophisticated and proprietary
computer applications; and (ii) the ability to standardize and scale work using
process management and classical work measurement techniques. Using this model,
HCRI believes that it can dramatically increase the productivity of the skilled
workers who will make up its labor force, and successfully implement pricing
strategies that will reward HCRI for those productivity gains.
HCRI believes that future development opportunities are likely to be
characterized by outsourcing services that produce predictable and recurring
revenue streams; competitive advantages from effective process management,
proprietary systems and the provision of knowledge-rich services;
development-stage niche markets; value-based pricing; and a focus
(non-exclusive) on healthcare information services.
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INDUSTRY
Outsourcing. The outsourcing of non-core specialized business functions
has been increasing in recent years. Outsourcing enables a client to concentrate
its resources on its core business. Because of expertise and economies of scale,
companies that provide specialized services are often able to deliver the
requisite service at lower cost and of similar or higher quality than could be
achieved by their clients.
Since the late 1980s, healthcare payors have experienced increasing (i)
price competition, (ii) regulatory complexity and related administrative
burdens, (iii) costs of healthcare claims, and (iv) average age of the insured
population. These factors, which result primarily from the rapid growth of
managed care, improvements in medical technology, consumer-oriented political
pressure and an aging U.S. population, tend to result in healthcare payors
concentrating their resources on their core business. This, in turn, provides
on-going opportunities for enterprises, like the Company, which are able to
perform non-core business functions on behalf of healthcare payors.
The recovery process is complex and although many healthcare payors operate
recovery departments, HCRI believes that these departments are not generally as
effective per insured life as the Company's operations. HCRI believes that (i)
the relatively small size of recoverable funds as a percentage of claims paid,
(ii) the need for healthcare payors to focus on core competencies and (iii) the
complexity of the recovery process and economies of scale will continue to
provide opportunities for continued growth for the Company.
Recovery Rights of Healthcare Payors. By contract and state law,
healthcare payors are generally entitled to certain rights with respect to paid
healthcare claims that may be the primary obligation of other insurance
carriers. For example, an HMO to which the injured person belongs may pay the
hospitalization and related health expenses of a person injured in an automobile
accident. However, the responsible party is generally liable to the injured
person for the damages arising from the injury, which damages include lost
wages, property loss, pain and suffering and medical benefits. The responsible
party usually has a liability insurance policy that will pay covered damages,
including medical benefits, upon the acceptance of the injured party's claim.
The healthcare payor actually providing or paying for the medical benefits
conferred on the injured party (in this example, an HMO) may have a variety of
rights through which it is entitled to recover the value of such medical
benefits from the responsible party and the responsible party's liability
insurer.
These recovery rights include:
(i) the right of subrogation, which allows the healthcare payor to
recover accident-related medical claims directly from the
responsible party or the responsible party's insurance carrier;
(ii) the right of reimbursement, which allows the healthcare payor to
recover from the injured party any payment received from the
responsible party or the responsible party's insurance carrier
relating to this injury;
(iii) the right of reimbursement for medical benefits provided for
work-related injuries, which are typically excluded from the
healthcare insurer's coverage; and
(iv) other recovery rights against automobile insurers and other
liability insurers arising from coordination of benefits
provisions in healthcare and property and casualty insurance
coverages.
Based on information contained in the Statistical Abstract of the United
States 1997, the Company calculates that there were approximately 150 million
persons covered by private health insurance under insurance policies or similar
agreements in states that allow healthcare payors to exercise subrogation and
related recovery rights and estimates that these 150 million insured persons
suffered between 20 to 24 million injuries in 1995. Based on its experience with
accident-related claims, HCRI estimates that these injuries gave rise to
approximately $19 to $23 billion in medical benefits and that approximately $1.0
to $1.4 billion of the total medical benefits resulting from injuries and paid
by healthcare payors in 1995 were potentially recoverable through subrogation.
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The industry conditions described above have contributed to the growing
need for a cost-effective provider of subrogation services. HCRI believes that
it is the leading independent provider of subrogation and related recovery
services for private healthcare payors in the United States, and that its
success is a result of the implementation of its recovery process, its
employees, its client base, its approach to sales and marketing, and its
proprietary information management system, all described below:
THE RECOVERY PROCESS
HCRI uses proprietary software and various business processes to identify
those claims that exceed a client-specific threshold dollar amount and as to
which its clients may have a recovery right for the medical benefits provided to
an insured. Following the identification and investigation of those claims, HCRI
proceeds to recover from the financially responsible party the value of those
covered medical benefits provided to the insured. HCRI has automated this
complex processing of all raw electronic data and the electronic guidance,
follow-up and generation of correspondence. The use of an automated process
increases productivity and enables specially trained personnel to focus more
intently on matters requiring their professional judgement and expertise. The
automated process also allows the Company to pursue claims that would otherwise
be deemed too small to pursue economically. HCRI believes that its ability to
effectively recover a broader range of claim sizes is an important competitive
advantage in the market. In addition to automating the recovery process, HCRI's
information management system (the "SubroSystem"), generates significant
operations and management information, which enables the Company to employ
production and quality standards in the context of providing specialized
services.
In order to obtain recoveries, HCRI has to establish whether or not the
healthcare payor has a right to recover from another person or entity, determine
which medical claims exceed the predetermined dollar threshold resulting from
accidents and take the actions needed to effect recovery. These tasks require
knowledge of the property and casualty insurance process, knowledge of
healthcare payment systems, knowledge of the law of torts, subrogation and
related legal doctrines, a skilled labor force, adequate information databases
and information systems, investigative and negotiating skills, and careful
workflow engineering.
HCRI has refined the recovery process to four major, interrelated steps:
(i) automated identification of accident-related claims provided electronically
by its clients; (ii) investigation of potentially recoverable claims; (iii)
assertion and management of potentially recoverable claims; and (iv) negotiation
and settlement of claims.
Automated Identification of Accident-Related Claims. The automated
selection, analysis and processing of raw claims data are handled primarily
through HCRI's proprietary software, the SubroSystem. Information regarding
diagnoses, the costs of treatment, insured demographics (names, addresses and
telephone numbers, etc.) and related claims matters are provided to HCRI
electronically by the payor. The primary vehicle for the identification of
injured insureds is an automated analysis of the clients' claims data. The
SubroSystem includes direct connections to HCRI's clients' claims information
systems, subject to various security controls to limit access internally. HCRI's
trained staff, using the SubroSystem's diagnostic tools, identifies, sorts, vets
and organizes raw claims data into usable form, essentially engaging in "data
mining." This system identifies accident-related claims and, using
client-specific protocols, opens an on-line, electronic file for such claims.
After files are opened, the SubroSystem automatically tracks the medical
expenses on files, so those files are updated as insureds undergo additional
treatments related to their injuries. Since its inception, HCRI has
automatically opened over 21.0 million of such on-line files.
Investigation of Potentially Recoverable Claims. When a file of claims
reaches a value determined by HCRI, the SubroSystem automatically generates a
series of inquiry letters that are sent to injured persons. The forms of the
inquiry letters are approved in advance by HCRI's clients. HCRI's well-trained
and courteous customer service representatives receive incoming phone calls from
injured insureds who typically call the Company in response to HCRI's
system-generated inquiry letters. HCRI also initiates phone calls if the insured
has not responded to the inquiry letters in a reasonable period of time. Based
on the Company's historical experience, approximately 90% of the injured
insureds ultimately respond to HCRI's inquiries.
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During the subsequent telephone call, the customer service representatives ask a
series of questions that enable them to determine whether a claim is
recoverable, based on carefully-selected investigation criteria and training.
Based on the Company's historical experience, approximately 18% of the claims
investigated by customer service representatives are classified as recoverable.
Once a claim or set of related claims in a file is identified as recoverable,
the system updates the backlog and assigns the file to the appropriate examiner
who begins the assertion and management of recoverable claims. Since its
inception, HCRI has investigated over 4.1 million accidents. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations -- Overview."
Assertion and Management of Potentially Recoverable Claims. Once a file of
claims is classified as recoverable, HCRI staff examiners, who are required to
undergo extensive training, proceed to assert the recovery rights of HCRI's
clients and track the claims' history and development. The Company requires that
within one year of employment, all of its examiners be licensed as insurance
adjusters or meet comparable accreditation standards in states where licensure
is not available. Examiners contact all necessary parties to inform them of the
existence and value of the recovery claim. These parties generally include the
liability insurer for a responsible party, the insured, and, the insured's
attorney, if any, in conjunction with the injury. Examiners maintain contact
with the injured party and responsible party (or insurance carrier) until the
matter is settled. Settlement may not occur until several years after the date
of the injury. During this phase of the recovery process, approximately 40% of
the amounts initially entered into backlog (the dollar amount of potentially
recoverable claims that the Company is pursuing) as recoverable are rejected, in
which case further activity is terminated and backlog is reduced.
All of the workflow performed by examiners is directed and guided
step-by-step by the SubroSystem. The SubroSystem creates a paperless,
interconnected record of correspondence and notes taken by the examiner with
respect to each on-line file. Examiners annotate the files on-line, as
necessary, to document progress, developments and status and otherwise maintain
the history of each claim. The SubroSystem provides HCRI's examiners access to a
library of more than 100 standardized correspondence packets, which may be
generated automatically at the request of the examiner.
Negotiation and Settlement of Claims. The recovery process culminates in
the negotiation and settlement of claim files. Within the settlement guidelines
established by each client and HCRI's standard operating procedures, examiners
close recoverable files and remove them from backlog by making recoveries or by
rejecting files and terminating recovery efforts. Once a settlement is made and
recorded on the SubroSystem, receipt of cash is anticipated and monitored by the
responsible examiner. Cash receipts are checked against settlement screens and
posted to the credit of the appropriate client.
Claims remain the property of HCRI's clients and litigation is commenced
solely at their written direction; similarly, clients may terminate litigation
or other recovery efforts at any time for any reason. Few files require
extensive attorney involvement. HCRI customarily bears the cost of legal
services as part of the services to its clients. HCRI has established what it
believes are cost-effective relationships with providers of legal services,
including its relationship with Sharps & Associates, PSC, a law firm solely
owned by Douglas R. Sharps, HCRI's Corporate Executive Vice President -- Finance
and Administration, Chief Financial Officer and Secretary. This law firm employs
sixteen attorneys and six paralegals at its offices in Louisville, Kentucky;
Oakland, California; Chicago, Illinois; and Dallas, Texas. However, Mr. Sharps
receives no personal benefit from his ownership of the firm. See Note 6 in Item
8. "Financial Statements and Supplementary Data."
Although some recoveries will be made during the first year of service, the
average time to make a recovery is 18 to 24 months from installation, with
substantially all recoveries made by the sixth year. The timing of recoveries is
driven by the payment cycle of property and casualty claims (which is the source
of recoveries made by the Company) and circumstances specific to each claim
(e.g., identification of responsible party, responsiveness of responsible party,
cooperation of parties involved, factual complexity and litigation). The amount
of subrogation recoveries made by the Company on behalf of a client is generally
less than the amount of backlog generated on behalf of such client. This is for
a number of reasons, including (i) the inadequacy of insurance coverage or other
available source of funds to pay the claim; (ii) the absence of third-
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party liability; or (iii) the settlement of the claim for less than full value
in accordance with HCRI's established policies.
Historically, approximately 67% of HCRI's recoveries on behalf of clients
involve automobile liability insurance, 15% involve premises liability
insurance, 10% involve workers' compensation insurance and 8% involve product
liability or other insurance.
MARKETING, SALES AND CLIENT SERVICE
HCRI primarily markets to and contracts with healthcare payors, including
HMOs, other types of managed healthcare plans, indemnity health insurers,
self-funded employee health plans, insured healthcare plans, third-party
administrators, Blue Cross and Blue Shield organizations and provider organized
health plans. HCRI employs a staff of sales managers, a marketing manager and
client services managers. Sales are made directly through contacts with
prospective clients, trade show presentations and employer seminars. Additional
business is also generated from existing clients, who have expanded their
business by growth or acquisitions or who have business segments not already
under contract with HCRI.
Due to the nature of the business, the sales process is lengthy and
involves demonstrating to prospective clients that HCRI's economies of scale,
proprietary processes and value-added services allow (i) HCRI to generate and
return to the clients a greater dollar amount of recoveries than the clients'
in-house recovery department and (ii) the clients to focus greater resources on
core business functions. New customer relationships are often established
through pilot programs, which have typically lasted 12 to 18 months.
Complementing the technical aspects of the recovery process, the client
support function is primarily responsible for communications with clients and
problem resolution. To facilitate strong working relationships, individual
members of the client services staff are assigned to specific clients. HCRI
believes that its investment in resources to resolve a wide variety of business
issues with clients is an important factor in obtaining customers and
maintaining good business relationships. During the last three years, HCRI has
lost eleven clients representing approximately 4.3 million lives. Terminations
occurred due to consolidations (Healthsource of 662,000 lives; Blue Shield of
California of 900,000 lives) and where another existing vendor was chosen by
Oxford Health Plans (1.98 million lives). However, subsequent to December 31,
1998, the Company has re-signed Oxford Health Plans as a client (1.5 million
lives).
CLIENT BASE
The Company provides services to healthcare plans that as of December 31,
1998 covered approximately 40.5 million lives. HCRI's clients are national and
regional healthcare payors, large third-party administrators or self-insured
corporations.
Major clients include the following:
Coventry Healthcare Kaiser Permanente
FIRST HEALTH NYLCare
General American Life Insurance The Principal Financial Group
Group Health, Inc. Prudential HealthCare
Humana Inc. UnitedHealth Group
HCRI's largest clients are UnitedHealth Group, Kaiser Permanente and
Humana. During 1998 and 1997, UnitedHealth Group, Kaiser Permanente and Humana
generated 28%, 8%, and 7%, and 31%, 9% and 9%, respectively, of HCRI's revenues.
The loss of one or more of these accounts could have a material adverse effect
on HCRI's business, results of operations and financial condition. However,
HCRI's contracts provide that in the event of termination, HCRI is generally
entitled to complete the recovery process on the backlog for that client. On
December 31, 1998, HCRI had backlog of $770.7 million.
HCRI's revenues are earned under written contracts with its clients that
generally provide for contingency fees from recoveries under a variety of
pricing regimes. The pricing arrangements offered by HCRI to its clients include
a fixed fee percentage, a fee percentage that declines as the number of lives
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covered by the client and subject to HCRI's service increases and a fee
percentage that varies with HCRI's recovery performance.
HCRI performs its services on a reasonable efforts basis and does not
obligate itself to deliver any specific result. Contracts with its customers are
generally terminable on 60 to 180 days' notice by either party, although in a
few cases the contracts extend over a period of years. Pursuant to the terms of
its client contracts, HCRI is generally entitled to continue to make recoveries
for the client and earn its fees on the backlog existing at the time of
termination.
COMPETITION
HCRI competes primarily with the internal recovery departments of potential
customers and other subrogation recovery service vendors. To the Company's
knowledge, there are two smaller, but significant, independent providers of
subrogation recovery services in addition to HCRI. Both independent competitors
preceded HCRI's entry into the recovery industry, and no major competitors have
entered the market since that time. HCRI believes that it has competitive
advantages in the bulk of its market, including process expertise, capital
requirements necessitated by the unusually long revenue cycle in the recovery
industry, assembling and training a qualified and productive employee base
possessing appropriate industry expertise, and an information processing system
designed to aid investigators and examiners engaged in the recovery process.
However, there are participants in the healthcare, insurance and transaction
processing industries that possess sufficient capital, and managerial and
technical expertise to develop competitive services.
EMPLOYEES
HCRI employs, and facilitates the development of, skilled
knowledge-workers. HCRI maintains an extensive, in-house training program, which
it believes is attractive to employees and essential in developing the necessary
industry-specific skills. All HCRI employees participate in one of four
incentive compensation plans, depending upon the responsibilities of each
employee. The Company believes the tight labor market in Louisville, Kentucky
could have an impact on future hiring. HCRI employed approximately 495 persons
as of December 31, 1998.
HCRI requires all employees to enter into confidentiality and nondisclosure
agreements, which generally prohibit them from divulging confidential
information and trade secrets after they terminate employment. Employees are
also required to enter into non-compete agreements, preventing them from working
for a competitor during the first year after they terminate employment. In
addition, the Company's customers generally agree not to employ HCRI employees
during the client's contract term plus a specified period.
A union does not represent HCRI's employees. HCRI believes its relations
with its employees are good.
THE SUBROSYSTEM AND PLATFORM
General. HCRI's SubroSystem consists of inter-related proprietary software
programs that function as an automated data and process management system. HCRI
holds a copyright registration from the United States Copyright Office on the
software.
The SubroSystem software is a character-based application that was
originally run on Intel-based personal computers in an MS-DOS operating
environment. The personal computers were arranged in local area networks
("LANs"), representing logical units of work. Typically one LAN serviced one to
four clients and up to 25 HCRI employees.
System Upgrade. Although the SubroSystem, a key component of HCRI's
recovery process, historically served the Company's operational and management
information needs, HCRI developed a plan (the "System Upgrade") under which it
would, over a 24-month to 36-month period, migrate the SubroSystem to a modern
network operating system and database architecture. The System Upgrade includes
a detailed process for the comprehensive testing of all key elements prior to
implementation of each step of the upgrade.
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At the end of January 1998, HCRI successfully migrated the SubroSystem to a
Windows NT environment, the first step of the System Upgrade. In the course of
migration, the Company encountered technical difficulties generally of the type
and number management believes are common with conversions of similar size and
scope. Following migration, HCRI has continued to maintain an inventory of
platform components for redundancy, to store on-line data on redundant devices,
and, on a daily basis, to copy all on-line storage systems to magnetic tapes,
which are then removed to a security vault off-site. HCRI's systems department
handles development and maintenance of the SubroSystem.
Work was completed in late 1998 on the second step of the System Upgrade
for the creation of a logical data model to support subrogation and other
processes. This work resulted in the initial implementation of a relational
database to support data warehousing. Planning for the last step of the System
Upgrade, the migration of data and process to the new platform, is presently
underway. The Company expects that it will complete the last step of the System
Upgrade during the latter part of 2000. As of December 31, 1998, the Company has
spent approximately $3.3 million on the System Upgrade.
Quality and Management Controls. The SubroSystem controls, measures and
generates reports on the recovery process. From data recorded on the
SubroSystem, a series of financial reports are generated for clients that allow
clients to monitor HCRI's success in making recoveries and building backlog on
their behalf. The data used for financial reports are also used to produce a
wide array of accounting and management information used by HCRI to operate its
business. HCRI employs a variety of quality control techniques to insure
consistently high quality service.
LEGAL AND REGULATORY ENVIRONMENT
The healthcare industry is subject to numerous regulations, which may
adversely affect HCRI's business. In addition to laws and regulations affecting
healthcare and insurance, changes in federal fair debt collection regulations
also may adversely affect HCRI's business.
General. From time to time, legislation is introduced in Congress and in
various state legislatures which would materially affect the Company's business.
The most significant legislation, laws and regulations may, for clarity, be
grouped into three categories: (i) legislation that would substantially limit
the ability of healthcare insurers to recover from third-parties
accident-related medical benefits incurred by injured insureds ("Health
Insurance Primacy Laws"); (ii) legislation that would substantially limit the
Company's ability to receive and utilize individual claim information from
healthcare insurers ("Confidentiality Laws"); and (iii) other federal and state
laws. The following identifies specific risks in these three categories:
Health Insurance Primacy Laws
Auto Choice Reform Act. In each of the last two sessions of Congress,
legislation known as the Auto Choice Reform Act of 1997 (the "Proposed Act") was
introduced, but not enacted. Proponents of these bills have expressed intent to
introduce a similar bill in 1999. Under this Proposed Act, in those states not
opting out of its provisions, individual drivers may choose to be covered by an
auto insurance system in which healthcare insurers, with some exceptions, could
be made primarily responsible for healthcare costs incurred by those injured in
automobile accidents. Consequently, even if the insured's injuries were caused
by the negligence of another driver, the healthcare insurer might have no rights
of recovery against the negligent party or that party's liability insurer.
Revenue generated from recoveries against automobile liability insurers
represented approximately 67% of the Company's 1998 revenues. Should this or
similar legislation be enacted, it could have a material adverse effect on the
Company's business, results of operations and financial condition.
Proponents of the Proposed Act assert that (i) the costs of operating a
motor vehicle are excessive due to legal and administrative costs associated
with the processing of claims under the fault-based liability system; and (ii)
the costly fault-based liability insurance system often fails to provide
compensation commensurate with loss and takes too long to pay benefits. Even if
the Proposed Act is ultimately abandoned, these policy reasons may result in
future legislation designed to significantly alter the fault-based liability
system used in
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most states, eliminate recovery rights of healthcare insurers and materially
adversely affect the Company's business.
Certain No Fault Insurance Systems. Certain states have adopted versions
of automobile "no fault" insurance systems in which the injured party's health
insurance carrier or provider is primarily responsible for healthcare related
expenses (and not the responsible party and his or her insurer or the injured
insured's automobile liability insurer). In 1996, California voters rejected a
no-fault automobile insurance measure, Proposition 200, which would have
required drivers with bodily injuries to be compensated by their healthcare
insurers. Although Proposition 200 was rejected by the voters, there can be no
assurance that similar measures will not again be presented in a ballot
initiative or as legislation in California or elsewhere in the future. Growth in
the number of states adopting similar systems could significantly reduce the
amounts otherwise recoverable by the Company in connection with automobile
injuries in such states.
Confidentiality Laws
Confidentiality Provisions of the Health Insurance Portability and
Accountability Act of 1996. Section 262 of the Health Insurance Portability and
Accountability Act of 1996 ("HIPAA") (42 U.S.C. sec.1177) prohibits any person
from knowingly obtaining or disclosing individually identifiable health
information relating to an individual in violation of the standards established
by the Secretary of the Department of Health and Human Services (the
"Secretary") relating to the electronic transmission of healthcare information
in connection with certain categories of transactions described in the statute.
Section 264 of the HIPAA requires the Secretary to issue recommendations on
standards with respect to the privacy of individually identifiable health
information. In September 1997, the Secretary submitted such recommendations to
Congress. Section 264 of the HIPAA also provides that if legislation governing
standards with respect to the privacy of individually identifiable health
information is not enacted by August 1999, the Secretary will be required to
issue final regulations containing such standards no later than February 2000.
During 1998, the Secretary issued several proposed rules that outline security
standards for healthcare information that is maintained or transmitted
electronically, including standards for electronic signatures; electronic
transaction standards, a standard employer identification number and
requirements concerning its implementation; and a standard healthcare provider
identifier and requirements concerning its implementation. The comment periods
for these proposed rules have ended; however, none of the rules have been issued
in final form. In addition to rules proposed by the Secretary, several bills
containing provisions relating to the privacy of individually identifiable
health information were introduced during the 105th Congress. Thus far in the
106th Congress, several managed care bills have been introduced that contain
provisions relating to the confidentiality of patient information. It is
anticipated that more comprehensive privacy legislation will be introduced later
in this Congress. The provisions of future federal legislation and regulations
could impair or prevent the acquisition and use by the Company of claims and
insurance information necessary to process recovery claims on behalf of its
clients. In addition, state laws governing privacy of medical or insurance
records and related matters may significantly affect the Company's business.
Other Federal and State Laws
Changes in the regulation of insurance and debt collection could also
affect the Company's business. Similarly, changes in law that would bar
healthcare subrogation or impair an injured party's ability to collect insured
damages (that is, an injured person would be prevented from recovering from the
wrongdoer damages for accident-related medical benefits covered by health
insurance) could similarly adversely affect the Company's business. Existing
debt collection laws also may be amended or interpreted in a manner that could
adversely affect the Company's business. Additionally, although the Company does
not believe that it engages in the unauthorized practice of law, changes in the
law or a judicial or administrative decision defining some of the Company's
activities as the practice of law, could have a material adverse effect on the
Company's business.
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Certain Legal Doctrines
With respect to recoverable claims, the rights of subrogation and
reimbursement may be limited in some cases by (i) the "made whole doctrine,"
which may limit the healthcare provider's ability to recover when the settlement
damage award received by the injured party is inadequate to cover the injured
party's damages; and (ii) the "common fund doctrine," which permits plaintiff's
attorneys to determine their compensation based on the entire amount covered by
a damage award and may, in some cases, proportionally diminish the amount
recoverable by HCRI on behalf of the healthcare payor out of that damage award.
ITEM 2. PROPERTIES
As of December 31, 1998, the Company leased property at the following three
locations: (i) approximately 88,161 square feet of space for its executive
offices and main operations in Louisville, Kentucky, under a lease agreement
with a five-year term expiring in 2002; (ii) approximately 10,206 square feet at
its regional operating office in Pittsburgh, Pennsylvania, under a lease
agreement with a five-year term expiring 2001; and (iii) approximately 566
square feet at its Minneapolis, Minnesota location, under a one-year lease
subject to annual renewals until 2001.
ITEM 3. LEGAL PROCEEDINGS
On March 15, 1994, a class action complaint ("Complaint") was filed against
HCRI in the United States District Court for the Northern District of West
Virginia, Michael L. DeGarmo, et al. v. Healthcare Recoveries, Inc. The
plaintiffs assert that HCRI's subrogation recovery efforts on behalf of its
clients violate a number of state and federal laws, including the Fair Debt
Collection Practices Act and the Racketeering Influenced and Corrupt
Organizations Act ("RICO"). The Complaint also seeks judgment, under the federal
Declaratory Judgment Act, that HCRI as the subrogation agent for various
healthcare payors be limited, in recovering from persons who caused accidents or
from the healthcare payors' injured insureds, to the actual costs of the medical
treatment provided to such injured insureds by such healthcare payors,
notwithstanding provisions in the applicable healthcare policies or agreements,
which generally allow recovery by the healthcare payors of the "reasonable
value" of such treatments. The Complaint alleges that HCRI made fraudulent
representations to recover sums in excess of those actually expended by the
applicable healthcare payor to pay for medical treatment. Plaintiffs, and the
putative class, demand compensatory damages, treble damages under RICO, costs
and reasonable attorneys' fees. HCRI believes that this case does not satisfy
requirements for a class action because the plaintiffs are not adequate
representatives of the putative class and potential claims by class members lack
the commonality required for class actions due to the number of states whose
laws apply to the subrogation provisions of applicable healthcare policies and
agreements and the varying language of such subrogation provisions. The DeGarmo
case is in discovery, and no class of plaintiffs has been certified.
This lawsuit, if successful, could prevent the Company from recovering the
"reasonable value" of medical treatment under discounted fee for service ("DFS")
capitation and other payment arrangements. By the end of 1993, at the direction
of certain clients, HCRI had ceased the practice of recovering on their behalf
the "reasonable value" of medical treatment provided by medical providers under
DFS arrangements with those clients. It is the Company's current policy not to
recover the "reasonable value" of medical treatment in DFS arrangements.
However, HCRI historically and currently recovers the "reasonable value" of
medical treatment provided under capitation arrangements and other payment
arrangements with medical providers on behalf of those clients that compensate
medical providers under these payment mechanisms, to the extent that these
benefits are related to treatment of the injuries as to which clients have
recovery rights. The Company believes that its clients' contracts, including the
contracts that provide for recovery under DFS, capitation and other payment
arrangements are enforceable under the laws of the states potentially applicable
in this case and that, as a result, this litigation will not have a material
adverse effect upon its business, results of operation or financial condition.
Nevertheless, if this lawsuit or another lawsuit seeking relief under similar
theories were to be successful, it could have a material adverse effect on the
Company's business, results of operations and financial condition.
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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of stockholders of the Company during
the quarter ended December 31, 1998.
SUPPLEMENTARY ITEM. CERTAIN RISK FACTORS
See "Healthcare Recoveries, Inc. Private Securities Litigation Reform Act
of 1995 Safe Harbor Compliance Statement For Forward-Looking Statements,"
included as Exhibit 99.1 to this Form 10-K and incorporated herein by reference.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company's Common Stock is traded on The Nasdaq National Market under
the symbol "HCRI." Set forth are the high and low closing prices for the Common
Stock for the periods indicated as reflected in The Nasdaq National Market.
QUARTER ENDED: HIGH LOW
- -------------- ------ ------
March 31, 1998......................................... $23.50 $20.25
June 30, 1998.......................................... 24.13 15.88
September 30, 1998..................................... 18.13 9.75
December 31, 1998...................................... 17.13 8.56
QUARTER ENDED: HIGH LOW
- -------------- ------ ------
March 31, 1997......................................... N/A N/A
June 30, 1997.......................................... $19.38 $14.00
September 30, 1997..................................... 22.50 17.25
December 31, 1997...................................... 24.38 17.75
On March 23, 1999, there were approximately 25 holders of record of the
Company's Common Stock.
The Company has paid no cash dividends since the sale of the Company by
Medaphis Corporation in May 1997. Any future determination to pay cash dividends
will be at the discretion of the Board of Directors (the "Board") and will be
dependent upon the Company's financial condition, results of operations, credit
agreements, capital requirements and other such factors, as the Board deems
relevant. The Company's current credit facility limits its ability to pay
dividends on its Common Stock. However, HCRI previously paid cash dividends in
the aggregate amount of $13.6 million to its parent company, Medaphis, from
August 1995 through May 1997. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Liquidity and Capital
Resources."
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ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth historical selected financial data of the
Company as of the dates and for the periods indicated, which have been derived
from, and are qualified by reference to, the Company's financial statements. The
information set forth below should be read in conjunction with the Company's
financial statements and notes thereto and "Management's Discussion and Analysis
of Financial Condition and Results of Operations" included herein.
The selected historical financial data as of December 31, 1998 and 1997 and
for the years ended December 31, 1998, 1997 and 1996 have been derived from, and
are qualified by reference to, the Company's financial statements appearing
elsewhere herein, which have been audited by PricewaterhouseCoopers LLP,
independent accountants. The selected historical financial data as of December
31, 1995 and for the years ended December 31, 1995 and 1994 have been derived
from, and are qualified by reference to, the Company's financial statements
included in the Company's registration statement on Form S-1 (which have been
audited by PricewaterhouseCoopers LLP, independent accountants). The selected
historical financial data as of December 31, 1994 was derived from the Company's
financial statements.
STATEMENTS OF INCOME DATA
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
DECEMBER 31,
-----------------------------------------------
1998 1997 1996 1995 1994
------- ------- ------- ------- -------
Revenues:
Subrogation.................................... $48,734 $39,277 $30,248 $22,496 $16,941
Other Revenues................................. -- -- 1,171 -- --
------- ------- ------- ------- -------
Total Revenues......................... 48,734 39,277 31,419 22,496 16,941
Cost of Services................................. 22,199 18,523 15,026 10,265 7,947
------- ------- ------- ------- -------
Gross Profit........................... 26,535 20,754 16,393 12,231 8,994
Support Expenses................................. 10,692 8,922 7,215 6,204 5,748
Depreciation & Amortization...................... 2,334 1,181 878 695 318
Non-recurring Compensation Charge(1)............. -- 2,848 -- -- --
------- ------- ------- ------- -------
Operating Income....................... 13,509 7,803 8,300 5,332 2,928
Interest Income, net............................. 1,657 1,158 486 580 320
------- ------- ------- ------- -------
Income Before Income Taxes............. 15,166 8,961 8,786 5,912 3,248
Provision for Income Taxes....................... 6,266 4,959 3,685 2,486 1,363
------- ------- ------- ------- -------
Net Income............................. $ 8,900 $ 4,002 $ 5,101 $ 3,426 $ 1,885
======= ======= ======= ======= =======
Basic Earnings per Common Share.................. $ 0.78 $ 0.37 $ 0.52
======= ======= =======
Diluted Earnings per Common Share................ $ 0.77 $ 0.37 $ 0.52
======= ======= =======
- ---------------
(1) In connection with the sale of the Company by Medaphis in May 1997, the
Company incurred a one-time $2.8 million non-cash compensation charge. This
charge was from the issuance by the Company of 200,000 shares of Common
Stock to the Company's management group, as a bonus for the successful
completion of the sale of the Company by Medaphis. This represents 2% of the
shares of Common Stock outstanding after the Company's initial public
offering and 1.7% of the shares of Common Stock outstanding following the
exercise of the underwriters' over-allotment option.
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BALANCE SHEET DATA
(DOLLARS IN THOUSANDS)
DECEMBER 31,
---------------------------------------------------
1998 1997 1996 1995 1994
------- ------- ------- ------- -------
Cash and Cash Equivalents................ $31,133 $24,674 $ 53 $ -- $ 5,950
Working Capital.......................... 30,898 22,911(1) 1,730 1,675 709
Total Assets............................. 61,003 48,170 23,969 13,390 15,872
Total Indebtedness....................... -- -- -- -- 2
Stockholders' Equity..................... 37,193 27,865 4,110 3,274 9,188
- ---------------
(1) The increase in working capital, including cash and cash equivalents, is
primarily attributable to the $19.2 million of proceeds received by the
Company from the exercise of the underwriters' over-allotment option granted
by the Company in connection with the May 1997 initial public offering.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
HCRI provides insurance subrogation and related recovery services to the
private healthcare payor industry. HCRI services comprise the complete
outsourcing of the identification, investigation and recovery of
accident-related medical benefits incurred by its clients on behalf of their
insureds, but for which other persons or entities have primary responsibility.
The rights of HCRI's clients to recover the value of these medical benefits
arise by law or contract, are known generally as the right of subrogation and
are generally paid from the proceeds of liability or workers' compensation
insurance.
For a typical new client, it takes three to six months from the contract
signing (when the lives are "sold") to complete the construction of electronic
data interfaces necessary for the Company to begin service. At this point, the
new client is considered "installed." During the installation period, the
Company must also hire and train quality staff necessary to provide contractual
services. After installation, HCRI receives data from the client from which it
creates an inventory of backlog.
"Backlog" is the total dollar amount of potentially recoverable claims that
the Company is pursuing on behalf of its clients at a given point in time. These
claims are gross figures, prior to estimates of claim settlement and rejection.
Backlog increases when the Company opens new files of potentially recoverable
claims and decreases when files of claims are recovered (or, after further
investigation, determined to be nonrecoverable). Historically, subrogation
recoveries (the amount actually recovered for its clients prior to the Company's
fee) have been produced from the backlog in a generally predictable cycle. This
is because any group of potential recoveries that has been sufficiently large in
number to display statistically significant characteristics and that originates
from a defined time period, tended to produce recovery results that have been
comparable to other groups having similar characteristics. Although some
recoveries will be made during the first year of service, the average time to
make a recovery is 18 to 24 months, with substantially all recoveries made by
the sixth year. Backlog for a client will range from newly identified potential
recoveries (which will be identified each year) to potential recoveries that are
in the late stages of the recovery process. As a result of this cycle,
approximately six years from the date of installation, the client's annual
amounts of subrogation recoveries as a percent of the client's backlog will be
generally constant, except for variations due to the number of installed lives
for the client.
For the most part, the Company is paid a contingency fee from the amount of
subrogation recoveries it makes from backlog on behalf of its clients. The
Company's revenues are a function of subrogation recoveries and effective fee
rates. Effective fee rates vary depending on the mix between recovery services
provided and client fee schedules. The fee schedules for each client are
separately negotiated and reflect the Company's standard fee rates, the services
to be provided and anticipated volume of services. The Company grants volume
discounts and negotiates a lower fee when it assumes backlog from a client
because the client will have already completed some of the recovery work. Since
the Company records expenses as costs are incurred and records
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revenues only when a file is settled, there is a significant lag between
recording of expenses and revenue recognition.
The Company's expenses are determined primarily by the number of employees
directly engaged in recovery activities ("cost of services") and by the number
of employees engaged in a variety of support activities ("support expenses").
Recovery-related employees must be hired and trained in advance of the
realization of recoveries and revenues and, during times of rapid growth,
installed lives and cost of service will grow more rapidly than revenue. The
number of employees accounted for in support expenses generally grows less
rapidly than revenue due to economies of scale.
RESULTS OF OPERATIONS
The following tables present certain key operating indicators and results
of operations data for the Company for the periods indicated:
KEY OPERATING INDICATORS
DECEMBER 31,
------------------------
1998 1997 1996
------ ------ ------
Cumulative Lives Sold, Beginning of Period................. 38.5 29.5 24.2
Lives from Existing Client Growth........................ (3.1) 1.9 0.7
Lives Added from Contracts with Existing Clients........... 2.0 5.9 2.6
Lives Added from Contracts with New Clients................ 3.1 1.2 2.0
------ ------ ------
Cumulative Lives Sold, End of Period....................... 40.5 38.5 29.5
====== ====== ======
Lives Installed............................................ 38.5 36.4 28.9
Backlog(1)................................................. $770.7 $668.3 $535.0
Subrogation Recoveries(2).................................. 177.7 144.9 112.5
Throughput(3).............................................. 24.7% 24.1% 25.0%
Effective Fee Rate......................................... 27.4 27.1 26.9
Subrogation Revenues....................................... $ 48.7 $ 39.3 $ 30.2
Employees:
Direct Operations........................................ 386 399 312
Support.................................................. 109 84 71
------ ------ ------
Total Employees.................................. 495 483 383
====== ====== ======
- ---------------
(1) Backlog represents the total dollar amount of potentially recoverable claims
that the Company is pursuing on behalf of clients at any point in time.
(2) Excludes approximately $8.2 million of recoveries and $1.2 million of
revenues in connection with the breast implant litigation settlement, during
1996.
(3) Throughput equals recoveries for the period divided by the average of
backlog at the beginning and end of the period.
STATEMENTS OF INCOME AS A PERCENTAGE OF SUBROGATION REVENUES
YEAR ENDED DECEMBER 31,
-----------------------
1998 1997 1996
----- ----- -----
Subrogation Revenues........................................ 100.0% 100.0% 100.0%
Cost of Services............................................ 45.6 47.2 49.7
Support Expenses............................................ 21.9 22.7 23.9
Operating Income............................................ 27.7 19.9 27.4
Income Before Income Taxes.................................. 31.1 22.8 29.1
Net Income.................................................. 18.3 10.2 16.9
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1998 COMPARED TO 1997
Revenues. Total revenues for the year ended December 31, 1998 increased
24%, to $48.7 million from $39.3 million in 1997. Growth in subrogation revenues
occurred primarily because of increased subrogation recoveries, from $144.9
million in 1997 to $177.7 million in 1998. The effective fee rate increased
slightly to 27.4% from 27.1%. The increase in total subrogation recoveries was
due primarily to growth in backlog, which in turn grew primarily because of an
increase in the number of lives installed. Backlog increased 15.3% to $770.7
million at December 31, 1998 from $668.3 million at December 31, 1997. The
Company was also able to obtain subrogation recoveries at a rate of
approximately 6% of average backlog per quarter during 1998 and 1997. Lives
installed grew 5.8% in 1998 to 38.5 million.
Cost of Services. Cost of services increased in 1998 to $22.2 million from
$18.5 million in 1997, which is an increase of 19.8%. As a percentage of
subrogation revenues, cost of services decreased to 45.6% in 1998 from 47.2% in
1997. The decrease is a result of lower growth of lives installed and their
associated costs in 1998 relative to the growth in revenue for the year and
increased efficiencies by the Company.
As a result of the nature of the Company's contingent fee arrangements with
its clients, the Company incurs significant current expense in an effort to
generate revenue, a significant portion of which will be recorded in future
periods. Because relatively little revenue is earned during the first year
following the installation of new lives, unless the Company assumes
responsibility for the new client's existing backlog, the growth rate for lives
installed exceeds the revenue growth rate.
Support Expenses. Support expenses increased 19.8% to $10.7 million for
the twelve months ended December 31, 1998, from $8.9 million for the comparable
period in 1997 due to hiring of additional support staff for the SubroSystem
upgrade project. Support expenses decreased as a percentage of subrogation
revenues from 22.7% for the twelve months ended December 31, 1997 to 21.9% for
the comparable period in 1998. The decline in support expenses as a percentage
of subrogation revenues resulted from improved economies of scale in the support
functions and also the capitalization of $564,000 of certain software
development costs associated with the upgrade of the SubroSystem for 1998. These
costs were capitalized in conjunction with the requirements under Statement of
Position 98-1 "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use," adopted January 1, 1998, which were historically
expensed.
Depreciation and Amortization. Depreciation and amortization expenses
increased 97.6% to $2.3 million for the twelve months ended December 31, 1998
from $1.2 million for the comparable period in 1997. The increase in
depreciation expense was mainly attributable to the capital expenditures for the
SubroSystem Upgrade.
Interest Income. Interest income, net totaled $1.7 million and $1.2
million for the twelve months ended December 31, 1998 and 1997, respectively.
The increase in interest income was a result of continued interest income earned
on $19.2 million of proceeds from the issuance by the Company of 1,470,000
shares of Common Stock on June 9, 1997 upon the exercise of the underwriters'
over-allotment option and on HCRI's cash provided by operating activities.
Compensation Charge. In connection with the sale of the Company by
Medaphis in May 1997, the Company incurred a one-time $2.8 million non-cash
compensation charge. This charge was from the issuance by the Company of 200,000
shares of Common Stock to the Company's management group, as a bonus for the
successful completion of the sale of the Company by Medaphis. This represented
2% of the shares of Common Stock outstanding after the Company's initial public
offering and 1.7% of the shares of Common Stock outstanding following the
exercise of the underwriters' over-allotment option.
Tax: Provision for income taxes was approximately 41.3% of pre-tax income
for the year ended December 31, 1998 and 42% for the year ended December 31,
1997. The effective tax rate exceeded the Federal statutory tax rate as a
consequence of state and local taxes and non-deductible expenses.
Net Income. Net income for the year ended December 31, 1998 increased $2.1
million, or 30.8%, to $8.9 million or $0.77 per diluted share, from $6.8 million
or $0.63 per diluted share for the year ended
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December 31, 1997, excluding the $2.8 million non-cash ($0.26 per diluted
share), compensation charge incurred in 1997. Net income as, reported for the
twelve months ended December 31, 1997 was $4.0 million, or $0.37 per diluted
share, including the non-recurring compensation charge. Net income and earnings
per share for the year ended December 31, 1998, excluding $564,000 of certain
software development costs associated with the upgrade of the SubroSystem and
capitalized in conjunction with the requirements under SOP 98-1, would have been
$8.57 million and $0.74 per diluted share, respectively. These capitalized costs
were historically expensed prior to the Company implementing Statement of
Position 98-1 on January 1, 1998.
1997 COMPARED TO 1996
Revenues. Total revenues for the year ended December 31, 1997 increased
25%, to $39.3 million. This increase is primarily attributable to a 30% growth
in subrogation revenues, from $30.2 million to $39.3 million. Total revenues for
the year ended December 31, 1996 include $1.2 million of non-recurring revenue
generated from the breast implant class action settlement services provided on
an ad hoc basis by the Company, net of related expenses incurred by the Company.
The Company assisted healthcare payors in obtaining a settlement with breast
implant manufacturers, other than Dow Corning, by, among other things,
calculating their aggregate medical benefit liability. Growth in subrogation
revenues occurred primarily because of increased subrogation recoveries, from
$112.5 million in 1996 to $144.9 million in 1997. The effective fee rate
increased slightly to 27.1% from 26.9%. The increase in total subrogation
recoveries was due primarily to growth in backlog, which in turn grew primarily
because of an increase in the number of lives installed. Backlog increased 25%
to $668.3 million at December 31, 1997 from $535.0 million at December 31, 1996.
The Company was also able to obtain subrogation recoveries at a rate of
approximately 6% of average backlog per quarter during 1996 and 1997. Lives
installed grew 26% in 1997 to 36.4 million.
Cost of Services. Cost of services increased to $18.5 million in 1997 from
$15.0 million in 1996, an increase of 23%. As a percentage of subrogation
revenues, cost of services decreased to 47.2% in 1997 from 49.7% for 1996. The
decrease is a result of lower growth of lives installed and their associated
costs in 1997 relative to the growth in revenue for the year and increased
efficiencies by the Company.
As a result of the nature of the Company's contingent fee arrangements with
its clients, the Company incurs significant current expenses in an effort to
generate revenue, a significant portion of which will be recorded in future
periods. Because relatively little revenue is earned during the first year
following the installation of new lives, unless the Company assumes
responsibility for the new client's existing backlog, the growth rate for lives
installed exceeds the revenue growth rate.
Support Expenses. Support expenses increased 24%, to $8.9 million for the
twelve months ended December 31, 1997, from $7.2 million for the comparable
period in 1996 due to hiring of additional support staff for the SubroSystem
upgrade project. Support expenses decreased as a percentage of subrogation
revenues (i.e., revenues excluding the non-recurring other revenue from the
silicone breast implant class action settlement) from 23.9% for the twelve
months ended December 31, 1996 to 22.7% for the comparable period in 1997. The
decline in support expenses as a percentage of subrogation revenues resulted
from improved economies of scale in the support functions.
Depreciation and Amortization. Depreciation and amortization expenses from
prior periods were restated separately to conform with current presentation.
Depreciation and amortization expenses increased 34.5% to $1.2 million for the
twelve months ended December 31, 1997 from $0.9 million for the comparable
period in 1996.
Compensation Charge. In connection with the sale of the Company by
Medaphis in May 1997, the Company incurred a one-time $2.8 million non-cash
compensation charge from the issuance by the Company of 200,000 shares of Common
Stock to the Company's management as a bonus for the successful completion of
the sale of the Company by Medaphis. These shares represented 2% of the
10,000,000 shares of Common Stock outstanding after the initial public offering
that closed on May 28, 1997 and 1.7% of the 11,470,000 shares of Common Stock
outstanding after the sale of 1,470,000 shares issued upon exercise of the
underwriters' over-allotment option.
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Interest Income. Interest income, net totaled $1.2 million and $0.5
million for the twelve months ended December 31, 1997 and 1996, respectively.
The increase in interest income was a result of interest income earned on $19.2
million of proceeds from the issuance by the Company of 1,470,000 shares of
Common Stock as of June 9, 1997 upon the exercise of the underwriters'
over-allotment option.
Tax. Provision for income taxes was approximately 42% of pre-tax income
excluding the non-cash non-recurring compensation charge, for the years ended
December 31, 1997 and 1996. The effective tax rate exceeded the Federal
statutory tax rate as a consequence of state and local taxes and non-deductible
expenses.
Net Income. Net income for the year ended December 31, 1997 increased $2.4
million, or 55%, to $6.8 million, or $0.63 per share, from $4.4 million, or
$0.45 per share, in the comparable period of 1996, excluding non-recurring
items. These non-recurring items were the $2.8 million ($.26 per share)
non-cash, non-recurring compensation charge in 1997 and $680,000 ($.07 per
share, net of tax) of net income from the breast implant class action settlement
in 1996. Net income as reported for the twelve months ended December 31, 1997
was $4.0 million, or $0.37 per share, compared to $5.1 million, or $0.52 per
share, for the comparable period of 1996.
LIQUIDITY AND CAPITAL RESOURCES
The Company's statements of cash flows for the years ended December 31,
1998, 1997 and 1996 are summarized below:
DECEMBER 31,
---------------------------
1998 1997 1996
------- ------- -------
(IN THOUSANDS)
Net Cash Provided by Operations........................... $ 9,814 $10,764 $ 5,876
Net Cash Used In Investing Activities..................... (3,783) (3,096) (1,558)
Net Cash Provided by (Used In) Financing Activities....... 428 16,953 (4,265)
------- ------- -------
Net Increase in Cash and Cash Equivalents................. $ 6,459 $24,621 $ 53
======= ======= =======
The Company had working capital of $30.9 million at December 31, 1998,
including cash and cash equivalents of $31.1 million, compared with working
capital of $22.9 million at December 31, 1997. The increase is primarily
attributable to $9.8 million of cash provided by operating activities offset by
furniture and equipment purchases.
Net cash provided by operations decreased $1.0 million for the year ended
December 31, 1998 compared to the year ended December 31, 1997, primarily as a
result of timing of recurring cash receipts and disbursements related to accrued
expenses and subrogation recoveries.
Net cash used in investing activities primarily reflects the Company's
capital expenditures for ongoing facility expansion and system enhancements,
including computer hardware, to meet the requirements of the Company's growing
revenue base. Capital expenditures for the year ending December 31, 1998 were
approximately $3.8 million for facility expansion, computer hardware and the
SubroSystem Upgrade. Over the next 12 months, the Company anticipates capital
expenditures approximating the same as 1998 for the upgrade and the integration
of the Subro-Audit, Inc. and a related entity, O'Donnell Leasing Co., LLP,
acquisition, which closed on January 25, 1999, and for the MedCap Medical Cost
Management, Inc. acquisition, which closed on February 15, 1999. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Recent Developments."
Net cash provided by financing activities for the year ended December 31,
1998 reflects $0.4 million in cash proceeds received in connection with the
exercise of a former employee's stock options. Net cash provided by financing
activities for the year ended December 31, 1997 reflects $19.2 million in cash
proceeds received in connection with the exercise of the underwriters'
over-allotment option, offset by a $2.2 million distribution to Medaphis. An
amount of $4.3 million representing a distribution to Medaphis is reflected in
the 1996 cash used in financing activities.
16
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In February 1998, the Company entered into a $50 million senior secured
revolving credit facility (the "Credit Facility") with National City Bank of
Kentucky and the lenders named therein, replacing the Company's $10 million line
of credit. The principal amount outstanding under the Credit Facility will
mature on January 31, 2001 and bears interest at the Company's option, at
either: (i) the Prime Rate plus the applicable margin in effect or (ii) the
Eurodollar Rate plus the applicable margin in effect. The applicable margin is
determined in accordance with a Pricing Grid based on the Company's ratio of
consolidated total indebtedness to consolidated earnings before interest, taxes,
depreciation and amortization. The agreement contains usual and customary
covenants including, but not limited to, financial tests for interest coverage,
net worth levels and leverage that may limit the Company's ability to pay
dividends. The Company's obligations under the Credit Facility are secured by
substantially all of the Company's assets, subject to certain permitted
exceptions. As of March 25, 1999, the Company was in compliance with the
covenants and a total of $12.3 million was drawn under the Credit Facility for
two acquisitions the Company recently completed. The Credit Facility was amended
in May 1998 and March 1999 to enable the Company to acquire entities that do not
maintain audited financials and to use proceeds from the Credit Facility to
repurchase up to $10 million of outstanding stock, respectively. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Recent Developments."
By contract, with respect to its standard recovery services, the Company
disburses recoveries to its clients on or before the 15th day of the month
following the month in which recoveries are made. At December 31, 1998 and
December 31, 1997, the Company reported on its balance sheet, as a current
asset, restricted cash of $16.9 million and $14.2 million, respectively,
representing subrogation recoveries effected by HCRI for its clients. At
December 31, 1998 and December 31, 1997, HCRI reported on its balance sheet, as
a current liability, funds due clients of $13.1 million and $11.6 million,
respectively, representing recoveries to be distributed to clients, net of the
fee earned on such recoveries.
The Company believes that its available cash resources, together with the
borrowings available under the Credit Facility, will be sufficient to meet its
current operating requirements and acquisitions and internal development
initiatives.
IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
There are no recently issued accounting pronouncements which are expected
to have a significant impact on the Company, other than those previously
disclosed and currently being applied.
RECENT DEVELOPMENTS
Acquisitions
On January 25, 1999, HCRI acquired the assets of Subro-Audit, Inc., a
Wisconsin corporation, and a related entity, O'Donnell Leasing Co., LLP, a
Wisconsin limited liability partnership (together, "SAI"), for approximately
$24.4 million, using available unrestricted cash, and may pay up to $8.5 million
over the next two years pursuant to an earn-out arrangement. SAI is based in
Wisconsin and has provided recovery services to an installed base of
approximately 8 million lives, who are covered by insurers, HMOs and
employer-funded plans throughout the United States. The acquisition will be
accounted for using the purchase method of accounting and will be operated as a
division of HCRI.
On February 15, 1999, HCRI acquired the assets of MedCap Medical Cost
Management Systems, Inc., a California corporation ("MedCap"), for approximately
$10 million, using existing cash and short-term borrowed funds, and may pay up
to fifty percent of the gross profits of the MedCap business for each of the
twelve month periods ending December 31, 1999 and 2000, pursuant to an earn-out
arrangement. MedCap provides a variety of medical cost management services to
health insurers and HMOs primarily in California. These services include
hospital bill auditing, contract compliance review, identification of certain
other payments, and cost management consulting services. The acquisition will be
accounted for using the purchase method of accounting and will be operated as a
division of HCRI.
17
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Anticipated First Quarter 1999 Results
On March 15, 1999, HCRI announced that based on information available as of
that date, the Company expected revenues for the first quarter of 1999 to be in
the range of $13.0 million to $14.0 million. The Company further anticipated
revenues in this range to result in earnings between $0.12 and $0.14 per share,
on a diluted basis.
Stock Repurchase Plan
HCRI also announced that its Board had authorized a stock repurchase plan
under which the Company may repurchase up to $10 million of HCRI Common Stock in
the open market, from time to time, at prices per share deemed favorable by it.
Shares will be repurchased using borrowed funds and will continue until such
time as the Company has repurchased $10 million of HCRI Common Stock or until it
otherwise determines to terminate the stock repurchase plan.
Adoption of a Rights Plan
On February 12, 1999, the Board of Directors adopted a Stockholder Rights
Plan and declared a dividend of one preferred stock purchase right (a "Right")
for each outstanding share of Common Stock of the Company. The dividend was
payable to stockholders of record on March 1, 1999. The Rights, which will
initially trade with the Common Stock, separate and become exercisable only upon
the earlier to occur of (i) 10 days after the date (the "Stock Acquisition
Date") of a public announcement that a person or group of affiliated persons has
acquired 20% or more of the Common Stock (such person or group being hereinafter
referred to as an "Acquiring Person") or (ii) 10 days (or such later date as the
Board of Directors shall determine) after the commencement of, or announcement
of an intention to make, a tender offer or exchange offer that could result in
such person or group owning 20% or more of the Common Stock (the earlier of such
dates being called the "Distribution Date"). When exercisable, each Right
initially entitles the registered holder to purchase from the Company one
one-hundredth of a share of a newly created class of preferred stock of the
Company at a purchase price of $65 (the "Purchase Price"). The Rights are
redeemable for $0.001 per Right at the option of the Board of Directors. The
Rights expire on March 1, 2009.
If any person becomes an Acquiring Person, each holder of a Right will
thereafter have the right (the "Flip-In Right") to receive, in lieu of shares of
preferred stock and upon payment of the Purchase Price, shares of Common Stock
having a value equal to two times the Purchase Price of the Right. Also, if at
any time on or after the Stock Acquisition Date, (i) the Company is acquired in
a transaction in which the holders of all the outstanding shares of Common Stock
immediately prior to the consummation of the transaction are not the holders of
all of the surviving corporation's voting power, or (ii) more than 50% of the
Company's assets, cash flow or earning power is sold or transferred other than
in the ordinary course of business, then each holder of a Right shall thereafter
have the right (the "Flip-Over Right") to receive, in lieu of shares of
preferred stock and upon exercise and payment of the Purchase Price, common
shares of the acquiring company having a value equal to two times the Purchase
Price. If a transaction would otherwise result in a holder having a Flip-In as
well as a Flip-Over Right, then only the Flip-Over Right will be exercisable. If
a transaction results in a holder having a Flip-Over Right subsequent to a
transaction resulting in the holder having a Flip-In Right, a holder will have a
Flip-Over Right only to the extent such holder's Flip-In Rights have not been
exercised.
Related Party Transaction
On February 12, 1999, the Board of Directors authorized a loan in the
amount of $350,000 to Patrick B. McGinnis, the Chairman and Chief Executive
Officer of the Company, in exchange for a full recourse promissory note in the
same amount from Mr. McGinnis. The full recourse promissory note bears interest
at a rate equal to the Company's cost of borrowing under its Credit Facility, or
if no loan amount is outstanding under the Credit Facility, the federal
short-term rate.
18
21
EXTERNAL FACTORS
The business of recovering subrogation and related claims for healthcare
payors is subject to a wide variety of external factors. Prominent among these
are factors that would materially change the healthcare payment, fault-based
liability or workers' compensation systems. Because the Company's profitability
depends in large measure upon obtaining and using claims data, and the
availability of property and casualty and workers' compensation coverages as
sources of recovery, changes in laws that would limit or bar either the access
to or use of claims data or the ability of healthcare payors to recover
subrogation and related claims represent an ongoing risk to the Company.
Moreover, because the Company's revenues derive from the recovery of the
costs of medical treatment of accidents, material changes in such costs will
tend to affect the Company's revenue or its rate of revenue growth. The
healthcare industry, and particularly the business of healthcare payors, is
subject to various external factors that may have the effect of significantly
altering the costs of healthcare. The Company is unable to predict which of
these factors, if any, could have a potentially material impact on healthcare
payors and through them, the healthcare subrogation recovery industry.
The Company provides services to healthcare plans that as of December 31,
1998 covered approximately 40.5 million lives. HCRI's clients are national and
regional healthcare payors, large third-party administrators or self-insured
corporations. During 1998 and 1997, HCRI's largest clients generated 28%, 8%,
and 7%, and 31%, 9% and 9%, respectively, of HCRI's revenues. The loss of one or
more of these accounts could have a material adverse effect on HCRI's business,
results of operations and financial condition. On December 31, 1998, HCRI had
backlog of $770.7 million. HCRI's revenues are earned under written contracts
with its clients that generally provide for contingency fees from recoveries
under a variety of pricing regimes. The pricing arrangements offered by HCRI to
its clients include a fixed fee percentage, a fee percentage that declines as
the number of lives covered by the client and subject to HCRI's service
increases and a fee percentage that varies with HCRI's recovery performance.
YEAR 2000 ISSUES
The year 2000 presents a problem for computer systems (software and
hardware) that were not designed to handle any dates beyond the year 1999. The
problem is pervasive and complex because virtually every computer operation will
be affected in some way by the rollover of the last two digits of the year "00."
In consequence, any such software and hardware will need to be modified some
time prior to December 31, 1999, in order to remain functional. Computer systems
that do not properly handle this rollover could generate erroneous data or fail
to function.
The Company has initiated a company-wide program to identify and address
the modifications to or replacements of computer code (including data received
from clients), hardware and office equipment, the testing and the implementation
procedures necessary to achieve year 2000 readiness ("Y2K Readiness" or
descriptively, "Y2K Ready"). As a result of this program, all functions within
the Company have been surveyed in order to first, identify software and hardware
that are not presently Y2K Ready, and secondly, to establish a schedule for
remediation or replacement of the items of software and hardware that are not
Y2K Ready.
The Company has completed its identification of the elements of its
software and hardware that are not Y2K Ready. Included among these elements are
certain fields contained in the SubroSystem, the Company's on-line subrogation
system. The first date of potential failure for all of these items of software
and hardware, including the SubroSystem, is January 1, 2000. The completion date
for replacement or remediation of all elements of Company software, including
the SubroSystem, and hardware which are not already Y2K Ready, is September 30,
1999. Although the Company had previously estimated a June 30, 1999 completion
date, the Company directed certain resources during the fourth quarter of 1998
to facilitate acquisitions and certain other matters which caused the delay. To
date, the costs of the Company's efforts to achieve Y2K Readiness have not
exceeded $75,000, and are not expected to exceed $150,000 in total.
19
22
Management believes that the greatest risk posed to the Company's Y2K
Readiness lies in the possible failure of its clients and other members of the
healthcare payor industry to achieve Y2K Readiness. The Company relies on its
clients to provide electronic claims data, through electronic data interfaces,
as the source of information from which the Company identifies potentially
recoverable claims. If clients are unable to provide such data because they are
not Y2K Ready, the Company could suffer a slow-down in its recovery efforts,
impairing its ability to make the recoveries from which it derives its revenue.
Moreover, to the extent that payors which are potential clients fail to achieve
Y2K Readiness, HCRI's ability to sell to and to install such payors may also be
impaired. With respect to current clients, HCRI has undertaken a survey of each
client's state of Y2K Readiness. The Company has received notifications from 70%
of its client base, representing more than 70% of its installed lives. All
notifications indicated that clients have Y2K efforts underway. The Company is
attempting to obtain surveys from its remaining client base. However, as the
Company is relying upon representations of client Y2K Readiness in response to
the surveys, the Company is closely monitoring progress through available means,
and preparing for contingencies, as necessary.
The Company's contingency planning calls for, among other things, early
identification of alternative means of obtaining electronic claims data should
the existing electronic data interfaces with clients fail. Contingency plans are
being developed on an as-needed, client-specific basis, as warranted.
ITEM 7A. QUANTITATIVE & QUALITATIVE MARKET RISK DISCLOSURES
The Company is exposed to market risk from changes in interest rates
related to its Credit Facility. The impact on earnings and value of any debt
under its Credit Facility is subject to change as a result of movements in
market rates and prices. The Credit Facility is subject to variable interest
rates. As of December 31, 1998, the Company had nothing outstanding under its
Credit Facility.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
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REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders
Healthcare Recoveries, Inc.
In our opinion, the accompanying balance sheets and the related statements
of income, changes in stockholders' equity and cash flows present fairly, in all
material respects, the financial position of Healthcare Recoveries, Inc. (the
Company) at December 31, 1998 and 1997, and the results of its operations and
its cash flows for each of the three years in the period ended December 31,
1998, in conformity with generally accepted accounting principles. These
financial statements are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these statements in accordance with
generally accepted auditing standards which require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion expressed
above.
PricewaterhouseCoopers LLP
February 16, 1999, except for
Note 15 as to which the date
is March 22, 1999.
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HEALTHCARE RECOVERIES, INC.
BALANCE SHEETS
DECEMBER 31, 1998 AND 1997
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
1998 1997
------- -------
ASSETS
Current assets:
Cash and cash equivalents................................. $31,133 $24,674
Restricted cash........................................... 16,927 14,207
Accounts receivable, less allowance for doubtful accounts
of $307 in 1998 and $251 in 1997....................... 3,607 2,507
Other current assets...................................... 1,583 676
------- -------
Total current assets.............................. 53,250 42,064
------- -------
Property and equipment, at cost:
Furniture and fixtures.................................... 2,527 2,177
Office equipment.......................................... 1,783 1,471
Computer equipment........................................ 7,991 5,066
Leasehold improvements.................................... 845 649
------- -------
13,146 9,363
Accumulated depreciation and amortization................. (6,962) (4,920)
------- -------
Property and equipment, net....................... 6,184 4,443
Other assets................................................ 1,569 1,663
------- -------
Total assets...................................... $61,003 $48,170
======= =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable.................................... $ 1,234 $ 986
Accrued expenses.......................................... 5,516 4,770
Funds due clients......................................... 13,118 11,643
Income taxes payable...................................... 2,484 1,754
------- -------
Total current liabilities......................... 22,352 19,153
Other liabilities........................................... 1,458 1,152
------- -------
Total liabilities................................. 23,810 20,305
------- -------
Commitments and contingencies
Stockholders' equity:
Preferred stock, $.001 par value; 2,000,000 shares
authorized; no shares issued or outstanding............ -- --
Common stock, $.001 par value; 20,000,000 shares
authorized; 11,502,987 shares and 11,470,000 shares
issued and outstanding, respectively................... 12 11
Capital in excess of par value............................ 22,428 22,001
Retained earnings......................................... 14,753 5,853
------- -------
Total stockholders' equity........................ 37,193 27,865
------- -------
Total liabilities and stockholders' equity........ $61,003 $48,170
======= =======
The accompanying notes are an integral part of the financial statements.
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HEALTHCARE RECOVERIES, INC.
STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
1998 1997 1996
------- ------- -------
Revenues:
Subrogation............................................... $48,734 $39,277 $30,248
Other revenues............................................ -- -- 1,171
------- ------- -------
Total revenues.................................... 48,734 39,277 31,419
Cost of services............................................ 22,199 18,523 15,026
------- ------- -------
Gross profit...................................... 26,535 20,754 16,393
Support expenses............................................ 10,692 8,922 7,215
Depreciation and amortization............................... 2,334 1,181 878
Non-recurring compensation charge (See Note 7).............. -- 2,848 --
------- ------- -------
Operating income.................................. 13,509 7,803 8,300
Interest income, net........................................ 1,657 1,158 486
------- ------- -------
Income before income taxes........................ 15,166 8,961 8,786
Provision for income taxes.................................. 6,266 4,959 3,685
------- ------- -------
Net income........................................ $ 8,900 $ 4,002 $ 5,101
======= ======= =======
Earnings per common share (basic)........................... $ 0.78 $ 0.37 $ 0.52
======= ======= =======
Earnings per common share (diluted)......................... $ 0.77 $ 0.37 $ 0.52
======= ======= =======
The accompanying notes are an integral part of the financial statements.
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HEALTHCARE RECOVERIES, INC.
STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(DOLLARS IN THOUSANDS)
EQUITY
CAPITAL IN FUNDING
COMMON STOCK EXCESS OF FROM (TO) RETAINED
---------------------- PAR MEDAPHIS EARNINGS
SHARES AMOUNT VALUE CORPORATION (DEFICIT) TOTAL
----------- -------- ---------- ----------- --------- -------
Balances, December 31, 1995....... 9,800,000 $ 10 -- $ 4,447 $(1,183) $ 3,274
Net income...................... 5,101 5,101
Distribution to Medaphis........ (4,265) (4,265)
----------- -------- ------- ------- ------- -------
Balances, December 31, 1996....... 9,800,000 10 -- 182 3,918 4,110
Net income...................... 4,002 4,002
Issuance of common stock........ 1,470,000 1 19,241 19,242
Non-recurring compensation
charge....................... 200,000 -- 2,800 2,800
Distributions to Medaphis
Corporation.................. (182) (2,067) (2,249)
Other........................... (40) (40)
----------- -------- ------- ------- ------- -------
Balances, December 31, 1997....... 11,470,000 11 22,001 -- 5,853 27,865
Net income...................... 8,900 8,900
Issuance of common stock........ 32,987 1 427 428
----------- -------- ------- ------- ------- -------
Balances, December 31, 1998....... $11,502,987 $ 12 $22,428 -- $14,753 $37,193
=========== ======== ======= ======= ======= =======
The accompanying notes are an integral part of the financial statements.
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HEALTHCARE RECOVERIES, INC.
STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(DOLLARS IN THOUSANDS)
1998 1997 1996
------- ------- -------
Cash flows from operating activities:
Net income................................................ $ 8,900 $ 4,002 $ 5,101
Adjustments to reconcile net income to net cash provided
by operating activities:
Non-recurring compensation charge...................... -- 2,848 --
Depreciation and amortization............................. 2,334 1,181 878
Deferred income taxes..................................... 341 (295) (27)
Changes in operating assets and liabilities:
Restricted cash........................................ (2,720) 4,548 (9,247)
Accounts receivable.................................... (1,100) (581) (630)
Other current assets................................... (960) (379) 89
Other assets........................................... (318) (1,085) (42)
Trade accounts payable................................. 248 400 296
Accrued expenses....................................... 746 1,109 1,473
Funds due clients...................................... 1,475 (3,310) 8,028
Income taxes payable................................... 730 1,754 --
Other liabilities...................................... 138 572 (43)
------- ------- -------
Net cash provided by operating activities......... 9,814 10,764 5,876
------- ------- -------
Cash flows from investing activities:
Purchases of property and equipment....................... (3,783) (3,096) (1,558)
------- ------- -------
Net cash used in investing activities............. (3,783) (3,096) (1,558)
Cash flows from financing activities:
Issuance of common stock.................................. 428 19,242 --
Distributions to Medaphis Corporation..................... -- (2,249) (4,265)
Other..................................................... -- (40) --
------- ------- -------
Net cash provided by (used in) financing activities......... 428 16,953 (4,265)
------- ------- -------
Net increase in cash and cash equivalents................... 6,459 24,621 53
Cash and cash equivalents, beginning of period.............. 24,674 53 --
------- ------- -------
Cash and cash equivalents, end of period.................... $31,133 $24,674 53
======= ======= =======
Supplemental cash flows disclosure:
Income tax payments......................................... $ 5,293 $ 3,753 $ 3,712
======= ======= =======
The accompanying notes are an integral part of the financial statements.
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HEALTHCARE RECOVERIES, INC.
NOTES TO FINANCIAL STATEMENTS
1. ORGANIZATION AND BASIS OF PRESENTATION:
Healthcare Recoveries, Inc. (the "Company") was incorporated on June 30,
1988 under the laws of the State of Delaware. The Company's services comprise
the complete outsourcing of the identification, investigation and recovery of
accident-related medical benefits incurred by its clients on behalf of their
insureds, but which other persons or entities have primary responsibility. The
Company's clients' rights to recover the value of these medical benefits,
arising by law or contract, are generally known as the right of subrogation and
paid from the proceeds of liability or workers' compensation insurance.
The Company operated as an independent entity until August 28, 1995 when it
was merged with and into a subsidiary of Medaphis Corporation ("Medaphis") in a
transaction accounted for as a pooling of interests (the "Merger"). Prior to the
Merger, the Company's redeemable convertible preferred stock was converted to
Common Stock. As of the effective time of the Merger, each share of the then
issued and outstanding Company Common Stock was exchanged for Medaphis common
stock. Employee stock options of the Company outstanding at the effective time
of the Merger were also substituted with similar options on Medaphis common
stock. Subsequent to the Merger, Medaphis recapitalized the Company effectively
canceling all but 100 shares of common stock (not adjusted for the Stock Split
discussed in Note 11), pledged the assets and shares as collateral for Medaphis'
bank debt, and made the Company a guarantor for Medaphis' bank debt.
On May 21, 1997, the Company completed its initial public offering (the
"Offering") of 9,800,000 shares of Common Stock, excluding 200,000 shares issued
in connection with the non-recurring compensation charge (see Note 7). Medaphis
sold all the shares. As a result, the Company received no proceeds from the sale
of shares in the Offering. On June 9, 1997, the Company sold 1,470,000 shares of
Common Stock to the underwriters of the Offering in satisfaction of the exercise
of an over-allotment option, resulting in proceeds to the Company of
approximately $19.2 million.
In connection with the Offering, certain revisions to allocations and
estimates were made by management in the accompanying financial statements for
the periods during which the Company was a subsidiary of Medaphis to present the
financial position, results of operations and cash flows of the Company as an
independent entity. Costs previously incurred by Medaphis on behalf of the
Company include executive salaries, employee benefits, insurance,
telecommunications, payroll processing and other general and administrative
expenses. The allocation of these costs was based principally on specific
identification, the ratio of the number of Company employees to total Medaphis
employees or the ratio of total Company assets to total Medaphis assets, as
appropriate. Total cost allocated to the Company was $361,000 for the year ended
December 31, 1996. Effective January 1, 1997, these costs were paid by the
Company. Management believes that, in the aggregate, costs of this nature
reflect the fair value of services rendered by Medaphis and that it would have
incurred similar costs as an independent entity.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
CASH, CASH EQUIVALENTS AND RESTRICTED CASH
Cash and cash equivalents include cash, demand deposits and highly liquid
investments with an original maturity of three months or less. Carrying values
of cash and cash equivalents approximate fair value due to the short-term nature
of the instruments.
Restricted cash represents the balance in client-specific bank accounts of
amounts collected on behalf of certain clients. A portion of the balance will be
disbursed to clients in accordance with the terms of the contracts between the
Company and its clients, while the remainder will be released to the Company.
The Company's cash, cash equivalents and restricted cash have been placed
with one financial institution.
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HEALTHCARE RECOVERIES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost. Depreciation and amortization
are provided using the straight-line method over the estimated useful lives of
the respective assets. Estimated useful lives of property and equipment range
from three to five years. Effective January 1, 1998, the Company adopted
Statement of Position 98-1, which requires the capitalization of internal and
external costs incurred to develop or obtain computer software for internal use.
REVENUE RECOGNITION
Subrogation revenues are generally derived from contingent fee arrangements
based on the recoveries effected by the Company on behalf of its clients.
Revenue is recognized when a fee is earned based on the settlement of a case. A
case is deemed settled when the parties agree on all material terms associated
with the settlement. Typically, a settlement is reached verbally over the
telephone, followed by a letter sent by Company personnel confirming the terms
of the settlement.
OTHER REVENUES
Other revenues represent amounts associated with non-recurring subrogation
services for clients in connection with class action tort claims relating to the
use of breast implants.
PROVISION FOR INCOME TAXES
The provision for income taxes has been prepared as if the Company was an
independent entity for all periods presented and in accordance with the
provisions of Statement of Financial Accounting Standards ("SFAS") No. 109,
"Accounting for Income Taxes."
STOCK-BASED COMPENSATION PLANS
The Company accounts for its employee stock-based compensation plans under
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees" ("APB No. 25"). Effective in 1996, the Company implemented the
disclosure requirements of SFAS No. 123, "Accounting for Stock-Based
Compensation." SFAS No. 123 requires companies that elect not to account for
stock-based compensation as prescribed by SFAS No. 123, to disclose the pro
forma effects on earnings and earnings per share as if SFAS No. 123 had been
adopted. Additionally, certain other disclosures are required with respect to
stock compensation and the assumptions used in determining the pro forma effects
of SFAS No. 123.
27
30
HEALTHCARE RECOVERIES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
EARNINGS PER COMMON SHARE
A reconciliation of the numerators and denominators of the basic and
diluted earnings per common share calculations follows (dollars in thousands,
except per share results):
PER-SHARE
NET INCOME SHARES RESULTS
---------- ---------- ---------
YEAR ENDED DECEMBER 31, 1998:
Basic earnings per common share..................... $8,900 11,484,266 $ 0.78
Effect of dilutive stock options.................... -- 70,676 (0.01)
Diluted earnings per common share................... 8,900 11,554,942 0.77
YEAR ENDED DECEMBER 31, 1997:
Basic earnings per common share..................... 4,002 10,752,384 0.37
Effect of dilutive stock options.................... -- 66,293 --
Diluted earnings per common share................... 4,002 10,818,677 0.37
YEAR ENDED DECEMBER 31, 1996:
Basic earnings per common share..................... 5,101 9,800,000 0.52
Effect of dilutive stock options.................... -- -- --
Diluted earnings per common share................... 5,101 9,800,000 0.52
Basic earnings per common share for 1997 were computed based on the
weighted-average number of shares outstanding during the period after giving
retroactive effect to the Stock Split (see Note 11). The dilutive effect of
stock options is calculated using the treasury stock method. Options to purchase
360,550 shares for the year ended December 31, 1998 were not included in the
computation of diluted earnings per common share as the options' exercise prices
were greater than the average market price of the common shares during the
period.
USE OF ESTIMATES AND ASSUMPTIONS
Preparation of the Company's financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions. These estimates and assumptions affect (i) reported amounts of
assets and liabilities, (ii) disclosure of contingent assets and liabilities at
the date of the financial statements and (iii) reported amounts of revenues and
expenditures during the reporting period. Actual results may differ from those
estimates.
3. LEASE COMMITMENTS:
The Company leases office space and certain equipment. Future minimum lease
payments, by year and in the aggregate, under noncancelable operating leases
with initial or remaining terms in excess of one year at December 31, 1998 are
as follows (in thousands):
1999........................................................ $1,195
2000........................................................ 1,179
2001........................................................ 1,156
2002........................................................ 587
------
$4,117
======
Rental expense, which includes amounts applicable to short-term leases, was
approximately $1,110,000, $979,000 and $806,000 for the years ended December 31,
1998, 1997 and 1996, respectively.
28
31
HEALTHCARE RECOVERIES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
4. INCOME TAXES:
The provision for income taxes for the years ended December 31, 1998, 1997
and 1996 consists of the following (in thousands):
1998 1997 1996
------ ------ ------
Current:
Federal................................................... $4,961 $3,941 $2,784
State and local........................................... 964 1,313 928
------ ------ ------
5,925 5,254 3,712
------ ------ ------
Deferred:
Federal................................................... 286 (246) (22)
State and local........................................... 55 (49) (5)
------ ------ ------
341 (295) (27)
------ ------ ------
$6,266 $4,959 $3,685
====== ====== ======
The following is a reconciliation of the effective tax rate to the federal
statutory rate for the years ended December 31, 1998, 1997 and 1996:
1998 1997 1996
---- ---- ----
Federal statutory rate...................................... 35.0% 35.0% 35.0%
State and local taxes, net of federal tax benefit........... 6.8 6.8 6.8
Non-recurring compensation charge........................... -- 13.3 --
Other, net.................................................. (0.5) 0.2 0.1
---- ---- ----
41.3% 55.3% 41.9%
==== ==== ====
Temporary differences giving rise to deferred taxes in the accompanying
balance sheets at December 31, 1998 and 1997 consist of the following (in
thousands):
1998 1997
-------------------- --------------------
ASSETS LIABILITIES ASSETS LIABILITIES
------ ----------- ------ -----------
Accrued bonuses.................................... $ 585 $ 456 --
Accounts receivable................................ $1,395 -- $940
Accrued litigation................................. 596 555 --
Other.............................................. 163 15 219 15
------ ------ ------ ----
$1,344 $1,410 $1,230 $955
====== ====== ====== ====
Management believes that the deferred tax assets are realizable based
primarily on the existence of sufficient taxable income within the allowable
carryback period.
5. MAJOR CLIENTS:
The following table presents the percentage of total revenues contributed
by the Company's largest clients for the years ended December 31, 1998, 1997 and
1996:
1998 1997 1996
---- ---- ----
UnitedHealth Group.......................................... 28% 31% 25%
Kaiser Permanente........................................... 8 9 12
-- -- --
36% 40% 37%
== == ==
29
32
HEALTHCARE RECOVERIES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
No other client accounted for more than 10% of the Company's total
revenues. The loss of one or both of these clients could have a material adverse
effect on the Company's results of operations, financial position and cash
flows.
6. RELATED PARTY TRANSACTION:
The Company has entered into a contract for legal services with a
professional service corporation that is wholly owned by one of the Company's
officers. This arrangement exists solely for the purpose of minimizing the costs
of legal services purchased by the Company on behalf of its clients. For the
years ended December 31, 1998, 1997 and 1996, approximately $1,320,000,
$1,001,000 and $748,000, respectively, was paid to this law firm for such legal
services.
7. NON-RECURRING COMPENSATION CHARGE:
During the second quarter of 1997, the Company recognized a non-recurring,
non-cash compensation charge of approximately $2.8 million relating to a bonus
comprised of 200,000 shares of the Company's Common Stock granted by the Company
to certain members of the Company's executive management upon consummation of
the Offering. The amount of the charge approximated the fair value of the shares
granted based on the Offering price of $14.00 per share.
8. EMPLOYEE BENEFIT PLAN:
PENSION PLAN
The Company's employees participated in the 401(k) defined contribution
pension plan of Medaphis prior to January 1, 1997. Effective on that date, the
Company's employees began participation in the Company's 401(k) defined
contribution pension plan. Annual expense provisions for both plans are based
upon the level of employee participation, as the plans require the Company to
match a certain portion of the employees' contributions. Total retirement plan
expense was approximately $342,700, $247,000 and $165,000 for the years ended
December 31, 1998, 1997 and 1996, respectively.
OTHER
Accrued bonuses included in the accompanying balance sheets at December 31,
1998 and 1997 approximate $4.4 and $3.4 million, respectively.
9. CONTINGENCIES:
The Company is engaged in the business of identifying and recovering
subrogation and related claims of its clients, many of which arise in the
context of personal injury lawsuits. As such, the Company operates in a
litigation-intensive environment. The Company has, from time to time, been, and
in the future expects to be, named as a party in litigation incidental to its
business operations. To date, the Company has not been involved in any
litigation which has had a material adverse effect upon the Company, but there
can be no assurance that pending litigation or future litigation will not have a
material adverse effect on the Company's business, results of operations or
financial condition.
10. CREDIT FACILITY:
On February 1, 1998, the Company entered into an agreement which provides
an unsecured revolving line of credit (the "Credit Facility") for borrowings up
to a maximum of $50 million, expiring January 31, 2001. There were no
outstanding borrowings on this line at December 31, 1998 (See Note 15). The
Credit Facility replaced an existing $10 million revolving line of credit, under
which there were no outstanding borrowings at December 31, 1997. Principal
amounts outstanding under the Credit Facility bear interest at a variable rate
30
33
HEALTHCARE RECOVERIES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
based on the Prime Rate or Eurodollar Rate, as applicable, plus a pre-determined
margin based on the ratio of the Company's total indebtedness to earnings before
interest, taxes, depreciation and amortization. The agreement contains customary
covenants and events of default including maintenance of certain minimum
interest coverage and leverage ratios and a minimum level of net worth. The
agreement also contains a material adverse change clause. The Company does not
expect changes in interest rates to have a material effect on its financial
position, results of operation or cash flows in 1999. The Credit Facility was
amended in May 1998 and March 1999 to enable the Company to acquire entities
that do not maintain audited financials and to use proceeds from the Credit
Facility to repurchase up to $10 million of outstanding Common Stock.
11. RECAPITALIZATION:
On May 16, 1997, the Company amended its Certificate of Incorporation to
authorize 2,000,000 shares of $.001 par value preferred stock and 20,000,000
shares of $.001 par value Common Stock, of which 9,800,000 shares of Common
Stock were issued and outstanding after a 98,000-for-1 Common Stock split
("Stock Split"), which the Company declared to be effective immediately prior to
the Offering. The Stock Split was effected in the form of a stock dividend.
Accordingly, all references in the accompanying financial statements to number
of shares and related per share results have been stated to reflect these
changes.
12. SEPARATION AGREEMENT WITH MEDAPHIS:
Effective May 21, 1997, the Company and Medaphis entered into a separation
agreement (the "Separation Agreement") that provided for the separation of the
Company from Medaphis. The Separation Agreement provided that on the date of the
Offering (i) the Company would (assuming none of the underwriters'
over-allotment option had been exercised) have a nominal amount of unrestricted
cash, and would not owe any amount to Medaphis (except as discussed below with
respect to purchased goods and services, certain employee benefit plan payments
and a distribution to be paid to Medaphis to reduce the Company's stockholders'
equity to $4,110,000) and (ii) Medaphis would not owe any amount to the Company.
The Separation Agreement also provided that (i) the Company would pay
(without markup or markdown) Medaphis after the consummation of the Offering for
any goods or services purchased from or through Medaphis prior to consummation
but not paid for prior to such consummation; (ii) Medaphis would cause its bank
lenders to release in connection with the Offering the Company's guaranty of
Medaphis' bank debt, all liens on the Company's assets and the common stock to
be sold by Medaphis pursuant to the Offering; (iii) the Company would upon
consummation of the Offering assume responsibility for providing health
insurance or insurance coverage to former company employees (and their eligible
dependents) who have exercised their right under federal law to obtain such
insurance or insurance coverage in accordance with applicable federal law; (iv)
assets and liabilities under the Medaphis "cafeteria" employee benefit plan
relating to the Company's employees would be transferred to a new Company
"cafeteria" benefit plan, together with an adjusting payment to or from the
Company to reflect any difference between plan assets and liabilities; (v) after
consummation of the Offering, Medaphis would transfer assets in the Medaphis
401(k) retirement plan that relate to the Company's employees to a new 401(k)
retirement plan in a manner that satisfies legal requirements for interplan
asset transfers; (vi) all stock options held by the Company's employees as of
the consummation of the Offering would, in accordance with the particular option
plan under which such options were granted, become immediately vested as of such
date and any such optionees would be entitled to exercise their options in
accordance with the terms of the particular option agreements relating to the
granting of such options; (vii) effective as of the consummation of the
Offering, the Company was required to have in place certain insured and
self-funded welfare benefit plans and arrangements to cover those Company
employees who were covered by such types of plans prior to such date; and (viii)
Medaphis would pay, in one lump sum, the account balances under the Medaphis
Executive Deferred Compensation Plan due
31
34
HEALTHCARE RECOVERIES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
to those plan participants who would be continuing employment with the Company
after consummation of the Offering.
With respect to indemnification, the Separation Agreement provided that (i)
the Company would indemnify Medaphis for federal, state and local income and
other tax liability relating to the Company for all periods ending on or prior
to August 28, 1995, the date of the Merger and for all periods after the
consummation of the Offering; (ii) Medaphis would indemnify the Company for
federal income tax liability relating to Medaphis or any of its subsidiaries
(including the Company), and for state and local income and other tax liability
relating to Medaphis or any subsidiaries (other than the Company) from August
29, 1995 to the date of consummation of the Offering; (iii) the Company would
indemnify Medaphis from liability due to or arising out of acts or failures to
act of the Company in the periods described in clause (i); (iv) Medaphis would
indemnify the Company from liability due to or arising out of the acts or
failures to act of Medaphis or any of its subsidiaries (other than the Company)
for all periods described in (i) and (ii); and (v) Medaphis would indemnify the
non-employee directors of the Company from certain liabilities arising out of
the Offering, including liabilities under the Securities Act of 1993.
13. COMMON STOCK OPTIONS:
Upon consummation of the Offering, the Company adopted the Healthcare
Recoveries, Inc. Non-Qualified Stock Option Plan for Eligible Employees (the
"Employees' Plan"), the Healthcare Recoveries, Inc. Amended and Restated
Directors' Stock Option Plan (the "Directors' Plan") and the Healthcare
Recoveries, Inc. Employee Stock Purchase Plan (the "Purchase Plan"). On December
8, 1997, the Company adopted the Healthcare Recoveries, Inc. 1997 Stock Option
Plan for Eligible Participants (the "1997 Plan").
The Employees' Plan provides for the award of stock options to certain
officers and key employees of the Company. Options under the Employees' Plan are
exercisable at 100% of the market value of the Company's Common Stock on the
date of grant. Awards under the Employees' Plan vest ratably over a three-year
period and expire ten years from the date of grant. As provided in the
Employees' Plan, all options granted to the Company's employees automatically
vest in the event of a change in control. At December 31, 1998, 673,750 shares
of Common Stock were reserved for issuance under the Employees' Plan, including
105,889 shares available for future award.
The Directors' Plan provides for the grant of options to purchase the
Company's Common Stock to each non-employee director of the Company. Options
under the Directors' Plan are exercisable at 100% of the market value of the
Company's Common Stock on the date of grant. Each eligible director is to be
granted on the date of each annual meeting of stockholders of the Company
beginning in 1998 an option to purchase 2,000 shares of Common Stock, for so
long as shares are available under the Plan, but not after March 31, 2002. Terms
of options granted under this Plan commence on the date of grant and expire on
the tenth anniversary of the grant date. Each option is to become exercisable
when vested. The options vest ratably over a three-year period, provided that
the optionee must be a non-employee Director of the Company on each such
anniversary in order for options to vest on such date. At December 31, 1998,
150,000 shares of Common Stock were reserved for issuance under the Directors'
Plan, including 90,000 shares available for future award.
Under the Purchase Plan, eligible employees may purchase shares of the
Company's Common Stock, subject to certain limitations, at 85% of its market
value. Purchases are made from payroll deductions up to a maximum of 15% of an
employee's eligible annual compensation. During the year ended December 31,
1998, 6,737 shares of the Company's Common Stock were purchased under the
Purchase Plan, resulting in 293,263 reserved shares of Common Stock being
available for purchase at December 31, 1998.
The 1997 Plan provides for the grant of options to purchase the Company's
Common Stock to eligible participants of the Company at 100% of the market value
of the Company's Common Stock on the date of grant. Awards under the 1997 Plan
expire ten years from the date of grant and vest according to the terms that
32
35
HEALTHCARE RECOVERIES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
the compensation committee of the Board of Directors determines in its sole
discretion. As provided in the 1997 Plan, all options granted to the Company's
employees automatically vest in the event of a change in control. At December
31, 1998, 860,000 shares of Common Stock have been reserved under the 1997 Plan
of which 402,700 shares are available for future award.
Activity related to the Employees' Plan, Directors' Plan and 1997 Plan for
the year ended December 31, 1998 is summarized as follows:
DECEMBER 31, 1998 DECEMBER 31, 1997
------------------------- -------------------------
SHARES WEIGHTED-AVERAGE SHARES WEIGHTED-AVERAGE
(000) EXERCISE PRICE (000) EXERCISE PRICE
------ ---------------- ------ ----------------
Options outstanding as of January 1, 1998........ 723 $14.93 -- --
Granted........................................ 537 $17.85 728 $ 14.94
Exercised...................................... (26) $17.60 -- --
Canceled....................................... (149) $15.79 (5) $ 15.87
------ -----
Options outstanding as of December 31, 1998...... 1,085 $16.58 723 $ 14.93
====== =====
Weighted-average fair value of options granted
during the year (per share).................... $ 8.07 $6.54
====== =====
The following table summarizes information about options outstanding under
the Employees' Plan, Directors' Plan and 1997 Plan at December 31, 1998:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
---------------------------------------------- ------------------------
NUMBER WEIGHTED- NUMBER
OUTSTANDING AVERAGE WEIGHTED- OUTSTANDING WEIGHTED-
DECEMBER 31, REMAINING AVERAGE DECEMBER 31, AVERAGE
1998 CONTRACTUAL EXERCISE 1998 EXERCISE
RANGE OF EXERCISE PRICES (000) LIFE (YEARS) PRICE (000) PRICE
- ------------------------ ------------ ------------------- --------- ------------ ---------
$8.56 - $15.938.................... 607 9.0 $15.34 207 $14.45
$16.37 - $23.50.................... 478 9.23 19.56 7 18.48
----- ---
1,085 9.12 16.58 214 16.47
===== ===
Employee stock options of the Company outstanding at the effective time of
the Merger were substituted with similar options on Medaphis common stock.
Subsequent to the Merger and prior to the Offering, employees of the Company
participated in the Non-Qualified Stock Option Plan and the Non-Qualified Stock
Option Plan for Non-Executive Employees (the "Medaphis Plans") of Medaphis.
Granted options under the Medaphis Plans expire 10 to 11 years after the date of
grant and generally vest over a three-to-five-year period; however, in
accordance with the terms of the Medaphis Plans, all options granted to the
Company's employees automatically vested in connection with the Offering. All
unexercised options held by the Company's employees under the Medaphis Plans
expired on November 21, 1997. Stock options granted to the Company's employees
under the Medaphis Plans do not affect the number of shares used in determining
the Company's earnings per common share results. The following presents
information related to the Company's employees' participation in the Medaphis
Plans prior to the Offering.
33
36
HEALTHCARE RECOVERIES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
All options under the Medaphis Plans were either exercised or canceled as
of December 31, 1997. Activity related to the years 1997 and 1996 is summarized
as follows:
1997 1996
------------------------- -------------------------
SHARES WEIGHTED-AVERAGE SHARES WEIGHTED-AVERAGE
(000) EXERCISE PRICE (000) EXERCISE PRICE
------ ---------------- ------ ----------------
Options outstanding as of January 1...... 412 $14.06 220 $14.06
Granted................................ -- $13.75 293 $13.75
Exercised.............................. (227) $ 7.37 (10) $ 7.37
Canceled............................... (185) $28.64 (91) $28.64
----- -----
Options outstanding as of December 31.... 0 $10.79 412 $10.79
===== =====
Options exercisable as of December 31.... 0 35 89
Weighted-average fair value of options
granted during the year (per share).... $ 0 $2.23
On October 25, 1996, Medaphis changed the exercise price of approximately
81,000 of its then outstanding stock options, which had an exercise price of
$15.00 or greater, to a new exercise price of $9.875. On April 25, 1997,
Medaphis re-priced all options then outstanding under the Medaphis Plans to the
market price of Medaphis common stock on that date of $5.375. No other terms of
these options were changed. The Company has not recognized compensation expense
as a result of the re-pricing of the stock options granted under the Medaphis
Plans.
The Company accounts for options granted under its employee stock-based
compensation plans in accordance with APB No. 25. As a result, the Company has
not recognized compensation expense for stock options granted with an exercise
price equal to the quoted market price of the common stock on the date of grant
and which vest based solely on continuation of employment by the recipient of
the option award. The Company adopted SFAS No. 123 for disclosure purposes in
1996. For SFAS No. 123 purposes, the fair value of each option grant and stock
based award has been estimated as of the date of grant using the Black-Scholes
option pricing model. The following summarizes the weighted average assumptions
used in valuing awards under the Employees' Plan, Directors' Plan and 1997 Plan
in 1998 and 1997 and the Medaphis Plans in 1997 and 1996.
1998 1997 1996
---- ---- ----
Expected life (years)....................................... 5.0 5.0 3.8
Risk-free interest rate..................................... 5.5% 5.8% 6.2%
Dividend yield.............................................. 0.0 0.0 0.0
Expected volatility......................................... 38.2 40.0 52.9
Had compensation expense been recognized under the provisions of SFAS No.
123, utilizing the assumptions in the table above, the Company's net income for
the years ended December 31, 1998, 1997 and 1996 and earnings per common share
(basic and diluted) for the years ended December 31, 1998, 1997 and 1996 would
have decreased to the following pro forma amounts:
1998 1997 1996
------ ------ ------
Net Income As reported...................................... $8,900 $4,002 $5,101
Proforma.................................................... 6,972 3,217 4,793
Earnings per common share (basic and diluted) As reported
(basic)................................................... 0.78 0.37 0.52
As reported (diluted)....................................... 0.77 0.37 0.52
Proforma.................................................... 0.60 0.30 0.49
The effects of applying SFAS No. 123 in the pro forma disclosures are not
likely to be representative of the effects on pro forma net income or earnings
per common share for future years because variables such as
34
37
HEALTHCARE RECOVERIES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
option grants, option exercises, and stock price volatility included in the
disclosures may not be indicative of actual future activity.
14. QUARTERLY FINANCIAL INFORMATION (UNAUDITED):
A summary of the Company's quarterly results of operations follows (dollars
in thousands except per share amounts):
FIRST SECOND THIRD FOURTH
------- ------- ------- -------
YEAR ENDED DECEMBER 31, 1998:
Revenues......................................... $11,196 $12,025 $12,719 $12,794
Income before income taxes....................... 3,608 3,704 3,865 3,989
Net income....................................... 2,093 2,171 2,277 2,359
Earnings per common share (basic)................ 0.18 0.19 0.20 0.21
Earnings per common share (diluted).............. 0.17 0.19 0.20 0.21
YEAR ENDED DECEMBER 31, 1997:
Revenues......................................... $ 8,917 $ 9,324 $10,180 $10,856
Income (loss) before income taxes................ 2,367 (118) 3,180(a) 3,532
Net income (loss)................................ 1,375 (1,264) 1,839(a) 2,052
Earnings (loss) per common share (basic and
diluted)....................................... 0.14 (0.12) 0.16(a) 0.18
- ---------------
(a) Includes a non-recurring compensation charge of approximately $2.8 million
($0.26 per share) related to a bonus granted by the Company to certain
members of the Company's executive management upon consummation of the
Offering.
15. SUBSEQUENT EVENTS:
ACQUISITIONS
On January 25, 1999, the Company acquired the assets of SAI for
approximately $24.4 million, using available unrestricted cash, and may pay up
to $8.5 million over the next two years pursuant to an earn-out arrangement. SAI
is based in Wisconsin and has provided recovery services to an installed base of
approximately 8 million lives, who are covered by insurers, HMO's and
employer-funded plans throughout the United States. The acquisition was
accounted for using the purchase method of accounting and will be operated as a
division of HCRI.
On February 15, 1999, the Company acquired the assets of MedCap for
approximately $10 million, using existing cash and short-term borrowed funds,
and may pay up to fifty percent of gross profits of the MedCap business for each
of the twelve month periods ending December 31, 1999 and 2000, pursuant to an
earn-out arrangement. MedCap provides a variety of medical cost management
services to health insurers and HMOs. These services include hospital bill
auditing, contract compliance review, identification of certain other payments,
and cost management consulting services. The acquisition was accounted for using
the purchase method of accounting and will be operated as a division of HCRI.
STOCK REPURCHASE PLAN
HCRI also announced on March 22, 1999 that its Board had authorized a stock
repurchase plan under which the Company may repurchase up to $10 million of HCRI
Common Stock in the open market, from time to time, at prices per share deemed
favorable by it. Shares will be repurchased using borrowed funds and will
continue until such time as the Company has repurchased $10 million of HCRI
Common Stock or until it otherwise determines to terminate the stock repurchase
plan.
35
38
HEALTHCARE RECOVERIES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
ADOPTION OF A RIGHTS PLAN
On February 12, 1999, the Board of Director adopted a Stockholder Rights
Plan and declared a dividend of one preferred stock purchase right (a "Right")
for each outstanding share of Common Stock of the Company. The dividend was
payable to stockholders of record on March 1, 1999. The Rights, which will
initially trade with the common stock, separate and become exercisable only upon
the earlier to occur of (i) 10 days after the date (the "Stock Acquisition
Date") of a public announcement that a person or group of affiliated persons has
acquired 20% or more of the common stock (such person or group being hereinafter
referred to as an "Acquiring Person") or (ii) 10 days (or such later date as the
Board of Directors shall determine) after the commencement of, or announcement
of an intention to make, a tender offer or exchange offer that could result in
such person or group owning 20% or more of the common stock (the earlier of such
dates being called the "Distribution Date"). When exercisable, each Right
initially entitles the registered holder to purchase from the Company one
one-hundredth of a share of a newly created class of preferred stock of the
Company at a purchase price of $65 (the "Purchase Price"). The Rights are
redeemable for $0.001 per Right at the option of the Board of Directors. The
Rights expire on March 1, 2009.
If any person becomes an Acquiring Person, each holder of a Right will
thereafter have the right (the "Flip-In Right") to receive, in lieu of shares of
preferred stock and upon payment of the Purchase Price, shares of Common Stock
having a value equal to two times the Purchase Price of the Right. Also, if, at
any time on or after the Stock Acquisition Date, (i) the Company is acquired in
a transaction in which the holders of all the outstanding shares of Common Stock
immediately prior to the consummation of the transaction are not the holders of
all of the surviving corporation's voting power, or (ii) more than 50% of the
Company's assets, cash flow or earning power is sold or transferred other than
in the ordinary course of business, then each holder of a Right shall thereafter
have the right (the "Flip-Over Right") to receive, in lieu of shares of
preferred stock and upon exercise and payment of the Purchase Price, common
shares of the acquiring company having a value equal to two times the Purchase
Price. If a transaction would otherwise result in a holder having a Flip-In as
well as a Flip-Over Right, then only the Flip-Over Right will be exercisable. If
a transaction results in a holder having a Flip-Over Right subsequent to a
transaction resulting in the holder having a Flip-In Right, a holder will have a
Flip-Over Right only to the extent such holder's Flip-In Rights have not been
exercised.
RELATED PARTY TRANSACTION
On February 12, 1999, the Board of Directors authorized a loan in the
amount of $350,000 to Patrick B. McGinnis, Chairman and Chief Executive Officer,
in exchange for a full recourse promissory note in the same amount from Mr.
McGinnis. The full recourse promissory note bears interest at a rate equal to
the Company's cost of borrowing under its Credit Facility, or, if no loan amount
is outstanding under the Credit Facility, the federal short-term rate.
36
39
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item with respect to Directors and
Executive Officers of the Registrant is included in the sections entitled
"Management of the Company", "Executive Officers" "Certain Relationships and
Related Transactions" and "Section 16(a) Beneficial Ownership Reporting
Compliance" of the Proxy Statement for the Annual Meeting of Stockholders to be
held on May 3, 1999 and is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is included in the sections entitled
"Executive Compensation", "Stock Option Grants", "Stock Option Exercises",
"Compensation Committee Report on Executive Compensation", and "Stock Price
Performance Graph" of the Proxy Statement for the Annual Meeting of Stockholders
to be held on May 3, 1999 and is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item is included in the sections entitled
"Management Common Stock Ownership" and "Principal Stockholders" of the Proxy
Statement for the Annual Meeting of Stockholders to be held on May 3, 1999 and
is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item is included in the section entitled
"Certain Relationships and Related Transactions" of the Proxy Statement for the
Annual Meeting of Stockholders to be held on May 3, 1999 and is incorporated
herein by reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) 1. Financial Statements
Report of Independent Accountants
Balance Sheets -- years ended December 31, 1998 and 1997
Statements of Income -- years ended December 31, 1998, 1997, and 1996
Statements of Changes in Stockholders' Equity -- years ended December
31, 1998, 1997, and 1996
Statements of Cash Flow -- years ended December 31, 1998, 1997, and
1996
2. Financial Statement Schedules (none required)
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3. Exhibits
The following list of Exhibits includes both exhibits submitted with this
Form 10-K as filed with the Commission and those incorporated by reference to
other filings:
2.1 -- Asset Purchase Agreement, dated as of December 4, 1998, by
and among the Registrant, MedCap Medical Cost Management,
Inc. and Marcia Deutsch (incorporated by reference to
Exhibit 2.1 of registrant's Current Report on Form 8-K,
filed December 11, 1998, File No. 000-22585.)
2.2 -- Asset Purchase Agreement, dated as of January 3, 1999, by
and among the Registrant, Subro-Audit, Inc., O'Donnell
Leasing Co., LLP, Kevin M. O'Donnell and Leah Lampone
(incorporated by reference to Exhibit 2.1 of Registrant's
Current Report on Form 8-K, filed January 11, 1999, File No.
000-22585).
2.3 -- Amendment to Asset Purchase Agreement by and among
Healthcare Recoveries, Inc., Subro-Audit, Inc., O'Donnell
Leasing Co., LLP, Kevin O'Donnell and Leah Lampone, dated as
of January 25, 1999 (incorporated by reference to Exhibit
2.2 of Registrant's Current Report on Form 8-K, filed
February 3, 1999, File No. 000-22585).
3.1 -- Amended and Restated Certificate of Incorporation of the
Registrant (incorporated by reference to Exhibit 3.1 of
Registrant's Amendment No. 2 to Registration Statement on
Form S-1, File No. 333-23287).
3.2 -- Amended and Restated Bylaws of the Registrant (incorporated
by reference to Exhibit 3.2 of Registrant's Amendment No. 2
to Registration Statement on Form S-1, File No. 333-23287).
4.1 -- Specimen Common Stock Certificate (incorporated by reference
to Exhibit 4.1 of Registrant's Amendment No. 1 to
Registration Statement on Form S-1, File No. 333-23287).
4.2 -- Rights Agreement, dated February 12, 1999, between the
Registrant and National City Bank, as Rights Agent, which
includes as Exhibit A the Form of Certificate of
Designations of the Preferred Stock, as Exhibit B the Form
of Right Certificate and as Exhibit C the Summary of Rights
to Purchase Preferred Stock (incorporated by reference to
Exhibit 4.1 of Registrant's Form 8-A, filed February 16,
1999).
10.1 -- Healthcare Recoveries, Inc. Non-Qualified Stock Option Plan
for Eligible Employees (incorporated by reference to Exhibit
4.2 of Registrant's Registration Statement on Form S-1, File
No. 333-23287).
10.2 -- Healthcare Recoveries, Inc. Amended and Restated Directors'
Stock Option Plan.
10.3 -- Healthcare Recoveries, Inc. 1997 Stock Option Plan for
Eligible Participants (incorporated by reference to Annex A
of Registrant's Proxy Statement for a Special Meeting, dated
November 10, 1997).
10.4 -- Healthcare Recoveries, Inc. Employee Stock Purchase Plan
(incorporated by reference to Registrant's Registration
Statement on Form S-8, File No. 333-41557).
10.5 -- Employment Agreement between the Registrant and Patrick B.
McGinnis (incorporated by reference to Exhibit 10.2 to
Registrant's Registration Statement on Form S-1, File No.
333-23287).
10.6 -- Amendment No. 1 to Employment Agreement between the
Registrant and Patrick B. McGinnis, dated February 12, 1999.
10.7 -- Form of Employment Agreement between the Registrant and
Douglas R. Sharps, Bobby T. Tokuuke and Debra M. Murphy
(incorporated by reference to Exhibit 10.3 to Registrant's
Registration Statement on Form S-1, File No. 333-23287).
10.8 -- Agreement relating to Employment and Stock Options, dated
June 23, 1998, by and between the Registrant and Bobby T.
Tokuuke.
10.9 -- Employment Agreement between the Registrant and Kevin M.
O'Donnell, dated January 25, 1999.
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10.10 -- Separation Agreement between Medaphis and the Registrant
(incorporated by reference to Exhibit 10.1 of Registrant's
Amendment No. 2 to Registration Statement on Form S-1, File
No. 333-23287).
10.11 -- Divestiture Bonus Agreement (incorporated by reference to
Exhibit 10.4 of Registrant's Amendment No. 2 to Registration
Statement on Form S-1, File No. 333.23287).
10.12 -- Supplemental Retirement Savings Plan (incorporated by
reference to Exhibit 10.5 of Registrant's Amendment No. 2 to
Registration Statement on Form S-1, File No. 333-23287).
10.13 -- Lease between W&M Kentucky, Inc. and the Registrant
(incorporated by reference to Exhibit 10.6 of Registrant's
Statement on Form S-1, File No. 333-23287).
10.14 -- Annual Bonus Plan (incorporated by reference to Exhibit 10.7
of Registrant's Amendment No. 2 to Registration Statement on
Form S-1, File No. 333-23287).
10.15 -- Credit Agreement, dated as of February 1, 1998 by and among
the Registrant, the Lending Institutions Named Therein and
National City Bank of Kentucky (incorporated by reference to
Exhibit 10.12 of Registrant's Form 10-K, for the period
ended December 31, 1997).
10.16 -- Amendment No. 1 to the Credit Agreement, dated as of May 15,
1998 by and among the Registrant, the Lending Institutions
Named Therein and National City Bank of Kentucky.
10.17 -- Amendment No. 2 to the Credit Agreement, dated as of March
19, 1999 by and among the Registrant, the Lending
Institutions Named Therein and National City Bank of
Kentucky.
23.1 -- Consent of PricewaterhouseCoopers LLP.
27.1 -- Financial Data Schedule. (for SEC use only)
99.1 -- Healthcare Recoveries, Inc. Private Securities Litigation
Reform Act of 1995 Safe Harbor Compliance Statement for
Forward-Looking Statement.
(b) Reports on Form 8-K
A report on Form 8-K, filed on December 4, 1998, announced that the Company
had entered into an Asset Purchase Agreement by and among the Company, MedCap
Medical Cost Management, Inc. ("MedCap") and Marcia Deutsch (the "Asset Purchase
Agreement"), pursuant to which the Company would purchase substantially all of
the assets and assume certain of the liabilities of MedCap. The Company agreed
to pay $10 million in cash at closing and additional amounts over two years
pursuant to an earn-out agreement.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
HEALTHCARE RECOVERIES, INC.
/s/ PATRICK B. MCGINNIS
--------------------------------------
Patrick B. McGinnis
Chairman, President and Chief
Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
--------- ----- ----
/s/ PATRICK B. MCGINNIS Chairman, President and Chief March 26, 1999
- -------------------------------------------------------- Executive Officer
Patrick B. McGinnis (Principal Executive
Officer)
/s/ DOUGLAS R. SHARPS Executive Vice President and March 26, 1999
- -------------------------------------------------------- Chief Financial Officer
Douglas R. Sharps (Principal Financial and
Accounting Officer)
/s/ WILLIAM C. BALLARD, JR. Director March 26, 1999
- --------------------------------------------------------
William C. Ballard, Jr.
/s/ JILL L. FORCE Director March 26, 1999
- --------------------------------------------------------
Jill L. Force
/s/ JOHN H. NEWMAN Director March 26, 1999
- --------------------------------------------------------
John H. Newman
/s/ ELAINE J. ROBINSON Director March 26, 1999
- --------------------------------------------------------
Elaine J. Robinson
/s/ CHRIS B. VAN ARSDEL Director March 26, 1999
- --------------------------------------------------------
Chris B. Van Arsdel
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