The Company does not own any real estate; it leases approximately 24,000 feet of office space in Chicago. The lease has a term expiring in 2000, with an option for the Company to extend the lease through 2003. In addition, the Company leases approximately 1,700 feet of office space in Milwaukee with a term expiring in 1999; 1,700 feet of office space in St. Louis with a term expiring in 2002; and 500 feet of office space in Detroit on a month to month lease.
(1) Earnings per share reflects the conversion of all outstanding shares of Series B Preferred Stock upon the consummation of initial public offering in November 1995.
The following discussion and analysis of the Company's consolidated results of operations and consolidated financial condition should be read in conjunction with the Selected Consolidated Financial and Operating Data and the Company's consolidated financial statements, including the notes thereto appearing elsewhere in this Form 10-K.
The Company began operations in the Chicago area in 1988 and has grown to be a leading provider of managed dental benefits in the upper Midwest, including the metropolitan areas of Chicago, Milwaukee, St. Louis, Detroit and Indianapolis. As of December 31, 1998, the Company had 482,200 members in its managed care plans, 75,600 members in its fully insured indemnity/PPO plans, and 87,100 members eligible to access the Company's PPO network and covered under its administrative services only ("ASO") arrangements. In 1992, the Company began marketing indemnity plans as part of its Managed ChoiceSM products. In January 1996, the Company introduced its new PPO product (Managed ChoiceSM Triple Option), which integrates a managed component, the PPO option, into the Company's indemnity plans. The Indemnity/PPO revenue line includes revenue from both indemnity business that includes the PPO component as well as indemnity business that does not include the PPO component. The PPO component was available to less than 23% of the Company's Indemnity/PPO members as of December 31, 1998. The Company's Managed ChoiceSM products enable the Company to completely replace an employer's existing indemnity plan with the Company's combined managed care and indemnity/PPO plan.
Both acquisitions offer managed care products that are typically at a lower gross margin level than what the Company has experienced in the past.
The Company's product pricing varies based on the type of plan, the services provided and the member copayment (or coinsurance). In addition, pricing varies by marketplace based on employer and employee preference and competition. Pricing also may vary as a result of different pricing terms of the plans in effect at companies when acquired by the Company. As a result, per member pricing can fluctuate based on product mix, shifting marketplace preferences and acquisition timing. As contracts are renewed, the Company will seek to improve profitability on lower margin plans by increasing pricing, by offering plans with additional services at higher prices and margins, and by offering higher margin plans with fewer services at lower costs.
The second largest source of Company revenue is generated from indemnity/PPO plan premiums. From 1996 to 1998, the Company's revenue from its indemnity/PPO products grew from $10.6 million to $15.2 million. For 1998 and 1996, revenue from indemnity/PPO enrollment accounted for approximately 24% of total revenue. The Company believes that revenue from indemnity/PPO enrollment will continue to increase in the future.
The third largest source of revenue is fee income which is generated from the Company's PPO network rental program and ASO arrangements. Under the network rental program, PPO network providers offer services according to a reduced fee schedule negotiated by the Company. The Company charges its PPO groups a monthly fee for each member eligible to access such reduced fee arrangements. The Company does not make any payments to its PPO network providers on behalf of the eligible members access such reduced fee arrangements. Under the Company's ASO arrangements, the Company provides claims payments and related services for self-insured employers' indemnity plans. Under these arrangements the Company does not assume any of the underwriting risk for the indemnity claims.
Benefit Coverage Expenses From 1996 to 1998, total benefit coverage expenses increased from $27.9 million to $42.7 million. Between 1996 and 1998, total benefit coverage expenses as a percentage of revenues increased from 63.2% to 66.6% of total revenue. This increase is largely the result of increases in the benefit coverage expenses of the Company's managed care products (primarily associated with the Company's acquisitions) and increases in benefit coverage expenses associated with indemnity/PPO plans.
Selling, general and administrative Selling, general and administrative ("SG&A") expenses as a percent of revenues declined from 27.8% in 1996 to 24.2% in 1998. The change is primarily the result of economies of scale in meeting the administrative needs of increased enrollment due to the relatively fixed nature of certain SG&A expenses, higher revenues relative to the SG&A expenses associated with indemnity/PPO plans. This decrease in SG&A expenses as a percentage of revenue from 1996 through 1998 to a large degree offsets the decreases in the gross margin percentage during that period. The Company expects SG&A as a percent of revenue to remain relatively constant in 1999 and management expects it to decline thereafter, as the Company continues to achieve economies of scale and operating efficiencies.
Many existing computer systems and applications abbreviate dates using only two digits ("98") rather than four digits ("1998"). If not corrected, this shortcut may cause problems when the century date "2000" occurs. On that date, some computer operating systems and applications and embedded technology may recognize the date as January 1, 1900 instead of January 1, 2000. If the Company fails to correct any critical Year 2000 processing problems prior to January 1, 2000, the affected systems may either cease to function or produce erroneous data, which could have material adverse operational and financial consequences. Currently, the Company believes that the major risks associated with the inability of systems and software to process Year 2000 data correctly include a disruption in the operation of its core enterprise systems, telephony systems, accounting and financial systems, and desktop and support systems. A failure of such systems could materially and adversely affect the Company's results of operations, financial position and cash flows.
Phase 1 included the identification of core business areas and processes, analysis of systems and hardware supporting the core business areas and the prioritization of renovation or replacement of systems and hardware that are not Year 2000 compliant. Included in the assessment phase is an analysis of risk management factors such as contingency plans and legal matters. The internal systems assessment process of Phase 1 categorized internal systems into 4 functional areas: (1) Core Enterprise System, (2) Telephony Systems, (3) Accounting and Financial Systems, and (4) Desktop and Support Systems. The Core Enterprise System includes computer systems that support key business functions such as billing, finance, customer service, and network provider payments. Within each of these areas it has been determined that the main suppliers of the systems utilized by the Company are able to provide year 2000 compliant releases. The acquisition of the available releases will be accomplished either through existing support arrangements or through the purchase of upgraded products. A fifth area requiring additional investigation is the assessment of the Company's major third party relationships outside of the information technology arena. This process has been completed.
The Company's Year 2000 most reasonably likely worst case scenario may involve interruption of data processing services and telecommunications services and/or interruption of customer billing, operating and other information systems. As part of its Year 2000 initiative, the Company is evaluating these worst-case scenarios and is in the process of developing contingency and business plans tailored for Year 2000-related occurrences. The contingency and business contingency plans are expected to assess the potential for business disruption in various scenarios, and to provide key operational back-up, recovery and restorational alternatives.
The Company's contingency plan initiatives include the following: personnel to be on call during the Year 2000 change to monitor critical systems, telecommunications and other processes and to react promptly to facilitate repairs; back-up plans in the event of failure or information or telecommunications systems or other Year 2000 disruptions; identification of alternate suppliers and implementation of plans to be in place for third-party products/services that fail to meet Year 2000 compliance commitment schedules; and data retention and recovery procedures to be in place for customer and critical business data to provide backups with on-site as well as off-site data copies. The Company anticipates having these contingency plans in place before December 31, 1999.
The above information, which contains statements that are "forward-looking" within the meaning of the Private Securities Litigation Reform Act of 1995, is based on the Company's current best estimates, which were derived using numerous assumptions of future events, including the availability and future costs of certain technological and other resources, third party modification actions and other factors. Given the complexity of these issues and the possibility of unidentified risks, actual results may vary materially from those anticipated and discussed above. Specific factors that might cause such differences include, among others, the availability and cost of personnel trained in this area, the ability to locate and correct all affected computer codes, the timing and success of remedial efforts of third party suppliers and similar uncertainties.
The following tables set forth certain information from the Company's consolidated statement of income for the periods indicated. In the opinion of management, these tables have been prepared on the same basis as the audited consolidated financial statements appearing elsewhere in this Annual Report and fairly present the results of operations of the Company for the periods covered thereby.
SG&A expenses increased by $1.9 million, or 14.4%, to $15.5 million for 1998 from $13.6 million in 1997. As a percentage of revenue, SG&A expenses increased to 24.2% for 1998 from 23.9% for 1997. This increase is attributable primarily to staffing and salary increases that were deferred in 1997 due to the Company's cost containment efforts that year. The Company expects SG&A as a percent of revenue to remain relatively constant in 1999 and management expects it to decline thereafter, as the Company continues to achieve economies of scale and operating efficiencies. Included in the SG&A total is $265,000, for 1998 and 1997, for the amortization of goodwill associated with the acquisitions.
The effective tax rate for 1998 was 39.9% compared to 40.7% for 1997. The decline in effective tax rate is primarily due to the purchase of federally tax exempt municipal bonds purchased during the 1998 as well as the purchase of United States Treasury Notes and Bills which are exempt from state tax. The Company expects to continue to hold and/or purchase federally tax exempt municipal bonds throughout 1999.
SG&A expenses increased by $1.3 million, or 10.6%, to $13.6 million for 1997 from $12.3 million in 1996. As a percentage of revenue, SG&A expenses dropped to 23.9% for 1997 from 27.8% for 1996. The change is primarily the result of economies of scale in meeting the administrative needs of increased enrollment due to the relatively fixed nature of certain SG&A expenses, higher revenues relative to the SG&A expenses associated with indemnity/PPO plans, and cost containment moves by the Company in 1997 to offset the decline in gross margin. Included in the SG&A total is $265,000 and $64,000, respectively, for 1997 and 1996, for the amortization of goodwill associated with the acquisitions.
Operating income increased by $1.2 million, or 29.3%, to $5.1 million for 1997 from $3.9 million in 1996. As a percentage of revenue, operating income was 9.0% in 1997 and 1996.
The effective tax rate for 1997 was 40.7% compared to 40.6% for 1996.
The Company's historical operating cash requirements have been met principally through operating cash flows. The primary uses of cash have been for operating activities and capital investments in the business. The acquisition of Champion was financed through proceeds from the Company's initial public offering and was paid in cash on January 2, 1997. The Company believes that cash generated from operations will be adequate to finance its anticipated operating needs for the foreseeable future.
The Company does not believe the impact of inflation has significantly affected the Company's operations.
Consolidated Statements of Income and Comprehensive Income for the years ended December 31, 1998, 1997 and 1996.................... 34
Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1997 and 1996.............................. 37
FIRST COMMONWEALTH, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS As of December 31, 1998, 1997 and 1996
The accompanying notes to consolidated financial statements are an integral part of these balance sheets.
FIRST COMMONWEALTH, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
FIRST COMMONWEALTH, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
FIRST COMMONWEALTH, INC. AND SUBSIDIARIES RECONCILIATIONS OF NET INCOME TO NET CASH PROVIDED BY OPERATING ACTIVITIES For the Years Ended December 31, 1998, 1997 and 1996
FIRST COMMONWEALTH, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1998, 1997 and 1996
As discussed in Note 15, FC Inc. completed the acquisitions of SDS on July 18, 1996, and CDS on December 31, 1996. Included in the consolidated statement of income for the year ended December 31, 1996, are the results of SDS since its acquisition. SDS's and CDS's balance sheets are also included in the accompanying consolidated balance sheets beginning December 31, 1996.
FC Insurance was incorporated in Illinois during 1997 and is a wholly owned subsidiary of FC Inc. It is licensed as a domestic life, accident and health insurer to underwrite indemnity dental business and also received licensure under the LHSO Act in November 1998, which will allow it to underwrite managed care dental business. Effective January 1, 1998, it consummated a reinsurance transaction with LHSC for the business that was previously reinsured to an independent party (see Reinsurance Activity) and onto FCRC. For the year ended December 31, 1998, its business was indemnity dental only.
SDS, a wholly owned subsidiary of FC Inc., is a Wisconsin based dental health maintenance organization administrator.
The accompanying financial statements include all the accounts of the Company. All material intercompany transactions and balances have been eliminated in consolidation.
The Company invoices most of its subscriber groups prior to the month in which the groups' members will be entitled to service. The Company records these invoices as accounts receivable on the date the invoices are sent and also records as deferred subscriber revenue those amounts either invoiced or received in advance of the period of service.
The excess of cost over fair value of net assets acquired resulting from the SDS and CDS acquisitions, accounted for using the purchase method, is being amortized using the straight-line method over 40 years.
Effective January 1, 1995, LHSC entered into an agreement with a third party insurer ("Insurer") whereby LHSC ceded certain losses on indemnity insurance policies to Insurer. Concurrent with the execution of this agreement, Insurer entered into an agreement with FCRC whereby Insurer ceded certain losses related to LHSC policies to FCRC. In 1997, a separate independent third party insurer was inserted into the agreement between Insurer and FCRC. The Company has effectively retained all insurance risk on these LHSC losses ceded to Insurer. Accordingly, LHSC accounts for net payments to Insurer as deposits and records a claims liability for all incurred and unpaid losses on such policies. FCRC records a payable to Insurer for amounts Insurer has deposited with FCRC. The Company does not recognize any revenue from these reinsurance arrangements.
In addition, in 1997, FC Inc., acting as agent for Insurer and according to a fronting agreement, began selling managed care and indemnity dental insurance policies in the state of Michigan. According to the same agreement, Insurer ceded all managed care and indemnity dental insurance policies in Michigan to the same separate independent third party insurer who ceded these policies to FCRC.
Effective January 1, 1998, LHSC, rather than reinsure the policies to the Insurer, assumptively reinsured the same policies to FC Insurance.
Subsequent to December 31, 1998, the Company issued 68,500 options to various key employees at the option price of $11.94 per share.
The Company considers its managed care and indemnity/PPO products to be operating segments as defined in SFAS No. 131. However, due to the similar economic characteristics of these segments, management has aggregated these segments for purposes of complying with the disclosure requirements of SFAS No. 131.
The State of Illinois statutes and related regulations of the Illinois Department of Insurance require LHSC, which is licensed under the LHSO Act, to maintain a minimum net worth of $500,000. LHSC maintains a deposit with the State of $200,000 in accordance with the State of Illinois requirements.
The State of Indiana statutes and related regulations of the Indiana Department of Insurance require LHSC, which is licensed as a Limited Service Health Maintenance Organization, to maintain a $50,000 deposit with the State.
The State of Arizona statutes and related regulations of the Arizona Department of Insurance require FCRC, which is licensed as a domestic life and disability reinsurer, to maintain a minimum of $100,000 deposited in trust with the State and a minimum surplus of $25,000. FCRC is required to maintain a trust account equal to the amount of claims payable on all insurance ceded. At December 31, 1998, 1997 and 1996, balances of $94,889, $632,767 and $705,867, respectively, were required in the trust account.
The State of Wisconsin insurance statutes require, among other provisions, that LHSCWI maintain a minimum capital of $100,000, apply a ten percent compulsory surplus factor to Point of Service/Indemnity ("POS") premium, and limit POS business to ten percent of total premium volume. LHSCWI has a certificate of deposit for $111,071 at Wisconsin bank and had POS business of $735,201 in 1998, $189,788 in 1997 and none in 1996.
The State of Missouri statutes and related regulations of the Missouri Department of Insurance require FCMO, which is licensed as a Prepaid Dental Plan Corporation, to maintain a $50,000 deposit with the state and to maintain a maximum net worth of $150,000.
The State of Illinois statutes and related regulations of the Illinois Department of Insurance require FC Insurance to maintain a minimum net worth of $1.5 million. FC Insurance maintains a deposit with the State of $1.6 million in accordance with State requirements.
The Company leases office space and various office equipment which are accounted for as operating leases. Rental costs under the operating lease agreements approximated $617,000, $617,000 and $486,000 for the years ended December 31, 1998, 1997 and 1996, respectively.
The current and deferred components of the provision for taxes are as follows:
December 31 -------------------------------------- 1998 1997 1996 ---------- ---------- ---------- Current provision $2,537,000 $2,195,000 $1,962,000 ---------- ---------- ----------
1998 1997 1996 ---- ---- ---- Statutory rate 34% 34% 34%
The following table shows the percentage of revenue attributable to each type of product offered:
1998 1997 1996 ---- ---- ---- Managed care 75% 77% 74%
The Company has a committed unsecured line of credit (the "Credit Agreement") available with a Chicago bank that expires June of 1999, which to date has not been utilized. Pursuant to this Credit Agreement, the Company may borrow up to $5 million at the rate of LIBOR plus one-half percent.
During 1995, the Board of Directors and stockholders of the Company approved an amendment and restatement of its Restated Certificate of Incorporation to, among other things, authorize 1,000,000 shares of preferred stock, $.001 par value, which may be issued from time to time in one or more series with such rights, preferences and qualifications as the Company's Board of Directors may determine. The Board of Directors has designated 150,000 shares of the preferred stock as Series A Junior Participating Preferred Stock. There are no shares issued or outstanding of the Series A Junior Participating Preferred Stock.
In November, 1995, the Company completed an initial public offering of 530,000 shares of its common stock at $15 per share.
The weighted average grant-date fair values of options granted in 1998, 1997 and 1996 were $6.00, $6.80 and $12.25, respectively. The fair value of each option grant was estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions for options issued in 1998, 1997 and 1996, respectively: risk- free interest rates of 5.4%, 6.8% and 6.5%; expected lives of 7 years; expected volatility of 41% in 1998 and in 1997 and 42% in 1996; and no expected dividends.
Under the 1987 Plan, the Company can award up to 250,000 options to key employees, granted at a price equal to the fair market value at the date of the grant as determined by the Board of Directors or the Stock Option Compensation Committee, and vesting ratably over a period of two to four years from the date of the grant. The Company had granted 248,125 total options as of December 31, 1998, 1997 and 1996, to key employees and directors at option prices ranging from $.50 to $15.00 per share. Of the total options granted, 109,240, 133,375 and 148,950 had vested and were exercisable as of December 31, 1998, 1997 and 1996, respectively, and 132,685, 87,925 and 60,675 of the total options, granted and vested had been exercised as of December 31, 1998, 1997 and 1996, respectively.
Of the 294,190 total options outstanding at December 31, 1998, 101,740 have option prices between $.70 and $1.70, with a weighted average option price of $1.38 and a weighted average remaining contractual life of three years. 101,740 of these options are exercisable at December 31, 1998, with a weighted average option price of $1.38.
The remaining 2,000 options outstanding at December 31, 1998, have option prices of $28.625, with a weighted average remaining contractual life of eight years. These options are exercisable at December 31, 1998.
Quarter ------------------------------------ First Second Third Fourth ----- ------ ----- ------ Subscriber revenue $15,615 $15,961 $16,145 $16,449 Gross margin 5,165 5,292 5,387 5,596 Net income 913 952 1,018 1,107 Basic earnings per common share .25 .26 .28 .30 Diluted earnings per common share .24 .25 .27 .30
Effective July 18, 1996, the Company completed the acquisition of SDS and an associated reinsurance transaction, for an aggregate purchase price (including transaction costs) of $5.6 million. The acquisition was financed through the issuance of 231,399 shares of the Company's common stock. The acquisition resulted in the excess of cost over fair value of net assets acquired of approximately $5.6 million.
Effective December 31, 1996, the Company completed the acquisition of CDS for an aggregate purchase price (including transaction costs) of $5.6 million. The acquisition was financed through proceeds from the Company's initial public offering and was paid in cash on January 2, 1997. The acquisition resulted in the excess of cost over fair value of net assets acquired of approximately $4.9 million.
Unaudited pro forma combined results of operations of the Company for the year ended December 31, 1996 for the acquisitions are as follows: Revenues (in thousands) for the year ended December 31, 1996 would be $50,860; Net income (in thousands) for the year ended December 31, 1996 would be $2,856; and diluted Net Income per share for the year ended December 31, 1996 would be $0.77. This pro forma information has been prepared assuming the acquisitions of SDS and CDS and the Company's initial public offering had occurred as of January 1, 1995.