The balance sheet and operating results of the HCLB (Cape Health Plan) acquisition have been included since May 15, 2006, the effective date of the acquisition.
Medical care ratio represents medical care costs as a percentage of premium revenue. The medical care ratio is a key operating indicator used to measure our performance in delivering efficient and cost effective healthcare services. Changes in the medical care ratio from period to period result from changes in Medicaid funding by the states, our ability to effectively manage costs, and changes in accounting estimates related to incurred but not reported claims. See Management’s Discussion and Analysis of Financial Condition and Results of Operation for further discussion.
Premium revenue is fixed in advance of the periods covered and is not generally subject to significant accounting estimates. For the year ended December 31, 2007, we received approximately 91.9% of our premium revenue as a fixed amount per member per month, or PMPM, pursuant to our contracts with state Medicaid agencies and other managed care organizations for which we operate as a subcontractor. These premium revenues are recognized in the month that members are entitled to receive health care services. The state Medicaid programs periodically adjust premium rates.
Certain components of premium revenue are subject to accounting estimates. Chief among these are: 1) that portion of premium revenue paid to our New Mexico health plan by the state of New Mexico that may be refunded to
Our contract with the state of New Mexico requires that we spend a minimum percentage of premium revenue on certain explicitly defined medical care costs. During 2007, we recorded adjustments totaling $6.0 million to reduce premium revenue associated with this requirement. At December 31, 2007, we have recorded a liability of approximately $12.9 million under our interpretation of the existing terms of this contract provision. Any change to the terms of this provision, including revisions to the definitions of premium revenue or medical care costs, the period of time over which the minimum percentage is measured or the manner of its measurement, or the percentage of revenue required to be spent on the defined medical care costs, may trigger a change in this amount. If the state of New Mexico disagrees with our interpretation of the existing contract terms, an adjustment to this amount may occur.
The Medicaid contract of our Utah health plan with the state of Utah is paid on a cost plus nine percent basis. In addition, in order to incentivize the plan to save the state money, the contract also entitles the health plan to be paid a percentage of the savings realized as measured against what claims would have been paid on a fee-for-service basis by the state. We had previously estimated the amount that we believe our Utah plan will recover under its savings sharing agreement with the state of Utah. However, as a result of an ongoing disagreement with the state, during 2007 our Utah health plan wrote off the entire receivable, totaling $4.7 million, $4.0 million of which was accrued as of December 31, 2006. Nevertheless, our Utah health plan has not waived any of its rights to recovery under the savings sharing provision of the contract, and continues to work with the state in an effort to assure an appropriate determination of amounts due. When additional information is known or agreement is reached with the state regarding the appropriate savings sharing payment amount, we will adjust the amount of savings sharing revenue recorded in our financial statements.
As of December 31, 2007, we have accrued a liability of approximately $2.3 million pursuant to our profit-sharing agreement with the state of Texas, for the 2006 and 2007 contract years. Because the final settlement calculations include a claims run-out period of nearly one year, the amounts recorded, based on our estimates, may be adjusted. We believe that the ultimate settlement will not differ materially from our estimate.
Our Ohio health plan commenced operations in December 2005, serving less than 250 members as of December 31, 2005.
Our operating expenses include expenses related to the provision of medical care services and general and administrative, or G&A, expenses. Our results of operations are impacted by our ability to effectively manage expenses related to health care services and to accurately estimate costs incurred. Expenses related to medical care services are captured in the following four categories:
Fee-for-service: Physician providers paid on a fee-for-service basis are paid according to a fee schedule set by the state or by our contracts with these providers. We pay hospitals in a variety of ways, including per diem amounts, diagnostic-related groups or DRGs, percent of billed charges, case rates, and capitation. We also have stop-loss agreements with the hospitals with which we contract. Under all fee-for-service arrangements, we retain the financial responsibility for medical care provided. Expenses related to fee-for-service contracts are recorded in the period in which the related services are dispensed. The costs of drugs administered in a physician or hospital setting that are not billed through our pharmacy benefit managers are included in fee-for-service costs.
Capitation: Many of our primary care physicians and a small portion of our specialists and hospitals are paid on a capitation basis. Under capitation contracts, we typically pay a fixed PMPM payment to the provider without regard to the frequency, extent, or nature of the medical services actually furnished. Under capitated contracts, we remain liable for the provision of certain health care services. Certain of our capitated contracts also contain incentive programs based on service delivery, quality of care, utilization management, and other criteria. Capitation payments are fixed in advance of the periods covered and are not subject to significant accounting estimates. These payments are expensed in the period the providers are obligated to provide services. The financial risk for pharmacy services for a small portion of our membership is delegated to capitated providers.
Other: Other medical care costs include medically related administrative costs, certain provider incentive costs, reinsurance cost, and other health care expense. Medically related administrative costs include, for example, expenses relating to health education, quality assurance, case management, disease management, 24-hour on-call nurses, and a portion of our information technology costs. Salary and benefit costs are a substantial portion of these expenses. For the years ended December 31, 2007, 2006 and 2005, medically related administrative costs were approximately $65.4 million, $52.6 million, and $44.4 million, respectively.
Year Ended December 31, 2007 Compared with the Year Ended December 31, 2006
A $57.2 million increase at our Michigan health plan principally due to a full year of operations which had included the revenue of the Cape Health Plan, compared to only eight months of operations including Cape Health Plan revenues in 2006 (the acquisition of Cape Health Plan was effective May 1, 2006);
A $39.2 million increase at our Washington health plan due to higher premium rates and slightly higher membership;
A $30.7 million increase as a result of our acquisition of Mercy CarePlus in Missouri effective November 1, 2007; and
An $82.9 million decrease due to the termination of operations of our Indiana health plan effective January 1, 2007; and
Investment income for 2007 increased $10.2 million to $30.1 million, from $19.9 million for 2006, as a result of higher invested balances, due in part to the investment of proceeds from our offering of convertible senior notes in the fourth quarter of 2007, and higher investment yields.
86.2% for all of 2008, we will need to achieve a medical care ratio of 91.0% for our ABD population to reach our expectation of an 88.0% medical care ratio plan-wide for Ohio. The recent addition of the ABD members (some of whom were not added until late summer of 2007) adds a degree of uncertainty to the medical care cost estimates in Ohio that is not found in our more mature health plans;
The medical care ratio of the Utah health plan increased due to the write-off of $4.7 million in savings share receivables in the second half of 2007. Medical care costs in Utah decreased on a PMPM basis in 2007 when compared to 2006. Absent the write-off of $4.7 million in savings share receivable in the second half of 2007 ($4.0 million of which was accrued as of December 31, 2006), the Utah health plan’s medical care ratio would have been 90.4%, an improvement over the 91.5% reported for 2006. Our Utah health plan serves the majority of its membership under a cost-plus contract with the state of Utah;
Depreciation and amortization expense increased $6.5 million for the year ended December 31, 2007 compared to 2006, primarily due to depreciation expense associated with investments in infrastructure. Of the total increase, amortization expense contributed $1.3 million, primarily due to the Cape Health Plan acquisition in
Michigan in 2006. The following table presents the components of depreciation and amortization expense (in thousands):
Interest expense increased to $4.6 million in 2007 from $2.4 million in 2006 primarily due to increased borrowings, including the issuance of our convertible senior notes in the fourth quarter of 2007.
The following summarizes premium revenue, medical care costs, medical care ratio, and premium taxes by health plan for the periods indicated (PMPM amounts are in whole dollars; other dollar amounts are in thousands):
For the year ended December 31, 2006, net income increased to $45.7 million, or $1.62 per diluted share, from $27.6 million, or $0.98 per diluted share, for the year ended December 31, 2005.
A $59.6 million increase contributed by the now-terminated Indiana health plan.
A $19.8 million decrease at the New Mexico health plan, which reduced revenue by $6.9 million in 2006 to meet a contractually required minimum medical care ratio; and
The Cape Health Plan (acquired effective May 15, 2006) experienced a higher medical care ratio during 2006 than our consolidated average; and
The medical care ratios for our start-up operations in Ohio, Texas, and Indiana were substantially higher than those experienced by the Company as a whole. Excluding these start-up operations, our medical care ratio decreased 300 basis points to 83.7% for the year ended December 31, 2006 compared with 86.7% in 2005. We believe our medical care cost control initiatives contributed substantially to the year-over-year decrease in our medical care ratio.
Core G&A increased to 8.4% of total revenue for 2006 from 7.1% of total revenue for 2005. The increase in Core G&A was due to continued investments in infrastructure and workforce to support our medical care cost control initiatives and improve our information technology, the expansion into Ohio and Texas, and the launch of our Medicare Advantage Special Needs Plans. Additionally, effective January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment.” This increased our G&A expenses by $3.2 million, or approximately $0.07 per diluted share, in 2006.
Interest expense increased to $2.4 million in 2006 from $1.5 million in 2005 due to increased borrowings on our credit facility and higher interest rates during 2006.
Income tax expense totaled $27.7 million in 2006, resulting in an effective tax rate of 37.8%, compared with $16.3 million in 2005, resulting in an effective tax rate of 37.1%. The increase in our effective tax rate during 2006 was primarily attributable to the accrual of a valuation allowance related to net operating loss carryforwards generated by certain states.
Effective November 1, 2007, we acquired Mercy CarePlus, a licensed Medicaid managed care plan based in St. Louis, Missouri. The purchase price for the acquisition was $80.0 million, subject to adjustment based on an analysis after closing of Mercy CarePlus’ risk-based capital and incurred but not reported medical costs (IBNR). We also contributed an additional $7.0 million to the Missouri health plan to fund its statutory net worth requirement. The sellers are entitled to an additional $5.0 million payment from us in the event the earnings of Mercy CarePlus in the twelve months ending June 30, 2008 are in excess of $22.0 million. Mercy CarePlus has a contractual agreement to provide healthcare services with the state of Missouri through June 2009 under the state’s MC+ Managed Care program. As of December 31, 2007, Mercy CarePlus served approximately 62,000 Medicaid and 6,000 SCHIP members primarily located in the St. Louis metropolitan area.
We generate cash from premium revenue and investment income. Our primary uses of cash include the payment of expenses related to medical care services and G&A expenses. We generally receive premium revenue in advance of payment of claims for related health care services.
Our investment policies are designed to provide liquidity, preserve capital, and maximize total return on invested assets, all in a manner consistent with state requirements which prescribe the types of instruments in which our subsidiaries may invest their funds. As of December 31, 2007, a substantial portion of our cash was invested in a portfolio of highly liquid money market securities, and our investments consisted solely of investment-grade debt securities, all of which are classified as current assets. Our investment policies require that all of our investments have final maturities of ten years or less (excluding auction rate securities and variable rate securities, for which interest rates are periodically reset) and that the average maturity be four years or less. Three professional portfolio managers operating under documented investment guidelines manage our investments. The average annualized portfolio yields for the years ended December 31, 2007, 2006, and 2005 were approximately 5.2%, 4.8%, and 3.0%, respectively.
The states in which we operate prescribe the types of instruments in which our subsidiaries may invest their funds. Our restricted investments are invested principally in certificates of deposit and U.S. Treasury securities.
Cash provided by operating activities for the year ended December 31, 2007 was $158.6 million, compared with $102.3 million for 2006, an increase of $56.3 million. Cash provided by operating activities described herein does not include the addition of operating assets and liabilities related to our acquisition of Mercy CarePlus, our new Missouri health plan, in 2007. These amounts are reflected in Net cash paid in purchase transactions in the accompanying Consolidated Statements of Cash Flows. The 2007 increase in cash provided by operating activities
Cash used in investing activities was $256.3 million for the year ended December 31, 2007, compared with $3.9 million provided by investing activities for 2006. The primary uses of cash in 2007 were attributable to investment of the proceeds from our issuance of convertible senior notes in the fourth quarter of 2007, and our acquisition of Mercy CarePlus.
Cash provided by financing activities totaled $153.1 million for the year ended December 31, 2007, compared with $48.2 million for 2006. The primary source of cash was the receipt of net proceeds from our issuance of convertible senior notes in 2007, offset by the reduction in borrowings and the repayment of amounts owed under our credit facility.
In October 2007, we completed our offering of $200.0 million aggregate principal amount of 3.75% Convertible Senior Notes due 2014 (the “Notes”). The sale of the Notes resulted in net proceeds totaling $193.4 million, from which we repaid the $20.0 million balance outstanding under our credit facility. In November 2007, we used $80.0 million of the net proceeds in connection with our acquisition of Mercy CarePlus in Missouri. In December 2007, we used $41.5 million for contributions to regulatory capital of certain of our health plan subsidiaries, including contributions of $32.5 million to our Ohio plan, $7.0 million to our Missouri plan, $1.5 million to our Texas plan, and $0.5 million to our Nevada plan. We intend to use the remaining net proceeds of approximately $52 million to fund future acquisitions and expansion and for general corporate purposes, including working capital. The Notes rank equally in right of payment with our existing and future senior indebtedness.
During any fiscal quarter after our fiscal quarter ending December 31, 2007, if the closing sale price per share of our common stock, for each of at least 20 trading days during the period of 30 consecutive trading days ending on the last trading day of the previous fiscal quarter, is greater than or equal to 120% of the conversion price per share of our common stock;
During the five business day period immediately following any five consecutive trading day period in which the trading price per $1,000 principal amount of the Notes for each trading day of such period was less than
98% of the product of the closing price per share of our common stock on such day and the conversion rate in effect on such day; or
An amount in cash (the “principal return”) equal to the sum of, for each of the 20 Volume-Weighted Average Price (VWAP) trading days during the conversion period, the lesser of the daily conversion value for such VWAP trading day and $50 (representing 1/20th of $1,000); and
At December 31, 2007, our health plans had aggregate statutory capital and surplus of approximately $350.9 million, compared to the required minimum aggregate statutory capital and surplus of approximately $202.5 million. All of our health plans were in compliance with the minimum capital requirements at December 31, 2007. We have the ability and commitment to provide additional working capital to each of our health plans when necessary to ensure that capital and surplus continue to meet regulatory requirements. Barring any change in regulatory requirements, we believe that we will continue to be in compliance with these requirements through 2008.
Our medical care costs include amounts that have been paid by us through the reporting date, as well as estimated liabilities for medical care costs incurred but not paid by us as of the reporting date. Such medical care cost liabilities include, among other items, capitation payments owed providers, unpaid pharmacy invoices, and various medically related administrative costs that have been incurred but not paid. We use judgment to determine the appropriate assumptions for determining the required estimates.
For the fifth month of service prior to the reporting date and earlier, we estimate our outstanding claims liability based on actual claims paid, adjusted for estimated completion factors. Completion factors seek to measure
The following table reflects the change in our estimate of claims liability as of December 31, 2007 that would have resulted had we changed our completion factors for the fifth through the twelfth months preceding December 31, 2007, by the percentages indicated. A reduction in the completion factor results in an increase in medical claims liabilities. Our Utah health plan is excluded from these calculations, because the majority of the Utah business is conducted under a cost-plus reimbursement contract. Dollar amounts are in thousands.
For the four months of service immediately prior to the reporting date, actual claims paid are not a reliable measure of our ultimate liability, given the inherent delay between the patient/physician encounter and the actual submission of a claim for payment. For these months of service, we estimate our claims liability based on trended PMPM cost estimates. These estimates are designed to reflect recent trends in payments and expense, utilization patterns, authorized services, and other relevant factors. The following table reflects the change in our estimate of claims liability as of December 31, 2007, that would have resulted had we altered our trend factors by the percentages indicated. An increase in the PMPM costs results in an increase in medical claims liabilities. Our Utah HMO is excluded from these calculations, because the majority of the Utah business is conducted under a cost-plus reimbursement contract. Dollar amounts are in thousands.
Assuming a hypothetical 1% change in completion factors from those used in our calculation of IBNR at December 31, 2007, net income for the year ended December 31, 2007 would increase or decrease by approximately $5.0 million, or $0.17 per diluted share, net of tax. Assuming a hypothetical 1% change in PMPM cost estimates from those used in our calculation of IBNR at December 31, 2007, net income for the year ended December 31, 2007 would increase or decrease by approximately $2.7 million, or $0.09 per diluted share, net of tax. The corresponding figures for a 5% change in completion factors and PMPM cost estimates would be $24.8 million, or $0.87 per diluted share, net of tax, and $13.3 million, or $0.47 per diluted share, net of tax, respectively.
It is important to note that any error in the estimate of either completion factors or trended PMPM costs would usually be accompanied by an error in the estimate of the other component, and that an error in one component would almost always compound rather than offset the resulting distortion to net income. When completion factors are overestimated, trended PMPM costs tend to be underestimated. Both circumstances will create an overstatement of net income. Likewise, when completion factors are underestimated, trended PMPM costs tend to be overestimated, creating an understatement of net income. In other words, errors in estimates involving both completion factors and trended PMPM costs will act to drive estimates of claims liabilities and medical care costs in the same direction. For example, if completion factors were overestimated by 1%, resulting in an overstatement of net
After we have established our base IBNR reserve through the application of completion factors and trended PMPM cost estimates, we then compute an additional liability, which also uses actuarial techniques, to account for adverse developments in our claims payments which the base actuarial model is not intended to and does not account for. We refer to this additional liability as the provision for adverse claims development. The provision for adverse claims development is a component of our overall determination of the adequacy of our IBNR. It is intended to capture the adverse development of factors such as the speed of claims payment, the relative magnitude or severity of claims, known outbreaks of disease such as influenza, our entry into new geographical markets, our provision of services to new populations such as the aged, blind and disabled (ABD), changes to state-controlled fee schedules upon which much of our provider payments are based, modifications and upgrades to our claims processing systems and practices, and increasing medical costs. Because of the complexity of our business, the number of states in which we operate, and the need to account for different health care benefit packages among those states, we make an overall assessment of IBNR after considering the base actuarial model reserves and the provision for adverse claims development. We also include in our IBNR liability an estimate of the administrative costs of settling all claims incurred through the reporting date. The development of IBNR is a continuous process that we monitor and refine on a monthly basis as additional claims payment information becomes available. As additional information becomes known to us, we adjust our actuarial model accordingly to establish IBNR.
As shown in greater detail in the table below, the amounts ultimately paid out on our liabilities recorded at both December 31, 2007 and 2006 were less than what we had expected when we established our reserves. While the specific reasons for the overestimation of our liabilities were different at each of the two reporting dates, in general the overestimations were tied to our assessment of specific circumstances at our various individual health plans which were unique to those reporting periods.
In New Mexico, during the second half of the year with respect to medical and drug costs associated with providing care related to behavioral health conditions, we underestimated the impact that the state’s assumption of financial responsibility for costs related to the treatment of those behavioral health conditions would have on our claims liability at December 31, 2005, resulting in our overestimating that liability.
In California, we underestimated costs associated with our members in San Diego County, a market we had first entered only seven months earlier. Additionally, a claims system upgrade during 2005 delayed claims processing and distorted our normal payment pattern for claims. Both of these circumstances led us to underestimate our claim liability at December 31, 2005.
We do not believe that the recognition of a benefit (or detriment) from prior period claims development had a material impact on our consolidated results of operations in either 2007 or 2006.
Our assessment regarding the impact of some overpayments made to certain Ohio providers in 2007 and 2006 and the impact of those overpayments on reported medical cost trends.
Uncertainties regarding the impact of state-mandated changes to the methodology used to pay outpatient claims in Michigan during 2007.
The addition to our California provider network during 2007 of a hospital that serves high cost patients, as well as changes implemented in September 2007 to our contract with a leading childrens’ hospital that provides care to a significant number of our California members.
The addition in November 2007 of approximately 4,300 members in Sacramento County, California where we have traditionally experienced higher medical costs.
Changes we made during 2007 to our pharmacy formulary in California in response to competitive pressures.
Increases in claims inventory at our California, New Mexico, and Texas health plans during the fourth quarter of 2007.
Decreases in claims inventory at our Michigan and Washington health plans during the fourth quarter of 2007.
Any absence of adverse claims development (as well as the expensing of the costs to settle claims held at the start of the period through general and administrative expense) will lead to the recognition of a benefit from prior period claims development in the period subsequent to the date of the original estimate. However, that benefit will affect current period earnings only to the extent that the replenishment of the reserve for adverse claims development (and the re-accrual of administrative costs for the settlement of those claims) is less than the benefit recognized from the prior period liability.
We seek to maintain a consistent claims reserving methodology across all periods. Accordingly, any prior period benefit from an un-utilized reserve for adverse claims development would likely be offset by the establishment of a new reserve in an approximately equal amount (relative to premium revenue, medical care costs, and medical claims and benefits payable) in the current period, and thus the impact on earnings for the current period would likely be minimal.
We are not an obligor to or guarantor of any indebtedness of any other party. We are not a party to off-balance sheet financing arrangements except for operating leases which are disclosed in Note 14 to the accompanying audited consolidated financial statements for the year ended December 31, 2007. We have certain advances to related parties, which are discussed in Note 13 to the accompanying audited consolidated financial statements for the year ended December 31, 2007
In the table below, we present our contractual obligations as of December 31, 2007. Some of the amounts we have included in this table are based on management’s estimates and assumptions about these obligations, including their duration, the possibility of renewal, anticipated actions by third parties, and other factors. Because these estimates and assumptions are necessarily subjective, the contractual obligations we will actually pay in future periods may vary from those reflected in the table. Amounts are in thousands.
We have audited the accompanying consolidated balance sheets of Molina Healthcare, Inc. (the Company) as of December 31, 2007 and 2006, and the related consolidated statements of income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2007. 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.
As discussed in Note 2 to the consolidated financial statements, Molina Healthcare, Inc. changed its method of accounting for Share-Based Payments in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004) on January 1, 2006.
Our results of operations include the results of recent acquisitions, including the acquisition of Mercy CarePlus, a Medicaid managed care organization based in St. Louis, Missouri, effective as of November 1, 2007, and the acquisition of Cape Health Plan, Inc. based in Southfield, Michigan, effective as of May 15, 2006.
Our Texas health plan began serving members in September 2006, and our Ohio health plan began serving members in late 2005. Our Indiana health plan ceased serving members effective January 1, 2007 because its Medicaid contract with the State of Indiana expired on December 31, 2006. Our Nevada health plan began serving only Medicare members in June 2007.
the delivery of a child - from the Medicaid programs in Michigan, Ohio, Texas, and Washington. Such payments are recognized as revenue in the month the birth occurs. Starting in 2006, our premium revenue also included premiums generated from Medicare, which totaled approximately $49.3 million for the year ended December 31, 2007. All of our Medicare revenue is paid to us as a fixed PMPM amount.
As of December 31, 2007, we had accrued a liability of approximately $2.3 million pursuant to our profit-sharing agreement with the state of Texas, for the 2006 and 2007 contract years. Because the final settlement calculations include a claims run-out period of nearly one year, the amounts recorded, based on our estimates, may be adjusted. We believe that the ultimate settlement will not differ materially from our estimate.
Other: Other medical care costs include medically related administrative costs, certain provider incentive costs, reinsurance cost, and other health care expense. Medically related administrative costs include, for example, expenses relating to health education, quality assurance, case management, disease management, 24-hour on-call nurses, and a portion of our information technology costs. Salary and benefit costs are a substantial portion of these expenses. For the years ended December 31, 2007, 2006, and 2005, medically related administrative costs were approximately $65.4 million, $52.6 million, and $44.4 million, respectively.
The following table provides the details of our consolidated medical care costs for the periods indicated:
We account for our investments in marketable securities in accordance with Statement of Financial Accounting Standards No. (SFAS) 115, Accounting for Certain Investments in Debt and Equity Securities. Realized gains and losses and unrealized losses judged to be other than temporary with respect to available-for-sale and held-to-maturity securities are included in the determination of net income. All unrealized losses at December 31, 2007 and 2006 were deemed to be temporary as all such losses were the result of increases in interest rates rather than a change in the credit quality of the investments. No losses will be realized if we hold these investments to maturity. The cost of securities sold is determined using the specific-identification method, on an amortized cost basis. Fair values of securities are based on quoted prices in active markets.
Except for restricted investments, marketable securities are designated as available-for-sale and are carried at fair value. Unrealized gains or losses, if any, net of applicable income taxes, are recorded in stockholders’ equity as
Receivables consist primarily of amounts due from the various states in which we operate. All receivables are subject to potential retroactive adjustment. As the amounts of all receivables are readily determinable and our creditors are state governments, our allowance for doubtful accounts is immaterial. Any amounts determined to be uncollectible are charged to expense when such determination is made. See Note 5, “Receivables.”
Property and equipment are stated at historical cost. Replacements and major improvements are capitalized, and repairs and maintenance are charged to expense as incurred. Software developed for internal use is capitalized in accordance with the provision of AICPA Statement of Position No. 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. Furniture and equipment are depreciated using the straight-line method over estimated useful lives ranging from three to seven years. Software is amortized over its estimated useful life of three years. Leasehold improvements are amortized over the term of the lease or five to 10 years, whichever is shorter. Buildings are depreciated over their estimated useful lives of 31.5 years. See Note 6, “Property and Equipment.”
Situations may arise where the carrying value of a long-lived asset may exceed the undiscounted expected cash flows associated with that asset. In such circumstances the asset is deemed to be impaired. We review material long-lived assets for impairment on an annual basis, as well as when events or changes in business conditions suggest potential impairment. Impaired assets are written down to fair value. In the second quarter of 2007, we recorded an impairment charge totaling $782, related to commercial software no longer used in operations. Other than this 2007 charge, we have determined that no long-lived assets were impaired at December 31, 2007 or 2006.
specific purposes as required by each state, or as protection against the insolvency of capitated providers. See Note 8, “Restricted Investments.”
Other assets include primarily deferred financing costs associated with long-term debt, certain investments held in connection with our employee deferred compensation program, and an investment in a vision services provider (see Note 13, “Related Party Transactions”). A liability approximately equal to the assets held in connection with our deferred employee compensation program is included in long-term liabilities. During 2007, deferred financing costs increased $6,498 for the deferral of fees paid in connection with the issuance of our convertible senior notes in October 2007. These fees are being amortized on a straight-line basis over the seven-year term of the convertible senior notes.
Income Taxes, including the Recently Adopted Financial Accounting Standard (FIN 48)
As a result of the implementation of FIN 48, we recognized a $445 increase to liabilities for uncertain tax positions, of which the entire increase was accounted for as an adjustment to the beginning balance of retained earnings as of January 1, 2007. Including the cumulative effect increase, at the beginning of 2007, we had $4,355 of total gross unrecognized tax benefits including $384 of accrued interest. Of this total, $1,524 represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in any future period. In May 2007, the FASB issued FASB Staff Position No. (FSP) FIN 48-1, Definition of Settlement in FASB Interpretation No. 48, which provides guidance on how a company should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. We have applied the provisions of FSP FIN 48-1 in our adoption of FIN 48. See Note 11, “Income Taxes.”
In December 2004, the FASB issued SFAS 123 (revised 2004) (SFAS 123(R)), Share-Based Payment. SFAS 123(R) is a revision of SFAS 123, Accounting for Stock Based Compensation, and supersedes APB 25. SFAS 123(R) eliminates the use of the intrinsic value recognition method, and requires companies to recognize the cost of employee services received in exchange for awards of equity instruments, based on the grant date fair value of those awards. As of January 1, 2006, we adopted SFAS 123(R) using the modified prospective transition method. Under this transition method, there is compensation cost attributable to the unvested portion of option and restricted stock awards granted prior to January 1, 2006. This cost is being recognized in periods subsequent to the adoption date based on the grant date fair values previously determined for pro forma disclosure purposes under SFAS 123, as illustrated in the table below.
The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions to stock-based employee compensation using the following weighted-average assumptions: a risk-free interest rate of 4.11%; expected stock price volatility of 53.2%; dividend yield of 0% and expected option lives of 60 months.
Our consolidated balance sheets include the following financial instruments: cash and cash equivalents, investments, receivables, trade accounts payable, medical claims and benefits payable, long-term debt and other liabilities. We consider the carrying amounts of current assets and liabilities to approximate their fair value because of the relatively short period of time between the origination of these instruments and their expected realization. The carrying amounts of other long-term obligations, including borrowings under our Credit Facility, approximated their fair values based on borrowing rates currently available to us for instruments with similar terms and remaining maturities, as of December 31, 2007 and 2006. Based on quoted market prices the fair value of our convertible senior notes, issued in October 2007, was $225,634 as of December 31, 2007. The carrying amount of the convertible senior notes totaled $200,000 as of December 31, 2007.
In September 2006, the FASB issued SFAS 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in U.S. generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We do not expect the adoption of SFAS 157 in 2008 to have a material impact on our consolidated financial statements.
In February 2007, the FASB issued SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115, which is effective for fiscal years beginning after November 15, 2007. SFAS 159 permits entities to measure eligible financial assets, financial liabilities and firm commitments at fair value, on an instrument-by-instrument basis, that are otherwise not permitted to be accounted for at fair value under other U.S. generally accepted accounting principles. The fair value measurement election is irrevocable and subsequent changes in fair value must be recorded in earnings. We do not expect the adoption of SFAS 159 in 2008 to have a material impact on our consolidated financial statements.
In December 2007, the FASB issued SFAS 141(R), Business Combinations and SFAS 160, Noncontrolling Interests in Consolidated Financial Statements. The standards are intended to improve, simplify, and converge internationally the accounting for business combinations and the reporting of noncontrolling (minority) interests in consolidated financial statements. SFAS 141(R) requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors and other users all of the information they need to evaluate and understand the nature and financial effect of the business combination. SFAS 141(R) is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. SFAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier adoption is prohibited.
Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the SEC did not, or are not believed by management to, have a material impact on our present or future consolidated financial statements.
In accordance with SFAS 141, Business Combinations, the purchase price of the acquisition described below was allocated to the fair value of assets acquired and liabilities assumed, including identifiable intangible assets, and the excess of purchase price over the fair value of net assets acquired was recorded as goodwill.
Of the $16,626 of acquired intangible assets, $354 was assigned to the tradename with a one-year life, $8,050 was assigned to the member list with a five-year life, $6,535 was assigned to the provider network with a ten-year life, and $1,687 was assigned to payor contracts with a fifteen-year life, for a weighted average amortization period of approximately 7.9 years. The acquired goodwill is not subject to amortization.
Pro forma earnings per share are based on 28.3 million and 28.0 million weighted average shares for the years ended December 31, 2007 and 2006, respectively. Pro forma earnings per share assuming full dilution is based on 28.4 million and 28.2 million weighted average shares for the years ended December 31, 2007 and 2006, respectively.
The contractual maturities of our investments as of December 31, 2007 are summarized below.
Gross realized gains and gross realized losses from sales of available-for-sale securities are calculated under the specific identification method and are included in investment income. Total proceeds from sales of available-for-sale securities were $13,136, $12,583 and $4,689 for the years ended December 31, 2007, 2006 and 2005, respectively. Net realized investment losses for the years ended December 31, 2007, 2006 and 2005 were $78, $151 and $220, respectively.
Substantially all receivables due our California and Missouri health plans at December 31, 2007 were collected in January 2008.
Our agreement with the state of Utah calls for the reimbursement of our Utah HMO of medical costs incurred in serving our members plus an administrative fee of 9% of medical costs and all or a portion of any cost savings realized, as defined in the agreement. Our Utah health plan bills the state of Utah monthly for actual paid health care claims plus administrative fees. Our receivable balance from the state of Utah includes: 1) amounts billed to the state for actual paid health care claims plus administrative fees; 2) amounts estimated to be due under the savings sharing provision of the agreement; and 3) amounts estimated for incurred but not reported claims, which, along with the related administrative fees, are not billable to the state of Utah until such claims are actually paid.
Depreciation expense recognized for building and improvements, furniture, equipment and automobiles was $8,494, $7,676, and $5,909 for the years ended December 31, 2007, 2006, and 2005, respectively. Amortization expense recognized for capitalized computer software costs was $8,624, $4,260 and $1,786 for the years ended December 31, 2007, 2006, and 2005, respectively.
by the addition of a reserve for adverse claims development when estimating the liability at the end of the period (captured as “components of medical care costs related to current year”).
The Notes are convertible into cash and, under certain circumstances, shares of our common stock. The initial conversion rate is 21.3067 shares of our common stock per one thousand dollar principal amount of the Notes. This
represents an initial conversion price of approximately $46.93 per share of our common stock. In addition, if certain corporate transactions that constitute a change of control occur prior to maturity, we will increase the conversion rate in certain circumstances. Prior to July 2014, holders may convert their Notes only under the following circumstances:
In 2005, we entered into the Amended and Restated Credit Agreement, dated as of March 9, 2005, among Molina Healthcare Inc., certain lenders, and Bank of America N.A., as Administrative Agent (the “Credit Facility”). Effective May 2007, we entered into a third amendment of the Credit Facility that increased the size of the revolving line of credit from $180,000 to $200,000, maturing in May 2012. The Credit Facility is intended to be used for working capital and general corporate purposes, and subject to obtaining commitments from existing or new lenders and satisfaction of other specified conditions, we may increase the amount available under the Credit Facility to up to $250,000.
Our effective tax rate is based on expected income, statutory tax rates, and tax planning opportunities available to us in the various jurisdictions in which we operate. Significant management estimates and judgments are required in determining our effective tax rate. We are routinely under audit by federal, state, or local authorities regarding the timing and amount of deductions, nexus of income among various tax jurisdictions, and compliance with federal, state, and local tax laws. We have pursued various strategies to reduce our federal, state and local taxes. As a result, we have reduced our state income tax expense due to California Economic Development Tax Credits.
During 2007, 2006, and 2005, excess tax benefits related to stock option exercises were $853, $1,227 and $1,872, respectively. Such benefits were recorded as a reduction of income taxes payable with an increase in additional paid-in capital.
A reconciliation of the beginning and ending balances of the total amounts of gross unrecognized tax benefits is as follows:
We also have a nonqualified deferred compensation plan for certain key employees. Under this plan, eligible participants can defer up to 100% of their base salary and 100% of their bonus to provide tax-deferred growth for retirement. The funds deferred are invested in various mutual funds, through a rabbi trust.
We lease two medical clinics from the Molina Family Trust, which each have five five-year renewal options. Rental expense for these leases totaled $97, $97, and $96 for the years ended December 31, 2007, 2006, and 2005, respectively. At December 31, 2007, minimum future lease payments for the clinics consisted of the following:
We have an equity investment in a medical service provider that provides certain vision services to our members. We account for this investment under the equity method of accounting because we have an ownership interest in the investee in excess of 20%. As of December 31, 2007 and 2006, our carrying amount for this investment totaled $3,460 and $1,375, respectively. During the third quarter of 2007, we invested an additional $2,100 in this medical service provider. Effective July 1, 2007 we paid this provider a $900 network access fee, which is being amortized over twelve months. For the years ended December 31, 2007, 2006, and 2005, we paid $10,894, $7,862 and $3,440, respectively, for medical service fees to this provider.
In 2006, we assumed an office lease from Millworks Capital Ventures with a remaining term of 52 months. Millworks Capital Ventures is owned by John C. Molina, our Chief Financial Officer, and his wife. The monthly base lease payment is approximately $18 and is subject to an annual increase. Based on a market report prepared by an independent realtor, we believe the terms and conditions of the assumed lease are at fair market value. We are currently using the office space under the lease for an office expansion. Payments made under this lease totaled $246 and $170 for the years ended December 31, 2007 and 2006, respectively.
We are a party to a fee for service agreement with Pacific Hospital of Long Beach (“Pacific Hospital”). Pacific Hospital is owned by Abrazos Healthcare, Inc., the shares of which are held as community property by the husband of Dr. Martha Bernadett, our Executive Vice President, Research and Development. Amounts paid under the terms of that agreement were $157 and $357 for the years ended December 31, 2007 and 2006, respectively. We believe that the claims submitted to us by Pacific Hospital were reimbursed at prevailing market rates. In 2006, we entered into an additional agreement with Pacific Hospital as part of a capitation arrangement. Under this arrangement, we pay Pacific Hospital a fixed monthly fee based on member type. For the years ended December 31, 2007 and 2006, we paid approximately $4,837 and $1,652, respectively, to Pacific Hospital for capitation services. We believe that this agreement with Pacific Hospital is based on prevailing market rates for similar services. Also as of December 31, 2007, we had an advance outstanding to this provider totaling $250, which will be offset to capitation payments in 2008.
Rental expense related to these leases totaled $18,127, $12,193 and $9,505 for the years ended December 31, 2007, 2006, and 2005, respectively.
During 2001 and 2002, we entered into employment agreements with three current executives with initial terms of one to three years, subject to automatic one-year extensions thereafter. In most cases, should the executive be terminated without cause or resign for good reason before a Change of Control, as defined, we will pay one year’s base salary and Target Bonus, as defined, for the year of termination, in addition to full vesting of 401(k) employer contributions and stock options, and continued health and welfare benefits for the earlier of 18 months or the date the executive receives substantially similar benefits from another employer. If any of the executives are terminated for cause, no further payments are due under the contracts.
Malpractice Action. On February 1, 2007, a complaint was filed in the Superior Court of the State of California for the County of Riverside by plaintiff Staci Robyn Ward through her guardian ad litem, Case No. 465374. The complaint purports to allege claims for medical malpractice against several unaffiliated physicians, medical groups, and hospitals, including Molina Medical Centers and one of its physician employees. The plaintiff alleges that the defendants failed to properly diagnose her medical condition which has resulted in her severe and permanent disability. On July 22, 2007, the plaintiff passed away. The proceeding is in the early stages, and no prediction can be made as to the outcome.
Starko. Our New Mexico HMO is named as a defendant in a class action lawsuit brought by New Mexico pharmacies and pharmacists, Starko, Inc., et al. v. NMHSD, et al., No. CV-97-06599, Second Judicial District Court, State of New Mexico. The lawsuit was originally filed in August 1997 against the New Mexico Human Services Department (“NMHSD”). In February 2001, the plaintiffs named health maintenance organizations participating in the New Mexico Medicaid program as defendants (the “HMOs”), including Cimarron Health Plan, the predecessor of our New Mexico HMO. Plaintiff asserts that NMHSD and the HMOs failed to pay pharmacy dispensing fees under an alleged New Mexico statutory mandate. Discovery is currently underway. It is not currently possible to assess the amount or range of potential loss or probability of a favorable or unfavorable outcome. On July 10, 2007, the court dismissed all damages claims against Molina Healthcare of New Mexico, leaving only a pending action for injunctive and declaratory relief. On August 15, 2007, the court held a hearing on the motion of Molina Healthcare of New Mexico to dismiss the plaintiffs’ claims for injunctive and declaratory relief. At that hearing, the court dismissed all remaining claims against Molina Healthcare of New Mexico. The plaintiffs have filed an appeal with respect to the court’s dismissal orders and have submitted their opening appellate brief. Molina Healthcare of New Mexico is preparing its responsive appellate brief. Under the terms of the stock purchase agreement pursuant to which we acquired Health Care Horizons, Inc., the parent company to the Molina Healthcare of New Mexico HMO, an indemnification escrow account was established and funded with $6,000 in order to indemnify our Molina
Healthcare of New Mexico HMO against the costs of such litigation and any eventual liability or settlement costs. Currently, approximately $4,100 remains in the indemnification escrow fund.
Our principal operations are conducted through our health plan subsidiaries operating in California, Michigan, Missouri, Nevada, New Mexico, Ohio, Texas, Washington and Utah. Our health plans are subject to state regulations that, among other things, require the maintenance of minimum levels of statutory capital, as defined by each state, and restrict the timing, payment and amount of dividends and other distributions that may be paid to us as the sole stockholder. To the extent the subsidiaries must comply with these regulations, they may not have the
financial flexibility to transfer funds to us. The net assets in these subsidiaries (after intercompany eliminations) which may not be transferable to us in the form of loans, advances or cash dividends was $332,209 at December 31, 2007, and $236,800 at December 31, 2006. The National Association of Insurance Commissioners, or NAIC, adopted rules effective December 31, 1998, which, if implemented by the states, set new minimum capitalization requirements for insurance companies, HMOs and other entities bearing risk for health care coverage. The requirements take the form of risk-based capital (RBC) rules. Michigan, Nevada, New Mexico, Ohio, Texas, Washington, and Utah have adopted these rules, which may vary from state to state. California has not yet adopted NAIC risk-based capital requirements for HMOs and has not formally given notice of its intention to do so. Such requirements, if adopted by California, may increase the minimum capital required for that state.
Stock option awards have an exercise price equal to the fair market value of our common stock on the date of grant, generally vest in equal annual installments over periods up to four years from the date of grant, and have a maximum term of ten years from the date of grant. Restricted stock awards are granted with a fair value equal to the market price of our common stock on the date of grant, and generally vest in equal annual installments over periods up to five years from the date of grant.
The following table illustrates the components of our stock-based compensation expense as reported in general and administrative expenses in the Consolidated Statements of Income:
As of December 31, 2007, there was $3,973 of unrecognized compensation expense related to non-vested stock options, which we expect to recognize over a weighted-average period of 2.3 years. Also as of December 31, 2007, there was $7,868 of unrecognized compensation cost related to non-vested restricted stock awards, which we expect to recognize over a weighted-average period of 3.0 years.
The Black-Scholes valuation model was used to estimate the fair value of the options at grant date based on the assumptions noted in the following table. The risk-free interest rate is based on the implied yield currently available on U.S. Treasury zero coupon issues. The expected volatility is primarily based on historical volatility levels along with the implied volatility of exchange-traded options to purchase our common stock. The expected option life of each award granted was calculated using the “simplified method” in accordance with SAB 107. There were no material changes made to the methodology used to determine the assumptions during 2007. The assumptions disclosed below represent a weighted-average of the assumptions used for all of our stock option grants throughout the year.
Stock option activity for the year ended December 31, 2007 was as follows:
The total intrinsic value of stock options exercised during the years ended December 31, 2007, 2006, and 2005 amounted to $4,251, $3,812, and $6,182, respectively.
Non-vested restricted stock activity for the year ended December 31, 2007 is summarized below.
The total fair value of restricted shares vested during the years ended December 31, 2007, 2006, and 2005 was $2,612, $1,993, and $723, respectively.
As described in Note 15, “Stock Plans,” we award shares of restricted stock to employees and others under our equity incentive plan. When these shares vest, employees may choose to settle their associated tax obligation by instructing the Company to withhold the number of shares that will settle the tax obligation based on the current market value of the stock. When we settle tax obligations associated with the vesting of restricted stock awards, we retire the stock used. During 2007, we retired 14,391 shares of common stock, totaling $480.
In November 2005, we filed a shelf registration statement on Form S-3 with the Securities and Exchange Commission covering the issuance of up to $300,000 of securities, including common stock or debt securities. In October 2007, we issued $200,000 in convertible senior notes under this shelf registration statement. See Note 10, “Long-Term Debt.” We may publicly offer securities from time to time at prices and terms to be determined at the time of the offering.
The following is a summary of the quarterly results of operations for the years ended December 31, 2007 and 2006.
Potentially dilutive shares issuable pursuant to the Company’s 2007 offering of convertible senior notes were not included in the computation of diluted net income per share because to do so would have been antidilutive for the year ended December 31, 2007.
During 2007, 2006, and 2005, the Registrant made capital contributions to certain subsidiaries totaling $55,887, 73,760, and $27,890 respectively, primarily to comply with minimum net worth requirements and to fund contract acquisitions. Such amounts have been recorded as an increase in investment in the respective subsidiaries.
The Registrant is a party to a fee for service agreement with Pacific Hospital of Long Beach (“Pacific Hospital”). Pacific Hospital is owned by Abrazos Healthcare, Inc., the shares of which are held as community property by the husband of Dr. Martha Bernadett, the Registrant’s Executive Vice President, Research and Development. Amounts paid under the terms of that agreement were $157 and $357 for the years ended December 31, 2007 and 2006, respectively. The Registrant believes that the claims submitted to it by Pacific Hospital were reimbursed at prevailing market rates. In 2006, the Registrant entered into an additional agreement with Pacific Hospital as part of a capitation arrangement. Under this arrangement, the Registrant pays Pacific Hospital a fixed monthly fee based on member type. For the years ended December 31, 2007 and 2006, the Registrant paid approximately $4,837 and $1,652, respectively, to Pacific Hospital for capitation services. The Registrant believes that this agreement with Pacific Hospital is based on prevailing market rates for similar services. Also as of December 31, 2007, the Registrant had an advance outstanding to this provider totaling $250, which will be offset to capitation payments in 2008.