As of December 31, 1997, the Company leased approximately 220,000 aggregate square feet of space for its principal corporate headquarters and executive offices in Santa Ana and Costa Mesa, California. In connection with its operations, as of December 31, 1997, the Company leased approximately 2.2 million aggregate square feet for office space, subsidiary operations, customer service centers and space for computer facilities. Such space corresponds to areas in which the Company's HMOs or specialty managed care products and services operate or where it has satellite administrative offices. The Company's leases expire at various dates through 2007.
The Company owns 32 buildings encompassing approximately 914,000 aggregate square feet of space. Six of the buildings, which represent approximately 348,000 aggregate square feet of space are primarily used for administrative operations and are located in California, Utah and Guam. The remaining 26
On February 14, 1997 the Company consummated the FHP Acquisition for a total purchase price including transaction costs of $2.2 billion. The FHP Acquisition has been accounted for as a purchase. The Company's consolidated results of operations include the results of FHP from the date of the FHP Acquisition (see Note 4 of the Notes to Consolidated Financial Statements).
Total operating revenue increased 87 percent to $9.0 billion for the year ended December 31, 1997 from $4.8 billion for the same period in the prior year. FHP contributed approximately $3.6 billion or 85 percent of the increase in revenue. Enrollment gains (net of the FHP Acquisition) in both the government and commercial programs increased revenue by six percent. Premium increases, mainly in the government programs, along with the Company's specialty managed care products and services, contributed the remainder of the increase. Total HMO membership increased 85 percent to approximately 3.8 million members at December 31, 1997, from approximately 2.0 million members at December 31, 1996, due primarily to the FHP Acquisition. The Company acquired approximately 1.5 million and 0.4 million commercial and government members, respectively, as part of the FHP Acquisition.
As a percentage of operating revenue, marketing, general and administrative expenses decreased slightly as compared to the prior year, excluding the pretax charges for 1997 and 1996 as discussed below. The decrease reflects reduced or eliminated FHP marketing, continued administrative savings, including lower than expected staffing and greater than expected efficiencies resulting from the integration of the FHP administrative operations and information systems.
During the fourth quarter of 1997, the Company recognized a $124 million ($111 million or $2.73 diluted loss per share, net of tax) charge for goodwill and intangible assets which were impaired and no longer recoverable from future operations. These pretax charges relate to the following markets and products:
As discussed in the second quarter, Utah's operating losses were related to lower than expected 1997 premium rate increases coupled with a shift of membership from capitated to non-capitated health care providers as a significant health care provider contract switched from capitation to fee-for-service. The Company agreed to continue this contract to ensure an adequate infrastructure to service the Utah membership. At the same time, the Utah information systems migrated to the standard FHP system in anticipation of the conversion of the FHP system into the Company's common system. As a result, increased utilization under the new fee-for-service contract was not visible until the fourth quarter of 1997 when conversion reconciliations discovered significant unpaid claims as well as claims paid inaccurately. The Company expects that economic and competitive conditions in Utah will continue to minimize premium increases and will make provider capitation contracting difficult. Because the 1997 losses and the cash flow analysis did not support the recoverability of goodwill, the Company recorded an impairment charge and announced that it will exit or otherwise dispose of the Utah operations.
In June 1996, a pretax charge was recognized of $25 million ($15 million, or $0.46 diluted loss per share, net of tax) for an increase of reserves in anticipation of negotiations relating to potential governmental claims for contracts with OPM. The Company's HMO subsidiaries have commercial contracts with OPM to provide managed health care services to members under FEHBP. In the normal course of business, OPM audits health plans with which it contracts to, among other things, verify that the premiums calculated and charged to OPM are established in compliance with the best price community rating guidelines established by OPM. OPM typically audits plans once every five or six years and each audit covers the prior five or six year period. Depending on the type of contract the Company has with OPM, OPM will audit one or more health plans at the same time. OPM has notified PacifiCare of its intent to audit or has recently completed an audit of the majority of the Company's health plans. While the government's initial on-site audits are usually followed by a post-audit briefing in which the government indicates its preliminary results, final resolution and settlement of the audits have historically taken a minimum of three to five years.
In addition to claims made by the auditors as part of the normal audit process, the OPM may also refer their results to the United States Department of Justice ("DOJ") for potential legal action under the False Claims Act. The DOJ has the authority to file a claim under the False Claims Act if it believes that
the health plan knowingly overcharged the government or otherwise submitted false documentation or certifications. In False Claim Act actions, the government may impose trebled damages and a civil penalty of not less than $5,000 nor more than $10,000 for each separate alleged false claim. In November 1997, the Company was notified that the 1995 audit of the operations of the Company's Oklahoma HMO subsidiary, had been referred to the DOJ. The Company is negotiating to settle this matter with the DOJ.
Interest income, net of interest expense, decreased approximately $29 million for the year ended December 31, 1997 compared to the prior year due primarily to increased borrowings to finance the FHP Acquisition.
For the year ended December 31, 1997 income excluding the pretax charges described above was $107 million or $2.43 diluted earnings per share. For the year ended December 31, 1996 income exclusive of the pretax charges was $138 million or $4.36 diluted earnings per share. The decrease over the prior year reflects the increase in the commercial medical care ratio, increased amortization expense, the increase in interest expense related to the FHP Acquisition and an increase in the shares used to calculate earnings per share.
For the year ended December 31, 1997 the Company adopted the provisions of Statement of Financial Accounting Standards ("SFAS")No. 128, "Earnings Per Share". This statement requires a dual presentation of earnings per share, basic and diluted and restatement of earnings per share for prior years. The adoption of this statement did not materially change the Company's calculation of earnings (loss) per share for any reported period.
Due mainly to the pretax charges in the fourth quarter, and the high effective tax rate which resulted in the Company reporting a net loss per share, the convertible preferred stock and stock options or potentially dilutive securities included in the calculation of diluted loss per share in the fourth quarter and for 1997 were anti-dilutive. Since the potentially dilutive securities were anti-dilutive, the calculation of the diluted loss per share is identical to the basic loss per share.
The Class A Common Stock, Class B Common Stock and Series A Preferred Stock issued in conjunction with the FHP Acquisition (see Note 4 of the Notes to Consolidated Financial Statements) caused a significant increase in the shares outstanding used in computing earnings per share between the fiscal quarters. Due to the significant increase in shares outstanding and the anti-dilutive effect of the potentially dilutive securities during the fourth quarter, the sum of the quarterly earnings (loss) per share does not equal the 1997 year-to-date loss per share.
Government premiums rose $550 million or 25 percent to $2.7 billion for the fiscal year ended September 30, 1996 from $2.2 billion in fiscal 1995. Enrollment gains, predominantly in the Secure Horizons programs, accounted for $430 million or 78 percent of the increase. The remainder of the premium increase is attributable to incremental acquisitions and premium rate increases averaging four percent.
The increase in the commercial medical care ratio for the fiscal year ended September 30, 1996 was primarily attributable to increased PPO and indemnity costs of the Company's specialty managed care products and services combined with higher physician and prescription drug costs in the Company's HMOs. Exclusive of the Company's PPO and indemnity products, the commercial medical care ratio decreased slightly through improved contracting arrangements. Many of the Company's newer markets experienced more membership growth than the Company as a whole. However, with provider networks less sophisticated in managed care, these newer markets contributed to a higher medical care ratio. The more mature commercial markets experienced slightly improved medical care ratios from fiscal year 1995.
As discussed previously, the Company recognized pretax charges for the fiscal year ended September 30, 1996 totaling $101 million ($62 million or $1.96 diluted loss per share, net of tax) (see Note 9 of the Notes to Consolidated Financial Statements).
Net interest income increased by approximately $10 million compared to the prior fiscal year primarily due to increased cash available for investment purposes at higher interest rates than fiscal year 1995 and lower interest expense associated with decreased debt service.
The increased consolidated effective income tax rate for the fiscal year ended September 30, 1996 was attributable to the charges for the disposition and goodwill impairment described in Note 9 of the Notes to Consolidated Financial Statements, some of which are not deductible for income tax purposes.
The Company has significant short-term liquidity with 1997 year-end cash, equivalents and marketable securities of $1.5 billion, a 61 percent increase from December 31, 1996 primarily attributable to the FHP Acquisition and results of operations. The Company's cash flow requirements for 1997 were met by funds provided from operations. Financing activities, including the issuance of common and preferred equity
In January 1998 the Company's board of directors approved a plan to repurchase shares of the Company's equity instruments. The Company successfully renegotiated terms of the credit facility to increase the maximum amount of repurchases permitted to $500 million. The Company will purchase stock using cash flows from operations and additional borrowings under its credit facility. Shares repurchased will be available for reissuance in connection with the Company's employee benefit plans or for other corporate purposes. As of February 28, 1998, the Company had repurchased 42,000 shares of its Class A Common Stock and 406,000 shares of its Class B Common Stock for an aggregate amount of $23 million.
The Financial Accounting Standards Board ("FASB") has issued several pronouncements regarding disclosure that the Company will adopt in 1998.
SFAS No. 129, "Disclosure of Information about Capital Structure," consolidates the existing guidance relating to an entity's capital structure. The required capital structure disclosures include liquidation preferences of preferred stock, information about the pertinent rights and privileges of the outstanding equity securities and the redemption amounts of all issues of capital stock that are redeemable at fixed or determinable prices on fixed or determinable dates.
SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," significantly changes the way public companies report segment information in annual financial statements and also requires those companies to report selected segment information in interim financial reports. Under Statement 131, public companies will report financial and descriptive information about their operating segments. Operating segments are revenue-producing components of the enterprise for which separate financial information is produced internally and are subject to evaluation by the chief operating decision maker in deciding how to allocate resources to segments.
In March 1998, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants is expected to issue Statement of Position ("SOP"), "Accounting for the Costs of Computer Software Developed For or Obtained For Internal-Use." Under the SOP, effective in 1999, certain computer software costs are required to be capitalized and amortized to income over the software's estimated useful life. The Company will adopt the SOP in 1999.
FORWARD LOOKING INFORMATION UNDER THE PRIVATE SECURITIES LITIGATION ACT OF 1995
MEMBERSHIP. The Company's membership for the year ended December 31, 1998 is expected to decline in the commercial program. In accordance with the Company's strategic focus shifting from one of rapid growth to improved margin performance, the Company's emphasis is on renewing employer contracts with sufficient price increases to improve gross margin. Specifically, the Company has implemented commercial price increases including increases of more than 10 percent in conjunction with open enrollment in all markets, including concentrated efforts in Utah and Washington which may result in net membership attrition. In addition to pricing increases, the Company has or intends to exit certain geographical areas where the premiums are insufficient to support the cost of health care in that area. Combined with continued increases in competition and the disposition of its Utah subsidiary which currently has approximately 154,000 commercial members, the Company expects to see minimal growth or declines in commercial membership in 1998.
An unforeseen loss of profitable membership could have a material adverse effect on the Company. Factors which could contribute to the loss of membership include issues related to the integration of the Company and FHP in retaining FHP's members as the Company combines the PacifiCare and FHP health plans, sale of certain managed care operations, failure to obtain new customers or to retain existing customers, effect of premium increases, reductions in workforce by existing customers, adverse publicity and news coverage, inability to carry out marketing and sales plans, or the loss of key executives or key employees.
COMMERCIAL MEDICAL CARE RATIO. The commercial medical care ratio for the year ended December 31, 1998 is expected to decrease as compared to 1997. The Company expects improvements as it continues renegotiation of provider contracts, implements capitated contracts and implements price increases. Price increases on a consolidated company basis are expected to increase by an average of four percent, with increases ranging from zero to over ten percent. Moreover, higher premium rates offered during open enrollment periods should result in the elimination of some high medical care ratio membership. During 1998, the Company will concentrate its efforts on continued renegotiations with providers, including the acquired FHP contracts. Successful renegotiation of these contracts should reduce the medical care ratio. Finally, the disposition of Utah, which currently runs a higher than average medical care ratio, should help to improve the commercial medical care ratio. These improvements are expected to be slightly offset by increased prescription drug costs.
MEDICAL CARE RISK FACTORS. The commercial and government medical care ratio expectations discussed above could be affected by various uncertainties, including increases in medical and prescription drug costs which have been escalating faster than premium increases in recent years, increases in utilization and costs of medical services and the effect of actions by competitors or groups of providers, termination of provider contracts or renegotiation thereof at less cost-effective rates or terms of payment, or the inability to complete a timely, successful disposition of the Company's Utah subsidiary. In addition, the commercial and government medical care ratio expectations for the HMOs acquired in the FHP Acquisition could be impacted by the conversion to PacifiCare computer systems over the next eighteen months which may result in reduced timely visibility of actual claims costs.
Marketing, general and administrative expenses could be adversely impacted by the need for additional advertising, marketing, administrative, or management information systems expenditures and the inability to carry out marketing and sales plans. The ability of PacifiCare to realize the anticipated benefits and synergies related to the FHP Acquisition is subject to the following additional uncertainties, among others: the ability to eliminate duplicative functions while maintaining acceptable performance levels and the possibility that the continued integration will result in a loss of providers, employers, members or key employees.
1998 DISPOSITIONS. While the Company has previously announced its intention to dispose of its Utah and workers' compensation operations in 1998, other dispositions could be announced as the Company continues to evaluate whether certain subsidiaries or products fit within its core business strategy. There is no guarantee that the Company will be successful in selling all or a portion of the Utah or workers' compensation operations at a price sufficient to avoid disposition losses. Such losses could include restructuring expenses for severance, lease and contract terminations as well as impairment of long-lived assets. There can be no assurance that the dispositions will not result in additional pretax charges. The Company believes, however, that any disposition operating losses would not materially affect the Company's consolidated financial position. However, the disposition losses could have a material adverse effect on the results of operations or cash flows of a future quarter.
IMPAIRMENT OF LONG-LIVED ASSETS. The Company assesses the recoverability of its long-lived assets (including goodwill and intangibles) on an annual basis or whenever adverse events or changes in circumstances or the business climate indicate that expected undiscounted future cash flows for individual business units may not be sufficient to support the recorded asset. Based on the 1997 annual analysis, certain of the Company's operations will require more frequent monitoring in 1998. In addition, at December 31, 1997 certain of the Company's property, plant and equipment was determined to be recoverable because of long-term operating lease agreements. Should there be a change in the rental income stream, an impairment for these assets may be necessary. The Company believes that this impairment would not materially affect the Company's consolidated financial position. However, the impairment charges could have a material adverse effect on the results of operations or cash flows.
LEGISLATION AND REGULATION. The Company's success is significantly impacted by federal and state legislation and regulation, including Medicare legislation. Almost 60 percent of the Company's revenue, and an even greater percentage of its profit, comes from its government programs, the majority of which is Medicare risk business. Actual results may differ materially from expected results discussed throughout this document because of adverse state and federal legislation and regulation. This includes limitations on premium levels; increases in minimum capital and reserves and other financial viability requirements; prohibition or limitation of capitated arrangements or provider financial incentives; benefit mandates (including mandatory length of stay and emergency room coverage, many of which are effective in 1998) and limitations on the ability to manage care and utilization of any willing provider and direct access laws. It also includes adverse actions of governmental payors, including unilateral reduction of Medicare premiums payable; discontinuance of or limitation on governmentally funded programs and recovery by governmental payors of previously paid amounts; the inability to increase premiums or prospective or retroactive reductions to premium rates for federal employees; adverse regulatory determinations resulting in care or limitations of licensure, and certification or contracts with governmental payors; and consolidation of operations or other efforts to integrate FHP.
On August 5, 1997, President Clinton signed into law the Balanced Budget Act of 1997, which enacted numerous revisions to the Medicare program. The law replaces the risk contract program with a new "Medicare+Choice" program, which is intended to increase Medicare enrollment in private health plans. During 1998, HCFA is expected to promulgate regulations that will allow participation in the Medicare+Choice program by HMOs, preferred provider organizations, point-of-service plans, provider-sponsored organizations and fee-for-service plans and provide for a new medical savings account demonstration project for Medicare beneficiaries. The law also revises the formula used by HCFA to calculate payments to Medicare health plans by establishing minimum payment levels and annual increases and limiting the overall rate of payment growth. Further, the law enacts new requirements for risk adjustment, information disclosure, quality measurement and improvement and beneficiary enrollment, among other provisions. The Company believes that any slowdown in the rate of premium growth may be offset by the effect of this new legislation encouraging managed health care for Medicare beneficiaries. The loss of Medicare contracts or termination or modification of the HCFA risk-based Medicare program could have a material adverse effect on the revenue, profitability and business prospects of the Company.
LEGAL PROCEEDINGS. The Company has been served with several purported class action suits alleging violations of federal securities laws by the Company and by certain of its officers and directors. The complaints relate to the period from the date of the FHP Acquisition through the Company's November 25, 1997 announcement that earnings for the fourth quarter of 1997 would be lower than expected. These complaints primarily allege that the Company previously omitted and/or misrepresented material facts with respect to its costs, earnings and profits. These suits are at a very early stage and no discovery has occurred. The Company believes it has good defenses to the claims in these suits and is contesting them vigorously.