As of December 31, 2003, the Company leased property at the following four locations: (i) approximately 105,718 square feet of space for its executive offices and main operations in Louisville, Kentucky, under a lease agreement and amendment expiring in 2009; (ii) approximately 10,206 square feet at a regional operating office in Pittsburgh, Pennsylvania, under a lease agreement expiring in 2006; (iii) approximately 8,125 square feet at its Encino, California location under a lease agreement expiring in 2004; and (iv) approximately 20,500 square feet at its New Berlin, Wisconsin location under a 5-year term expiring in 2006. The Company is currently in negotiations to extend the lease for the Encino, California office for a five-year term expiring in 2009, with substantially the same terms as the current lease.
The tables below summarize selected recent financial information for the Company. For further information, refer to the Company’s financial statements and notes thereto presented under Part II, Item 8 of the Form 10-K.
The Company believes that the following critical accounting policies affect the more significant judgments and estimates used in the preparation of the Company’s financial statements.
Approximately $2.9 million and $4.4 million of the Company’s accounts receivable balance of $7.0 and $9.4 million at December 31, 2003 and 2002, respectively, is attributable to provider bill audit services. The provider bill audit accounts receivable represents the amounts invoiced by the Company to its clients for its fee for completed provider audits. For each completed audit, prior to invoicing, the Company obtains a sign-off
At December 31, 2003 and 2002, goodwill and other long-lived assets represented 49% and 54%, respectively, of the Company’s total assets and 79% and 91%, respectively, of the Company’s total stockholders’ equity.
Goodwill must be tested at least annually for impairment at a level of reporting referred to as the reporting unit and more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. The Company’s reporting units are generally consistent with the operating segments underlying the segments in Note 15 to Item 8. “Financial Statements and Supplementary Data”. All of the Company’s goodwill relates to the Healthcare Recovery Services segment.
Long-lived assets consist of property and equipment and other identifiable intangible assets. These assets are depreciated or amortized over their estimated useful life, and are subject to impairment reviews. The Company periodically reviews long-lived assets whenever adverse events or changes in circumstances indicate the carrying value of such assets may not be recoverable. In assessing recoverability, the Company must make assumptions regarding estimated future cash flows and other factors to determine if an impairment loss may exist, and, if so, estimate fair value. The Company also must estimate and make assumptions regarding the useful lives assigned to its long-lived assets. If these estimates, or their related assumptions, change in the future, the Company may be required to record impairment losses or change the useful life including accelerating depreciation or amortization for these assets.
Provision for income taxes is based upon the Company’s estimate of taxable income or loss for each respective accounting period. An asset or liability is recognized for the deferred tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements. These temporary differences will result in taxable or deductible amounts in future periods when the reported amounts of assets are recovered or liabilities are settled. The Company regularly reviews its deferred tax assets to determine the amount that is more likely than not to be realized. When this amount is less than the deferred tax asset recorded, the Company records a valuation allowance to reduce the asset to its estimated realizable value. If the Company determined that it was not going to be able to fully realize its recorded deferred tax assets, it would make an adjustment to the valuation allowance. This would reduce net income in the period that the Company made its determination. Similarly, if the Company realized that it was going to be able to fully realize a deferred tax asset in excess of its net recorded value, net income would be increased in the period that the Company made its determination.
The Company also reviews its deferred tax liabilities on a regular basis to determine that the amount recorded is adequate to cover the expected reversal of temporary income tax liabilities. In the event that the amount recorded was less than adequate, the deferred tax liability would be increased to its estimated realizable value and net income would be decreased accordingly. In the event that the deferred tax liability was determined to be overstated, it would be reduced to its estimated realizable value and net income would increase accordingly.
The Company generally determines its effective tax rate by considering the statutory federal income tax rate, the statutory state and local tax rates (net of the federal income tax benefit) and any nondeductible expenses. This rate could also be affected by increases or decreases to deferred tax assets or liabilities as described above.
The Company reviews its contingent liabilities, which arise primarily from litigation and litigation defense costs, in accordance with Statement of Financial Accounting Standards No. 5 (SFAS 5), “Accounting for Contingencies”. Contingent liabilities are recorded as liabilities when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable. Contingent liabilities are often resolved over long periods. Estimating probable losses requires judgments about both the amount of liability, which may or may not be readily determinable, and the likelihood of liability, which involves ranges of probability that can at times be broad and depend on the potential actions of third parties.
compensation expense for stock options granted with an exercise price equal to the quoted market price of the Common Stock on the date of grant and that vest based solely on continuation of employment by the recipient of the option award. The Company adopted Statement of Financial Accounting Standards No. 123 (SFAS No. 123) for disclosure purposes in 1996. For SFAS No. 123 purposes, the fair value of each option grant and stock-based award has been estimated as of the date of grant using the Black-Scholes option pricing model. If the Company were to adopt SFAS No. 123 to account for options, compensation expense would be recognized resulting in a decrease in net income and earnings per share for the years ended December 31, 2003, 2002 and 2001, as set forth in Notes 2 and 12 in Item 8. “Financial Statements and Supplementary Data”.
In January 2003, the FASB issued FASB Interpretation (FIN) 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51”. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The Company does not have any variable interest entities as defined under FIN 46.
In December 2003, the FASB issued FIN 46-R, “Consolidation of Variable Interest Entities - an interpretation of ARB 51 (revised December 2003)”, which replaces FIN 46. FIN 46-R incorporates certain modifications to FIN 46 adopted by the FASB subsequent to the issuance of FIN 46, including modifications of the scope of FIN 46. For all non-special purpose entities (“SPE”) created prior to February 1, 2003, public
entities will be required to adopt FIN 46-R at the end of the first interim or annual reporting period ending after March 15, 2004. For all entities (regardless of whether the entity is an SPE) that were created subsequent to January 31, 2003, public entities are already required to apply the provisions of FIN 46, and should continue doing so unless they elect to adopt the provisions of Fin 46-R early as of the first interim or annual reporting period ending after December 15, 2003. If they do not elect to adopt FIN 46-R early, public entities would be required to apply FIN 46-R to those post-January 31, 2003 entities as of the end of the first interim or annual reporting period ending after March 15, 2004. Management did not elect to adopt FIN 46-R early and will need to review and assess the effects, if any, FIN 46-R will have on the Company’s financial statements.
Represents the net of losses from contract terminations and organic declines in the clients’ installed base measured in the number of persons covered by clients, and gains from organic growth in the clients’ installed base measured in the number of persons covered by clients.
Backlog is the total dollar amount of potentially recoverable claims that the Company is pursuing or auditing on behalf of its clients at a given point in time.
At December 31, 2003, 2002 and 2001, approximately $289.8 million, $370.2 million and $133.0 million, respectively, of the backlog derived from terminated clients and clients that, by that date, had given notice of termination. See “Concentration of Clients”.
Claims Revenues. Healthcare Recovery Services revenues for the year ended December 31, 2003 decreased 6.0%, to $64.7 million from $68.8 million in 2002, on a decline in recoveries and in the effective fee rate. The effective fee rate decreased to 27.4% in 2003 from 27.6% in 2002, primarily as a result of a shift in the mix of recoveries, with relatively more recoveries coming from lower priced contract arrangements.
Healthcare claims recoveries for 2003 decreased approximately $12.9 million, or 5.2%, from 2002 claims recoveries. Healthcare subrogation recoveries for 2003 were approximately $18.6 million, or 9.0%, less than in the prior year, primarily due to a decrease in the number of installed lives. Provider bill audit recoveries increased approximately $4.6 million, or 11.7 %, compared to 2002, primarily because of an increase in the number of audits performed by the Company. Significant increases in the hospital fee-for-service charges, due in part to medical inflation, resulted in more hospital claims meeting the Company’s threshold for data mining and audit. Total backlog decreased 2.4% to $1,521.8 million as of December 31, 2003 from $1,559.0 million as of December 31, 2002. The subrogation backlog decreased approximately $177.8 million, or 19.4%, compared to the prior year, because of the decline in the number of installed lives for this service and the related liquidation of the backlog from terminated subrogation clients. The provider bill audit backlog grew approximately $138.3 million, or 21.7%, compared to the prior year as a result of the increase in the number of hospital claims meeting the Company’s threshold for audit and of improvements to data mining identification of audit-worthy claims. The decline in total throughput from 16.7% in 2002 to 15.3% in 2003, resulted from two causes. The first is the effect of the shift in the backlog mix, with a greater percentage of backlog and recoveries coming from provider bill audit, which typically exhibits a lower throughput than does healthcare subrogation. Second, recoveries for the year ended December 31, 2003 contained, relative to the year ended December 31, 2002, a higher percentage of dollars derived from the backlog of terminated subrogation clients, which exhibits a lower throughput rate than does backlog derived from active subrogation clients.
revenues in 2003 compared to 2002 was primarily due to a larger proportion of the segment revenues coming from provider bill audit, which generates lower margins than does healthcare subrogation.
Support Expenses. Support expenses for the Healthcare Recovery Services segment decreased 4.8% to $4.0 million in 2003, from $4.2 million in 2002 primarily as a result of a decrease in incentive compensation in 2003. Support expenses as a percentage of claims revenues were 6.2% in 2003, the same as in 2002.
Depreciation and Amortization. Depreciation and amortization expenses decreased 34.0% to $2.7 million for the year ended December 31, 2003 from $4.1 million in 2002. The decrease in depreciation expense was due to a significant number of fixed assets acquired in prior years becoming fully depreciated during the year ended December 31, 2003.
Claims Revenues. Healthcare Recovery Services revenues for the year ended December 31, 2002 increased 7.5%, to $68.8 million from $64.0 million in 2001. This growth in claims revenues came primarily from two sources. First, provider bill audit revenue increased $3.4 million in 2002 compared to 2001. The Company realized approximately $300,000 from a special provider bill audit project during 2002. The remainder of the increase in provider bill audit revenue was primarily the result of procedures implemented by the Company in late 2001 in response to various hospitals’ attempts to limit the Company’s access to medical records, which impeded the audit of provider bills. Second, the Company realized $1.7 million of incremental healthcare subrogation revenue from the fee increase associated with the decline in lives from UHG. The effective fee rate increased to 27.6% in 2002 from 26.8% in 2001, primarily as a result of the UHG fee increase.
Installed lives decreased 5.6 million, from 45.5 million at December 31, 2001 to 39.9 million at December 31, 2002. The net decrease included an increase of approximately 3.0 million lives installed related to new sales and a decrease of approximately 8.5 million lives related to contract terminations or attrition. Approximately 6.7 million of the total decrease of 8.5 million installed lives was related to UnitedHealth Group.
Support Expenses. Support expenses for the Healthcare Recovery Services segment decreased 14.3% to $4.2 million in 2002, from $4.9 million in 2001. Support expenses as a percentage of claims revenues decreased from 7.6% in 2001 to 6.2% in 2002. The decrease in support expenses as a percentage of claims
revenues resulted from the increase in claims revenues described above and from the change in the reporting structure of certain systems support personnel from the Healthcare Recovery Services segment to Corporate Sales & Marketing. Prior to January 1, 2002, those personnel performed support functions primarily related to healthcare subrogation. Effective January 1, 2002, such personnel moved under Corporate Sales & Marketing as they assumed a more active role in the management of client data and as members of the client solutions team. Prior year amounts have not been reclassified because management of the Company views this as a change in position.
Depreciation and Amortization. Depreciation and amortization expenses decreased 31.8% to $4.1 million for the year ended December 31, 2002 from $6.0 million in 2001. The decrease in amortization expense was due to the adoption of FAS 142 by the Company on January 1, 2002. See Item 8. “Financial Statements and Supplementary Data - Note 7 - Goodwill and Other Intangible Assets”.
Outsourcing refers to the full replacement of a client’s internal subrogation recovery function by the Company, typically with a view to an ongoing relationship of indefinite period.
Backlog is the total dollar amount of potentially recoverable claims that the Company is pursuing on behalf of its clients at a given point in time.
Claims Revenues. Total Property and Casualty Recovery Services revenues for the year ended December 31, 2003 increased $311,000, or 45.9%, from the year ended December 31, 2002. Property and Casualty Recovery Services claims recoveries for 2003 were $4.9 million, an increase of $2.1 million over 2002. Backlog grew from $15.3 million as of December 31, 2002 to $17.9 million as of December 31, 2003. The recoveries and revenues increased at a greater rate than did the backlog due to business signed in the middle of 2002 which provided a significant increase to the backlog in 2002 but did not begin to produce significant recoveries until 2003.
The Property and Casualty Recovery Services segment had a throughput rate of approximately 29.3% and 29.6% of average backlog for the years ended December 31, 2003 and 2002, respectively. The decrease was due to average backlog growing slightly more than recoveries for the year ended December 31, 2003 compared to the year ended December 31, 2002.
Cost of Revenues. Cost of revenues for the Property and Casualty Recovery Services segment increased 36.4% for the year ended December 31, 2003 to $1.5 million, from $1.1 million in 2002. The increase was due to the addition of human resources and other expenses necessary to service the additional backlog. As a percentage of claims revenues, cost of revenues decreased to 153% in 2003 compared to 163% in 2002, due to the increase in revenue described above. In the subrogation industry, typically expenses related to investigations and other recovery-related activities are incurred well in advance of revenue recognition.
Support Expenses. Support expenses for the Property and Casualty Recovery Services segment were $0.4 million in 2003 and 2002. Support expenses decreased as a percentage of claims revenues from 62.2% in 2002 to 37.5% in 2003. The decrease in support expenses as a percentage of revenue resulted from the increase in revenue noted above under “Claims Revenues”.
Cost of Revenues. Cost of revenues for the Software segment for 2003 was approximately $1.0 million, an increase of $0.4 million, or 67%, over 2002. This includes approximately $825,000 and $454,000 for the years ended December 31, 2003 and 2002, respectively, of depreciation and amortization of software in service. Approximately $138,000 and $144,000, respectively, of the cost of revenues for the years ended December 31, 2003 and 2002 related to the support and maintenance of the software.
The Company expects to incur additional expenses of between $1.0 million and $1.5 million with respect to enhancements of existing software applications to be made in 2004, of which approximately $600,000 is expected to be capitalized. In addition, as of December 31, 2003, the Company had capitalized approximately $2.8 million of costs in accordance with accounting principles generally accepted in the United States of America for the development of software for sale to unrelated parties.
Research and Development. The Company incurred approximately $1.6 million of expenses in 2001 related to research and development activities in connection with the creation of new products for the insurance industry, of which approximately $1.1 million were capitalized, resulting in net reported expenses of $0.5 million. There were no research and development expenses in the year ended December 31, 2002 because the products that were in development in 2001 became operational in 2002. See Item 1. “Business - Industry - Software”.
Support Expenses. During 2003, the Company incurred $1.5 million of charges related to the exploration of strategic alternatives. See “- Recent Developments”.
Management believes that adequate amounts of tax and related interest and penalties, if any, have been provided for any adjustments that may result.
Net Income. Net income for the year ended December 31, 2003 decreased $1.0 million, or 14.9%, to $5.8 million or $0.66 per diluted common share, from $6.8 million, or $0.72 per diluted common share, for the year ended December 31, 2002. The primary reasons for the decreases in net income and diluted earnings per share were: (i) the decrease in 2003 revenues from the Healthcare Recovery Services segment described above, (ii) the charges of approximately $918,000, net of tax, related to the exploration of strategic alternatives in 2003, and (iii) the decrease in 2003 depreciation expense as described under “Depreciation and Amortization” above.
Depreciation and Amortization. Depreciation and amortization expenses decreased 29.0% to $4.8 million for the year ended December 31, 2002 from $6.7 million in 2001. The decrease in amortization expense was due to the adoption of FAS 142 by the Company on January 1, 2002. See Item 8. “Financial Statements and Supplementary Data - Note 7 - Goodwill and Other Intangible Assets”. In addition, approximately $454,000 of depreciation and amortization related to the Software segment is included in Cost of Revenues for
the year ended December 31, 2002 as it is a direct cost of software in service. For the year ended December 31, 2001, the corresponding depreciation and amortization was recorded in the Depreciation and Amortization line item.
The effective income tax rate was approximately 31.3% for the year ended December 31, 2001. The lower effective income tax rate as compared to 2002, resulted from the reversal in 2001 of previously accrued taxes reducing the tax provision for the third quarter by $681,000, net, or approximately $0.07 per share. This accrual related primarily to certain non-cash compensation charges taken in connection with the initial public offering of the Company’s stock in 1997.
2002 and paid in 2003. Net cash provided by operating activities increased by $7.8 million for the year ended December 31, 2002 over the year ended December 31, 2001, primarily as a result of the $3.0 million litigation settlement that was accrued as an expense in 2000 and paid in 2001. In addition, an increase of approximately $2.0 million in accrued expenses, primarily related to incentive compensation and benefit accruals, including the healthcare self-insurance provision for future claims that the Company began to accrue on January 1, 2002, contributed to the increase in net cash provided by operating activities. Although accounts receivable as of December 31, 2002 were approximately the same as the balance as of December 31, 2001, the number of days’ sales outstanding decreased from 55 days to 49 days because the Company resolved a collection issue with a provider bill audit client.
Net cash used in investing activities for the years ended December 31, 2003 and 2002 includes purchases of property and equipment principally related to the development and conversion to the Troveris software. The Company capitalized approximately $1.0 million and $1.9 million, respectively, of internally-developed software during 2003 and 2002.
On November 1, 2001, the Company entered into a revolving credit facility with National City Bank of Kentucky, Bank One Kentucky, N.A. and Fifth Third Bank (the “Revolving Credit Facility”). The Company’s obligations under the Revolving Credit Facility are collateralized by substantially all of the Company’s assets, subject to certain permitted exceptions. The Revolving Credit Facility carries a maximum borrowing capacity of $40 million and will mature October 31, 2004. Principal amounts outstanding under the Revolving Credit Facility bear interest at a variable rate based on the Prime Rate or Eurodollar Rate, as applicable, plus a pre-determined fixed margin. At December 31, 2003, the interest rate was 2.92% based on the one-month Eurodollar Rate plus the fixed margin. The Revolving Credit Facility contains customary covenants and events of default including, but not limited to, financial tests for interest coverage, net worth levels and leverage that may limit the Company’s ability to pay dividends. The Company was in compliance with these covenants at December 31, 2003. It also contains a material adverse change clause. At December 31, 2003, $4 million was outstanding under the Revolving Credit Facility. Effective November 1, 2003, this balance was classified as short-term borrowings in the current liabilities section of the balance sheet because the Revolving Credit Facility matures on October 31, 2004. See Item 8. “Financial Statements and Supplementary Data - Note 10 - Derivatives” and “- Note 11 - Credit Facility”.
The Company believes that its available cash resources, together with the borrowings available under the Revolving Credit Facility, will be sufficient to meet its current operating requirements and acquisition and internal development activities.
The Company provides services to healthcare plans that as of December 31, 2003 covered approximately 39.9 million lives. The Company’s clients are national and regional healthcare payors, large third-party administrators or self-insured corporations. The Company currently has one client, Wellpoint Health Network Inc., that individually accounts for more than 10% of the Company’s revenue. It also has a former client, UnitedHealth Group (“UHG”), which historically accounted for more than 10% of the Company’s revenue. For the years ended December 31, 2003, 2002 and 2001, UHG generated 24%, 28% and 27% of the Company’s revenues, respectively. Wellpoint Health Network Inc. accounted for 17%, 14% and 11% of the Company’s total revenues for the years ended December 31, 2003, 2002 and 2001, respectively as well as 30% and 32% of the Company’s accounts receivable balance at December 31, 2003 and 2002, respectively. HealthNet accounted for 10% and 15% of the Company’s accounts receivable balance at December 31, 2003 and 2002, respectively.
The Company’s revenues are earned under written contracts with its clients that generally provide for contingency fees from recoveries under a variety of pricing regimes. The pricing arrangements offered by the Company to its clients include a fixed fee percentage, a fee percentage that declines as the number of lives covered by the client and subject to the Company’s service increases and a fee percentage that varies with the Company’s recovery performance.
The Company performs its services on a reasonable efforts basis and does not obligate itself to deliver any specific result. Contracts with its customers are generally terminable on 60 to 180 days’ notice by either party, although in a few cases the contracts extend over a period of years. The Company’s contracts generally provide that in the event of termination, the Company is entitled to complete the recovery process on the existing backlog or to receive a cash payment designed to approximate the gross margin that would otherwise have been earned from the recovery on the backlog of the terminating client. On December 31, 2003, the Company had Healthcare Recovery Services backlog of $1,521.8 million.
During 2002, UHG management informed the Company of its intention to terminate subrogation services with respect to all but 1.8 million lives of the 9.7 million lives then subject to the Company’s services under a contract with UHG. UHG’s termination of these services resulted from its decision to bring subrogation recovery services back inside UHG, where they are being performed by its Ingenix strategic business unit. The Company’s contract with UHG expired in accordance with its terms on February 1, 2003, except with respect to the 1.8 million lives. In December 2003, UHG gave notice of the termination of the remaining business under contract, effective February 1, 2004. The Company expects to continue recovering on the backlog as to which UHG terminated the Company’s services, a process that the Company expects will be completed in 5 to 6 years from the dates of termination.
The Company’s Board of Directors authorized the repurchase of up to $20 million of the Company’s Common Stock in the open market at prices per share deemed favorable by the Company. Shares may be repurchased using cash from operations and borrowed funds and may continue until such time as the Company has repurchased $20 million of the Company’s Common Stock or until it otherwise terminates the stock repurchase plan. The Company repurchased 172,622 shares of Common Stock during the year ended December 31, 2003 at a cost of $0.9 million, or an average cost of $5.23 per share. From inception of the program through December 31, 2003, the Company repurchased 3,269,630 shares at a cost of $14.5 million, or an average cost of $4.43 per share. Except for 8,874 shares previously repurchased but reissued in connection with an employee restricted stock award, all of the reacquired shares of Common Stock through December 31, 2003 are reflected as treasury stock on the accompanying Balance Sheets.
If any person becomes an Acquiring Person, each holder of a Right will thereafter have the right (the “Flip-In Right”) to receive, in lieu of shares of preferred stock and upon payment of the Purchase Price, shares of Common Stock having a value equal to two times the Purchase Price of the Right. Also, if at any time on or after the Stock Acquisition Date, (i) the Company is acquired in a transaction in which the holders of all the outstanding shares of Common Stock immediately prior to the consummation of the transaction are not the holders of all of the surviving corporation’s voting power, or (ii) more than 50% of the Company’s
assets, cash flow or earning power is sold or transferred other than in the ordinary course of business, then each holder of a Right shall thereafter have the right (the “Flip-Over Right”) to receive, in lieu of shares of preferred stock and upon exercise and payment of the Purchase Price, common shares of the acquiring company having a value equal to two times the Purchase Price. If a transaction would otherwise result in a holder having a Flip-In as well as a Flip-Over Right, then only the Flip-Over Right will be exercisable. If a transaction results in a holder having a Flip-Over Right subsequent to a transaction resulting in the holder having a Flip-In Right, a holder will have a Flip-Over Right only to the extent such holder’s Flip-In Rights have not been exercised.
The Company has entered into a contract for legal services with a professional service corporation, Sharps & Associates, PSC, an entity owned solely by one of the Company’s officers, Douglas R. Sharps. This arrangement exists solely for the benefit of the Company. Its purpose is to minimize the costs of legal services purchased by the Company on behalf of its clients. Mr. Sharps receives no financial or other personal benefit from his ownership of the firm. All payments to Sharps & Associates, PSC are reviewed and approved by the Audit Committee of the Company’s Board of Directors. For the years ended December 31, 2003, 2002 and 2001, approximately $3.4 million, $3.3 million and $3.4 million was paid to this law firm for such legal services, including all employee and other expenses.
At Mr. McGinnis’s request, following conversations with his lender, on February 12, 1999 the Board of Directors approved a loan in the amount of $350,000 to Mr. McGinnis, in exchange for a full recourse promissory note in the same amount from Mr. McGinnis. On June 30, 2000, at the direction of the Board of Directors and in accordance with terms authorized by it, the Company loaned Mr. McGinnis an additional $500,000. Under these terms, the $500,000 loan to Mr. McGinnis was combined with his existing debt to the Company of $350,000 of principal and $36,520 of accrued interest. Mr. McGinnis delivered to the Company his full recourse promissory note in the amount of $886,520, bearing interest at a fixed rate of 6.62% per annum (the applicable Federal mid-term rate in effect for tax purposes at the date of the note), compounded annually (the “Amended Promissory Note”), and the Company cancelled the old promissory note evidencing the prior debt. The Amended Promissory Note provides for mandatory prepayments from certain of the proceeds received by Mr. McGinnis from his sale of the Company’s securities and any related transactions. The promissory note and all accrued interest are due and payable upon the earlier of January 1, 2005 or the termination of Mr. McGinnis’s employment with the Company. At December 31, 2003, the promissory note of $886,520 and accrued interest of $101,237 were outstanding.
On June 30, 2000, pursuant to Board authorization and in accordance with the terms of the Amended Promissory Note, the Company and Mr. McGinnis entered into a deferred compensation agreement (the “Agreement”). Under the Agreement, 50% of the amount otherwise payable to Mr. McGinnis under the Company’s Management Group Incentive Compensation Plan is to be deferred until the Amended Promissory Note is paid in full, with such deferred compensation then being paid in full to Mr. McGinnis within 30 days thereafter. The Company has full right of set-off against any deferred compensation under the Agreement should Mr. McGinnis default under the Amended Promissory Note. At the election of Mr. McGinnis, the payment of the deferred compensation, upon payment of the Amended Promissory Note,
“Financial Statements and Supplementary Data - Note 10 - Derivatives” and “- Note 11 - Credit Facility”.
February 12, 2004, except for that information in Note 19 as to which the date is February 20, 2004
Accounts receivable, less allowance for doubtful accounts of $479 and $531 at December 31, 2003 and 2002, respectively
Common stock, $.001 par value; 20,000 shares authorized; 8,477 shares and 8,588 shares outstanding at December 31, 2003 and 2002, respectively
Trover Solutions, Inc., a Delaware corporation (the “Company”), was incorporated on June 30, 1988. The Company provides subrogation and certain other claims recovery and cost containment services, on an outsourcing basis, to the private healthcare payor industry and the property and casualty insurance industry. Its primary business is medical claims recovery, and its primary product is subrogation recovery, i.e., the Company identifies, investigates and recovers accident-related medical benefits incurred by its healthcare payor and insurance clients on behalf of their insureds, but for which other persons or entities have primary responsibility. The Company’s clients’ rights to recover the value of these medical benefits, arising by law or contract, are generally known as the right of subrogation and are generally paid from the proceeds of liability or workers’ compensation insurance. The Company’s other medical claims recovery services include (1) the auditing of the bills of medical providers, particularly hospitals, for accuracy, correctness and compliance with contract terms (“provider bill audit”), (2) the recovery of overpayments attributable to duplicate payments, failures to coordinate benefits and similar errors in payment (“overpayments”), and (3) the auditing of physician evaluation and management claims for consistency with medical records, in accordance with federal guidelines (“MD Audit”).
Restricted cash represents the balance in client-specific bank accounts of amounts collected on behalf of certain clients. A portion of the balance will be disbursed to clients in accordance with the terms of the contracts between the Company and its clients, while the remainder will be released to the Company in payment of its fees.
Substantially all of the Company’s cash, cash equivalents and restricted cash have been placed with one financial institution.
Depreciation expense for the years ended 2003, 2002 and 2001 was $3.1 million, $4.1 million, and $4.0 million, respectively.
Revenues for the Property and Casualty Recovery Services segment are generally derived from contingent fee arrangements whereby the Company receives a percentage of the amount successfully recovered on behalf of its clients. These revenues and the related receivables are recognized when a fee is earned upon receipt of recoveries on a cash basis.
The Company has various stock-based compensation plans, which are described in Note 12. No stock-based employee compensation cost is reflected in net income as all options granted under those plans had an exercise price equal to the market value of the underlying Common Stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123. “Accounting for Stock-Based Compensation” to stock-based employee compensation (dollars in thousands, except per share results):
Basic earnings per common share were computed based on the weighted-average number of shares outstanding during the year. The dilutive effect of stock options is calculated using the treasury stock method. Options to purchase 890,252, 947,834 and 1,298,653 shares for the years ended December 31, 2003, 2002 and 2001, respectively, were not included in the computation of diluted earnings per common share because the exercise prices of these options were greater than the average market price of the common shares during the respective years, and therefore, the effect would have been antidilutive.
The Company accounts for derivative instruments in accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133), as amended by Statement of Financial Account Standard No 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities - an Amendment of FAS 133” and by Statement of Financial Accounting Standards No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”. SFAS 133 requires that all derivatives, including interest rate swap agreements, be recognized on the balance sheet at their fair value. Derivatives that are not hedges must be recorded at fair value through earnings. If a derivative is a hedge, depending on the nature of the hedge, changes in the fair value of the derivative are either offset against the change in fair value of the underlying assets or liabilities through earnings or recognized in other comprehensive income until the underlying hedge item is recognized in earnings. The ineffective portion of a derivative’s change in fair value is to be immediately recognized in earnings. See Note 10 “Derivatives”.
Other comprehensive income (loss) refers to revenues, expenses, gains and losses that under accounting principles generally accepted in the United States of America are included in comprehensive income (loss) but are excluded from net income as these amounts are recorded directly as an adjustment to stockholders’ equity, net of tax. The Company’s other comprehensive income is composed of a deferred gains and losses on a cash flow hedge related to the Company’s interest rate swap agreement. See Note 10 “Derivatives”.
Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information”, established standards for reporting information about operating segments in the Company’s financial statements. It also established standards for related disclosures about products and services, and geographic areas. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision making group is the Board of Directors of the Company.
In April 2003, the FASB issued SFAS 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” which amends and clarifies the accounting guidance on derivative instruments and hedging activities that fall within the scope of SFAS 133, “Accounting for Derivative Instruments and Hedging Activities”. SFAS 149 is effective (1) for contracts entered into or modified after June 30, 2003, with certain exceptions, and (2) for hedging relationships designated after June 30, 2003. The Company will apply the provisions of SFAS 149 to future contracts entered into or future hedging relationships.
EITF 00-21 was effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 did not have a significant impact on the Company’s financial statements. The Company was previously following the requirements provided under SAB 104 and, accordingly, the implementation of this pronouncement had no impact on the Company’s financial position or results of operations as reported.
In December 2003, the FASB issued FIN 46-R, “Consolidation of Variable Interest Entities - an interpretation of ARB 51 (revised December 2003)”, which replaces FIN 46. FIN 46-R incorporates certain modifications to FIN 46 adopted by FASB subsequent to the issuance of FIN 46, including modifications of the scope of FIN 46. For all non-special purposes entities (“SPE”) created prior to February 1, 2003, public entities will be required to adopt FIN 46-R at the end of the first interim or annual reporting period ending after March 15, 2004. For all entities (regardless of whether the entity is an SPE) that were created subsequent to January 31, 2003, public entities are already required to apply the provisions of FIN 46, and should continue doing so unless they elect to early adopt the provisions of Fin 46-R as of the first interim or annual reporting period ending after December 15, 2003. If they do not elect to early adopt FIN 46-R, public entities would be required to apply FIN 46-R to those post-January 31, 2003 entities as of the end of the first interim or annual reporting period ending after March 15, 2004. Management will need to review and assess the effects, if any, FIN 46-R will have on the Company’s financial statements.
Preparation of the Company’s financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. These estimates and assumptions affect (i) reported amounts of assets and liabilities, (ii) disclosure of contingent assets and liabilities at the date of the financial statements and (iii) reported amounts of revenues and expenditures during the reporting period. Actual results may differ from those estimates.
In September 2001, the Company concluded that, in light of the passage of time with respect to the filing of the Company’s income tax returns for years up to and including 1997, it was proper to reverse previously accrued taxes by reducing the tax provision for the year ended December 31, 2001 by $681,000, net. This accrual related primarily to certain non-cash compensation charges taken in connection with the initial public offering of the Company’s stock in 1997. Management believes that adequate amounts of tax and related interest and penalties, if any, have been provided for any adjustments that may be required.
The provision (benefit) for income taxes for the years ended December 31, 2003, 2002 and 2001 consists of the following (in thousands):
The following is a reconciliation of the effective tax rate to the federal statutory rate for the years ended December 31, 2003, 2002 and 2001:
Reversal of previously accrued income taxes for 1997 non-cash compensation charge
UnitedHealth Group (“UHG”), a terminated client, accounted for 24%, 28% and 27% of the Company’s total revenues for the years ended December 31, 2003, 2002, and 2001, respectively. Wellpoint Health Network Inc. (“Wellpoint”) accounted for 17%, 14% and 11% of the Company’s total revenues for the years ended December 31, 2003, 2002 and 2001, respectively. No other client accounted for more than 10% of the Company’s total revenues. The loss of Wellpoint could have a material adverse effect on the Company’s results of operations, financial position and cash flows.
The Company has a contract for legal services with a professional service corporation, Sharps & Associates, PSC, an entity owned solely by one of the Company’s officers, Douglas R. Sharps. This arrangement exists solely for the benefit of the Company. Its purpose is to minimize the costs of legal services purchased by the Company on behalf of its clients. Mr. Sharps receives no financial or other personal benefits from his ownership of the firm. All payments to Sharps & Associates, PSC are reviewed and approved by the Audit Committee of the Company’s Board of Directors. For the years ended December 31, 2003, 2002 and 2001, approximately $3.4 million, $3.3 million and $3.4 million, respectively, was paid to this law firm for such legal services, including all employee and other expenses.
On June 30, 2000, pursuant to Board authorization and in accordance with the terms of the Amended Promissory Note, the Company and Mr. McGinnis entered into a deferred compensation agreement (the “Agreement”). Under the Agreement, 50% of the amount otherwise payable to Mr. McGinnis under the Company’s Management Group Incentive Compensation Plan is to be deferred until the Amended Promissory Note is paid in full, with such deferred compensation then being paid in full to Mr. McGinnis within 30 days thereafter. The Company has full right of set-off against any deferred compensation under the Agreement should Mr. McGinnis default under the Amended Promissory Note. At the election of Mr. McGinnis, the payment of the deferred compensation, upon payment of the Amended Promissory Note, may be extended for a period of not more than ten years. At December 31, 2003, the amount of deferred compensation was $182,012, with accrued interest of $19,323. At December 31, 2002, the amount of deferred compensation was $72,354 with accrued interest of $7,627.
Effective January 1, 2002, the Company adopted FAS 142 under which Goodwill is no longer amortized but instead will be assessed for impairment at least annually. The Company performs its annual impairment review during the second quarter of each year. The review performed during the quarter ended June 30, 2003 did not result in an impairment charge for the Company. The Company’s reporting units are generally consistent with the operating segments underlying the segments identified in Note 15 “Segment Information”. All recorded Goodwill and Intangible Assets relate to the Healthcare Recovery Services segment.
Accrued payroll and bonuses in the accompanying balance sheets at December 31, 2003 and 2002 approximate $4.4 million and $5.3 million, respectively.
Effective on January 1, 1997, the Company’s employees began participation in the Company’s 401(k) defined contribution pension plan. An annual expense provision for the plan is based upon the level of employee participation, as the plan requires the Company to match a certain portion of the employees’ contributions. For the years ended December 31, 2003, 2002 and 2001, participants were given the option of receiving their match in cash or in Common Stock of the Company. For participants choosing the stock match, the Company contributed up to 100% of the participant’s contribution, not to exceed 6% of the participant’s annual compensation. For participants choosing the cash match, the Company contributed up to 50% of the participant’s contribution, not to exceed 6% of the participant’s annual compensation. Total retirement plan expense was approximately $760,000, $786,000 and $707,000 for the years ended December 31, 2003, 2002 and 2001, respectively.
December 31, 2003 and 2002 and the related gain (or loss) on the contract is deferred in shareholders’ equity (as a component of accumulated other comprehensive income). This deferred gain (or loss) is then amortized as an adjustment to interest expense over the same period in which the related interest payments being hedged are recognized in income.
On November 1, 2001, the Company entered into a revolving credit facility with National City Bank of Kentucky, Bank One Kentucky, N.A. and Fifth Third Bank (the “Revolving Credit Facility”), and the existing credit facility was terminated. The Company’s obligations under the Revolving Credit Facility are collateralized by substantially all of the Company’s assets, subject to certain permitted exceptions. The Revolving Credit Facility carries a maximum borrowing capacity of $40 million and will mature October 31, 2004. Principal amounts outstanding under the Revolving Credit Facility bear interest at a variable rate based on the Prime Rate or Eurodollar Rate, as applicable, plus a pre-determined fixed margin. At December 31, 2003, the interest rate was 2.92% based on the one-month Eurodollar Rate plus the fixed margin. The Revolving Credit Facility contains customary covenants and events of default including, but not limited to, financial tests for interest coverage, net worth levels and leverage that may limit the Company’s ability to pay dividends. The Company was in compliance with these covenants at December 31, 2003. It also contains a material adverse change clause. At December 31, 2003 and 2002, $4 million was outstanding under the Revolving Credit Facility.
In May 1997, the Company adopted its Non-Qualified Stock Option Plan for Eligible Employees (the “Employees Plan”), the Employee Stock Purchase Plan (the “Purchase Plan”), and the Directors’ Stock Option Plan, which it amended and restated in August 1998 (the “Directors’ Plan”). On December 8, 1997, the Company adopted its 1997 Stock Option Plan for Eligible Participants, which it amended in May 1999 (the “1997 Plan”). On May 10, 2002, the Company adopted its Outside Directors Equity Compensation Plan (the “2002 Outside Directors Stock Plan”).
The Directors’ Plan provided for the grant of options to purchase the Company’s Common Stock to each non-employee director of the Company. Options under the Directors’ Plan are exercisable at 100% of the
market value of the Company’s Common Stock on the date of grant. Pursuant to the Directors’ Plan, each eligible director was granted on the date he or she first becomes a director an option to purchase 10,000 shares of Common Stock, and each eligible director was granted on the date of each annual meeting of stockholders of the Company beginning in 1998 an option to purchase 2,000 shares of Common Stock, for so long as shares are available under the Directors’ Plan, but not after March 31, 2002 at which time the plan terminated. Terms of options granted under this plan commence on the date of grant and expire on the tenth anniversary of the grant date. Each option is to become exercisable when vested. Pursuant to individual option agreements under the Directors’ Plan, options granted under the Directors’ Plan vest ratably over a three-year period, provided that the optionee must be a non-employee director of the Company on each such anniversary in order for options to vest on such date. At December 31, 2003, 150,000 shares of Common Stock were reserved for issuance under the Directors’ Plan, none for future award.
The 2002 Outside Directors Stock Plan was approved on May 10, 2002. Each director of the Company that is not an employee of the Company has a right to elect to receive Common Stock in lieu of cash for all or part of his or her outside director compensation package. In any event, each director will receive not less than one-third of his or her annual retainer fee in Common Stock regardless of whether he or she makes an election under the plan. In addition, each director automatically will be granted an option under the plan to purchase 10,000 shares of Common Stock on the effective date of his or her initial election or appointment as a member of the Board at an option exercise price equal to the fair market value of a share of Common Stock on such date. Further, each director automatically will be granted each calendar year subsequent to the calendar year in which his or her initial election or appointment as a member of the Board becomes effective, options under the plan to purchase 1,000 shares of Common Stock as of each March 31, June 30, September 30 and December 31, if he or she is still a director on such grant date, at an exercise price equal to the fair market value of a share on such date. At December 31, 2003, 243,350 shares of Common Stock have been reserved under the 2002 Outside Directors Stock Plan, of which 208,350 shares are available for future issue.
The following table summarizes information about options outstanding under the Employees’ Plan, Directors’ Plan, 1997 Plan and 2002 Outside Directors Stock Plan at December 31, 2003:
The Company accounts for options granted under its employee stock-based compensation plans in accordance with APB No. 25, “Accounting for Stock Issued to Employees”. As a result, the Company has not recognized compensation expense for stock options granted with an exercise price equal to the quoted market price of the Common Stock on the date of grant and that vest based solely on continuation of employment by the recipient of the option award. The Company adopted SFAS No. 123 (as amended by SFAS No. 148 in 2002) for disclosure purposes in 1996. For SFAS No. 123 purposes, the fair value of each option grant and stock-based award has been estimated as of the date of grant using the Black-Scholes option pricing model. The following summarizes the weighted average assumptions used in valuing awards under the Employees’ Plan, Directors’ Plan, 1997 Plan and 2002 Outside Directors Stock Plan:
the Company. The dividend was payable to stockholders of record on March 1, 1999. The Rights, which will initially trade with the Common Stock, separate and become exercisable only upon the earlier to occur of (i) 10 days after the date (the “Stock Acquisition Date”) of a public announcement that a person or group of affiliated persons has acquired 20% or more of the Common Stock (such person or group being hereinafter referred to as an “Acquiring Person”) or (ii) 10 days (or such later date as the Board of Directors shall determine) after the commencement of, or announcement of an intention to make, a tender offer or exchange offer that could result in such person or group owning 20% or more of the Common Stock (the earlier of such dates being called the “Distribution Date”). When exercisable, each Right initially entitles the registered holder to purchase from the Company one one-hundredth of a share of a newly created class of preferred stock of the Company at a purchase price of $65 (the “Purchase Price”). The Rights are redeemable for $0.001 per Right at the option of the Board of Directors. The Rights expire on March 1, 2009.
On February 19, 2004, in connection with the Proposed Transaction, the Company and National City Bank, as Rights Agent, executed a First Amendment to Rights Agreement, which amends the Stockholders Rights Plan and renders the Rights inapplicable to the transactions contemplated by the definitive agreement announced by the Company on February 20, 2004. See Note 19 “Subsequent Event” below.
The Company’s Board of Directors authorized the repurchase of up to $20 million of the Company’s Common Stock in the open market at prices per share deemed favorable by the Company. Shares may be repurchased using cash from operations and borrowed funds and may continue until such time as the Company has repurchased $20 million of the Company’s Common Stock or until it otherwise terminates the stock repurchase plan. The Company repurchased 172,622 shares of Common Stock during the year ended December 31, 2003 at a cost of $0.9 million, or an average price of $5.23 per share. From inception of the program through December 31, 2003, the Company repurchased 3,269,630 shares at a cost of $14.5 million, or an average cost of $4.43 per share. Except for 8,874 shares of previously repurchased but reissued in connection with an employee restricted stock award, all of the reacquired shares of Common Stock through December 31, 2003 are reflected as treasury stock on the accompanying Balance Sheets.
Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information”, established standards for reporting information about operating segments in the Company’s financial statements. It also established standards for related disclosures about products and services, and geographic areas. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance.
Prior to January 1, 2002, the Company reported one segment, Healthcare Services. The Company did not have any products or services which met the quantitative or qualitative guidelines for segment reporting through December 31, 2001. Effective January 1, 2002, the Company reported three segments based on qualitative guidelines. The Company’s three segments are: (1) Healthcare Recovery Services, which encompasses its healthcare recovery products: healthcare subrogation, provider bill audit, overpayments, and MD Audit; (2) Property and Casualty Recovery Services, which is subrogation recovery services for property and casualty insurers, sold under the name TransPaC Solutions; and (3) Software, which is subrogation recovery software in a browser-based application service provider (ASP) form, sold under the name Troveris. The segment profit measure is income before income taxes.
Segment results for the years ended December 31, 2003, 2002 and 2001 are as follows (in thousands):
Future minimum lease payments for office space, by year, under noncancelable operating leases with initial or remaining terms in excess of one year at December 31, 2003 are as follows (in thousands):
Rental expense, which includes amounts applicable to short-term leases, was approximately $2,292,000, $2,386,000, and $2,092,000 for the years ended December 31, 2003, 2002 and 2001, respectively.
The Company is engaged in the business of identifying and recovering subrogation and related claims of its clients, many of which arise in the context of personal injury lawsuits. As such, the Company operates in a litigation-intensive environment. The Company has, from time to time, been, and in the future expects to be, named as a party in litigation incidental to its business operations. There can be no assurance that pending litigation or future litigation will not have a material adverse effect on the Company’s business, results of operations and financial condition.
In January 2001, the Company reached an agreement in principle to settle the DeGarmo class action litigation for $3.0 million which was reported in the fourth quarter of 2000. The settlement was paid in July 2001.
If completed, the Proposed Transaction will constitute a going private transaction and will result in the Company no longer being publicly traded and no longer filing annual, quarterly and current reports with the Securities and Exchange Commission (“SEC”). The Proposed Transaction must be approved by the Company’s stockholders at a special meeting of the stockholders, which the Company expects will occur in the second quarter of 2004. The Proposed Transaction is also subject to customary closing conditions. The obligation of Tailwind to proceed under the definitive agreement expires if the Company is unable to close the Proposed Transaction by July 15, 2004.