buildings are medical office buildings leased under a master lease agreement. All 26 medical buildings are being marketed for sale. The Company also owns nine parcels of vacant land for a total of 46 acres, all of which are being marketed for sale.
The Company considers its facilities to be in good working condition, well maintained and adequate for its present and anticipated needs. The Company believes that additional space can be obtained at competitive rates upon the expiration of current leases or in the event additional space is needed.
In February 1997, PacifiCare's board of directors approved a change in the Company's fiscal year end from September 30 to December 31. This resulted in a transition period of October 1, 1996 through December 31, 1996. The following selected financial and operating data are derived from the audited financial statements of the Company and its subsidiaries or from the Company's unaudited internal financial data. For clarity of presentation and comparability, the following selected financial and operating data includes the unaudited period for the twelve months ended December 31, 1996. The selected financial and operating data should be read in conjunction with "
In February 1997, PacifiCare's board of directors approved a change in the Company's fiscal year end from September 30 to December 31. This resulted in a transition period from October 1, 1996 to December 31, 1996, which has been audited. However, for clarity of presentation and comparability, the discussion of results of operations compares the year ended December 31, 1997 to the unaudited twelve months ended December 31, 1996, followed by a comparison of the fiscal year ended September 30, 1996 to the fiscal year ended September 30, 1995. For purposes of the comparison of the year ended December 31, 1997 to the twelve months ended December 31, 1996, the unaudited twelve months ended December 31, 1996 are referred to as the prior year.
Commercial premiums increased 97 percent over the prior year with approximately 92 percent of the total increase related to the FHP Acquisition. Enrollment gains in the commercial programs, net of acquisition membership, accounted for seven percent, while premium rates remained relatively flat. Excluding the FHP Acquisition, the Company has experienced a decrease in the rate of membership growth compared to the prior year. This decrease is partly due to the disposition of the Company's Florida operations. Additionally, the Company has shifted its focus from one of rapid growth to improved profit margins through the use of a more disciplined product pricing strategy.
Government premiums increased 85 percent as compared to the twelve months ended December 31, 1996 with 81 percent of the total increase related to the FHP Acquisition. On January 1, 1997, the Company received premium rate increases from HCFA averaging over six percent. Government per member premium rates also increased as a result of the Company's exit of its Medicaid lines of business in certain of the Company's markets, which have lower average per member premiums. These increases were offset slightly by reductions in member paid supplemental premiums in several of the Company's markets. The combined increases in the per member premium rates increased revenue by almost 14 percent as compared to the prior year. Enrollment gains in the government programs, net of acquisition membership, accounted for an additional five percent of the increase in government premiums.
The government programs' medical care ratio for the year ended December 31, 1997 remained flat as compared to the prior year. This consistency largely reflects the FHP Acquisition, which had lower cost provider contracts and generally higher reimbursement for Medicare risk membership. Additionally, the wind down of the Medicaid business contributed to slight decreases in the government medical care ratio. These decreases were partially offset by enhanced prescription drug benefits provided to enrollees combined with lower member paid supplemental premiums.
The Company recognized pretax charges totaling $155 million ($129 million or $3.18 diluted loss per share, net of tax) for the year ended December 31, 1997 and $101 million ($62 million or 1.97 diluted loss per share, net of taxes) for the twelve months ended December 31, 1996. The 1997 pretax charges included fourth quarter write-offs associated with the impairment of goodwill in certain of the Company's markets, restructuring charges and certain other charges. The 1996 pretax charges included an impairment of goodwill, a disposition loss restructuring and OPM charges.
Since its acquisition, the Washington market has had a history of operating losses. While capitated contracts have been implemented, claims payment issues continue as most providers are not able to administer the claims process. Utilization also continues to be higher than expected. The Company determined that goodwill and intangibles were no longer recoverable and recorded an impairment charge in light of the historical and increasing losses in the market and expected future cash flows.
The Company owns a subsidiary which provides workers' compensation benefits. In developing its 1998 business plan, the Company determined that California legislation did not allow workers' compensation products to be priced at a competitive rate that would result in the required return on investment. Without a profitable California revenue stream, the remaining business did not support the recoverability of the goodwill and the impairment was recorded.
The Company is committed to the successful integration of FHP and as part of that process continually assesses the efficiency of its operations and determines whether duplicative functions or facilities exist. As a result of that commitment, the Company identified opportunities to restructure and streamline operations which resulted in recording a restructuring charge in the fourth quarter of 1997 in the amount of $15 million ($9 million or $0.22 diluted loss per share, net of tax). The restructuring charges include work force reductions, facility consolidation and other related cost accruals. To improve efficiency and reduce costs, the Company experienced a work force reduction. Work force costs of $8 million primarily include employee severance related to involuntary termination programs. Lease terminations of $5 million pretax were associated with the consolidation of administrative and operations office space. Other related charges totaled $2 million, pretax. Cash flows from operations are expected to fund all of the restructuring charges. The restructuring should be complete by December 1998.
Effective June 1, 1996, Florida sold the assets of its staff-model medical clinics resulting in a pretax loss of $9 million ($8 million or $0.26 diluted loss per share, net of tax).
During 1996, management approved a plan relating for the discontinuation of certain specialty heath care products and services that do not meet the Company's strategic and economic return objectives, including a reduction in work force and the establishment of regional customer service centers. A restructuring charge of $8 million ($5 million or $0.15 diluted loss per share, net of tax) was recognized which included employee severance related to an involuntary work force reduction of approximately $4 million, write-offs of assets designated for disposition of approximately $3 million, and other related costs of approximately $1 million. The restructuring was financed by cash flows from operations and actual expenditures did not differ materially from amounts accrued.
The majority of the pretax charges the Company recorded in the fourth quarter of 1997 are not deductible for income tax purposes. Therefore, the Company did not record an income tax benefit for most of these charges. The magnitude of these charges, in conjunction with the inability to record a related income tax benefit, resulted in the Company reporting a disproportionately high effective income tax rate. The effective income tax rate without the effect of the pretax charges was approximately 50 percent, which is an increase over the prior year. This increase reflects the additional goodwill amortization expense over the prior year related to the FHP Acquisition.
Total operating revenue increased $906 million to $4.6 billion for the fiscal year ended September 30, 1996 from $3.7 billion for the same period in the prior fiscal year. Enrollment gains in both the government and commercial programs, offset slightly by decreases in commercial premium rates, provided an increase in total operating revenue of $787 million. The remaining operating revenue increase was contributed by the incremental operations of acquisitions described in Note 4 of the Notes to Consolidated Financial Statements and the Company's specialty managed care products and services.
Commercial premiums increased $355 million or 23 percent to $1.9 billion for the fiscal year ended September 30, 1996 from $1.5 billion in fiscal 1995. Commercial HMO membership increased by 0.2 million to 1.4 million due to continued growth in all markets except Florida. Commercial HMO membership growth provided $281 million of the increase, more than offsetting average premium rate
decreases of one percent, primarily in California. The effects of acquisitions described above and the commercial specialty managed care products and services provided the remainder of the increase in commercial premiums.
The increase in the medical care ratio for the government programs reflected increased physician and hospital costs on a per member basis due to higher membership growth in areas with higher provider costs combined with lower member supplemental premiums and enhanced benefits to enrollees. These increased costs are partially offset by January 1, 1996 HCFA premium rate increases.
Marketing, general and administrative expenses increased $78 million to $576 million for the fiscal year ended September 30, 1996 from $498 million for fiscal year 1995. However, as a percentage of operating revenue, marketing, general and administrative expenses decreased by one percent. The decrease was primarily attributable to the Company's reduction of performance based employee incentives due to current fiscal year operating results not meeting anticipated fiscal year 1996 targets. Additionally, the Company realized the benefit derived from prior investments in the Company's infrastructure which have proven adequate to support the growth in membership.
Income exclusive of the impairment, disposition, restructuring and OPM charges described above was $134 million or a 24 percent increase over fiscal year 1995. Diluted earnings per share before impairment, disposition, restructuring and OPM charges, increased 17 percent or $0.61 to $4.23 for the fiscal year ended September 30, 1996. The increases reflect membership growth in both the commercial and government programs and lower marketing, general and administrative costs, partially offset by increases in health care service expenses.
securities, provided funds for the FHP Acquisition. The Company issued 2,339,402 shares of Class A Common Stock, 7,352,965 shares of Class B Common Stock and 10,517,044 shares of Series A Preferred Stock in connection with the FHP Acquisition.
Net cash used in investing activities included $1.0 billion, $5 million and $135 million for acquisitions and $68 million, $23 million and $25 million for property, plant and equipment purchases in 1997, fiscal 1996 and fiscal 1995, respectively. In 1997, net cash provided by financing activities included $1.1 billion in borrowings under its $1.5 billion credit facility. Cash payments of $210 million reduced the credit facility balance to $910 million at December 31, 1997 (see Note 5 of the Notes to Consolidated Financial Statements). The cash received from the sale of the Talbert stock in 1997 substantially offset the capital contributions made to Talbert (see Note 4 of the Notes to Consolidated Financial Statements). Cash received for the issuance of common stock provided cash in 1997, fiscal 1996 and fiscal 1995 of $44 million, $13 million and $201 million, respectively. The Company issued 991,813 shares, 381,418 shares and 338,608 shares of common stock for benefit plans in 1997, fiscal 1996 and fiscal 1995, respectively. The Company paid approximately $9 million of preferred stock dividends in 1997.
The rate of increase in government membership is expected to decline in 1998 as compared to 1997 as competition increases and the Company continues the migration of FHP senior members into the Company's benefit structures and the combined provider network. Additionally, the government membership will decrease by the approximately 25,000 government members serviced by Utah when the disposition is complete.
HEALTH CARE PROVIDER CONTRACTS. The Company's profitability depends, in part, on its ability to maintain effective control over health care costs while providing members with quality care. Specifically, capitating providers in Utah, Nevada and Washington and recontracting with providers in Oregon will be critical to improved results of operations for those markets. Securing cost effective contracts with existing and new physician groups is more difficult due to increased competition. The negotiation of provider contracts, generally as of January 1, may be impacted by adverse state and federal legislation and regulation discussed below. Failure to secure cost effective contracts may result in a loss in membership or a higher medical care ratio. The Company's inability to contract with providers, loss of contracts with providers, inability of providers to provide adequate care or insolvency of providers could materially and adversely affect the Company. These contracting and insolvency risks include: a loss of membership; incurring additional expenses to meet the requirement to continue to arrange for health care services,
among other things, for members; the inability to obtain reimbursement due the Company from providers; the expenditure of additional funds to maintain adequate provider networks and assertion of claims by third parties against the Company. The effect of these risks could result in the recognition of a charge in a future period.
GOVERNMENT MEDICAL CARE RATIO. In 1998, the government medical care ratio is expected to remain consistent with that of 1997. The Company has received notice from HCFA that in 1998 it will be receiving premium rate increases ranging from two percent in the Company's largest markets to six percent in smaller markets resulting in overall weighted average premium rate increases of a little over two percent. Competitive pressures in the Medicare market may require enhanced benefits. The implementation of Medicare reform provisions which curtail program spending and allow the entry of new forms of competitor plans could further increase competitive pressures (see Legislation and Regulation below). The 1998 HCFA rate increases and lower FHP government medical care ratio are expected to be offset by these competitive pressures.
MARKETING, GENERAL AND ADMINISTRATIVE SUPPORT. In 1998, marketing, general and administrative expenses as a percentage of operating revenue are expected to decrease slightly from 1997. The Company expects to experience additional costs associated with the integration of FHP largely related to upgrading and converting information systems to maintain and enhance the Company's competitive edge in information technology. These additional costs are expected to be offset as the Company realizes the benefits of restructuring and a full year of synergies as a result of the FHP transaction.
YEAR 2000. In 1996, the Company developed and began execution of an enterprise wide plan to ensure application and systems compliance for the year 2000. The Company currently expects the project to be complete by the end of 1998 and to cost less than $10 million. This estimate includes internal costs, but excludes the costs to upgrade and replace systems in the normal course of business. As of December 31, 1997, approximately $2 million had been expensed related to this project. An additional component of this project is the written confirmation from all systems vendors ensuring year 2000 compliance in conjunction with the Company's target deadlines. The Company is currently assessing the impact, if any, of year 2000 issues it may encounter with entities with which it electronically interacts, including HCFA. If HCFA or certain other entities experience significant failures or erroneous applications, it could have a material adverse effect on the Company's financial position, results of operations or cash flows.
OFFICE OF PERSONNEL MANAGEMENT CONTINGENCIES. The Company intends to negotiate with OPM and DOJ on all matters to attain a mutually satisfactory result. While there is no assurance that the negotiations will be concluded satisfactorily or that additional liability will not be incurred, management believes that any ultimate liability in excess of amounts accrued, which could arise upon completion of the audits by OPM of the health plans, would not materially affect the Company's consolidated financial position. However, such liability could have a material adverse effect on results of operations or cash flows of a future quarter if resolved unfavorably (see Note 10 of the Notes to Consolidated Financial Statements).
LIQUIDITY AND CAPITAL RESOURCES. The Company's credit facility requires mandatory reductions of the outstanding principal balance beginning January 1999 and is required to be paid in full by January 1, 2002. As of December 31, 1997, the outstanding balance on the credit facility would not require a reduction until July 1, 2001. The Company believes cash flows from operations, existing cash equivalents, marketable securities and other financing sources will be sufficient to meet the requirements of the credit facility and will provide sufficient liquidity for operations in the foreseeable future.
Cash flows could be adversely affected because the Company is subject to greater operating leverage due to its higher levels of indebtedness as a result of the FHP Acquisition. The Company's plan to repurchase shares of outstanding stock may result in the reduction of cash and equivalents or in additional borrowings on its credit facility. Additional borrowings on the credit facility may result in the Company
being subject to earlier mandatory reduction of its outstanding balance. Additionally, should the credit facility be fully drawn, the Company's ability to make a payment on, or repayment of, its future obligations under the credit facility and $100 million of senior notes of FHP assumed by the Company will be significantly dependent upon the receipt of funds from the Company's subsidiaries. These subsidiary payments represent fees for management services rendered by the Company to the subsidiaries and cash dividends by the subsidiaries to the Company. Nearly all of the subsidiaries are subject to HMO regulations or insurance regulations and may be subject to substantial supervision by one or more HMO or insurance regulators. Subsidiaries subject to regulation must meet or exceed various fiscal standards imposed by HMO or insurance regulations, which may from time to time, impact the amount of funds that may be paid by subsidiaries to the Company. Additionally, from time to time, the Company advances funds, in the form of a loan or capital contribution, to its subsidiaries to assist them in satisfying federal or state financial requirements. If a federal or state regulator has concerns about the financial position of a subsidiary, as a result of costs being incurred by such subsidiary, a regulator may impose additional financial requirements on the subsidiary which may require additional funding from the Company.
Additionally, recently adopted federal legislation, among other things, repeals the requirement that at least half of a Medicare health plan's enrollment be drawn from commercial contracts (the "50/50 Rule") beginning January 1, 1999, and gives the Department of Health and Human Services broad authority to waive the 50/50 Rule for certain plans beginning January 1, 1998. The Company believes that the repeal of the 50/50 Rule will allow it to develop Medicare risk programs in markets where it does not have
operations through expansion of the Secure Horizons programs and affiliations between its Medicare risk management subsidiary and health plans or providers in such markets.
The Company is also involved in legal actions in the normal course of business, some of which seek monetary damages, including claims of punitive damages which are not covered by insurance. After review, including consultation with counsel, based on current information, management believes any ultimate liability in excess of amounts accrued which would likely arise from these actions (including the purported class actions) would not materially affect the Company's consolidated financial position, results of operations or cash flows. However, management's evaluation of the likely impact of these actions could change in the future and an unfavorable outcome, depending upon the amount and timing, could have a material adverse effect on the Company's results of operations or cash flows of a future quarter.