The selected consolidated statement of income data and balance sheet data as of, and for, the years ended December 31, 1998, 1997 and 1996 are derived from, and are qualified by reference to, the consolidated financial statements of the Company audited by Arthur Andersen LLP, independent public accountants, appearing elsewhere herein. The selected consolidated statement of income data and balance sheet data as of, and for, the years ended December 31, 1995 and 1994 are derived from audited financial statements of the Company not included herein. The selected consolidated financial information set forth below should be read in conjunction with "Management's Discussion and Analysis of Results of Operations and Financial Condition" and the Company's consolidated financial statements and related notes appearing elsewhere herein. The selected operating data has been derived from the accounting records of the Company and has not been audited.
(3) Reflects results of the acquisition of Smileage Dental Services, Inc. from July 18, 1996. Balance sheet data (but not income or operating data) as of December 31, 1996 includes amounts relating to Champion Dental Services, Inc., which was acquired as of December 31, 1996.
Acquisitions Effective July 18, 1996, the Company completed the acquisition of Smileage Dental Services, Inc. ("Smileage"), a Wisconsin-based dental HMO administrator, which provided services to approximately 50,000 members, and an associated reinsurance transaction, for an aggregate purchase price (including transaction costs) of $5.6 million. The acquisition was financed through the issuance of the Company's common stock.
Effective December 31, 1996, the Company completed the acquisition of Champion Dental Services, Inc. ("Champion"), a Missouri-based prepaid dental plan, which provided services to approximately 60,000 members, for an aggregate purchase price (including transaction costs) of $5.6 million. The acquisition was financed through proceeds from the Company's initial public offering and was paid in cash on January 2, 1997.
The largest source of Company revenue is derived from members enrolled in managed care plans. From 1996 to 1998, the Company's revenue from its managed care products grew from $32.8 million to $47.9 million. This increase is primarily attributable to managed care enrollment growth and, to a lesser degree, a shift toward managed care products with higher benefit and premium levels, as well as the acquisition of Smileage and Champion in 1996. In 1996, 1997 and 1998, managed care revenue accounted for approximately 74%, 77%, and 75%, respectively, of total revenue.
Gross Margin From 1996 to 1998, gross margin increased from $16.2 million to $21.4 million. Between 1996 and 1998, gross margin as a percentage of total revenue decreased from 36.8% to 33.4% of total revenue. This change is due to a decline in the gross margin of the Company's managed care products, primarily due to the lower gross margin on the managed care products acquired in the Wisconsin and Missouri marketplaces and the decrease in the gross margin on the Company's indemnity/PPO products in 1998. During 1998, the Company successfully transitioned portions of its lower gross margin business acquired in Wisconsin and Missouri to its higher gross margin standard products. In addition, the Company transitioned substantially all of its Illinois managed care membership to its new "template plan" line of products which has improved the managed care gross margin. The Company expects the managed care gross margin to continue to improve in 1999 as a result of the full year effect of the rollout of the new template plan design as well as the price increases that went into effect during 1998. The Company also expects the indemnity/PPO gross margin percentage to remain fairly consistent with the 1998 level throughout 1999. Overall gross margin percentages will vary if the mix of the Company's indemnity/PPO and managed care business changes from current levels.
Throughout 1998 the Company has been actively working on its plan to address year 2000 compliance. The plan consists of three phases. Phase 1 involves an assessment of the Company's internal systems. Phase 1 is completed. The Company has found as a result of the assessment process that its core enterprise systems have always contained the ability to store and process the full four-digit year. Although this capability exists, several functional points of the system have not fully utilized the capability. Phase 2, scheduled for completion by July 1999, is the development and execution of specific action plans to resolve known potential year 2000 issues. Phase 3, scheduled for the second and third quarters of 1999, is the final testing of each major area determined as critical to ongoing business operations.
Phase 2 will consist of the conversion or replacement of selected platforms, applications, databases and utilities. Phase 3 will include the testing, verifying and validating the renovated or replaced platforms, applications, databases and utilities.
The Company's current schedule is subject to change depending on developments that may arise through unforeseen circumstances, and through execution of the Company's compliance efforts. The Company is dependent on its vendors for compliant hardware, systems and applications and upgrades by experts, both internal and external, and the availability of critical resources with the requisite skill sets. The Company's ability to meet its target dates is dependent upon the timely provision of necessary upgrades and modifications by its suppliers and internal resources. In addition, the Company cannot guarantee that third parties on whom it depends for essential services (such as utilities, telecommunications operators, etc.) will convert their critical systems and processes in a timely manner. Failure or delay by any of these parties could significantly disrupt the Company's business. The Company's contingency plans will address mechanisms for preventing or mitigating interruption caused by such third parties.
The Company believes that it will spend approximately $100,000 in 1999 to finish upgrading and verifying all critical areas identified. This cost includes the purchase of required software and hardware as well as outside contracting services. The Company has already secured the necessary resources for 1999.
Based on the Company's current schedule for completion of Year 2000 tasks, the Company believes that its planning is adequate to secure Year 2000 readiness of its critical systems. Nevertheless, management cannot provide assurance that its plans to achieve Year 2000 compliance will be successful or that the cost of its efforts will not differ materially from estimates, as each is subject to various risks and uncertainties, many of which are described above. Accordingly, the Company's goal is to develop business continuity and contingency plans in 1999 to address high-risk areas as they are identified. These plans are expected to assess the potential for business disruption in various scenarios, and to provide for key operational back-up, recovery and restoration alternatives. However, if the Company, or third parties with whom it has significant business relationships, fails to achieve Year 2000 readiness with respect to critical systems, there could be a material adverse affect on the Company's results of operations, financial position and cash flows.
Total subscriber revenue increased by $7.6 million, or 13.4%, to $64.2 million in 1998 from $56.6 million in 1997. The $7.6 million increase was primarily attributable to increased enrollment in the Company's managed care and indemnity/PPO dental plans, as well as price increases that went into effect during 1998. Managed care revenue increased $4.4 million over the same period, primarily due to an increase in new members and price increases. Indemnity/PPO revenue increased $3.0 million to $15.2 million in 1998 from $12.2 million in 1997, primarily as a result of adding new indemnity/PPO plan members and price increases.
Total gross margin increased by $2.8 million, or 14.9%, to $21.4 million in 1998 from $18.7 million in 1997. Total gross margin as a percentage of revenue was 33.4% in 1998 as compared to 33.0% in 1997. This percentage increase was the result of improved gross margins on both the managed care and indemnity/PPO lines of business. Managed care gross margin as a percentage of revenue was 37.8% in 1998 as compared to 36.9% in 1997. The improved managed care gross margin was the result of transitioning lower gross margin business acquired in Wisconsin and Missouri to the Company's higher gross margin standard products, and transitioning the Company's Illinois membership to the new higher gross margin "template plan" line of products, as well as price increases which were implemented throughout 1998. The level of indemnity/PPO gross margin as a percentage of revenue increased to 14.6% in 1998 from 14.3% in 1997. This increase in indemnity/PPO gross margin was the result of price increases which were passed on during 1998.
Operating income increased by $830,000, or 16.2%, to $5.9 million for 1998 from $5.1 million in 1997. As a percentage of revenue, operating income was 9.3% in 1998 and 9.0% in 1997. The Company expects its operating income percentage to continue to improve as a result of its improved managed care gross margin.
Net income increased by $668,000, or 20.1%, to $4.0 million for 1998 from $3.3 million for 1997.
Total subscriber revenue increased by $12.5 million, or 28.3%, to $56.6 million in 1997 from $44.1 million in 1996. Of this increase, $3.3 million, or 26.4%, was attributable to the operations added through the acquisition of Missouri based Champion. The remaining $9.2 million increase was a 20.9% increase in revenues and was primarily attributable to increased enrollment in the Company's managed care and indemnity/PPO dental plans, as well as a full year effect of the Wisconsin based Smileage transaction. Managed care revenue increased $10.7 million over the same period, primarily due to an increase in new members and $3.3 million from Champion. Indemnity/PPO revenue increased $1.6 million to $12.2 million in 1997 from $10.6 million in 1996, primarily as a result of adding new indemnity/PPO plan members.
Total gross margin increased by $2.5 million, or 15.4%, to $18.7 million in 1997 from $16.2 million in 1996. Total gross margin as a percentage of revenue was 33.0% in 1997 as compared to 36.8% in 1996. This percentage decline was the result of the lower gross margin from the Champion and Smileage acquisitions as well as from a decrease in gross margin in the Company's indemnity/PPO plans. Managed care gross margin as a percentage of revenue was 36.9% in 1997 as compared to 40.4% in 1996. This percentage decline was primarily the result of revenue acquired through the two acquisitions which had a combined gross margin percentage of 28.0% as compared with the existing managed care business which had a gross margin percentage of 40.0%. The level of indemnity/PPO gross margin as a percentage of revenue decreased to 14.3% in 1997 from 21.7% in 1996. This decline in indemnity/PPO gross margin was the result of increased expenses in the Company's indemnity/PPO plans, primarily attributable to higher utilization patterns.
Net income increased by $592,000, or 21.9%, to $3.3 million for 1997 from $2.7 million for 1996.
Cash flow provided by (used in) operations was $5.7 million, ($0.6) million and $3.7 million for the years ended December 31, 1998, 1997 and 1996, respectively. The Company primarily receives premium payments in advance of disbursing managed care dentist capitation payments and indemnity/PPO claims payments. Cash balances in excess of current needs are invested in interest- bearing accounts or cash equivalents. Cash flow from operations consist primarily of subscriber premiums and investment income net of capitation payments to network dentists, claims paid, brokers' commissions, general and administrative expenses and income taxes. In 1997, $2.0 million was transferred to restricted cash for the formation of an insurance company.
Capital expenditures were $748,000 for 1998 and $682,000 for 1997 mainly for computer system enhancements, furniture, and leasehold improvements. Capital expenditures were $745,000 for the year ended December 31, 1996, primarily for office furniture and new computer systems.
Cash provided by (used in) financing activities was $99,000, $43,000, and ($45,000) for the years ended December 31, 1998, 1997 and 1996, primarily from issuance of common stock in 1998 and 1997.
As of December 31, 1998, the Company had cash and cash equivalents of $6.2 million, short-term investments of $4.8 million, long term investments of $3.1 million, restricted cash of $3.0 million, and no long term debt outstanding, except as of December 31, 1996, included in other current liabilities is a payable to the parent of Champion for the $5.5 million purchase price. In addition, the Company has a committed unsecured line of credit (the "Credit Agreement") available which expires June 30, 1999, and to date has not been executed and utilized. Upon execution of this Credit Agreement, the Company may borrow up to $5 million at the rate of LIBOR plus one-half percent. To the extent the Company makes acquisitions, a portion of the purchase price may be financed through borrowings.
Under applicable insurance laws of the states in which the Company conducts business, the Company's subsidiaries operating in the particular state are required to maintain a minimum level of net worth and reserves. The Company may be required from time to time to invest funds in one or more of its subsidiaries to meet regulatory requirements, or to expand its operations into new geographic areas. In addition, applicable laws generally limit the ability of the Company's subsidiaries to pay dividends to the extent that required regulatory capital or surplus would be impaired.
Consolidated Balance Sheets as of December 31, 1998, 1997 and 1996.. 32
Consolidated Statements of Changes in Stockholders' Equity for the years ended December 31, 1998, 1997 and 1996.................... 35
Reconciliations of Net Income to Net Cash Provided by Operating Activities for the years ended December 31, 1998, 1997 and 1996..... 38
We have audited the accompanying consolidated balance sheets of FIRST COMMONWEALTH, INC. (a Delaware corporation) AND SUBSIDIARIES as of December 31, 1998, 1997 and 1996, and the related consolidated statements of income and comprehensive income, changes in stockholders' equity and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of First Commonwealth, Inc. and Subsidiaries as of December 31, 1998, 1997 and 1996, and the results of their operations and their cash flows for the years then ended, in conformity with generally accepted accounting principles.
FIRST COMMONWEALTH, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS-continued As of December 31, 1998, 1997 and 1996
FIRST COMMONWEALTH, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY-continued
The accompanying consolidated financial statements include the accounts of First Commonwealth, Inc. ("FC Inc."), First Commonwealth of Illinois, Inc.("FCI"), First Commonwealth Limited Health Services Corporation ("LHSC"), First Commonwealth Health Services Corporation ("HSC"), First Commonwealth Reinsurance Company ("FCRC"), First Commonwealth Insurance Company ("FC Insurance"), First Commonwealth Limited Health Service Corporation ("LHSCWI"), Smileage Dental Services, Inc. ("SDS") and First Commonwealth of Missouri, Inc. ("FCMO"), formerly Champion Dental Services, Inc. ("CDS"). These companies are collectively referred to hereinafter as "the Company".
The Company is a provider of managed dental benefits in the upper Midwest, including the metropolitan areas of Chicago, Milwaukee, Detroit and Indianapolis, and with the acquisition of CDS, St. Louis. The Company provides dental care coverage and/or arranges for dental care services to be provided to its subscribers primarily on a prepaid basis. The Company also provides indemnity/Preferred Provider Organization dental coverage and administrative claim services.
FC Inc. operates as an Illinois and Michigan licensed Third Party Administrator ("TPA"). As a TPA, FC Inc. provides administrative and marketing services to certain subsidiaries pursuant to management agreements. It also provides claim processing services for self-funded employers.
FCI is an Illinois corporation and is a wholly owned subsidiary of FC Inc. FCI operates as a Preferred Provider Administrator which directly contracts with general dentists and specialists. These provider arrangements are made available to LHSC, LHSCWI, FCMO and HSC, as well as health maintenance organizations and self-funded employers. In making these provider arrangements available, FCI does not undertake any underwriting risk.
LHSC is an Illinois for-profit corporation and is a wholly owned subsidiary of FC Inc. LHSC is licensed under the Illinois Limited Health Service Organization Act ("LHSO Act"). LHSC is also licensed by the Indiana Department of Insurance as a Limited Service Health Maintenance Organization. LHSC has entered into a Provider Agreement with FCI whereby FCI arranges for dental care services to LHSC's subscribers through FCI's network of private practice dentists. Consistent with its authority under the LHSO Act, LHSC also provides reimbursement for covered dental care provided outside of this network. In providing such services, LHSC undertakes underwriting risk. The LHSO Act requires, among other provisions, that LHSC meet certain net worth and deposit requirements discussed in Note 4. It is management's opinion that LHSC was in compliance with these provisions as of December 31, 1998, 1997 and 1996.
HSC is an affiliated Illinois corporation, licensed under the Voluntary Health Services Plans Act (the "VHSP Act"). In accordance with the VHSP Act, HSC is operated and conducted not for profit and is also governed by the provisions of the General Not for Profit Corporation Act. HSC was initially capitalized by FC Inc. through the purchase of a subordinated note.
FCRC was incorporated in Arizona during 1994 and is a wholly owned subsidiary of FC Inc. It is licensed by the Arizona Department of Insurance as a domestic life and disability reinsurer.
FCMO is a Missouri corporation and is a wholly owned subsidiary of FC Inc. FCMO is a St. Louis, Missouri based prepaid dental plan corporation organized under Section 379.900 RSMo.
HSC, a not-for-profit company managed by FC Inc., has been included in the accompanying consolidated financial statements. HSC's financial position and results of operations are not material to the Company's financial statements.
For purposes of these statements, the Company considers all cash and short-term investments with original maturities of less than 90 days to be cash and cash equivalents.
The Company has invested funds in municipal bonds that are federally tax exempt as well as United States Treasury notes.
Subscriber revenue collected for dental care is recognized as revenue in the period in which the member is entitled to service. Related costs for dental care are expensed in the period the Company is obligated to provide such service.
The Company pays its providers to render covered dental care to eligible enrolled subscribers and dependents. Payment is typically made during the month prior to the month in which the subscribers and dependents become eligible for coverage. This payment is recorded as a prepaid expense at December 31, 1998 and 1997.
The Company records payables to dental service providers for certain services not included in the monthly prepayment to such providers discussed above.
Other current liabilities at December 31, 1996, represents the Company's liability relating to its acquisition of CDS. This amount was paid on January 2, 1997.
The Company provides indemnity dental coverage for certain customers and records a liability for incurred but not reported and unpaid claims related to this coverage. Generally, this liability is estimated based on the age of existing claims and the Company's historical lag with respect to the reporting and payment of such claims. Changes in these estimates are reflected in the results of operations in the period in which such changes occur.
In 1997, the Company adopted Financial Accounting Standards Board Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings per Share." Under SFAS No. 128, primary earnings per share is replaced by "Basic" earnings per share, which excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. "Diluted" earnings per share, which is computed similarly to fully diluted EPS, reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. All prior-period EPS information (including interim EPS) has been restated to conform with the provisions of SFAS No. 128.
The following tables reconcile the numerators (net income) and denominators (shares) of the basic and diluted earnings per share computations.
Options to purchase shares of common stock outstanding during 1998, 1997, and 1996 that were not included in the computation of diluted EPS because the options' exercise price was greater than the average market price of the common shares are summarized in the following table.
FIRST COMMONWEALTH, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-continued December 31, 1998, 1997 and 1996
1998 1997 1996 ---- ---- ---- Weighted average shares under option 62,500 17,875 31,167
The State of Illinois statutes and related regulations of the Illinois Department of Insurance require HSC, which is licensed under the VHSP Act, to maintain a contingency reserve in contributed capital of $20,050, $19,037 and $15,674 at December 31, 1998, 1997 and 1996.
Interest income earned on restricted funds is included in interest income, net in the consolidated statements of income.
The Company's claims liability, claims incurred and payments related to indemnity/PPO policies for the years ended December 31, 1998, 1997 and 1996, are as follows:
Minimum future obligations under operating leases in effect at December 31, 1998, are:
A reconciliation of the effective tax rate from statutory U.S. federal income tax rate of 34% for 1998, 1997 and 1996, is as follows:
Income from municipal bond investments (1) -- -- ---- ---- ----
As of December 31, 1998, 1997 and 1996, total net current deferred tax assets were $982,000, $859,000 and $869,000, respectively, and total net noncurrent deferred tax liabilities were $176,000, $247,300 and $167,157, respectively. The temporary differences that give rise to deferred tax assets and liabilities are as follows:
There are no customers that accounted for a significant amount of the Company's subscriber revenue in the years ended December 31, 1998, 1997 and 1996.
The holder of each share of common stock is entitled to one vote on each matter submitted to a vote to the stockholders of the Company.
The Company has two incentive plans, a 1987 Statutory-Nonstatutory Stock Option Plan ("1987 Plan") and a 1995 Long-Term Incentive Plan ("1995 Plan"), which were approved by the Board of Directors and stockholders. The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation." Accordingly, no compensation cost has been recognized for the stock option plans. Had compensation cost for the Company's two stock option plans been determined based on the fair value at the grant date for awards in 1998, 1997 and 1996 consistent with the provisions of SFAS No. 123, the Company's net income (in thousands) and diluted earnings per share would have been reduced to the pro forma amounts of $3,789 and $1.01 in 1998, $3,268 and $0.88 in 1997 and $2,645 and $0.73 in 1996.
In connection with the initial public offering, the Company adopted the 1995 Long-Term Incentive Plan (the "1995 Plan"). Under the 1995 Plan, the Company may grant incentive stock options or nonqualified stock options. The 1995 Plan also provides for the grant of stock appreciation rights, bonus stock awards which are vested upon grant, stock awards which may be subject to a restriction period and specified performance measures, and performance shares. A total of 350,000 shares of common stock have been reserved for issuance under the 1995.
Under the 1995 Plan, options are granted at a price equal to the fair market value at the date of the grant as determined by the Board of Directors and vest ratably over a period of one to four years from the date of the grant. For the years ended December 31, 1998, 1997 and 1996, the Company had granted 64,000, 94,000 and 105,500, respectively, total options to key employees and directors at option prices ranging from $11.25 to $28.625 per share. Of the total options granted, 90,863, 38,813 and 11,000 had vested and were exercisable as of December 31, 1998, 1997 and 1996, respectively, and 2,750 of the total options, granted and vested had been exercised during the year ended December 31, 1998. In addition, 0, 77,238 and 42,000 options were rescinded during the years ended December 31, 1998, 1997 and 1996.
A summary of the status of the Company's two stock option plans at December 31, 1998, 1997 and 1996 and changes during the years then ended is presented in the table below:
Of the total options outstanding at December 31, 1998, 129,950 have option prices between $11.25 and $11.75 with a weighted average option price of $11.52 and with a weighted average remaining contractual life of nine years. 54,488 of these options are exercisable at December 31, 1998, with a weighted average option price of $11.51.
Of the total options outstanding at December 31, 1998, 60,500 have option prices between $14.56 and $17.00, with a weighted average option price of $15.08 and a weighted average remaining contractual life of seven years. 41,875 of these options are exercisable at December 31, 1998, with a weighted average option price of $15.14.
During 1995, the Board of Directors adopted a stockholders rights plan. Under the stockholders rights plan, each share of common stock will have associated with it one preferred share purchase right (a "Right"). Under certain circumstances, each Right would entitle the holders thereof to purchase one one-hundredth of a share of Series A Junior Participating Preferred Stock for a price of $40 per one one-hundredth of a share. The Rights are not presently exercisable and are transferable only with the related shares of common stock.
The Rights would become exercisable at the specified exercise price upon the occurrence of certain events, including the acquisition of 15% or more of the Company's common stock by a person or group, as defined. The Rights may be redeemed, as a whole, at a redemption price of $.01 per Right, subject to adjustment, at the direction of the Board of Directors, at any time prior to the occurrence of certain events. In addition, in certain circumstances, the Board of Directors may direct the exchange of shares of common stock (or preferred shares) for all or any part of the Rights at the exchange rate of one share of common stock (or one one-hundredth of a preferred share) per Right, subject to adjustment.
13. QUARTERLY FINANCIAL DATA (Unaudited) (in thousands, except per share data)
Subscriber revenue $13,463 $13,856 $14,519 $14,756 Gross margin 4,700 4,733 4,573 4,656 Net income 760 798 882 883 Basic earnings per common share .21 .22 .24 .24 Diluted earnings per common share .20 .21 .24 .24
Subscriber revenue $ 9,773 $10,019 $11,786 $12,521 Gross margin 3,747 3,799 4,220 4,460 Net income 669 698 667 697 Basic earnings per common share .20 .21 .19 .19 Diluted earnings per common share .19 .20 .18 .19
The Company has a 401(k) salary deferral plan in which all employees of the Company who have completed at least ninety days of service are eligible to participate. Under the plan, the Company provides a matching contribution of $.50 for every dollar an employee invests in the plan up to an annual maximum of 2% of the employee's compensation for the year. The Company may make additional discretionary contributions to the plan. The Company incurred 401(k) contributions expense of $84,051, $91,949 and $58,937 during the years ended December 31, 1998, 1997 and 1996, respectively.
The acquisitions of SDS and CDS were accounted for using the purchase method of accounting with SDS's results of operations included in the accompanying consolidated statement of income for the year ended December 31, 1996 from the effective date of the acquisition.
The pro forma results include the historical accounts of the Company and the historical accounts of the acquired businesses and pro forma adjustments including the amortization of the excess purchase price over the fair value of the net assets acquired, the reduction of salaries and expenses which will not be incurred on an ongoing basis, and the applicable income tax effects of these adjustments. The pro forma results of operations are not necessarily indicative of actual results which may have occurred had the operations of the acquired companies been combined in prior periods.