The Company owns an office building of approximately 216,000 square feet on approximately 9.2 acres of land in Cypress, California which serves as the executive and administrative offices of its California HMO operation. The Company also owns a child care facility on one acre of land in Cypress, California and an office building of approximately 16,000 square feet on 1.4 acres of land in Tustin, California. The Company considers its facilities to be in good working condition, well maintained and adequate for its present needs.
Total operating revenue increased 29.0 percent or $838 million to $3.7 billion for the year ended September 30, 1995 from $2.9 billion for the same period in the prior year. Enrollment gains in both the government (Medicare and Medicaid) and commercial programs, offset slightly by decreases in commercial premium rates, provided an increase in total operating revenue of $659 million. Membership growth is expected to continue in both the commercial and government programs. However, competition for members and the expected Medicaid disenrollment in California and Florida, combined with a larger membership base is expected to cause the rate of the membership growth to decline from the 28 percent and 32 percent increases experienced in the commercial and government programs, respectively, in 1995. Approximately $149 million of the increase in total operating revenue represents the incremental operations of acquisitions described in Note 5 of the Notes to Consolidated Financial Statements. The remaining $30 million was contributed by the Company's specialty managed care products and services and its joint venture medical groups.
Commercial premiums increased $275 million or 22 percent to $1.5 billion for the year ended September 30, 1995 from $1.2 billion in 1994. Commercial HMO membership increased by 267,000 or 28 percent to 1,216,000 due to continued growth in California, Oregon, Texas and Washington. The increase in membership includes the effects of acquisitions in California and Washington of 67,000 and 33,000 members, respectively. The Company expects the 1996 membership growth rate to be lower than 1995 because more competitors are offering consumers more choices with pricing consistent with 1995 rates. Commercial HMO membership growth provided $177 million of the increase, more than offsetting average premium rate decreases of two percent, primarily in California. The effects of acquisitions described above and the commercial specialty managed care products and services and joint venture medical groups provided the remainder of the increase in commercial premiums.
Total health care services expenses as a percent of premium revenue (the "medical loss ratio"; See Item 6. Selected Financial Data, page 14) for the year ended September 30, 1995, increased to 83.6 percent from 83.1 percent in 1994. The commercial medical loss ratio increased to 82.5 percent from 80.5 percent while the government medical loss ratio decreased to 84.3 percent from 85.2 percent.
For the year ended September 30, 1995, the Company made net positive reserve adjustments totaling $12 million. These net positive reserve adjustments have historically been made in the third quarter and result primarily from the periodic reconciliation of amounts reserved for physician and hospital incentive programs. For the year ended September 30, 1995, however, net positive reserve adjustments were made in insignificant amounts throughout the year. For the year ended September 30, 1994, net positive reserve adjustments of $9 million were made in the third quarter.
For the year ended September 30, 1995, earnings per share increased 20 percent to $3.62 compared to $3.02 for 1994 before the cumulative effect of a change in accounting principle. The increase is primarily related to membership growth derived substantially from the government programs predominantly Secure Horizons. Increases in health care service expenses were partially offset by decreases in marketing, general and administrative expenses. The results for the years ended September 30, 1995 and 1994 included approximately $0.24 and $0.18, respectively, related to the net positive reserve adjustments previously described. Earnings per share for the year ended September 30, 1994 were $3.22 which included approximately $0.20 due to changes in income tax accounting principles (see Note 2j of the Notes to Consolidated Financial Statements).
The Company's ability to expand is affected by increasing competition not only in product choices but also in the number of competitors in the Company's service areas. Certain large employer groups and other purchasers of health care services continue to demand minimal premium rate increases or reductions in premium rates while limiting the number of choices offered to employees. In addition, securing cost effective contracts with additional physicians is becoming difficult due to increasing competition among HMOs for physician 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. Factors such as health care reform, levels of utilization of health care services, new technologies, hospital costs, major epidemics, and numerous other external influences may affect the Company's operating results. Accordingly, past financial performance is not necessarily a reliable indicator of future performance, and investors should not use historical performance to anticipate results or future period trends.
The medical loss ratio for the year ended September 30, 1994, decreased to 83.1 percent from 84.1 percent for the same period in 1993. The commercial medical loss ratio decreased to 80.5 percent from 82.5 percent while the government medical loss ratio declined slightly to 85.2 percent from 85.6 percent. The decrease in the commercial
The health care service expenses for the years ended September 30, 1994 and 1993, reflect the impact of net positive reserve adjustments of approximately $9 million and $6 million, respectively. The $3 million increase in net positive reserve adjustments was primarily attributable to increases in members served under hospital capitation arrangements and improved contracting. Commercial net positive reserve adjustments for the year ended September 30, 1994 increased to $4 million compared to $1 million for the same period in the prior year. Government net positive reserve adjustments for each of the years ended September 30, 1994 and 1993 totaled $5 million.
Marketing, general and administrative expenses increased $115 million to $395 million for the year ended September 30, 1994 from $280 million for 1993. As a percentage of operating revenue, marketing, general and administrative expenses increased to 13.6 percent from 12.6 percent. These increases were primarily attributable to higher costs related to developing markets, products and services in new as well as established geographic areas and incremental expenses to integrate acquisitions.
Cash generated from operations was $147 million, principally from net income and non-cash items including depreciation and amortization. In fiscal 1994, cash generated from operations of $288 million reflected net income, non-cash items and a $153 million increase in unearned premium revenue because October HCFA premiums were received in September. Because fiscal 1995 also reflects October HCFA premiums received in September, unearned premium revenue increased slightly over 1994, decreasing cash generated from operations by $141 million.
a) Cash and Equivalents. Cash and equivalents are defined as cash, money market funds and certificates of deposit with a maturity of three months or less.
b) Marketable Securities. As of October 1, 1994, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities." In connection with the adoption of SFAS No. 115, the Company determined that all marketable securities (which are comprised of municipal bonds, corporate notes, commercial paper and U.S. Treasury securities) held as of that date are available for sale. Accordingly, such securities are carried at fair value and unrealized gains or losses, net of applicable income taxes, are recorded in shareholders' equity. The Company also determined that these marketable securities are available for use in current operations and, accordingly, classified such securities as current assets without regard to the securities' contractual maturity dates. Prior to the adoption of SFAS No. 115, the Company carried marketable securities at cost, unless there was a permanent impairment of value. The adoption of SFAS No. 115 had no effect on net income, but decreased marketable securities as of October 1, 1994 by $6.3 million, decreased shareholders' equity by $3.8 million and increased deferred tax assets by $2.5 million.
The Company is required by state regulatory agencies to set aside funds for the protection of their plan members in accordance with the laws of the various states in which they operate. Such funds are included in marketable securities- restricted (which are comprised of U.S. government securities and certificates of deposit held by trustees or state regulatory agencies). The Company determined that all marketable securities-restricted are held-to-maturity since the Company has the intent and ability to hold the securities to maturity. Held-to-maturity securities continue to be stated at amortized cost, adjusted for amortization of premiums and accretion of discounts to maturity, and are classified as noncurrent assets.
c) Property, Plant and Equipment. Property, plant and equipment are recorded at cost; replacements and major improvements are capitalized, while repairs and maintenance are charged to expense as incurred. Upon sale or retirement of property, plant and equipment, the costs and related accumulated depreciation are eliminated from the accounts. Any resulting gains and losses are included in the determination of net income. Property, plant and equipment are depreciated using the straight-line method for financial reporting purposes over estimated useful lives ranging from five to twenty-five years. Leasehold improvements are amortized using the straight-line method over the term of the lease or ten years, whichever is shorter.
d) Goodwill and Intangible Assets. Goodwill and intangible assets represent principally the unamortized excess of the cost of acquiring subsidiary companies over the fair values of such companies' net tangible assets at the dates of acquisition. Goodwill and intangible assets are amortized on a straight-line basis over periods not exceeding forty years. Net intangible assets totaling $0.8 million were written off in 1993, reducing earnings per
share by approximately $0.03. These assets, which were related to the Company's life and health insurance subsidiary, were determined to have no continuing value. As of September 30, 1995 and 1994, accumulated amortization totaled $16.0 and $8.8 million, respectively.
h) Utilization Review and Case Management Services. The Company's HMOs conduct utilization review and case management programs to ensure that their providers deliver a consistent quality of care to members. The utilization review program essentially provides patients with second opinions, while the case management program assigns nurses to complicated, high-risk or chronic cases to evaluate and recommend treatment options to the patient and provider. The costs associated with providing these medical services are recorded in general and administrative expenses and totaled $14.6 million, $10.9 million and $8.9 million for the fiscal years ended September 30, 1995, 1994 and 1993, respectively.
j) Taxes Based on Premiums and Income. Certain states in which the Company does business require the remittance of excise, per capita or premium taxes based upon a specified rate for enrolled members or a percentage of billed premiums. Such taxes may be levied in lieu of a state income tax. These amounts are recorded in general and administrative expenses and totaled $4.3 million, $4.0 million and $3.3 million for the fiscal years ended September 30, 1995, 1994 and 1993.
The Company completed several acquisitions in the years ended September 30, 1995 and 1994. During fiscal 1995, the Company made the following acquisitions (the "1995 Acquisitions"): (i) Preferred Solutions, a San Jose-based pharmacy benefit management company, in January 1995; (ii) ValuCare, a Fresno, California-based HMO with approximately 67,000 members in March 1995; and (iii) the membership of Pacific Health Plans, a Washington-based HMO, with approximately 33,000 members in March 1995.
The total purchase price for the Acquisitions, including contingent purchase payments, was approximately $220.0 million. Based on the fair values of the assets and liabilities of the Acquired Companies, the preliminary estimate of excess purchase price is approximately $220.4 million. A final allocation of purchase price will be determined when appraisals and other studies are completed. The Acquisitions have been accounted for as purchases and the operating results of each completed acquisition are included in the consolidated financial statements from the date of purchase.
The authorized capital stock of the Company consists of 30 million shares of the Class A Common Stock, par value $0.01 per share (the "Class A Common Stock"), 60 million shares of the Class B Common Stock and 10 million shares of Preferred Stock, par value $1.00 per share (the "Preferred Stock"). As of November 1, 1995, there were 12,331,408 shares of the Class A Common Stock outstanding, 18,551,697 of the Class B Common Stock outstanding and no shares of Preferred Stock outstanding. Holders of the Class A Common Stock have one vote per share while holders of the Class B Common Stock have no voting rights other than as required by Delaware law. Holders of the Class A Common Stock and Class B Common Stock are entitled to equal per share cash and stock dividends, if any, distributions upon liquidation of the Company and consideration in a merger or consolidation of the Company.
The Company received net proceeds of approximately $197.6 million from the sale of the 3,000,000 shares of Class B Common Stock after deducting underwriting discounts and commissions and expenses of the offering payable by the Company. The Company did not receive any of the proceeds from the sale of shares of Class B Common Stock by UniHealth. The Company used approximately $186.0 million of the net proceeds to repay the amount outstanding under its B of A Credit Line and to replenish working capital used to pay for certain of the Acquisitions (see Note 5 - "Acquisitions").
In December 1994, the Company completed a public offering of 90,000 shares of its Class B Common Stock to certain physician groups which currently contract with the Company. Each group has entered into an irrevocable obligation to purchase a fixed number of shares of the Class B Common Stock over a five year period beginning May 1, 1996 at $64.88 per share.
UniHealth purchased health care coverage from the Company in the amounts of $12.0 million, $10.0 million and $7.3 million for the years ended September 30, 1995, 1994 and 1993, respectively. Amounts receivable from UniHealth were $0.9 million and $1.0 million at September 30, 1995 and 1994, respectively.
The Company and its subsidiaries file a consolidated Federal income tax return. The Company also files a combined California franchise tax return with its subsidiaries.
b) Stock Option Plans. The Company has granted stock options for employees and Directors under various plans including the Stock Option Plan for Executive and Key Employees, as amended (the "1985 Plan"), the Second Amended and Restated 1989 Stock Option Plan for Officers and Key Employees, as amended (the "1989 Employee Plan"), the 1989 Non-Officer Directors Stock Option Plan (the "1989 Director Plan") and the 1992 Non-Officer Directors Stock Option Plan (the "1992 Director Plan").
The 1992 Director Plan provides for a maximum of 140,000 shares of Class B Common Stock issuable upon the exercise of NQSQs granted to eligible non-officer Directors of the Company. Non-officer Directors of the Company who are not eligible to receive options under the 1989 Employee Plan are eligible to receive NQSQs under the 1992 Director Plan.
At September 30, 1995, approximately 2,049,575 shares were reserved for issuance upon the exercise of outstanding options. As of that date, options were exercisable for 342,984 shares of Class A Common Stock at exercise prices of $1.63 - $19.75 per share and 394,289 shares of Class B Common Stock at exercise prices of $1.63 - $66.75. No SARs have been awarded under the 1989 Employee Plan.
c) Performance Incentive Programs. The Company has a long-term performance incentive program, under which all executive officers of the Company and certain officers and key employees of the Company and its subsidiaries are eligible to participate. Incentive compensation is based on the achievement of objectives established by the Compensation Committee (the "Committee") of the Board of Directors and approved by the shareholders of the Company. For fiscal years ended September 30, 1995, 1994 and 1993, the incentive compensation expense for this program was $3.0 million, $2.5 million and $1.9 million, respectively.
The Company also has an annual incentive compensation program. All executive officers of the Company or any subsidiary of the Company are eligible to participate and any officer or full-time employee of the Company or any subsidiary of the Company, determined by the Committee to have a direct, significant and measurable impact on the attainment of the Company's or subsidiary's annual growth and profitability objectives is eligible to participate. Amounts charged to expense for the annual compensation program were $2.7 million, $7.0 million and $2.2 million for the years ended September 30, 1995, 1994 and 1993, respectively.
b) Employment Agreements. The Company has entered into employment agreements with the President of the Company and certain other executive officers. The agreements contain provisions that would entitle each to receive severance benefits which are payable if employment is terminated for various reasons, including termination following a change of ownership or control of the Company as defined by the agreements. The maximum contingent liability for severance payments that the Company would be required to make under the employment agreements (excluding amounts which may be payable under incentive plans and the value of certain benefits) would be approximately $7.4 million at September 30, 1995.
The Company has entered into interest rate swaps to reduce the impact of changes in interest rates on a portion of its investments in marketable securities. Interest rate swaps are contractual agreements between the Company and third parties to exchange floating interest rate payments periodically over the life of the agreements without the exchange of the underlying principal amounts ("notional amounts"). At September 30, 1995, the total notional amount of such agreements with off-balance sheet risk was $150.0 million. At September 30, 1995, the fair value of such agreements, representing the estimated amount the Company would receive to terminate the agreement based on current interest rates, was not significant.
We have audited the accompanying consolidated balance sheets of PacifiCare Health Systems, Inc. as of September 30, 1995 and 1994, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended September 30, 1995. Our audits also included the financial statement schedule listed in the Index at Item 14(a)(2). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
As discussed in Note 2 to the Consolidated Financial Statements, as of October 1, 1994 the Company changed its method of accounting for marketable securities.
(1) The results for the quarter ended June 30, 1994 includes $0.18 of positive reserve adjustments which are described in Management's Discussion and Analysis on page 16.