HealthSpring, Inc. (the “company” or “HealthSpring”) is a managed care organization whose primary focus is Medicare, the federal government-sponsored health insurance program for U.S. citizens aged 65 and older, qualifying disabled persons, and persons suffering from end-stage renal disease.
We acquired LMC Health Plans, which had approximately 25,800 members at the date of acquisition on October 1, 2007.
Total cash and cash equivalents at December 31, 2007 was $324.1 million, including cash of $36.2 million held at unregulated subsidiaries.
On October 1, 2007, we completed the acquisition of all of the outstanding capital stock of LMC Health Plans pursuant to the terms of a Stock Purchase Agreement, dated as of August 9, 2007 (the “Stock Purchase Agreement”). LMC Health Plans is a Miami, Florida-based Medicare Advantage HMO with approximately 26,000 members. Pursuant to the Stock Purchase Agreement, we acquired LMC Health Plans for $355.0 million in cash and contingent consideration of 2,666,667 shares of HealthSpring common stock, which share consideration has been deposited in escrow and will be released to the former stockholders of LMC Health Plans if Leon Medical Centers, Inc. (“LMC”) completes the construction of two additional medical centers in accordance with the timetable set forth in the purchase agreement. As part of the transaction, we entered into an exclusive long-term provider contract (“the “Leon Medical Services Agreement”) with LMC. LMC operates five Medicare-only medical clinics located in Miami-Dade County and has a ten-year history of providing medical care and customer service to the Hispanic Medicare-eligible community of South Florida. The Leon Medical Services Agreement is for an initial term of approximately ten years with an additional five-year renewal term at our option.
On October 10, 2006, we completed a secondary public offering of our common stock. In connection with the secondary offering certain stockholders of the company, including funds affiliated with GTCR Golder Rauner, LLC, or the GTCR Funds, sold 11,600,000 shares of common stock at a price of $18.98 per share. We did not receive any proceeds from the sale of the shares in the secondary offering.
Prior to the recapitalization, approximately 15% of the ownership interests in two of our Tennessee management subsidiaries and approximately 27% of the membership interests of our Texas HMO subsidiary, Texas HealthSpring, LLC, were owned by outside investors. Contemporaneously with the recapitalization, we purchased all of the minority interests in our Tennessee subsidiaries and a portion of the membership interests held by the minority investors in Texas HealthSpring, LLC. Following the purchase, the outside investors in Texas HealthSpring, LLC owned an approximately 9% ownership interest. Following a private placement in June 2005, and as of December 31, 2005, the outside investors owned an approximately 15.9% interest in Texas HealthSpring,
General. Our revenue consists primarily of (i) premium revenue we generate from our Medicare and commercial lines of business; (ii) fee revenue we receive for management and administrative services provided to independent physician associations, health plans, and self-insured employers, and for access to our provider networks; and (iii) investment income.
Premiums for our Medicare and commercial products are generally fixed by contract in advance of the period during which health care is covered. Each of our Medicare plans submits rate proposals to CMS, generally by county or service area, in June for each Medicare product that will be offered beginning January 1 of the subsequent year. Retroactive rate adjustments are made periodically with respect to each of our Medicare plans based on the aggregate health status and risk scores of our plan populations. For a further explanation of the company’s accounting for retroactive risk payments, see “-Risk Adjustment Payments” section below. Our commercial premium rates are generally fixed for the plan year, in most cases beginning January 1.
We recognize prescription drug costs as incurred, net of rebates from drug companies.
The following table sets forth the consolidated and combined statements of income data expressed in dollars (in thousands) and as a percentage of revenues for each period indicated.
Commercial membership has declined since 2005 as a result of the non-renewal by employers in Tennessee and Alabama.
Medicare Advantage. Our Medicare Advantage membership increased by 33.1% to 153,197 members at December 31, 2007 as compared to 115,132 members at December 31, 2006. The increase was principally attributable to the addition of 25,946 members as a result of the acquisition of LMC Health Plans and to 10.5% organic growth in membership in our existing core markets through increased penetration in existing service areas. Medicare Advantage (including MA-PD) membership as of January 1, 2008 was 151,671 reflecting decreases in two of our markets as a result of exiting certain poorer performing counties and discontinuing certain product offerings.
Our Medicare premium revenue is subject to adjustment based on the health risk of our members under CMS’s risk adjustment payment methodology. Under the risk adjustment payment methodology, managed care plans must capture, collect, and report diagnosis code information to CMS. After
Adjustments to reflect in 2005 the 2005 final payment from CMS of $5.7 million and related risk-sharing costs, which were recorded in 2006 results.
Adjustments to exclude from 2005 results the 2004 final payment from CMS of $1.6 million and related risk-sharing costs, which were recorded in 2005, as such amounts related to fiscal 2004.
Comparison of the Year Ended December 31, 2007 to the Year Ended December 31, 2006
Premium Revenue: Total premium revenue for 2007 was $1,526.2 million as compared with $1,270.3 million in the same period in 2006, representing an increase of $255.9 million, or 20.1%. The components of premium revenue and the primary reasons for changes were as follows:
Medicare Advantage: On an as-adjusted basis (see “Risk Adjustment Payments” table above), Medicare Advantage premiums were $1,348.8 million for year ended December 31, 2007 versus $1,057.6 million in the same period in 2006, representing an increase of $291.2 million, or 27.5%. The increase in Medicare Advantage premiums in 2007 is attributable to increases in membership (which we measure in membership months) and PMPM premium rates. Member months increased 20.9% for the 2007 period as compared to the 2006 period. PMPM premiums increased 5.5% to $858.78 for 2007 from $814.08 for 2006 (as adjusted to exclude the effect of the retroactive risk payments related to prior periods) as a result of the inclusion of the LMC Health Plans’ higher PMPM premiums from the date of acquisition in October 2007 and as a result of increases in rates as affected by risk scores and the mix of members qualifying as dual-eligibles. The inclusion of LMC Health Plans’ results since the date of acquisition in October 2007 contributed 140 basis points of the 2007 PMPM increase as compared to 2006 PMPMs. As reported, Medicare Advantage premiums were $1,363.6 million for the year ended December 31, 2007 versus $1,048.5 million in the same period in 2006, representing an increase of $315.1 million, or 30.1%. For 2008, we expect average reimbursement rates for our Medicare Advantage plans to increase by 10% to 11% over 2007 (or 7 to 8% excluding the reimbursement rates for our Florida market).
Fee Revenue. Fee revenue was $24.6 million in the year ended December 31, 2007 as compared with $26.7 million in the comparable period of 2006, representing a decrease of $2.1 million, or 7.8%. The decrease in the current period is primarily attributable to the termination of a management agreement on December 31, 2006, which was partially offset by increases in other fee revenue.
Medicare Advantage. For the year ended December 31, 2007, the Medicare Advantage (including MA-PD) MLR was 80.3% versus 78.3% for the same period of 2006 on an as-adjusted basis (see “- Risk Adjustment Payments” above). The deterioration in 2007 as compared to the same period of 2006 resulted primarily from higher medical services expenses and facility charges in outpatient and emergency room settings and higher in-patient utilization. As reported, Medicare Advantage (including MA-PD) medical expense for the year ended December 31, 2007 increased $261.4 million, or 31.6%, to $1,087.3 million from $825.9 million for the comparable period of 2006, primarily as a result of the medical expense incurred by LMC Health Plans from October 1, 2007, the date we acquired the health plan, and as a result of increased membership and utilization in our existing health plans.
Our Medicare Advantage (including MA-PD) medical expense calculated on a PMPM basis was $690.03 for the year ended December 31, 2007, compared with $637.77 for the 2006 period (adjusted to exclude the portion of risk sharing with providers associated with retroactive risk payments relating to prior periods, net (see “- Risk Adjustment Payments” above)), reflecting an increase of 8.2%, primarily as a result of the factors discussed previously regarding the deterioration in the MLR during 2007 along with medical cost inflation.
Interest expense was $7.5 million in the year ended December 31, 2007 as compared with $8.7 million in 2006. Interest expense recognized in the 2007 period was the result of the company’s borrowing $300.0 million in term loans on October 1, 2007 in connection with the purchase of LMC Health Plans and the write-off of deferred financing costs of $0.7 million. We expect increases in the amount of interest expense in future periods as a result of these borrowings.
The company’s interest expense in the 2006 period related to interest on outstanding borrowings, the write-off of deferred financing costs of $5.4 million, and an early payment premium of $1.1 million related to the payoff of all the company’s outstanding indebtedness and related accrued interest in February 2006 with proceeds from the IPO.
Comparison of the Year Ended December 31, 2006 to the Combined Twelve-Month Period Ended December 31, 2005
Medicare Advantage: On an as-adjusted basis (see “Risk Adjustment Payments” table above), Medicare Advantage (including MA-PD) premiums were $1,057.6 million for 2006 versus $709.8 million in the prior year, representing an increase of $347.8 million, or 49.0%. The increase in Medicare Advantage (including MA-PD) premiums in 2006 is attributable to increases in membership and PMPM premium rates and the addition of Part D premiums. Membership months increased 30.4% for 2006 as compared to 2005. PMPM premiums (as adjusted to exclude the effect of the retroactive risk payments related to prior periods) increased 14.3% to $814.06 for 2006 from $712.43 for 2005, primarily as a result of additional PMPM premium relating to the Part D benefit received by MA-PD members beginning January 1, 2006. On a similarly adjusted basis, our Medicare Advantage premiums (excluding the Part D-related premium under MA-PD) calculated on a PMPM basis was $744.49 for 2006, compared with $712.43 for 2005, reflecting an increase of 4.5% primarily as a result of increases in rates and risk scores and the mix of our members qualifying as dual-eligibles. As reported, Medicare Advantage (including MA-PD) premiums were $1,048.5 million for 2006 versus $705.7 million in the prior year representing an increase of $342.8 million or 48.6%.
PDP: PDP premiums (after risk corridor adjustments) were $101.4 million in 2006. Our average PMPM premiums received from CMS (after risk corridor adjustments) were $100.10 for PDP members for 2006. Because the Medicare Part D program was implemented effective January 1, 2006, there are no comparable PDP operating or financial results for 2005.
Commercial: Commercial premiums were $120.5 million in 2006 as compared with $126.9 million in the combined twelve months of 2005, reflecting a decrease of $6.4 million, or 5.0%. The decrease was attributable to the decline in membership, which was partially offset by average commercial premium increases of approximately 7.4%.
Commercial. Commercial medical expense increased by $1.1 million, or 1.0%, to $108.2 million for 2006 as compared to $107.1 million for the combined twelve months of 2005. The commercial MLR was 89.8% for 2006 as compared with 84.4% in 2005, an increase of 540 basis points, which was primarily attributable to an unusually large number of high dollar in-patient cases during 2006.
In 2006, the company accrued $2.0 million of dividends payable on the preferred stock issued in connection with the recapitalization as compared to a dividend accrued in the same combined period in 2005 of $15.6 million for the ten months following the recapitalization. In February 2006, in connection with the IPO, the preferred stock and all accrued and unpaid dividends were converted into common stock.
We finance our operations primarily through internally generated funds. All of our outstanding funded indebtedness was incurred in connection with the acquisition of the LMC Health Plans in October 2007. See “-Indebtedness” below.
We generate cash primarily from premium revenue and our primary use of cash is the payment of medical and SG&A expenses. We anticipate that our current level of cash on hand, internally generated cash flows, and borrowings available under our new revolving credit facility will be sufficient to fund our working capital needs and anticipated capital expenditures over the next twelve months.
The reported changes in cash and cash equivalents for the years ended December 31, 2007, 2006 and 2005, are summarized below:
Our primary sources of liquidity are cash flow provided by our operations, available cash on hand and our revolving credit facility. We generated cash from operating activities of $72.8 million during the year ended December 31, 2007, compared to $167.6 million during the year ended December 31, 2006.
The increase in cash flow provided by operating activities to $167.6 million for the year ended December 31, 2006 as compared with $72.1 million for the combined twelve months ended December 31, 2005 is primarily attributable to increases in earnings and from favorable cash flows as a result of our entering the Part D business as of January 1, 2006. In addition, the following working capital items had a significant impact on cash flows from operating activities for the year ended December 31, 2006:
During the year ending December 31, 2007, our financing activities consisted of proceeds received from the issuance of long-term debt in October 2007 of $300.0 million, which was used in our acquisition of the LMC Health Plans, payments of $10.6 million for financing costs associated with the issuance of this debt and $15.4 million of funds received from CMS in excess of the funds withdrawn for the benefit of members with Part D drug coverage. We anticipate settling the liability related to such funds with CMS in 2008 as part of the final settlement of Part D for the 2007 plan year. We expect cash flows in 2008 to include inflows for similar subsidies (or funds) from CMS related to the 2008 Medicare year.
In June 2007 the company’s board of directors authorized a stock repurchase program to repurchase up to $50.0 million of the company’s common stock. The company’s credit agreement permits such repurchases, subject to certain limitations relating to minimum liquidity requirements and the sources of funds for such repurchases. As of December 31, 2007, the company had not repurchased any common stock under the program. As of February 27, 2008, the company had repurchased 478,500 shares of common stock at an average price of $18.55 per share during 2008 in open market transactions pursuant to the stock repurchase program.
Our HMO subsidiaries are required to maintain satisfactory minimum net worth requirements established by their respective state departments of insurance. At December 31, 2007, our Texas (minimum $8.9 million; actual $42.5 million), Tennessee (minimum $14.8 million; actual $59.4 million), Florida (minimum $6.8 million; actual $16.0 million) and Alabama (minimum $1.1 million; actual $36.7 million) HMO subsidiaries were in compliance with statutory minimum net worth requirements at December 31, 2007. Notwithstanding the foregoing, the state departments of insurance can require our HMO subsidiaries to maintain minimum levels of statutory capital in excess of amounts required under the applicable state law if they determine that maintaining additional statutory capital is in the best interest of our members.
Long-term debt at December 31, 2007 and 2006 consisted of the following (in thousands):
Amounts borrowed under the revolving credit facility also must be repaid no later than October 1, 2012.
Loans under the New Credit Agreement are secured by a first priority lien on substantially all assets of the company and its non-HMO subsidiaries, including a pledge by the company and its non-HMO subsidiaries of all of the equity interests in each of their domestic subsidiaries.
On April 21, 2006, HealthSpring and certain of its non-HMO subsidiaries as guarantors entered into a revolving credit facility, which provided up to a maximum aggregate principal amount outstanding of $75.0 million. The company terminated this facility on October 1, 2007, in connection with the acquisition of LMC Health Plans and entered into the New Credit Agreement. As a result, the company recognized a charge in the 2007 fourth quarter of $0.7 million from the write-off of unamortized debt issuance cost associated with the terminated credit facility.
The IBNR component of total medical claims liability is based on our historical claims data, current enrollment, health service utilization statistics, and other related information. Estimating IBNR is complex and involves a significant amount of judgment. Accordingly, it represents our most critical accounting estimate. Changes
in this estimate can materially affect, either favorably or unfavorably, our consolidated operating results and overall financial position.
The completion and claims trend factors are the most significant factors impacting the IBNR estimate. The following table illustrates the sensitivity of these factors and the impact on our operating results caused by changes in these factors that management believes are reasonably likely based on our historical experience and December 31, 2007 data:
The following table provides a reconciliation of changes in medical claims liability for the years ended December 31, 2007 and 2006.
The negative amounts reported in the table above for incurred related to prior periods result from claims being ultimately settled for amounts less than originally estimated (a favorable development). A positive amount reported for incurred related to prior periods would result from claims ultimately being settled for amounts greater than originally estimated (an unfavorable development). For the years ended December 31, 2007 and 2006, actual claims expense developed favorably by 1.9% and 1.3%, respectively, as compared to estimated medical claims expense.
The favorable overall claims development experienced in 2007 includes favorable commercial claims liability development of $3.3 million. Our commercial HMO membership declined from 31,970 members at December 31, 2006 to 11,801 members at December 31, 2007, or by 63.1%, primarily as a result of the non-renewal by employers in Tennessee and Alabama. Commercial medical claims payable decreased from $11.7 million at December 31, 2006 to $3.4 million at December 31, 2007.
We generally receive premiums on a monthly basis in advance of providing services. Premiums collected in advance are deferred and reported as deferred revenue. We recognize premium revenue during the period in which we are obligated to provide services to our members. Any amounts that have not been received are recorded on the balance sheet as accounts receivable.
Intangible assets with estimable useful lives are amortized over their respective estimated useful lives. We determine the useful life and amortization method for definite-life intangible assets based on the guidance in FASB Statement No. 142, “Goodwill and Other Intangible Assets”. For all periods through the quarter ended September 30, 2007, the straight-line method of amortization was applied for Medicare member network intangible asset associated with our 2005 recapitalization (the “recapitalization asset”), as a better pattern could not be reliably determined based on available information. Effective October 1, 2007, we began applying a 17-year accelerated method of amortization for this asset. Since the date of acquiring the
member network asset in 2005, we have tracked actual attrition rates experienced within the member network and believe that there is now adequate historical data to make reliable estimates regarding future attrition rates for amortization purposes. Based on our review of historical attrition rates, we believe the accelerated method of amortization over the revised estimated life better approximates the distribution of economic benefits realized from the recapitalization asset. The use of an accelerated method prior to September 30, 2007 would have resulted in the recognition of amortization expense that is not materially different from the amounts recognized under the straight-line method used by us during the same periods. We will continue to monitor our actual attrition rates realized in future periods and adjust amortization schedules accordingly. Similarly, we are using a 20-year accelerated method of amortization for the Medicare member network intangible acquired as part of the acquisition of Leon Medical Centers Health Plans, Inc. on October 1, 2007.
Our accounting for this change related to the recapitalization asset resulted in incremental amortization expense of $0.3 million during the quarter ended December 31, 2007 over the amount of expense recognized using the straight-line method in prior quarters of 2007 and did not have a material effect on our reported income before income taxes, net income, or net income per share for the quarter and year ended December 31, 2007. As a result of the change related to the recapitalization asset, we expect amortization expense for the year ended December 31, 2008 to increase approximately $0.6 million over the amount recognized in the year ended December 31, 2007.
We review our deferred tax assets for recoverability and establish a valuation allowance based on historical taxable income, projected future taxable income, applicable tax strategies, and the expected timing of the reversals of existing temporary differences. A valuation allowance is provided when it is more likely than not that some portion or all of the deferred tax assets will not be realized.
We also have accruals for taxes and associated interest that may become payable in future years as a result of audits by tax authorities. We accrue for tax contingencies when it is more likely than not that a liability to a taxing authority has been incurred and the amount of the contingency can be reasonably estimated. Although we believe that the positions taken on previously filed tax returns are reasonable, we nevertheless have established tax and interest reserves in recognition that various taxing authorities may challenge the positions taken by us resulting in additional liabilities for taxes and interest. These amounts are reviewed as circumstances warrant and adjusted
as events occur that affect our potential liability for additional taxes, such as lapsing of applicable statutes of limitations, conclusion of tax audits, additional exposure based on current calculations, identification of new issues, release of administrative guidance, or rendering of a court decision affecting a particular tax issue.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”. SFAS No. 159 permits entities to choose to measure at fair value many financial instruments and certain other items that are not currently required to be measured at fair value. Subsequent changes in fair value for designated items will be required to be reported in earnings in the current period. SFAS No. 159 also establishes presentation and disclosure requirements for similar types of assets and liabilities measured at fair value. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We do not expect the adoption of SFAS No. 159 will have an impact on our consolidated financial statements.
Consolidated Balance Sheets of HealthSpring, Inc. as of December 31, 2007 and December 31, 2006
Consolidated Statements of Income of HealthSpring, Inc. for the years ended December 31, 2007, 2006, the ten-month period ended December 31, 2005 and the Predecessor for the two-month period ended February 28, 2005
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), HealthSpring, Inc.’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 27, 2008 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of HealthSpring, Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for the years then ended and for the ten-month period from March 1, 2005 (inception) to December 31, 2005; and the consolidated statements of income, members’ equity and comprehensive income, and cash flows of NewQuest, LLC and subsidiaries for the two months ended February 28, 2005, and our report dated February 27, 2008 expressed an unqualified opinion on those consolidated financial statements.
The consolidated financial statements include the accounts of HealthSpring, Inc. and its wholly and majority owned subsidiaries as of December 31, 2007 and 2006, for the years ended December 31, 2007 and 2006, for the ten-month period from March 1, 2005 (inception) to December 31, 2005, and NewQuest, LLC and subsidiaries (collectively, the “Predecessor”), for the two-month period ended February 28, 2005. The financial statements of HealthSpring, Inc. and the Predecessor are presented in comparative format. Although their accounting policies are consistent, their financial statements are not directly comparable primarily because of the purchase accounting adjustments resulting from a recapitalization transaction, which was accounted for as a purchase. All significant inter-company accounts and transactions have been eliminated in consolidation. For purposes of these financial statements and notes, where appropriate the term “Company” includes HealthSpring, Inc. and Predecessor. The Company considers its businesses and related operating structure as one reporting segment.
For purposes of the consolidated statements of cash flows, the Company considers all highly liquid investments that have maturities of three months or less at the date of purchase to be cash equivalents. Cash equivalents include such items as certificates of deposit, commercial paper, and money market funds.
Restricted investments include U.S. Government securities, money market fund investments, and certificates of deposit held by the various state departments of insurance to whose jurisdiction the Company’s subsidiaries are subject. At December 31, 2006 and 2007, these restricted assets are recorded at amortized cost and classified as long-term regardless of the contractual maturity date because of the restrictive nature of the state’s requirements.
Long lived assets, such as property and equipment and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated future undiscounted cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated fair value, an impairment charge is recognized by the amount of the excess. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and no longer depreciated.
Intangible assets with estimable useful lives are amortized over their respective estimated useful lives. The Company determines the useful life and amortization method for definite-life intangible assets based on the guidance in FASB Statement No. 142, “Goodwill and Other Intangible Assets”. For all periods through the quarter ended September 30, 2007, the straight-line method of amortization was applied for the Medicare member network intangible asset associated with the Company’s 2005 recapitalization (the“recapitalization asset”) (See Note 7), as a better pattern could not be reliably determined based on available information. Effective October 1, 2007, the Company began applying a 17-year accelerated method of amortization for the recapitalization asset. Since the date of acquiring the member network asset in 2005, the Company has tracked actual attrition rates experienced within the member network and believes that there is now adequate historical data to make reliable estimates regarding future attrition rates for amortization purposes. Based on its review of historical attrition rates, the Company believes the accelerated method of amortization over the revised estimated life better approximates the distribution of economic benefits realized from the member network intangible asset. The use of an accelerated method prior to September 30, 2007 would have resulted in the recognition of amortization expense that is not materially different from the amounts recognized under the straight-line method used by the Company during the same periods. The Company will continue to monitor its actual attrition rates realized in future periods
The Company’s accounting for this change related to the recapitalization asset resulted in incremental amortization expense of $250 during the quarter ended December 31, 2007 over the amount of expense recognized using the straight-line method in prior quarters of 2007 and did not have a material effect on the Company’s reported income before income taxes, net income, or net income per share for the quarter and year ended December 31, 2007. As a result of the change related to the recapitalization asset, the Company expects amortization expense for the year ended December 31, 2008 to increase approximately $600 over the amount recognized in the year ended December 31, 2007.
The Company uses the asset and liability method of accounting for income taxes. Under this method, deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes and net operating loss and tax credit carryforwards. The amount of deferred taxes on these temporary differences is determined using the tax rates that are expected to apply to the period when the asset is realized or the liability is settled, as applicable, based on tax rates and laws in the respective tax jurisdiction enacted as of the balance sheet date.
The Company leases facilities and equipment under non-cancelable operating agreements, which include scheduled increases in minimum rents and renewal provisions at the option of the Company. The lease term used in all lease accounting calculations begins with the date the Company takes possession of the facility or the equipment and ends on the expiration of the primary lease term or the expiration of any renewal periods that are deemed to be reasonably assured at the inception of the lease. Rent holidays and escalating payment terms are recognized on a straight-line basis over the lease term. For certain facility leases, the Company receives allowances from its landlords for improvement or expansion of its properties. Tenant improvement allowances are recorded as a deferred rent liability and recognized ratably as a reduction to rent expense over the remaining lease term.
Health plan premiums are due monthly and are recognized as revenue during the period in which the Company is obligated to provide services to the members. The Company recognizes premium revenue for the Part D payments received from CMS for which it assumes risk. The Company does not record revenue related to Part D payments from CMS that represent payments for claims for which it assumes no risk (See Note 3).
The Company’s Medicare premium revenue is subject to adjustment based on the health risk of its members. This process for adjusting premiums is referred to as the CMS risk payment methodology. Under the risk adjustment payment methodology, managed care plans must capture, collect, and report diagnosis code information to CMS. After reviewing the respective submissions, CMS establishes the payments to Medicare plans generally at the beginning of the calendar year, and then adjusts premium levels on two separate occasions on a retroactive basis. The first retroactive risk premium adjustment for a given fiscal year generally occurs during the third quarter of such fiscal year. This initial settlement (the “Initial CMS Settlement”) represents the updating of risk scores for the current year based on the prior year’s dates of service. CMS then issues a final retroactive risk premium adjustment settlement for the fiscal year in the following year (the “Final CMS Settlement”). Prior to 2007 the Company was unable to estimate the impact of either of these risk adjustment settlements, and as such recorded them upon notification from CMS of such amounts. In the first quarter of 2007, the Company began estimating and recording on a monthly basis the Initial CMS Settlement, as we concluded we had the ability to reasonably estimate such amounts. In the fourth quarter of 2007, the Company estimated and recorded the Final CMS Settlement for 2007, as the Company concluded such amounts were reasonably estimable. The Final CMS Settlement for 2006 was recorded during the second quarter of 2007 when received from CMS. Premium revenue for 2007 includes both Final CMS Settlements for 2007 and 2006. As of January 2008, the Company will estimate and record on a monthly basis both the Initial CMS Settlement and the Final CMS Settlement for the 2008 CMS plan year. All such estimated amounts are periodically updated as necessary as additional diagnosis code information is reported to CMS and adjusted to actual amounts when the ultimate adjustment settlements are either received from CMS or the Company receives notification from CMS of such settlement amounts.
Comprehensive income consists of only net income for all periods presented.
Certain of the Company’s HMO subsidiaries have reinsurance arrangements with respect to its commercial lines of business with well-capitalized, highly-rated reinsurance providers. In addition, the Company’s Florida HMO has reinsurance arrangements with respect to its Medicare Advantage business. These arrangements include maximum medical payment amounts per member per year and per such member’s lifetime. Premiums paid and amounts recovered under these agreements have not been material in any period covered by these consolidated financial statements.
The Company’s HMO subsidiaries also maintain risk-sharing arrangements with providers, including independent physician associations. See Note 12.
Net income per common share and member unit is measured at two levels: basic net income per common share and member unit and diluted net income per common share and member unit. Basic net income per common
shares and member unit is computed by dividing net income available to common stockholders and members by the weighted average number of common shares or member units outstanding during the period. Diluted net income per common share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding after considering the dilution related to stock options and restricted stock. Diluted net income per member unit is computed by dividing net income by the weighted average number of member units outstanding after considering dilution related to warrants to purchase 500,000 Series A units of NewQuest, LLC. Also see Note 2.
Prior to January 1, 2006, the Company applied the intrinsic-value-based method of accounting prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations including Financial Accounting Standards Board (“FASB”) Interpretation No. 44, “Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25,” to account for its fixed-plan stock options. Under this method, compensation expense was recorded for fixed-plan stock options only if the current market price of the underlying stock exceeded the exercise price on the date of grant. SFAS No. 123 “Accounting for Stock-Based Compensation,” and SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment to FASB Statement No. 123,” established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company had elected to continue to apply the intrinsic-value-based method of accounting described above, and had adopted only the disclosure requirements of these statements.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”. SFAS No. 159 permits entities to choose to measure at fair value many financial instruments and certain other items that are not currently required to be measured at fair value. Subsequent changes in fair value for designated items will be required to be reported in earnings in the current period. SFAS No. 159 also establishes presentation and disclosure requirements for similar types of assets and liabilities measured at fair value. SFAS No.
159 is effective for fiscal years beginning after November 15, 2007. The Company does not expect the adoption of SFAS No. 159 will have an impact on its consolidated financial statements.
On October 1, 2007, the Company completed the acquisition of all of the outstanding capital stock of Leon Medical Centers Health Plans, Inc. (“LMC Health Plans”) pursuant to the terms of a Stock Purchase Agreement, dated as of August 9, 2007 (the “Stock Purchase Agreement”). LMC Health Plans is a Miami, Florida-based Medicare Advantage HMO with approximately 26,000 members. Pursuant to the Stock Purchase Agreement, the Company acquired LMC Health Plans for $355.0 million in cash and 2,666,667 shares of the Company’s common stock, $.01 par value per share, which share consideration has been deposited in escrow and will be released to the former stockholders of LMC Health Plans if Leon Medical Centers, Inc. (“LMC”) completes the construction of two additional medical centers in accordance with the timetable set forth in the Stock Purchase Agreement. Such escrowed shares will be excluded from the computation of basic and diluted earnings per share until such time that all conditions for their release from escrow have been satisfied.
Payments for medical services under the Leon Medical Services Agreement are based on agreed upon rates for each service, multiplied by the number of plan members as of the first day of each month. There is a sharing arrangement with regard to LMC Health Plans’ annual medical loss ratio (“MLR”) whereby the parties share equally any surplus or deficit of up to 5% with regard to agreed-upon MLR benchmarks. The initial target for the annual MLR is 80.0%, which increases to 81.0% during the term of the agreement.
As further described in Note 14, in connection with funding the acquisition, on October 1, 2007, the Company entered into a $400.0 million, five-year credit agreement (the “New Credit Agreement”) which, subject to the terms and conditions set forth therein, provides for $300.0 million in term loans and a $100.0 million revolving credit facility. The remainder of the cash purchase price was funded through available cash and cash equivalents.
The acquisition was accounted for using the purchase method. The aggregate consideration for the acquisition was $357,946, which included $2,947 of capitalized acquisition related costs. The contingent consideration represented by the 2.7 million common shares placed in escrow are not included in the purchase price and are excluded from outstanding and issued shares on the Company’s consolidated balance sheet as management has not concluded that it is determinable beyond a reasonable doubt that the share release conditions will be met. The Company acquired $357,946 of net assets, including $169,300 of identifiable intangible assets, and goodwill of $246,163. The $169,300 of identifiable intangible assets recorded is being amortized over periods ranging from 15-20 years. All intangible assets, including goodwill, are non-deductible for income tax purposes.
The unaudited pro forma information includes the results of operations for LMC Health Plans for the periods prior to the acquisition, adjusted for interest expense on long-term debt and reduced investment income related to the cash used to fund the acquisition, additional amortization associated with the purchase and the related income tax effects. The unaudited pro forma financial information is presented for informational purposes only and may not be indicative of the results of operations had LMC Health Plans been owned by the Company for the full years ended December 31, 2007 and 2006, nor is it necessarily indicative of future results of operations. The following summary of unaudited pro forma financial information presents revenues, net income and per share data of HealthSpring, Inc., as if the acquisition of LMC Health Plans had occurred at the beginning of the periods presented.
In 2006, the Company began offering prescription drug benefits in accordance with Medicare Part D. The Company currently offers Medicare Part D prescription drug plans to persons in all 50 states. We refer to our Medicare Advantage plans (including plans providing Part D prescription drug benefits, or MA-PD plans) collectively as “Medicare Advantage” plans. We refer to our stand-alone prescription drug plan as “PDP.” In addition to standard coverage plans, the Company offers supplemental benefits in excess of the standard coverage.
Rebates for drug costs represent estimated rebates owed to the Company from prescription drug companies. The Company has entered into contracts with certain drug manufacturers which provide for rebates to the Company based on the utilization of specific prescription drugs by the Company’s members. Accounts receivable relating to unpaid health plan enrollee premiums are recorded during the period the Company is obligated to provide services to enrollees and do not bear interest. The Company does not have any off-balance sheet credit exposure related to its health plan enrollees. Other receivables include management fees receivable as well as amounts owed the Company from other health plans and the Company’s pharmacy benefits manager for the refund of certain medical expenses paid by the Company.
U.S. Treasury Securities, Municipal Bonds and Government Agencies: The unrealized gains/losses on investments in U.S. Treasury securities, municipal bonds and government agencies were caused by interest rate changes. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Because the Company has the ability and intent to hold these investments until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired.
Depreciation expense on property and equipment for the year ended December 31, 2007, 2006, the ten months ended December 31, 2005, and the two months ended February 28, 2005 was $6,175, $2,626, $1,963, and $263, respectively.
Changes to the carrying value of identifiable intangible assets during 2007 are as follows:
At December 31, 2007, all intangible assets are amortized using a straight-line method except for member network intangible assets which are amortized using an accelerated method. Also see Note 1(f).
Amortization expense on identifiable intangible assets for the year ended December 31, 2007, 2006, the ten months ended December 31, 2005, and the two months ended February 28, 2005, was $10,045, $7,528, $5,027, and $52, respectively. In addition, the Company recorded a $4.5 million charge during the 2007 second quarter for the impairment of intangible assets associated with commercial customer relationships in the Company’s Tennessee health plan. This charge was the result of the Company’s expectation that significant declines in commercial membership will occur as a result of its decision in the second quarter of 2007 to implement premium increases upon renewal for large group plans. The carrying value of the related intangible asset was $0.3 million at December 31, 2007 and is being amortized through March 2008.
Amortization expense expected to be recognized during fiscal years subsequent to December 31, 2007 is as follows:
The unrealized losses at December 31, 2006, on investments in government securities were caused by interest rate changes. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Because the Company has the ability and intent to hold these investments until a market price recovery or maturity, the impairment of these held to maturity investments is not considered other-than-temporary.
On February 8, 2006, the Company completed an initial public offering, or IPO, of its common stock. In connection with the IPO, the Company sold 10.6 million shares of common stock at a price of $19.50 per share. Total proceeds to the Company were approximately $188,400, net of $18,300 of offering costs. From the proceeds of the offering and available cash, the Company repaid all of its long-term debt and accrued interest, including a $1,100 prepayment penalty, totaling $189,900. Additionally, the Company issued approximately 12,600,000 shares of common stock in exchange for all of the outstanding preferred stock, including cumulative dividends.
In connection with the IPO, the Company also issued approximately 2.0 million shares of common stock in exchange for all the minority interest in the membership units of its Texas HMO subsidiary. The total value of the purchase of the minority interest was approximately $39,800, which resulted in additional goodwill of $26,562 and identifiable intangible assets of $1,028.
The Company has options outstanding under its 2006 Equity Incentive Plan and its 2005 Stock Option Plan.
The weighted average fair value of options granted in 2007 and 2006 is provided below. The fair value for all options as determined on the date of grant was estimated using the Black-Scholes option-pricing model with the following assumptions:
outstanding stock options until March 2005, the expected term assumption was also based on industry peer information. The risk-free interest rate was-based on a traded zero-coupon U.S. Treasury bond with a term substantially equal to the option’s expected term. The Company recognized a deferred income tax benefit of approximately $3,001 and $2,242 in the year ended December 31, 2007 and 2006, respectively, related to the share-based compensation expense. The actual tax benefit realized from stock options exercised during 2007 and 2006 was $2 and $30, respectively. There was no capitalized stock-based compensation expense in 2007 or 2006.
The fair value of shares vested during the years ended December 31, 2007, and 2006 was $1,025 and $1,128, respectively. Total compensation expense related to nonvested restricted stock awards not yet recognized was $1,356 at December 31, 2007. The Company expects to recognize this compensation expense over a weighted average period of approximately 1.7 years. There are no other contractual terms covering restricted stock awards under the 2006 Plan once the vesting restrictions have lapsed.
In June 2007, the Company’s Board of Directors authorized a stock repurchase program to buy back up to $50.0 million of the Company’s common stock over the subsequent 12 months. The program is intended to be implemented through purchases made from time to time in either the open market or through private transactions, in accordance with SEC and other applicable legal requirements. The timing, prices, and sizes of purchases will depend upon prevailing stock prices, general economic and market conditions, and other considerations. Funds for the repurchase of shares are expected to come primarily from unrestricted cash on hand and unrestricted cash generated from operations. The repurchase program does not obligate the Company to acquire any particular amount of common stock and the repurchase program may be suspended at any time at the Company’s discretion. As of December 31, 2007, the Company had not repurchased any common stock under the program.
Diluted EPS reflects the potential dilution that could occur if stock options or other share-based awards were exercised or converted into common stock. The dilutive effect is computed using the treasury stock method, which assumes all share-based awards are exercised and the hypothetical proceeds from exercise are used by the
Company to purchase common stock at the average market price during the period. The incremental shares (difference between shares assumed to be issued versus purchased), to the extent they would have been dilutive, are included in the denominator of the diluted EPS calculation. Options on 3.3 million shares and 2.7 million shares were antidilutive and therefore excluded from the computation of diluted earnings per share for the years ended December 31, 2007 and 2006, respectively.
For the years ended December 31, 2007, and 2006, the ten months ended December 31, 2005, and the two months ended February 28, 2005. GulfQuest L.P. earned management and other fees from RPO of approximately $16,313, $15,630, $11,395, and $2,023, respectively. These amounts are reflected in management and other fee income in the accompanying consolidated statements of income.
In December 2007, Herbert A. Fritch, the Company’s Chairman of the Board of Directors, President, and Chief Executive Officer, acquired a 15.8% membership interest in Predators Holdings, LLC (“Predators Holdings”), the owner of the Nashville Predators National Hockey League team. In addition, in December 2007 Mr. Fritch loaned Predators Holdings $2,000. Mr. Fritch is also a member of the executive committee of Predators Holdings. A subsidiary of Predators Holdings manages the Sommet Center where the hockey team plays its home games. The Company is a party to a suite license agreement with another subsidiary of Predators Holdings pursuant to which the company leases a suite for Predators games and other functions. In 2007, the Company paid $130 under the license agreement for the use of the suite (including 16 tickets, but not food and beverage concessions), for Predators’ home games during the 2007-2008 hockey season.
On October 1, 2007, the Company completed the acquisition of all the outstanding capital stock of LMC Health Plans (see Note 2- Acquisition of Leon Medical Centers Health Plans). Prior to the closing, Benjamin Leon, Jr., who was subsequently elected as a director of the Company, owned a majority of LMC Health Plans’ outstanding capital stock.
On October 1, 2007, LMC Health Plans entered into a Medical Services Agreement with LMC (the “Medical Services Agreement”) pursuant to which LMC provides or arranges for the provision of certain medical services to LMC Health Plan’s members. The Medical Services Agreement is for an initial term of approximately ten years with an additional five-year renewal term at LMC Health Plan’s option. Mr. Leon is the majority owner, chairman of the board of directors, and chief executive officer of LMC.
On October 1, 2007, LMC Health Plans entered into an Office Space Agreement with LMC whereby LMC Health Plans reimburses LMC for the use of certain space currently occupied by LMC Health Plans. The term of the Office Space Agreement is one year, with an extension of 180 days at LMC Health Plan’s option. LMC Health Plans is responsible for its pro rata share of lease and equipment expenses, which are estimated to total $530 annually.
At December 31, 2007 the Company had liabilities of $5,047 on its consolidated balance sheets for amounts owed to the sellers of LMC Health Plans under working capital settlement provisions included in the purchase agreement.
The Company leases certain facilities and equipment under noncancelable operating lease arrangements with varying terms. The facility leases generally contain renewal options of five years. For the years ended
December 31, 2007, and 2006, the ten months ended December 31, 2005, and the two months ended February 28, 2005, the Company recorded lease expense of $6,371, $5,108, $3,274, and $501, respectively.
Long-term debt at December 31, 2007 and 2006 consisted of the following:
Borrowings under the New Credit Agreement accrue interest on the basis of either a base rate or a LIBOR rate plus, in each case, an applicable margin (initially 250 basis points for LIBOR advances) depending on the Company’s debt-to-EBITDA leverage ratio. The LIBOR rate plus margin as of December 31, 2007 was 7.78%. The Company also will pay commitment fees on the unfunded portion of the lenders’ commitments under the revolving credit facility, the amounts of which will also depend on the Company’s leverage ratio. The New Credit Agreement matures, the commitments thereunder terminate, and all amounts then outstanding thereunder are payable on October 1, 2012.
The term loans are payable in quarterly principal installments. Maturities of long-term debt under the New Credit Agreement are as follows:
Loans under the New Credit Agreement are secured by a first priority lien on substantially all assets of the Company and its non-HMO subsidiaries, including a pledge by the Company and its non-HMO subsidiaries of all of the equity interests in each of their domestic subsidiaries.
The New Credit Agreement contains conditions precedent to extensions of credit and representations, warranties, and covenants, including financial covenants, customary for transactions of this type. Financial covenants include (i) a maximum leverage ratio comparing total indebtedness to consolidated adjusted EBITDA, (ii) minimum net worth requirements for each HMO subsidiary calculated with reference to applicable regulatory requirements, and (iii) maximum capital expenditures.
On April 21, 2006, HealthSpring, Inc. and certain of its non-HMO subsidiaries as guarantors entered into a $75.0 million, five-year senior secured revolving credit agreement (the “Prior Credit Agreement”) with UBS Securities LLC, Citigroup Global Markets, Inc. and the lenders party thereto. The Prior Credit Agreement provided up to a maximum aggregate principal amount outstanding of $75.0 million, including a $2.5 million swingline subfacility and a maximum of $5.0 million in outstanding letters of credit. In connection with terminating the Prior Credit Agreement in the fourth quarter of 2007, unamortized debt issuance costs of $0.7 million were charged to earnings.
The Company’s medical liabilities at December 31, 2007 and 2006 consisted of the following:
Pharmacy accounts payable at December 31, 2007 and 2006 included $0.3 million and $7.1 million, respectively, for claims payable to other health plans for drug costs under CMS’s Plan to Plan and State to Plan reconciliation processes.
Medical claims liability represents the liability for services that have been performed by providers for the Company’s Medicare Advantage and commercial HMO members. The liability includes medical claims reported to the plans as well as an actuarially determined estimate of claims that have been incurred but not yet reported to the plans, or IBNR. The IBNR component is based on our historical claims data, current enrollment, health service utilization statistics, and other related information.
The Company records a valuation allowance to reduce its net deferred tax assets to the amount that is more likely than not to be realized. As of December 31, 2007 and 2006, the Company carried a valuation allowance against deferred tax assets of $327 and $606, respectively. To the extent the valuation allowance is reduced that was previously recorded as a result of business combinations, the offsetting credit will be recognized first as a reduction to goodwill, then to other intangible assets, and lastly as a reduction in the current period’s income tax provision. A portion of the valuation allowance release related to the 2005 recapitalization transaction, therefore; goodwill was reduced by $150. As of December 31, 2007, the Company had $327 of valuation allowance remaining from the 2005 recapitalization which could potentially result in future reductions to goodwill.
Income taxes payable of $4,904 and $2,519 at December 31, 2007 and 2006, respectively, are included in other current liabilities on the Company’s consolidated balance sheets.
The Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (“FIN 48”) on January 1, 2007. The adoption of FIN 48 did not have a material effect on the Company’s consolidated financial position or results of operations.
The HMOs are required to maintain satisfactory minimum net worth requirements established by their respective state departments of insurance. At December 31, 2007, the statutory minimum net worth requirements and actual statutory net worth were $14,823 and $59,407 for the Tennessee HMO; $1,112 and $36,691 for the Alabama HMO; $6,771 and $16,040 for the Florida HMO; and $8,912 and $42,491 for the Texas HMO, respectively. Each of these subsidiaries were in compliance with applicable statutory requirements as of December 31, 2007. The HMOs are restricted from making dividend payments to the Company without appropriate regulatory notifications and approvals or to the extent such dividends would put them out of compliance with statutory capital requirements. At December 31, 2007, $389.3 million of the Company’s $425.5 million of cash, cash equivalents, investment securities and restricted investments were held by the Company’s HMO subsidiaries and subject to these dividend restrictions.
Prior to the recapitalization, approximately 15% of the ownership interests in two of our Tennessee management subsidiaries and approximately 27% of the membership interests of our Texas HMO subsidiary, Texas HealthSpring, LLC, were owned by outside investors. Contemporaneously with the recapitalization, we purchased all of the minority interests in our Tennessee subsidiaries and a portion of the membership interests held by the minority investors in Texas HealthSpring, LLC. Following the purchase, the outside investors in Texas HealthSpring, LLC owned an approximately 9% ownership interest. Following a private placement in June 2005, and as of December 31, 2005, the outside investors owned an approximately 15.9% interest in Texas HealthSpring, LLC, which interest was automatically exchanged, without additional consideration, for 2,040,194 shares of our common stock immediately prior to the IPO.
The recapitalization was accounted for using the purchase method. The aggregate transaction value for the recapitalization was $438,576, which was substantially in excess of NewQuest, LLC’s book value. The transaction value included $5,295 of capitalized acquisition related costs and $6,366 of deferred financing costs. In addition, NewQuest, LLC incurred $6,941 of transaction costs which were expensed during the two-month period ended February 28, 2005 and the Company incurred $4,000 of transaction costs which were expensed during the ten-month period ended December 31, 2005.
Selected unaudited quarterly financial data in 2007 and 2006 are as follows: