10-Q 1 fhg02q2.txt FORM 10Q FOR QUARTERLY PERIOD ENDED JUNE 30, 2002 FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 {X} QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2002 OR { } TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition period from ________ to ________ Commission file number 0-15846 First Health Group Corp. (formerly HealthCare COMPARE Corp.) (Exact name of registrant as specified in its charter) Delaware 36-3307583 ------------------------------- ------------------------------------ (State or other jurisdiction of (IRS Employer Identification Number) incorporation or organization) 3200 Highland Avenue, Downers Grove, Illinois 60515 --------------------------------------------------- (Address of principal executive offices, Zip Code) (630) 737-7900 ------------------------------------------------ (Registrant's phone number, including area code) __________________________ (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ________ Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. The number of shares of Common Stock, par value $.01 per share, outstanding on August 7, 2002, was 101,299,204. First Health Group Corp. and Subsidiaries INDEX Part I. Financial Information Page Number ----------- Item 1. Financial Statements Consolidated Balance Sheets - Assets at June 30, 2002 and December 31, 2001 ................................... 3 Consolidated Balance Sheets - Liabilities and Stockholders' Equity at June 30, 2002 and December 31, 2001 ........... 4 Consolidated Statements of Operations for the three months ended June 30, 2002 and 2001 ............................ 5 Consolidated Statements of Operations for the six months ended June 30, 2002 and 2001 ............................ 6 Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2002 and 2001 ....... 7 Consolidated Statements of Cash Flows for the six months ended June 30, 2002 and 2001 ............................ 8-9 Notes to Consolidated Financial Statements ................ 10-15 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ............ 16-22 Item 3. Quantitative and Qualitative Disclosures About Market Risk .................................... 23 Part II. Other Information Item 4. Submission of Matters to a Vote of Security Holders ............................... 24 Item 6. Exhibits and Reports on Form 8-K ................. 24 Signatures....................................................... 25 PART 1. Financial Information First Health Group Corp. and Subsidiaries CONSOLIDATED BALANCE SHEETS (in thousands) (Unaudited) ---------------------------------------------------------------------------- ASSETS June 30, 2002 December 31, 2001 ---------- ---------- Current Assets: Cash and cash equivalents ............ $ 31,611 $ 14,001 Short-term investments ............... 2,130 2,381 Accounts receivable, less allowances for doubtful accounts of $16,220 and $ 14,327 respectively.......... 75,689 78,793 Deferred income taxes ................ 27,540 27,429 Other current assets ................. 15,996 20,757 Assets held for sale ................. -- 6,958 --------- --------- Total current assets ................. 152,966 150,319 Long-Term Investments: Marketable securities ................ 67,943 65,766 Other ................................ 56,081 55,205 --------- --------- 124,024 120,971 --------- --------- Property and Equipment: Land, buildings and improvements ..... 94,247 87,468 Computer equipment and software ...... 193,480 180,152 Office furniture and equipment ....... 24,449 20,282 --------- --------- 312,176 287,902 Less accumulated depreciation and amortization....................... (127,832) (105,393) --------- --------- Net property and equipment ........... 184,344 182,509 --------- --------- Goodwill, less accumulated amortization of $ 17,341 and $ 17,341, respectively 280,105 255,855 Intangible assets, less accumulated amortization of $ 2,447 and $ 955, respectively ......................... 47,025 42,859 Reinsurance recoverable................. 25,277 26,140 Other Assets............................ 4,795 2,081 --------- --------- $ 818,536 $ 780,734 ========= ========= See Notes to Consolidated Financial Statements First Health Group Corp. and Subsidiaries CONSOLIDATED BALANCE SHEETS (in thousands) (Unaudited) ---------------------------------------------------------------------------- LIABILITIES AND STOCKHOLDERS' EQUITY June 30, 2002 December 31, 2001 --------- --------- Current Liabilities: Accounts payable ..................... $ 43,225 $ 33,257 Accrued expenses ..................... 65,102 66,384 Current maturities of long-term debt.. -- 197,500 Claims reserves ...................... 13,745 12,308 Income taxes payable ................. 13,574 -- --------- --------- Total current liabilities ............ 135,646 309,449 Long-Term Debt.......................... 130,000 -- Claims Reserves - Non-Current........... 25,277 26,140 Deferred Taxes.......................... 84,579 84,828 Other Non-Current Liabilities........... 21,191 21,018 --------- --------- Total liabilities .................... 396,693 441,435 --------- --------- Commitments and Contingencies........... -- -- Stockholders' Equity: Common stock ......................... 1,334 1,313 Additional paid-in capital ........... 289,768 255,489 Retained earnings .................... 449,807 386,309 Stock option loan receivable ......... (1,688) (1,776) Accumulated comprehensive gain (loss). (302) 161 Treasury stock, at cost .............. (317,076) (302,197) --------- --------- Total stockholders' equity ........... 421,843 339,299 --------- --------- $ 818,536 $ 780,734 ========= ========= See Notes to Consolidated Financial Statements First Health Group Corp. and Subsidiaries CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands) (Unaudited) ---------------------------------------------------------------------------- Three Months Ended June 30, --------------------------- 2002 2001 --------- --------- Revenues............................ $ 175,923 $ 138,949 --------- --------- Operating expenses: Cost of services ................. 75,077 60,438 Selling and marketing ............ 17,755 13,233 General and administrative ....... 11,956 8,622 Healthcare benefits .............. 3,903 3,396 Depreciation and amortization .... 13,356 11,285 --------- --------- 122,047 96,974 --------- --------- Income from operations.............. 53,876 41,975 Other (income) expense: Interest expense ................. 1,503 1,119 Interest income .................. (1,544) (1,714) --------- --------- Income before income taxes.......... 53,917 42,570 Income taxes........................ (21,433) (17,241) --------- --------- Net income $ 32,484 $ 25,329 ========= ========= Weighted average shares outstanding - basic 101,217 97,765 ========= ========= Net income per common share - basic. $ .32 $ .26 ========= ========= Weighted average shares outstanding - diluted 104,735 102,396 ========= ========= Net income per common share - diluted $ .31 $ .25 ========= ========= See Notes to Consolidated Financial Statements First Health Group Corp. and Subsidiaries CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands) (Unaudited) ---------------------------------------------------------------------------- Six Months Ended June 30, ------------------------- 2002 2001 --------- --------- Revenues............................ $ 345,284 $ 275,933 --------- --------- Operating expenses: Cost of services ................. 148,049 120,175 Selling and marketing ............ 34,833 26,177 General and administrative ....... 23,349 16,992 Healthcare benefits .............. 7,684 7,099 Depreciation and amortization .... 26,328 21,887 --------- --------- 240,243 192,330 --------- --------- Income from operations.............. 105,041 83,603 Other (income) expense: Interest expense ................. 2,819 3,590 Interest income .................. (3,172) (3,565) --------- --------- Income before income taxes.......... 105,394 83,578 Income taxes........................ (41,896) (33,849) --------- --------- Net income.......................... $ 63,498 $ 49,729 ========= ========= Weighted average shares outstanding - basic 100,759 97,270 ========= ========= Net income per common share - basic $ .63 $ .51 ========= ========= Weighted average shares outstanding - diluted 104,584 102,034 ========= ========= Net income per common share - diluted $ .61 $ .49 ========= ========= See Notes to Consolidated Financial Statements First Health Group Corp. and Subsidiaries CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (in thousands) (Unaudited) ---------------------------------------------------------------------------- Three Months Ended June 30, --------------------------- 2002 2001 --------- --------- Net income.................................. $ 32,484 $ 25,329 --------- --------- Unrealized gains (losses) on securities, before tax................................ (179) 79 Income tax (expense) benefit related to items of other comprehensive income....... 66 (45) --------- --------- Other comprehensive income (loss)........... (113) 34 --------- --------- Comprehensive income........................ $ 32,371 $25,363 ========= ========= Six Months Ended June 30, ------------------------- 2002 2001 --------- --------- Net income.................................. $ 63,498 $ 49,729 --------- --------- Unrealized gains (losses) on securities, before tax................................ (712) 1,673 Income tax (expense) benefit related to items of other comprehensive income....... 249 (630) --------- --------- Other comprehensive income (loss)........... (463) 1,043 --------- --------- Comprehensive income........................ $ 63,035 $ 50,772 ========= ========= See Notes to Consolidated Financial Statements First Health Group Corp. and Subsidiaries CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (Unaudited) ---------------------------------------------------------------------------- Six Months Ended June 30, ------------------------- 2002 2001 --------- --------- Cash flows from operating activities: Cash received from customers ............ $ 350,126 $ 265,706 Cash paid to suppliers and employees .... (202,665) (163,697) Healthcare benefits paid ................ (7,418) (8,545) Interest income received ................ 1,684 2,613 Interest expense paid ................... (2,500) (3,848) Income taxes paid, net .................. (7,439) (15,976) --------- --------- Net cash provided by operating activities 131,788 76,253 --------- --------- Cash flows from investing activities: Purchases of investments ................ (30,355) (22,711) Sales of investments .................... 27,096 12,211 Acquisition, net of cash acquired ....... (24,227) -- Assets held for sale .................... 923 -- Purchase of property and equipment ...... (27,001) (37,107) --------- --------- Net cash used in investing activities ... (53,564) (47,607) --------- --------- Cash flows from financing activities: Purchase of treasury stock .............. (14,813) -- Issuances of long-term debt ............. 150,000 -- Repayment of long-term debt ............. (217,500) (65,000) Stock option loans to employees ......... (2,272) (1,500) Stock option loan repayments ............ 2,360 756 Proceeds from issuance of common stock .. 21,436 25,649 Sales of put options on common stock .... 375 -- --------- --------- Net cash used in financing activities ... (60,414) (40,095) --------- --------- Net increase (decrease) in cash and cash equivalents......................... 17,810 (11,449) Cash and cash equivalents, beginning of period...................... 14,001 23,538 --------- --------- Cash and cash equivalents, end of period... $ 31,811 $ 12,089 ========= ========= See Notes to Consolidated Financial Statements First Health Group Corp. and Subsidiaries CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (Unaudited) ---------------------------------------------------------------------------- Six Months Ended June 30, -------------------------- 2002 2001 --------- --------- Reconciliation of Net Income to Net Cash Provided by Operating Activities: Net Income.................................. $ 63,498 $ 49,729 --------- --------- Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities Net of Effects of Acquisition: Depreciation and amortization .......... 26,328 21,887 Change in provision for uncollectible receivables .......................... 1,893 2 Tax benefit from stock options exercised 12,423 10,935 Deferred income taxes .................. (111) 5,649 Other, net ............................. 503 (1,024) Changes in Assets and Liabilities: Accounts receivable .................... 1,790 (11,320) Other current assets ................... 4,788 2,436 Reinsurance recoverable ................ 863 1,023 Accounts payable and accrued expenses... 8,206 (1,903) Claims reserves ........................ 574 (1,155) Income taxes payable ................... 13,574 -- Non-current assets and liabilities ..... (2,541) (6) --------- --------- Total adjustments ........................ 68,290 26,524 --------- --------- Net cash provided by operating activities $ 131,788 $ 76,253 ========= ========= See Notes to Consolidated Financial Statements First Health Group Corp. and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. The unaudited financial statements herein have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission. The accompanying interim financial statements have been prepared under the presumption that users of the interim financial information have either read or have access to the audited financial statements for the latest fiscal year ended December 31, 2001. Accordingly, footnote disclosures which would substantially duplicate the disclosures contained in the December 31, 2001 audited financial statements have been omitted from these interim financial statements. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. Although the Company believes that the disclosures are adequate to make the information presented not misleading, it is suggested that these interim financial statements be read in conjunction with the financial statements and the notes thereto included in the Company's latest Annual Report on Form 10-K. 2. On August 16, 2001, the Company completed the acquisition of all of the outstanding shares of capital stock of CCN Managed Care, Inc. ("CCN") and Preferred Works, Inc. ("PW" and together with CCN, the "CCN Companies") from HCA-The Healthcare Company and VH Holdings, Inc. (collectively, the "Sellers") for a purchase price of $195 million in cash, plus a working capital adjustment which increased the purchase price to $198 million. The allocation of the purchase price is subject to completion of the Company's restructuring and integration plan. Changes to the preliminary purchase price allocation resulting from the finalization of these items may be material. The allocation of the purchase price to the fair value of assets acquired and liabilities assumed is as follows: (in thousands) Purchase price $195,000 Working capital adjustment 3,514 Transaction costs 2,000 ------- Total estimated purchase price $200,514 ------- Purchase price has been allocated as follows: Fair value of assets acquired $ 33,611 Assets held for sale 9,965 Goodwill 177,350 Intangible assets acquired 43,814 Liabilities assumed (23,113) Liability for restructuring and integration costs (41,113) ------- $200,514 ------- In conjunction with the acquisition, the Company recorded as part of the purchase price a $41.1 million reserve for restructuring and integration costs as part of an overall plan to reduce operating expenses and integrate the business of the acquired companies. The specific actions included in the restructuring plan are expected to be substantially complete by December 31, 2002. Components of the purchase reserve are as follows: Accrual 2002 Accrual (in thousands) Total Balance Balance Amount -------------- Charges 1/01/02 Incurred 6/30/02 ------- ------- -------- ------- Severance and related $13,712 $ 6,031 $(2,766) $ 3,265 benefits Facilities integration 10,370 9,528 (693) 8,835 Contract losses 10,000 9,750 (267) 9,483 Other reserves 7,031 7,028 (21) 7,007 ------- ------- -------- ------- Total $41,113 $32,337 $(3,747) $28,590 ======= ======= ======== ======= The restructuring plan includes the reduction of employees from various offices within the United States. The Company expects to reduce the number of CCN employees from approximately 1,300 at the time of the acquisition to approximately 650 at December 31, 2002. There were approximately 700 such employees as of June 30, 2002. During the first six months of 2002, approximately $2.8 million was charged to the purchase reserve for severance and related employee benefits with $1.6 million of such costs charged during the second quarter. Facilities integration costs represent the costs the Company expects to incur to integrate CCN's facilities into the Company's existing operations. The majority of the facilities integration costs will be incurred to consolidate CCN's former corporate headquarters and various sales offices throughout the United States. Approximately $0.7 million of costs for facilities integration was charged to the purchase reserve in the first six months of 2002 with $0.4 million charged during the second quarter. Contract losses relate to the anticipated net loss to be incurred on an assumed contract to provide certain screening services to individuals who have agreed to be bound by a proposed settlement in a legal matter. CCN signed a contract in March 2000 to provide these services for four years and the Company has agreed to have its network providers provide these services as part of the acquisition of CCN. The Company estimates as many as 250,000 covered persons may seek such screening services and the Company will incur a significant administrative burden in completing claims to the satisfaction of the contractual terms. Approximately $0.3 million of costs under this contract was charged to the purchase reserve during the six months ended June 30, 2002 with $0.1 million charged during the second quarter. Other reserves represent various operational and tax liabilities the Company expects to incur to fully integrate the Company's operations. Approximately $21,000 was charged to the purchase reserve in the six months ended June 30, 2002, none in the second quarter. The Company reviewed the various businesses comprising the CCN Companies and determined to hold the PW and the Resource Opportunity, Inc. ("ROI") businesses of CCN for sale. The sale of ROI was completed on December 28, 2001 for a sale price of $9 million. The sale of PW was completed on June 28, 2002 for a sale price of $4.1 million. The Company adjusted the goodwill on the CCN acquisition from $171.3 million to $177.3 million as a result of the completion of these sales. The following unaudited pro forma information reflects the results of the Company's operations as if the acquisition had occurred at the beginning of 2001 adjusted for (i) the effect of recurring charges related to the acquisition, primarily the amortization of intangible assets over estimated useful lives of 15 or 20 years, as appropriate, and the recording of interest expense on borrowings to finance the acquisition; (ii) the reduction of depreciation expense due to the write-down to fair value of fixed assets, the reduction of amortization expense related to the CCN Companies' preexisting goodwill at the date of acquisition and the elimination of compensation and benefit expenses for certain executives of the CCN Companies who were terminated at or immediately subsequent to the acquisition and will not be replaced; and (iii) the removal of revenues and related cost of services and expenses for acquired businesses that are held for sale. Three Months Six Months Ended June 30, Ended June 30, 2001 2001 (In thousands except per share data) -------------- -------------- Pro forma: Revenue $163,834 $325,703 Net income 24,892 49,394 Net income per common share - basic .25 .51 Net income per common share - diluted .24 .48 These pro forma results have been prepared for comparative purposes only and do not purport to be indicative of what operating results would have been had the acquisition actually taken place at the beginning of 2001, nor do they purport to represent results of future operations of the merged companies. On May 1, 2002, the Company completed the acquisition of HealthCare Value Management ("HCVM") for an initial purchase price of $24 million. The Company may pay an additional $16 million over the next three years based upon certain HCVM performance measures. HCVM is a small New England based PPO company, headquartered in suburban Boston. The acquisition was accounted for by the purchase method of accounting in accordance with Statement of Financial Accounting Standards No. 141. The acquisition was financed from borrowings under the Company's existing line of credit. The results of operations and assets acquired are immaterial to the consolidated financial statements of the Company. Consequently, no pro forma financial results are included herein. 3. On April 23, 2002, the Company obtained a $400 million revolving credit facility to replace its previous $350 million credit facility that was due to expire on June 30, 2002. This new credit facility has a five- year term and provides for interest at a Euro dollar rate (which approximates LIBOR) plus a variable margin which fluctuates based on the Company's debt rating. The facility also has a corresponding fee calculated at a variable rate of the available facility balance depending on the debt rating of the Company. The interest rate at June 30, 2002 was approximately 5% per annum. No principal payments are due on this facility until its maturity. 4. The Company's investments in marketable securities which are classified as available for sale had a net unrealized loss in market value of $463,000, net of deferred income taxes, for the six month period ended June 30, 2002. The net unrealized loss as of June 30, 2002, included as a component of stockholders' equity, was $302,000, net of deferred income taxes. The Company has six separate investments in a limited partnership which invests in equipment which is leased to third parties. The total investment as of June 30, 2002 and December 31, 2001 was $47.9 million and $47.1 million, respectively, and is accounted for using the equity method. The Company's proportionate share of the partnership's income was $1.5 million and $1.4 million for the six months ended June 30, 2002 and 2001, respectively, and is included in interest income. Approximately 90 percent of this partnership is owned by parties related to a former member of the Company's Board of Directors. All transactions are made on an arms- length basis at equal terms between all limited partners. 5. The Company's Board of Directors has approved the repurchase of up to 15 million shares of the Company's outstanding common stock under its current authorization. Purchases may be made from time to time, depending on market conditions and other relevant factors. During the quarter ended June 30, 2002 the Company repurchased 525,000 shares on the open market for approximately $14.8 million. As of June 30, 2002, approximately 4.7 million shares remain available for repurchase under the Company's current repurchase authorization. In connection with this stock repurchase plan, during the quarter ended June 30, 2002, the Company sold put options which obligated the Company, at the election of the option holders, to repurchase up to 500,000 shares of common stock at a price of $26.45. No such put options were outstanding as of June 30, 2001. 6. Weighted average shares outstanding increased for diluted earnings per share by 3,518,000 and 3,825,000 and by 4,631,000 and 4,764,000 respectively, for the three and six months ended June 30, 2002 and 2001 due to the effect of stock options outstanding. Diluted net income per share was .01 and .02 less than basic net income per share for the three and six months ended June 30, 2002 due to the effect of stock options outstanding. Diluted net income per share was .01 and .02 less than basic net income per share for the three and six months ended June 30, 2001 due to the effect of stock options outstanding. 7. Effective January 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 133, ("SFAS No. 133), "Accounting For Derivative Instruments and Hedging Activities". SFAS No. 133 requires that all derivative instruments be recognized as either assets or liabilities in the balance sheet and that derivative instruments be measured at fair value. This statement also requires changes in the fair value of derivatives to be recorded each period in current earnings or comprehensive income depending on the intended use of the derivative. There was no material effect on the Company's results of operations or financial position as a result of the adoption of SFAS No. 133. In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 141 ("SFAS 141"), "Business Combinations." SFAS 141 requires the purchase method of accounting for business combinations initiated after June 30, 2001 and eliminates the pooling-of-interests method. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets", which the Company adopted effective January 1, 2002. SFAS 142 requires, among other things, the discontinuance of goodwill amortization effective December 31, 2001. In addition, the standard includes provisions for the reassessment of the useful lives of existing recognized intangibles and the identification of reporting units for purposes of assessing potential future impairments of goodwill. In accordance with these pronouncements, the Company accounted for the acquisition of CCN as a purchase and allocated the purchase price to all identifiable tangible and intangible assets and liabilities. The goodwill resulting from this acquisition of approximately $177 million has not been amortized. Goodwill and intangible assets of approximately $102 million acquired in business combinations completed before July 1, 2001 was amortized through December 31, 2001. In accordance with SFAS 142, none of the Company's $280 million in net goodwill was amortized during the six months ended June 30, 2002. The following table reflects the effect of SFAS 142 on net income and earnings per share as if SFAS 142 had been in effect for all periods presented: Three Months Six Months (in thousands) Ended Ended June 30, June 30, 2001 2001 ------- ------- Net income $25,329 $49,729 Add back goodwill amortization 867 1,734 Tax effect of amortization (351) (702) ------- ------- Adjusted net income $25,845 $50,761 ======= ======= Adjusted income per common share - Basic $ .26 $ .52 ======= ======= Adjusted income per common share - Diluted $ .25 $ .50 ======= ======= In accordance with the provisions of SFAS 142, the Company completed a transitional goodwill impairment test within six months of the date of adoption. The Company used standard valuation techniques including an analysis of expected business performance and analysis of recent acquisitions within the healthcare industry. There was no impairment in goodwill amounts as a result of this transitional impairment test. The Company will perform an annual impairment during the third quarter of each year or at such earlier time that circumstances warrant an interim valuation. Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 144 ("SFAS 144"), "Accounting for the Impairment or Disposal of Long-Lived Assets". SFAS 144 addresses accounting and reporting for the impairment or disposal of long-lived assets, including discontinued operations, and establishes a single accounting model for long-lived assets to be disposed of by sale. The adoption of this pronouncement did not have a material impact on the financial position and results of operations of the Company. 8. On July 1, 2002, the Company completed its acquisition of the operational and administrative assets from CNA Insurance Company for a purchase price of $20 million. Included in this transaction is the transfer of approximately 1,000 CNA employees and related assets which support the Mail Handlers Benefit Plan (the "Plan") offices in various cities. The acquisition relates to a long-term contract that the Company announced in April 2002 to provide its comprehensive health plan services to the Plan. 9. The Company and its subsidiaries are subject to various claims arising in the ordinary course of business and are parties to various legal proceedings that constitute litigation incidental to the business of the Company and its subsidiaries. The Company's wholly owned subsidiary, First Health Services Corporation ("Services") continues to be subject to an investigation by the District of Columbia Office of Inspector General ("OIG"). In July 2000, the OIG issued a report evaluating the District of Columbia's Medicaid program and suggesting ways to improve the program. Services, a subsidiary of the Company that was acquired in July 1997, has acted as the program's fiscal agent intermediary for more than 20 years. The OIG report included allegations that from 1993 to 1996, Services, in its role as fiscal agent intermediary, made erroneous Medicaid payments to providers on behalf of patients no longer eligible to receive Medicaid benefits. The Company does not believe that the outcome of the claim or the investigation will have a material adverse effect on the Company's business or financial position. First Health Group Corp. and Subsidiaries Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Unaudited) Forward-Looking Information --------------------------- This Management's Discussion and Analysis of Financial Condition and Results of Operations may include certain forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including (without limitation) statements with respect to anticipated future operating and financial performance, growth and acquisition opportunities and other similar forecasts and statements of expectation. Words such as "expects", "anticipates", "intends", "plans", "believes", "seeks", "estimates", "could" and "should" and variations of these words and similar expressions, are intended to identify these forward-looking statements. Forward-looking statements made by the Company and its management are based on estimates, projections, beliefs and assumptions of management at the time of such statements and are not guarantees of future performance. The Company disclaims any obligation to update or revise any forward-looking statement based on the occurrence of future events, the receipt of new information or otherwise. Actual future performance, outcomes and results may differ materially from those expressed in forward-looking statements made by the Company and its management as a result of a number of risks, uncertainties and assumptions. Representative examples of these factors include (without limitation) general industry and economic conditions; interest rate trends; cost of capital and capital requirements; competition from other managed care companies; the ability to expand certain areas of the Company's business; shifts in customer demands; changes in operating expenses, including employee wages, benefits and medical inflation; governmental and public policy changes and the continued availability of financing in the amounts and on the terms necessary to support the Company's future business. In addition, if the Company does not continue to successfully implement new contracts and programs and control healthcare benefit expenses; if the Company is not able to successfully integrate CCN (defined below) and achieve the cost synergies anticipated as a result of the acquisition; or if the Company does not successfully integrate the recently acquired Mail Handlers Benefit Plan administrative assets (discussed below); the Company may not achieve its anticipated 2002 financial results. Recent Developments ------------------- Mail Handlers Benefit Plan -------------------------- On April 16, 2002, the Company entered into a long-term contract with the National Postal Mail Handlers Union, the sponsor of the Mail Handlers Benefit Plan (the "Plan"), whereby the Company will provide its comprehensive health plan services to the Plan. The Plan has nearly 400,000 federal employees and annuitants representing approximately one million members nationwide, and is one of the nation's largest health plans. This new contract builds on an existing agreement which the Company has to provide the First Health NetworkR to the Plan's members. The new contract is valued at over $1.3 billion in service revenue over the initial five-year term. On July 1, 2002, the Company completed the acquisition of the operational and administrative assets used to provide the various services required by this new contract (see Note 8) for a purchase price of $20 million. The transaction includes the transfer of approximately 1,000 CNA employees and related assets which support the Plan in various offices throughout the United States. These employees will assume the same function for First Health providing the Company with an experienced team of personnel already accustomed to administering the one-million-member plan. The Company believes this acquisition will significantly reduce the need for typical implementation efforts related to the new contract. CCN Acquisition --------------- On August 16, 2001, the Company completed the acquisition of all of the outstanding shares of capital stock of CCN Managed Care, Inc. ("CCN") and Preferred Works, Inc. ("PW" and together with CCN, the "CCN Companies") from HCA-The Healthcare Company and VH Holdings, Inc. (collectively, the "Sellers") for a purchase price of $195 million in cash, plus a working capital adjustment which increased the purchase price to $198 million. The acquisition was effected pursuant to the terms of a Stock Purchase Agreement, dated as of May 18, 2001 (as amended as of August 16, 2001), among the Company and the Sellers. The acquisition was financed from borrowings under the Company's previous line of credit. The Company reviewed the various businesses comprising the CCN Companies and determined to hold the PW and the Resource Opportunity, Inc. ("ROI") businesses of CCN for sale. The Company completed the sale of ROI on December 28, 2001 for a sale price of $9 million. The sale of PW was completed on June 28, 2002 for a sale price of $4.1 million. In conjunction with the acquisition, the Company recorded as part of the purchase price a $41.1 million reserve for restructuring and integration costs as part of an overall plan to reduce operating expenses and integrate the business of the acquired companies. The specific actions included in the restructuring plan are expected to be substantially complete by December 31, 2002. The actions taken to implement the restructuring plan are expected to generate in excess of $25 million in annualized savings for the Company from lower salaries and benefits costs and lower overall operating expenses, beginning in 2002. Components of the purchase reserve are as follows: Accrual 2002 Accrual (in thousands) Total Balance Amount Balance -------------- Charges 1/01/02 Incurred 6/30/02 ------- ------- -------- ------- Severance and related benefits $13,712 $ 6,031 $ (2,766) $ 3,265 Facilities integration 10,370 9,528 (693) 8,835 Contract losses 10,000 9,750 (267) 9,483 Other reserves 7,031 7,028 (21) 7,007 ------- ------- -------- ------- Total $41,113 $32,337 $ (3,747) $28,590 ======= ======= ======== ======= The restructuring plan includes the reduction of employees from various offices within the United States. The Company expects to reduce the number of CCN employees from approximately 1,300 at the time of the acquisition to approximately 650 at December 31, 2002. There were approximately 680 such employees as of June 30, 2002. During the first six months of 2002, approximately $2.8 million was charged to the purchase reserve for severance and related employee benefits with $1.6 million of such costs charged during the second quarter. Facilities integration costs represent the costs the Company expects to incur to integrate CCN's facilities into the Company's existing operations. The majority of the facilities integration costs will be incurred to consolidate CCN's former corporate headquarters and various sales offices throughout the United States. Approximately $0.7 million of costs for facilities integration was charged to the purchase reserve in the first six months of 2002 with $0.4 million charged during the second quarter. Contract losses relate to the anticipated net loss to be incurred on an assumed contract to provide certain screening services to individuals who have agreed to be bound by a proposed settlement in a legal matter. CCN signed a contract in March 2000 to provide these services for four years and the Company has agreed to have its network providers provide these services as a part of the acquisition of CCN. The Company estimates as many as 250,000 covered persons may seek such screening services and the Company will incur a significant administrative burden in completing claims to the satisfaction of the contractual terms. Approximately $0.3 million of costs under this contract was charged to the purchase reserve during the six months ended June 30, 2002 with $0.1 million charged during the second quarter. Other reserves represent various operational and tax liabilities the Company has incurred to fully integrate the Company's operations. Approximately $21,000 was charged to the reserve in the six months ended June 30, 2002, none during the second quarter. HCVM Acquisition ---------------- On May 1, 2002, the Company completed the acquisition of HealthCare Value Management ("HCVM") for an initial purchase price of $24 million. The Company may pay an additional $16 million over the next three years if HCVM meets certain performance measures. HCVM is a small New England based PPO company, headquartered in suburban Boston. The acquisition was financed from borrowings under the Company's existing line of credit. Results of Operations --------------------- The Company's revenues consist primarily of fees for cost management services provided under contracts on a percentage of savings basis (PPO) or on a predetermined contractual basis (claims administration, fee schedule, pharmacy benefit management and clinical management services). As a result of the Company's insurance company acquisitions, revenues also include premium revenue. The following table sets forth information with respect to the sources of the Company's revenues for the three and six months ended June 30, 2002 and 2001, respectively: Sources of Revenue ($ in thousands) Three Months Ended June 30, --------------------------- 2002 % 2001 % ------- --- ------- --- Sources of Revenue: PPO Services $110,078 63% $ 78,104 56% Claims Administration 44,491 25 42,529 31 Fee Schedule Services 10,583 6 7,759 5 Clinical Management Services 6,961 4 6,824 5 Premiums, Net 3,810 2 3,733 3 ------- --- ------- --- Total Revenue $175,923 100% $138,949 100% ======= === ======= === ($ in thousands) Six Months Ended June 30, --------------------------- 2002 % 2001 % ------- --- ------- --- Sources of Revenue: PPO Services $214,999 62% $153,815 56% Claims Administration 88,311 26 84,074 30 Fee Schedule Services 20,614 6 16,513 6 Clinical Management Services 13,540 4 13,911 5 Premiums, Net 7,820 2 7,620 3 ------- --- ------- --- Total Revenue $345,284 100% $275,933 100% ======= === ======= === Revenue for the three and six months ended June 30, 2002 increased $36,974,000 (27%) and $69,351,000 (25%), respectively, from the same periods of 2001 due to strong PPO revenue which increased 41% from the second quarter of 2001. The increase in PPO revenue for the three and six months ended June 30, was due to new client activity, existing clients utilizing more PPO services, the overall increase in PPO providers and the addition of CCN and HCVM revenue. Claims administration revenue increased $1,962,000 (5%) and $4,237,000 (5%) from the same periods last year due primarily to new business particularly in the commercial sector. Revenue from fee schedule services increased $2,824,000 (36%) and $4,101,000 (25%) from the comparable periods in 2001 due primarily to the inclusion of CCN business. Revenue from clinical cost management services increased $137,000 (2%) for the three months ended June 30, 2002 and decreased $371,000 (3%) for the six months ended June 30, 2002 from the comparable periods in 2001. The overall decrease is due principally to the termination of certain healthcare management contracts with various state Medicaid programs. Premium revenue increased $77,000 (2%) and $200,000 (3%) for the three and six months ended June 30, 2002 due primarily to the addition of new stop loss insurance clients. Cost of services increased $14,639,000 (24%) and $27,874,000 (23%) for the three and six months ended June 30, 2002 from the comparable periods of 2001 due primarily to the inclusion of CCN and HCVM costs. Cost of services consists primarily of salaries and related costs for personnel involved in claims administration, PPO administration, development and expansion, utilization management programs, fee schedule and other cost management and administrative services offered by the Company. To a lesser extent, cost of services includes telephone expenses, facility expenses and information processing costs. As a percentage of revenue, cost of services decreased to 42.7% and 42.9% for the three and six months ended June 30, 2002, respectively, from 43.5% and 43.6% in the comparable periods last year. More importantly, cost of services remained consistent with the fourth quarter of 2001 due to the synergies associated with combining various CCN and First Health operations. Selling and marketing costs for the three and six months ended June 30, 2002 increased $4,522,000 (34%) and $8,656,000 (33%) from the comparable periods of 2001 also as a result of the addition of CCN costs. To a lesser extent, the increase is due to increased expenditures for the Company's focused national marketing campaign which began in the first quarter of 2000 and to the addition of new sales personnel. General and administrative costs for the three and six months ended June 30, 2002 increased $3,334,000 (39%) and $6,357,000 (37%) from the comparable periods of 2001 due primarily to the inclusion of CCN costs. These expenses remain consistent with the fourth quarter of 2001 as a result of synergies achieved by combining CCN and First Health operations. Healthcare benefits represent medical losses incurred by insureds of the Company's insurance entities. Healthcare benefits increased $507,000 (15%) and $585,000 (8%) for the three and six months ended June 30, 2002 from the comparable periods of 2001. This increase was due primarily to new client activity. The loss ratio (healthcare benefits as a percent of premiums) was 102% and 98% for the three and six months ended June 30, 2002 compared to 91% and 93% for the comparable periods of 2001. Management continues to review the book of business in detail to minimize the loss ratio. Stop-loss insurance is related to the PPO business and is used as a way to attract additional PPO business, which is the Company's most profitable product. Depreciation and amortization expenses increased $2,071,000 (18%) and $4,441,000 (20%) for the three and six months ended June 30, 2002 from the comparable periods of 2001 due primarily to increased infrastructure investments made over the course of the past few years as well as various software applications which came on-line during 2001 and 2002. The increase was partially offset by the reduction in goodwill amortization of $867,000 and $1,734,000 for the three and six months ended June 30, 2002 (See Note 7). Depreciation expense will continue to grow primarily as a result of continuing investments the Company is making in its infrastructure. Interest income for the three and six months ended June 30, 2002 decreased $170,000 (10%) and $393,000 (11%), respectively, from the comparable periods of 2001 due primarily to the aggressive debt repayments the Company has made with its available cash as well as the overall reduction in interest rates earned on marketable securities. Interest expense for the three and six months ended June 30, 2002, increased $384,000 (34%) and decreased $771,000 (21%) from the comparable periods of 2001. The fluctuations in interest expense are primarily due to changes in the interest rate on the Company's credit facility. The interest rate at June 30, 2002 was approximately 5% per annum and the Company had $130 million of debt outstanding. Net income for the three and six months ended June 30, 2002, increased $7,155,000 (28%) and $13,769,000 (28%) from the comparable periods of 2001. This increase is due primarily to the increase in PPO revenue as well as the synergies achieved in combining CCN and First Health and, to a lesser extent, the other factors discussed above. Diluted net income per common share for the three and six months ended June 30, 2002 increased 24% to $.31 per share and 24% to .61 per share from the comparable periods of 2001. The increase in net income per common share was favorably impacted by the repurchase of 525,000 shares of Company common stock during the second quarter of 2002. The increase was also favorably impacted by the adoption of SFAS No. 142 (See Note 7 and "New Accounting Pronouncements"). For the three months and six months ended June 30, 2002, diluted common shares outstanding increased 2% from the comparable periods of 2001. Liquidity and Capital Resources ------------------------------- The Company had $17,320,000 in working capital at June 30, 2002 compared with negative working capital of $159,130,000 at December 31, 2001. All of the Company's outstanding debt at December 31, 2001 was classified as a current liability as the Company's credit facility was due to expire on June 30, 2002. On April 23, 2002, management obtained a new credit facility which matures in 2007; consequently, the outstanding debt is now classified as long-term. Through the first six months of the year, operating activities provided $131,788,000 of cash. Investment activities used $53,564,000 of cash representing purchases of fixed assets of $27,001,000, the acquisition of HCVM for $24,227,000 and net purchases of investments of $3,259,000 partially offset by $923,000 in changes in assets held for sale. Financing activities used $60,414,000 of cash representing $67,500,000 in repayment of long-term debt (net of $150,000,000 in debt issuance), $14,813,000 in purchases of Company common stock partially offset by $21,436,000 in proceeds from issuance of common stock, $375,000 in proceeds from the sale of put options and $88,000 in stock option loan repayments (net of $2,272,000 in stock option loans granted). The Company had a revolving line of credit in the amount of $350 million which was due to expire on June 30, 2002. On April 23, 2002, the Company obtained a new $400 million revolving line of credit that replaced the previous credit facility. The new facility has a five-year term and provides for interest at a Euro dollar rate (which approximates LIBOR) plus a variable margin and a facility fee that fluctuate based on the Company's debt rating. As of June 30, 2002, $130 million was outstanding under the new facility. The Company believes that its working capital, long-term investments, credit facility and cash generated from future operations will be sufficient to fund the Company's anticipated operations and expansion plans. New Accounting Pronouncements ----------------------------- Effective January 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 133, ("SFAS No. 133), "Accounting For Derivative Instruments and Hedging Activities". SFAS No. 133 requires that all derivative instruments be recognized as either assets or liabilities in the balance sheet and that derivative instruments be measured at fair value. This statement also requires changes in the fair value of derivatives to be recorded each period in current earnings or comprehensive income depending on the intended use of the derivative. There was no material effect on the Company's results of operations or financial position as a result of the adoption of SFAS No. 133. In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 141 ("SFAS 141"), "Business Combinations." SFAS 141 requires the purchase method of accounting for business combinations initiated after June 30, 2001 and eliminates the pooling-of-interests method. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets", which the Company adopted effective January 1, 2002. SFAS 142 requires, among other things, the discontinuance of goodwill amortization effective December 31, 2001. In addition, the standard includes provisions for the reassessment of the useful lives of existing recognized intangibles and the identification of reporting units for purposes of assessing potential future impairments of goodwill. In accordance with these pronouncements, the Company accounted for the acquisition of CCN as a purchase and allocated the purchase price to all identifiable tangible and intangible assets and liabilities. The goodwill resulting from this acquisition of approximately $177 million has not been amortized. Goodwill and intangible assets of approximately $102 million acquired in business combinations completed before July 1, 2001 was amortized through December 31, 2001. In accordance with SFAS 142, none of the Company's $280 million in net goodwill was amortized during the six months ended June 30, 2002. The Company recorded goodwill amortization expense of approximately $0.9 million and $1.7 million, respectively, during the three and six months ended June 30, 2001. In accordance with the provisions of SFAS 142, the Company completed a transitional goodwill impairment test within six months of the date of adoption. The Company used standard valuation techniques including an analysis of expected business performance and analysis of recent acquisitions within the healthcare industry. There was no impairment in goodwill amounts as a result of this transitional impairment test. The Company will perform an annual impairment during the third quarter of each year or at such earlier time that circumstances warrant an interim valuation. Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 144 ("SFAS 144"), "Accounting for the Impairment or Disposal of Long-Lived Assets". SFAS 144 addresses accounting and reporting for the impairment or disposal of long-lived assets, including discontinued operations, and establishes a single accounting model for long-lived assets to be disposed of by sale. The adoption of this pronouncement did not have a material impact on the financial position and results of operations of the Company. Legal Proceedings ----------------- The Company and its subsidiaries are subject to various claims arising in the ordinary course of business and are parties to various legal proceedings that constitute litigation incidental to the business of the Company and its subsidiaries. The Company's wholly owned subsidiary, First Health Services Corporation ("Services") continues to be subject to an investigation by the District of Columbia Office of Inspector General (OIG"). In July 2000, the OIG issued a report evaluating the District of Columbia's Medicaid program and suggesting ways to improve the program. Services, a subsidiary of the Company that was acquired in July 1997, has acted as the program's fiscal agent intermediary for more than 20 years. The OIG report included allegations that from 1993 to 1996, Services, in it role as fiscal agent intermediary, made erroneous Medicaid payments to providers on behalf of patients no longer eligible to receive Medicaid benefits. The Company does not believe that the outcome of the claim or the investigation will have a material adverse effect on the Company's business or financial position. Item 3. Quantitative and Qualitative Disclosures About Market Risk The Company's market risk exposure at June 30, 2002 is consistent with the types of market risk and amount of exposure presented in its 2001 Annual Report on Form 10-K. PART II Item 4. Submission of Matters to a Vote of Security Holders At the annual meeting of stockholders of the Company on May 15, 2002, all directors of the Company who stood for reelection were re-elected. The number of votes cast for and withheld for each director were as follows: For Withheld ---------- --------- Michael J. Boskin 91,441,076 2,366,606 Daniel S. Brunner 91,936,325 1,871,357 Raul Cesan 92,482,680 1,325,002 Robert S. Colman 92,487,930 1,319,752 Ronald H. Galowich 91,015,254 2,792,428 Harold S. Handelsman 91,320,918 2,486,764 Don Logan 92,485,151 1,322,531 William Mayer 92,488,240 1,319,442 David E. Simon 87,519,392 6,288,290 James C. Smith 77,072,545 16,735,137 Edward L. Wristen 91,932,667 1,875,015 A proposal to approve an amendment to the Company's restated certificate of incorporation to increase the number of authorized shares of common stock from 155,000,000 shares to 400,000,000 shares was approved with 81,817,429 shares cast for, 11,180,033 shares against and 810,220 shares abstaining. Item 6. Exhibits and Reports on Form 8-K Exhibits: (a) Exhibit 11 - Computation of Basic Earnings Per Common Share (b) Exhibit 11 - Computation of Diluted Earnings Per Common Share (c) Exhibit 99.1 - Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 - Edward L. Wristen (d) Exhibit 99.2 - Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 - Joseph E. Whitters Reports on Form 8-K: None SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. First Health Group Corp. Dated: August 13, 2002 /s/Edward L. Wristen ------------------------------------ Edward L. Wristen President and Chief Executive Officer Dated: August 13, 2002 /s/Joseph E. Whitters ------------------------------------ Joseph E. Whitters Vice President, Finance and Chief Financial Officer (Principal Financial Officer)