10-K 1 fchn200310k.txt 1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10 - K [ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2003 OR [ ] TRANSITION REPORT PURSUANT SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File No. 0-23998 FIRST CHOICE HEALTH NETWORK, INC. (Exact name of Registrant as specified in its charter) Washington 91-1272766 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 600 University Street Suite 1400 Seattle, Washington 98101 (Address of principal executive offices) (206) 292-8255 (Registrant telephone number, including area code) 1 2 Securities registered pursuant to Section 12 (b) of the Act: None Securities registered under Section 12 (g) of the Act: Class A Common Stock, par value $1.00 per share 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 by check mark whether the registrant is an accelerated filer (as Defined in Rule 12B-2 of the Act). Yes _____ No __X___ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] There is no trading market for the Registrant's common equity (Class A Common Stock, $1.00 par value and Class B Common Stock, $1.00 par value) and, accordingly, the market value of the stock held by non-affiliates of the Registrant based on bid and asked prices cannot be determined. The aggregate number of Registrant's shares outstanding on December 31, 2003 was 537 shares of Class A Common Stock, and 40,600 shares of Class B Common Stock, $1.00 par value, respectively. Documents incorporated by reference: Portions of the definitive Proxy Statement for the 2004 Annual Meeting of Shareholders are hereby incorporated by reference into Part III of Form 10-K. 2 3 PART I ITEM 1 BUSINESS 4 ITEM 2 PROPERTIES 6 ITEM 3 LEGAL PROCEEDINGS 6 ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 6 PART II ITEM 5 MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS 6 ITEM 6 SELECTED FINANCIAL DATA 7 ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 7 ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 11 ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 12 ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE 32 ITEM 9A CONTROLS AND PROCEDURES 32 PART III ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT 32 ITEM 11 EXECUTIVE COMPENSATION 32 ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS 33 ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 33 ITEM 14 PRINCIPAL ACCOUNTANT FEES AND SERVICES 33 PART IV ITEM 15 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K 34 SIGNATURES 36 3 4 PART I ITEM 1. BUSINESS Company Overview First Choice Health Network, Incorporated ("the Company") is a physician and hospital owned company offering preferred provider organization ("PPO"), health benefits management services to large self-funded plan sponsors and until year end 2003 has offered insured health plan products through a subsidiary, First Choice Health Plan, Incorporated ("the Plan"). The Company was organized under the laws of the State of Washington in 1984 and is owned by 537 physicians all of whom own Class A common stock, seven hospital systems who own Class B common stock and four additional hospital participants. The Company's web address is www.1stchoiceofwa.com. The Company's operations have historically consisted of two business segments. The parent company, First Choice Health Network (the "Network"), operates a PPO rental network and the subsidiary company, First Choice Health Plan (the "Plan"), operated as a health care service contractor that accepted insurance risk. The Plan no longer provides insurance services as of January 1, 2004. FORWARD-LOOKING STATEMENTS This report includes forward-looking statements about the future operations of the Company, including discussion of the effects of the Company's exit from the insured health care business, the prospects for the Company's Health Benefits Management("HBM") business, and the adequacy of the Company's reserves for claims expenses and unreported claims. These forward-looking statements involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such factors include the Company's ability to attract and retain HBM customers, the cost of maintaining technological and staff capabilities for health benefits administration, and the risks associated with potential claim volatility and adverse selection as a result of the reduced membership in the Plan due to the Company's decision to exit the insured health care business. Because of these uncertainties, actual future results, performance or achievements may be materially different from the results, performance or achievements expressed or implied by these forward-looking statements. Discontinued Operations As a result of the decision by the Plan's Board of Directors in 2002 authorizing management to exit the insured health care business by no later than December 31, 2003, no business was renewed after January 2003 and the Plan operations are in the process of being wound down in an orderly fashion. As a result of the exit, the Plan's insured membership declined from 28,715 at December 31, 2002 to 4,400 in the month of December, 2003. The Plan's financial information is presented as a discontinued segment in the financial statements. As the Plan ceased to offer its commercial insurance products, a new business strategy of offering health benefits administration services to self-funded employers(health benefits management "HBM") is being implemented. This strategy allows the Company to take advantage of its extensive technological and staff capabilities for health benefits management that were developed for the commercial insurance business. Development of this HBM has helped to mitigate some of the administrative costs of exiting the commercial insurance business by utilizing current infrastructure. HBM membership is 10,470 at December 31, 2003. As a result, the HBM has now replaced the discontinued insurance business as a business segment for the Company. 4 5 PPO Business Segment The Company's principal business since inception has been the development and operation of a preferred provider network ("PPO") of hospitals, physicians and ancillary service providers. Currently, the PPO has approximately 21,700 professional providers and 110 hospitals serving approximately 1.1 million employees and dependents through contracts with 125 payors including insurers, third party administrators ("TPAs"), union trusts and employers. PPO product offerings include medical and utilization management services for certain PPO clients and various specialty network services including a complementary and alternative medicine PPO and Employee Assistance Program (EAP) product and network services, both of which were new PPO product offerings in 2002. The geographic focus of the Company's PPO offerings is Washington State but includes healthcare providers in Alaska, Montana and Idaho to serve employees and dependents in these areas. Revenue from PPO network services including utilization management services takes the form of monthly access fees from participating payors and fees from payers based on a percentage of the savings generated by PPO provider contracts. In addition, participating hospitals pay fees based on PPO claims volumes in those hospitals. HBM business segment The HBM segment offers benefits management and administration services to self-funded employers and insurance carriers. This strategy allows the Company to take advantage of its extensive technological and staff capabilities for health benefits administration that were developed for the commercial insurance business. With certain well defined exceptions, these self-funded benefits administration services will not be offered to potential clients that currently obtain such services from benefit administrators that access the Company's PPO products. PPO Business Segment Products Products currently offered within the PPO business segment include: (1) Access to the PPO or to subsets of the PPO (e.g. Hospital Only access) (2) Medical management services including utilization management services (pre- certification, concurrent review, gap analysis, etc.), catastrophic case management, disease management, consumer decision support tools, etc. (3) Employee Assistance Program provider network and services. (4) Complementary and alternative medicine provider network. Health Benefits Management Business Segment Products (1) Health benefit administration for self-funded employers and insurance carriers. (2) Flexible spending account and health reimbursement account administration. (3) COBRA benefits administration. (4) Medical management services including utilization management services (pre- certification, concurrent review, gap analysis, etc.), catastrophic case management, disease management, consumer decision support tools, etc. Marketing and Sales PPO products are marketed to payers including insurers, third party administrators, union trusts, and employers through an internal sales force that also works closely with the broker and consultant community. HBM products are marketed to insurers and employers through an internal sales force that also works closely with the broker and consultant community. 5 6 Competition The PPO and HBM businesses operate in a highly competitive market. The PPO network competes with other managed health care companies primarily in terms of provider contract reimbursement terms, credentialing quality, accuracy and timeliness of provider maintenance, claim repricing, utilization management and other services provided to payer clients as well as the price of accessing the PPO. The PPO offers excellent provider contract and service value to payer clients compared to other independent PPO networks in Washington and the Northwest as shown by the Company's market position as the largest independent PPO in Washington. The PPO product also competes well against the PPO networks of the two dominant regional insurers in the Northwest. The Company's Heath Benefits Management business competes with numerous other insurance carriers and Third Party Administrators operating in Washington, many of which are significantly larger and have greater financial resources than the Company. Competition for HBM clients is based primarily on price, HBM management operational performance and provider contract terms. Government Regulation The PPO and HBM are subject to significant regulation. The HBM business and the PPO are subject to standards regarding privacy and maintenance and transmission of health information established under the Health Insurance Portability and Accountability Act of 1996 ("HIPAA"). The Company believes it is in compliance with these regulations. Employees As of December 31, 2003, the company had 141 employees. None of the Company's employees are unionized or subject to collective bargaining agreement. Company management believes that its relationship with its employees is good. Item 2. PROPERTIES Prior to June 2003, the Company leased and occupied two offices in Seattle, Washington. Both leases expired in the Summer of 2003. The Company has entered into a new five-year office lease agreement effective June 2003 that has allowed the Company to consolidate its operations at one office at a substantial reduction in lease costs. The new facility is also located in Seattle, Washington. ITEM 3. LEGAL PROCEEDINGS In the normal course of business, the Company may encounter claims, assessments, and litigation brought against the Company. If and when these situations arise, the Company assesses the situation and accrues for financial exposure, if appropriate. As of December 31, 2003, the Company is not aware of any such material situations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable PART II ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS There is no public trading market for any of the Company's equity securities. As of December 31, 2003, there were 537 holders of the Company's Class A Common Stock, seven holders of the Company's Class B Common Stock, three Hospital Participants and a hospital holder of a redeemable equity participation. 6 7 Holders of each class of Common Stock are entitled to share ratably on a share- for-share basis with respect to any dividends on such class of Common Stock, when, as and if declared by the Board of Directors out of funds legally available. Pursuant to the Company's contracts with the Hospital Participants, if the Company pays any dividends or other distributions with respect to the Class B Common Stock, it must make an equivalent distribution to the Hospital Participants. See Item 6 below for information regarding cash dividends paid in December 2003. See "Liquidity and Capital Resources" in Item 7 below for a discussion of anticipated future cash dividends. ITEM 6. SELECTED FINANCIAL DATA
2003 2002 2001 2000 1999 ------------ ------------ ----------- ----------- ---------- Operating revenue, continuing and discontinued operations $ 51,053,380 $ 93,034,185 $122,652,504 $139,144,059 $ 92,097,975 Net income from continuing operations after minority interest 3,936,138 5,776,678 3,067,942 3,758,220 3,301,410 Net income(loss) 4,690,921 1,924,891 (1,407,987) (1,349,859) 1,660,238 Total assets 25,695,039 28,802,641 31,217,479 32,658,089 30,899,535 Total liabilities 6,508,654 13,869,499 18,649,453 20,083,110 16,626,642 Redeemable equity participation 2,520,000 2,385,443 1,991,850 1,617,000 1,260,000 Total Equity 14,744,079 11,325,169 9,338,690 10,784,920 12,148,644 Net income from continuing operations after minority interest per common share 67.24 98.68 52.39 64.16 56.34 Net income(loss) per common share 80.13 32.88 (24.04) (23.04) 28.33 Dividends declared per common share, Class A 187.62 - - - - Dividends declared on Class B shareholders and non-shareholder district hospitals with equivalent rights, per entity 100,000 - - - -
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW The following table summarizes income from continuing operations, discontinued operations and net income for 2001-2003: (In millions) 2003 2002 2001 ---- ---- ---- Income from continuing operations $3.9 5.8 3.1 Income (loss) from discontinued operations .8 (3.9) (4.5) Net income (loss) 4.7 1.9 (1.4) The Company's income from continuing operations decreased by $1.8 million from 2002 to 2003 due to the following: (1) The change in business focus from the insured health plan to the new HBM business segment. The start-up HBM business experienced a net loss of $.6 million in 2003 compared to no activity in 2002. 7 8 (2) As a result of the profitability of the discontinued insured health plan, minority interest expense increased by $.9 million from income of $.5 million in 2002 to expense of $.4 million in 2003 (this represents 20% of the health plan legal entity's net income). Income from continuing operations increased $2.7 million from 2001 to 2002 due primarily to pricing and higher hospital fees received and operational efficiency gains. Consolidated net income has significantly increased by $2.8 million in 2003 to $4.7 million. The increase in 2003 is primarily due to the increased income from discontinued operations of $4.6 million offset by the decrease in income from continuing operations previously noted. Consolidated net income increased by $3.3 million from a loss of $1.4 million in 2001 to $1.9 million income in 2002. This increase is primarily due to the increase in income from continuing operations noted earlier. Financial results for 2003 showed a significant improvement in the Company's financial condition. Shareholders' equity increased by $3.4 million from $11.3 million in 2002 to $14.7 million in 2003. The Company's current ratio (current assets/current liabilities)improved from 1.7 in 2002 to 3.5 at year end 2003. Generally, a higher current ratio indicates increased financial strength. RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 2003 COMPARED TO YEARS ENDED DECEMBER 31, 2002 AND 2001 The following table summarizes operating revenues for 2001-2003: (in millions) 2003 2002 2001 ---- ---- ---- Network access fees $10.0 9.1 8.6 Hospital administrative fees 9.0 9.6 7.7 Health benefit management fees 1.9 - - Other .6 .2 .2 ---- ---- ---- Total Operating Revenues 21.4 18.9 16.6 Operating revenue of continuing operations increased $2.5 million (13.5%) from 2002 to 2003 and increased $2.3 million (13.9%) from 2001 to 2002. The increase from 2002 to 2003 was primarily attributable to income from the new health benefits management business segment with an operating revenue of $1.9 million and income from additional services offered through the PPO business segment in employee assistance programs and case management services of $.4 million. Hospital administrative fees increased $1.9 million (24.2%) from 2001 to 2002. This increase was primarily due to higher volume of services provided by the hospitals and billed charge inflation at hospitals with administrative fees based on charges. The following table summarizes operating expenses for 2001-2003: (in millions) 2003 2002 2001 ---- ---- ---- Payroll and related expenses $8.2 5.9 6.0 Selling, general and administrative 6.3 4.6 3.7 Amortization - - 1.0 ---- ---- ---- Total Operating Expenses 14.5 10.5 10.7 Payroll and related expenses increased $2.3 million (39%)from 2002 to 2003 while selling, general and administrative expenses increased $1.7 million (37%) from 2002 to 2003. These increases are primarily due to a shift of $2.9 million in expenses from the discontinued operations of the Plan to the HBM operations as the Plan exits the insurance business. The remaining increase is due to higher operating expenses for the PPO segment resulting from various initiatives including obtaining Utilization Review Accreditation Commission (URAC) accreditation for credentialing, implementation of a new proprietary PPO information system and various provider initiatives. Selling, general and 8 9 administrative expenses increased $.9 million from 2001 to 2002. This increase resulted from higher spending in several cost categories with the single largest increase of $.4 million for advisory fees related to exploring options for the disposition of the Health Plan. Amortization expense was $1.0 million in 2001. This amount was due to the amortization of the intangible asset related to a 1998 acquisition becoming fully amortized in November 2001. Therefore, there was no such amortization in 2002 and 2003. The following table summarizes interest, net and write-down of investment and other: (in millions) 2003 2002 2001 ---- ---- ---- Interest, net $ .2 .1 - Write down of investment and other (.3) (.1) (.9) Interest, net results from interest income earned on investments and fluctuates depending on interest rates and balances invested. Write-down of investment and other expense in 2001 primarily represents the Company's write-down of its investment in the Plan to the Plan's estimated net realizable value. Discontinued Operations The financial performance of discontinued operations improved by $4.6 million in 2003 from a loss of $3.9 million in 2002 to income of $.8 million in 2003. This primarily resulted from a 25 percent increase in per member per month premium yields in 2003 vs. 2002, while per member per month health care costs increased by 10 percent. Health care costs were favorably impacted by favorable development of claims reserves of approximately $2 million. This resulted from a reduction in the healthcare cost trend from the first half of 2002 that was not fully evident at year end 2002. Related Party Transactions The Company's related party transactions consist of hospital administrative fees from owner hospitals. Inflation Health care costs in the United States have increased more rapidly than the national consumer price index in recent years, and that trend is expected to continue. The Company's operating results have not been significantly affected by general inflation, and the Company does not anticipate that inflation will have a significant impact on its operating results in the near term. Market Risk The Company offers its PPO and HBM products in a highly competitive environment. The Company has numerous competitors, including for-profit and not-for-profit HMOs, TPAs, preferred provider organizations ("PPOs") and indemnity insurance carriers, some of which have substantially larger enrollments and greater financial resources than the Company. The Company's ability to retain existing PPO clients and attract new PPO and HBM clients is largely dependent on its ability to offer competitive provider contract value and maintain a network of high quality, efficient, fully credentialed providers who agree to accept competitive reimbursement rates. LIQUIDITY AND CAPITAL RESOURCES Since inception in 1984, the Company has financed its operations from equity investments from over 870 physicians, from the seven hospitals constituting the Company's Class B shareholders, non-equity capital contributions from four additional hospitals pursuant to their respective participation agreements, and funds from operations. 9 10 The Company's cash flow consists of operating, investing and financing cash flows. Operating cash flow is generated by operating income, depreciation and fluctuations in various balance sheet accounts. In the event of ongoing negative operating cash flow, the Company's investment portfolio of marketable securities is available to meet liquidity needs. The Company does not anticipate significant financing activities in 2004 other than as noted below. As a result from the exit from the capital intensive health insurance business, the Company paid a $1.2 million dividend to shareholders in 2003. This was the first dividend in the Company's history. Based on expected consistently positive cash flow generated from continuing operations, the Company expects to pay dividends annually. The balance sheet presents all assets and liabilities of the health plan legal entity as discontinued. During 2004 the Plan expects to request regulatory approval to distribute as dividends a significant portion of its assets. During 2005 the Company expects to request regulatory approval to dissolve the Plan and distribute any remaining assets as dividends. The Company expects to declare a special dividend to distribute its share of these non-recurring cash flows to its shareholders in the year in which they are received. At December 31, 2003, the Company's continuing operations had cash and cash equivalents of approximately $1.5 million as compared to approximately $2.3 million at December 31, 2002. As the company generates cash flow from continuing operations, significant amounts are being invested in investment securities available for sale which increased by $2.4 million (51.4%) from 2002 to 2003. Investment securities consist of U.S. Government Agency asset-backed and mortgage-backed adjustable rate securities and municipal bonds that are marketable in the event additional cash is needed. Following are explanations of significant balance sheet account fluctuations: The decrease in service fees receivable from related parties and others of $.6 million (31.4%) is due to the timing of cash receipts on outstanding receivables. The increase in other current assets of $.3 million is due to new receivables for the health benefits management business segment. The increase in accrued expenses of $.6 million (47.9%) is primarily attributable to a long term incentive plan implemented in 2003 and employee health benefit programs. The 2002 liability for federal income tax payable to subsidiary of $1.6 million was satisfied by payments in 2003. The fluctuation in discontinued operations balance sheet items primarily result from the exit of the insurance business and is shown in detail in note 11, Discontinued Operations, to the Company's financial statements included in Item 8 below. On December 20, 1999, the Company executed an agreement with University of Washington Academic Medical Center (UWMC) to become a participant in the administration, operations and any incentives bestowed upon any shareholders in the Company effective January 1, 2000. UWMC is not a shareholder or member of the Company. UWMC will participate in any incentive or reward program established by the Company as if UWMC owned 5,800 shares of class B common stock. Dividends, distributions, and liquidation of the Company are also calculated as if UWMC owned 5,800 shares of class B stock. If the Company performs certain actions that substantially change the organization, the Company discontinues the health care facility services contract with UWMC, or if total managed care enrollment falls below 500,000 member months, then UWMC can withdraw from the agreement, but no refunds are given. If the Company merges, is sold, or if the Company takes a material action that proves detrimental to UWMC, then UWMC may redeem its interest for the equivalent of the fair value of 5,800 shares of class B stock, less any amounts still owed by UWMC. The UWMC ownership interest is classified as redeemable equity participation. 10 11 CRITICAL ACCOUNTING POLICIES AND ESTIMATES As a result of the decision to exit the insured health care business by December 31, 2003, the Company's 80% ownership in the Plan was written down at December 31, 2001 to the expected net realizable value, which is the Plan's book value. Management believes this measurement of the expected net realizable value is still valid as of December 31, 2003. The reserve for unpaid claims and claims adjustment expenses in discontinued operations of the Plan represents reported and unreported claims which have been incurred but have not been paid at the date of the financial statements. The reserve for unreported claims is determined actuarially using prior experience and the nature of current health insurance contracts and volume. Included in the liability is an estimate of the future expenses necessary to settle claims. Due to the uncertainties inherent in the estimation process, actual costs may differ from the estimated amounts in the near term, and these differences may be significant. As a result of the decreasing membership in the Plan, management has increased the level of conservatism in the estimate due to increased risk associated with potential claim volatility resulting from a lower membership base. The development and selection of "critical" accounting estimates and the associated disclosures in this discussion have been discussed by management with the audit committee of the Board of Directors. OFF-BALANCE SHEET ARRANGEMENTS The Company has no off-balance sheet arrangements. CONTRACTUAL OBLIGATIONS Contractual obligations consist of operating lease arrangements and are payable as follows: Less than 1 Year 2 - 3 Years 4 - 5 Years More than 5 Years --------------- ----------- ----------- ----------------- $785,260 $1,471,592 $1,028,535 0 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable as of December 31, 2003. 11 12 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Independent Auditors' Report . . . . . . . . . . . . . . . . . . . . . . 13 Consolidated Balance Sheets as of December 31, 2003 and 2002 . . . . . . 14 Consolidated Statements of Income for the years ended December 31, 2003, 2002, and 2001. . . . . . . 16 Consolidated Statements of Shareholders' Equity for the years ended December 31, 2003, 2002, and 2001. . . . . . . 17 Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002, and 2001. . . . . . . 18 Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . 19 12 13 INDEPENDENT AUDITORS' REPORT Shareholders and Board of Directors First Choice Health Network, Inc. We have audited the accompanying consolidated balance sheet of First Choice Health Network, Inc., as of December 31, 2003 and 2002 and the related consolidated statements of income, shareholders' equity, and cash flows for the years ended December 31, 2003, 2002 and 2001. These financial statements are the responsibility of First Choice Health Network, Inc.'s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of First Choice Health Network, Inc., as of December 31, 2003 and 2002 and the results of its operations and its cash flows for the years ended December 31, 2003, 2002 and 2001, in conformity with accounting principles generally accepted in the United States of America. Moss Adams LLP February 2, 2004 Everett, Washington 13 14 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS DECEMBER 31, 2003 and 2002
ASSETS 2003 2002 CURRENT ASSETS: Cash and cash equivalents $ 1,459,881 $ 2,324,382 Investment securities available-for-sale, at fair value 7,132,880 4,712,815 Service fees receivable, net of allowance for doubtful accounts of $ 77,194 and $131,840 950,498 1,400,693 Service fees receivable from related parties 354,114 502,000 Prepaid expenses 442,072 508,900 Deferred tax assets 164,066 181,711 Other current assets 340,025 39,165 Receivable from subsidiary 51,650 102,273 Federal income tax benefit receivable from subsidiary 6,677 - Current assets of discontinued operations 11,715,163 14,219,465 ----------- ----------- Total current assets 22,617,026 23,991,404 FURNITURE, EQUIPMENT, AND COMPUTER SOFTWARE: Furniture and equipment 5,303,600 4,538,941 Computer software 1,386,784 1,277,375 ----------- ----------- 6,690,384 5,816,316 Less accumulated depreciation (5,392,963) (4,362,200) ----------- ----------- Furniture, equipment, and computer software, net 1,297,421 1,454,116 DEFERRED TAX ASSETS 1,140,249 945,214 OTHER ASSETS: Investment in One Health Port 141,984 337,400 Other assets 114,135 - Assets of discontinued operations 384,224 2,074,507 ----------- ----------- Total other assets 640,343 2,411,907 ----------- ----------- TOTAL ASSETS $25,695,039 $28,802,641 =========== ===========
See notes to consolidated financial statements. 14 15 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS DECEMBER 31, 2003 and 2002
LIABILITIES AND SHAREHOLDERS' EQUITY 2003 2002 CURRENT LIABILITIES: Accounts payable $ 627,631 $ 487,291 Accrued expenses 1,986,532 1,342,978 Federal income tax payable 70,703 110,582 Federal income tax benefit due to subsidiary - 1,607,743 Current liabilities of discontinued operations 3,823,788 10,320,905 ----------- ----------- Total current liabilities 6,508,654 13,869,499 MINORITY INTEREST 1,922,306 1,222,530 REDEEMABLE EQUITY PARTICIPATION 2,520,000 2,385,443 COMMITMENTS (Note 5) SHAREHOLDERS' EQUITY: Common stock: Class A, par value $1 - Authorized, 30,000 shares; issued and outstanding, 537 and 538 shares 537 538 Class B, par value $1 - Authorized, 70,000 shares; issued and outstanding, 40,600 shares 40,600 40,600 Additional paid-in capital 4,305,356 4,306,221 Additional capital from affiliates 1,472,108 1,472,108 Retained earnings 8,943,283 5,452,362 Accumulated other comprehensive income (loss), net of tax (17,805) 53,340 ----------- ----------- Total shareholders' equity 14,744,079 11,325,169 ----------- ----------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $25,695,039 $28,802,641 =========== ===========
See notes to consolidated financial statements. 15 16 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF INCOME YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001
2003 2002 2001 OPERATING REVENUE: Network access fees $ 9,953,530 $ 9,092,039 $ 8,636,915 Hospital administrative fees 4,936,034 5,067,915 4,628,533 Hospital administrative fees, related parties 4,032,114 4,523,692 3,094,633 Health Benefit Management fees 1,908,246 - - Employee Assistance Program and Other 582,765 189,140 203,255 ----------- ----------- ----------- Total operating revenue 21,412,689 18,872,786 16,563,336 OPERATING EXPENSES: Payroll and related expenses 8,222,612 5,944,538 6,040,006 Selling, general, and administrative expenses 6,312,450 4,606,129 3,659,480 Amortization expense - - 1,026,175 ----------- ----------- ----------- Total operating expenses 14,535,062 10,550,667 10,725,661 ----------- ----------- ----------- Operating income 6,877,627 8,322,119 5,837,675 OTHER INCOME (EXPENSE): Interest, net 193,700 128,737 19,602 Write-down of investment and other (276,327) (93,703) (854,436) ----------- ----------- ----------- Total other income (expense), net ( 82,627) 35,034 (834,834) ----------- ----------- ----------- Income from continuing operations before federal income taxes and minority interest 6,795,000 8,357,153 5,002,841 Provision for federal income taxes on continuing operations 2,410,199 2,984,601 2,107,961 ----------- ----------- ----------- Income from continuing operations before minority interest 4,384,801 5,372,552 2,894,880 MINORITY INTEREST, net of tax (448,663) 404,126 173,062 ----------- ----------- ----------- Income from continuing operations after minority interest 3,936,138 5,776,678 3,067,942 Discontinued operations Income (loss) from discontinuation of First Choice Health Plan Insurance operations (net of applicable income tax expense (benefit) of $ 388,826, ($1,970,074) and ($2,065,462)) 754,783 (3,851,787) (4,475,929) ------------ ------------ ------------ NET INCOME (LOSS) $ 4,690,921 $ 1,924,891 $(1,407,987) =========== =========== =========== NET INCOME FROM CONTINUING OPERATIONS AFTER MINORITY INTEREST PER COMMON SHARE $ 67.24 $ 98.68 $ 52.39 =========== =========== =========== NET INCOME (LOSS) PER COMMON SHARE $ 80.13 $ 32.88 $ (24.04) =========== =========== =========== WEIGHTED AVERAGE SHARES OUTSTANDING 58,538 58,538 58,565 =========== =========== ===========
See notes to consolidated financial statements. 16 17 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
Common Stock Accumulated Class A Class B Additional Additional Other Total Comprehensive paid-in capital from Retained Comprehensive Shareholders' Income Shares Amt Shares Amt capital affiliates Earnings Income (Loss) Equity (Loss) BALANCE, December 31, 2000 572 $572 40,600 $40,600 $4,336,182 $1,472,108 $4,935,458 -0- $10,784,920 Repurchase of Class A common stock and membership rights from physicians (33) (33) (29,601) (29,634) Unrealized loss on investments,net of tax $ (8,609) (8,609) $ (8,609) Net loss (1,407,987) (1,407,987) (1,407,987) ---- ---- ------ ------ ---------- ---------- ---------- -------- ----------- ----------- BALANCE, $(1,416,596) December 31, 2001 539 539 40,600 40,600 4,306,581 1,472,108 3,527,471 (8,609) 9,338,690 =========== Repurchase of Class A common stock and membership rights from physicians (1) (1) (360) (361) Unrealized gain on investments, net of tax 61,949 61,949 $ 61,949 Net Income 1,924,891 ,924,891 1,924,891 ---- ---- ------ ------ ---------- ---------- ---------- -------- ----------- ----------- Balance, $ 1,986,840 December 31, 2002 538 538 40,600 40,600 4,306,221 1,472,108 5,452,362 53,340 11,325,169 =========== Repurchase of Class A common stock and membership rights from physicians (1) (1) (865) (866) Dividends Paid (1,200,000) (1,200,000) Unrealized loss on investments, net of tax (71,145) (71,145) $ (71,145) Net income 4,690,921 4,690,921 4,690,921 ---- ---- ------ ------- ---------- ---------- ---------- -------- ----------- ----------- Balance, $ 4,619,776 December 31, 2003 537 $537 40,600 $40,600 $4,305,356 $1,472,108 $8,943,283 $(17,805) $14,744,079 =========== ==== ==== ====== ======= ========== ========== ========== ======== ===========
See notes to consolidated financial statements. 17 18 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001
2003 2002 2001 CASH FLOWS FROM OPERATING ACTIVITIES: Net income from continuing operations $ 3,936,138 $ 5,776,678 $ 3,067,942 Adjustments to reconcile net income to net cash from operating activities: Depreciation 1,030,763 1,083,314 818,428 Amortization - - 1,026,175 Deferred income taxes, net (177,390) 73,630 286,302 Provision for doubtful accounts (54,646) (288,657) (229,528) Minority interest 709,456 (20,527) 1,064,424 Changes in operating assets and liabilities: Service fees receivable 652,727 465,990 855,237 Due to subsidiary including tax accrual (1,563,797) 741,406 (1,568,365) Prepaid expenses 66,828 258,501 71,914 Other current assets (300,860) (24,063) 388 Other assets (114,135) - - Accounts payable 140,340 35,516 (226,281) Accrued expenses 643,554 303,169 245,354 Federal income tax accrual (39,879) 667,922 (66) Adjustment in value of investment in One Health Port 195,416 - - ----------- ----------- ----------- Net cash provided by continuing operations 5,124,515 9,072,879 5,411,924 CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of investment in One Health Port - (337,400) - Purchase of investments available for sale (8,990,862) (6,364,075) (624,333) Principal paydowns and sales of investments available for sale 6,538,370 2,306,647 - Purchase of furniture, equipment, and computer software (874,068) (334,421) (412,807) ----------- ----------- ----------- Net cash used by investing activities (3,326,560) (4,729,249) (1,037,140) ----------- ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES: Repurchase of Class A common stock and membership rights from physicians (866) (361) (29,634) Redeemable equity participation 134,557 393,593 374,850 Payment of note payable - (698,170) (301,830) Dividends to shareholders (1,200,000) - - ----------- ----------- ----------- Net cash from financing activities (1,066,309) (304,938) 43,386 ----------- ----------- ----------- CASH FLOWS TO DISCONTINUED OPERATIONS (1,596,147) (3,335,044) (2,878,383) ----------- ----------- ----------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (864,501) 703,648 1,539,787 CASH AND CASH EQUIVALENTS, Beginning of year 2,324,382 1,620,734 80,947 ----------- ----------- ----------- CASH AND CASH EQUIVALENTS, End of year $ 1,459,881 $ 2,324,382 $ 1,620,734 =========== =========== =========== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid (received) during the year for Federal income taxes $ 2,892,635 $ (303,633) $ - =========== =========== =========== Interest $ - $ 32,294 $ 84,540 =========== =========== ===========
See notes to consolidated financial statements. 18 19 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003, 2002 and 2001 NOTE 1: DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description of business: First Choice Health Network, Inc. (the Company) was incorporated under the laws of the state of Washington on September 28, 1984. The Company was formed initially to organize a network of independent participating physicians and hospitals to serve insurers, third party administrators, union trusts and employers. Subsequently the Company created additional related PPO services including utilization management services and an Employee Assistance Program (EAP). In 2003 the Company initiated a program for providing health benefit management services ("HBM" business) for self funded employers and insurance carriers. The Company's business is conducted primarily in Washington, with some additional business located in Alaska, Montana and Idaho. The Company's majority owned subsidiary, First Choice Health Plan, Inc. (the Plan), is a health care services contractor, which was formed on January 31, 1995, to offer fully insured health products in Washington state. As a result of the decision by the Plan's Board of Directors authorizing management to exit the insured health care business, the Plan did not renew any business after January 1, 2003. The Plan's financial information for the Plan's insured healthcare business is presented as a discontinued operation in the financial statements. All financial statement presentations for prior years have been restated accordingly. Principles of consolidation: The consolidated financial statements include the accounts of the Company and the Plan, with the Plan's insured healthcare business being presented as a discontinued operation. Due to this presentation, certain intercompany accounts are included in the financial statements. New accounting pronouncements: In June 2002, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 146, Accounting for Costs Associated with Exit or Disposal Activities. This Statement requires that a liability for costs associated with an exit or disposal activity be recognized when the liability is incurred, and be measured at fair value and adjusted for changes in estimated cash flows. The discontinuance of the Plan's operation is accounted for pursuant to SFAS No. 60, Accounting and Reporting by Insurance Enterprises. This statement requires recording a liability for all costs expected to be incurred in connection with the settlement of unpaid claims to be accrued when the related liability for unpaid claims is incurred. In January 2003, the FASB issued Interpretation No. 46, consolidation of Variable Interest Entities (VIE). The Company does not have any VIEs and accordingly the implementation of the Interpretation did not result in an impact on its financial position or results of operations. In May 2003, the FASB issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. Adoption of this Statement did not result in an impact on the Company's financial position or results of operations. In November 2003, the Emerging Issues Task Force (EITF) reached a consensus that certain quantitative and qualitative disclosures should be required for debt and marketable equity securities classified as available-for-sale or held-to-maturity under FASB Statements No. 115 and 124, that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. This EITF consensus is effective for fiscal years ending after December 15, 2003. Accordingly, the Company has adopted this statement as of December 31, 2003 and the result did not have an impact on the Company's financial position or results of operations. 19 20 Cash equivalents: The Company considers all investments purchased with an original maturity of three months or less to be cash equivalents. At December 31, 2003 and 2002, cash and cash equivalents consisted of cash management funds of $1,459,881 and $2,324,382, respectively. Investment securities: The Company owns U.S. Government Agency mortgage-backed adjustable rate securities and municipal bonds that are classified as available for sale. Investment securities categorized as available for sale are generally held for investment purposes (to maturity), although unanticipated future events may result in the sale of some securities. Available for sale securities are recorded at fair value, with the net unrealized gain or loss included in comprehensive income, net of the related tax effect. Realized gains or losses on dispositions are based on the net proceeds and the adjusted carrying amount of securities sold, using the specific identification method. Declines in the fair value of individual available for sale securities below their cost that are other than temporary are recognized by write-downs of the individual securities to their fair value. Such write-downs would be included in earnings as realized losses. Premiums and discounts are recognized in interest income using the interest method over the period to call or maturity. Service fees receivable: Service fees receivable consists primarily of outstanding invoices. Allowance for doubtful accounts: The Company performs periodic credit evaluations of its customers and maintains an allowance for potential credit losses related to receivables. Furniture, equipment and computer software: Furniture, equipment and computer software are recorded at cost. Depreciation is computed using the straight-line method over the lesser of the estimated useful lives of the assets or lease term ranging from three to five years. Operating revenue: Operating revenue consists primarily of network access fees, hospital administrative fees, health benefit management fees and employee assistance program and utilization management fees. Network access fees are recognized as earned during the period of coverage and are recorded at contractual rates. Hospital administrative fees are recognized as earned in the period hospital claims are incurred by a subscriber and are recorded at a contractual amount or percentage of the claims. Health benefit management fees and EAP and utilization management fees are recognized in the month services are provided. Income taxes: Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of assets and liabilities and their respective tax bases using the liability method. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to reverse. The effect on the deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established to the extent that it is more likely than not that deferred tax assets will not be realized. Valuation of long-lived assets: Using its best estimates, based on reasonable and supportable assumptions and projections, the Company reviews its long- lived assets for impairment whenever events or changes in circumstances have indicated that the carrying amounts of its assets might not be recoverable. At December 31, 2003 the investment in One Health Port was written down by $195,416 to reflect current equity ownership. In 2002 no write-downs were required. Write-down of investment in the Plan: As a result of the decision to exit the insured health care business by December 2003, the Company's 80% ownership interest in the Plan was written down to the expected net realizable value, which is the Plan's book value at December 31, 2001. The write-down of $1,237,486 is included in Other Expense. Further write-downs of $260,793 and $383,600 were recorded in 2003 and 2002, respectively, representing 20% of the capital contributions to the Plan in those years. 20 21 Earnings per share: Net income per common share (Class A and B) is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period, including 41,138, 41,138 and 41,165 common shares and 17,400 shares applicable to affiliate common share equivalents (Note 2) in 2003, 2002 and 2001, respectively. Shares issued and reacquired during each period were weighted for the portion of the period that they were outstanding. There are no dilutive securities. Use of estimates: Preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of unpaid claims, claims adjustment expenses, the write-down of the investment in the Plan, the allowance for service fees receivable and deferred income taxes. Reclassifications: Certain amounts in the 2002 and 2001 financial statements have been reclassified to conform with the 2003 presentation. Discontinued Operations: As a result of the decision by the Plan's Board of Directors authorizing management to exit the insured health care business, the Plan did not renew any business after January 1, 2003. The financial information for the Plan's insured healthcare business is presented as a discontinued operation in the financial statements. All financial statement presentations for the prior years have been restated accordingly. NOTE 2: SHAREHOLDERS' EQUITY Ownership of stock: Class A voting common stock may be held solely by physicians licensed in the state of Washington who contract with the Company to provide health care services and who hold active, associate or provisional medical staff privileges at one or more of the hospitals that contract with the Company to provide health care services. Class B voting common stock may be held by hospitals in the state of Washington that contract with the Company to provide health care services. Voting rights: Holders of each outstanding share of Class A or Class B common stock are entitled to one vote on each matter submitted to a vote at meetings of shareholders, and each class of common stock votes as a separate class. Transfer of stock: Shareholders may only transfer their stock in the Company to the Company for repurchase. The repurchase price is established by the Board of Directors each fiscal year as set forth in the bylaws. Class A shares were repurchased at $866, $752 and $898 per share during 2003, 2002 and 2001, respectively. Dividends: The Board of Directors may declare and pay dividends on one or more classes of common stock at such times and in such amounts as it designates, but in no event may dividends be paid while there is an outstanding obligation to repurchase shares. Dividends are allocated among shareholders of each class of stock according to the number of shares outstanding to each Class A or Class B shareholder. Any dividends paid to the Class B shareholders must be shared with the non-shareholders that have rights equivalent to those of the other shareholders. In 2003 the Company paid a dividend totaling $1.2 million to Class A shareholders of $187.62 per share and $100,000 to each Class B shareholder and non-shareholder district hospital that has equivalent rights to shareholders. 21 22 Liquidation rights: Upon liquidation or dissolution, the Board of Directors, at its discretion, will allocate the value of assets among the classes of its outstanding stock in proportion to the capital contributions of shareholders of each class. For these purposes, the contributions by the non-shareholder district hospitals that have rights equivalent to those of the Class B shareholders and the membership fees paid by Class A shareholders are considered capital contributions. The allocation to Class A shareholders will be shared among all Class A shareholders in accordance with the number of shares outstanding to each Class A shareholder. The allocation of the Class B shareholders must be shared with the non-shareholder hospitals that have rights equivalent to those of Class B shareholders. Paid-in capital from affiliates: District hospitals are not shareholders of the Company, but have contractual agreements with the Company that provide for certain rights and obligations equivalent, but not identical, to those of Class B shareholders, including liquidation and dividend rights. The capital contributions of the non-shareholders are recorded as paid-in capital from affiliates. These contractual agreements are considered to be common share equivalents for purposes of calculating net income per common share. NOTE 3: REDEEMABLE EQUITY PARTICIPATION On December 20, 1999, the Company executed a participation agreement with the University of Washington Academic Medical Center (UWMC) to become a participant in the administration, operations, and any incentives bestowed upon any shareholders in the Company effective January 1, 2000. UWMC agreed to pay a fee of $2,520,000, $1,260,000 payable upon execution of the agreement and the remaining $1,260,000 payable in three equal annual payments of $420,000, consisting of principal and interest at 5%. The final payment in 2003 was adjusted for outstanding principal and interest. UWMC did not become a shareholder or a member of the Company. UWMC will participate in any incentive or reward program established by the Company as if UWMC owned 5,800 shares of Class B common stock. Dividends, distributions and liquidation of the Company are also determined as if UWMC owned 5,800 shares of Class B common stock. If the Company performs certain activities that substantially change the organization, the Company discontinues the health care facility services contract with UWMC, or if total managed care enrollment falls below 500,000 member months, then UWMC can withdraw from the agreement, but no refunds will be given. If the Company merges, is sold, or if the Company takes a material action that proves detrimental to UWMC, then UWMC may redeem its interest for the equivalent of the fair value of 5,800 Class B common shares of Company stock, less any amounts still owed by UWMC. Since redemption, under certain terms, is outside the control of the Company, the amounts received are recorded as a redeemable equity participation. NOTE 4: FEDERAL INCOME TAXES Federal income taxes consist of the following components:
2003 2002 2001 Current $ 2,232,809 $ 3,058,231 $ 2,393,993 Deferred 177,390 (73,630) (286,302) ----------- ----------- ----------- $ 2,410,199 $ 2,984,601 $ 2,107,691 =========== =========== ===========
22 23 Federal income taxes differ from the amount computed by applying the expected U.S. corporate income tax rate to income before federal income taxes for the years ended December 31 as follows: 2003 2002 2001 Amount Percent Amount Percent Amount Percent Computed expected tax rate $2,310,300 34.0 $2,841,432 34.0 $1,700,966 34.0 Tax effect of permanent differences: Write-down of investment in subsidiary 88,670 1.3 130,424 1.6 420,745 8.4 Other 11,229 .2 12,745 .1 (13,750) (.3) --------- ---- ---------- ---- ---------- ---- $2,410,199 35.5 $2,984,601 35.7 $2,107,961 42.1 ========== ==== ========== ==== ========== ====
The deferred tax assets and liabilities resulting from the tax effects of temporary differences at December 31 are presented below:
2003 2002 Deferred tax assets: Net operating loss $2,216,807 $2,216,807 Reduction of shareholders' equity 213,724 213,724 Allowance for doubtful accounts 26,246 53,997 Depreciation and amortization 790,086 731,490 Vacation 137,819 127,714 Other 136,440 - ---------- ---------- Gross deferred tax assets 3,521,122 3,343,732 Valuation allowance (2,216,807) (2,216,807) ---------- ---------- Net deferred tax assets 1,304,315 1,126,925 ========== ========== Current portion of deferred tax assets $ 164,066 $ 181,711 Long-term portion of deferred tax assets 1,140,249 945,214 ---------- ---------- Total deferred tax assets $1,304,315 $1,126,925 ========== ==========
23 24 A valuation allowance was established in 1997 for the tax benefit of the 1997 net operating losses (NOLs) of the Plan which is being reported as a discontinued operation. The Company filed a separate federal income tax return for the final six months of 1997 and the first three weeks of 1998, and the realization of the tax benefit is unlikely. The allowance also provides for NOLs acquired in acquisition of a business in 1997. The following schedule represents the amounts of the Plan's NOLs and their expiration date: 2007 $ 150,754 2008 53,781 2009 20,754 2010 1,584,667 2011 2,075,894 2012 2,353,449 2018 280,723 ----------- Total net operating losses 6,520,022 Valuation Allowance (6,520,022) ---------- $ - ===========
Because the operations of the Plan is being discontinued, future income will not be available to utilize the NOLs. Upon the ultimate liquidation and dissolution of the Plan, these NOLs may be potentially utilized by the Company. Because the timing and ultimate realization of these NOLs is uncertain, they are fully reserved. NOTE 5: COMMITMENTS Leases: The Company leases its office facilities and some office equipment under operating leases expiring through 2008. The leases provide for monthly minimum rent payments, and some include renewal options for an additional five years. Rental expense charged to operations under the operating leases for the years ended December 31, 2003, 2002 and 2001 were $834,564, $928,093 and $923,239, respectively. Future minimum lease payments under operating leases for the years ending December 31 are as follows: 2004 $ 785,260 2005 757,192 2006 714,400 2007 687,663 2008 340,872 ---------- $3,285,387 ==========
24 26 Information about profit or loss and assets of reportable segments:
First Choice Health Benefits Health Network Management Total 2003: Revenues from external customers $ 19,504,443 $ 1,908,246 $ 21,412,689 Intersegment revenue 74,413 (74,413) - Interest revenue 193,700 - 193,700 Depreciation expense 851,670 179,093 1,030,763 Income tax expense (benefit) 2,740,230 (330,031) 2,410,199 Expenditures on furniture, equipment and computer software 874,068 - 874,068 Segment profit (loss) 5,025,449 (640,648) 4,384,801 Minority interest (448,663) Income from discontinued operations 754,783 Consolidated net income 4,690,921 Assets of reportable segments 13,491,308 104,344 13,595,652 Liabilities of reportable segments 2,684,866 - 2,684,866 2002: Revenues from external customers $ 18,872,786 $ - $ 18,872,786 Intersegment revenue 28,125 (28,125) - Interest revenue 128,737 - 128,737 Depreciation expense 1,083,314 - 1,083,314 Income tax expense (benefit) 2,989,081 ( 4,480) 2,984,601 Expenditures on furniture, equipment and computer software 334,421 - 334,421 Segment profit (loss) 5,381,248 ( 8,696) 5,372,552 Minority interest 404,126 Loss from discontinued operations (3,851,787) Consolidated net income 1,924,891 Assets of reportable segments 12,508,669 - 12,508,669 Liabilities of reportable segments 3,548,594 - 3,548,594 2001: Revenues from external customers $ 16,563,336 $ - $ 16,563,336 Intersegment revenue - - - Interest revenue 19,602 - 19,602 Depreciation/amortization expense 1,844,603 - 1,844,603 Income tax expense 2,107,961 - 2,107,961 Expenditures on furniture, equipment and computer software 412,807 - 412,807 Segment profit 2,894,880 - 2,894,880 Minority interest 173,062 Loss from discontinued operations (4,475,929) Consolidated net loss (1,407,987) Assets of reportable segments 9,090,106 - 9,090,106 Liabilities of reportable segments 2,975,528 - 2,975,528 2003 2002 2001 Revenues: Total revenues from reportable segments and discontinued operations $ 51,053,380 $ 93,034,185 $122,652,504 ============ ============ ============ Profit or loss: Total profit or (loss) for reportable segments and discontinued operations $ 5,139,584 $ 1,520,765 $ (1,581,049) Adjustment for minority interest in consolidated statements (448,663) 404,126 173,062 ------------ ------------ ------------ Consolidated net income (loss) $ 4,690,921 $ 1,924,891 $ (1,407,987) ============ ============ ============
26 27
2003 2002 2001 Assets: Total assets for reportable segments $ 13,595,652 $ 12,508,669 $ 9,090,106 Assets of discontinued operations 12,099,387 16,293,972 22,127,373 ------------ ------------ ------------ Consolidated total assets $ 25,695,039 $ 28,802,641 $ 31,217,479 ============ ============ ============ Liabilities: Total liabilities for reportable segments $ 2,684,866 $ 3,548,594 $ 2,975,531 Liabilities of discontinued operations 3,823,788 10,320,905 15,673,922 ------------ ------------ ------------ Consolidated total liabilities $ 6,508,654 $ 13,869,499 $ 18,649,453 ============ ============ ============
Substantially all of the revenues from external customers are derived from within the state of Washington. NOTE 7: FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amount of cash and cash equivalents, short-term investments, service fees receivable, and accounts payable approximates fair value because of the short maturity of these instruments. NOTE 8: INVESTMENT SECURITIES AVAILABLE FOR SALE Investment securities available for sale consist of the following:
Gross Gross Gross Amortized Unrealized Unrealized Unrealized Cost Gains Losses Losses Less Than More Than 12 Months 12 Months Fair Value --------------------------------------------------------------- December 31, 2003 Mortgage-backed adjustable rate securities $ 1,098,214 $ 4,262 $( 4,365) $ (782) $ 1,097,329 Municipal bonds 6,043,750 2,260 (10,459) - 6,035,551 ----------- -------- --------- ------- ----------- $ 7,141,964 $ 6,522 $(14,824) $ (782) $ 7,132,880 ============ ======== ========= ======= =========== December 31, 2002 Government-backed adjustable rate securities $ 1,478,103 $ 10,369 $( 1,550) $ - $ 1,486,922 Mortgage-backed adjustable rate securities 3,217,244 9,720 ( 1,071) $ - 3,225,893 ----------- -------- -------- ------- ----------- $ 4,695,347 $ 20,089 $( 2,621) $ - $ 4,712,815 ============ ======== ========= ======= ===========
Certain investment securities shown above currently have fair values less than amortized cost and therefore contain unrealized losses. The Company has evaluated these securities and has determined that the decline in value is temporary and is related to the change in market interest rates since purchase The decline in value is not related to any company or industry specific event. At December 31, 2003, there are approximately 12 investment securities with unrealized losses. The Company anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of a more favorable market interest rate environment. 27 28 Contractual maturities of investment securities as of December 31, 2003 are shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without prepayment penalties.
Available for Sale Amortized Fair Maturity Costs Value ----------------- ----------- ----------- One to ten years $ 1,500,111 $ 1,497,350 Over ten years 5,641,853 5,635,530 ----------- ----------- $ 7,141,964 $ 7,132,880 =========== ===========
Proceeds from sales and maturities of investment securities in 2003 and 2002 were $6,538,370 and $2,306,647, respectively. Sales of investment securities resulted in gross gains of $8,949 in 2003 and gross losses of $54,207 in 2003 and $566 in 2002. NOTE 9: RETIREMENT PLAN The Company has a qualified 401(k) Employee Savings and Profit Sharing Plan covering all full-time employees. Under the plan, employees can defer up to the maximum established by the Internal Revenue Service. The Company matches 50% of each employee's contribution, up to 6% of the employee's eligible salary. Employees are fully vested in employee contributions and vest over two years for employer contributions. The Company also has the option to make an additional profit sharing contribution to the plan. Employer contributions to the plan for the years ended December 31, 2003 and 2002, amounted to $151,173 and $139,691, respectively. The Company also has a non-qualified contribution retirement program covering executive management employees. Participants must have been employed by the Company for at least one year and hold a position approved by the President and Board of Directors as having a significant corporate-wide impact on accomplishing the Company's strategic goals and objectives. Under this program, the Company funds the deferred benefits through participant accounts based upon the percentages of the individual participant's base salary approved by the Board of Directors. Deferred benefits of the trust, which have been included in accrued expenses, were $114,135 at December 31, 2003. The expenses in relation to the program were $97,234 for the year ended December 31, 2003. The market value of the trust assets was $114,135 at December 31, 2003. Realized and unrealized gains and losses on the assets accrue to the individual participants. NOTE 10: NOTE PAYABLE The Company's note payable at December 31, 2001 in the amount of $698,170 bearing interest at 9.86% was fully paid in 2002. NOTE 11 DISCONTINUED OPERATIONS As the Plan's business model shifted from capitated contracts to fee for service contract arrangements over the past three (3) years, management and the Board of Directors have reevaluated the strategic importance of the Plan. As a result, the Plan's existing commercial insured business is being wound down in an orderly manner with the non-renewal of all commercial business during 2003 and the run-out of outstanding claim liabilities through 2004. 28 29 At the balance sheet date the following assets included in the consolidated balance sheet apply to the discontinued operations of the Plan:
December 31, 2003 2002 Assets Cash and cash equivalents $ 2,687,652 $ 501,078 Investment securities available for sale, at fair value 8,020,730 9,094,340 Premiums receivable, net of allowance for doubtful accounts of $17,916 and $77,768 898,489 2,642,137 Prepaid expenses and other receivables 72,026 215,411 Deferred tax assets 36,266 158,756 Federal income tax benefit receivable from parent - 1,607,743 Restricted indemnity cash and investments 384,224 2,074,507 ----------- ----------- Total assets $ 12,099,387 $ 16,293,972 ============ ============ Liabilities Accrued expenses $ 595,351 $ 592,489 Reserve for unpaid loss and loss adjustment expenses 3,069,224 8,637,313 Provider settlements payable 83,787 225,630 Unearned premiums 17,099 763,200 Federal income tax expense payable to parent 6,677 - Amount due to parent 51,650 102,273 ----------- ----------- Total liabilities $ 3,823,788 $ 10,320,905 ============ ============
The following amounts representing revenue and income and loss from discontinued operations are included in the consolidated statement of income:
2003 2002 2001 Operating revenue $ 29,640,691 $ 74,161,399 $106,089,168 Income (loss) on discontinued operations before federal income tax 1,143,609 (5,821,861) (6,541,391) Income (loss) on discontinued operations after federal income tax 754,783 (3,851,787) (4,475,929) Net income (loss) from discontinued operations per common share 12.89 (65.80) (76.43)
29 30 NOTE 12: UNAUDITED QUARTERLY FINANCIAL DATA - CONDENSED CONSOLIDATED STATEMENT OF INCOME
Quarter Quarter Quarter Quarter 12/31/2003 09/30/2003 06/30/2003 03/31/2003 ---------- ---------- ---------- ---------- OPERATING REVENUE Network access fees $ 2,511,915 $ 2,527,073 $ 2,508,243 $ 2,406,299 Hospital administrative fees 1,244,569 1,235,692 1,159,794 1,295,979 Hospital administrative fees, related parties 1,076,095 980,097 991,955 983,967 Health Benefit Management fees 518,730 503,313 467,914 418,289 Employee assistance program and other 185,820 163,917 129,155 103,873 ----------- ----------- ----------- ----------- Total operating revenue 5,537,129 5,410,092 5,257,061 5,208,407 ----------- ----------- ----------- ----------- OPERATING EXPENSES Payroll and related expenses 2,177,048 2,113,680 2,040,929 1,890,955 Selling, general and administrative expenses 1,750,627 1,633,585 1,499,520 1,428,718 ----------- ----------- ----------- ----------- Total operating expenses 3,927,675 3,747,265 3,540,449 3,319,673 ----------- ----------- ----------- ----------- Operating income 1,609,454 1,662,827 1,716,612 1,888,734 OTHER INCOME (EXPENSE) Interest, net 59,154 39,380 40,615 54,551 Write-down of investment and other (393,614) 42,179 15,064 60,044 ----------- ----------- ----------- ----------- Total other income (expense), net (334,460) 81,559 55,679 114,595 ----------- ----------- ----------- ----------- Income from continuing operations before federal income taxes and minority interest 1,274,994 1,744,386 1,772,291 2,003,329 Provision for federal income taxes on continuing operations 514,309 594,864 618,024 683,002 ----------- ----------- ----------- ----------- Income from continuing operations before minority interest 760,685 1,149,522 1,154,267 1,320,327 MINORITY INTEREST, net of tax (85,120) (122,728) (181,275) (59,540) ----------- ----------- ----------- ----------- Income from continuing operations after minority interest 675,565 1,026,794 972,992 1,260,787 DISCONTINUED OPERATIONS Income (loss) from discontinuation of First Choice Health Plan operations (net of applicable income tax expense (benefit) of $136,985, $82,657, $265,486 and ($ 96,302)) 265,914 160,453 513,713 (185,297) ----------- ----------- ----------- ----------- NET INCOME $ 941,479 $ 1,187,247 $ 1,486,705 $ 1,075,490 =========== =========== =========== =========== NET INCOME PER COMMON SHARE $ 16.08 $ 20.28 $ 25.40 $ 18.37 =========== =========== =========== =========== WEIGHTED AVERAGE SHARES OUTSTANDING 58,537 58,538 58,538 58,538 =========== =========== =========== ===========
30 31
Quarter Quarter Quarter Quarter 12/31/2002 09/30/2002 06/30/2002 03/31/2002 ---------- ---------- ---------- ---------- OPERATING REVENUE Network access fees $ 2,385,083 $ 2,361,009 $ 2,303,410 $ 2,042,537 Hospital administrative fees 1,309,631 1,273,188 1,276,551 1,208,545 Hospital administrative fees, related parties 1,127,050 1,130,497 1,205,289 1,060,856 Employee assistance program and other 47,325 41,372 62,563 37,880 ----------- ----------- ----------- ----------- Total operating revenue 4,869,089 4,806,066 4,847,813 4,349,818 ----------- ----------- ----------- ----------- OPERATING EXPENSES Payroll and related expenses 1,386,003 1,468,226 1,587,873 1,502,436 Selling, general and administrative expenses 1,189,623 1,164,326 1,226,742 1,025,438 ----------- ----------- ----------- ----------- Total operating expenses 2,575,626 2,632,552 2,814,615 2,527,874 ----------- ----------- ----------- ----------- Operating income 2,293,463 2,173,514 2,033,198 1,821,944 OTHER INCOME (EXPENSE) Interest, net 52,504 12,356 52,134 11,743 Write-down of investment and other 65,082 (305,214) 68,519 77,910 ----------- ----------- ----------- ----------- Total other income (expense), net 117,586 (292,858) 120,653 89,653 ----------- ----------- ----------- ----------- Income from continuing operations before federal income taxes and minority interest 2,411,049 1,880,656 2,153,851 1,911,597 Provision for federal income taxes on continuing operations 822,518 799,002 712,434 650,647 ----------- ----------- ----------- ----------- Income from continuing operations before minority interest 1,588,531 1,081,654 1,441,417 1,260,950 MINORITY INTEREST, net of tax (33,347) 12,569 389,801 35,103 ----------- ----------- ----------- ----------- Income from continuing operations after minority interest 1,555,184 1,094,223 1,831,218 1,296,053 DISCONTINUED OPERATONS Loss from discontinuation of First Choice Health Plan Insurance operations (net of applicable income tax benefit of ($156,023), ($298,124), ($1,198,509) and ($317,418)) (302,869) (513,679) (2,391,547) (643,692) ----------- ----------- ----------- ----------- NET INCOME (LOSS) $ 1,252,315 $ 580,544 $ (560,329) $ 652,361 =========== =========== =========== =========== NET INCOME (LOSS) PER COMMON SHARE $ 21.39 $ 9.91 $ (9.57) $ 11.14 =========== =========== =========== =========== WEIGHTED AVERAGE SHARES OUTSTANDING 58,538 58,572 58,540 58,540 =========== =========== =========== ===========
31 32 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures: An evaluation of the Registrant's disclosure controls and procedures (as defined in Rule 13(a)- 15e under the Securities Exchange Act of 1934 (the "Act")) was carried out under the supervision and with the participation of the Registrant's Chief Executive Officer, Executive Vice President of Finance and several other members of the registrant's senior management as of the end of the period covered by this report. Based on that evaluation, the Registrant's Chief Executive Officer and Executive Vice President of Finance concluded that the Registrant's disclosure controls and procedures are effective in ensuring that the information required to be disclosed by the Registrant in the reports it files or submits under the Act is (i) accumulated and communicated to the Registrant's management (including the Chief Executive Officer and Executive Vice President of Finance) as appropriate to allow timely decisions regarding required disclosure, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. (b) Changes in Internal Control over financial reporting: In the quarter ended December 31, 2003, there has been no change in the Registrant's internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, its internal control over financial reporting. Disclosure Controls and Internal Controls. Disclosure controls are procedures that are designed with the objective of ensuring that information required to be disclosed in the Registrant's reports filed under the Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's (SEC) rules and forms. Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, as appropriate to allow timely decisions regarding required disclosure. Internal Controls are procedures which are designed with the objective of providing reasonable assurance that (1) transactions are properly authorized; (2) assets are safeguarded against unauthorized or improper use; and (3) transactions are properly recorded and reported, all to permit the preparation of financial statements in conformity with accounting principles generally accepted in the United States of America. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information required to be included in this Item 10 concerning directors and executive officers of the Company is incorporated into this report by reference to the Company's definitive Proxy Statement for its 2004 Annual Meeting of Shareholders to be filed within 120 days of the Company's fiscal year end December 31, 2003 (the "2004 Proxy Statement"), as set forth under the headings "Election of Directors," "Section 16(a) Beneficial Ownership Reporting Compliance," "Management," "Code of Ethics," and "Meetings and Committees of the Board-Current Board Committees-Audit Committee." ITEM 11. EXECUTIVE COMPENSATION Information required by this Item 11 concerning executive and director compensation is incorporated into this report by reference to the 2004 Proxy Statement, in which required information is set forth under the headings "Executive Compensation," "Meetings and Committees of the Board of Directors- Current Board Committees-Compensation Committee," and "{Meetings and Committees of the Board-Compensation of Directors." 32 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS Information required by this Item 12 concerning the security ownership of certain beneficial owners and management is incorporated into this report by reference to the 2004 Proxy Statement, in which required information is set forth under the heading "Security Ownership of Certain Beneficial Owners and Management-Beneficial Ownership Table." The Company does not have any equity compensation plans. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required by this Item 13 concerning certain relationships and related transactions is incorporated into this report by reference to the 2004 Proxy Statement, in which required information is set forth under the heading "Certain Relationships and Related Transactions." ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES Information required by this Item 14 concerning fees paid to our independent auditors is incorporated into this report by reference to the 2004 Proxy Statement, in which required information is set forth under the heading "Matters Relating to Our Independent Auditors." 33 34 PART IV Item 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Financial Statements and Schedules. The financial statements and related documents listed in Item 8 of this report are filed as part of this report. All other schedules to the consolidated financial statements are omitted because they are not applicable or not material or because the information is included in the consolidated financial statements or related notes in Item 8 above. (b) Reports on Form 8-K. No reports on Form 8-K were filed during the quarter ended December 31, 2003. (c) Exhibits 2.1 Copy of Registrant's Restated Articles of Incorporation, as filed August 13, 2003. 2.2 Copy of Registrant's Restated By-Laws as amended June 26, 2003. 10.1 Form of Agreement between Registrant and Physician participating in PPO. (1) 10.2 Form of Health Care Facility Service Contract between Registrant and Hospital participating in PPO. (1) 10.3 Form of Agreement between Registrant and Health Care Provider other than Hospitals and Physicians participating in PPO. (1) 10.4 Form of Agreement between Registrant and Third Party Administrator. (1) 10.5 Form of Agreement between Registrant and Insurance Company.(1) 10.6 Copy of Participation Agreement dated March 27, 1985, between Registrant and King County Public Hospital District No.2 (Evergreen General Hospital).(1) 10.7 Copy of Participation Agreement dated March 26, 1985, between Registrant and Valley Medical Center. (1) 10.8 Copy of Participation Agreement dated December 19, 1991, between Registrant and Public Hospital District No.2 of Snohomish County (Stevens Memorial Hospital) and related Promissory Note in the aggregate principal amount of $ 566,000. (1) 10.9 Copy of Participation Agreement dated December 20, 1999 between Registrant and University of Washington Academic Medical Center, and related Promissory Note in the aggregate principal amount of $1,260,000. (2) 10.10 Copy of the Chief Executive Officer's 2003 Compensation Agreement. (3) * 10.11 Copy of the Registrant's 2003 - 2005 Long-Term Incentive Program. (4) * 10.12 Copy of the Registrant's Supplemental Executive Retirement Plan. (5) * 14.1 Code of Conduct for Chief Executive Officer. 14.2 Code of Conduct for Chief Financial Officer. 14.3 Code of Conduct for Controller. 34 35 31.1 Certification pursuant to Rule 13(a)-14(a) for Gary R. Gannaway. 31.2 Certification pursuant to Rule 13(a)-14(a) for Kenneth A. Hamm. 32.1 Section 1350 Certification for Gary R. Gannaway, Chief Executive Officer. 32.2 Section 1350 Certification for Kenneth A. Hamm, Executive Vice President. * Denotes a management contract or compensatory plan or arrangement required to be filed as an exhibit to this Annual Report on Form 10-K. (1) Filed as an Exhibit to Registrant's Registration Statement on Form 10-SB. (2) Filed as Exhibit 10.23 to Registrant's Current Report on Form 8-K filed on January 3, 2000. (3) Filed as Exhibit 10.24 to Registrant's Annual Report on Form 10-K for the year ended December 31, 2002 (the "2002 10-K"). (4) Filed as Exhibit 10.25 to the 2002 10-K. (5) Filed as Exhibit 10.26 to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 2003. 35 36 SIGNATURES In accordance with Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 30th day of March, 2004. FIRST CHOICE HEALTH NETWORK, INC. By: /s/ -------------------------------------- KENNETH A. HAMM Executive Vice President of Finance (Principal Financial and Accounting Officer and Duly Authorized Officer) In accordance with the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 30, 2004.
Signature Title --------- ----- /s/ President and Chief Executive Officer ---------------------------- (Principal Executive Officer) GARY R. GANNAWAY /s/ Executive Vice President of Finance ---------------------------- (Principal Financial and Accounting Officer) KENNETH A. HAMM /s/ Director ---------------------------- DIANE E. CECCHETTINI /s/ Director ---------------------------- GERALD A. CUFLEY, M.D. /s/ Chairman of the Board of Directors ---------------------------- PAUL M. ELLIOTT /s/ Director ---------------------------- KENNETH D. GRAHAM /s/ Director ---------------------------- PHILLIP J. HAAS /s/ Director ---------------------------- WILLIAM F. JOHNSTON, M.D. /s/ Director ---------------------------- SCOTT F. KRONLUND, M.D.
36 37
Signature Title --------- ----- /s/ Director ---------------------------- GARMAN E. LUTZ /s/ Director ---------------------------- RICHARD A. MCGEE, M.D. /s/ Director ---------------------------- BARBARA L. MITCHELL /s/ Director ---------------------------- RICHARD H. PETERSON /s/ Director ---------------------------- PAUL G. RAMSEY, M.D. /s/ Director ---------------------------- RICHARD E. RUST, M.D. /s/ Director ---------------------------- GREG VAN PELT /s/ Director ---------------------------- CLYDE D. WALKER /s/ Director ---------------------------- MITCHELL B. WEINBERG
37