UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
For the quarterly period ended March 31, 2005
or
Commission file number: 001-31719
Molina Healthcare, Inc.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
(562) 435-3666
(Registrant’s telephone number, including area code)
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 Securities Exchange Act of 1934). Yes x No ¨
The number of shares of the issuer’s Common Stock, par value $0.001 per share, outstanding as of April 28, 2005, was 27,668,108.
MOLINA HEALTHCARE, INC.
Index
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PART I - FINANCIAL INFORMATION
Item 1: Financial Statements.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except per share data)
March 31,
2005
(Unaudited)
December 31,
2004
Current assets:
Cash and cash equivalents
Investments
Receivables
Deferred income taxes
Prepaid and other current assets
Total current assets
Property and equipment, net
Intangible assets, net
Goodwill
Restricted investments
Other assets
Total assets
Current liabilities:
Medical claims and benefits payable
Accounts payable and accrued liabilities
Net liability for termination of commercial operations
Income taxes payable
Current maturities of long-term debt
Total current liabilities
Long-term debt, less current maturities
Other long-term liabilities
Total liabilities
Stockholders’ equity:
Common stock, $0.001 par value; 80,000,000 shares authorized; issued and outstanding: 27,668,108 shares at March 31, 2005 and 27,602,443 shares at December 31, 2004
Preferred stock, $0.001 par value; 20,000,000 shares authorized, no shares issued and outstanding
Paid-in capital
Accumulated other comprehensive income (loss)
Retained earnings
Treasury stock (1,201,174 shares, at cost)
Total stockholders’ equity
Total liabilities and stockholders’ equity
See accompanying notes.
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CONSOLIDATED STATEMENTS OF INCOME
(amounts in thousands, except per share data)
Revenue:
Premium revenue
Other operating revenue
Total premium and other operating revenue
Investment income
Total revenue
Expenses:
Medical care costs:
Medical services
Hospital and specialty services
Pharmacy
Total medical care costs
Salary, general and administrative expenses
Depreciation and amortization
Total expenses
Operating income
Other income (expense):
Interest expense
Other, net
Total other (expense) income
Income before income taxes
Provision for income taxes
Net income
Net income per share:
Basic
Diluted
Weighted average shares outstanding:
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CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
Operating activities
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of credit facility fees
Tax benefit from exercise of employee stock options recorded as additional paid-in capital
Stock-based compensation
Changes in operating assets and liabilities:
Net cash provided by operating activities
Investing activities
Purchase of equipment
Purchases of investments
Increase in restricted cash
Sales and maturities of investments
Net cash provided by (used in) investing activities
Financing activities
Issuance of common stock
Proceeds from exercise of stock options
Borrowings under credit facility
Principal payments on capital lease obligation and mortgage note
Net cash provided by financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
Supplemental cash flow information
Cash paid during the period for:
Income taxes
Interest
Schedule of non-cash investing and financing activities:
Change in unrealized gain on investments
Deferred taxes
Change in net unrealized gain on investments
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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
March 31, 2005
1. The Reporting Entity
Molina Healthcare, Inc. (the Company) is a multi-state managed care organization that arranges for the delivery of health care services to persons eligible for Medicaid and other programs for low-income families and individuals. We were founded in 1980 as a provider organization serving the Medicaid population through a network of primary care clinics in California. In 1994, we began operating as a health maintenance organization (HMO). We operate our HMO business through subsidiaries in California (California HMO), Indiana (Indiana HMO), Michigan (Michigan HMO), New Mexico (New Mexico HMO), Utah (Utah HMO) and Washington (Washington HMO)).
2. Basis of Presentation
The unaudited consolidated interim financial statements have been prepared under the assumption that users of the interim financial data have either read or have access to our audited consolidated financial statements for the latest fiscal year ended December 31, 2004. Accordingly, certain note disclosures that would substantially duplicate the disclosures contained in the December 31, 2004 audited financial statements have been omitted. These unaudited consolidated interim financial statements should be read in conjunction with our December 31, 2004 audited financial statements.
The consolidated financial statements include the accounts of the Company and all majority owned subsidiaries. In the opinion of management, all adjustments considered necessary for a fair presentation of the results as of the date and for the interim periods presented, which consist solely of normal recurring adjustments, have been included. All significant inter-company balances and transactions have been eliminated in consolidation. The consolidated results of operations for the current interim period are not necessarily indicative of the results that may be expected for the entire year ending December 31, 2005.
Stock-Based Compensation
At March 31, 2005 we had two stock-based employee compensation plans, the 2000 Omnibus Stock and Incentive Plan and the 2002 Equity Incentive Plan. The 2000 Omnibus Stock and Incentive Plan is frozen. We account for stock-based compensation under the recognition and measurement principles (the intrinsic-value method) prescribed in Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Compensation cost for stock options is reflected in net income and is measured as the excess of the market price of the Company’s stock at the date of grant over the amount an employee must pay to acquire the stock. We have adopted the disclosure provisions required by SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure.
Common shares issued pursuant to the exercise of stock options for the three months ended March 31, 2005 and 2004 were 65,665 and 172,402, respectively.
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The following table illustrates the effect on net income and earnings per share as if we had applied the fair value recognition provisions to stock-based employee compensation permitted by SFAS No. 148.
Net income, as reported
Reconciling items (net of related tax effects):
Add: Stock-based employee compensation expense determined under the intrinsic-value based method for all awards
Deduct: Stock-based employee compensation expense determined under the fair-value based method for all awards
Net adjustment
Net income, as adjusted
Earnings per share:
Basic—as reported
Basic—as adjusted
Diluted—as reported
Diluted—as adjusted
The following table illustrates the components of our stock-based compensation expense (net of tax) for the three months ended March 31, 2005 and 2004 as reported in the Consolidated Statements of Income:
Stock options
Stock grants
Total stock-based compensation expense
The recognition and measurement of stock grants is the same under APB Opinion No. 25 and SFAS No. 123, Accounting for Stock Based Compensation. The related expenses for the fair value of stock grants were charged to salary, general and administrative expenses and are included in the net income, as reported amounts in the pro forma net income table above.
In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment. SFAS No. 123R is a revision of SFAS No. 123, and supersedes APB 25. Among other items, SFAS 123R eliminates the use of APB 25 and the intrinsic value method of accounting, and requires companies to recognize the cost of employee services received in exchange for awards of equity instruments, based on the grant date fair value of those awards, in the financial statements. The effective date of SFAS 123R is the beginning of our next fiscal year, which means we do not need to adopt it until the first quarter of 2006, although early adoption is allowed. SFAS 123R permits companies to adopt its requirements using either a “modified prospective” method or a “modified retrospective” method. Under the “modified prospective” method, compensation cost is recognized in the financial statements beginning with the effective date, based on the requirements of SFAS 123R for all share-based payments granted after that date, and based on the requirements of SFAS 123 for all unvested awards granted prior to the effective date of SFAS 123R. Under the “modified retrospective” method, the requirements are the same as under the “modified prospective” method, but entities are also permitted to restate financial statements of previous periods based on proforma disclosures made in accordance with SFAS 123.
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Earnings Per Share
The denominators for the computation of basic and diluted earnings per share are calculated as follows:
Three months ended
March 31
Shares outstanding at the beginning of the period
Weighted average number of shares issued in public offering
Weighted average number of shares issued for stock options and employee stock purchases
Weighted-average number of shares acquired
Denominator for basic earnings per share
Dilutive effect of employee stock options
Denominator for diluted earnings per share
3. Other Income
For the quarter ended March 31, 2004, we recognized $1,162 in income arising from the termination of a split dollar life insurance arrangement with a related party.
4. Receivables
Receivables consist primarily of amounts due from the various states in which we operate. Accounts receivable by operating subsidiary are comprised of the following:
California HMO
Utah HMO
Washington HMO
Other
Total receivables
Substantially all receivables due our California HMO at March 31, 2005 and December 31, 2004, were collected in April and January of 2005, respectively. The receivable due our Utah HMO as of March 31, 2005 increased as a result of a late payment received from the state of Utah in April 2005.
Our agreement with the state of Utah calls for the reimbursement of our Utah HMO of medical costs incurred in serving our members plus an administrative fee of 9% of medical costs and all or a portion of any cost savings realized, as defined in the agreement. Our Utah HMO bills the state of Utah monthly for actual paid health care claims plus administrative fees. Our receivable balance from the state of Utah includes: 1) amounts billed to the state for actual paid health care claims plus administrative fees; 2) amounts estimated to be due under the savings sharing provision of the agreement; and 3) amounts estimated for incurred but not reported claims, which, along with the related administrative fees, are not billable to the state of Utah until such claims are actually paid.
5. Long-Term Debt
On March 9, 2005, we entered into an amended and restated five-year secured credit agreement for a $180 million revolving credit facility with a syndicate of lenders. The credit facility will be used for working capital purposes. This credit facility replaced the facility that we entered into on March 19, 2003.
The credit facility has a term of five years and all amounts outstanding under the credit facility will be due and payable on March 8, 2010. Subject to obtaining commitments from existing or new lenders and satisfaction of other specified conditions, we may increase the credit facility to up to $200 million.
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Borrowings under the credit facility are based, at our election, on the London interbank deposit, or LIBOR, rate or the base rate plus an applicable margin. The base rate will equal the higher of Bank of America’s prime rate or 0.5% above the federal funds rate. We also will pay a commitment fee on the total unused commitments of the lenders under the credit facility. Until the delivery of a compliance certificate with respect to the our financial statements for the quarter ending June 30, 2005, the applicable margin is fixed at 1.25% for LIBOR loans and 0.25% for base rate loans and the commitment fee is fixed at 0.30%. Thereafter, the applicable margins and commitment fee will be based on our ratio of consolidated funded debt to consolidated EBITDA. The applicable margins will range between 1.00% and 1.75% for LIBOR loans and between 0% and 0.75% for base rate loans. The commitment fee will range between 0.25% and 0.375%. In addition, we will pay a fee for each letter of credit issued under the credit facility equal to the applicable margin for LIBOR loans and a customary fronting fee.
As with our prior credit facility, our obligations under the amended and restated credit facility are secured by a lien on substantially all of our assets and by our previous pledge of the capital stock of our Michigan, New Mexico, Utah, and Washington HMO subsidiaries.
The credit agreement includes usual and customary covenants for credit facilities of this type, including covenants limiting liens, mergers, asset sales, other fundamental changes, debt, acquisitions, dividends and other distributions, capital expenditures, and investments. The credit agreement also requires us to maintain a ratio of total consolidated debt to total consolidated EBITDA of not more than 2.00 to 1.00 as of the end of each fiscal quarter and a fixed charge coverage ratio of 2.00 to 1.00 (which increases to 3.00 to 1.00 as of December 31, 2006). At March 31, 2005 we were in compliance with all covenants under the credit agreement.
At March 31, 2005, $3.1 million was outstanding under the credit facility.
6. Commitments and Contingencies
Legal
The health care industry is subject to numerous laws and regulations of federal, state, and local governments. Compliance with these laws and regulations can be subject to government review and interpretation, as well as regulatory actions unknown and unasserted at this time. Penalties associated with violations of these laws and regulations include significant fines and penalties, exclusion from participating in publicly-funded programs, and the repayment of previously billed and collected revenues. Additionally, many of our medical contracts are complex in nature and may be subject to differing interpretations regarding amounts due for the provision of various services. Such differing interpretations may lead to disputes with medical providers which may seek additional monetary compensation.
In July 2004, our California HMO received a demand for arbitration from USC/Tenet Hospital, or Tenet, seeking damages of approximately $4,500 involving certain disputed medical claims. In September 2004, Tenet amended its demand to join additional Tenet hospital claimants and to increase its damage claim to approximately $8,000. To date no significant discovery has taken place. We believe that the California HMO has meritorious defenses to Tenet’s claims and we intend to vigorously defend this matter. We do not believe that the ultimate resolution of this matter will materially affect our consolidated financial position, results of operations, or cash flows.
We are involved in other legal actions in the normal course of business, some of which seek monetary damages, including claims for punitive damages, which are not covered by insurance. These actions, when finally concluded and determined, will not, in our opinion, have a material adverse effect on our consolidated financial position, results of operations, or cash flows.
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Provider Claims
The Los Angeles County Department of Health (Department of Health) has contacted our California HMO seeking additional or first-time reimbursement of claims for services ostensibly provided by Los Angeles County Hospitals to members of our California HMO that purportedly were not paid or were underpaid by us. The total amount claimed by the Department of Health in additional and first-time reimbursement is approximately $2,900. Much of the amount claimed by the Department of Health involves issues of contract compliance, interpretation and intent. We are evaluating the Department of Health claims and are unable at this time to determine either the validity of those claims or the degree, if any, of our liability in regards to this matter. Nevertheless, we do not believe that the ultimate resolution of this matter will materially affect our consolidated financial position, results of operations, or cash flows.
Regulatory Capital and Dividend Restrictions
Our principal operations are conducted through our five HMO subsidiaries operating in California, Michigan, New Mexico, Utah and. Washington. Our HMOs are subject to state regulations that, among other things, require the maintenance of minimum levels of statutory capital, as defined by each state, and restrict the timing, payment and amount of dividends and other distributions that may be paid to us as the sole stockholder. To the extent the subsidiaries must comply with these regulations, they may not have the financial flexibility to transfer funds to us. The net assets in these subsidiaries (after intercompany eliminations), which may not be transferable to us in the form of loans, advances or cash dividends was $142,400 at March 31, 2005, and $130,000 at December 31, 2004. The National Association of Insurance Commissioners, or NAIC, adopted rules effective December 31, 1998, which, if implemented by the states, set new minimum capitalization requirements for insurance companies, HMOs and other entities bearing risk for health care coverage. The requirements take the form of risk-based capital (RBC) rules. Washington, Michigan, and Utah have adopted these rules, which may vary from state to state. While New Mexico has not formally adopted the RBC rules, that state holds our New Mexico HMO to those rules. California has not yet adopted NAIC risk-based capital requirements for HMOs and has not formally given notice of its intention to do so. Such requirements, if adopted by California, may increase the minimum capital required for that state.
As of March 31, 2005, our HMOs had aggregate statutory capital and surplus of approximately $171,700 compared with the required minimum aggregate statutory capital and surplus of approximately $85,100. All of our HMOs were in compliance with the minimum capital requirements. We have the ability and commitment to provide additional working capital to each of our HMOs when necessary to ensure that statutory capital and surplus continue to meet regulatory requirements.
7. Acquisitions
Pro Forma Financial Information
On July 1, 2004, we acquired the capital stock of Health Care Horizons, Inc., or HCH,, which is the parent company of New Mexico-based Cimarron Health Plan, Inc. Our consolidated results of operations include HCH from July 1, 2004. The pro forma results listed below are unaudited and reflect the consolidated results of operations of the Company and HCH as if HCH had been acquired, and the commercial membership had been transferred to Lovelace Sandia Health Systems, Inc., as of January 1, 2004. The pro forma adjustments include amortization of intangibles, reduction of investment income for proceeds used to pay the purchase price consideration, elimination of incremental commercial activities (premiums, medical care costs, administrative expenses), and related income tax effects.
Total operating revenue
Basic income per share
Diluted earnings per share
The pro forma results are not necessarily indicative of what actually would have occurred if the acquisition had been in effect for the entire period presented. In addition, they are not intended to be a projection of future results and do not reflect any synergies that might be achieved from the combined operations.
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We established a reserve to record our net liability incurred in regard to the termination of the commercial health plan operations of HCH and Cimarron Health Plan. That reserve was calculated to be $2,900 representing the estimated cash outflows for the termination of commercial operations and transition services agreement, offset by $260, the net cash inflows of the commercial operations for the one-month period ended July 31, 2004. A summary of activity for this reserve for the period July 1, 2004 through March 31, 2005 follows:
Net liability for termination of commercial operations at July 1, 2004
Revenue earned on transition services agreement
Expenses incurred in providing transition services
Net liability for termination of commercial operations at March 31, 2005
8. Public Offerings of Common Stock
In March 2004, we completed a public offering of our common stock. We sold 1,800,000 shares, generating net proceeds of approximately $47,282 after deducting approximately $600 in fees, costs and expenses and $2,520 in the underwriters’ discount.
9. Subsequent Events
On April 1, 2005 our Indiana HMO became operational, serving about 5,000 members.
On April 4, 2005 we filed a registration statement on Form S-3 (No. 333-123783) with the Securities and Exchange Commission relating to the proposed follow-on offering of 3,000,000 shares of common stock, 1,000,000 shares of which are being offered by us and 2,000,000 shares of which are being offered by three selling stockholders - the Molina Siblings Trust, the MRM GRAT 903/2 and the MRM GRAT 904/2. We will use the net proceeds from the offering of shares to repay amounts outstanding under our credit facility and for working capital and other general corporate purposes, which may include acquisitions. We will not receive any proceeds from the sale of shares by the selling stockholders.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Forward- Looking Statements
The information made available below and elsewhere in this quarterly report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. These forward-looking statements are often accompanied by words such as “believe,” “anticipate,” “plan,” “expect,” “estimate,” “intend,” “seek,” “goal,” “may,” “will” and similar expressions. These statements include, without limitation, statements about our market opportunity, our growth strategy, competition, expected activities and future acquisitions and investments and the adequacy of our available cash resources. Investors are cautioned that matters subject to forward-looking statements involve risks and uncertainties that may affect our business, including economic, regulatory, competitive and other factors that may be described in our Annual Report on Form 10-K and/or other filings with the Securities and Exchange Commission. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions.
Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual results in future periods to differ materially from those projected or contemplated in the forward-looking statements as a result of, but not limited to, the following factors:
Investors should also refer to our Annual Report on Form 10-K for the year ended December 31, 2004 for a discussion of certain risk factors. Given these risks and uncertainties, we can give no assurances that any forward-looking statements will in fact occur and therefore caution investors not to place undue reliance on them.
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This document and the following discussion of our financial condition and results of operations should be read in conjunction with the accompanying consolidated financial statements and the notes to those statements appearing elsewhere in this report and the audited financial statements and Management’s Discussion and Analysis appearing in our Report on Form 10-K for the year ended December 31, 2004.
Overview
We are a multi-state managed care organization that arranges for the delivery of health care services to persons eligible for Medicaid and other programs for low-income families and individuals. Our objective is to become the leading managed care organization in the United States focused primarily on serving people who receive health care benefits through state-sponsored programs for low-income populations.
We generate revenues primarily from premiums we receive from the states in which we operate. Premium revenue is fixed in advance of the periods covered and is not subject to significant accounting estimates. In the three months ended March 31, 2005 we received approximately 87.4% of our premium revenue as a fixed amount per member per month pursuant to our contracts with state Medicaid agencies and other managed care organizations with which we operate as a subcontractor. These premium revenues are recognized in the month members are entitled to receive health care services. Approximately 6.4% of our premium revenue in the three months ended March 31, 2005 was realized under a cost plus reimbursement agreement that our Utah HMO has with that state. We also received approximately 6.2% of our premium revenue for the three months ended March 31, 2005 in the form of birth payments (one-time payments for the delivery of children) from the Medicaid programs in Michigan, New Mexico and Washington. Such payments are recognized as revenue in the month the birth occurs. The state Medicaid programs periodically adjust premium rates.
Membership growth has been the primary reason for our increasing revenues. We have increased our membership through both internal growth and acquisitions. The following table sets forth the approximate number of members by state as of the dates indicated.
Market
California
Michigan
New Mexico
Utah
Washington
Total
The following table details member months (defined as the aggregation of each month’s membership for the period) by state for the three-months ended March 31, 2005 and 2004:
Other operating revenue primarily includes fee-for-service revenue generated by our clinics in California; savings sharing revenues in California and Utah, where we receive additional incentive payments from those states if medical costs are less than prescribed amounts; and certain ancillary revenues in New Mexico.
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Our operating expenses include expenses related to the provision of medical care services and salary, general and administrative, or SG&A, costs. Our results of operations depend on our ability to effectively manage expenses related to health benefits and accurately predict costs incurred.
Expenses related to medical care services include two components: direct medical expenses and medically related administrative costs. Direct medical expenses include payments to physicians, hospitals and providers of ancillary medical services, such as pharmacy, laboratory and radiology services. Medically-related administrative costs include expenses relating to health education, quality assurance, case management, disease management, 24-hour on-call nurses, member services and compliance. In general, primary care physicians are paid on a capitation basis (a fixed amount per member per month regardless of actual utilization of medical services), while specialists and hospitals are paid on a fee-for-service basis. For the three months ended March 31, 2005, approximately 86% of our direct medical expenses were related to fees paid to providers on a fee-for-service basis, with the balance paid on a capitation basis. Physician providers not paid on a capitated basis are paid on a fee schedule set by the state or by our contracts with these providers. We pay hospitals in a variety of ways, including fee-for-service, per diems, diagnostic-related groups and case rates.
Capitation payments are fixed in advance of periods covered and are not subject to significant accounting estimates. These payments are expensed in the period the providers are obligated to provide services. Fee-for-service payments are expensed in the period services are provided to our members. Medical care costs include actual historical claims experience and estimates of medical expenses incurred but not reported, or IBNR. Monthly, we estimate our IBNR based on a number of factors, including prior claims experience, inpatient hospital utilization data and prior authorization of medical services. As part of this review, we also consider estimates of amounts to cover uncertainties related to fluctuations in provider billing patterns, claims payment patterns, membership and medical cost trends. These estimates are adjusted monthly as more information becomes available. We employ our own actuary and engage the service of independent actuaries as needed. We believe that our process for estimating IBNR is adequate, but there can be no assurance that medical care costs will not exceed such estimates.
SG&A costs are largely comprised of wage and benefit costs related to our employee base and other administrative expenses. Some SG&A services are provided locally, while others are delivered to our health plans from a centralized location. The major centralized functions are claims processing, information systems, finance and accounting services, and legal and regulatory services. Locally-provided functions include marketing (to the extent permitted by law and regulation), plan administration and provider relations. Included in SG&A expenses are premium taxes for our Michigan, Washington and, beginning with its acquisition on July 1, 2004, New Mexico HMOs.
Results of Operations
The following table sets forth selected operating ratios. All ratios with the exception of the medical care ratio are shown as a percentage of total revenue. The medical care ratio is shown as a percentage of premium and other operating revenue because there is a direct relationship between the premium and other operating revenue earned and the cost of health care.
Medical care ratio
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Three Months Ended March 31, 2005 Compared to Three Months Ended March 31, 2004
Premium Revenue
Premium revenue for the first quarter of 2005 was $390.9 million, representing an increase of $173.0 million, or 79.4%, over premium revenue of $217.9 million for the same period of 2004.
Membership growth contributed $106.7 million to the increase in premium revenue. Enrollment was significantly higher in Washington and Michigan, principally due to the transfer of members from other health plans in the second and fourth quarters of 2004, respectively, in those states. Additionally, the first quarter of 2005 benefited from our New Mexico acquisition, which closed on July 1, 2004.
Higher premium rates contributed the remaining $66.3 million to the increase premium revenue. Blended premium increases were most pronounced at our Michigan and Washington HMOs. Additionally, premium rates at our New Mexico HMO are considerably higher than the average for our company as a whole.
Other Operating Revenue
Other operating revenue was $1.3 million for the three months ended March 31, 2005 and March 31, 2004. Other operating revenue primarily includes fee-for-service revenue generated by our clinics in California; savings sharing revenues in Utah and California, where we receive additional incentive payments from those states if medical costs are less than prescribed amounts; and certain ancillary revenues in New Mexico.
Investment Income
Investment income for the three months ended March 31, 2005 increased to $1.8 million from $0.9 million for the same period of 2004, principally as a result of larger invested balances as well as higher investment yields.
Medical Care Costs
Medical care costs as a percentage of premium and other operating revenue (the medical care ratio) increased to 84.9% in the first quarter of 2005 from 84.1% in the first quarter of 2004. Medical care costs increased in absolute terms to $333.1 million in the first quarter of 2005 from $184.2 million in the first quarter of 2004.
The primary source of the increase in the medical care ratio was the acquisition of the New Mexico HMO, which has traditionally experienced a higher medical care ratio than our other HMOs. Excluding our New Mexico HMO, our medical care ratio for the first quarter of 2005 was 84.2%, essentially flat when compared to the 84.1% medical care ratio experienced in the first quarter of 2004.
Our medical margin (defined as the difference between the total of premium and other operating revenue and medical costs) grew substantially in the first quarter of 2005 when compared with the first quarter of 2004. Medical margin increased to $24.69 per member per month in 2005 from $20.10 per member per month in 2004, an increase of approximately 23%.
Salary, General and Administrative Expenses
SG&A expenses were $33.5 million for the first quarter of 2005, representing 8.5% of total revenue, as compared with $17.5 million, or 7.9% of total revenue, for the first quarter of 2004. Excluding premium taxes, SG&A expenses decreased to 5.9% of total revenue in the first quarter of 2005, as compared with 6.6% in the first quarter of 2004.
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Depreciation and Amortization
Depreciation and amortization expense for the three months ended March 31, 2005 increased to $3.2 million from $1.6 million for the same period of the prior year. The increase was primarily due to the amortization of identifiable intangible assets acquired in the Washington (Premera) and New Mexico acquisitions, as well as increased capital expenditures.
Provision for Income Taxes
Income tax expense increased approximately to $9.0 million in the first quarter of 2005 from $6.6 million in the first quarter of 2004. The effective tax rate for the first quarter of 2005 was 38.0% as compared with an effective tax rate of 37.2% for the first quarter of 2004.
Liquidity and Capital Resources
We generate cash from premium revenue, services provided on a fee-for-service basis at our clinics and investment income. Our primary uses of cash include the payment of expenses related to medical care services and SG&A expenses. We generally receive premium revenue in advance of payment of claims for related health care services.
Our investment policies are designed to provide liquidity, preserve capital and maximize total return on invested assets. As of March 31, 2005, we invested a substantial portion of our cash in a portfolio of highly liquid money marketable securities. Our investments (all of which are classified as current assets) consisted solely of investment grade debt securities with a maximum maturity of eight years and an average duration of three years. Two professional portfolio managers operating under documented investment guidelines manage our investments. The average annualized portfolio yield for the three months ended March 31, 2005 and 2004 was approximately 2.2% and 1.5%, respectively.
The states in which we operate prescribe the types of instruments in which our subsidiaries may invest their funds. Our restricted investments are invested principally in certificates of deposit and treasury securities with maturities of up to 12 months.
Net cash provided by operating activities was $2.4 million for the three months ended March 31, 2005 and $12.0 million for the three months ended March 31, 2004. The decrease in net cash provided by operations for the three months ended March 31, 2005 when compared to the three months ended March 31, 2004 was due to the following factors:
These factors were offset in part by the following factors:
Because we generally receive premium revenue in advance of payment for the related medical care costs (with the exception of our Utah HMO), our cash has increased during periods when we experienced enrollment growth. Our ability to support the increase in membership with existing infrastructure also allows us to retain a larger portion of the additional premium revenue as profit.
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At March 31, 2005, we had working capital of $219.2 million as compared to $202.2 million at December 31, 2004. At March 31, 2005 and December 31, 2004, cash, cash equivalents and investments (all classified as current assets) were $315.6 million and $316.6 million, respectively.
Our subsidiaries are required to maintain minimum capital prescribed by various jurisdictions in which we operate. As of March 31, 2005, all of our subsidiaries were in compliance with the minimum capital requirements. Barring any change in regulatory requirements, we believe that we will continue to be in compliance with these requirements at least through 2005. We also believe that our cash resources and internally generated funds will be sufficient to support our operations, regulatory requirements and capital expenditures for at least the next 12 months.
Our principal operations are conducted through our five HMO subsidiaries operating in California, Michigan, New Mexico, Utah and Washington, respectively. Our Indiana HMO began operating on April 1, 2005. The HMOs are subject to state laws that, among other things, may require the maintenance of minimum levels of statutory capital, as defined by each state, and may restrict the timing, payment and amount of dividends and other distributions that may be paid to their stockholders.
The National Association of Insurance Commissioners, or NAIC, adopted rules effective December 31, 1998, which, if implemented by the states, set new minimum capitalization requirements for insurance companies, HMOs and other entities bearing risk for health care coverage. The requirements take the form of risk-based capital, or RBC, rules. These rules, which may vary from state to state, have been adopted in, Michigan, Utah and Washington. While New Mexico has not formally adopted the RBC rules, that state holds our New Mexico HMO to those rules. California has not adopted RBC rules and has not formally given notice of any intention to do so. The RBC rules, if adopted by California, may increase the minimum capital required for that state.
As of March 31, 2005 our HMOs had aggregate statutory capital and surplus of approximately $171.7 million, compared with the required minimum aggregate statutory capital and surplus of approximately $85.1 million. All of our HMOs were in compliance with the minimum capital requirements. We have the ability and commitment to provide additional working capital to each of our HMOs when necessary to ensure that total adjusted capital continually meets regulatory requirements.
Contractual Obligations
In our Report on Form 10-K for the year ended December 31, 2004, we reported on our contractual obligations as of that date. There have been no material changes to our contractual obligations since that report.
Critical Accounting Policies
When we prepare our consolidated financial statements, we use estimates and assumptions that may affect reported amounts and disclosures. The determination of our liability for claims and medical benefits payable is particularly important to the determination of our financial position and results of operations and requires the application of significant judgment by our management and, as a result, is subject to an inherent degree of uncertainty.
Our medical care costs include actual historical claims experience and estimates for medical care costs incurred but not reported to us (IBNR). We, together with our inhouse actuaries, estimate medical claims liabilities using actuarial methods based upon historical data adjusted for payment patterns, cost trends, product mix, seasonality, utilization of health care services and other relevant factors. The estimation methods and the resulting reserves are frequently reviewed and updated, and adjustments, if necessary, are reflected in the period known. We also record reserves for estimated referral claims related to medical groups under contract with us that are financially troubled or insolvent and that may not be able to honor their obligations for the payment of medical services provided by other providers. In these instances, we may be required to honor these obligations for legal or business reasons. Based on our current assessment of providers under contract with us, such losses are not expected to be significant. In applying this policy, we use judgment to determine the appropriate assumptions for determining the required estimates. While we believe our estimates are adequate, it is possible that future events could require us to make significant adjustments or revisions to these estimates. In assessing the adequacy of accruals for medical claims liabilities, we consider our historical experience, the terms of existing contracts, our knowledge of trends in the industry, information provided by our customers and information available from other sources as appropriate.
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The most significant estimates involved in determining our claims liability concern the determination of claims payment completion factors and trended per member per month cost estimates.
For the five months of service prior to the reporting date and earlier, we estimate our outstanding claims liability based upon actual claims paid, adjusted for estimated completion factors. Completion factors seek to measure the cumulative percentage of claims expense that will have been paid for a given month of service as of the reporting date based on historical payment patterns. The following table reflects the change in our estimate of claims liability as of March 31, 2005 that would have resulted had we changed our completion factors for the fifth through the twelfth months preceding March 31, 2005 by the percentages indicated. A reduction in the completion factor results in an increase medical liabilities. Our Utah HMO is excluded from these calculations, as the majority of its business is conducted under a cost reimbursement contract. Amounts are in thousands.
Increase (Decrease) in
Estimated
Completion Factors
(3)%
(2)%
(1)%
1%
2%
3%
For the four months of service immediately prior to the reporting date, actual claims paid are not a reliable measure of our ultimate liability, given the inherent delay between the patient/physician encounter and the actual submission of a claim. For these months of service we estimate our claims liability based upon trended per member per month (PMPM) cost estimates. These estimates reflect recent trends in payments and expense, utilization patterns, authorized services and other relevant factors. The following table reflects the change in our estimate of claims liability as of March 31, 2005 that would have resulted had we altered our trend factors by the percentages indicated. An increase in the PMPM costs results in an increase in medical liabilities. Our Utah HMO is excluded from these calculations, as the majority of its business is conducted under a cost reimbursement contract. Amounts are in thousands.
Trended Per member Per Month
Cost Estimates
Assuming a hypothetical 1% change in both completion factors and per member per month cost estimates from those used in our calculation of IBNR at March 31, 2005 net income for the three months ended March 31, 2005 would increase or decrease by approximately $1.7 million, or $0.06 per diluted share, net of tax.
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The following table shows the components of the change in medical claims and benefits payable for the three months ended March 31, 2005 and 2004:
Balances at beginning of period
Components of medical care costs related to:
Current year
Prior years
Payments for medical care costs related to:
Total paid
Balances at end of period
Inflation
We use various strategies to mitigate the negative effects of health care cost inflation. Specifically, our health plans try to control medical and hospital costs through contracts with independent providers of health care services. Through these contracted providers, our health plans emphasize preventive health care and appropriate use of specialty and hospital services.
While we currently believe our strategies to mitigate health care cost inflation will continue to be successful, competitive pressures, new health care and pharmaceutical product introductions, demands from health care providers and customers, applicable regulations, or other factors may affect our ability to control health care costs.
Compliance Costs
Our health plans are regulated by both state and federal government agencies. Regulation of managed care products and health care services is an evolving area of law that varies from jurisdiction to jurisdiction. Regulatory agencies generally have discretion to issue regulations and interpret and enforce laws and rules. Changes in applicable laws and rules occur frequently. Compliance with such laws and rules may lead to additional costs related to the implementation of additional systems, procedures and programs that we have not yet identified.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Concentrations of Credit Risk
Financial instruments that potentially subject us to concentrations of credit risk consist primarily of cash and cash equivalents, investments, receivables and restricted investments. We invest a substantial portion of our cash in the CADRE Affinity Fund and CADRE Reserve Fund (CADRE Funds), a portfolio of highly liquid money market securities. Three professional portfolio managers operating under documented investment guidelines manage our investments. Restricted investments are invested principally in certificates of deposit and treasury securities. Concentration of credit risk with respect to accounts receivable is limited due to payors consisting principally of the governments of each state in which our HMO subsidiaries operate.
As of March 31, 2005, we had cash and cash equivalents of $242.4 million, investments of $73.2 million and restricted investments of $10.9 million. Cash equivalents consist of highly liquid securities with original maturities of up to three months. Our investments (all of which are classified as current assets) consist solely of investment grade debt securities with a maximum maturity of eight years and an average duration of three years. The restricted investments consist of interest-bearing deposits required by the respective states in which we operate. These investments are subject to interest rate risk and will decrease in value if market rates increase. All non-restricted investments are maintained at fair market value on the balance sheet. We have the ability to hold these investments until maturity, and as a result, we would not expect the value of these investments to decline significantly as a result of a sudden change in market interest rates. Declines in interest rates over time will reduce our investment income.
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Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures: Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, has concluded, based upon its evaluation as of the end of the period covered by the report, that the Company’s “disclosure controls and procedures” (as defined in Rules 13(a)-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) are effective to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.
Changes in Internal Controls: There were no changes in our internal control over financial reporting during the three months ended March 31, 2005 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
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PART II – OTHER INFORMATION
Item 6. Exhibits
Title
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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.
(Registrant)
/s/ JOSEPH M. MOLINA, M.D.
Joseph M. Molina, M.D.
Chairman of the Board,
Chief Executive Officer and President
(Principal Executive Officer)
/s/ JOHN C. MOLINA, J.D.
John C. Molina, J.D.
Executive Vice President, Financial Affairs,
Chief Financial Officer and Treasurer
(Principal Financial Officer)
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