10-Q 1 fchn10q2_2002.txt 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10 - Q [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2002 [ ] TRANSITION REPORT PURSUANT TO 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 number) 601 Union Street Suite 1100 Seattle, Washington 98101 (Address of principal executive offices) (206) 292-8255 (Issuer's telephone number, including area code) Check whether the issuer: (1) filed all reports required to be filed by Section 13 or 15 (d) of the Exchange Act during the past 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 ______ The aggregate number of Registrant's shares of Class A Common Stock and Class B Common Stock outstanding on June 30, 2002, was 538 shares and 40,600 shares, respectively. 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. Therefore, such dividends may not be paid while an obligation to repurchase shares remains outstanding. Pursuant to the Company's contracts with the Hospital Participants, if First Choice pays any dividends or other distributions with respect to the Class B Common Stock, First Choice must make an equivalent distribution to the Hospital Participants. The Company does not currently anticipate paying cash dividends on its capital stock. 1 2 FIRST CHOICE HEALTH NETWORK, INC. INDEX TO FORM 10-Q Page Part I Financial Information Item 1 Financial Statements Condensed Consolidated Balance Sheets (Unaudited) at June 30, 2002 and December 31, 2001 . . . . . . . . . . 3 Condensed Consolidated Statements of Operations (Unaudited)for the Three Months and Six Months Ended June 30, 2002 and 2001 . . . . . . . . . . . . . . . . . . 5 Condensed Consolidated Statements of Cash Flows (Unaudited) for the Six Months Ended June 30, 2002 and 2001 . . . . . . . . . . . . . . . . . . . . . . . . . 6 Notes to Condensed Consolidated Financial Statements (Unaudited). . . . . . . . . . . . . . . . . . . . . . . . 7 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations . . . . . . 10 Item 3 Quantitative and Qualitative Disclosures About Market Risk . . . . . . . . . . . . . . . . . . . 11 Part II Other Information Item 1 Legal Proceedings . . . . . . . . . . . . . . . . . . . . 12 Item 2 Changes in Securities and Use of Proceeds . . . . . . . . 12 Item 3 Defaults Upon Senior Securities . . . . . . . . . . . . . 12 Item 4 Submission of Matters to a Vote of Security Holders . . . 12 Item 5 Other Information . . . . . . . . . . . . . . . . . . . . 12 Item 6 Exhibits and Reports on Form 8-K . . . . . . . . . . . . . 12 Item 7 Forward-Looking Statements . . . . . . . . . . . . . . . . 12 Signatures . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 2 3 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED BALANCE SHEETS JUNE 30, 2002 AND DECEMBER 31, 2001 UNAUDITED

See Notes to Condensed Consolidated Financial Statements. 3 4 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED BALANCE SHEETS JUNE 30, 2002 AND DECEMBER 31, 2001 UNAUDITED

See Notes to Condensed Consolidated Financial Statements. 4 5 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 2002 AND 2001 UNAUDITED

See Notes to Condensed Consolidated Financial Statements. 5 6 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED JUNE 30, 2002 AND 2001 UNAUDITED

See Notes to Condensed Consolidated Financial Statements. 6 7 FIRST CHOICE HEALTH NETWORK, INC AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE SIX MONTHS ENDED JUNE 30, 2002 AND 2001 NOTE 1 PRESENTATION OF INTERIM INFORMATION The accompanying unaudited interim condensed consolidated financial statements and related notes have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission and in accordance with accounting principles generally accepted in the United States of America. In the opinion of the management of First Choice Health Network, Inc. and Subsidiary, the accompanying unaudited interim condensed consolidated financial statements include all normal adjustments considered necessary to present fairly the financial position as of June 30, 2002, and the results of operations for the three months and six months ended June 30, 2002 and 2001, and cash flows for the six months ended June 30, 2002 and 2001. The condensed consolidated financial statements were prepared on the same basis as the annual 2001 consolidated financial statements. The results of interim operations are not necessarily indicative of operating results for the entire year. NOTE 2 INVESTMENTS The amortized cost, unrealized gains or losses and fair values of investments in debt securities, as of June 30, 2002, are as follows:

7 8 In determining fair value, management obtains quotations from independent sources who make markets in similar securities, generally broker dealers. These quotes are generally estimates of fair value based on an evaluation of appropriate facts such as trading in similar securities, yields, credit quality, coupon rate, maturity, type of issue, and other market data. Sales of investments available for sale totaled $2,246,436 and principal buydowns on these investments during the second quarter of 2002 were $1,364,191. NOTE 3 RECENTLY ISSUED ACCOUNTING STANDARDS In October 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations, which is effective for business combinations initiated after June 30, 2001. This statement establishes the purchase method as the only acceptable method of accounting for business combinations and eliminates the pooling-of-interest method. Also, in October 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets, which is effective for fiscal years beginning after December 15, 2001. SFAS No. 142 establishes new accounting and reporting standards for goodwill and other intangible assets. Under this statement, goodwill will no longer be amortized, but will be recognized and measured based on its fair value. Management performed an impairment test in January 2002 upon adoption of SFAS No. 142 and determined there was impairment of the remaining portion of goodwill resulting in a charge to amortization and other expense of $27,526. The value of goodwill was determined to be impaired as a result of the decision to proceed with an orderly exit from the insured health care business. Management does not believe that adoption of these statements will have a further, material effect on the Company's financial condition or results of operations. The following table reflects the pro forma effect on goodwill and net income of the Company if SFAS No. 142 was in effect for the six months ended June 30, 2002 and June 30, 2001. For the six months ended June 30, 2002 2001 ------ ------ Goodwill amortization - 27,538 Net Income/(Loss) 92,031 (498,880) The remaining portion of amortization for the six months ended June 30, 2001 relates to the intangible asset acquired in the Sound Health purchase in 1998, which was fully amortized in November 2001. NOTE 4 REPORTABLE OPERATING SEGMENTS Factors management used to identify the enterprise's reportable segments: The Company has two reportable segments which correspond to the organization of the Company and its majority-owned subsidiary, First Choice Health Plan, Inc. (the "Plan"). Each segment requires distinct tracking capabilities in the areas of revenues, claims processing, marketing strategies, and reporting to regulatory organizations. Description of the types of products and services from which each reportable segment derives its revenue: The Company has two primary products which have been aggregated into one reportable segment: network access fees and hospital administration fees. Network access fees arise from the rental of the Company's large PPO network while hospital administrative 8 9 fees arise from charges to the network hospitals based on claims incurred by members. The other reportable segment, the Plan, offers a variety of fully insured health insurance plans to employer groups. The Plan's Board of Directors have authorized management to proceed with an orderly exit of the insured health care business by no later than December 2003. This exit strategy is currently being implemented through rating actions and by ceasing new sales activities, except in selected offerings. Insured membership has decreased by 26% from 47,956 members at December 2001 to 35,376 members at June 2002. The exit will be completed by the non-renewal of all business beginning in February 2003. Measurement of segment profit or loss and segment assets: The accounting policies of the segments are the same as those used by the consolidated company. The Company evaluates performance based on profit and loss from operations before income taxes not including nonrecurring gains and losses. The Company accounts for intersegment revenues by assigning a management fee to the Plan that is an estimate of resources expended on the Plan's behalf. Information about profit or loss and assets of reportable segments:

9 10 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY Item 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview The Company's operations consist of two business segments. The parent company, First Choice Health Network (the "Network"), operates a PPO rental network. The subsidiary company, First Choice Health Plan (the "Plan"), operates as a health care service contractor that accepts insurance risk. The Network's revenues consist of access fees arising from the rental of the PPO network. The Plan's revenues consist primarily of commercial premiums resulting from the offering of health insurance products. Medical expenses are largely comprised of a negotiated fee for the health care services rendered. The company's related party transactions consist of two components. One component is the premium revenue that is received from the Company's owner hospitals for their employee groups that are members of the Plan. The other component is the Company's payment to the owner hospitals in the form of claims payments for medical services rendered to any member of the Plan. These two components are independent of each other and have no relationship for analytical purposes. The Plan's Board of Directors have authorized management to proceed with an orderly exit of the insured health care business by no later than December 2003. THREE MONTHS ENDED JUNE 30, 2002 COMPARED TO THREE MONTHS ENDED JUNE 30, 2001 Operating revenue decreased $6.5 million (21.4%) from the quarter ended June 2002 as compared to the quarter ended June 2001. The decrease was due to the decreased membership for the Plan and a resultant decrease in premium revenue. Commercial member months decreased by 34.7% during the quarter ended June 2002 as compared to the quarter ended June 2001, while the average commercial premium rates increased by 10.0% during the same period. Premium revenue decreased $7.5 million, or 28.3% from the second quarter 2002 compared to the second quarter 2001. This has been the result of a sharp decrease in the membership that is covered by the Plan. Operating expenses decreased $5.9 million (18.7%) from the quarter ended June 2002 compared to the same period in 2001. The decrease during this period was primarily due to reduced medical expenses of $4.9 million as a result of decrease in the Plan membership. Medical claims expenses have increased 23.2% on a per member per month basis during the three months ended June 2002 as compared to the three months ended June 2001. This is due to both increased utilization of healthcare services and increased healthcare unit costs. The remaining $1.0 million decrease in operating expenses is the result of cost savings from payroll and administrative expenses due to employee reductions as the Company transitions away from the insured health care business. SIX MONTHS ENDED JUNE 30, 2002 COMPARED TO SIX MONTHS JUNE 30, 2001 Operating revenue decreased $14.6 million (23.1%) from 2001 to 2002. This Decrease was due to the decreased membership for the Plan and a resultant decrease in premium revenue. Commercial member months decreased by 35.2% in 2002 while the average commercial premium rates increased by 10.0% during the same period. Premium revenue decreased $16.0 million or 28.9%, year to date 2002 versus year to date 2001. This has been the result of a sharp decrease in the membership that is covered by the Plan. 10 11 Operating expenses decreased $15.3 million (23.6%) from 2001 to 2002. The decrease during this period was primarily due to reduced medical expenses of $13.2 million as a result of decrease in the Plan membership. Medical claims expenses have increased 14.8% on a per member per month basis during the six months ended June 2002 as compared to the six months ended June 2001. This is due to both increased utilization of healthcare services and increased healthcare unit costs. The remaining $2.1 million decrease in operating expenses is the result of cost savings from payroll and administrative expenses due to employee reductions as the Company transitions away from the insured health care business. MARKET RISK HMOs and health insurance companies operate in a highly competitive environment. The Company has numerous competitors, including; for-profit and not-for-profit HMOs, preferred provider organizations ("PPOs"), and indemnity insurance carriers, some of which have substantially larger enrollments and greater financial resources than the Company. The Network's ability to retain existing clients and attract new clients is largely dependent on its ability to control health care costs by creating and maintaining a network of high quality, efficient, fully credentialed providers who agree to accept competitive reimbursement rates and on its ability to control excess utilization through its utilization management program. Pursuant to the Plan's decision to exit the insured healthcare market by the end of 2003, it is likely to experience greater volatility in claims costs than it has historically. As the insured membership base decreases, the effect of large claims are absorbed over fewer members, causing this increased volatility. Although the Plan does purchase reinsurance for catastrophic claims, it is anticipated that claims costs will experience greater volatility than historically. LIQUIDITY AND CAPITAL RESOURCES Since inception in 1986, the Company has financed its operations from equity investments from over 870 physicians, from the seven hospitals comprising the Company's Class B shareholders, non-equity capital contributions from four additional hospitals pursuant to their respective participation agreements, and funds from operations. As indicated on the Company's Condensed Consolidated Statement of Cash Flows at June 30, 2002, the Company had cash and cash equivalents of approximately $3.4 million compared to approximately $3.2 million at December 31, 2001. The cash has remained static as the Company has used the sale of investment securities available for sale to fund our cash flow needs. These investment securities consist of U.S. Government Agency asset-backed and mortgage-backed adjustable rate securities that are marketable in the event additional cash is needed. Following are explanations of significant balance sheet account fluctuations: The decrease in premium receivable of 90%, or $2,527,747, is primarily due to faster payment from a large customer. The decrease in Other Current Assets of 55%, or $911,912, is primarily due to the receipt of the Company's expected tax refund and the reduction of pharmacy rebates receivable and claims adjustments as a result of the decrease in Plan membership. The decrease in provider settlements payable of 60%, or $847,469, resulted from additional claims run out paid in 2002 related to 2001 provider contracts. The decrease in unearned premium of 46%, or $744,786, is due to the Plan's 26% decrease in membership and timing of receipts. 11 12 The Company anticipates that the revenue generated by operations, cash and cash equivalents and investment securities available for sale as of June 30, 2002 will be sufficient to meet its cash requirements throughout 2002. The expected reduction in the Plan's insured membership is expected to be funded by a corresponding reduction in the Plan's reserve for unpaid claims and claim adjustment expenses. CRITICAL ACCOUNTING POLICIES AND ESTIMATES As a result of the decision to exit the insured health care business by December 2003, at December 31, 2001 the Company's 80% ownership in the Plan was written down 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 June 30, 2002. The reserve for unpaid claims and claims adjustment expenses 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. Item 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable as of June 30, 2002 Part II Other Information Item 1 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 June 30, 2002, the Company is not aware of any such material situations. Item 2 Changes in Securities and use of Proceeds No changes in the Company's securities occurred during period Item 3 Defaults Upon Senior Securities No senior securities of the Company are outstanding. Item 4 Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders. Item 5 Other Information None 12 13 Item 6 Exhibits and Reports on Form 8-K (a) Exhibits Exhibit Number Title ------- --------------------------------------------------- 99.1 CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 (b) Reports on Form 8-K None were filed during quarter ended June 30, 2002. Item 7 Forward-Looking Statements This quarterly report on From 10-Q includes forward-looking statements about the future operations of the Company. These forward-looking statements involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Because of these uncertainties, actual future results may be materially different from the results indicated by these forward-looking statements. In addition, the Company's past results do not necessarily indicate its future results. 13 14 SIGNATURES In accordance with the requirements of the Exchange Act, the registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FIRST CHOICE HEALTH NETWORK, INC. Date: August 14, 2002 By: / s /Kenneth A. Hamm ----------------------------- Kenneth A. Hamm Sr. Vice President of Finance (Principal Financial and Accounting Officer and Duly Authorized Officer) 14 15 Exhibit 99.1 ------------ Certification To my knowledge, this Report on Form 10-Q for the quarter ended June 30, 2002, fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, and the information contained in this Report fairly presents, in all material respects, the financial condition and the results of operations of First Choice Health Network, Inc. and Subsidiary. By: / s /Gary Gannaway ----------------------------- Gary Gannaway, President and Chief Executive Officer By: / s /Kenneth A. Hamm ----------------------------- Kenneth A. Hamm, Senior Vice President and Chief Financial Officer 15

FIRST CHOICE HEALTH NETWORK INC 10-Q