10-Q 1 fchn10q-0604.txt 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10 - Q [ X ] QUARTERLY REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended JUNE 30, 2004 [ ] 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) 600 University Street Suite 1400 Seattle, Washington 98101 (Address of principal executive offices) (206) 292-8255 (Registrant's telephone number, including area code) Indicate by checkmark 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 checkmark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act) Yes ______ No __X___ The aggregate number of Registrant's shares of Class A Common Stock and Class B Common Stock outstanding on June 30, 2004, was 537 shares and 40,600 shares, respectively. 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, 2004 and December 31, 2003 3 Condensed Consolidated Statements of Income (Unaudited) for the Three Months and Six Months Ended June 30, 2004 and 2003 5 Condensed Consolidated Statements of Cash Flows (Unaudited) for the Six Months Ended June 30, 2004 and 2003 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 15 Item 4 Controls and Procedures 15 Part II Other Information Item 1 Legal Proceedings 16 Item 6 Exhibits and Reports on Form 8-K 16 Signatures 17 2 3 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) JUNE 30, 2004 and DECEMBER 31, 2003

See notes to condensed consolidated financial statements. 3 4 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) JUNE 30, 2004 and DECEMBER 31, 2003

See notes to condensed consolidated financial statements. 4 5 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) FOR THE THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 2004 AND 2003

See notes to condensed consolidated financial statements. 5 6 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) FOR THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003

See notes to condensed consolidated financial statements. 6 7 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) FOR THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003 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.(the "Company") and its subsidiary, First Choice Health Plan, Inc. (the "Plan"), the accompanying unaudited interim condensed consolidated financial statements include all normal adjustments considered necessary to present fairly the financial position as of June 30, 2004, and the results of operations for the three months and six months ended June 30, 2004 and 2003, and cash flows for the six months ended June 30, 2004 and 2003. The interim condensed consolidated financial statements include the segregation of the discontinued operations of the insured health plan business. (See Note 4.) The results of interim operations are not necessarily indicative of operating results for the entire year. Certain amounts in the prior period financial statements have been reclassified to conform with the current period presentation. NOTE 2 INVESTMENTS During the six months ended June 30, 2004, the Company purchased $2.4 million and sold $.7 million of investments available for sale. Principal paydowns on investments in debt securities during the first six months of 2004 were $.1 million. The amortized cost, unrealized gains or losses and fair values of investments in debt securities as of June 30, 2004 and December 31, 2003 are as follows:

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. 7 8 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. NOTE 3 REPORTABLE OPERATING SEGMENTS Factors management used to identify the enterprise's reportable segments: The Company has two reportable segments representing 100% of its revenue. Each segment requires distinct tracking capabilities in the areas of revenues and expenses. As a result of exiting the commercial insurance market, the Plan segment that offered a variety of fully insured health insurance plans to employer groups is being reported as a discontinued operation and is not included as an operating segment (see Note 4). Description of the types of products and services from which each reportable segment derives its revenue: The Network operations have two primary products which have been aggregated into one reportable segment, network access fees and hospital administrative fees. Network access fees arise from the rental of the Company's large preferred provider organization ("PPO") and other network products while hospital administrative fees arise from charges to the network hospitals based on claims incurred by members or fixed monthly contractual payments. The other reportable segment, Health Benefits Management ("HBM"), offers benefits management and administration services to employers who are self-funding their company health benefit plans. This segment offers manage- ment and administration services for health benefit plans, flexible spending accounts, health reimbursement accounts and COBRA benefits. Measurement of segment profit or loss and segment assets: The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on profit and loss from operations before income taxes not including nonrecurring gains and losses. Information about profit or loss of reportable segments:

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NOTE 4 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. The discontinuance of the Plan's operation is accounted for pursuant to SFAS 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 liability for unpaid claims is incurred. At the Balance Sheet date the following assets included in the condensed consolidated balance sheet apply to the discontinued operations of the Plan:

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The following amounts, representing revenue and income and loss from discontinued operations, are included in the condensed consolidated statement of income for the three months and six months ended June 30, 2004 and 2003:

NOTE 5 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 41,137 shares for the three months and six months ended June 30, 2004 and 41,138 shares for the three months and six months ended June 30, 2003, and 17,400 shares for district hospitals applicable to affiliate common share equivalents for each period. 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 additional capital from affiliates. These contractual agreements are considered to be common share equivalents for purposes of calculating net income per common share. Item 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW First Choice Health Network, Inc. (the "Company"), is a physician and hospital owned company offering a preferred provider organization ("PPO") and health benefits management services ("HBM") to large self-funded plan sponsors. Until year end 2003, the Company also offered insured health plan products through a subsidiary, First Choice Health Plan, Inc. (the "Plan"). The Plan no longer provides insurance services as of January 1, 2004 and is reported as discontinued operations in the financial statements. 10 11 Revenue from PPO network services including utilization management services takes the form of monthly access fees from participating payers 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. Other 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. The HBM segment offers benefits management and administration services to self-funded employers and insurance carriers. The HBM membership was 20,949 at June 30, 2004 compared to 10,470 at December 31, 2003. 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. The HBM revenues consist primarily of fees paid to administer health benefit plans, flexible spending accounts and various forms of consumer directed health plans such as health reimbursement accounts. FORWARD-LOOKING STATEMENTS This quarterly report on Form 10-Q 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 entry into the HBM business, and the adequacy of the Company's reserves for claims expenses and unreported claims for the discontinued Plan operations. 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 new HBM customers and the cost of maintaining technological and staff capabilities for health benefits management and administration. 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. RESULTS OF OPERATIONS THREE MONTHS ENDED JUNE 30, 2004 COMPARED TO THREE MONTHS ENDED JUNE 30, 2003 The following table summarizes operating revenues for the three months ended June 30, 2004 and 2003: (in millions) Three Months Ended June 30, 2004 2003 ---- ---- Network access fees $3.0 $2.8 Hospital administrative fees 2.0 1.9 Health benefit management fees .8 .5 Other .2 .1 ---- ---- Total operating revenues $6.0 $5.3 Operating revenue, net of discontinued operations, increased $.7 million (13.2%) from 2003 to 2004. The increase in 2004 resulted principally from an increase of $.3 million from revenue of the Company's HBM business segment and the impact of increasing rates for network access fees of $.2 million. 11 12 The following table summarizes operating expenses for the three months ended June 30, 2004 and 2003: (in millions) Three Months Ended June 30, 2004 2003 ---- ---- Payroll and related expenses $2.5 $2.0 Selling, general and administrative 1.6 1.5 ---- ---- Total operating expenses $4.1 $3.5 Payroll and related expenses of the ongoing business segments increased $.5 million (23.9%) from 2003 to 2004. The increase resulted primarily from the redirection of costs from the discontinued insured business to the new HBM business. Selling, general and administrative expenses of the ongoing business segments remained relatively constant with an increase of $.1 million (5.4%) from 2003 to 2004. The Plan's net income as shown on the discontinued operations line on the condensed consolidated statements of income for the three months ended June 30, 2004 and 2003 is $288,149 and $513,713, respectively. The decrease in net income in 2004 of $255,564 results from the discontinuance of the Plan's membership in 2004. Net income in 2004 is the result of favorable development of claims reserves upon the exit of the Plan from the insured healthcare business. SIX MONTHS ENDED JUNE 30, 2004 COMPARED TO SIX MONTHS ENDED JUNE 30, 2003 The following table summarizes operating revenues for the six months ended June 30, 2004 and 2003: (in millions) Six Months Ended June 30, 2004 2003 ---- ---- Network access fees $ 6.0 $ 5.5 Hospital administrative fees 3.9 3.9 Health benefit management fees 1.6 .9 Other .4 .2 ---- ---- Total operating revenues $11.9 $10.5 Operating revenue, net of discontinued operations, increased $1.4 million (13.3%) from 2003 to 2004. The increase in 2004 resulted principally from an increase of $.7 million from revenue of the Company's HBM business segment and the impact of increasing rates for network access fees of $.5 million. The following table summarizes operating expenses for the six months ended June 30, 2004 and 2003: (in millions) Six Months Ended June 30, 2004 2003 ---- ---- Payroll and related expenses $5.1 $4.0 Selling, general and administrative 3.1 2.9 ---- ---- Total operating expenses $8.2 $6.9 12 13 Payroll and related expenses of the ongoing business segments increased $1.1 million (28.5%) from 2003 to 2004. The increase resulted primarily from the redirection of costs from the insured business to the new HBM business. Selling, general and administrative expenses of the ongoing business segments remained relatively constant with an increase of $.2 million (6.9%) from 2003 to 2004. The Plan's net income and loss as shown on the discontinued operations line on the condensed consolidated statements of income for the six months ended June 30, 2004 and 2003 is $1,037,138 and $328,416, respectively. The increase in net income from 2003 to 2004 results from the favorable development of claims reserves upon the exit of the Plan from the insured health care business in 2003. Based upon the six months of claims run out paid in 2004, the reserve for unpaid loss and loss adjustment expense recorded at December 31, 2003 has restated favorably by approximately $1.4 million. This represents the bulk of the pre-tax income of discontinued operations in 2004. RELATED PARTY TRANSACTIONS The Company's related party transactions consist of two components. One component is the fees received from the Company's owner hospitals for HBM services. The other component is hospital administrative fees from owner hospitals. MARKET RISK FROM COMPETITORS 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, third party administrators ("TPAs"), 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 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 Balance Sheet at June 30, 2004, the Company had cash and cash equivalents of approximately $2.0 million compared to approximately $1.5 million at December 31, 2003. The Company anticipates that the revenue generated by operations, cash and cash equivalents and investment securities available for sale as of June 30, 2004, will be sufficient to meet its cash requirements throughout 2004. The run-out of claims liability reserves during 2004 in the Plan's discontinued operations is expected to be funded by the Plan's cash and investments totaling $9.7 million at June 30, 2004. Following are explanations of significant balance sheet account fluctuations: Investments in securities available for sale increased $1.6 million from $7.1 million at December 31, 2003, to $8.7 million at June 30, 2004, due to the re- investment of operating cash flow. The $5.2 million increase in receivable from subsidiary represents the Company's proceeds from the Plan's preferred stock retirement and common stock dividend payable July 26, 2004. The $5.2 million increase in dividend payable represents the Company's common stock 13 14 dividend declared June 24, 2004 and payable July 26, 2004. The following table summarizes the $1.3 million decrease in minority interest for the six months ended June 30, 2004: (in millions) Minority interest in Plan's net income $ .2 Payment to Plan's minority stockholders (.4) Plan's common stock dividend to minority stockholders (.6) Plan's minority interest preferred stock redemption (.5) -------- Total $(1.3) The above payment to the Plan's minority stockholders of $.4 million represents the minority stockholders 20% interest in the contractually required capital contribution from the Company to the plan for 2003. Because of the wind down of the Plan's business activities, the Plan's stockholders approved this payment in lieu of a full capital contribution to the Plan. The effect is that the minority interest stockholders received the 20% interest that they would have enjoyed had the full capital contribution been made. Other balance sheet account fluctuations primarily result from normal payment and collection timing differences. Current assets of discontinued operations decreased by $2.0 million from $11.7 million at December 31, 2003 to $9.7 million at June 30, 2004, due to the orderly exit from the health insurance business and the resulting payment of claims run out. The $3.2 million increase in current liabilities of discontinued operations is due to the following fluctuations: (in millions) Accrued expenses $ (.3) Reserve for unpaid loss and loss adjustment expense (2.6) Dividends payable .5 Preferred stock redemption payable .5 Amount due to parent 5.2 Other (.1) -------- Total $ 3.2 Following are explanations for these fluctuations: Accrued expenses - Payment of outstanding expenses as the Plan's run-out business is processed. Reserve for unpaid loss and loss adjustment expense - Payment of claims run- out of $.9 million, release of loss adjustment expense as run-out costs are incurred of $.3 million, and release of claim volatility margin of $1.4 million. As a result of favorable claims run-out, the claim volatility margin was not needed. Dividends payable - Common stock dividends payable to the Plan's minority shareholders. Preferred stock redemption payable - Preferred stock redemption payable to the Plan's minority shareholders. Amount due to parent - The $5.2 million increase in amount due to parent represents the amount of preferred stock redemption and common stock dividends payable to the Company. DIVIDENDS The balance sheet presents all assets and liabilities of the health plan legal entity as discontinued. On June 22, 2004, the Plan's Board of Directors authorized the redemption of 100% of the Plan's outstanding preferred stock of 14 15 $3.5 million and a common stock dividend of $2.7 million. Both transactions received the appropriate regulatory approval and were paid July 26, 2004. The Plan generated cash for the dividend by selling marketable securities. At the same time, the Company's Board of Directors declared a special dividend of $5.2 million that was paid to its shareholders July 26, 2004. This amount represents all of the Company's proceeds from the Plan transactions. During 2005, the Company expects to request regulatory approval to dissolve the Plan and distribute any remaining assets as dividends. The Company plans to declare a special dividend to distribute its share of these non-recurring cash flows to its shareholders as they are received. The Company had not paid any dividends in its history until 2003, when it declared and paid a $1.2 million dividend to shareholders in connection with the winding down of the Plan. Based on its expectations of generating positive cash flow on a consistent basis in the future, the Company plans to pay annual cash dividends. 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 June 30, 2004. 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 decreasing membership in the Plan during 2003, management increased the level of conservatism in the estimate due to increased risk associated with potential claim volatility resulting from a lower membership base. This conservatism is now being realized as shown by the approximate $1.4 million favorable development of the reserve for unpaid loss and loss adjustment expense recorded at December 31, 2003. 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. Item 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There have been no material changes in the reported market risks faced by the Company since the end of its most recent fiscal year. Item 4 CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures: An evaluation of the Registrant's disclosure controls and procedures (as defined in Rule 13a- 15(e) 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 15 16 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 six months ended June 30, 2004, 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 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, 2004, the Company is not aware of any such material situations. Item 6 Exhibits and Reports on Form 8-K (a) The following exhibits are furnished with this report: 31.1 Certification pursuant to Rule 13a-14(a) for Gary R. Gannaway. 31.2 Certification pursuant to Rule 13a-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. (b) The following report on Form 8-K was filed by the registrant during the quarter ended June 30, 2004: On June 25, 2004, the Company filed a Current Report on Form 8-K reporting under Item 2 that the Board of Directors declared a dividend of $5,164,451 payable, contingent on regulatory approval, to the holders of the Company's Class A and Class B Common Stock and to participating hospitals with certain contract rights in connection with liquidation of the Plan. 16 17 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, on the 11th day of August, 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) 17

FIRST CHOICE HEALTH NETWORK INC 10-Q