10-Q 1 fchn10q0605.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, 2005 [ ] 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, 2005, was 428 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, 2005 and December 31, 2004 3 Condensed Consolidated Statements of Income (Unaudited) for the Three Months and Six Months Ended June 30, 2005 and 2004 5 Condensed Consolidated Statements of Cash Flows (Unaudited) for the Six Months Ended June 30, 2005 and 2004 6 Notes to Condensed Consolidated Financial Statements (Unaudited) 7 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 11 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 2 Unregistered Sales of Equity Securities and Use of Proceeds 16 Item 4 Submission of Matters to a Vote of Securities Holders 17 Item 6 Exhibits 17 Signatures 17 2 3 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) JUNE 30, 2005 and DECEMBER 31, 2004

June 30, December 31, ASSETS 2005 2004 ~~2003~~ CURRENT ASSETS: Cash and cash equivalents $ 14,~~981~~496,~~368~~274 $ 12,~~459~~376,~~881~~158 Investment securities available-for-sale, at fair value 810,~~672~~263,~~292~~310 79,~~132~~904,~~880~~175 Service fees receivable, net of allowance for doubtful accounts of $~~124~~81,~~927~~787 and $7786,~~194~~606 1,~~097~~078,~~251~~777 ~~950~~1,~~498~~134,320 Service fees receivable from related parties ~~205~~119,~~197~~280 ~~354~~31,~~114~~310 Prepaid expenses ~~370~~392,~~442~~498 ~~442~~478,~~072~~220 Deferred tax assets ~~194~~252,~~065~~843 ~~164~~186,~~066~~931 Federal income tax receivable - 61,304 Other current assets 94152,~~669~~323 ~~340~~236,~~025~~874 Receivable from subsidiary 5196,~~213,882~~254 5138,~~650~~090 Federal income tax receivable from subsidiary 35,~~238~~255 617,~~677~~053 Current assets of discontinued operations 938,~~721,178~~138 113,~~715~~128,~~163~~417 ----------- ----------- Total current assets 2716,~~553~~994,~~582~~952 2217,~~617~~592,~~026~~852 FURNITURE, EQUIPMENT, AND COMPUTER SOFTWARE: Furniture and equipment 5,~~473~~876,~~950~~620 5,~~303~~537,~~600~~067 Computer software 1,~~503~~723,~~514~~844 1,~~386~~582,~~784~~945 ----------- ----------- 67,~~977~~600,464 67,~~690~~120,~~384~~012 Less accumulated depreciation (56,~~833~~418,~~017~~617) (56,~~392~~159,~~963~~001) ----------- ----------- Furniture, equipment, and computer software, net 1,~~144~~181,~~447~~847 1961,~~297,421~~011 DEFERRED TAX ASSETS 1,~~237~~319,~~416~~455 1,~~140~~287,~~249~~460 OTHER ASSETS: Investment in One Health Port 112,995 201,184 ~~141,984~~ Other assets ~~166~~302,~~563~~398 ~~114~~236,~~135~~175 Assets of discontinued operations ~~384~~389,~~628~~921 ~~384~~385,~~224~~758 ----------- ----------- Total other assets ~~752~~805,~~375~~314 ~~640~~823,~~343~~117 ----------- ----------- TOTAL ASSETS $3020,~~687~~301,~~820~~568 $2520,~~695~~664,~~039~~440 =========== ===========

See notes to condensed consolidated financial statements. 3 4 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) JUNE 30, 2005 and DECEMBER 31, 2004

June 30, December 31, LIABILITIES AND SHAREHOLDERS' EQUITY 2005 2004 ~~2003~~ CURRENT LIABILITIES: Accounts payable $ ~~545~~765,~~750~~571 $ ~~627~~693,~~631~~296 Accrued expenses 12,~~890~~899,~~068~~420 12,~~986~~371,~~532~~044 Federal income tax payable 34455,~~533~~349 ~~70,703 Dividends payable 5,165,952~~ - Current liabilities of discontinued operations 7244,~~053,407~~415 3368,~~823,788~~778 ----------- ----------- Total current liabilities 144,~~689~~364,~~710~~755 63,~~508~~433,~~654~~118 MINORITY INTEREST ~~633~~36,~~877~~729 1670,~~922,306~~635 REDEEMABLE EQUITY PARTICIPATION 2,520,000 2,520,000 SHAREHOLDERS' EQUITY: Common stock: Class A, par value $1 - Authorized, 30,000 shares; issued and outstanding, ~~537~~428 and 447 shares ~~537~~428 ~~537~~447 Class B, par value $1 - Authorized, 70,000 shares; issued and outstanding, 40,600 shares 40,600 40,600 Additional paid-in capital 4,~~305~~022,~~356~~184 4,~~305~~080,~~356~~410 Additional capital from affiliates 1,472,108 1,472,108 Retained earnings 7,~~164~~864,~~481~~143 8,~~943~~484,~~283~~084 Accumulated other comprehensive loss, net of tax (~~138~~19,~~849~~379) (1736,~~805~~962) ----------- ----------- Total shareholders' equity 1213,~~844~~380,~~233~~084 14,~~744~~040,~~079~~687 ----------- ----------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $3020,~~687~~301,~~820~~568 $2520,~~695~~664,~~039~~440 =========== ===========

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, 2005 AND 2004

Three Months Ended Six Months Ended June 30, June 30, 2005 2004 ~~2003~~2005 2004 ~~2003~~ OPERATING REVENUE: Network access fees $ 32,~~014~~856,~~383~~339 $ 2,~~808~~864,~~243~~383 $ 65,~~039~~795,~~012~~798 $ 5,~~514~~739,~~542~~012 Hospital administrative fees 889,270 931,069 ~~859~~1,~~794~~760,452 1,853,711 ~~1,855,773~~ Hospital administrative fees, related parties 889,587 1,015,859 ~~991~~1,~~955~~781,552 1,998,096 ~~1,975,922~~ Health benefit management fees 942,642 793,709 ~~467~~1,~~914~~840,842 1,598,006 ~~886,203~~ Other ~~214~~618,681 364,597 ~~129~~1,~~155~~210,936 ~~430~~730,619 ~~233,028~~ ----------- ----------- ----------- ----------- Total operating revenue 6,196,519 5,969,617 512,~~257~~389,~~061~~580 11,919,444 ~~10,465,468~~ ----------- ----------- ----------- ----------- OPERATING EXPENSES: Payroll and related expenses 3,248,709 2,529,361 26,~~040~~421,~~929~~381 5,063,322 ~~3,931,884~~ Selling, general, and administrative expenses 1,~~580~~730,~~346~~676 1,~~499~~580,~~520~~346 3,~~141~~609,~~493~~091 23,~~928~~141,~~238~~491 ----------- ----------- ----------- ----------- Total operating expenses 4,979,385 4,109,707 310,~~540~~030,~~449~~472 8,204,815 ~~6,860,122~~ ----------- ----------- ----------- ----------- Operating income 1,217,134 1,859,910 12,~~716~~359,~~612~~108 3,714,629 ~~3,605,346~~ ----------- ----------- ----------- ----------- OTHER INCOME: Interest 121,370 87,783 40241,~~615~~429 165,044 ~~95,166~~ Other (34,635) (36,593) 15(49,~~064~~379) (27,368) ~~75,108~~ ----------- ----------- ----------- ----------- Total other income 86,735 51,190 55192,~~679~~050 137,676 ~~170,274~~ ----------- ----------- ----------- ----------- Income from continuing operations before federal income taxes and minority interest 1,303,869 1,911,100 12,~~772~~551,~~291~~158 3,852,305 ~~3,775,620~~ Provision for federal income taxes on continuing operations 417,836 633,539 ~~618~~789,~~024~~027 1,272,961 ~~1,301,026~~ ----------- ----------- ----------- ----------- Income from continuing operations before minority interest 886,033 1,277,561 1,~~154~~762,~~267~~131 2,579,344 ~~2,474,594~~ MINORITY INTEREST, net of tax (3,486) (37,808) (~~181~~7,~~275~~728) (187,569) ~~(240,815)~~ ----------- ----------- ----------- ----------- Income from continuing operations after minority interest 882,547 1,239,753 ~~972~~1,~~992~~754,403 2,391,775 ~~2,233,779~~ Discontinued operations: Income from discontinuation of First Choice Health Plan Insurance operations (net of applicable income tax expense of $146,737, $265,486, $532,131 and $169,184) 446 288,149 ~~513~~21,~~713~~656 1,037,138 ~~328,416~~ ---------- ----------- ----------- ----------- NET INCOME $ 882,993 $ 1,527,902 $ 1,~~486~~776,~~705~~059 $ 3,428,913 ~~$ 2,562,195~~ =========== =========== =========== =========== NET INCOME FROM CONTINUING OPERATIONS AFTER MINORITY INTEREST PER CLASS A COMMON SHARE $ 21168.1830 $ 16192.6239 $ 40331.8652 $ 38371.16 ~~===========~~NET ~~==========~~INCOME ~~===========~~FROM ~~===========~~CONTINUING OPERATIONS AFTER MINORITY INTEREST PER CLASS B COMMON SHARE $ 13.95 $ 19.59 $ 27.73 $ 37.80 NET INCOME FROM CONTINUING OPERATIONS AFTER MINORITY INTEREST PER DILUTED CLASS B COMMON SHARE $ 2612.1068 $ 17.81 $ 25.4021 $ 5834.5836 NET INCOME PER CLASS A COMMON SHARE $ 43170.7630 ~~===========~~$ ~~==========~~237.10 ~~===========~~$ ~~===========~~335.61 $ 532.11 NET INCOME PER CLASS B COMMON SHARE $ 14.11 $ 24.15 $ 28.07 $ 54.19 NET INCOME PER DILUTED CLASS B COMMON SHARE $ 12.83 $ 21.95 $ 25.52 $ 49.27 WEIGHTED AVERAGE CLASS A SHARES OUTSTANDING 437 537 441 537 WEIGHTED AVERAGE CLASS B SHARES OUTSTANDING 58,~~537~~000 58,~~538~~000 58,~~537~~000 58,~~538~~000 ~~===========~~WEIGHTED ~~==========~~AVERAGE ~~===========~~CLASS ~~===========~~B DILUTED SHARES OUTSTANDING 63,800 63,800 63,800 63,800 DIVIDENDS PER CLASS A COMMON SHARE $ - $ - $ 446.68 $ - DIVIDENDS PER CLASS B COMMON SHARE $ - $ - $ 37.87 $ - DIVIDENDS PER DILUTED CLASS B COMMON SHARE $ - $ - $ 34.43 $ -

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, 2005 AND 2004

Six Months Ended June 30, 2005 2004 ~~2003~~ CASH FLOWS FROM OPERATING ACTIVITIES: Net income from continuing operations $ 21,~~391~~754,~~775~~403 $ 2,~~233~~391,~~779~~775 Adjustments to reconcile net income to net cash provided by continuing operating activities: Depreciation 259,616 440,054 ~~493,462~~ Deferred income taxes, net (~~127~~97,~~166~~907) (34127,~~521~~166) Provision for doubtful accounts (4,819) 47,733 ~~10,754~~ Minority interest (34,906) 187,569 ~~283,416~~ Interest in earnings of One Health Port 88,189 40,800 - Changes in operating assets and liabilities: Service fees receivable (27,608) (45,569) ~~263,030~~ Due from subsidiary including tax accrual ~~5,658~~ (2146,~~089,066~~366) 5,658 Prepaid expenses 85,722 71,630 ~~52,024~~ Other current assets 84,551 245,356 ~~(155,226)~~ Other assets (66,223) (52,428) - Accounts payable 72,275 (81,881) ~~(69,841)~~ Accrued expenses 528,376 (94,963) ~~(50,611)~~ Federal income tax payable 516,653 (36,170) ~~214,969~~ ------------ ----------- Net cash provided by continuing operating activities 3,011,956 2,992,398 ~~1,152,169~~ CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of furniture, equipment, and computer software (~~287~~480,~~080~~452) (~~533~~287,~~189~~080) Purchase of investments available for sale (21,~~390~~835,~~945~~795) (2,~~944~~390,~~977~~945) Principal paydowns and sales of investments available for sale ~~776,093~~ 1,~~206~~494,~~748~~243 776,093 Investment in One Health Port - (100,000) - ------------ ----------- Net cash used by investing activities (2822,~~001,932~~004) (2,~~271~~001,~~418~~932) CASH FLOWS FROM FINANCING ACTIVITIES: ~~Redeemable~~Repurchase ~~equity~~of ~~participation~~Class A common stock (58,245) - ~~134~~Dividends paid (2,~~557~~396,000) - Payments to minority interest - (440,450) - ------------ ----------- Net cash ~~provided (~~used) by financing activities (2,454,245) (440,450) ~~134,557~~ CASH FLOWS FROM (TO) DISCONTINUED OPERATIONS 2,384,409 (28,529) ~~(1,016,071)~~ ------------ ----------- NET INCREASE ~~(DECREASE)~~ IN CASH AND CASH EQUIVALENTS ~~521,487 (~~2,~~000~~120,~~763)~~116 521,487 CASH AND CASH EQUIVALENTS: Beginning of year 2,376,158 1,459,881 ~~2,324,382~~ ------------ ----------- End of period $ 14,~~981~~496,~~368~~274 $ ~~323~~1,~~619~~981,368 ============ =========== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the period for: Federal income taxes $ 1380,~~936,408~~000 $ 1,~~212~~936,~~000~~408

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, 2005 AND 2004 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, 2005, and the results of operations for the three months and six months ended June 30, 2005 and 2004, and cash flows for the six months ended June 30, 2005 and 2004. 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, 2005, the Company purchased $1.8 million and sold $1.5 million of investments available for sale. Principal paydowns on investments in debt securities during the first six months of 2005 were $10,968. The amortized cost, unrealized gains or losses and fair values of investments in debt securities as of June 30, 2005 and December 31, 2004 are as follows:

Gross Gross Gross Amortized Unrealized Unrealized Unrealized Cost Gains Losses Losses Less Than More Than 12 Months 12 Months Fair Value --------------------------------------------------------------- June 30, ~~2004~~2005 ~~Mortgage-backed adjustable rate securities $ 770,353 $ 52 $( 4,749) $(2,897) $ 762,759~~ Municipal bonds ~~7,986,463 22,105 (99,035) - 7,909,533 ----------- -------- --------- ------- -----------~~ $ 810,~~756~~294,~~816~~510 $ 2262,~~157~~313 $(~~103~~31,~~784~~716) $(261,~~897~~797) $ 810,~~672~~263,~~292~~310 ============ ======== ========= ========= =========== December 31, ~~2003~~2004 Mortgage-backed adjustable rate securities $ 112,~~098,214~~123 $ ~~4,262~~21 $( ~~4,365~~19) $ ~~(782)~~- $ 112,~~097,329~~125 Municipal bonds 69,~~043~~929,~~750~~241 223,~~260~~842 (1061,~~459~~033) - 69,~~035~~892,~~551~~050 ----------- -------- --------- --------- ----------- $ 79,~~141~~941,~~964~~364 $ 623,~~522~~863 $(1461,~~824~~052) $ ~~(782)~~- $ 79,~~132~~904,~~880~~175 ============ ======== ========= ========= ===========

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 management and administration services for health benefit plans, flexible spending accounts, health savings 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:

First Choice Health Benefits Health Network Management Total -------------- -------------- ----------- Three months ended June 30, ~~2004~~2005: Revenues from external customers $ 5,~~175~~253,~~908~~877 $ ~~793~~942,~~709~~642 $ 56,~~969~~196,~~617~~519 Intersegment revenue 15(expense) 19,~~926~~298 (1519,~~926~~298) - Net income (loss) 1,~~471~~046,~~317~~900 (~~193~~160,~~756~~866) 1886,~~277,561~~033 Minority interest ( 373,~~808~~486) Income from discontinued operations ~~288,149~~446 Consolidated net income 1882,~~527,902~~993 Three months ended June 30, ~~2003~~2004: Revenues from external customers $ 45,~~789~~175,~~147~~908 $ ~~467~~793,~~914~~709 $ 5,~~257~~969,~~061~~617 Intersegment revenue 20(expense) 15,~~196~~926 (2015,~~196~~926) - Net income (loss) 1,~~273~~471,~~369~~317 (~~119~~193,~~102~~756) 1,~~154~~277,~~267~~561 Minority interest (~~181~~ 37,~~275~~808) Income from discontinued operations ~~513~~288,~~713~~149 Consolidated net income 1,~~486~~527,~~705~~902

8 9

First Choice Health Benefits Health Network Management Total -------------- -------------- ----------- Six months ended June 30, ~~2004~~2005: Revenues from external customers $10,~~321~~548,~~438~~738 $ 1,~~598~~840,~~006~~842 $1112,~~919~~389,~~444~~580 Intersegment revenue 31(expense) 38,~~628~~807 (3138,~~628~~807) - Net income (loss) 2,~~878~~119,~~979~~105 (~~299~~356,~~635~~973) 21,~~579~~762,~~344~~131 Minority interest (~~187~~7,~~569~~728) Income from discontinued operations 121,~~037,138~~656 Consolidated net income 31,~~428~~776,~~913~~059 Six months ended June 30, ~~2003~~2004: Revenues from external customers $ 910,~~579~~321,~~265~~438 $ ~~886~~1,~~203~~598,006 $1011,~~465~~919,~~468~~444 Intersegment revenue 40(expense) 31,~~464~~628 (4031,~~464~~628) - Net income (loss) 2,~~638~~878,~~196~~979 (~~163~~299,~~602~~635) 2,~~474~~579,~~594~~344 Minority interest (~~240~~187,~~815~~569) Income from discontinued operations ~~328~~1,~~416~~037,138 Consolidated net income 23,~~562~~428,~~195~~913

NOTE 4 DISCONTINUED OPERATIONS As the Plan's business model shifted from capitated contracts to fee for service contract arrangements over the past three years, management and the Board of Directors reevaluated the strategic importance of the Plan. As a result, the Plan's existing commercial insured business was 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 2005. 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:

Assets June 30, ~~2004~~2005 December 31, ~~2003~~2004 Cash and cash equivalents $ 138,~~931,441~~138 $ 2,~~687~~503,~~652~~998 Investment securities available for sale ~~7,754,972 8,020,730 Premiums receivable~~ - ~~898~~622,~~489~~058 Prepaid expenses and other receivables ~~30,518~~- ~~72,026~~738 Deferred tax asset 41,~~247~~195 361,~~266~~623 Restricted indemnity cash and investments ~~384~~388,~~628~~726 ~~384~~385,~~224~~758 ----------- ----------- Total assets $ 10428,~~105,806~~059 $ 123,~~099~~514,~~387~~175 =========== ===========

9 10

Liabilities June 30, ~~2004~~2005 December 31, ~~2003~~2004 Accrued expenses $ ~~319~~42,~~749~~906 $ ~~595~~125,~~351~~105 Reserve for unpaid loss and loss adjustment expenses ~~479,260 3,069,224 Provider settlements payable~~ - 83188,~~787~~530 ~~Dividends payable 541,110 - Payable on preferred stock redemption 494,438 - Unearned premiums 1,730 17,099~~ Federal income tax expense payable to parent 35,~~238~~255 617,~~677~~053 Amount due to parent 5196,~~213,882~~254 5138,~~650~~090 ----------- ----------- Total liabilities $ 7244,~~053,407~~415 $ 3368,~~823,788~~778 =========== ===========

The following amounts, representing revenue and income from discontinued operations, are included in the condensed consolidated statement of income for the three months and six months ended June 30, 2005 and 2004:

Operations For the Three Months For the Six Months Ended June 30, Ended June 30, 2005 2004 ~~2003~~2005 2004 ~~2003~~ Operating revenue $ - $ 42,935 $ ~~9,820,053~~- $ 69,288 ~~$21,887,274~~ Income from discontinued operations before federal income tax 476 434,886 ~~779~~31,~~199~~804 1,569,269 ~~497,600~~ Income from discontinued operations after federal income tax 446 288,149 ~~513~~21,~~713~~656 1,037,138 ~~328,416~~Net income from discontinued operations per Class A common share .09 44.72 4.09 160.95 Net income from discontinued operations per Class B common share .01 4.9255 8.7834 1716.7239 5Net income from discontinued operations per diluted Class B common share .6101 4.14 .31 14.90

NOTE 5 EARNINGS PER SHARE Net income per Class A common share is computed by dividing income available to Class A common shareholders by the weighted average number of Class A common shares outstanding during the period, including 437 and 441 Class A shares for the three months and six months ended June 30, 2005, respectively and 537 Class A shares for the three months and six months ended June 30, 2004. Net income per Class B common share is computed by dividing income available to Class B common shareholders by the weighted average number of Class B common shares and Class B common share equivalents outstanding during the period, including 40,600 Class B shares for the three months and six months ended June 30, 2005 and 2004 and 17,400 Class B common share equivalents for the three months and six months ended June 30, 2005 and 2004. Class B common share equivalents are owned by district hospitals which 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 Class B common share. Net income per diluted Class B common share is computed by dividing income available to Class B common shareholders by the weighted average number of Class B common shares, common share equivalents and redeemable equity common share equivalents outstanding during the period. The Class B redeemable equity common share equivalents outstanding during the period were 5800 shares for the three months and six months ended June 30, 2005 and 2004. Class B redeemable equity common share equivalents are owned by a public hospital which is not a shareholder of the Company, but has a contractual agreement with the Company that provides for 10 11 certain rights and obligations equivalent, but not identical, to those of Class B shareholders, including liquidation and dividend rights. The capital contributions of this non-shareholder are recorded as redeemable equity participation. NOTE 6 CONTINGENCIES An audit of the Company's 2003 federal income tax return by the Internal Revenue Service is currently in process. The results of the audit are yet to be finalized and the outcome is uncertain at this time. The State of Washington Office of Insurance Commissioner recently completed a financial examination of the Plan for the period January 1, 1999 through December 31, 2003. A draft report of the examination has been issued to the Plan and is currently being reviewed by management. Management does not expect there will be a material adjustment to its financial statements as a result of the examination. 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. 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 25,295 at June 30, 2005 compared to 21,570 at December 31, 2004. 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 savings accounts and 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 and the prospects for the Company's entry into the HBM business. 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 11 12 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, 2005 COMPARED TO THREE MONTHS ENDED JUNE 30, 2004 The following table summarizes operating revenues for the three months ended June 30, 2005 and 2004: (in millions) Three Months Ended June 30, 2005 2004 ---- ---- Network access fees $2.9 $2.9 Hospital administrative fees 1.8 1.9 Health benefit management fees .9 .8 Other .6 .4 ---- ---- Total operating revenues $6.2 $6.0 Operating revenue, net of discontinued operations, increased $.2 million (3.3%) from 2004 to 2005. The increase in 2005 resulted principally from an increase of $.2 million from EAP and medical management revenue. The following table summarizes operating expenses for the three months ended June 30, 2005 and 2004: (in millions) Three Months Ended June 30, 2005 2004 ---- ---- Payroll and related expenses $3.3 $2.5 Selling, general and administrative 1.7 1.6 ---- ---- Total operating expenses $5.0 $4.1 Payroll and related expenses of the ongoing business segments increased $.8 million (32.0%) from 2004 to 2005. The increase resulted primarily from the redirection of costs from the insured business to the HBM business and additional staffing to support increased medical management activities. Selling, general and administrative expenses of the ongoing business segments remained relatively constant with an increase of $.1 million (6.3%) from 2004 to 2005. 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, 2005 and 2004 is $446 and $288,149, respectively. The decrease is due to the final runout of the activity of the Plan being nearly complete. 12 13 SIX MONTHS ENDED JUNE 30, 2005 COMPARED TO SIX MONTHS ENDED JUNE 30, 2004 The following table summarizes operating revenues for the six months ended June 30, 2005 and 2004: (in millions) Six Months Ended June 30, 2005 2004 ---- ---- Network access fees $ 5.8 $ 5.7 Hospital administrative fees 3.6 3.9 Health benefit management fees 1.8 1.6 Other 1.2 .7 ---- ---- Total operating revenues $12.4 $11.9 Operating revenue, net of discontinued operations, increased $.5 million (4.2%) from 2004 to 2005. The increase in 2005 resulted principally from an increase of $.5 million from EAP and medical management revenue. The following table summarizes operating expenses for the six months ended June 30, 2005 and 2004: (in millions) Six Months Ended June 30, 2005 2004 ----- ---- Payroll and related expenses $ 6.4 $5.1 Selling, general and administrative 3.6 3.1 ----- ---- Total operating expenses $10.0 $8.2 Payroll and related expenses of the ongoing business segments increased $1.3 million (25.5%) from 2004 to 2005. The increase resulted primarily from the redirection of costs from the insured business to the new HBM business and additional staffing to support increased medical management activities. Selling, general and administrative expenses of the ongoing business segments increased $.5 million (16.1%) from 2004 to 2005. This increase is primarily due to transaction costs incurred based on increased volumes of claims being received electronically. Also contributing to the increase are additional costs associated with equipment leasing and license fees, supplies and directors fees. 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, 2005 and 2004 is $21,656 and $1,037,138, respectively. The decrease is due to the final runout of the activity of the Plan being nearly complete. 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 13 14 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, 2005, the Company had cash and cash equivalents of approximately $4.5 million compared to approximately $2.4 million at December 31, 2004. The Company anticipates that the revenue generated by operations, cash and cash equivalents and investment securities available for sale as of June 30, 2005 will be sufficient to meet its cash requirements throughout 2005. Cash and cash equivalents increased $2.1 million from $2.4 million at December 31, 2004 to $4.5 million at June 30, 2005 due to operating cash flow. Federal income tax payable increased from $0 at December 31, 2004 to $.5 million at June 30, 2005. This increase is due to the timing of estimated federal income tax payments. Accrued expenses increased $.5 million from $2.4 million at December 31, 2004 to $2.9 million at June 30, 2005 primarily resulting from timing differences on payroll related accruals. Other balance sheet account fluctuations primarily result from normal payment and collection timing differences. Current assets of discontinued operations decreased by $3.1 million from $3.1 million at December 31, 2004 to $38,138 at June 30, 2005 due to the payment of $3.0 million in dividends to the Plan's shareholders. DIVIDENDS The balance sheet presents all assets and liabilities of the health plan legal entity as discontinued. As a result of its exit from the capital intensive health insurance business, the Company requested and received regulatory approval to distribute as dividends a significant portion of its assets in 2004. As a result, the Company paid $6.4 million in dividends to shareholders in 2004. Of this amount, $5.2 million was the result of a nonrecurring special dividend representing the Company's proceeds from the redemption of the Plan's preferred stock and the Plan's $2.7 million dividend on its common stock. The remaining $1.2 million dividend was paid from the Company's operating cash flows. During 2005 the Plan requested regulatory approval to dissolve the Plan and distribute any remaining assets as dividends. On January 27, 2005, the Company declared a special dividend of $2.4 million to distribute its share of these non-recurring cash flows to its shareholders. The $2.4 million was distributed in April 2005 as $446.68 per share to Class A shareholders and $199,666.67 to each Class B shareholder and non-shareholder hospital that have equivalent rights. In the future, the Company expects to pay annual dividends from available positive cash flow from continuing operations. Amounts distributed in 2004 and the first two quarters of 2005 in connection with exiting the health insurance industry are not indicative of the amount of future dividends, which is dependent on cash flow from continuing operations. 14 15 CRITICAL ACCOUNTING POLICIES AND ESTIMATES A valuation allowance was established in 1997 for the tax benefit of net operating losses (NOLs) of the Plan which is being reported as discontinued operations. Because the operation of the Plan is being discontinued, future income will not be available to utilize the NOLs. Upon the ultimate liquidation and dissolution of the Plan, these NOLs may be potentially utilized by the Company. Because the timing and ultimate realization of these NOLs is uncertain, they are fully reserved. 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 The table below represents the balances of the Company's investment securities that are subject to interest rate risk as of June 30, 2005. The investment securities consist solely of municipal bonds with varying maturity dates. Repayment of these bonds can accelerate significantly as interest rates decrease and negatively impact the expected return on the investment. Conversely, as interest rates increase, the bonds will likely not pay until maturity reducing the Company's ability to invest its assets at current market interest rates without taking losses on its current investment portfolio. The expected maturities identified in the table below are based upon the stated maturity date of the bond. In the event of changes in interest rates, prepayments of the bonds could cause significant variations from the maturities presented in the table.

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, Chief Financial Officer 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 Chief Financial Officer concluded that the Registrant's disclosure controls and procedures are effective in ensuring that the information required to be disclosed by the Registrant in the reports it files or submits under the Act is (i) accumulated and communicated to the Registrant's management (including the Chief Executive Officer and Chief Financial Officer as appropriate to allow timely decisions regarding required disclosure, and (ii) recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission ("SEC"). (b) Changes in Internal Control over financial reporting: In the six months ended June 30, 2005, 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. 15 16 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 SEC's 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, 2005, the Company is not aware of any such material situations. Item 2 Unregistered Sales of Equity Securities and Use of Proceeds

(1) Shares of Class A Common Stock were repurchased from shareholders no longer meeting eligibility standards for ownership of such shares. These shareholders were advised by the Company of their ineligibility and the terms of repurchase of their shares individually. 16 17 Item 4 Submission of Matters to a Vote of Securities Holders The Company held its 2005 annual meeting of shareholders on June 23, 2005. The following directors were elected at the annual meeting:

Item 6 Exhibits The following exhibits are furnished with this report: 31.1 Certification pursuant to Rule 13a-14(a) for Gary R. Gannaway, Chief Executive Officer. 31.2 Certification pursuant to Rule 13a-14(a) for Stacy A. Kessel, Chief Financial Officer. 32.1 Section 1350 Certification for Gary R. Gannaway, Chief Executive Officer. 32.2 Section 1350 Certification for Stacy A. Kessel, Chief Financial Officer. 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 18th day of August, 2005. FIRST CHOICE HEALTH NETWORK, INC. By: /s/ Stacy A. Kessel -------------------------------------- STACY A. KESSEL Chief Financial Officer (Principal Financial and Accounting Officer and Duly Authorized Officer) 17 ?? ?? ?? ??

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