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 May 31, 2005
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
Commission File Number000-19364
AMERICAN HEALTHWAYS, INC.
(Exact Name of Registrant as Specified in its Charter)
| Delaware (State or Other Jurisdiction of Incorporation) | 62-1117144 (I.R.S. Employer Identification No.) |
| 3841 Green Hills Village Drive Nashville, Tennessee (Address of Principal Executive Offices) | 37215 (Zip Code) |
| (615) 665-1122 (Registrant’s telephone number, including area code) |
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes [X] No [ ]
As of July 5, 2005 there were outstanding 33,766,359 shares of the Registrant’s Common Stock, par value $.001 per share.
Part I
Item 1. Financial Statements
AMERICAN HEALTHWAYS, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited)
ASSETS
| May 31, 2005 | August 31, 2004 | |||||||
|---|---|---|---|---|---|---|---|---|
| Current assets: | ||||||||
| Cash and cash equivalents | $ | 40,640 | $ | 45,147 | ||||
| Restricted cash | 3,789 | 1,524 | ||||||
| Investments | 2,990 | 7,040 | ||||||
| Accounts receivable, net | ||||||||
| Billed | 38,114 | 33,235 | ||||||
| Unbilled | 457 | 866 | ||||||
| Other current assets | 6,282 | 6,502 | ||||||
| Income taxes receivable | 3,570 | -- | ||||||
| Deferred tax asset | 2,568 | 2,248 | ||||||
| Total current assets | 98,410 | 96,562 | ||||||
| Property and equipment: | ||||||||
| Leasehold improvements | 11,289 | 10,067 | ||||||
| Computer equipment and related software | 59,538 | 53,379 | ||||||
| Furniture and office equipment | 15,265 | 14,514 | ||||||
| 86,092 | 77,960 | |||||||
| Less accumulated depreciation | (50,573 | ) | (36,957 | ) | ||||
| 35,519 | 41,003 | |||||||
| Other assets | 2,319 | 2,456 | ||||||
| Intangible assets, net | 17,104 | 19,854 | ||||||
| Goodwill, net | 92,398 | 93,574 | ||||||
| $ | 245,750 | $ | 253,449 | |||||
| See accompanying notes to the consolidated financial statements. | ||||||||
2
AMERICAN HEALTHWAYS, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
(Unaudited)
LIABILITIES AND STOCKHOLDERS’ EQUITY
| May 31, 2005 | August 31, 2004 | |||||||
|---|---|---|---|---|---|---|---|---|
| Current liabilities: | ||||||||
| Accounts payable | $ | 6,401 | $ | 10,343 | ||||
| Accrued salaries and benefits | 14,212 | 4,616 | ||||||
| Accrued liabilities | 4,362 | 4,688 | ||||||
| Contract billings in excess of earned revenue | 7,415 | 4,898 | ||||||
| Income taxes payable | -- | 3,294 | ||||||
| Current portion of long-term debt | 159 | 12,243 | ||||||
| Current portion of long-term liabilities | 1,949 | 1,018 | ||||||
| Total current liabilities | 34,498 | 41,100 | ||||||
| Long-term debt | 458 | 36,562 | ||||||
| Long-term deferred tax liability | 9,254 | 12,658 | ||||||
| Other long-term liabilities | 8,720 | 7,694 | ||||||
| Stockholders' equity: | ||||||||
| Preferred stock | ||||||||
| $.001 par value, 5,000,000 shares | ||||||||
| authorized, none outstanding | -- | -- | ||||||
| Common stock | ||||||||
| $.001 par value, 75,000,000 shares authorized, | ||||||||
| 33,589,282 and 32,857,041 shares outstanding | 34 | 33 | ||||||
| Additional paid-in capital | 103,659 | 90,980 | ||||||
| Retained earnings | 89,127 | 64,387 | ||||||
| Accumulated other comprehensive income | -- | 35 | ||||||
| Total stockholders' equity | 192,820 | 155,435 | ||||||
| $ | 245,750 | $ | 253,449 | |||||
| See accompanying notes to the consolidated financial statements. | ||||||||
3
AMERICAN HEALTHWAYS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except earnings per share data)
(Unaudited)
| Three Months Ended May 31, | Nine Months Ended May 31, | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2005 | 2004 | 2005 | 2004 | |||||||||||
| Revenues | $ | 78,357 | $ | 65,354 | $ | 224,880 | $ | 173,555 | ||||||
| Cost of services | 50,931 | 41,413 | 145,035 | 112,577 | ||||||||||
| Gross margin | 27,426 | 23,941 | 79,845 | 60,978 | ||||||||||
Selling, general and administrative expenses | 7,136 | 5,842 | 20,596 | 17,006 | ||||||||||
| Depreciation and amortization | 5,890 | 4,784 | 16,845 | 13,354 | ||||||||||
| Interest | 289 | 841 | 1,402 | 2,676 | ||||||||||
| Income before income taxes | 14,111 | 12,474 | 41,002 | 27,942 | ||||||||||
| Income tax expense | 5,575 | 4,990 | 16,262 | 11,177 | ||||||||||
| Net income | $ | 8,536 | $ | 7,484 | $ | 24,740 | $ | 16,765 | ||||||
| Basic income per share: | $ | 0.26 | $ | 0.23 | $ | 0.75 | $ | 0.52 | ||||||
| Diluted income per share: | $ | 0.24 | $ | 0.22 | $ | 0.70 | $ | 0.48 | ||||||
| Weighted average common shares | ||||||||||||||
| and equivalents: | ||||||||||||||
| Basic | 33,221 | 32,442 | 33,072 | 32,094 | ||||||||||
| Diluted | 35,702 | 34,803 | 35,503 | 34,607 | ||||||||||
| See accompanying notes to the consolidated financial statements. | ||||||||||||||
4
AMERICAN HEALTHWAYS, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY
For the Nine Months Ended May 31, 2005
(In thousands)
(Unaudited)
| Preferred Stock | Common Stock | Additional Paid-in Capital | Retained Earnings | Accumulated Other Comprehensive Income | Total | |||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Balance, August 31, 2004 | $ | -- | $ | 33 | $ | 90,980 | $ | 64,387 | $ | 35 | $ | 155,435 | ||||||||
| Net income | -- | -- | -- | 24,740 | -- | 24,740 | ||||||||||||||
| Termination of interest rate swap | -- | -- | -- | -- | (35 | ) | (35 | ) | ||||||||||||
| Total comprehensive income | 24,705 | |||||||||||||||||||
| Exercise of stock options and other | -- | 1 | 3,908 | -- | -- | 3,909 | ||||||||||||||
| Tax benefit of option exercises | -- | -- | 8,771 | -- | -- | 8,771 | ||||||||||||||
| Balance, May 31, 2005 | $ | -- | $ | 34 | $ | 103,659 | $ | 89,127 | $ | -- | $ | 192,820 | ||||||||
| See accompanying notes to the consolidated financial statements. | ||||||||||||||||||||
5
AMERICAN HEALTHWAYS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
| Nine Months Ended May 31, | ||||||||
|---|---|---|---|---|---|---|---|---|
| 2005 | 2004 | |||||||
| Cash flows from operating activities: | ||||||||
| Net income | $ | 24,740 | $ | 16,765 | ||||
| Adjustments to reconcile net income to net cash provided by | ||||||||
| operating activities, net of business acquisitions: | ||||||||
| Depreciation and amortization | 16,845 | 13,354 | ||||||
| Amortization of deferred loan costs | 380 | 576 | ||||||
| Tax benefit of stock option exercises | 8,771 | 8,159 | ||||||
| Increase in accounts receivable, net | (4,470 | ) | (2,595 | ) | ||||
| Increase in other current assets | (3,092 | ) | (1,696 | ) | ||||
| (Decrease) increase in accounts payable | (3,942 | ) | 394 | |||||
| Increase (decrease) in accrued salaries and benefits | 9,596 | (5,261 | ) | |||||
| (Decrease) increase in other current liabilities | (1,103 | ) | 1,987 | |||||
| Deferred income taxes | (3,701 | ) | 9 | |||||
| Other | 1,815 | 1,994 | ||||||
| Decrease in other assets | 487 | 204 | ||||||
| Payments of other long-term liabilities | (650 | ) | (300 | ) | ||||
| Net cash flows provided by operating activities | 45,676 | 33,590 | ||||||
| Cash flows from investing activities: | ||||||||
| Acquisition of property and equipment | (7,595 | ) | (15,734 | ) | ||||
| Purchases of investments | (2,000 | ) | (2,000 | ) | ||||
| Proceeds on sale of investments | 6,050 | 55 | ||||||
| Business acquisitions, net of cash acquired | 1,176 | (60,223 | ) | |||||
| Net cash flows used in investing activities | (2,369 | ) | (77,902 | ) | ||||
| Cash flows from financing activities: | ||||||||
| Increase in restricted cash | (2,265 | ) | (585 | ) | ||||
| Proceeds from issuance of long-term debt | 48,000 | 60,000 | ||||||
| Deferred loan costs | (730 | ) | (2,315 | ) | ||||
| Payments of long-term debt | (96,188 | ) | (9,329 | ) | ||||
| Exercise of stock options | 3,369 | 3,090 | ||||||
| Net cash flows (used in) provided by financing activities | (47,814 | ) | 50,861 | |||||
| Net (decrease) increase in cash and cash equivalents | (4,507 | ) | 6,549 | |||||
| Cash and cash equivalents, beginning of period | 45,147 | 34,846 | ||||||
| Cash and cash equivalents, end of period | $ | 40,640 | $ | 41,395 | ||||
| See accompanying notes to the consolidated financial statements. | ||||||||
6
AMERICAN HEALTHWAYS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(1) Interim Financial Reporting
The accompanying consolidated financial statements of American Healthways, Inc. and its wholly-owned subsidiaries for the nine months ended May 31, 2005 and May 31, 2004 are unaudited. However, in our opinion, the financial statements reflect all adjustments consisting of normal, recurring accruals necessary for a fair presentation. We have reclassified certain items in prior periods to conform to current classifications.
We have omitted certain financial information that is normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States but that is not required for interim reporting purposes. You should read the accompanying consolidated financial statements in conjunction with the financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended August 31, 2004.
(2) Segment Disclosures
Statement of Financial Accounting Standards (“SFAS” or “Statement”) No. 131, “Disclosures About Segments of an Enterprise and Related Information,” establishes disclosure standards for segments of a company based on a management approach to defining operating segments. Through November 2003, we distinguished operating and reportable segments based upon the types of customers, hospitals or health plans, that contract for our services. In order to improve operational efficiency, in December 2003 we merged our operations into a single operating segment for purposes of presenting financial information and evaluating performance.
(3) Recently Issued Accounting Standards
Consolidation of Variable Interest Entities
In 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation (“FIN”) No. 46(R), “Consolidation of Variable Interest Entities.” FIN No. 46(R) requires consolidation of variable interest entities if certain conditions are met and generally applies to periods ending after March 15, 2004. The adoption of FIN No. 46(R) did not have a material impact on our financial position or results of operations.
Share-Based Payment
In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” Statement 123(R) supersedes Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in Statement 123(R) is similar to the approach described in Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. The Statement is effective for fiscal years beginning after June 15, 2005.
Statement 123(R) permits public companies to adopt its requirements using one of two methods:
A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of Statement 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of Statement 123 for all awards granted to employees prior to the effective date of Statement 123(R) that remain unvested on the effective date.
A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate, based on the amounts previously recognized under Statement 123 for purposes of pro forma disclosures, either (a) all prior periods presented or (b) prior interim periods of the year of adoption.
We plan to adopt Statement 123(R) on September 1, 2005 using the modified prospective method.
7
As permitted by Statement 123, we currently account for share-based payments to employees using Opinion 25‘s intrinsic value method and, as such, generally recognize no compensation cost for employee stock options. Accordingly, the adoption of Statement 123(R)‘s fair value method will have a significant impact on our results of operations, although it will have no impact on our overall financial position. We cannot predict the impact of adopting Statement 123(R) at this time because it will partially depend on levels of share-based payments granted in the future. However, had we adopted Statement 123(R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma net income and earnings per share in Note 6 to our consolidated financial statements.
Statement 123(R) also requires the benefits of tax deductions in excess of amounts recognized as compensation cost to be reported as a financing cash flow, rather than an operating cash flow, as required under current accounting guidance. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While we cannot estimate what the benefits of these tax deductions will be in the future (because they depend on, among other things, when employees exercise stock options), we recognized $8.8 million and $8.2 million of such amounts in cash flow from operating activities for the nine months ended May 31, 2005 and May 31, 2004, respectively.
(4) Restricted Cash
Restricted cash represents funds held in escrow in connection with contractual requirements (see Note 10).
(5) Investments
Investments at August 31, 2004 consist of auction rate securities and floating rate investments. Investments at May 31, 2005 consist of floating rate investments only. Auction rate securities and floating rate investments have stated maturities that typically are at least twenty years, but have their interest rates reset approximately every 7-35 days.
These investments are carried at fair value (which approximates cost), and are classified as current assets because they are available for sale and are generally available to support our current operations. Auction rate securities and floating rate investments of $7.0 million were reclassified from cash in the prior year financial statements to conform to the current year presentation.
(6) Stock-Based Compensation
We account for stock options issued to employees and outside directors pursuant to APB No. 25. We have adopted the disclosure requirements of SFAS No. 123 and SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – an Amendment of FASB Statement No. 123.”
For the nine months ended May 31, 2005 and May 31, 2004, we recorded compensation expense under APB No. 25 of approximately $0.4 million and $0.7 million, respectively. This expense resulted primarily from a grant, which was subject to stockholder approval, of stock options issued to two new directors of the Company in June 2003. We obtained such approval at the Annual Meeting of Stockholders in January 2004, at which time we issued the options. We recognize compensation expense related to fixed award stock options on a straight-line basis over the vesting period.
8
The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation:
| Three Months Ended May 31, | Nine Months Ended May 31, | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2005 | 2004 | 2005 | 2004 | |||||||||||
| (In $000s, except per share data) | ||||||||||||||
| Net income, as reported | $ | 8,536 | $ | 7,484 | $ | 24,740 | $ | 16,765 | ||||||
| Add: Stock-based employee compensation | ||||||||||||||
| expense included in reported net | ||||||||||||||
| income, net of related tax effects | 89 | 90 | 266 | 419 | ||||||||||
| Deduct: Total stock-based employee | ||||||||||||||
| compensation expense determined under | ||||||||||||||
| fair value based method for all awards, net | ||||||||||||||
| of related tax effects | (1,665 | ) | (1,339 | ) | (4,919 | ) | (3,876 | ) | ||||||
| Pro forma net income | $ | 6,960 | $ | 6,235 | $ | 20,087 | $ | 13,308 | ||||||
| Earnings per share: | ||||||||||||||
| Basic - as reported | $ | 0.26 | $ | 0.23 | $ | 0.75 | $ | 0.52 | ||||||
| Basic - pro forma | $ | 0.21 | $ | 0.19 | $ | 0.61 | $ | 0.41 | ||||||
| Diluted - as reported | $ | 0.24 | $ | 0.22 | $ | 0.70 | $ | 0.48 | ||||||
| Diluted - pro forma | $ | 0.19 | $ | 0.18 | $ | 0.57 | $ | 0.38 | ||||||
(7) Business Acquisitions
On September 5, 2003, we acquired StatusOne Health Systems, Inc. (“StatusOne”), a provider of health management services for high-risk populations of health plans and integrated systems nationwide. We paid an aggregate purchase price for StatusOne of approximately $64.4 million, which was allocated to the related assets acquired and liabilities assumed based upon their respective fair values, as shown below.
| (In $000s) | |||||
| Fair value of current net tangible assets acquired | $ | 1,683 | |||
| Fair value of long-term net tangible liabilities assumed | (8,854 | ) | |||
| Intangible assets: | |||||
| Acquired technology | 10,163 | ||||
| Customer contracts | 9,137 | ||||
| Trade name | 4,344 | ||||
| Goodwill | 47,959 | ||||
| Total purchase price | $ | 64,432 | |||
The change in the carrying amount of goodwill during the nine months ended May 31, 2005 is shown below:
| (In $000s) | |||||
| Balance, August 31, 2004 | $ | 93,574 | |||
| Purchase price adjustments | (1,176 | ) | |||
| Balance, May 31, 2005 | $ | 92,398 | |||
The purchase price adjustments primarily relate to $1.3 million that we received from escrow during the first quarter of fiscal 2005 after the termination of the StatusOne escrow agreement.
9
(8) Intangible and Other Assets
Intangible assets subject to amortization at May 31, 2005 consist of the following:
| Gross Carrying Amount | Accumulated Amortization | Net | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| (In $000s) | |||||||||||
| Acquired technology | $ | 10,163 | $ | 3,557 | $ | 6,606 | |||||
| Customer contracts | 9,248 | 3,274 | 5,974 | ||||||||
| Other | 200 | 20 | 180 | ||||||||
| Total | $ | 19,611 | $ | 6,851 | $ | 12,760 | |||||
Acquired technology, customer contracts, and other intangible assets are being amortized on a straight-line basis over a five-year estimated useful life. Total amortization expense for the nine months ended May 31, 2005 and May 31, 2004 was $2.9 million and $3.2 million, respectively. Estimated amortization expense for the remainder of fiscal 2005 and the following four fiscal years thereafter is $1.0 million, $3.9 million, $3.9 million, $3.9 million, and $40,000, respectively. We assess the potential impairment of intangible assets subject to amortization whenever events or changes in circumstances indicate that the carrying values may not be recoverable.
Intangible assets not subject to amortization at May 31, 2005 consist of a trade name associated with the StatusOne acquisition of $4.3 million. We review intangible assets not subject to amortization on an annual basis or more frequently whenever events or circumstances indicate that the assets might be impaired.
Other assets consist primarily of deferred loan costs net of accumulated amortization.
(9) Long-Term Debt
On October 29, 2004, we amended our previous revolving credit and term loan agreement dated September 5, 2003 (the “Former Credit Agreement”) by entering into a First Amended and Restated Revolving Credit Loan Agreement (the “Amended Credit Agreement”). The Amended Credit Agreement provides us with up to $150.0 million in borrowing capacity, including a $75.0 million sub facility for letters of credit, under a senior revolving credit facility that expires on October 29, 2009. Under the Amended Credit Agreement, we converted the outstanding $48.0 million term loan under the Former Credit Agreement to revolving debt. As of May 31, 2005, our available line of credit totaled $149.2 million.
The Amended Credit Agreement requires us to repay the principal on any loans at the maturity date of October 29, 2009. Borrowings under the Amended Credit Agreement bear interest, at our option, at the prime rate plus a spread of 0.0% to 1.0% or LIBOR plus a spread of 1.25% to 2.25%, or a combination thereof. The Amended Credit Agreement also provides for a fee ranging between 0.25% and 0.5% of unused commitments. Substantially all of our assets are pledged as collateral for any borrowings under the credit facility.
The Amended Credit Agreement contains various financial covenants, which require us to maintain, as defined, minimum ratios or levels of (i) total funded debt to EBITDA, (ii) interest coverage, (iii) fixed charge coverage, and (iv) net worth. The Amended Credit Agreement also prohibits the payment of dividends and limits the amount of repurchases of the Company’s common stock. As of May 31, 2005, we were in compliance with all of the covenant requirements of the Amended Credit Agreement.
On September 16, 2003, we entered into an interest rate swap agreement to manage our interest rate exposure under the Former Credit Agreement. In September 2004, in anticipation of amending and restating our Former Credit Agreement, as described above, we terminated the interest rate swap agreement and recognized a gain of approximately $22,000.
(10) Commitments and Contingencies
In conjunction with contractual requirements under one contract that began on March 1, 2004, we have funded an escrow account in the amount of approximately $3.8 million. We were required to deposit a percentage of all fees received from this customer during the first year of the contract into the escrow account to be used to repay fees under the contract in the event we do not perform at target levels.
10
In June 1994, a former employee whom we dismissed in February 1994 filed a “whistle blower” action on behalf of the United States government. Subsequent to its review of this case, the federal government determined not to intervene in the litigation. The employee sued American Healthways, Inc. and our wholly-owned subsidiary, American Healthways Services, Inc. (“AHSI”), as well as certain named and unnamed medical directors and one named client hospital, West Paces Medical Center (“WPMC”), and other unnamed client hospitals.
American Healthways, Inc. has since been dismissed as a defendant; however, the case is still pending against AHSI before the United States District Court for the District of Columbia. In addition, WPMC has settled claims filed against it as part of a larger settlement agreement that WPMC’s parent organization, HCA Inc., reached with the United States government.
The complaint alleges that AHSI, the client hospitals and the medical directors associated with the Company’s hospital-based diabetes treatment center operation violated the federal False Claims Act by entering into certain arrangements that allegedly violated the federal anti-kickback statute and provisions of the Social Security Act prohibiting physician self-referrals. Although no specific monetary damage has been claimed, the plaintiff, on behalf of the federal government, seeks treble damages plus civil penalties and attorneys’ fees. The plaintiff also has requested an award of 30% of any judgment plus expenses. Substantial discovery has taken place to date and additional discovery is expected to occur. No trial date has been set. The parties have had initial discussions regarding their respective positions in the case; however, no resolution of this case has been reached or can be assured prior to the case proceeding to trial.
We believe that we have conducted our operations in full compliance with applicable statutory requirements and that we have meritorious defenses to the claims made in the case and intend to contest the claims vigorously. Nevertheless, it is possible that resolution of this legal matter could have a material adverse effect on our consolidated results of operations and cash flows in a particular financial reporting period. We believe that we will continue to incur legal expenses associated with the defense of this case which may be material to our consolidated results of operations in a particular financial reporting period. However, we believe that any resolution of this case will not have a material effect on our liquidity or financial condition.
(11) Comprehensive Income
SFAS No. 130, “Reporting Comprehensive Income,” requires that changes in the amounts of certain items, including changes in the fair value of interest rate swap agreements, be shown in the financial statements. We display comprehensive income, which includes net income and net changes in the fair value of the interest rate swap agreement (see Note 9), in the consolidated statement of changes in stockholders’ equity. In September 2004, we terminated the interest rate swap agreement and recognized a gain of approximately $22,000. Comprehensive income, net of income taxes, was $8.5 million and $24.7 million, respectively, for the three and nine months ended May 31, 2005.
11
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Overview
Founded in 1981, American Healthways, Inc. (the “Company”) provides specialized, comprehensive care enhancement and disease management services to health plans and hospitals in all 50 states, the District of Columbia, Puerto Rico, and Guam. These services include, but are not limited to:
| • | providing members with educational materials and personal interactions with highly trained nurses; |
| • | incorporating current evidence-based clinical guidelines in interventions to optimize patient care; |
| • | developing care support plans and motivating members to set attainable goals for themselves; |
| • | providing local market resources to address acute episode interventions; and |
| • | coordinating members’ care with local health-care providers. |
Our integrated care enhancement programs serve entire health plan populations through member and physician care support interventions, advanced neural network predictive modeling, and a confidential, secure Internet-based application that provides patients and physicians with individualized health information. Our programs enable health plans to develop relationships with all of their members, not just the chronically ill, and to identify those at highest risk for a health problem, allowing for early interventions.
Our programs are designed to help people lead healthier lives by making sure they understand and follow doctors’ orders, including medication compliance, are aware of and can recognize early warning signs associated with a major health episode, and are setting achievable goals for themselves to exercise more, lose weight, quit smoking or otherwise improve their current health status.
We believe that our patient and physician support regimens, delivered and/or supervised by a multi-disciplinary team, have demonstrated that they assist in providing effective care for the treatment of the disease or condition, which will improve the health status of the enrollee populations with the disease or condition and reduce both the short-term and long-term health-care costs for these enrollees.
Our integrated care enhancement product line includes programs for people with diabetes, coronary artery disease, heart failure, asthma, chronic obstructive pulmonary disease, end-stage renal disease, cancer, chronic kidney disease, depression, tobacco addiction, acid-related stomach disorders, atrial fibrillation, decubitus ulcer, fibromyalgia, hepatitis C, inflammatory bowel disease, irritable bowel syndrome, low-back pain, osteoarthritis, osteoporosis, urinary incontinence, and high-risk population management. We design our programs to create and maintain key desired behaviors of each program member and of the providers who care for them in order to improve member health status, thereby reducing health-care costs. The programs incorporate interventions necessary to optimize member care and are based on the most up-to-date, evidence-based clinical guidelines.
The flexibility of our programs allows customers to enter the disease management and care enhancement market at the level they deem appropriate for their organization. Customers may select a single or multiple chronic disease approach, or a total-population or high-risk approach, in which people with more than one disease or condition receive the benefit of multiple programs at a single cost.
As of May 31, 2005, the Company had contracts with 46 health plans to provide 154 disease management and care enhancement program services, and also had 47 contracts to provide its services at 65 hospitals.
In December 2004, we were selected by the Centers for Medicare & Medicaid Services (“CMS”) to participate in two of nine pilots awarded under Medicare Health Support (“MHS”, formerly Chronic Care Improvement Program). In addition to directly operating one pilot to serve 20,000 Medicare fee-for-service beneficiaries in Maryland and the District of Columbia, we will serve 20,000 beneficiaries in Georgia in collaboration with CIGNA HealthCare, Inc. Both of the pilots are for diabetes and congestive heart failure disease management services and are operationally similar to American Healthways’ programs for commercial and Medicare Advantage health plan populations.
12
Highlights of Performance for the Nine Months Ended May 31, 2005
| • | Revenues increased 30% compared to the nine months ended May 31, 2004. |
| • | Net income increased 48% compared to the nine months ended May 31, 2004. |
| • | Actual lives under management at May 31, 2005 increased 35% from May 31, 2004, which included a 78% increase in self-insured employer actual lives under management to 562,000 at May 31, 2005 from 315,000 at May 31, 2004. |
Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements, which are based upon current expectations and involve a number of risks and uncertainties. Forward-looking statements include all statements that do not relate solely to historical or current facts, and can be identified by the use of words like “may”, “believe”, “will”, “expect”, “project”, “estimate”, “anticipate”, “plan”, or “continue”. In order for us to use the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, we caution you that the following important factors, among others, may affect these forward-looking statements. Consequently, actual operations and results may differ materially from those expressed in the forward-looking statements. The important factors include, but are not limited to,:
| • | our ability to sign and implement new contracts for disease management and care enhancement services; |
| • | our ability to execute agreements with CMS and/or a partner for disease management services under MHS, authorized by the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (“MMA”); |
| • | our ability to accurately forecast performance and the timing of revenue recognition under any potential agreement for disease management services under the terms of our health plan contracts and/or our cooperative agreement with CMS ahead of data collection and reconciliation in order to provide forward-looking guidance; |
| • | the timing and costs of implementation, and the effect, of regulations and interpretations relating to MMA; |
| • | the risks associated with a significant concentration of our revenues with a limited number of customers; |
| • | our ability to effect cost savings and clinical outcomes improvements under disease management and care enhancement contracts and reach mutual agreement with customers and/or CMS with respect to cost savings, or to effect such savings and improvements within the time frames contemplated by us; |
| • | our ability to collect contractually earned performance incentive bonuses; |
| • | the ability of our customers and/or CMS to provide timely and accurate data that is essential to the operation and measurement of our performance under the terms of our health plan contracts; |
| • | our ability to favorably resolve contract billing and interpretation issues with our customers; |
| • | our ability to integrate acquired businesses or technologies into our business; |
| • | our ability to develop new products and deliver outcomes on those products; |
| • | our ability to effectively integrate new technologies and approaches, such as those encompassed in our care enhancement initiatives or otherwise licensed or acquired by us, into our care enhancement platform; |
| • | our ability to renew and/or maintain contracts with our customers under existing terms or restructure these contracts on terms that would not have a material negative impact on our results of operations; |
| • | our ability to implement our care enhancement strategy within expected cost estimates; |
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| • | our ability to obtain adequate financing to provide the capital that may be necessary to support the growth of our operations and to support or guarantee our performance under new contracts; |
| • | unusual and unforeseen patterns of health-care utilization by individuals with diabetes, cardiac, respiratory and/or other diseases or conditions for which we provide services, in the health plans with which we have executed a disease management contract; |
| • | the ability of the health plans to maintain the number of covered lives enrolled in the plans during the terms of our agreements with the health plans; |
| • | our ability to attract and/or retain and effectively manage the employees required to implement our agreements; |
| • | the impact of litigation involving us and/or our subsidiaries; |
| • | the impact of future state and federal health-care and other applicable legislation and regulations on our ability to deliver our services and on the financial health of our customers and their willingness to purchase our services; |
| • | our ability to have our internal controls positively attested to by our independent auditors as required by Section 404 of the Sarbanes-Oxley Act of 2002; |
| • | current geopolitical turmoil and the continuing threat of domestic or international terrorism; |
| • | general worldwide and domestic economic conditions and stock market volatility; and |
| • | other risks detailed in our other filings with the Securities and Exchange Commission. |
We undertake no obligation to update or revise any such forward-looking statements.
Customer Contracts
Contract Terms
We generally determine our contract fees by multiplying a contractually negotiated rate per health plan member per month (“PMPM”) by the number of health plan members covered by our services during the month. We set the PMPM rates during contract negotiations with customers based on the value we expect our programs to create and a sharing of that value between the customer and the Company. In some contracts, the PMPM rates may differ between the health plan’s lines of business [e.g., Preferred Provider Organizations (“PPO”), Health Maintenance Organizations (“HMO”), Medicare Advantage, Administrative Services Only (“ASO”)]. Contracts with health plans generally range from three to seven years with provisions for subsequent renewal; contracts between our health plan customers and their ASO customers typically have one-year terms.
Some contracts provide that a portion (up to 100%) of our fees may be refundable to the customer (“performance-based”) if our programs do not achieve, when compared to a baseline year, a targeted percentage reduction in the customer’s health-care costs and selected clinical and/or other criteria that focus on improving the health of the members. Approximately 12% of revenues recorded during the nine months ended May 31, 2005 were performance-based and are subject to final reconciliation. We anticipate that this percentage will fluctuate due to the level of performance-based fees in new contracts, revenue recognition associated with performance-based fees, and the timing of data reconciliation, which varies according to contract terms. A limited number of contracts also provide opportunities for us to receive incentive bonuses in excess of the contractual PMPM rate if we exceed contractual performance targets.
Our hospital contracts represent hospital-based diabetes treatment centers located in and operated under contracts with general acute-care hospitals. The primary goal of each center is to create a center of excellence for the treatment of diabetes in the community in which it is located to enhance the quality of care to this population, thereby increasing the hospital’s market share of diabetes patients and lowering the hospital’s cost of providing services. For the nine months ended May 31, 2005, revenues from our 47 hospital contracts accounted for approximately 4% of total revenues.
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Information Systems
Disease management and care enhancement contracts require sophisticated management information systems to help us manage the care of large populations of health plan members with targeted chronic diseases or other medical conditions and to report clinical and financial outcomes before and after we implement our programs. We have developed and are continually expanding and improving our proprietary clinical, data management, and reporting systems to continue to meet our information management needs for our disease management and care enhancement services. Due to the anticipated expansion and improvement in our information management systems, we expect to continue making significant investments in our information technology software and hardware and in our information technology staff.
Operating Contract Renewals
Our contract revenues depend on the contractual terms we establish and maintain with health plans to provide disease management and care enhancement services to their members. Some contracts allow the health plan to terminate early under certain conditions. Of the eight health plan contracts scheduled to expire in fiscal 2005, representing in the aggregate approximately 9% of revenues for the nine months ended May 31, 2005, one contract, comprising approximately 1% of such revenues, was renewed and expanded, and four contracts, representing approximately 5% of such revenues, were renewed. Restructurings and possible terminations at or prior to renewal could have a material negative impact on our results of operations and financial condition.
Approximately 40% and 39% of our revenues for the three and nine months ended May 31, 2005, respectively, were derived from two customers that each comprised more than 10% of our revenues for the period. The loss of either of these customers or any other large health plan customer or a reduction in the profitability of any contract with these customers would have a material negative impact on our results of operations, cash flows, and financial condition.
Actual Lives under Management
We measure the volume of participation in our programs by the actual number of health plan members and hospital patients who are benefiting from our services, which is reported as “actual lives under management.” The number of actual lives under management and annualized revenue in backlog are shown below at May 31, 2005 and May 31, 2004.
| At May 31, | 2005 | 2004 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| Actual lives under management | 1,633,000 | 1,211,000 | ||||||||
| Annualized revenue in backlog (in $000s) | $ | 45,191 | $ | 13,507 | ||||||
Annualized revenue in backlog represents the estimated annualized revenue at target performance associated with signed contracts at May 31, 2005 for which we have not yet begun providing services.
Employers typically make decisions on which health insurance carriers they will offer to their employees and may also allow employees to switch between health plans on an annual basis. These annual membership disenrollment and re-enrollment processes of employers (whose employees are the health plan members) from health plans can result in a seasonal reduction in actual lives under management during our second fiscal quarter.
Historically, we have found that a majority of employers and employees make these decisions effective December 31 of each year. An employer’s change in health plans or employees’ changes in health plan elections may cause a decrease in our actual lives under management for existing contracts as of January 1. Although these decisions may also cause a gain in enrollees as new employers sign on with our customers, the identification of new members eligible to participate in our programs is based on the submission of health-care claims, which lags enrollment by an indeterminate period.
As a result, historically, actual lives under management for existing contracts have decreased between 6% and 8% on January 1 and have not been restored through new member identification until later in the fiscal year, thereby negatively affecting our revenues on existing contracts in our second fiscal quarter.
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We have seen increasing demand for our care enhancement and disease management services from health plans’ ASO customers. These customers are typically self-insured employers for which our health plan customers do not assume medical cost risk but provide primarily administrative claims and health network access services. Signed contracts between these self-insured employers and our health plan customers are incorporated in our contracts with our health plan customers, and these program-eligible members are included in the lives under management or the annualized revenue in backlog reported in the table above, when appropriate.
Business Strategy
Our primary strategy is to develop new and to expand existing relationships with health plans to provide disease management and care enhancement services, including assisting these health plans in creating value for their large self-insured employers. We plan to use our scaleable state-of-the-art care enhancement centers and medical information content and proprietary technologies to gain a competitive advantage in delivering our disease management and care enhancement services.
In addition, we expect to continue adding services to our product mix that extend our programs beyond a chronic disease focus and provide care enhancement services to individuals who currently have, or face the risk of developing, one or more additional medical conditions. We believe that we can achieve improvements in care, and therefore significant cost savings, by addressing care enhancement and treatment requirements for these additional selected diseases and conditions, which will enable us to address a larger percentage of a health plan’s population and total health-care costs.
We anticipate that we will incur significant costs during the remainder of fiscal 2005 to enhance and expand our clinical programs and data and financial reporting systems, enhance our information technology support, continue to integrate our StatusOne information systems, and open additional or expand current care enhancement centers as needed. We may add some of these new capabilities and technologies through strategic alliances with other entities, one or more of which we may make minority investments in or acquire for stock and/or cash.
Critical Accounting Policies
We describe our accounting policies in Note 1 of the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the fiscal year ended August 31, 2004. We prepare the consolidated financial statements in accordance with U.S. generally accepted accounting principles, which require us to make estimates and judgments that affect the reported amounts of assets and liabilities and related disclosures at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates.
We believe the following accounting policies to be the most critical in understanding the judgments that are involved in preparing our financial statements and the uncertainties that could impact our results of operations, financial condition and cash flows.
Revenue Recognition
We generally determine our contract fees by multiplying a contractually negotiated rate per health plan member per month (“PMPM”) by the number of health plan members covered by our services during the month. We set the PMPM rates during contract negotiations with customers based on the value we expect our programs to create and a sharing of that value between the customer and the Company. In some contracts, the PMPM rate may differ between the health plan’s lines of business (e.g., PPO, HMO, Medicare Advantage, ASO). Contracts with health plans generally range from three to seven years with provisions for subsequent renewal; contracts between our health plan customers and their ASO customers typically have one-year terms.
Some contracts provide that a portion (up to 100%) of our fees may be refundable to the customer (“performance-based”) if our programs do not achieve, when compared to a baseline year, a targeted percentage reduction in the customer’s health-care costs and selected clinical and/or other criteria that focus on improving the health of the members. Approximately 12% of revenues recorded during the nine months ended May 31, 2005 were performance-based and are subject to final reconciliation. We anticipate that this percentage will fluctuate due to the level of performance-based fees in new contracts, revenue recognition associated with performance-based fees, and the timing of data reconciliation, which varies according to contract terms. A limited number of contracts also provide opportunities for us to receive incentive bonuses in excess of the contractual PMPM rate if we exceed contractual performance targets.
We bill our customers each month for the entire amount of the fees contractually due for the prior month’s enrollment, which typically includes the amount, if any, that is performance-based and may be subject to refund should we not meet performance targets. Contractually, we cannot bill for any incentive bonus until after contract settlement.
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We recognize revenue as follows: 1) we recognize the fixed portion of the monthly fees as revenue during the period we perform our services; 2) we recognize the performance-based portion of the monthly fees based on our performance to date in the contract year as determined below; and 3) we recognize additional incentive bonuses based on our performance to date in the contract year, to the extent we consider such amounts collectible.
We assess our level of performance based on medical claims and other data that the health plan customer is contractually required to supply each month. A minimum of four to six months’ data is typically required for us to measure performance. In assessing our performance, we may include estimates such as medical claims incurred but not reported and a health plan’s medical cost trend compared to a baseline year. In addition, we may also provide contractual reserves, when appropriate, for billing adjustments at contract reconciliation.
If data from the health plan is insufficient or incomplete to measure performance, or interim performance measures indicate that we are not meeting performance targets, we do not recognize performance-based fees as revenues but instead record them in a current liability account “contract billings in excess of earned revenue.” If we do not meet performance levels by the end of the contract year, we are contractually obligated to refund some or all of the performance-based fees. We would only reverse revenues that we had already recognized if performance to date in the contract year, previously above targeted levels, dropped below targeted levels due to subsequent adverse performance and/or adjustments in contractual reserves.
During the settlement process under a contract, which generally occurs six to eight months after the end of a contract year, we settle any performance-based fees and reconcile health-care claims and clinical data. Data reconciliation differences, for which we provide contractual allowances until we reach agreement with respect to identified issues, can arise between the customer and us due to health plan data deficiencies, omissions, and/or data discrepancies.
Impairment of Intangible Assets and Goodwill
In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” we review goodwill for impairment on an annual basis or more frequently whenever events or circumstances indicate that the carrying value may not be recoverable.
If we determine that the carrying value of goodwill is impaired based upon an impairment review, we calculate any impairment using a fair-value-based goodwill impairment test as required by SFAS No. 142. Fair value is the amount at which the asset could be bought or sold in a current transaction between two willing parties. We may estimate fair value using a number of techniques, including quoted market prices or valuations by third parties, present value techniques based on estimates of cash flows, or multiples of earnings or revenues performance measures.
We amortize other identifiable intangible assets, such as acquired technologies, customer contracts, and other intangibles, on the straight-line method over their estimated useful lives, except for trade names, which have an indefinite life and are not subject to amortization. We review intangible assets not subject to amortization on an annual basis or more frequently whenever events or circumstances indicate that the assets might be impaired. We assess the potential impairment of intangible assets subject to amortization whenever events or changes in circumstances indicate that the carrying values may not be recoverable.
If we determine that the carrying value of other identifiable intangible assets may not be recoverable, we calculate any impairment using an estimate of the asset’s fair value based on the projected net cash flows expected to result from that asset, including eventual disposition.
Future events could cause us to conclude that impairment indicators exist and that goodwill and/or other intangible assets associated with our acquired businesses are impaired. Any resulting impairment loss could have a material adverse impact on our financial condition and results of operations.
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Results of Operations
The following table shows the components of the statements of operations for the three and nine months ended May 31, 2005 and May 31, 2004 expressed as a percentage of revenues.
| Three Months Ended May 31, | Nine Months Ended May 31, | ||||||||
|---|---|---|---|---|---|---|---|---|---|
| 2005 | 2004 | 2005 | 2004 | ||||||
| Revenues | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % | |
| Cost of services | 65.0 | % | 63.4 | % | 64.5 | % | 64.9 | % | |
| Gross margin | 35.0 | % | 36.6 | % | 35.5 | % | 35.1 | % | |
| Selling, general and administrative expenses | 9.1 | % | 8.9 | % | 9.2 | % | 9.8 | % | |
| Depreciation and amortization | 7.5 | % | 7.3 | % | 7.5 | % | 7.7 | % | |
| Interest expense | 0.4 | % | 1.3 | % | 0.6 | % | 1.5 | % | |
| Income before income taxes | 18.0 | % | 19.1 | % | 18.2 | % | 16.1 | % | |
| Income tax expense | 7.1 | % | 7.6 | % | 7.2 | % | 6.4 | % | |
| Net income | 10.9 | % | 11.5 | % | 11.0 | % | 9.7 | % | |
Revenues
Revenues for the three and nine months ended May 31, 2005 increased 19.9% and 29.6%, respectively, compared to the same periods in fiscal 2004, primarily due to the following:
| • | an increase in the self-insured employer actual lives under management from 315,000 at May 31, 2004 to 562,000 at May 31, 2005; |
| • | existing health plan customers adding or expanding 14 programs since May 31, 2004; and |
| • | the commencement of seven new health plan contracts since May 31, 2004. |
We anticipate that total revenues for the remainder of fiscal 2005 will increase over fiscal 2004 revenues primarily due to the expansion of existing contracts, increasing demand for our care enhancement services from self-insured employers who contract with our health plan customers, and anticipated new health plan contracts. We anticipate that this increase will be partially offset by a decline in the level of contract performance incentive bonus revenues from the $2.5 million recorded in fiscal 2004 as we have restructured existing contracts in the last two fiscal years to eliminate incentive bonus opportunities in return for lower performance-based fee risk, longer contract terms, and more programs.
Cost of Services
Cost of services as a percentage of revenues increased to 65.0% for the three months ended May 31, 2005 compared to 63.4% for the same period in fiscal 2004. Excluding contract performance incentive bonus revenues, which totaled $1.7 million for the three months ended May 31, 2004 compared to no contract performance incentive bonus revenues during the three months ended May 31, 2005, cost of services as a percentage of revenues would have decreased to 65.0% from 65.1% for the three months ended May 31, 2005 and 2004, respectively.
Cost of services as a percentage of revenues decreased to 64.5% for the nine months ended May 31, 2005 compared to 64.9% for the same period in fiscal 2004. Excluding contract performance incentive bonus revenues, which totaled $2.5 million for the nine months ended May 31, 2004 compared to no contract performance incentive bonus revenues during fiscal 2005, cost of services as a percentage of revenues would have decreased to 64.5% from 65.8% for the nine months ended May 31, 2005 and 2004, respectively.
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The decreases in cost of services as a percentage of revenues excluding the impact of contract performance incentive bonus revenues for the three and nine months ended May 31, 2005 compared to the same periods in fiscal 2004 are primarily due to initial operating costs related to the opening of two new care enhancement centers in January 2004 and March 2004 and increased capacity utilization, economies of scale, and productivity enhancements during the three and nine months ended May 31, 2005 compared to the same periods in fiscal 2004. These decreases were partially offset by an increase in the employee bonus accrual and increased expenses related to securing and preparing for MHS pilots during the three and nine months ended May 31, 2005 compared to the same periods in fiscal 2004.
We anticipate that cost of services for the remainder of fiscal 2005 will increase over fiscal 2004 primarily as a result of finalizing, implementing and/or operating the MHS pilots, increased operating staff required for expected increases in demand for our services, increased indirect staff costs associated with the continuing development and implementation of our care enhancement services, and increases in information technology and other support staff and costs.
Selling, General and Administrative Expenses
Selling, general and administrative expenses as a percentage of revenues increased to 9.1% for the three months ended May 31, 2005 compared to 8.9% for the same period in fiscal 2004. Excluding contract performance incentive bonus revenues, which totaled $1.7 million for the three months ended May 31, 2004 compared to no contract performance incentive bonus revenues during the three months ended May 31, 2005, selling, general and administrative expenses as a percentage of revenues would have decreased to 9.1% from 9.2% for the three months ended May 31, 2005 and 2004, respectively.
Selling, general and administrative expenses as a percentage of revenues decreased to 9.2% for the nine months ended May 31, 2005 compared to 9.8% for the same period in fiscal 2004. Excluding contract performance incentive bonus revenues, which totaled $2.5 million for the nine months ended May 31, 2004 compared to no contract performance incentive bonus revenues during fiscal 2005, selling, general and administrative expenses as a percentage of revenues would have decreased to 9.2% from 9.9% for the nine months ended May 31, 2005 and 2004, respectively.
The decreases in selling, general and administrative expenses as a percentage of revenues excluding the impact of contract performance incentive bonus revenues for the three and nine months ended May 31, 2005 compared to the same periods in fiscal 2004 are primarily due to our ability to more effectively leverage our selling, general and administrative expenses as a result of growth in our operations. These decreases were partially offset by an increase in the employee bonus accrual and increased expenses related to securing and preparing for MHS pilots during the three and nine months ended May 31, 2005 compared to the same periods in fiscal 2004.
We anticipate that selling, general and administrative expenses for the remainder of fiscal 2005 will increase over fiscal 2004 primarily due to finalizing, implementing and/or operating the MHS pilots, and increased indirect support costs for our existing and anticipated new and expanded health plan contracts.
Depreciation and Amortization
Depreciation and amortization expense for the three and nine months ended May 31, 2005 increased 23.1% and 26.1%, respectively, over the same periods in fiscal 2004 primarily due to increased depreciation and amortization expense associated with equipment, software development, leasehold improvements, and computer-related capital expenditures. We made these capital expenditures to enhance our health plan information technology capabilities and expand our corporate office and calling capacity at existing care enhancement centers.
We anticipate that depreciation and amortization expense for the remainder of fiscal 2005 will increase over fiscal 2004 primarily as a result of additional capital expenditures associated with expected increases in demand for our services and growth and improvement in our information technology capabilities.
Interest Expense
Interest expense for the three and nine months ended May 31, 2005 decreased 65.6% and 47.6%, respectively, compared to the three and nine months ended May 31, 2004. The decrease in interest expense is primarily attributable to a reduction in our long-term debt balance resulting from a $48.0 million repayment of revolving debt since October 29, 2004, as well as lower interest rates under the Amended Credit Agreement compared to the Former Credit Agreement (described more fully in “-Liquidity and Capital Resources” below).
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We anticipate that interest expense for the remainder of fiscal 2005 will decrease compared to fiscal 2004 primarily as a result of a lower balance of long-term debt.
Income Tax Expense
Our effective tax rate changed to 39.5% and 39.7% for the three and nine months ended May 31, 2005, respectively, compared to 40.0% for the three and nine months ended May 31, 2004, primarily as a result of our geographic mix of earnings, which impacts our average state income tax rate, and other factors. The differences between the statutory federal income tax rate of 35% and our effective tax rate are due primarily to the impact of state income taxes and certain non-deductible expenses for income tax purposes.
Liquidity and Capital Resources
Operating activities for the nine months ended May 31, 2005 generated cash of $45.7 million compared to $33.6 million for the nine months ended May 31, 2004. The increase in operating cash flow of $12.1 million resulted primarily from an increase in net income and an increase in accrued employee bonuses, the payment of which generally occurs in the first quarter of the following fiscal year. These increases to cash flow from operations were partially offset by increased estimated income tax payments of $12.3 million for the nine months ended May 31, 2005 compared to the same period in fiscal 2004.
Investing activities during the nine months ended May 31, 2005 used $2.4 million in cash, which primarily consisted of investments in property and equipment of $7.6 million. This amount was partially offset by the return to the Company of $1.3 million that was previously held in escrow in connection with the StatusOne acquisition and net proceeds from the purchase and sale of investments of $4.1 million. The purchase of property and equipment was primarily associated with enhancements in our information technology capabilities.
Financing activities for the nine months ended May 31, 2005 used $47.8 million in cash primarily due to net payments on long-term debt of $48.2 million, deferred loan costs related to the Amended Credit Agreement of $0.7 million, and funding of an escrow account of $2.3 million in conjunction with contractual requirements under one contract. These uses of cash were slightly offset by proceeds from the exercise of stock options of $3.4 million.
On October 29, 2004, we amended our Former Credit Agreement dated September 5, 2003 by entering into the Amended Credit Agreement. The Amended Credit Agreement provides us with up to $150.0 million in borrowing capacity, including a $75.0 million sub facility for letters of credit, under a senior revolving credit facility that expires on October 29, 2009. Under the Amended Credit Agreement on October 29, 2004, we converted the outstanding $48.0 million term loan under the Former Credit Agreement to revolving debt. As of May 31, 2005, our available line of credit totaled $149.2 million.
The Amended Credit Agreement requires us to repay the principal on any loans at the maturity date of October 29, 2009. Borrowings under the Amended Credit Agreement bear interest, at our option, at the prime rate plus a spread of 0.0% to 1.0% or LIBOR plus a spread of 1.25% to 2.25%, or a combination thereof. The Amended Credit Agreement also provides for a fee ranging between 0.25% and 0.5% of unused commitments. Substantially all of our assets are pledged as collateral for any borrowings under the credit facility.
The Amended Credit Agreement contains various financial covenants, which require us to maintain, as defined, minimum ratios or levels of (i) total funded debt to EBITDA, (ii) interest coverage, (iii) fixed charge coverage, and (iv) net worth. The Amended Credit Agreement also prohibits the payment of dividends and limits the amount of repurchases of the Company’s common stock. As of May 31, 2005, we were in compliance with all of the covenant requirements of the Amended Credit Agreement.
On September 16, 2003, we entered into an interest rate swap agreement to manage our interest rate exposure under the Credit Agreement. In September 2004, in anticipation of amending and restating our Former Credit Agreement, as described above, we terminated the interest rate swap agreement and recognized a gain of approximately $22,000.
As of May 31, 2005, there were letters of credit outstanding under the Amended Credit Agreement totaling $0.8 million primarily to support our requirement to repay fees under two health plan contracts in the event we do not perform at established target levels and do not repay the fees due in accordance with the terms of the contract. We have never had a draw under an outstanding letter of credit.
In conjunction with contractual requirements under one contract that began on March 1, 2004, we have funded an escrow account in the amount of approximately $3.8 million. We were required to deposit into the escrow account a percentage of all fees received from this customer during the first year of the contract to be used to repay fees under the contract in the event we do not perform at established target levels.
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We believe that cash flow from operating activities, our available cash, and our available credit under the Amended Credit Agreement will continue to enable us to meet our contractual obligations and to fund the current level of growth in our operations for the foreseeable future. However, if expanding our operations requires significant additional financing resources, such as capital expenditures for technology improvements, additional care enhancement centers and/or letters of credit or other forms of financial assurance to guarantee our performance under the terms of new contracts, or if we are required to refund performance-based fees pursuant to contract terms, we may need to raise additional capital by expanding our existing credit facility and/or issuing debt or equity. If we face a limited ability to arrange such financing, it may restrict our ability to expand our operations.
In addition, if contract development accelerates or acquisition opportunities arise that would expand our operations, we may need to issue additional debt or equity to provide the funding for these growth opportunities. We may also issue equity in connection with future acquisitions or strategic alliances. We cannot assure you that we would be able to issue additional debt or equity on terms that would be acceptable to us.
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Contractual Obligations
The following schedule summarizes our contractual cash obligations at May 31, 2005.
| Twelve Months Ended May 31, | ||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (In $000s) | 2006 | 2007 – 2008 | 2009 – 2010 | 2011 and After | Total | |||||||||||||||||
| Long-term debt(1) | $ 159 | $ 370 | $88 | $ -- | $617 | |||||||||||||||||
| Deferred compensation | ||||||||||||||||||||||
| plan payments | 1,474 | 1,687 | 718 | 2,597 | 6,476 | |||||||||||||||||
| Operating lease obligations | 6,210 | 10,665 | 6,912 | 7,067 | 30,854 | |||||||||||||||||
| Other contractual cash | ||||||||||||||||||||||
| obligations(2) | 700 | 350 | -- | -- | 1,050 | |||||||||||||||||
| Total contractual cash | ||||||||||||||||||||||
| obligations | $8,543 | $13,072 | $7,718 | $9,664 | $38,997 | |||||||||||||||||
| (1) Long-term debt consists of payments due under capital lease obligations and excludes future cash obligations for interest associated with our outstanding indebtedness. | ||||||||||||||||||||||
(2) Other contractual cash obligations represent cash payments in connection with a strategic alliance agreement with Johns Hopkins University and Health System. | ||||||||||||||||||||||
Recently Issued Accounting Standards
Consolidation of Variable Interest Entities
In 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation (“FIN”) No. 46(R), “Consolidation of Variable Interest Entities.” FIN No. 46(R) requires consolidation of variable interest entities if certain conditions are met and generally applies to periods ending after March 15, 2004. The adoption of FIN No. 46(R) did not have a material impact on our financial position or results of operations.
Share-Based Payment
In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” Statement 123(R) supersedes Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in Statement 123(R) is similar to the approach described in Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. The Statement is effective for fiscal years beginning after June 15, 2005.
Statement 123(R) permits public companies to adopt its requirements using one of two methods:
A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of Statement 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of Statement 123 for all awards granted to employees prior to the effective date of Statement 123(R) that remain unvested on the effective date.
A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate, based on the amounts previously recognized under Statement 123 for purposes of pro forma disclosures, either (a) all prior periods presented or (b) prior interim periods of the year of adoption.
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We plan to adopt Statement 123(R) on September 1, 2005 using the modified prospective method.
As permitted by Statement 123, we currently account for share-based payments to employees using Opinion 25‘s intrinsic value method and, as such, generally recognize no compensation cost for employee stock options. Accordingly, the adoption of Statement 123(R)‘s fair value method will have a significant impact on our results of operations, although it will have no impact on our overall financial position. We cannot predict the impact of adopting Statement 123(R) at this time because it will partially depend on levels of share-based payments granted in the future. However, had we adopted Statement 123(R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma net income and earnings per share in Note 6 to our consolidated financial statements.
Statement 123(R) also requires the benefits of tax deductions in excess of amounts recognized as compensation cost to be reported as a financing cash flow, rather than an operating cash flow, as required under current accounting guidance. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While we cannot estimate what the benefits of these tax deductions will be in the future (because they depend on, among other things, when employees exercise stock options), we recognized $8.8 million and $8.2 million of such amounts in cash flow from operating activities for the nine months ended May 31, 2005 and May 31, 2004, respectively.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are subject to market risk related to interest rate changes, primarily as a result of the Former Credit Agreement and the Amended Credit Agreement, which bear interest based on floating rates. Borrowings under the Former Credit Agreement bore interest, at our option, at the prime rate plus a spread of 0.5% to 1.25% or LIBOR plus a spread of 2.0% to 2.75%, or a combination thereof. Borrowings under the Amended Credit Agreement bear interest, at our option, at the prime rate plus a spread of 0.0% to 1.0% or LIBOR plus a spread of 1.25% to 2.25%, or a combination thereof.
In order to manage our interest rate exposure under the Former Credit Agreement, we entered into an interest rate swap agreement in September 2003, effectively converting $40.0 million of floating rate debt to a fixed obligation with an interest rate of 4.99%. We do not execute transactions or hold derivative financial instruments for trading purposes. In September 2004, in anticipation of amending and restating our Former Credit Agreement, we terminated the $40.0 million interest rate swap agreement.
A one-point interest rate change on the variable rate debt outstanding at May 31, 2005 would have resulted in interest expense fluctuating approximately $0.1 million for the nine months ended May 31, 2005.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Our chief executive officer and chief financial officer have reviewed and evaluated the effectiveness of our disclosure controls and procedures [as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”)] as of May 31, 2005. Based on that evaluation, the chief executive officer and chief financial officer have concluded that our disclosure controls and procedures effectively and timely provide them with material information relating to the Company and its consolidated subsidiaries required to be disclosed in the reports the Company files or submits under the Exchange Act.
During the period covered by this report, there have been no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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Part II
Item 1. Legal Proceedings.
In June 1994, a former employee whom we dismissed in February 1994 filed a “whistle blower” action on behalf of the United States government. Subsequent to its review of this case, the federal government determined not to intervene in the litigation. The employee sued American Healthways, Inc. and our wholly-owned subsidiary, American Healthways Services, Inc. (“AHSI”), as well as certain named and unnamed medical directors and one named client hospital, West Paces Medical Center (“WPMC”), and other unnamed client hospitals.
American Healthways, Inc. has since been dismissed as a defendant; however, the case is still pending against AHSI before the United States District Court for the District of Columbia. In addition, WPMC has settled claims filed against it as part of a larger settlement agreement that WPMC’s parent organization, HCA Inc., reached with the United States government.
The complaint alleges that AHSI, the client hospitals and the medical directors associated with the Company’s hospital-based diabetes treatment center operation violated the federal False Claims Act by entering into certain arrangements that allegedly violated the federal anti-kickback statute and provisions of the Social Security Act prohibiting physician self-referrals. Although no specific monetary damage has been claimed, the plaintiff, on behalf of the federal government, seeks treble damages plus civil penalties and attorneys’ fees. The plaintiff also has requested an award of 30% of any judgment plus expenses. Substantial discovery has taken place to date and additional discovery is expected to occur. No trial date has been set. The parties have had initial discussions regarding their respective positions in the case; however, no resolution of this case has been reached or can be assured prior to the case proceeding to trial.
We believe that we have conducted our operations in full compliance with applicable statutory requirements and that we have meritorious defenses to the claims made in the case and intend to contest the claims vigorously. Nevertheless, it is possible that resolution of this legal matter could have a material adverse effect on our consolidated results of operations and cash flows in a particular financial reporting period. We believe that we will continue to incur legal expenses associated with the defense of this case which may be material to our consolidated results of operations in a particular financial reporting period. However, we believe that any resolution of this case will not have a material effect on our liquidity or financial condition.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
Not Applicable.
Item 3. Defaults Upon Senior Securities.
Not Applicable.
Item 4. Submission of Matters to a Vote of Security Holders.
Not Applicable.
Item 5. Other Information.
Not Applicable.
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Item 6. Exhibits.
(a) Exhibits
| 11 | Earnings Per Share Reconciliation |
31.1 | Certification pursuant to section 302 of the Sarbanes-Oxley Act of 2002 made by Ben R. Leedle, Jr., President and Chief Executive Officer |
31.2 | Certification pursuant to section 302 of the Sarbanes-Oxley Act of 2002 made by Mary A. Chaput, Executive Vice President and Chief Financial Officer |
32 | Certification Pursuant to 18 U.S.C section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 made by Ben R. Leedle, Jr., President and Chief Executive Officer and Mary A. Chaput, Executive Vice President and Chief Financial Officer |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| American Healthways, Inc. (Registrant) | ||
Date July 8, 2005 | By | /s/ Mary A. Chaput Mary A. Chaput Executive Vice President Chief Financial Officer (Principal Financial Officer) |
Date July 8, 2005 | By | /s/ Alfred Lumsdaine Alfred Lumsdaine Senior Vice President and Controller (Principal Accounting Officer) |
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