not assume medical cost risk but provide primarily administrative claim 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, as appropriate.
Our primary strategy is to develop new and to expand existing relationships with health plans and CMS to provide health and care support programs and services, including creating value for 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 health and care support services.
We expect to continue adding services to our product mix that extend our programs beyond a chronic disease focus and provide 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 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. In addition, we expect to continue developing proprietary, proactive health support for whole populations across the continuum of care, including next generation wellness solutions.
We anticipate that we will incur significant costs during the remainder of fiscal 2006 to enhance and expand our clinical programs and data and financial reporting systems, pursue opportunities in international markets, enhance our information technology support, 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.
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, 2005. 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.
We generally determine our contract fees by multiplying a contractually negotiated rate per member per month (“PMPM”) by the number of 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, and 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 10% of revenues recorded during the three months ended November 30, 2005 were performance-based and remain 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.
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; 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 subject to refund as revenues but instead record them in a current liability account “contract billings in excess of earned revenue”. Only in the event we do not meet performance levels by the end of the contract year are we 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. Historically, any such adjustments have been immaterial to our financial condition and results of operations.
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. As of November 30, 2005, performance-based fees that have not yet been settled with our customers but that have been recognized as revenue in the current and prior years totaled approximately $62.1 million. Of this amount, $44.6 million was based entirely on actual data received from our customers, while $17.5 million was based on calculations which include estimates such as medical claims incurred but not reported and/or a health plan’s medical cost trend compared to a baseline year. Data
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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.
Performance-related adjustments (including any amounts recorded as revenue that were ultimately refunded), changes in estimates, data reconciliation differences, or adjustments to incentive bonuses may cause us to recognize or reverse revenue in a current fiscal year that pertains to services provided during the prior fiscal year. During the three months ended November 30, 2005, we recognized a net increase in revenue of $1.0 million that related to services provided prior to fiscal 2006.
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 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 and customer contracts, 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.
Share-Based Compensation
On September 1, 2005, we adopted SFAS No. 123(R), which requires the measurement and recognition of compensation expense for all share-based payment awards based on estimated fair values at the date of grant. Determining the fair value of share-based awards at the grant date requires judgment in developing assumptions, which involve a number of variables. These variables include, but are not limited to, the expected stock price volatility over the term of the awards, and expected stock option exercise behavior. In addition, we also use judgment in estimating the number of share-based awards that are expected to be forfeited. In June 2005, we changed the method we use to estimate the fair values of stock options from the Black-Scholes model to a lattice binomial model, which we consider preferable to the Black-Scholes model because the lattice binomial model considers characteristics of fair value option pricing, such as an option’s contractual term and the probability of exercise before the end of the
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contractual term, that are not available under the Black-Scholes model. We use a third party to assist in developing the assumptions used in estimating the fair values of stock options.
Results of Operations
The following table shows the components of the statements of operations for the three months ended November 30, 2005 and November 30, 2004 expressed as a percentage of revenues.
| | Three Months Ended
November 30, |
| |
|
| | | 2005 | | 2004 | |
| |
|
| | Revenues | | 100.0 | % | | 100.0 | % |
| Cost of services | | 70.5 | % | | 64.6 | % |
| |
|
| Gross margin | | 29.5 | % | | 35.4 | % |
| | | | | | | |
| Selling, general and administrative expenses | | 11.2 | % | | 8.7 | % |
| Depreciation and amortization | | 6.2 | % | | 7.7 | % |
| Interest expense | | 0.3 | % | | 0.9 | % |
| |
|
| | | | | | | |
| Income before income taxes | | 11.8 | % | | 18.1 | % |
| Income tax expense | | 4.7 | % | | 7.3 | % |
| |
|
| | | | | | | |
| Net income | | 7.1 | % | | 10.8 | % |
| |
|
Revenues
Revenues for the three months ended November 30, 2005 increased 27.3% over the three months ended November 30, 2004, primarily due to the following:
| • | an increase in the number of self-insured employer actual lives under management from 405,000 at November 30, 2004 to 666,000 at November 30, 2005; |
| • | the commencement of thirteen new health plan contracts since November 30, 2004; |
| • | existing health plan customers adding or expanding ten new programs since November 30, 2004; |
| • | revenues from the MHS pilots of $1.6 million during the three months ended November 30, 2005; and |
| • | increased membership in our customers’ existing programs. |
We anticipate that total revenues for the remainder of fiscal 2006 will increase over fiscal 2005 revenues primarily due to the expansion of existing contracts, increasing demand for our health and care support services from self-insured employers who contract with our health plan customers, anticipated new health plan contracts, and revenues from the MHS pilots.
Cost of Services
Cost of services as a percentage of revenues increased to 70.5% for the three months ended November 30, 2005 compared to 64.6% for the same period in fiscal 2004. This increase is primarily related to costs of servicing the two MHS pilots, which began in August and September of 2005, respectively. A substantial majority of our fees under these pilots are performance-based and, consistent
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with our experience with new contracts with performance-based fees, have not yet been recognized as revenue because we are not yet able to measure performance. For the three months ended November 30, 2005, excluding both revenues of $1.6 million, which represent the non-performance-based portion of our fees under one of the MHS pilots, and costs of $4.8 million attributable to the MHS pilots, cost of services as a percentage of revenues would have increased to 66.3% from 64.6% for the three months ended November 30, 2005 and 2004, respectively, primarily due to the following:
| • | long-term incentive compensation costs of $1.5 million during the first quarter of fiscal 2006, including share-based compensation expensed under SFAS No. 123(R) and cash-based awards issued in lieu of share-based awards that were historically granted to certain levels of management, compared to no corresponding long-term incentive costs during the first quarter of fiscal 2005; |
| • | an increase in the employee bonus accrual during the three months ended November 30, 2005 compared to the three months ended November 30, 2004; and |
| • | a new enterprise agreement for software licensing and servicing entered into in November 2004, which enhanced and expanded a previous agreement that expired in August 2004. |
These increases were slightly offset by decreases related to increased capacity utilization, economies of scale, and productivity enhancements during the first quarter of fiscal 2006 compared to the first quarter of fiscal 2005.
We anticipate that cost of services for the remainder of fiscal 2006 will increase over fiscal 2005 primarily as a result of share-based payments required to be expensed under SFAS No. 123(R) and other long-term employee incentive costs, operating costs related to the MHS pilots, increases in operating staff required for expected increases in demand for our services, increases in indirect staff costs associated with the continuing development and implementation of our health and care support 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 11.2% for the three months ended November 30, 2005 compared to 8.7% for the same period in fiscal 2005. Excluding costs attributable to pursuing opportunities in international markets, which totaled $0.6 million for the three months ended November 30, 2005 compared to no corresponding costs during the three months ended November 30, 2004, selling, general and administrative expenses as a percentage of revenues would have increased to 10.5% from 8.7% for the three months ended November 30, 2005 and 2004, respectively, primarily due to the following:
| • | long-term incentive compensation costs of $1.8 million during the first quarter of fiscal 2006, which consisted of share-based compensation expensed under SFAS No. 123(R) and cash-based awards issued in lieu of share-based awards that were historically granted to certain levels of management, compared to $0.1 million of share-based compensation costs during the first quarter of fiscal 2005; and |
| • | investments in market assessment and enterprise scalability initiatives to support our anticipated future growth. |
We anticipate that selling, general and administrative expenses for the remainder of fiscal 2006 will increase over fiscal 2005 primarily due to share-based payments required to be expensed under SFAS No. 123(R) and other long-term employee incentive costs, anticipated investments in international
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initiatives, and increases in indirect support costs for our existing and anticipated new and expanded health plan contracts.
Depreciation and Amortization
Depreciation and amortization expense for the three months ended November 30, 2005 increased 3.7% over the same period in fiscal 2005 primarily due to increased depreciation and amortization expense associated with equipment, software, leasehold improvements, and computer-related capital expenditures. We made these capital expenditures to enhance our health plan information technology capabilities, expand our corporate office, and increase calling capacity at existing care enhancement centers.
We anticipate that depreciation and amortization expense for the remainder of fiscal 2006 will increase over fiscal 2005 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 months ended November 30, 2005 decreased 60.3% compared to the three months ended November 30, 2004 primarily due to a reduction in our long-term debt balance resulting from net repayments of $25.0 million of revolving debt since November 30, 2004.
We anticipate that interest expense for the remainder of fiscal 2006 will decrease over fiscal 2005 primarily as a result of a lower balance of long-term debt.
Income Tax Expense
Our effective tax rate decreased to 39.7% for the three months ended November 30, 2005 compared to 40.0% for the three months ended November 30, 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 three months ended November 30, 2005 generated cash flows of $4.5 million compared to $8.3 million for the three months ended November 30, 2004. The decrease in operating cash flow of $3.8 million resulted primarily from a higher employee bonus payment in the first quarter of fiscal 2006 compared to the first quarter of fiscal 2005 and a decrease in cash collections on accounts receivable due to a delay in monthly payments from two large customers, which were received in early December 2005. These decreases were slightly offset by increased payments in the first quarter of fiscal 2005 related to accounts payable accrued at August 31, 2004 associated with capital expenditures for upgrades to hardware in support of core business functions and an increase in cash collections recorded to contract billings in excess of earned revenue in the first quarter of fiscal 2006 compared to the first quarter of 2005, primarily related to the MHS pilots.
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Investing activities during the three months ended November 30, 2005 used $4.7 million in cash, which primarily consisted of the purchase of property and equipment associated with the addition of information technology hardware and software.
Financing activities for the three months ended November 30, 2005 generated $5.5 million in cash primarily due to proceeds from the exercise of stock options and the related tax benefit.
On September 19, 2005, we amended and restated the First Amended Credit Agreement and entered into the Second Amended Credit Agreement, which provides us with a $250.0 million revolving credit facility, including a swingline sub facility of $10.0 million and a $75.0 million sub facility for letters of credit, together with an uncommitted incremental accordion facility of $50.0 million, and expires on September 19, 2010. As of November 30, 2005, our available line of credit totaled $249.3 million.
The Second Amended Credit Agreement requires us to repay the principal on any loans at the maturity date of September 19, 2010. Borrowings under the Second Amended Credit Agreement generally bear interest, at our option, at LIBOR plus a spread of 0.875% to 1.5% or at the prime rate. The Second Amended Credit Agreement also provides for a fee ranging between 0.175% and 0.3% of unused commitments. The Second Amended Credit Agreement is secured by guarantees from our active domestic subsidiaries and by security interests in substantially all of our and our subsidiaries’ assets.
The First Amended Credit Agreement provided us with up to $150.0 million in borrowing capacity and contained various financial covenants, which required us to maintain, as defined, ratios or levels of (i) total funded debt to EBITDA, (ii) interest coverage, (iii) fixed charge coverage, and (iv) net worth. The Second Amended Credit Agreement contains similar financial covenants with the exclusion of the interest coverage ratio. Both agreements restrict the payment of dividends and limit the amount of repurchases of the Company’s common stock. As of November 30, 2005, we were in compliance with all of the covenant requirements of the Second Amended Credit Agreement.
As of November 30, 2005, there were letters of credit outstanding under the Second Amended Credit Agreement totaling $0.7 million primarily to support our requirement to repay fees under one health plan contract 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.
In conjunction with contractual requirements under one contract beginning on March 1, 2004, we have funded an escrow account in the amount of approximately $3.8 million. We are 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.
We believe that cash flow from operating activities, our available cash, and our available credit under the Second 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.
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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 increased 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.
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 Second Amended Credit Agreement and the First Amended Credit Agreement, which bear interest based on floating rates. Borrowings under the First Amended Credit Agreement bore 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. Borrowings under the Second Amended Credit Agreement generally bear interest, at our option, at LIBOR plus a spread of 0.875% to 1.5% or at the prime rate. We do not execute transactions or hold derivative financial instruments for trading purposes.
Because there was no variable rate debt outstanding during the three months ended November 30, 2005, a one-point interest rate change would not have caused interest expense to fluctuate for the three months ended November 30, 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 November 30, 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.
Changes in Internal Control over Financial Reporting
During the first quarter of fiscal 2006, we implemented an enterprise resource planning system including modules for cash management, fixed assets, payables, purchasing, general ledger, and financial reporting. We expect this implementation to improve our internal control over financial reporting by allowing us to maintain more detailed financial information and implement more automated controls, thereby reducing manual processes. Other than this change, there have been no other 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 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 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. We believe that any resolution of this case will not have a material effect on our liquidity or financial condition.
Item 1A. Risk Factors.
Not Applicable.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
Not Applicable.
Item 3. Defaults Upon Senior Securities.
Not Applicable.
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Item 4. Submission of Matters to a Vote of Security Holders.
Not Applicable.
Item 5. Other Information.
Not Applicable.
Item 6. 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 hereunto duly authorized.
| | | American Healthways, Inc.
——————————————
(Registrant) |
| | |
|
Date January 9, 2006
—————————— | | By | /s/ Mary A. Chaput
——————————————
Mary A. Chaput
Executive Vice President
Chief Financial Officer
(Principal Financial Officer) |
| | |
|
Date January 9, 2006
—————————— | | By | /s/ Alfred Lumsdaine
——————————————
Alfred Lumsdaine
Senior Vice President and
Controller
(Principal Accounting Officer) |
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