Table of Contents

 

 

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 


 

FORM 10-Q

 

(Mark One)

 

                          x

  

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2005

 

OR

 

                          ¨

  

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                          to

 


 

Commission file number 000-33395

 


 

Centene Corporation

(Exact name of registrant as specified in its charter)

 

Delaware    42-1406317

(State or other jurisdiction of

   (I.R.S. Employer

incorporation or organization)

   Identification Number)
7711 Carondelet Avenue, Suite 800     
St. Louis, Missouri    63105

(Address of principal executive offices)

   (Zip Code)

 

Registrant’s telephone number, including area code:

(314) 725-4477

 

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 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:

x  Yes    ¨  No

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

x  Yes    ¨  No

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

¨  Yes    x  No

 

As of October 14, 2005, the registrant had 42,672,834 shares of common stock outstanding.

 



Table of Contents

CENTENE CORPORATION

 

QUARTERLY REPORT ON FORM 10-Q

 

TABLE OF CONTENTS

 

          PAGE

     Part I     
     Financial Information     

Item 1.

  

Financial Statements

    
    

Consolidated Balance Sheets as of September 30, 2005 (unaudited) and December 31, 2004

   1
    

Consolidated Statements of Earnings for the Three Months and Nine Months Ended September 30, 2005 and 2004 (unaudited)

   2
    

Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2005 and 2004 (unaudited)

   3
    

Notes to the Consolidated Financial Statements (unaudited)

   4

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   9

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

   27

Item 4.

  

Controls and Procedures

   27
     Part II     
     Other Information     

Item 1.

  

Legal Proceedings

   28

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

   28

Item 3.

  

Defaults Upon Senior Securities

   28

Item 4.

  

Submission of Matters to a Vote of Security Holders

   28

Item 5.

  

Other Information

   28

Item 6.

  

Exhibits

   29

Signatures

   31


Table of Contents

PART I

 

FINANCIAL INFORMATION

ITEM 1. Financial Statements

 

CENTENE CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

 

     September 30,     December 31,  
     2005

    2004

 
     (Unaudited)        
ASSETS                 

Current assets:

                

Cash and cash equivalents

   $ 121,424     $ 84,105  

Premium and related receivables, net of allowances of $156 and $462, respectively

     43,235       31,475  

Short-term investments, at fair value (amortized cost $58,760 and $94,442, respectively)

     58,642       94,283  

Other current assets

     20,500       14,429  
    


 


Total current assets

     243,801       224,292  

Long-term investments, at fair value (amortized cost $132,394 and $117,177, respectively)

     130,347       116,787  

Restricted deposits, at fair value (amortized cost $22,614 and $22,295, respectively)

     22,344       22,187  

Property, software and equipment

     55,073       43,248  

Goodwill

     159,579       101,631  

Other intangible assets

     21,217       14,439  

Other assets

     7,250       5,350  
    


 


Total assets

   $ 639,611     $ 527,934  
    


 


LIABILITIES AND STOCKHOLDERS’ EQUITY                 

Current liabilities:

                

Medical claims liabilities

   $ 148,889     $ 165,980  

Accounts payable and accrued expenses

     47,302       31,737  

Unearned revenue

     12,437       3,956  

Current portion of long-term debt and notes payable

     486       486  
    


 


Total current liabilities

     209,114       202,159  

Long-term debt

     87,650       46,973  

Other liabilities

     9,614       7,490  
    


 


Total liabilities

     306,378       256,622  

Stockholders’ equity:

                

Common stock, $.001 par value; authorized 100,000,000 shares; issued and outstanding 42,646,184 and 41,316,122 shares, respectively

     43       41  

Additional paid-in capital

     186,659       165,391  

Accumulated other comprehensive income:

                

Unrealized loss on investments, net of tax

     (1,522 )     (407 )

Retained earnings

     148,053       106,287  
    


 


Total stockholders’ equity

     333,233       271,312  
    


 


Total liabilities and stockholders’ equity

   $ 639,611     $ 527,934  
    


 


 

See notes to consolidated financial statements.

 

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Table of Contents

CENTENE CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF EARNINGS

(In thousands, except share data)

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2005

    2004

    2005

    2004

 
     (Unaudited)     (Unaudited)  

Revenues:

                                

Premiums

   $ 395,667     $ 251,536     $ 1,075,027     $ 705,556  

Services

     4,975       2,207       7,619       7,320  
    


 


 


 


Total revenues

     400,642       253,743       1,082,646       712,876  
    


 


 


 


Expenses:

                                

Medical costs

     331,050       202,974       881,021       570,720  

Cost of services

     2,002       2,111       3,573       6,149  

General and administrative expenses

     52,450       32,187       139,274       88,915  
    


 


 


 


Total operating expenses

     385,502       237,272       1,023,868       665,784  
    


 


 


 


Earnings from operations

     15,140       16,471       58,778       47,092  

Other income (expense):

                                

Investment and other income

     2,818       1,683       7,461       4,529  

Interest expense

     (1,190 )     (126 )     (2,386 )     (317 )
    


 


 


 


Earnings before income taxes

     16,768       18,028       63,853       51,304  

Income tax expense

     4,662       6,677       22,087       19,002  
    


 


 


 


Net earnings

   $ 12,106     $ 11,351     $ 41,766     $ 32,302  
    


 


 


 


Earnings per share:

                                

Basic earnings per common share

   $ 0.28     $ 0.28     $ 0.99     $ 0.79  

Diluted earnings per common share

   $ 0.27     $ 0.26     $ 0.93     $ 0.74  

Weighted average number of shares outstanding:

                                

Basic

     42,582,129       40,972,858       42,120,149       40,693,804  

Diluted

     45,278,328       43,640,180       45,078,852       43,364,120  

 

See notes to consolidated financial statements.

 

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Table of Contents

CENTENE CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

     Nine Months Ended
September 30,


 
     2005

    2004

 
     (Unaudited)  

Cash flows from operating activities:

                

Net earnings

   $ 41,766     $ 32,302  

Adjustments to reconcile net earnings to net cash provided by operating activities —

                

Depreciation and amortization

     9,658       7,219  

Deferred income taxes

     (3,567 )     (303 )

Tax benefits related to stock options

     4,511       1,858  

Stock compensation expense

     3,557       44  

Loss (gain) on sale of investments

     58       (212 )

Changes in assets and liabilities —

                

Premium and related receivables

     (9,396 )     (2,431 )

Other current assets

     (1,990 )     (4,803 )

Other assets

     (1,380 )     (1,773 )

Medical claims liabilities

     (17,091 )     19,825  

Unearned revenue

     5,892       (3 )

Accounts payable and accrued expenses

     11,798       5,184  

Other operating activities

     1,096       568  
    


 


Net cash provided by operating activities

     44,912       57,475  
    


 


Cash flows from investing activities:

                

Purchase of property, software and equipment

     (16,837 )     (9,487 )

Purchase of investments

     (108,630 )     (207,385 )

Sales and maturities of investments

     129,095       188,918  

Acquisitions, net of cash acquired

     (55,410 )     (7,005 )
    


 


Net cash used in investing activities

     (51,782 )     (34,959 )
    


 


Cash flows from financing activities:

                

Reduction of long-term debt and notes payable

     (4,323 )     (507 )

Proceeds from borrowings

     45,000        

Proceeds from stock options and employee stock purchase plan

     3,925       2,332  

Other financing activities

     (413 )      
    


 


Net cash provided by financing activities

     44,189       1,825  
    


 


Net increase in cash and cash equivalents

     37,319       24,341  
    


 


Cash and cash equivalents, beginning of period

     84,105       64,346  
    


 


Cash and cash equivalents, end of period

   $ 121,424     $ 88,687  
    


 


Interest paid

   $ 2,184     $ 324  

Income taxes paid

   $ 19,658     $ 18,844  

Supplemental schedule of non-cash investing and financing activities:

                

Common stock issued for acquisitions

   $ 8,991     $  

 

See notes to consolidated financial statements.

 

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Table of Contents

CENTENE CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except share data)

 

1. Organization

 

Centene Corporation (Centene or the Company) provides multi-line managed care programs and related services to individuals receiving benefits under government subsidized programs including Medicaid, Supplemental Security Income (SSI) and the State Children’s Health Insurance Program (SCHIP). Centene’s Medicaid Managed Care segment operates health plans under its own state licenses in seven states and contracts with other managed care organizations to provide risk and non-risk management services. Centene’s Specialty Services segment contracts with Centene owned companies, as well as other healthcare organizations and state programs, to provide specialty services including behavioral health, disease management, nurse triage and treatment compliance.

 

2. Basis of Presentation

 

The unaudited interim financial statements herein have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). The accompanying interim financial statements have been prepared under the presumption that users of the interim financial information have either read or have access to the audited financial statements for the latest fiscal year ended December 31, 2004. Accordingly, footnote disclosures, which would substantially duplicate the disclosures contained in the December 31, 2004 audited financial statements, have been omitted from these interim financial statements where appropriate. In the opinion of management, these financial statements reflect all adjustments, consisting only of normal recurring adjustments, which are necessary for a fair presentation of the results of the interim periods presented.

 

Certain 2004 amounts in the consolidated financial statements have been reclassified to conform to the 2005 presentation. These reclassifications have no effect on net earnings or stockholders’ equity as previously reported.

 

The Company accounts for stock-based compensation under APB Opinion No. 25, “Accounting for Stock Issued to Employees.” The Company has adopted the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” and SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure.” The following table illustrates the effect on net earnings and earnings per share if a fair value based method had been applied to all awards.

 

     Three Months Ended     Nine Months Ended  
     September 30,

    September 30,

 
     2005

    2004

    2005

    2004

 

Net earnings

   $ 12,106     $ 11,351     $ 41,766     $ 32,302  

Stock-based employee compensation expense included in net earnings, net of tax

     777       8       2,206       27  

Stock-based employee compensation expense determined under fair value based method, net of tax

     (2,003 )     (909 )     (6,035 )     (2,358 )
    


 


 


 


Pro forma net earnings

   $ 10,880     $ 10,450     $ 37,937     $ 29,971  
    


 


 


 


Basic earnings per common share:

                                

As reported

   $ 0.28     $ 0.28     $ 0.99     $ 0.79  

Pro forma

   $ 0.26     $ 0.26     $ 0.90     $ 0.74  

Diluted earnings per common share:

                                

As reported

   $ 0.27     $ 0.26     $ 0.93     $ 0.74  

Pro forma

   $ 0.24     $ 0.24     $ 0.85     $ 0.69  

 

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Table of Contents

3. Recent Accounting Pronouncements

 

In December 2004 SFAS 123 (revised 2004), “Share Based Payment,” (SFAS 123R) was issued. In March 2005 the SEC issued Staff Accounting Bulletin No. 107 (SAB 107). SAB 107 expresses views of the SEC staff regarding the interaction between SFAS 123R and certain SEC rules. SFAS 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS 123R requires public entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. The grant-date fair value of employee share options and similar instruments will be estimated using option-pricing models adjusted for the unique characteristics of those instruments. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award. In April 2005 the SEC delayed the implementation of SFAS 123R for public companies until the first annual period beginning after June 15, 2005. SFAS 123R is required to be adopted by the Company by January 1, 2006.

 

The Company currently utilizes a closed form option-pricing model to measure the fair value of stock-based compensation for employees. SFAS 123R permits the use of this model or other models such as a lattice model. The Company has not yet determined which model it will use to measure the fair value of share-based grants to employees upon the adoption of SFAS 123R. The effect of expensing stock options in accordance with the original SFAS 123 is presented above under Note 2, Basis of Presentation. SFAS 123R also requires that the benefits associated with the tax deductions in excess of recognized compensation cost be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This presentation may reduce net operating cash flows and increase net financing cash flows in periods after the effective date. The amount of this excess tax deduction benefit was $4,511 and $1,858 in the nine months ended September 30, 2005 and 2004, respectively.

 

In October 2005 the Compensation Committee approved the immediate and full acceleration of vesting of 260,000 “out-of-the-money” stock options to certain of the Company’s employees. These employees did not include any of the Company’s executive officers or other employees at Vice President level or above. Each stock option issued as a part of these grants has an exercise price greater than the closing price per share on the date of the Compensation Committee’s action. The purpose of the acceleration is to enable the Company to avoid recognizing compensation expense associated with these options in future periods in its consolidated statements of earnings, as a result of SFAS 123R. The pre-tax charge to be avoided totals approximately $3,000 which would have been recognized over the years 2006, 2007, 2008 and 2009. This amount will be reflected in the pro forma disclosures of the 2005 consolidated year-end financial statements. The options that have been accelerated have an exercise price in excess of the current market value of the Company’s common stock, and, accordingly, the Compensation Committee determined that the expense savings outweighs the objective of incentive compensation and retention.

 

In May 2005 SFAS No. 154, “Accounting Changes and Error Corrections – replacement of APB Opinion No. 20 and FASB Statement No. 3,” (SFAS No. 154) was issued. SFAS No. 154 changes the accounting for and reporting of a change in accounting principle by requiring retrospective application to prior periods’ financial statements of changes in accounting principle unless impracticable. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. The Company does not expect the adoption of SFAS No. 154 to have a material impact on its results of operations, financial position or cash flows.

 

4. Acquisitions

 

AirLogix

 

Effective July 22, 2005, the Company acquired AirLogix, Inc., a disease management provider. The Company paid approximately $36,200 in cash and related transaction costs. If certain performance criteria are achieved, additional consideration of up to $5,000 may be paid. The results of operations for AirLogix are included in the consolidated financial statements since July 22, 2005.

 

The preliminary purchase price allocation resulted in estimated identified intangible assets of $5,000 and associated deferred tax liabilities of $1,900, and goodwill of approximately $31,200. The estimated identifiable intangible assets have an estimated useful life of five years. The acquired goodwill is not deductible for income tax purposes. Pro forma disclosures related to the acquisition have been excluded as immaterial.

 

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Table of Contents

SummaCare

 

Effective May 1, 2005, the Company acquired certain Medicaid-related assets from SummaCare, Inc. for a purchase price of approximately $30,300. The purchase price and related transaction costs consisted of approximately $21,300 in cash and 318,735 shares of common stock. The cost to acquire the Medicaid-related assets has been preliminarily allocated to the assets acquired and liabilities assumed according to estimated fair values. The results of operations for SummaCare are included in the consolidated financial statements since May 1, 2005.

 

The preliminary purchase price allocation resulted in identified intangible assets of $1,900, representing purchased contract rights and a non-compete agreement, and goodwill of $28,400. The contract rights and non-compete agreement are being amortized over periods ranging from five to ten years. The acquired goodwill is deductible for income tax purposes. Pro forma disclosures related to the acquisition have been excluded as immaterial.

 

FirstGuard

 

The Company purchased FirstGuard Inc. and FirstGuard Health Plan, Inc. (collectively, FirstGuard) from Swope Community Enterprises (Swope) effective December 1, 2004. Centene paid approximately $96,020 in cash and transaction costs. In accordance with terms in the agreement, the purchase price may be adjusted on certain conditions up to sixteen months after the acquisition date. The results of operations for FirstGuard are included in the consolidated financial statements since December 1, 2004.

 

The purchase price and costs associated with the acquisition exceeded the preliminary estimated fair value of the net tangible assets acquired by approximately $91,885. The Company has preliminarily allocated the excess purchase price over the fair value of the net tangible assets acquired to identifiable intangible assets of $10,000 and associated deferred tax liabilities of $3,800 and goodwill of $85,685. The identifiable intangible assets have an estimated useful life of ten years. The acquired goodwill is not deductible for income tax purposes.

 

5. Earnings Per Share

 

The following table sets forth the calculation of basic and diluted net earnings per common share:

 

     Three Months Ended
September 30,


   Nine Months Ended
September 30,


     2005

   2004

   2005

   2004

Net earnings

   $ 12,106    $ 11,351    $ 41,766    $ 32,302
    

  

  

  

Shares used in computing per share amounts:

                           

Weighted average number of common shares outstanding

     42,582,129      40,972,858      42,120,149      40,693,804

Common stock equivalents (as determined by applying the treasury stock method)

     2,696,199      2,667,322      2,958,703      2,670,316
    

  

  

  

Weighted average number of common shares and potential dilutive common shares outstanding

     45,278,328      43,640,180      45,078,852      43,364,120
    

  

  

  

Basic earnings per common share

   $ 0.28    $ 0.28    $ 0.99    $ 0.79

Diluted earnings per common share

   $ 0.27    $ 0.26    $ 0.93    $ 0.74

 

The calculation of diluted earnings per common share for the three months and nine months ended September 30, 2005 excludes the impact of 197,500 and 265,155 shares, respectively, related to stock options, unvested restricted stock and restricted stock units which are anti-dilutive. There were no anti-dilutive shares for the periods presented in 2004.

 

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Table of Contents

6. Contingencies

 

Aurora Health Care, Inc. (Aurora) provides medical professional services under a contract with the Company’s Wisconsin health plan subsidiary. In May 2003, Aurora filed a lawsuit in the Milwaukee County Circuit Court claiming the Company had failed to adequately reimburse Aurora for services rendered during the period from 1998 to the present.

 

On September 1, 2005, the Company entered into a settlement and release agreement (Agreement) with Aurora which provides for complete and final settlement of the lawsuit. Under the terms of the Agreement, the Company paid $9,500 to Aurora, $5,000 of which was previously reserved and $4,500 was recorded as a pre-tax charge in the quarter ended September 30, 2005. Both parties agreed on the rates for ambulatory services through December 31, 2005 when the current contract expires. Subsequent to entering into the Agreement, the Company and Aurora agreed to a new, five year contract that will become effective as of January 1, 2006.

 

7. Comprehensive Earnings

 

Differences between net earnings and total comprehensive earnings resulted from changes in unrealized gains and losses on investments available for sale and follow:

 

     Three Months Ended
September 30,


        Nine Months Ended
September 30,


 
     2005

     2004

        2005

     2004

 

Net earnings

   $ 12,106      $ 11,351         $ 41,766      $ 32,302  

Reclassification adjustment, net of tax

     25        224           92        (354 )

Change in unrealized gain (loss) on investments, net of tax

     (738 )      1,257           (1,207 )      (374 )
    


  

       


  


Total comprehensive earnings

   $ 11,393      $ 12,832         $ 40,651      $ 31,574  
    


  

       


  


 

8. Revolving Line of Credit

 

In September 2005, the Company executed an amendment to the five-year Revolving Credit Agreement dated September 14, 2004 with various financial institutions, for which LaSalle Bank National Association serves as administrative agent and co-lead arranger. The amendment increased the total amount available under the credit agreement to $200,000 from $100,000 including a sub-facility for letters of credit in an aggregate amount up to $50,000. In addition, under the amendment the lending institutions released the Company’s prior grant of a security interest in the outstanding common stock and membership interests of each of the Company’s subsidiaries. The credit agreement is now an unsecured facility. Borrowings under the agreement bear interest based upon LIBOR rates, the Federal Funds Rate or the Prime Rate. The agreement contains non-financial and financial covenants, including requirements of minimum fixed charge coverage ratios, minimum debt-to-EBITDA ratios and minimum tangible net worth. The agreement will expire in September 2010 or on an earlier date in the instance of a default as defined in the agreement. As of September 30, 2005, the Company was in compliance with all covenants. At September 30, 2005, the outstanding borrowings totaled $75,000 bearing interest at a weighted average composite of 5.2% and outstanding letters of credit totaled $15,000.

 

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9. Segment Information

 

Factors used in determining the reportable business segments include the nature of operating activities, existence of separate senior management teams, and the type of information presented to the Company’s chief operating decision makers to evaluate all results of operations.

 

Centene operates in two segments: Medicaid Managed Care and Specialty Services. The Medicaid Managed Care segment consists of Centene’s health plans including all of the functions needed to operate them. The Specialty Services segment consists of Centene’s specialty companies including behavioral health, disease management, nurse triage and treatment compliance functions.

 

        Segment information for the three months ended September 30, 2005, follows:

     Medicaid
Managed Care


   Specialty
Services


    Eliminations

    Consolidated
Total


Revenue from external customers

   $ 373,589    $ 27,053     $     $ 400,642

Revenue from internal customers

     18,488      9,475       (27,963 )    
    

  


 


 

Total revenue

   $ 392,077    $ 36,528     $ (27,963 )   $ 400,642
    

  


 


 

Earnings from operations

   $ 15,542    $ (402 )   $     $ 15,140
    

  


 


 

        Segment information for the three months ended September 30, 2004, follows:

 

     Medicaid
Managed Care


   Specialty
Services


    Eliminations

    Consolidated
Total


Revenue from external customers

   $ 251,944    $ 1,799     $     $ 253,743

Revenue from internal customers

     15,307      5,358       (20,665 )    
    

  


 


 

Total revenue

   $ 267,251    $ 7,157     $ (20,665 )   $ 253,743
    

  


 


 

Earnings from operations

   $ 17,162    $ (691 )   $     $ 16,471
    

  


 


 

        Segment information for the nine months ended September 30, 2005, follows:

 

     Medicaid
Managed Care


   Specialty
Services


    Eliminations

    Consolidated
Total


Revenue from external customers

   $ 1,052,102    $ 30,544     $     $ 1,082,646

Revenue from internal customers

     53,306      26,108       (79,414 )    
    

  


 


 

Total revenue

   $ 1,105,408    $ 56,652     $ (79,414 )   $ 1,082,646
    

  


 


 

Earnings from operations

   $ 60,194    $ (1,416 )   $     $ 58,778
    

  


 


 

        Segment information for the nine months ended September 30, 2004, follows:

 

     Medicaid
Managed Care


   Specialty
Services


    Eliminations

    Consolidated
Total


Revenue from external customers

   $ 706,790    $ 6,086     $     $ 712,876

Revenue from internal customers

     44,864      15,135       (59,999 )    
    

  


 


 

Total revenue

   $ 751,654    $ 21,221     $ (59,999 )   $ 712,876
    

  


 


 

Earnings from operations

   $ 47,973    $ (881 )   $     $ 47,092
    

  


 


 

 

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ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this filing, and in our annual report on Form 10-K for the year ended December 31, 2004. The discussion contains forward-looking statements that involve known and unknown risks and uncertainties, including those set forth below under “Factors that May Affect Future Results and the Trading Price of Our Common Stock.”

 

OVERVIEW

 

We are a multi-line managed care organization that provides Medicaid and Medicaid-related programs and related services to organizations and individuals through government subsidized programs, including Medicaid, Supplemental Security Income (SSI) and the State Children’s Health Insurance Program (SCHIP). We operate health plans in seven states. We also provide specialty services through contracts with our health plans, as well as other healthcare organizations and state programs. These specialty services include behavioral health, disease management, nurse triage and treatment compliance.

 

RECENT ACQUISITIONS AND NEW BUSINESS IMPLEMENTATION

 

Effective July 22, 2005, we acquired AirLogix, Inc., a disease management provider, for a purchase price of approximately $36.2 million. The results of operations of this entity are included in our consolidated financial statements since July 22, 2005. The preliminary purchase price allocation resulted in estimated identifiable intangible assets of $5.0 million and goodwill of $31.2 million. The estimated identifiable intangible assets are being amortized over an estimated life of five years.

 

During the third quarter of 2005 we were awarded Medicaid contracts in Georgia by the Georgia Department of Community Health. Our subsidiary, Peach State Health Plan, Inc., will manage care for a portion of the Medicaid and SCHIP recipients in the Atlanta, Central and Southwest regions. Membership operations for the Atlanta and Central regions will commence April 1, 2006. Membership operations for the Southwest region will commence December 1, 2006.

 

Effective July 1, 2005, we began performing under our contract with the State of Arizona to facilitate the delivery of mental health and substance abuse services to behavioral health recipients in Arizona. We are now serving approximately 94,000 members in Arizona.

 

Effective May 1, 2005, we acquired certain Medicaid-related assets of SummaCare, Inc. for a purchase price of approximately $30.3 million. The results of operations of this entity are included in our consolidated financial statements beginning May 1, 2005. The purchase price allocation resulted in estimated identifiable intangible assets of $1.9 million, representing purchased contract rights and a non-compete agreement, and goodwill of $28.4 million. The contract rights and non-compete agreement are being amortized over periods ranging from five to ten years.

 

Effective December 1, 2004, we acquired FirstGuard, Inc. and FirstGuard Health Plan, Inc. (FirstGuard) for a purchase price of $96.0 million. The results of operations of this entity are included in our consolidated financial statements beginning December 1, 2004. The preliminary purchase price allocation resulted in estimated identifiable intangible assets of $10.0 million and goodwill of $85.7 million. The estimated identifiable intangible assets are being amortized over an estimated life of ten years.

 

Effective January 1, 2004, we commenced operations in Ohio through the acquisition of the Medicaid-related assets of Family Health Plan, Inc. (FHP) for a purchase price of $6.9 million. The results of operations of this entity are included in our consolidated financial statements beginning January 1, 2004. The purchase price allocation resulted in identifiable intangible assets of $1.8 million, representing purchased contract rights, provider network and a non-compete agreement, and goodwill of $5.1 million. The contract rights, provider network and non-compete agreement are being amortized over periods ranging from five to ten years.

 

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REVENUE AND EXPENSE DISCUSSION AND KEY METRICS

 

Revenues and Revenue Recognition

 

We generate revenues in our Medicaid Managed Care segment primarily from premiums we receive from the states in which we operate to provide health benefits to our members. We receive a fixed premium per member per month pursuant to our state contracts. We generally receive premium payments during the month we provide services and recognize premium revenue during the period in which we are obligated to provide services to our members. Revenues are recorded based on membership and eligibility data provided by the states, which may be adjusted by the states for updates to this data. In addition, revenue is adjusted for rebates due to the states in the event profits exceeds established levels. These adjustments are immaterial in relation to total revenue recorded and are reflected in the period known.

 

Our Specialty Services companies generate revenues from a variety of sources. Our behavioral health company generates revenue via capitation payments from our health plans, state contracts, and fees for school programs in Arizona. Our disease management programs receive fees from healthcare organizations for disease management services. Our treatment compliance program receives fee income from the manufacturers of pharmaceuticals. Our nurse triage line receives fees from health plans, physicians and other organizations for providing continuous access to nurse advisors.

 

Premiums collected in advance are recorded as unearned revenue. Premiums due to us are recorded as premium and related receivables and are recorded net of an allowance based on historical trends and our management’s judgment on the collectibility of these accounts. As we generally receive premiums during the month in which services are provided, the allowance is typically not significant in comparison to total premium revenue and does not have a material impact on the presentation of our financial condition or results of operations.

 

One of the primary drivers of our increasing revenue has been membership growth in our Medicaid Managed Care segment. We have increased our membership through internal growth as well as acquisitions. From September 30, 2004 to September 30, 2005, we increased our membership by 32.1%, of which 3.8% was due to organic growth and 28.3% was growth from acquisitions. The following table sets forth our membership by state in our Medicaid Managed Care segment:

     September 30,

 
     2005

    2004

 

Indiana

   176,300     150,000  

Kansas

   107,600      

Missouri

   37,300      

New Jersey

   50,900     53,200  

Ohio

   58,100     23,500  

Texas

   243,600     250,200  

Wisconsin

   173,900     164,700  
    

 

Total

   847,700     641,600  
    

 

The following table sets forth our membership by line of business in our Medicaid Managed Care segment:  
     September 30,

 
     2005

    2004

 

Medicaid

   657,500     479,500  

SCHIP

   176,900     152,100  

SSI

   13,300  (a)   10,000  (b)
    

 

Total

   847,700     641,600  
    

 

(a) 6,800 at-risk, 6,500 ASO

(b) 4,500 at-risk, 5,500 ASO

 

During the last 12 months, we entered the Kansas and Missouri markets through our acquisition of FirstGuard. We serve Medicaid and SCHIP membership in these two states. We increased our membership in Ohio through our acquisition of the

 

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Medicaid-related assets of SummaCare, Inc. Our membership increased in Indiana and Wisconsin from additions to our provider networks, increases in counties served and growth in the overall number of Medicaid beneficiaries. Our membership decreased in Texas due to more stringent requirements for the SCHIP program.

 

Another primary driver of our increasing revenue has been growth in our Specialty Services segment. This segment provides behavioral health services to approximately 131,000 members through direct contracts with states and 652,000 members through contracts with our health plans.

 

Operating Expenses

 

Our operating expenses include medical costs, cost of services, and general and administrative expenses.

 

Our medical costs include payments to physicians, hospitals, and other providers for healthcare and specialty services claims. Medical costs also include estimates of medical expenses incurred but not yet reported, or IBNR, and estimates of the cost to process unpaid claims. Monthly, we estimate our IBNR based on a number of factors, including inpatient hospital utilization data and prior claims experience. As part of this review, we also consider the costs to process medical claims and estimates of amounts to cover uncertainties related to fluctuations in provider billing patterns, membership, products and inpatient hospital trends. These estimates are adjusted as more information becomes available. We utilize the services of independent actuaries who are contracted to review our estimates quarterly. While we believe that our process for estimating IBNR is actuarially sound, we cannot assure you that healthcare claim costs will not materially differ from our estimates.

 

Our results of operations depend on our ability to manage expenses related to health benefits and to accurately predict costs incurred. Our health benefits ratio represents medical costs as a percentage of premium revenues and reflects the direct relationship between the premium received and the medical services provided. The table below depicts our health benefits ratios by member category and in total:

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2005

    2004

    2005

    2004

 

Medicaid and SCHIP

   83.0 %   80.4 %   81.5 %   80.5 %

SSI

   96.2     92.8     92.6     96.6  

Medicaid Managed Care Total

   83.3     80.7     81.7     80.9  

Specialty Services

   89.7     —       91.0     —    

Total

   83.7     80.7     82.0     80.9  

 

Our total health benefits ratio increased in 2005 from 2004. This increase was due to the settlement of a lawsuit with Aurora Health Care, Inc., which increased our health benefits ratio by 1.2% for the three months ended September 30, 2005, and by 0.5% for the nine months ended September 30, 2005. Our ratio also increased due to the behavioral health contract in Arizona which necessitates a higher health benefits ratio, increasing it by 0.4% for the three months ended September 30, 2005 and 0.3% for the nine months ended September 30, 2005. Expansion into new markets, previously unmanaged by us, and increased SSI membership also contributed to the increase.

 

Our cost of services expenses include all direct costs to support the local functions responsible for generation of our services revenues. These expenses primarily consist of the labor and supplies related to the provision of services, cost of materials purchased and teacher salaries.

 

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Our general and administrative expenses primarily reflect wages and benefits and other administrative costs related to the centralized functions that support all of our business units. The major centralized functions are claims processing, information systems and finance. Premium taxes are classified as general and administrative expenses. Our general and administrative expense ratio represents general and administrative expenses as a percentage of total revenues and reflects the relationship between revenues earned and the costs necessary to drive those revenues. The following table sets forth the general and administrative expense ratios by business segment and in total:

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2005

     2004

    2005

     2004

 

Medicaid Managed Care

   10.6 %    10.5 %   10.6 %    10.4 %

Specialty Services

   30.2      56.0     38.9      51.8  

Total

   13.1      12.7     12.9      12.5  

 

Our total general and administrative expense ratio increased due to implementation costs related to our new contracts in Arizona and Georgia, higher spending on information systems process improvements and increased contributions to our charitable foundation.

 

The Specialty Services ratio may vary depending on the various contracts and nature of the service provided and will have a higher general and administrative expense ratio than the Medicaid Managed Care segment. The results for the three and nine months ended September 30, 2005 reflect the operations of our behavioral health company in Arizona, effective July 1, 2005.

 

Other Income (Expense)

 

Other income (expense) consists of investment and other income and interest expense.

 

    Investment income is derived from our cash, cash equivalents and investments. Information about our investments is included below under “Liquidity and Capital Resources.”

 

    Interest expense reflects interest on the borrowings under our credit facility, fees in conjunction with our credit facility and mortgage interest.

 

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RESULTS OF OPERATIONS

 

Nine Months Ended September 30, 2005 Compared to Nine Months Ended September 30, 2004

 

Summarized comparative financial data are as follows ($ in millions except per share data):

 

     Nine Months Ended September 30,

 
     2005

   2004

   % Change
2004-2005


 

Premium revenue

   $ 1,075.0    $ 705.6    52.4 %

Services revenue

     7.6      7.3    4.1 %
    

  

  

Total revenues

     1,082.6      712.9    51.9 %

Medical costs

     881.0      570.7    54.4 %

Cost of services

     3.6      6.2    (41.9 )%

General and administrative expenses

     139.2      88.9    56.6 %
    

  

  

Earnings from operations

     58.8      47.1    24.8 %

Investment and other income, net

     5.1      4.2    20.5 %
    

  

  

Earnings before income taxes

     63.9      51.3    24.5 %

Income tax expense

     22.1      19.0    16.2 %
    

  

  

Net earnings

   $ 41.8    $ 32.3    29.3 %
    

  

  

Diluted earnings per common share

   $ 0.93    $ 0.74    25.7 %
    

  

  

 

Revenues

 

Premium revenue for the nine months ended September 30, 2005 increased 52.4% from the comparable period in 2004. This increase was due to the expansion of operations with our behavioral health contract in the state of Arizona, effective July 1, 2005; the acquisition of the Medicaid-related assets of SummaCare, Inc., effective May 1, 2005; the acquisition of FirstGuard, effective December 1, 2004; organic growth in our existing markets; and the addition of EPO members in Texas, effective September 1, 2004. In addition, we received premium rate increases of 3.2% on a composite basis across all our markets.

 

Services revenue for the nine months ended September 30, 2005 increased 4.1% from the comparable period in 2004. This increase was due to the acquisition of AirLogix, effective July 22, 2005, partially offset by the closing of clinic facilities in Texas and California as our behavioral health company transitioned from an employer of providers to a managed behavioral healthcare organization.

 

Operating Expenses

 

Medical costs increased 54.4% due to the growth in our membership as discussed above. Our health benefits ratio in 2005 was 82.0% compared to 80.9% in 2004. This increase was due to the settlement of a lawsuit with Aurora Health Care, Inc. as previously discussed, the behavioral health contract in Arizona which necessitates a higher health benefits ratio, expansion into new markets and increased SSI membership.

 

Cost of services decreased 41.9% due to a decline in service revenue from our behavioral health company as discussed above partially offset by the increase in expenses related to AirLogix, effective July 22, 2005.

 

General and administrative expenses increased 56.6% primarily due to expenses for additional facilities and staff to support our growth, especially in Arizona, Georgia, Kansas and Missouri, as previously described. For example, we incurred approximately $5.1 million during the period in implementation costs related to our new contracts in Arizona and Georgia.

 

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Other Income

 

Investment and other income increased 20.5% for the nine months ended September 30, 2005 from the comparable period in 2004. The increase was due to higher average investment balances and an increase in market interest rates partially offset by higher interest expense from increased borrowings under our credit facility and mortgages.

 

Income Tax Expense

 

Our effective tax rate in 2005 was 34.6%, compared to 37.0% in 2004. The decrease was primarily due to lower state income tax expense resulting from the resolution of state income tax examinations and the recognition of deferred tax benefits related to a change in law during the quarter.

 

Three Months Ended September 30, 2005 Compared to Three Months Ended September 30, 2004

 

Summarized comparative financial data are as follows ($ in millions except per share data):

 

     Three Months Ended September 30,

 
     2005

   2004

   % Change
2004-2005


 

Premium revenue

   $ 395.6    $ 251.5    57.3 %

Services revenue

     5.0      2.2    125.4 %
    

  

  

Total revenues

     400.6      253.7    57.9 %

Medical costs

     331.1      203.0    63.1 %

Cost of services

     2.0      2.1    (5.2 )%

General and administrative expenses

     52.4      32.2    63.0 %
    

  

  

Earnings from operations

     15.1      16.4    (8.1 )%

Investment and other income, net

     1.6      1.6    4.6 %
    

  

  

Earnings before income taxes

     16.7      18.0    (7.0 )%

Income tax expense

     4.6      6.7    (30.2 )%
    

  

  

Net earnings

   $ 12.1    $ 11.3    6.7 %
    

  

  

Diluted earnings per common share

   $ 0.27    $ 0.26    3.8 %
    

  

  

 

Revenues

 

Premium revenue for the three months ended September 30, 2005 increased 57.3% from the comparable period in 2004. This increase was due to the expansion of operations with our behavioral health contract in Arizona, effective July 1, 2005; the acquisition of the Medicaid-related assets of SummaCare, Inc., effective May 1, 2005; the acquisition of FirstGuard, effective December 1, 2004; organic growth in our existing markets; and the addition of EPO members in Texas, effective September 1, 2004. In addition, we received premium rate increases of 1.2% on a composite basis across all our markets.

 

Services revenue for the three months ended September 30, 2005 increased 125.4% from the comparable period in 2004. This increase was due to the acquisition of AirLogix, effective July 22, 2005 partially offset by the closing of clinic facilities in Texas and California as our behavioral health company transitioned from an employer of providers to a managed behavioral healthcare organization.

 

Operating Expenses

 

Medical costs increased 63.1% due to the growth in our membership as discussed above. Our health benefits ratio in 2005 was 83.7% compared to 80.7% in 2004. This increase was due to the settlement of a lawsuit with Aurora Health Care, Inc., as previously discussed, the behavioral health contract in Arizona which necessitates a higher health benefits ratio, expansion into new markets and increased SSI membership.

 

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Cost of services decreased 5.2% due to a decline in service revenue from our behavioral health company as discussed above partially offset by the increase in expenses related to AirLogix, effective July 22, 2005.

 

General and administrative expenses increased 63.0% primarily due to expenses for additional facilities and staff to support our growth especially in Arizona, Georgia, Kansas and Missouri. For example, we incurred approximately $2.6 million during the period in implementation costs related to our new contracts in Arizona and Georgia.

 

Other Income

 

Investment and other income increased 4.6% for the three months ended September 30, 2005 from the comparable period in 2004. The increase was due to higher average investment balances and an increase in market interest rates partially offset by higher interest expense from increased borrowings under our credit facility and mortgages.

 

Income Tax Expense

 

Our effective tax rate in 2005 was 27.8% compared to 37.0% in 2004. The decrease was primarily due to lower state income tax expense resulting from the resolution of state income examinations and the recognition of deferred tax benefits related to a change in law during the quarter.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Our operating activities provided cash of $44.9 million in the nine months ended September 30, 2005 and provided cash of $57.5 million in the comparable period in 2004. The decrease was primarily due to a decrease in medical claims liabilities combined with an increase in premium and related receivables offset by an increase in net income. The decrease in medical claims liabilities resulted from the payment made to Aurora Health Care, Inc. under the settlement agreement signed in September 2005; a decrease in pended claims, claims on hold awaiting further clarification; and a decrease in average claims inventory due to operational improvements made during the period. The increase in receivables resulted primarily from the timing of delivery receivable collections.

 

Our investing activities used cash of $51.8 million in the nine months ended September 30, 2005 compared to $35.0 million in the comparable period in 2004. The largest component of investing activities related to the acquisitions of AirLogix and certain Medicaid-related assets from SummaCare, Inc. Approximately $34.1 million was paid, net of cash acquired, for AirLogix. Of the total purchase price of approximately $30.3 million paid to SummaCare, $21.3 million was paid in cash and the remaining $9.0 million was paid through the issuance of our common stock. Our investment policies are designed to provide liquidity, preserve capital and maximize total return on invested assets within our investment guidelines. Net cash provided by and used in investing activities will fluctuate from year to year due to the timing of investment purchases, sales and maturities. As of September 30, 2005, our investment portfolio consisted primarily of fixed-income securities with an average duration of 1.8 years. Cash is invested in investment vehicles such as municipal bonds, corporate bonds, insurance contracts, commercial paper and instruments of the U.S. Treasury. The states in which we operate prescribe the types of instruments in which our regulated subsidiaries may invest their cash.

 

Our financing activities provided cash of $44.2 million in the nine months ended September 30, 2005 compared to $1.8 million in the comparable period in 2004. The increase in cash was primarily related to proceeds of $45.0 million from borrowings on our revolving credit facility.

 

We spent $16.8 million and $9.5 million in the nine months ended September 30, 2005 and 2004, respectively, on capital assets. We anticipate spending an additional $9.5 million on capital expenditures in 2005 related to office and market expansions and system upgrades.

 

At September 30, 2005, we had working capital, defined as current assets less current liabilities, of $34.7 million as compared to $22.1 million at December 31, 2004. Our investment policies are designed to provide liquidity and preserve capital. We manage our short-term and long-term investments to ensure that a sufficient portion is held in investments that are highly liquid and can be sold to fund short-term capital requirements as needed.

 

Cash, cash equivalents and short-term investments were $180.1 million at September 30, 2005 and $178.4 million at December 31, 2004. Long-term investments were $152.7 million at September 30, 2005 and $139.0 million at December 31, 2004, including restricted deposits of $22.3 million and $22.2 million, respectively. At September 30, 2005, cash and investments held by our unregulated entities totaled $27.7 million while cash and investments held by our regulated entities totaled $305.1 million.

 

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On September 9, 2005, we executed an amendment to our Revolving Credit Agreement dated September 14, 2004, with several lending institutions, for which LaSalle Bank National Association serves as administrative agent and co-lead arranger. The amendment increased the total amount available under the credit agreement to $200 million from $100 million, including a sub-facility for letters of credit in an aggregate amount up to $50 million. In addition, under the amendment the lending institutions released our prior grant of a security interest in the outstanding common stock and membership interests of each of our subsidiaries. The credit agreement is now an unsecured facility. Borrowings under the agreement bear interest based upon LIBOR rates, the Federal Funds Rate or the Prime Rate. Under our current capital structure, borrowings under the agreement bear interest at LIBOR plus 1.25%. This rate may change under differing capital structures over the life of the agreement. The agreement contains non-financial and financial covenants, including requirements of minimum fixed charge coverage ratios, minimum debt-to-EBITDA ratios and minimum tangible net worth. The agreement will expire on September 9, 2010 or on an earlier date in the instance of a default as defined in the agreement. As of September 30, 2005, we had $75.0 million in borrowings outstanding under the agreement, $15.0 million in letters of credit outstanding and were in compliance with all covenants.

 

We have filed a shelf registration statement on Form S-3 with the Securities and Exchange Commission, or the SEC, covering the issuance of up to $300 million of securities including common stock and debt securities. No securities have been issued under the shelf registration. We may publicly offer securities from time-to-time at prices and terms to be determined at the time of the offering.

 

There were no other material changes outside the ordinary course of our business in lease obligations or other contractual obligations in the nine months ended September 30, 2005. Based on our operating plan, we expect that our available funding will be sufficient to finance our operations and capital expenditures for at least 12 months from the date of this filing.

 

REGULATORY CAPITAL AND DIVIDEND RESTRICTIONS

 

As managed care organizations, our subsidiaries are subject to state regulations that, among other things, require the maintenance of minimum levels of statutory capital, as defined by each state, and restrict the timing, payment and amount of dividends and other distributions that may be paid to us. Generally, the amount of dividend distributions that may be paid by a regulated subsidiary without prior approval by state regulatory authorities is limited based on the entity’s level of statutory net income and statutory capital and surplus.

 

Our subsidiaries are required to maintain minimum capital requirements prescribed by various regulatory authorities in each of the states in which we operate. As of September 30, 2005, our subsidiaries had aggregate statutory capital and surplus of $176.4 million, compared with the required minimum aggregate statutory capital and surplus requirements of $82.6 million.

 

The National Association of Insurance Commissioners has adopted rules which set minimum risk-based capital requirements for insurance companies, managed care organizations and other entities bearing risk for healthcare coverage. As of September 30, 2005, our Indiana, Ohio, Texas and Wisconsin health plans were in compliance with risk-based capital requirements. If adopted by Kansas, Missouri or New Jersey, risk-based capital may increase the minimum capital required for these subsidiaries. We continue to monitor the requirements in Kansas, Missouri and New Jersey and do not expect that they will have a material impact on our results of operations, financial position or cash flows.

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

In December 2004 SFAS 123 (revised 2004), “Share Based Payment,” (SFAS 123R) was issued. In March 2005 the SEC issued Staff Accounting Bulletin No. 107 (SAB 107). SAB 107 expresses views of the SEC staff regarding the interaction between SFAS 123R and certain SEC rules. SFAS 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS 123R requires public entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. The grant-date fair value of employee share options and similar instruments will be estimated using option-pricing models adjusted for the unique characteristics of those instruments. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award. In April 2005 the SEC delayed the implementation of SFAS 123R for public companies until the first annual period beginning after June 15, 2005. We are required to adopt SFAS 123R by January 1, 2006.

 

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We currently utilize a closed form option-pricing model to measure the fair value of stock-based compensation for employees. SFAS 123R permits the use of this model or other models such as a lattice model. We have not yet determined which model we will use to measure the fair value of share-based grants to employees upon the adoption of SFAS 123R. The effect of expensing stock options in accordance with the original SFAS 123 is presented in Note 2 of our Notes to Consolidated Financial Statements included elsewhere in this Form 10-Q. SFAS 123R also requires that the benefits associated with the tax deductions in excess of recognized compensation cost be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This presentation may reduce net operating cash flows and increase net financing cash flows in periods after the effective date. The amount of this excess tax deduction benefit was $4.5 million and $1.9 million in the nine months ended September 30, 2005 and 2004, respectively.

 

In October 2005 the Compensation Committee approved the immediate and full acceleration of vesting of 260,000 “out-of-the-money” stock options to certain of our employees. These employees did not include any of our executive officers or other employees at Vice President level or above. Each stock option issued as a part of these grants has an exercise price greater than the closing price per share on the date of the Compensation Committee’s action. The purpose of the acceleration is to enable us to avoid recognizing compensation expense associated with these options in future periods in our consolidated statements of earnings, as a result of SFAS 123R. The pre-tax charge to be avoided totals approximately $3.0 million which would have been recognized over the years 2006, 2007, 2008 and 2009. This amount will be reflected in the pro forma disclosures of the 2005 consolidated year-end financial statements. The options that have been accelerated have an exercise price in excess of the current market value of our common stock, and, accordingly, the Compensation Committee determined that the expense savings outweighs the objective of incentive compensation and retention.

 

In May 2005 SFAS No. 154, “Accounting Changes and Error Corrections – replacement of APB Opinion No. 20 and FASB Statement No. 3,” (SFAS No. 154) was issued. SFAS No. 154 changes the accounting for and reporting of a change in accounting principle by requiring retrospective application to prior periods’ financial statements of changes in accounting principle unless impracticable. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. We do not expect the adoption of SFAS No. 154 to have a material impact on our results of operations, financial position or cash flows.

 

FORWARD-LOOKING STATEMENTS

 

This filing contains forward-looking statements that relate to future events or our future financial performance. We have attempted to identify these statements by terminology including “believe,” “anticipate,” “plan,” “expect,” “estimate,” “intend,” “seek,” “goal,” “may,” “will,” “should,” “can,” “continue” or the negative of these terms or other comparable terminology. These statements include statements about our market opportunity, our growth strategy, competition, expected activities and future acquisitions, investments and the adequacy of our available cash resources. These statements may be found in the section of this filing entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Readers are cautioned that matters subject to forward-looking statements involve known and unknown risks and uncertainties, including economic, regulatory, competitive and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions.

 

Actual results may differ from projections or estimates due to a variety of important factors. Our results of operations and projections of future earnings depend in large part on accurately predicting and effectively managing health benefits and other operating expenses. A variety of factors, including competition, changes in healthcare practices, changes in federal or state laws and regulations or their interpretations, inflation, provider contract changes, new technologies, government-imposed surcharges, taxes or assessments, reduction in provider payments by governmental payers, major epidemics, disasters and numerous other factors affecting the delivery and cost of healthcare, such as major healthcare providers’ inability to maintain their operations, may in the future affect our ability to control our medical costs and other operating expenses. Governmental action or business conditions could result in premium revenues not increasing to offset any increase in medical costs and other operating expenses. Once set, premiums are generally fixed for one-year periods and, accordingly, unanticipated costs during such periods cannot be recovered through higher premiums. The expiration, cancellation or suspension of our Medicaid managed care contracts by the state governments would also negatively affect us. Due to these factors and risks, we cannot give assurances with respect to our future premium levels or our ability to control our future medical costs.

 

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FACTORS THAT MAY AFFECT FUTURE RESULTS AND THE TRADING PRICE OF OUR COMMON STOCK

 

Risks Related to Being a Regulated Entity

 

Reduction in Medicaid, SCHIP and SSI Funding Could Substantially Reduce Our Profitability.

 

Most of our revenues come from Medicaid, SCHIP and SSI premiums. The base premium rate paid by each state differs, depending on a combination of factors such as defined upper payment limits, a member’s health status, age, gender, county or region, benefit mix and member eligibility categories. Future levels of Medicaid, SCHIP and SSI funding and premium rates may be affected by continued government efforts to contain medical costs and may further be affected by state and federal budgetary constraints. For example, in August 2004, the Centers for Medicare & Medicaid Services, or CMS, proposed a rule that would have required states to estimate improper payments made under their Medicaid and SCHIP programs, report such overpayments to Congress, and, if necessary, take actions to reduce erroneous payments. In October 2005, CMS announced an interim rule under which a CMS contractor will randomly select states for review once every three years to estimate each state’s rate of erroneous payments, the federal share of which the states will be required to return to CMS. In February 2005, the Bush administration called for changes in Medicaid that would cut payments for prescription drugs and give states new power to reduce or reconfigure benefits. The Bush administration has also proposed to reduce total federal funding for the Medicaid program, with a reduction of $10 billion in the budget over the next five years. It is unclear whether states (such as Texas) will receive supplemental Federal funds sufficient to reflect the unanticipated arrival of large numbers of beneficiaries from Gulf Coast areas evacuated as a result of hurricanes Katrina and Rita. Changes to Medicaid, SCHIP and SSI programs could reduce the number of persons enrolled or eligible, reduce the amount of reimbursement or payment levels, or increase our administrative or healthcare costs under those programs. States periodically consider reducing or reallocating the amount of money they spend for Medicaid, SCHIP and SSI. In recent years, the majority of states have implemented measures to restrict Medicaid, SCHIP and SSI costs and eligibility. We believe that reductions in Medicaid, SCHIP and SSI payments could substantially reduce our profitability. Further, our contracts with the states are subject to cancellation by the state after a short notice period in the event of unavailability of state funds.

 

If Our Medicaid and SCHIP Contracts are Terminated or are Not Renewed, Our Business Will Suffer.

 

We provide managed care programs and selected services to individuals receiving benefits under federal assistance programs, including Medicaid, SSI and SCHIP. We provide those healthcare services under contracts with regulatory entities in the areas in which we operate. The contracts expire on various dates between December 31, 2005 and August 31, 2007. Our contracts may be terminated if we fail to perform up to the standards set by state regulatory agencies. In addition, the Indiana contract under which we operate can be terminated by the state without cause. Our contracts are generally intended to run for one or two years and may be extended for one or two additional years if the state or its contractor elects to do so. When our contracts expire, they may be opened for bidding by competing healthcare providers. There is no guarantee that our contracts will be renewed or extended. If any of our contracts are terminated, not renewed, or renewed on less favorable terms, our business will suffer, and our operating results may be materially affected.

 

Changes in Government Regulations Designed to Protect the Financial Interests of Providers and Members Rather Than Our Stockholders Could Force Us to Change How We Operate and Could Harm Our Business.

 

Our business is extensively regulated by the states in which we operate and by the federal government. The applicable laws and regulations are subject to frequent change and generally are intended to benefit and protect the financial interests of health plan providers and members rather than stockholders. Changes in existing laws and rules, the enactment of new laws and rules or changing interpretations of these laws and rules could, among other things:

 

    force us to restructure our relationships with providers within our network;

 

    require us to implement additional or different programs and systems;

 

    mandate minimum medical expense levels as a percentage of premium revenues;

 

    restrict revenue and enrollment growth;

 

    require us to develop plans to guard against the financial insolvency of our providers;

 

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    increase our healthcare and administrative costs;

 

    impose additional capital and reserve requirements; and

 

    increase or change our liability to members in the event of malpractice by our providers.

 

For example, Congress has considered various forms of patient protection legislation commonly known as the Patients’ Bill of Rights and such legislation is frequently proposed in Congress. We cannot predict the impact of this legislation, if adopted, on our business.

 

Regulations May Decrease the Profitability of Our Health Plans.

 

Our Texas plan is required to pay a rebate to the state in the event profits exceed established levels. Similarly, our New Jersey plan is required to pay a rebate to the state in the event its health benefits ratio is less than 80%. These regulatory requirements, changes in these requirements or the adoption of similar requirements by our other regulators may limit our ability to increase our overall profits as a percentage of revenues. The states of Indiana, New Jersey and Texas have implemented prompt-payment laws and are enforcing penalty provisions for failure to pay claims in a timely manner. Failure to meet these requirements can result in financial fines and penalties. In addition, states may attempt to reduce their contract premium rates if regulators perceive our health benefits ratio as too low. Any of these regulatory actions could harm our operating results.

 

In recent years, CMS has reduced the rates at which states are permitted to reimburse non-state government-owned or operated hospitals for inpatient and outpatient hospital services. The upper limit is currently 100% of Medicare payments for comparable services. Any further reductions in this limit could decrease the profitability of our health plans.

 

Failure to Comply With Government Regulations Could Subject Us to Civil and Criminal Penalties.

 

Federal and state governments have enacted fraud and abuse laws and other laws to protect patients’ privacy and access to healthcare. Violation of these and other laws or regulations governing our operations or the operations of our providers could result in the imposition of civil or criminal penalties, the cancellation of our contracts to provide services, the suspension or revocation of our licenses or our exclusion from participating in the Medicaid, SSI and SCHIP programs. If we were to become subject to these penalties or exclusions as the result of our actions or omissions or our inability to monitor the compliance of our providers, it would negatively affect our ability to operate our business. For example, failure to pay our providers promptly could result in the imposition of fines and other penalties. In some states, we may be subject to regulation by more than one governmental authority, which may impose overlapping or inconsistent regulations.

 

The Health Insurance Portability and Accountability Act of 1996, or HIPAA, broadened the scope of fraud and abuse laws applicable to healthcare companies. HIPAA created civil penalties for, among other things, billing for medically unnecessary goods or services. HIPAA established new enforcement mechanisms to combat fraud and abuse. Further, HIPAA imposes civil and, in some instances, criminal penalties for failure to comply with specific standards relating to the privacy, security and electronic transmission of most individually identifiable health information. It is possible that Congress may enact additional legislation in the future to increase penalties and to create a private right of action under HIPAA, which could entitle patients to seek monetary damages for violations of the privacy rules.

 

We Will Incur Significant Increased Costs as a Result of Compliance With New Government Regulations and Our Management Will Be Required to Devote Substantial Time to Compliance.

 

The issuance of future judicial or regulatory guidance regarding the interpretation of regulations, the states’ ability to promulgate stricter rules, and continuing uncertainty regarding many aspects of the regulations’ implementation may make compliance with this regulatory landscape difficult. For example, our existing programs and systems may not enable us to comply in all respects with recent security regulations. In order to comply with new regulatory requirements, we were required to employ additional or different programs and systems. Further, compliance with new regulations could require additional changes to many of the procedures we currently use to conduct our business, which may lead to additional costs that we have not yet identified. We do not know whether, or the extent to which, we will be able to recover from the states our costs of complying with these new regulations. The new regulations and the related compliance costs could have a material adverse effect on our business.

 

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In addition, the Sarbanes-Oxley Act, as well as rules subsequently implemented by the SEC and the New York Stock Exchange, or the NYSE, have imposed various requirements on public companies, including requiring changes in corporate governance practices. Our management and other personnel will need to devote a substantial amount of time to these new compliance initiatives. Moreover, these rules and regulations will increase our legal and financial compliance costs and will make some activities more time-consuming and costly.

 

The Sarbanes-Oxley Act requires, among other things, that we maintain effective internal control over financial reporting. In particular, we must perform system and process evaluation and testing of our internal controls over financial reporting to allow management to report on the effectiveness of our internal controls over our financial reporting as required by Section 404 of the Sarbanes-Oxley Act. Our testing, or the subsequent testing by our independent registered public accounting firm, may reveal deficiencies in our internal controls over financial reporting that are deemed to be material weaknesses. Our compliance with Section 404 requires that we incur substantial accounting expense and expend significant management efforts. Moreover, if we are not able to comply with the requirements of Section 404 in a timely manner, or if we or our independent registered public accounting firm identifies deficiencies in our internal control over financial reporting that are deemed to be material weaknesses, the market price of our stock could decline and we could be subject to sanctions or investigations by the NYSE, SEC or other regulatory authorities, which would require additional financial and management resources.

 

Changes in Healthcare Law and Benefits May Reduce Our Profitability.

 

Numerous proposals relating to changes in healthcare law have been introduced, some of which have been passed by Congress and the states in which we operate or may operate in the future. Changes in applicable laws and regulations are continually being considered, and interpretations of existing laws and rules may also change from time to time. We are unable to predict what regulatory changes may occur or what effect any particular change may have on our business. For example, these changes could reduce the number of persons enrolled or eligible for Medicaid, reduce the reimbursement or payment levels for medical services or reduce benefits included in Medicaid coverage. More generally, we are unable to predict whether new laws or proposals will favor or hinder the growth of managed healthcare. Legislation or regulations that require us to change our current manner of operation, benefits provided or our contract arrangements may seriously harm our operations and financial results.

 

If a State Fails to Renew a Required Federal Waiver for Mandated Medicaid Enrollment into Managed Care or Such Application is Denied, Our Membership in That State Will Likely Decrease.

 

States may administer Medicaid managed care programs pursuant to demonstration programs or required waivers of federal Medicaid standards. Waivers and demonstration programs are generally approved for two-year periods and can be renewed on an ongoing basis if the state applies. We have no control over this renewal process. If a state does not renew such a waiver or demonstration program or the Federal government denies a state’s application for renewal, membership in our health plans in the state could decrease and our business could suffer.

 

Changes in Federal Funding Mechanisms May Reduce Our Profitability.

 

The Bush Administration has proposed a major long-term change in the way Medicaid and SCHIP are funded. The proposal, if adopted, would allow states to elect to receive, instead of federal matching funds, combined Medicaid-SCHIP “allotments” for acute and long-term healthcare for low-income, uninsured persons. Participating states would be given flexibility in designing their own health insurance programs, subject to federally-mandated minimum coverage requirements. It is uncertain whether this proposal will be enacted. Accordingly, it is unknown whether or how many states might elect to participate or how their participation may affect the net amount of funding available for Medicaid and SCHIP programs. If such a proposal is adopted and decreases the number of persons enrolled in Medicaid or SCHIP in the states in which we operate or reduces the volume of healthcare services provided, our growth, operations and financial performance could be adversely affected.

 

In April 2004, the Bush Administration adopted a new policy that seeks to reduce states’ use of intergovernmental transfers for the states’ share of Medicaid program funding. By restricting the use of intergovernmental transfers as part of states’ Medicaid contributions, this policy, if continued, may restrict some states’ funding for Medicaid, which could adversely affect our growth, operations and financial performance.

 

In February 2005, the Bush Administration called for changes in Medicaid that would cut payments for prescription drugs and give states new power to reduce or reconfigure benefits. The Administration has also proposed to reduce Federal Medicaid spending by $10 billion over the next five years. It is unclear whether, and if so, when, states (such as Texas) will receive supplemental Federal funds sufficient to reflect the unanticipated arrival of large numbers of beneficiaries from Gulf Coast areas evacuated as a result of

 

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hurricanes Katrina and Rita. Any reduction or reconfiguration of state funding could adversely affect our growth, operations and financial performance.

 

Recent legislative changes in the Medicare program may also affect our business. For example, the Medicare Prescription Drug, Improvement and Modernization Act of 2003, enacted in December 2003, will, upon taking effect in 2006, revise cost-sharing requirements for some beneficiaries and require states to reimburse the federal Medicare program for costs of prescription drug coverage provided to beneficiaries who are enrolled simultaneously in both the Medicaid and Medicare programs. These changes may reduce the availability of funding for some states’ Medicaid programs, which could adversely affect our growth, operations and financial performance.

 

If State Regulatory Agencies Require a Statutory Capital Level Higher than the State Regulations, We May Be Required to Make Additional Capital Contributions.

 

Our operations are conducted through our wholly owned subsidiaries, which include HMOs and managed care organizations, or MCOs. HMOs and MCOs are subject to state regulations that, among other things, require the maintenance of minimum levels of statutory capital, as defined by each state. Additionally, state regulatory agencies may require, at their discretion, individual HMO’s to maintain statutory capital levels higher than the state regulations. If this were to occur to one of our subsidiaries, we may be required to make additional capital contributions to the affected subsidiary. Any additional capital contribution made to one of the affected subsidiaries could have a material adverse effect on our liquidity and our ability to grow.

 

If We Are Unable to Participate in SCHIP Programs, Our Growth Rate May be Limited.

 

SCHIP is a federal initiative designed to provide coverage for low-income children not otherwise covered by Medicaid or other insurance programs. The programs vary significantly from state to state. Participation in SCHIP programs is an important part of our growth strategy. If states do not allow us to participate or if we fail to win bids to participate, our growth strategy may be materially and adversely affected.

 

If State Regulators Do Not Approve Payments of Dividends and Distributions by Our Subsidiaries to Us, We May Not Have Sufficient Funds to Implement Our Business Strategy.

 

We principally operate through our health plan subsidiaries. If funds normally available to us become limited in the future, we may need to rely on dividends and distributions from our subsidiaries to fund our operations. These subsidiaries are subject to regulations that limit the amount of dividends and distributions that can be paid to us without prior approval of, or notification to, state regulators. If these regulators were to deny our subsidiaries’ request to pay dividends to us, the funds available to our company as a whole would be limited, which could harm our ability to implement our business strategy.

 

Risks Related to Our Business

 

Failure to Accurately Predict Our Medical Expenses Could Negatively Affect Our Reported Results.

 

Our medical expenses include estimates of IBNR medical expenses. We estimate our IBNR medical expenses monthly based on a number of factors. Adjustments, if necessary, are made to medical expenses in the period during which the actual claim costs are ultimately determined or when criteria used to estimate IBNR change. We cannot be sure that our IBNR estimates are adequate or that adjustments to those estimates will not harm our results of operations. From time to time in the past, our actual results have varied from our estimates, particularly in times of significant changes in the number of our members. Our failure to estimate IBNR accurately may also affect our ability to take timely corrective actions, further harming our results.

 

Receipt of Inadequate Premiums Would Negatively Affect Our Revenues and Profitability.

 

Nearly all of our revenues are generated by premiums consisting of fixed monthly payments per member. These premiums are fixed by contract, and we are obligated during the contract periods to provide healthcare services as established by the state governments. We use a large portion of our revenues to pay the costs of healthcare services delivered to our members. If premiums do not increase when expenses related to medical services rise, our earnings will be affected negatively. In addition, our actual medical services costs may exceed our estimates, which would cause our health benefits ratio, or our expenses related to medical services as a percentage of premium revenues, to increase and our profits to decline. In addition, it is possible for a state to increase the rates payable to the hospitals without granting a corresponding increase in premiums to us. If this were to occur in one or more of the states in which we operate, our profitability would be harmed.

 

Failure to Effectively Manage Our Medical Costs or Related Administrative Costs Would Reduce Our Profitability.

 

Our profitability depends, to a significant degree, on our ability to predict and effectively manage expenses related to health benefits. We have less control over the costs related to medical services than we do over our general and administrative expenses. Historically, our health benefits ratio has fluctuated. For example, over the last six years, our health benefits ratio has ranged from 80.7% to 88.9%. Because of the narrow margins of our health plan business, relatively small changes in our health benefits ratio can create significant changes in our financial results. Changes in healthcare regulations and practices, the level of use of healthcare

 

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services, hospital costs, pharmaceutical costs, major epidemics, new medical technologies and other external factors, including general economic conditions such as inflation levels, are beyond our control and could reduce our ability to predict and effectively control the costs of providing health benefits. We may not be able to manage costs effectively in the future. If our costs related to health benefits increase, our profits could be reduced or we may not remain profitable.

 

Difficulties in Executing Our Acquisition Strategy Could Adversely Affect Our Business.

 

Historically, the acquisition of Medicaid businesses, contract rights and related assets of other health plans both in our existing service areas and in new markets has accounted for a significant amount of our growth. Many of the other potential purchasers of Medicaid assets have greater financial resources than we have. In addition, many of the sellers are interested either in (a) selling, along with their Medicaid assets, other assets in which we do not have an interest or (b) selling their companies, including their liabilities, as opposed to the assets of their ongoing businesses.

 

We generally are required to obtain regulatory approval from one or more state agencies when making acquisitions. In the case of an acquisition of a business located in a state in which we do not currently operate, we would be required to obtain the necessary licenses to operate in that state. In addition, even if we already operate in a state in which we acquire a new business, we would be required to obtain additional regulatory approval if the acquisition would result in our operating in an area of the state in which we did not operate previously, and we could be required to renegotiate provider contracts of the acquired business. We cannot assure you that we would be able to comply with these regulatory requirements for an acquisition in a timely manner, or at all. In deciding whether to approve a proposed acquisition, state regulators may consider a number of factors outside our control, including giving preference to competing offers made by locally owned entities or by not-for-profit entities. Furthermore, our credit facility may prohibit some acquisitions without the consent of our bank lender.

 

In addition to the difficulties we may face in identifying and consummating acquisitions, we will also be required to integrate and consolidate any acquired business or assets with our existing operations. This may include the integration of:

 

    additional personnel who are not familiar with our operations and corporate culture;

 

    provider networks that may operate on different terms than our existing networks;

 

    existing members, who may decide to switch to another healthcare plan; and

 

    disparate administrative, accounting and finance, and information systems.

 

Accordingly, we may be unable to identify, consummate and integrate future acquisitions successfully or operate acquired businesses profitably. We also may be unable to obtain sufficient additional capital resources for future acquisitions. If we are unable to effectively execute our acquisition strategy, our future growth will suffer and our results of operations could be harmed.

 

If Competing Managed Care Programs are Unwilling to Purchase Specialty Services From Us, We May Not be Able to Successfully Implement Our Strategy of Diversifying Our Business Lines.

 

We are seeking to diversify our business lines into areas that complement our Medicaid business in order to grow our revenue stream and balance our dependence on Medicaid risk reimbursement. In 2005, for example, we acquired Airlogix, Inc., a disease management company. In order to diversify our business, we must succeed in selling the services of our specialty subsidiaries not only to our managed care plans, but to programs operated by third-parties. Some of these third-party programs may compete with us in some markets, and they therefore may be unwilling to purchase specialty services from us. In any event, the offering of these services will require marketing activities that differ significantly from the manner in which we seek to increase revenues from our Medicaid programs. Our inability to market specialty services to other programs may impair our ability to execute our business strategy.

 

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Failure to Achieve Timely Profitability in Any Business Would Negatively Affect Our Results of Operations.

 

Start-up costs associated with a new business can be substantial. For example, in order to obtain a certificate of authority in most jurisdictions, we must first establish a provider network, have systems in place and demonstrate our ability to obtain a state contract and process claims. If we were unsuccessful in obtaining the necessary license, winning the bid to provide service or attracting members in numbers sufficient to cover our costs, any new business of ours would fail. We also could be obligated by the state to continue to provide services for some period of time without sufficient revenue to cover our ongoing costs or recover start-up costs. The expenses associated with starting up a new business could have a significant impact on our results of operations if we are unable to achieve profitable operations in a timely fashion.

 

We Derive a Majority of Our Premium Revenues From Operations in a Small Number of States, and Our Operating Results Would be Materially Affected by a Decrease in Premium Revenues or Profitability in Any One of Those States.

 

Operations in Arizona, Indiana, Kansas, Missouri, New Jersey, Ohio, Texas and Wisconsin have accounted for most of our premium revenues to date. If we were unable to continue to operate in each of those states or if our current operations in any portion of one of those states were significantly curtailed, our revenues could decrease materially. Our reliance on operations in a limited number of states could cause our revenue and profitability to change suddenly and unexpectedly depending on legislative actions, economic conditions and similar factors in those states. Our inability to continue to operate in any of the states in which we operate would harm our business.

 

Competition May Limit Our Ability to Increase Penetration of the Markets That We Serve.

 

We compete for members principally on the basis of size and quality of provider network, benefits provided and quality of service. We compete with numerous types of competitors, including other health plans and traditional state Medicaid programs that reimburse providers as care is provided. Subject to limited exceptions by federally approved state applications, the federal government requires that there be choices for Medicaid recipients among managed care programs. Voluntary programs and mandated competition may limit our ability to increase our market share.

 

Some of the health plans with which we compete have greater financial and other resources and offer a broader scope of products than we do. In addition, significant merger and acquisition activity has occurred in the managed care industry, as well as in industries that act as suppliers to us, such as the hospital, physician, pharmaceutical, medical device and health information systems businesses. To the extent that competition intensifies in any market that we serve, our ability to retain or increase members and providers, or maintain or increase our revenue growth, pricing flexibility and control over medical cost trends may be adversely affected.

 

In addition, in order to increase our membership in the markets we currently serve, we believe that we must continue to develop and implement community-specific products, alliances with key providers and localized outreach and educational programs. If we are unable to develop and implement these initiatives, or if our competitors are more successful than we are in doing so, we may not be able to further penetrate our existing markets.

 

If We are Unable to Maintain Satisfactory Relationships With Our Provider Networks, Our Profitability Will be Harmed.

 

Our profitability depends, in large part, upon our ability to contract favorably with hospitals, physicians and other healthcare providers. Our provider arrangements with our primary care physicians, specialists and hospitals generally may be cancelled by either party without cause upon 90 to 120 days prior written notice. We cannot assure you that we will be able to continue to renew our existing contracts or enter into new contracts enabling us to service our members profitably.

 

From time to time providers assert or threaten to assert claims seeking to terminate noncancelable agreements due to alleged actions or inactions by us. Even if these allegations represent attempts to avoid or renegotiate contractual terms that have become economically disadvantageous to the providers, it is possible that in the future a provider may pursue such a claim successfully. In addition, we are aware that other managed care organizations have been subject to class action suits by physicians with respect to claim payment procedures, and we may be subject to similar claims. Regardless of whether any claims brought against us are successful or have merit, they will still be time-consuming and costly and could distract our management’s attention. As a result, we may incur significant expenses and may be unable to operate our business effectively.

 

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We will be required to establish acceptable provider networks prior to entering new markets. We may be unable to enter into agreements with providers in new markets on a timely basis or under favorable terms. If we are unable to retain our current provider contracts or enter into new provider contracts timely or on favorable terms, our profitability will be harmed.

 

Changes in Stock Option Accounting Rules May Have a Significant Adverse Affect on Our Operating Results.

 

We have a history of using broad based employee stock option programs to hire, incentivize and retain our workforce in a competitive marketplace. Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” allows companies the choice of either using a fair value method of accounting for options that would result in expense recognition for all options granted, or using an intrinsic value method, as prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” or APB 25, with a pro forma disclosure of the impact on net income (loss) of using the fair value option expense recognition method. We have previously elected to apply APB 25, and, accordingly, we generally have not recognized any expense with respect to employee stock options as long as such options are granted at exercise prices equal to the fair value of our common stock on the date of grant.

 

In December 2004, the Financial Accounting Standards Board issued SFAS 123R which would require all companies to measure compensation cost for all share-based payments, including employee stock options, at fair value. In April 2005 the SEC delayed the implementation until the first annual period beginning after June 15, 2005. We are required to adopt SFAS 123R by January 1, 2006. The effect of expensing stock options in accordance with the original SFAS 123 is presented in Note 2 of our Notes to Consolidated Financial Statements included elsewhere in this Form 10-Q. SFAS 123R also requires that the benefits associated with the tax deductions in excess of recognized compensation cost be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This presentation may reduce net operating cash flows and increase net financing cash flows in periods after the effective date. The amount of this excess tax deduction benefit was $4.5 million and $1.9 million in the nine months ended September 30, 2005 and 2004, respectively.

 

We May be Unable to Attract and Retain Key Personnel.

 

We are highly dependent on our ability to attract and retain qualified personnel to operate and expand our business. If we lose one or more members of our senior management team, including our chief executive officer, Michael F. Neidorff, who has been instrumental in developing our business strategy and forging our business relationships, our business and operating results could be harmed. Our ability to replace any departed members of our senior management or other key employees may be difficult and may take an extended period of time because of the limited number of individuals in the Medicaid managed care and specialty services industry with the breadth of skills and experience required to operate and successfully expand a business such as ours. Competition to hire from this limited pool is intense, and we may be unable to hire, train, retain or motivate these personnel.

 

Negative Publicity Regarding the Managed Care Industry May Harm Our Business and Operating Results.

 

The managed care industry has received negative publicity. This publicity has led to increased legislation, regulation, review of industry practices and private litigation in the commercial sector. These factors may adversely affect our ability to market our services, require us to change our services, and increase the regulatory burdens under which we operate. Any of these factors may increase the costs of doing business and adversely affect our operating results.

 

Claims Relating to Medical Malpractice Could Cause Us to Incur Significant Expenses.

 

Our providers and employees involved in medical care decisions may be subject to medical malpractice claims. In addition, some states, including Texas, have adopted legislation that permits managed care organizations to be held liable for negligent treatment decisions or benefits coverage determinations. Claims of this nature, if successful, could result in substantial damage awards against us and our providers that could exceed the limits of any applicable insurance coverage. Therefore, successful malpractice or tort claims asserted against us, our providers or our employees could adversely affect our financial condition and profitability. Even if any claims brought against us are unsuccessful or without merit, they would still be time-consuming and costly and could distract our management’s attention. As a result, we may incur significant expenses and may be unable to operate our business effectively.

 

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Loss of Providers Due to Increased Insurance Costs Could Adversely Affect Our Business.

 

Our providers routinely purchase insurance to help protect themselves against medical malpractice claims. In recent years, the costs of maintaining commercially reasonable levels of such insurance have increased dramatically, and these costs are expected to increase to even greater levels in the future. As a result of the level of these costs, providers may decide to leave the practice of medicine or to limit their practice to certain areas, which may not address the needs of Medicaid participants. We rely on retaining a sufficient number of providers in order to maintain a certain level of service. If a significant number of our providers exit our provider networks or the practice of medicine generally, we may be unable to replace them in a timely manner, if at all, and our business could be adversely affected.

 

Growth in the Number of Medicaid-Eligible Persons During Economic Downturns Could Cause Our Operating Results and Stock Prices to Suffer if State and Federal Budgets Decrease or Do Not Increase.

 

Less favorable economic conditions may cause our membership to increase as more people become eligible to receive Medicaid benefits. During such economic downturns, however, state and federal budgets could decrease, causing states to attempt to cut healthcare programs, benefits and rates. We cannot predict the impact of changes in the United States economic environment or other economic or political events, including acts of terrorism or related military action, on federal or state funding of healthcare programs or on the size of the population eligible for the programs we operate. If federal funding decreases or remains unchanged while our membership increases, our results of operations will suffer.

 

Growth in the Number of Medicaid-Eligible Persons May be Countercyclical, Which Could Cause Our Operating Results to Suffer When General Economic Conditions are Improving.

 

Historically, the number of persons eligible to receive Medicaid benefits has increased more rapidly during periods of rising unemployment, corresponding to less favorable general economic conditions. Conversely, this number may grow more slowly or even decline if economic conditions improve. Therefore, improvements in general economic conditions may cause our membership levels to decrease, thereby causing our operating results to suffer, which could lead to decreases in our stock price during periods in which stock prices in general are increasing.

 

We Intend to Expand Our Medicaid Managed Care Business Primarily into Markets Where Medicaid Recipients are Required to Enroll in Managed Care Plans.

 

We expect to continue to focus our business in states in which Medicaid enrollment in managed care is mandatory. Currently, approximately two-thirds of the states require health plan enrollment for Medicaid eligible participants in all or a portion of their counties. The programs are voluntary in other states. Because we concentrate on markets with mandatory enrollment, we expect the geographic expansion of our Medicaid Managed Care segment to be limited to those states.

 

If We are Unable to Integrate and Manage Our Information Systems Effectively, Our Operations Could be Disrupted.

 

Our operations depend significantly on effective information systems. The information gathered and processed by our information systems assists us in, among other things, monitoring utilization and other cost factors, processing provider claims, and providing data to our regulators. Our providers also depend upon our information systems for membership verifications, claims status and other information.

 

Our information systems and applications require continual maintenance, upgrading and enhancement to meet our operational needs and regulatory requirements. Moreover, our acquisition activity requires frequent transitions to or from, and the integration of, various information systems. We regularly upgrade and expand our information systems’ capabilities. If we experience difficulties with the transition to or from information systems or are unable to properly maintain or expand our information systems, we could suffer, among other things, from operational disruptions, loss of existing members and difficulty in attracting new members, regulatory problems and increases in administrative expenses. In addition, our ability to integrate and manage our information systems may be impaired as the result of events outside our control, including acts of nature, such as earthquakes or fires, or acts of terrorists.

 

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We Rely on the Accuracy of Eligibility Lists Provided by State Governments. Inaccuracies in Those Lists Would Negatively Affect Our Results of Operations.

 

Premium payments to us are based upon eligibility lists produced by state governments. From time-to-time, states require us to reimburse them for premiums paid to us based on an eligibility list that a state later discovers contains individuals who are not in fact eligible for a government sponsored program or are eligible for a different premium category or a different program. Alternatively, a state could fail to pay us for members for whom we are entitled to payment. Our results of operations would be adversely affected as a result of such reimbursement to the state if we had made related payments to providers and were unable to recoup such payments from the providers.

 

We May Not be Able to Obtain or Maintain Adequate Insurance.

 

We maintain liability insurance, subject to limits and deductibles, for claims that could result from providing or failing to provide managed care and related services. These claims could be substantial. We believe that our present insurance coverage and reserves are adequate to cover currently estimated exposures. We cannot assure you that we will be able to obtain adequate insurance coverage in the future at acceptable costs or that we will not incur significant liabilities in excess of policy limits.

 

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ITEM 3. Quantitative and Qualitative Disclosures About Market Risk.

 

INVESTMENTS

 

As of September 30, 2005, we had short-term investments of $58.6 million and long-term investments of $152.7 million, including restricted deposits of $22.3 million. The short-term investments consist of highly liquid securities with maturities between three and twelve months. The long-term investments consist of municipal, corporate and U.S. agency bonds, life insurance contracts and U.S. Treasury investments and have maturities greater than one year. Restricted deposits consist of investments required by various state statutes to be deposited or pledged to state agencies. Due to the nature of the states’ requirements, these investments are classified as long-term regardless of the contractual maturity date. Our investments are subject to interest rate risk and will decrease in value if market rates increase. Assuming a hypothetical and immediate 1% increase in market interest rates at September 30, 2005, the fair value of our fixed income investments would decrease by approximately $3.5 million. Declines in interest rates over time will reduce our investment income.

 

INFLATION

 

Although the general rate of inflation has remained relatively stable and healthcare cost inflation has stabilized in recent years, the national healthcare cost inflation rate still exceeds the general inflation rate. We use various strategies to mitigate the negative effects of healthcare cost inflation. Specifically, our health plans try to control medical and hospital costs through contracts with independent providers of healthcare services. Through these contracted care providers, our health plans emphasize preventive healthcare and appropriate use of specialty and hospital services.

 

While we currently believe our strategies to mitigate healthcare cost inflation will continue to be successful, competitive pressures, new healthcare and pharmaceutical product introductions, demands from healthcare providers and customers, applicable regulations or other factors may affect our ability to control the impact of healthcare cost increases.

 

COMPLIANCE COSTS

 

Federal and state regulations governing standards for electronic transactions, data security and confidentiality of patient information have been issued recently. Due to the uncertainty surrounding the regulatory requirements, we cannot be sure that the systems and programs that we have implemented will comply adequately with the security regulations that are ultimately adopted. Implementation of additional systems and programs may be required. Further, compliance with these regulations would require changes to many of the procedures we currently use to conduct our business, which may lead to additional costs that we have not yet identified. We do not know whether, or the extent to which, we will be able to recover our costs of complying with these new regulations from the states.

 

ITEM 4. Controls and Procedures.

 

Evaluation of Disclosure Controls and Procedures

 

As of September 30, 2005, an evaluation was carried out under the supervision and with the participation of the Company’s management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the design and operation of these disclosure controls and procedures were effective to ensure that information required to be disclosed by the company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in applicable rules and forms.

 

Changes in Internal Control Over Financial Reporting During the Quarter Ended September 30, 2005

 

There were no significant changes in our internal controls over financial reporting that occurred during the Company’s quarter ended September 30, 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II

 

OTHER INFORMATION

 

ITEM 1. Legal Proceedings.

 

Aurora Health Care, Inc. (Aurora) provides medical professional services under a contract with our Wisconsin health plan subsidiary. In May 2003, Aurora filed a lawsuit in the Milwaukee County Circuit Court claiming we had failed to adequately reimburse Aurora for services rendered during the period from 1998 to the present.

 

On September 1, 2005, we entered into a settlement and release agreement (Agreement) with Aurora which provides for complete and final settlement of the lawsuit. Under the terms of the Agreement, we paid $9.5 million to Aurora, $5 million of which was previously reserved and $4.5 million was recorded as a pre-tax charge in the quarter ended September 30, 2005. Both parties agreed on the rates for ambulatory services through December 31, 2005 when the current contract expires. Subsequent to entering into the agreement, both parties agreed to a new, five year contract that will become effective as of January 1, 2006.

 

ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds.

 

None.

 

ITEM 3. Defaults Upon Senior Securities.

 

None.

 

ITEM 4. Submission of Matters to a Vote of Security Holders.

 

We held a Special Meeting of Stockholders on July 22, 2005. At the meeting, our stockholders approved amendments to our 2003 Stock Incentive Plan (the Plan) to the effect that the number of shares of common stock available under the Plan was increased from 3,750,000 to 5,100,000 among other changes. The results were 30,880,605 votes for, 4,052,675 votes against, and 52,268 abstentions.

 

ITEM 5. Other Information.

 

None.

 

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ITEM 6. Exhibits

 

Exhibits.

 

EXHIBIT

NUMBER


  

DESCRIPTION


10.1   

Contract Between the Georgia Department of Community Health and Peach State Contract for provision of Services to Georgia Healthy Families, incorporated herein by reference to Exhibit 10.1 of Form 8-K filed July 22, 2005.

10.2   

2003 Stock Incentive Plan, as amended, incorporated herein by reference to Exhibit 10.1 of Form 8-K filed July 28, 2005.

10.3   

Form of Restricted Stock Unit Agreement, incorporated herein by reference to Exhibit 10.2 of Form 8-K filed July 28, 2005.

10.4   

Form of Nonstatutory Stock Option Agreement (Non-employees), incorporated herein by reference to Exhibit 10.3 of Form 8-K filed July 28, 2005.

10.5   

Form of Nonstatutory Stock Option Agreement (Employees), incorporated herein by reference to Exhibit 10.4 of Form 8-K filed July 28, 2005.

10.6   

Form of Incentive Stock Option Agreement, incorporated herein by reference to Exhibit 10.5 of Form 8-K filed July 28, 2005.

10.7   

Form of Stock Appreciation Right Agreement, incorporated herein by reference to Exhibit 10.6 of Form 8-K filed July 28, 2005.

10.8   

Form of Restricted Stock Agreement.

10.9   

Amendment #1 to the Contract No. 0653 Between Georgia Department of Community Health and Peach State.

10.10   

Settlement and Release Agreement with Aurora Health Care, Inc.

10.11   

Amendment No. 2 to Credit Agreement dated as of September 14, 2004 among Centene Corporation, the various financial party hereto and LaSalle Bank National Association.

10.12   

Summary of Compensatory Arrangements with Executive Officers.

 

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12.1   

Computation of ratio of earnings to fixed charges.

31.1   

Certification of Chairman and Chief Executive Officer pursuant to Rule 13(a)-14(a) under the Securities Exchange Act of 1934, as amended.

31.2   

Certification of Senior Vice President, Chief Financial Officer, Secretary and Treasurer pursuant to Rule 13(a)-14(a) under the Securities Exchange Act of 1934, as amended.

32.1   

Certification of Chairman and Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2   

Certification of Senior Vice President, Chief Financial Officer, Secretary and Treasurer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

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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 as of October 25, 2005.

 

CENTENE CORPORATION
By:  

/s/ Michael F. Neidorff

   

Michael F. Neidorff

Chairman and Chief Executive Officer

(principal executive officer)

By:  

/s/ Karey L. Witty

   

Karey L. Witty

Senior Vice President, Chief Financial Officer,

Secretary and Treasurer

(principal financial and accounting officer)

 

31