METROPOLITAN HEALTH NETWORKS INC – 10-Q – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH OUR ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDEDDECEMBER 31, 2011 , INCLUDING THE FINANCIAL STATEMENTS AND NOTES THERETO, AS WELL AS THE FINANCIAL STATEMENTS AND NOTES THAT APPEAR ELSEWHERE IN THIS REPORT. GENERAL Unless otherwise indicated or the context otherwise requires, all references in this Form 10-Q to "we," "us," "our," "Metropolitan" or the "Company" refer toMetropolitan Health Networks, Inc. and its consolidated subsidiaries. CAUTIONARY NOTE REGARDING FORWARD LOOKING STATEMENTS Sections of this Quarterly Report contain statements that are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including, without limitation, statements with respect to anticipated future operations and financial performance, growth and acquisition opportunities and other similar forecasts and statements of expectation. We intend such statements to be covered by the safe harbor provisions for forward-looking statements created thereby. These statements involve known and unknown risks and uncertainties, such as our plans, objectives, expectations and intentions, 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 the forward-looking statements. In some cases, you can identify forward-looking statements by statements that include the words "estimate," "project," "anticipate," "expect," "intend," "may," "should," "believe," "seek" or other similar expressions.
Specifically, this report contains forward-looking statements, including statements regarding the following topics:
? the ability of our provider services network ("PSN"), acting through our
contracting subsidiaries, to renew its agreements with the health plans
operated by Humana, Inc. and its subsidiaries ("Humana"),
affiliated companies, a subsidiary of Coventry Health Care, Inc. ("Coventry"),
and Wellcare Health Plans, Inc. and its affiliated companies ("
together with Humana, United and Coventry, the "Contracting HMOs") that have
renewable one-year terms, and to maintain all of its agreements with Contracting HMOs on favorable terms; ? our ability to increase the number of customers assigned to us by the
Contracting HMOs ("Participating Customers") using our PSN, either within our
current geographic markets or in additional markets, and our ability to
realize the benefits of any such increases, including the anticipated benefits
of economies of scale;
? our ability to accurately estimate the premium deficiency for the remaining
term of one existing agreement with a Contracting HMO other than Humana (the
"Contracting HMO Agreement") covering approximately 6,600 new Participating
Customers added in 2012; ? the anticipated benefits of our acquisition ofContinucare Corporation ("Continucare");
? our intention to sell the sleep diagnostic business that we acquired in the
? the factors that we believe may mitigate the impact of anticipated premium
reductions; ? our ability to make, and the expected timing of, payments on our senior
secured first lien credit agreement (the "First Lien Credit Agreement") and
our senior secured second lien credit agreement (the "Second Lien Credit
Agreement" and, together with the First Lien Credit Agreement, the "Credit
Facilities"); 16
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? our ability to adequately predict and control medical expense and to make
reasonable estimates and maintain adequate accruals for estimated medical
claims expense payable; and
? our ability to make reasonable estimates of
fee adjustments. The forward-looking statements reflect our current view about future events and are subject to risks, uncertainties and assumptions. We wish to caution readers that certain important factors may have affected and could in the future affect our actual results and could cause actual results to differ significantly from those expressed in any forward-looking statement. The following important factors could prevent us from achieving our goals and cause the assumptions underlying the forward-looking statements and the actual results to differ materially from those expressed in or implied by those forward-looking statements:
? our ability to integrate the operations of
any, that we may acquire in the future, and to realize any anticipated
revenues, economies of scale, cost synergies or productivity gains in
connection with our acquisition of
that we may acquire in the future, including the potential for unanticipated
issues, expenses and liabilities associated with those acquisitions and the
risk that
expected financial and operating targets;
? the potential for diversion of management time and resources in seeking to
integrate
? our potential failure to retain key employees of
? the impact of our significantly increased levels of indebtedness entered into
in connection with the acquisition of
operating flexibility and ability to fund ongoing operations with additional
borrowings, particularly in light of ongoing volatility in the credit and
capital markets;
? the potential for dilution to our shareholders as a result of our acquisition
ofContinucare ;
? our ability to operate pursuant to the terms of our Credit Facilities and to
meet all financial covenants; ? reductions in premium payments toMedicare Advantage plans; ? the loss of, or a material negative amendment, to any of our significant contracts;
? disruptions in the PSN's or any Contracting HMO's healthcare provider network;
? failure to receive accurate and timely revenue, claim, membership and other
information from the Contracting HMOs; ? our ability to sell the sleep diagnostic business; ? future legislation and changes in governmental regulations; ? increased operating costs;
? reductions in government funding of the
political environment that may affect public policy and have an adverse impact
on the demand for our services; ? the impact of Medicare Risk Adjustments on payments we receive from Contracting HMOs; 17</pre>--------------------------------------------------------------------------------? the impact of the
Medicare prescription drug plan on our operations;? general economic and business conditions;
? increased competition;? the relative health of our Participating Customers;
? changes in estimates and judgments associated with our critical accounting
policies; ? federal and state investigations;? our ability to successfully recruit and retain key management personnel and
qualified medical professionals; and ? impairment charges that could be required in future periods. Additional information concerning these and other risks and uncertainties is contained in our filings with theUnited States Securities and Exchange Commission (the "Commission"), including the section entitled "Risk Factors" in our Annual Report on Form 10-K for the year endedDecember 31, 2011 and in our Quarterly Reports on Form 10-Q for the quarters endedMarch 31, 2012 andJune 30, 2012 . Forward-looking statements should not be relied upon as a prediction of actual results. Subject to any continuing obligations under applicable law or any relevant listing rules, we expressly disclaim any obligation to disseminate, after the date of this Quarterly Report on Form 10-Q, any updates or revisions to any such forward-looking statements to reflect any change in expectations or events, conditions or circumstances on which any such statements are based.We undertake no obligation to publicly update or revise any forward-looking statements to reflect events or circumstances that may arise after the date of this report unless otherwise required by law.
18 --------------------------------------------------------------------------------BACKGROUND Merger Agreement OnNovember 3, 2012 , we entered into an Agreement and Plan of Merger (the "Merger Agreement") with Humana andMiner Acquisition Subsidiary, Inc. , aFlorida corporation and a wholly-owned subsidiary of Humana ("Merger Subsidiary"). The Merger Agreement provides that, upon the terms and subject to the conditions set forth in the Merger Agreement, Merger Subsidiary will merge with and into the Company (the "Merger"), with the Company surviving the Merger as a wholly-owned subsidiary of Humana. Pursuant to the terms of the Merger Agreement, at the effective time of the Merger, each issued and outstanding share of our common stock (other than shares owned by us, Humana or Merger Subsidiary, or any of our respective subsidiaries) will be converted into the right to receive$11.25 in cash, without interest and less any required withholding taxes. Prior to the effective time of the Merger, each outstanding option to purchase shares of our common stock will become fully vested and exercisable and will be cancelled in exchange for the right to receive an amount in cash equal to the product of (1) the total number of shares of our common stock subject to such option, multiplied by (2) the excess, if any, of$11.25 over the exercise price per share of such option, without interest and less any required withholding taxes. Immediately prior to the effective time of the Merger, each restricted share of our common stock will become fully vested and will be converted into the right to receive$11.25 in cash, without interest and less any required withholding taxes. The Merger Agreement contains customary covenants, including covenants requiring each of the parties to use its commercially reasonable efforts to cause the transactions contemplated by the Merger Agreement to be consummated. The Merger Agreement also contains covenants requiring us to call and hold a meeting of our shareholders for the purpose of voting to adopt and approve the Merger Agreement and the Merger. Under the Merger Agreement, if the Merger Agreement is terminated in certain circumstances, including because our Board of Directors has changed its recommendation that our shareholders approve and adopt the Merger Agreement and the Merger or because we have entered into a definitive agreement (or announced our intention to enter into a definitive agreement) to be acquired by an entity other than Humana or one of its affiliates, we will be required to pay to Humana a termination fee of$16 million and reimburse Humana for up to$5.3 million of its and Merger Subsidiary's out-of-pocket expenses incurred in connection with the Merger. The consummation of the Merger is subject to certain conditions, including (1) the affirmative vote of a majority of the outstanding shares of our common stock in favor of the approval and adoption of the Merger Agreement and the Merger; (2) the expiration or termination of applicable waiting periods under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the "HSR Act"); (3) the absence of any law, order, injunction or other prohibition that restrains, enjoins, prevents or makes illegal the consummation of the Merger; (4) subject to certain materiality exceptions, the accuracy of the representations and warranties of each party contained in the Merger Agreement; (5) the performance by each party in all material respects of its covenants in the Merger Agreement; and (6) the absence of any change, effect, development or event betweenNovember 3, 2012 and consummation of the Merger that has had or would reasonably be expected to result in a material adverse effect on the Company.The Merger is expected to close by the end of the first quarter of 2013.
Redemption of Series A Preferred Stock
OnNovember 2, 2012 , we delivered a notice of redemption to the holder (the "Series A Holder") of all 5,000 of the outstanding shares of our Series A Preferred Stock. Pursuant to the notice of redemption, we notified the Series A Holder that we are exercising our right to redeem all of the outstanding shares of Series A Preferred Stock held by him at a redemption price of$105 per share($525,000) in accordance with the provisions of our Articles of Incorporation, as amended to date. Subject to certain conditions, the redemption of the Series A Preferred Stock is expected to occur onNovember 16, 2012 .Business
Our primary business is the operation of our provider services network ("PSN") primarily through our wholly owned subsidiaries, Metcare ofFlorida , Inc. andContinucare Corporation ("Continucare"), the latter of which we acquired onOctober 4, 2011 . Prior to 2012, the PSN provided and arranged for the provision of healthcare services to, Medicaid and commercially insured customers only inFlorida . In 2012, the PSN expanded its operations to includeOhio ,Kentucky andIndiana . AtSeptember 30, 2012 , we operated the PSN through 33 wholly-owned primary care practices, a wholly-owned oncology practice and contracts with independent physician affiliates (each an "IPA"). As ofSeptember 30, 2012 , the PSN operated throughout theFlorida market including the cities ofMiami , Ft. Lauderdale,West Palm Beach ,Tampa , Daytona andPensacola , as well as theCincinnati, Ohio /Northern Kentucky and theIndianapolis, Indiana markets. InAugust 2012 , we formed a joint venture with Humana, Inc. (together with its subsidiaries, "Humana") through which we have begun to operate in theCincinnati, Ohio /Northern Kentucky andIndianapolis, Indiana markets. The joint venture,Symphony Health Partners -Midwest, LLC ("Symphony"), is owned by our wholly-owned subsidiary,Symphony Health Partners, Inc. and Humana, withSymphony Health Partners, Inc. being the majority owner. InAugust 2012 , Symphony entered into two new agreements with Humana. Pursuant to one of these agreements, which was effective retroactive toJanuary 1, 2012 , Symphony has agreed to manage the provision of healthcare services to HumanaMedicare Advantage members in theCincinnati, Ohio /Northern Kentucky market. There were approximately 7,900 Participating Customers covered under this agreement atSeptember 30, 2012 . Through 2013, Symphony is entitled to receive a monthly administrative fee based on the number of Humana Medicare Advantage members covered under the agreement and a percentage of the surplus, if any, generated under the agreement. Symphony is expected to assume partial medical risk for the members covered under the agreement in 2014 and is expected to assume substantially all medical risk for such members in 2015 and thereafter. Pursuant to the second agreement, which was effective as ofAugust 1, 2012 , Symphony has agreed to manage the provision of healthcare services to HumanaMedicare Advantage members in theIndianapolis, Indiana market. There were approximately 2,000 Participating Customers covered under this agreement atSeptember 30, 2012 . Through 2013, Symphony is entitled to receive a monthly administrative fee based on the number of Humana Medicare Advantage members covered under the agreement and a percentage of the surplus, if any, generated under the agreement. Symphony is expected to assume partial medical risk for the members covered under the agreement in 2014 and is expected to assume substantially all medical risk for such members in 2015 and thereafter.The other material terms of these two agreements are similar to the material terms of our other managed care agreements with Humana.
InAugust 2012 , Metcare ofFlorida , Inc. entered into an agreement with Humana to manage, on a non-risk basis, the provision of healthcare services to approximately 7,000Medicare Advantage members covered under certainHumana Medicare Advantage Preferred Provider Organization ("PPO") and Private Fee-For-Service ("PFS") plans in a three year pilot program covering the 2013 through 2015 plan years. The agreement covers members in the Daytona andPensacola areas ofFlorida , includingOkaloosa andWalton counties, two counties where we did not previously have operations. We will receive a monthly administrative fee based on the number of Humana Medicare Advantage members covered under the agreement and a percentage of the surplus, if any, generated under the agreement. InOctober 2012 , we completed the acquisition of the practice of an IPA with which we currently contract. The practice operates two primary care offices inPalm Beach County, Florida and provides medical care to approximately 1,100 Humana Participating Customers atSeptember 30, 2012 . As we currently provide services to these Participating Customers under contractual arrangements with the IPA, they are included in the total number of Participating Customers we report atSeptember 30, 2012 .Humana Agreements
Pursuant to our risk agreements with Humana (the "Humana Agreements"), atSeptember 30, 2012 , the PSN provided or arranged for the provision of healthcare services toMedicare Advantage ,Medicaid and commercial customers inFlorida and has contract rights to expand its service offerings to additionalFlorida counties. Our PSN assumes full financial responsibility for the provision or management of all necessary medical care for each Participating Customer covered by the Humana Agreements (each a "Humana Participating Customer"), even for services we do not provide directly. For approximately 25,000 Humana Participating Customers, our PSN and Humana share in the cost of inpatient hospital services and the PSN is responsible for the full cost of all other medical care provided to the Humana Participating Customers. For the remaining Humana Participating Customers, our PSN is responsible for the cost of all medical care provided, including the cost of inpatient hospital services. In return for the provision of these medical services, our PSN receives from Humana a capitation fee for each Humana Participating Customer established pursuant to the Humana Agreements. The amount we receive from Humana represents a substantial percentage of the monthly premiums received by Humana from theCenters for Medicare and Medicaid Services ("CMS") or theState of Florida with respect to Humana Participating Customers. 19 -------------------------------------------------------------------------------- The Humana Agreements covering a majority of the Humana Participating Customers have one-year terms, subject to automatic renewal unless either party provides the other party notice of non-renewal 90, 120 or 180 days prior to the end of the subject agreement's term (as applicable). The remaining Humana Agreements have terms that extend to betweenAugust 31, 2013 andJuly 31, 2014 , subject to automatic renewal for additional terms of one to three years, unless either party provides the other party notice of non-renewal 90 or 120 days prior to the end of the subject agreement's term (as applicable). Under several of our PSN's Humana Agreements, Humana may amend the benefit and risk obligations and compensation rights from time to time by providing the PSN 30 days' prior written notice of the proposed amendment. Thereafter, the PSN will generally have 30 days to object to or be deemed to have accepted the proposed amendment. Upon receipt of such an objection, Humana may terminate the subject agreement upon 90 days' notice. In the 13 years that we have been working with Humana, after Humana and we have agreed upon the terms pursuant to which we will provide services for an upcoming year, Humana has only occasionally requested contract amendments and has never requested a contract amendment that has materially, negatively impacted our benefit obligations, risk obligations or compensation rights. Humana may immediately terminate a Humana Agreement and/or the services of any individual physician in our primary care physician network if: (i) the PSN's or such physician's continued participation may adversely affect the health, safety or welfare of any Humana customer or bring Humana into disrepute; (ii) Humana loses its authority to do business in total or as to any limited segment or business provided that, in the event of a loss of authority with respect to a limited segment, Humana may only terminate a Humana Agreement as to that segment; (iii) the PSN or such physician violates certain provisions of Humana's policies and procedures manual; and (iv) under certain of the Humana Agreements, the PSN or any of its physicians fails to meet Humana's credentialing or re-credentialing criteria or is excluded from participation in any federal healthcare program. In addition to the foregoing termination provisions, each of the Humana Agreements permits the PSN or Humana to terminate any such agreement upon 60 to 90 days prior written notice (subject to certain cure periods) in the event the other party breaches other provisions of the agreement. Under most of the Humana Agreements, our subsidiary that is party to such agreement and its affiliated providers are generally prohibited, during the term of the applicable agreement plus one year, from: (i) engaging in any activities that are in competition with Humana's health insurance, HMO or benefit plans business; (ii) having a direct or indirect interest in any provider sponsored organization or network that administers, develops, implements or sells government sponsored health insurance or benefit plans; (iii) contracting or affiliating with another licensed managed care organization for the purpose of offering and sponsoring HMO, PPO or point of service ("POS") products where such subsidiary and/or its affiliated providers obtain an ownership interest in the HMO, PPO or POS products to be marketed; and (iv) under certain provisions of the Humana Agreements, entering into agreements with managed care entities, insurance companies, or provider sponsored networks for the provision of healthcare services to Medicare HMO, POS and/or replacement Participating Customers at the same office sites or within five miles of the office sites where services are provided to the Humana Plan Customers. In addition, under the Humana Agreements covering a majority of the areas we serve, or are eligible to serve, our subsidiary that is party to any such agreement and/or its participating physicians and affiliated entities (including us) are prohibited from entering into a risk contract with any non-Humana Medicare Advantage HMO or provider sponsored organization in the counties subject to the agreement. These restrictions lapse betweenJanuary 1, 2013 andJanuary 1, 2015 , as applicable, and are not applicable to certain previously established contracts our subsidiaries have with non-Humana HMOs with respect to a number of designated counties. In addition, under each of our Humana Agreements, our subsidiary that is party to any such agreement and/or its participating physicians and affiliated entities (including us) are prohibited from causing groups ofMedicare Participating Customers assigned to an individual physician to disenroll from a Humana plan and to enroll in a competing HMO plan. 20 -------------------------------------------------------------------------------- The foregoing discussion relates only to our risk agreements with Humana and does not include theCincinnati agreement, theIndianapolis agreement or the new PPO and PFS agreement with Humana, each of which is described under the heading "Background." Except as described under the heading "Background," the material terms of those agreements are similar to the material terms of the Humana Agreements as described above.Agreements With Other HMOs
As ofSeptember 30, 2012 , the PSN also had agreements to provide or arrange for the provision of medical services to Participating Customers of otherMedicare Advantage plans including those offered by United, Coventry andWellcare . The majority of such services are provided on a risk basis pursuant to which our PSN receives a capitated fee with respect to each of these Participating Customers. Our agreements with United, Coventry andWellcare have one-year terms expiring betweenDecember 31, 2012 andSeptember 30, 2013 , subject to automatic renewal for an additional one-year term each unless either party provides the other with 60, 90 or 120 days' notice of its intent to terminate such agreement, as applicable. These agreements are generally subject to the same type of amendment, termination, non-solicitation and/or non-competition provisions as those included in the Humana Agreements. In the third quarter of 2012, we realized a loss of$0.6 million , including a premium deficiency reserve of$1.1 million , (under the "Contracting HMO Agreement"). Included in the third quarter was favorable claims development from the first half of 2012 of$1.6 million which reduced medical claims expense. OnNovember 6, 2012 , we provided written notice to the Contracting HMO terminating this agreement effectiveMarch 5, 2013 as we were unable to reach more favorable contract terms with the Contracting HMO. As a result, we recorded in medical claims expense in the third quarter of 2012 a premium deficiency of$1.1 million , which is our estimate of the loss that we will incur under the Contracting HMO Agreement throughMarch 5, 2013 . For the nine months endedSeptember 30, 2012 , our loss under the Contracting HMO Agreement was$5.0 million .Our Physician Network
AtSeptember 30, 2012 , the 33 primary care practices owned and operated by the PSN were responsible for providing and arranging for medical care to 51.9% of the PSN's Participating Customers under risk agreements. The PSN contracts with IPAs to provide and manage care for our remaining Participating Customers. Some of these contracts provide for payment to the provider of a fixed per customer per month ("PCPM") amount and require the provider to provide all the necessary primary care medical services to Participating Customers. The monthly amount is negotiated and is subject to change based on certain quality of service metrics. Other contracts provide for payments on a fee-for-service basis, pursuant to which the provider is paid only for the services provided. Appropriate Risk Coding We strive to ensure that our Participating Customers are assigned the proper risk scores. Our processes include ongoing training of medical staff responsible for coding and routine auditing of Participating Customers' charts to assure risk-coding compliance. Participating Customers with higher risk codes generally require more healthcare resources than those with lower risk codes. Proper coding helps to ensure that we receive capitation fees consistent with the cost of treating these Participating Customers. Our efforts related to coding compliance are ongoing and we continue to dedicate considerable resources to this important discipline. 21--------------------------------------------------------------------------------Insurance Arrangements
To mitigate our exposure to high cost medical claims under our risk agreements, we have reinsurance arrangements that provide for the reimbursement of certain customer medical expenses. AtSeptember 30, 2012 , for 59.2% of our Participating Customers under risk agreements, we purchase reinsurance through the HMOs with which we contract. The HMOs charge us a per customer per month fee that limits our healthcare costs for any individual Participating Customer. Healthcare costs in excess of an annual deductible, which generally ranges from$30,000 to $40,000 per Participating Customer, are paid directly by the HMOs and we are not entitled to and do not receive any related insurance recoveries.The remaining Participating Customers are covered under one policy with an annual per customer deductible of
$250,000 in 2012 and$225,000 in 2011. Reinsurance recoveries under these policies are remitted to us and are recorded as a reduction to medical claims expense.All policies have a maximum annual benefit per customer of$1.0 million . Although we maintain insurance of the types and in the amounts that we believe are reasonable, there can be no assurances that the insurance policies maintained by us will insulate us from material expenses and/or losses in the future.Healthcare Reform Legislation
The healthcare reform legislation described below is not directly applicable to us since we are not aMedicare Advantage plan. However, this legislation will directly impactMedicare Advantage plans such as those offered by the Contacting HMOs, and, therefore, are expected to indirectly affect PSNs such as ours.The United States' healthcare system, including theMedicare Advantage program, is subject to a broad array of laws and regulations as a result of the Patient Protection and Affordable Care Act, which became law onMarch 23, 2010 as amended by the Health Care and Education Reconciliation Act of 2010, which became law onMarch 30, 2010 (collectively, the "Reform Acts"). The Reform Acts are considered by some to be the most dramatic change to the country's healthcare system in decades. This legislation made significant changes to theMedicare program and to the health insurance market overall. Among other things, the Reform Acts limitMedicare Advantage payment rates, stipulate a prescribed minimum ratio for the amount of premium revenues to be expended on medical costs, give the Secretary ofHealth and Human Services the ability to denyMedicare Advantage plan bids that propose significant increases in cost sharing or decreases in benefits, and make certain changes toMedicare Part D . Because substantially all of our revenue is directly or indirectly derived from reimbursements generated byMedicare Advantage health plans, any changes that limit or reduceMedicare reimbursement levels, such as reductions in or limitations of reimbursement amounts or rates under programs, reductions in funding of programs, expansion of benefits without adequate funding, elimination of coverage for certain benefits, or elimination of coverage for certain individuals or treatments under programs, could have a material adverse effect on our business. There are numerous steps required to implement the Reform Acts, andCongress may seek to alter or eliminate some of their provisions. InJune 2012 , the UnitedStates Supreme Court upheld most of the provisions of the Affordable Care Act, including the health insurance mandate. While Federal regulatory agencies are moving forward with implementation of the provisions of the Reform Act,Congress is attempting to pass legislation which would reverse the Reform Acts. Furthermore, various health insurance reform proposals are also emerging at the state level. Due to the unsettled nature of these reforms and the numerous steps required to implement them, we cannot predict to what extent (if at all)Congress will succeed in limiting or reversing the Reform Acts, whether (and if so, what) additional health insurance reforms will be implemented at the Federal or state level and/or the effect that any future legislation or regulation will have on our business. For additional information on the Reform Acts see "Business - Healthcare Reform Legislation in 2011 and 2010" included in our Annual Report on Form 10-K for the fiscal year endedDecember 31, 2011 and the Risk Factor captioned "Risk Factors - Reductions in Funding for Medicare Programs and Other Provisions Under the Recent Healthcare Reform Legislation…" included in Part II, Item 1A of this Quarterly Report on Form 10-Q. 22 --------------------------------------------------------------------------------CRITICAL ACCOUNTING POLICIES
A description of our critical accounting policies is contained in our Annual Report on Form 10-K for the year endedDecember 31, 2011 . Included within these policies are certain policies that contain critical accounting estimates and, therefore, have been deemed to be "critical accounting policies." Critical accounting estimates are those which require management to make assumptions about matters that were uncertain at the time the estimate was made and for which the use of different estimates, which reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur from period to period, could have a material impact on the presentation of our financial condition, changes in financial condition or results of operations.ACQUISITION OF CONTINUCARE
We closed on the acquisition ofContinucare onOctober 4, 2011 . We paid an aggregate of$404.4 million in cash and issued an aggregate of 2.5 million shares of our common stock, valued at$11.5 million , toContinucare's stockholders and option holders in consideration for their shares ofContinucare common stock and options to purchase shares ofContinucare common stock. At the date of acquisition,Continucare provided and managed care for approximately 36,400 Participating Customers through its 19 medical centers and contracted IPAs.Continucare also operated a sleep diagnostic business. Substantially all ofContinucare's revenues were derived from managed care agreements with Humana, United, Coventry andWellcare .COMPARISON OF RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED
SEPTEMBER 30, 2012 ANDSEPTEMBER 30, 2011 Summary Net income for the third quarter of 2012 was$9.3 million compared to$6.0 million in the third quarter of 2011, an increase of$3.3 million or 55.0%. In the third quarter of 2012, we realized the tax benefits related to the elimination of$0.8 million of prior years' accrued uncertain tax positions for years that are no longer subject to audit. In the third quarter of 2011, we incurred pre-tax expenses of$2.1 million associated with theContinucare acquisition. Basic and diluted earnings per share were$0.22 and$0.21 , respectively, for the third quarter of 2012 as compared to$0.15 , basic, and$0.14 , diluted, for the same period in 2011. Diluted and basic earnings per share in 2012 were increased by$0.02 per share as a result of the elimination of prior years' accrued uncertain tax positions for years that are no longer subject to audit. The after tax impact of theContinucare transaction costs reduced basic and diluted earnings per share by$0.03 in 2011. Basic and diluted earnings per share from income from continuing operations was$0.21 and$0.20 for the third quarter of 2012 as compared to$0.15 , basic, and$0.14 , diluted, for the same period in 2011. Basic and diluted earnings from discontinued operations for the third quarter of 2012 were$0.01 per share. In the third quarter of 2012, we realized a loss of$0.6 million , including a premium deficiency reserve of$1.1 million , on an agreement with a Contracting HMO (the "Contracting HMO Agreement") covering approximately 6,600 new Participating Customers added in 2012. Included in the third quarter was favorable claims development from the first half of 2012 of$1.6 million which reduced medical claims expense. OnNovember 6, 2012 , we provided written notice to the Contracting HMO terminating this agreement effectiveMarch 5, 2013 as we were unable to reach more favorable contract terms with the Contracting HMO. As a result, we recorded in medical claims expense in the third quarter of 2012 a premium deficiency of$1.1 million , which is our estimate of the loss that we will incur under the Contracting HMO Agreement throughMarch 5, 2013 . For the nine months endedSeptember 30, 2012 , our loss under the Contracting HMO Agreement was$5.0 million . Revenue for the third quarter of 2012 was$191.1 million compared to$92.7 million for the third quarter of 2011, an increase of$98.4 million or 106.1%. The increase in revenue was primarily attributable to Participating Customers added with the acquisition ofContinucare , the net addition of new Participating Customers under risk arrangements sinceDecember 31, 2011 and an increase in the average risk scores of our Participating Customers. Total medical expense for the third quarter of 2012 was$152.8 million compared to$74.4 million for the third quarter of 2011, an increase of$78.4 million or 105.4%. This increase is primarily attributable to the addition of the Continucare Participating Customers, the medical costs associated with the net addition of new Participating Customers under risk arrangements in 2012, the addition of the 19Continucare medical practices and an increase in benefits, utilization and medical cost inflation. Total medical expense was partially offset by favorable prior period medical claims development of$1.3 million and$2.0 million in the third quarter of 2012 and 2011, respectively, as well as the impact of the decrease in the aggregate customer months during the third quarter of 2011. 23--------------------------------------------------------------------------------Gross profit was
$38.3 million for the third quarter of 2012 as compared to$18.3 million for the same quarter in 2011, an increase of$20.0 million or 109.3%.The medical expense ratio ("MER"), which is computed by dividing total medical expense by revenue, represents a statistic used to measure gross profit. In the third quarter of 2012 our MER was 79.9%, compared to 80.3% for the third quarter of 2011.Excluding the revenue and medical costs associated with the Contracting HMO Agreement our MER for the third quarter of 2012 would have been 77.9%. Operating expenses increased to$16.9 million for the third quarter of 2012 as compared to$6.6 million for the same period in 2011, an increase of$10.3 million or 156.1%. The increase in operating expenses is primarily due to the additional expenses ofContinucare and an increase in amortization expense of$3.1 million , related to the amortizable intangible assets recorded with theContinucare acquisition. Other expense increased by$6.1 million due primarily to an increase in interest expense of$8.1 million for the third quarter of 2012 related to the debt used to finance theContinucare acquisition. We expensed$2.1 million of transaction costs in the third quarter of 2011 that were associated with our acquisition ofContinucare . Income before income taxes from continuing operations for the third quarter of 2012 was$13.4 million as compared to income before income taxes for the third quarter of 2011 of$9.8 million . The primary reasons for the increase are discussed above. In the third quarter of 2012, we realized the tax benefits related to the elimination of$0.8 million of prior years' accrued uncertain tax positions for years that are no longer subject to audit, which lowered our effective income tax rate.Income from discontinued operations for the third quarter of 2012 was
$0.2 million . This amount represents the income realized by the sleep diagnostic business, net of income tax expense.Customer Information
The table set forth below provides (i) the total number of customers to whom we were providing healthcare services as ofSeptember 30, 2012 and 2011 and (ii) the aggregate customer months for the third quarter of both 2012 and 2011. Customer months are the aggregate number of months of healthcare services we have provided to customers during a period of time.Participating Customer Percentage Increase
Participating Customers at Months In The Quarter In Participating September 30, Ended September 30, Customer Months 2012 2011 2012 2011 Risk arrangements 70,400 34,400 211,400 102,600 106.0% Non-risk arrangements 17,100 - 51,000 - N/A 87,500 34,400 262,400 102,600 155.8%The following table sets forth the number of Participating Customers by program at
September 30, 2012 andSeptember 30, 2011 :Participating Customers Percentage Increase at September 30, In Participating 2012 2011 Customers Medicare Advantage 71,600 34,400 108.1% Medicaid 13,400 - N/A Commercial 2,500 - N/A 87,500 34,400 154.4% 24-------------------------------------------------------------------------------- The increase in total customer months under risk arrangements for the third quarter of 2012 as compared to the same period in 2011 is primarily a result of the Participating Customers added with theContinucare acquisition and the net addition of new Participating Customers under risk arrangements in 2012. Changes in our customer base are also a result of new enrollments and/or transfers from other physician's practices and individuals aging intoMedicare and becoming a Participating Customer, reduced by disenrollments, deaths, Participating Customers moving from the covered areas, Participating Customers transferring to another physician practice or Participating Customers making other insurance selections.The increase in customer months under non-risk arrangements is a result of the
Continucare acquisition and the addition of theCincinnati andIndianapolis contracts with Humana.Revenue
The most significant component of our revenue is generated from
Medicare Advantage risk arrangements with the Contracting HMOs.Medicare risk revenue increased by$88.5 million , or 96.1%, during the third quarter of 2012 as compared to the same period in 2011. The increase in revenue is primarily attributable to Participating Customers added with the acquisition ofContinucare , the net addition of new Participating Customers under risk arrangements in 2012 and increased risk scores for our Participating Customers.Our PCPM Medicare risk revenue increased by$82 for the third quarter of 2012 compared to the same period in 2011. The increase in our PCPM revenue was primarily generated by the acquisition ofContinucare , which realizes higher rates inMiami-Dade County, Florida than we realize in our other service areas, and increases in our capitation payments as a result of changes in theMedicare risk adjustment scores of our Participating Customers. There was no material difference between the estimated final settlement for 2011 of$2.7 million and the final settlement that was received in the third quarter of 2012. AtDecember 31, 2010 , we recorded a$2.2 million receivable representing our estimate of the final retroactive MRA capitation fee for 2010. InAugust 2011 , we were notified that the final settlement was$1.0 million . The difference of$1.2 million reduced revenue in the third quarter of 2011. Fee-for-service revenue represents amounts earned from medical services provided to non-Participating Customers in our owned medical practices. Fee-for-service revenue represents less than 0.5% of our total revenue for the three months endedSeptember 30, 2012 andSeptember 30, 2011 .Total Medical Expense
Total medical expense represents the estimated total cost of providing medical care and is comprised of two components, medical claims expense and medical practice costs. Medical claims expense is recognized in the period in which services are provided and includes an estimate of our obligations for medical services that have been provided to our Participating Customers but for which we have neither received nor processed claims. Medical claims expense includes such costs as inpatient and outpatient services, pharmacy benefits and physician services by providers other than the IPAs and physician practices owned by the PSN (collectively "Non-Affiliated Providers"). Medical practice costs represent the operating costs of the physician practices owned by the PSN. We develop our estimated medical expense payable using an actuarial process that is consistently applied. The actuarial process develops a range of estimated medical claims expense payable and we record the amount in the range that is our best estimate of the ultimate liability. Each period, we re-examine previously recorded medical claims expense payable estimates based on actual claim submissions and other changes in facts and circumstances. As medical claims expense payable recorded in prior periods becomes more exact, we adjust the amount of the estimate and include the change in medical claims expense in the period in which the change is identified. In each reporting period, our operating results include a change in medical expense from the effects of more completely developed medical claims expense payable estimates associated with previously reported periods. While we believe our estimated medical claims expense payable is adequate to cover future claims payments required, such estimates are based on our claims experience to date and various management assumptions. Therefore, the actual liability could differ materially from the amount recorded. 25--------------------------------------------------------------------------------Total medical expense and the MER are as follows (in thousands):
Three Months EndedSeptember 30,
20122011
Estimated medical expense for the period, excluding prior period claims development $ 154,093 $ 76,357 (Favorable) prior period medical claims development in current period based on actual claims submitted (1,271 ) (1,992 ) Total medical expense for period $ 152,822$ 74,365
Medical Expense Ratio for period 79.9 % 80.3 %Favorable claims development is a result of actual medical claim cost for prior periods being less than the original estimated cost which reduces the total reported medical expense and the MER in the reporting period.
The reported MER is impacted by both revenue and expense. Periodically we receive retroactive adjustments of the capitation fees paid to us. Retroactive adjustments of prior periods' capitation fees that are recorded in the current period impact the MER of that period. If the retroactive adjustment increases revenue then the impact reduces the MER for the period. Conversely, if the retroactive adjustment reduces revenue, then the MER for the period is higher. These retroactive adjustments include, among other things, the mid-year and annual retroactive MRA capitation fee adjustments and settlement of Part D program capitation fees. Actual medical claims expense usually develops differently than originally estimated. Because the risk agreements provide that the PSN is financially responsible for all medical services provided to the Participating Customers, medical claims expense includes the cost of medical services provided to Participating Customers by providers other than the physician practices owned by the PSN. Total medical expense for the third quarter of 2012 increased by$78.4 million , or 105.4%, to$152.8 million from$74.4 million for the third quarter of 2011. Medical claims expense, which is the largest component of medical services expense, increased by$68.9 million , or 99.3%, to$138.3 million for the third quarter of 2012 from$69.4 million for the same period in 2011, primarily due to the acquisition ofContinucare and the net addition of new Participating Customers under risk arrangements in 2012. Our PCPM Medicare risk expense increased by$38 for the third quarter of 2012 compared to the same period in 2011. The increase in our PCPM expense was primarily generated by the acquisition ofContinucare . The counties in whichContinucare operates, particularlyMiami-Dade County, Florida , have higher costs than those in most of the counties in which we had operated prior to the acquisition ofContinucare . The MER for the third quarter of 2012 was 79.9%, compared to 80.3% for the third quarter of 2011. Excluding the revenue and medical costs associated with the Contracting HMO Agreement, our MER for the third quarter of 2012 would have been 77.9%. Medical practice costs include the salaries, taxes and benefits of the PSN's employed health professionals and staff providing primary care services and the costs associated with the operations of our wholly-owned medical practices. Medical practice costs increased by$9.6 million , or 195.9%, to$14.5 million for the third quarter of 2012 from$4.9 million for the third quarter of 2011. The increase in medical practice costs was primarily a result of our acquisition ofContinucare , which has 19 wholly-owned centers. AtSeptember 30, 2012 , we determined that the range for estimated medical claims payable was between$44.1 million and $45.6 million and we recorded a liability of$44.7 million . Based on historical results, we believe that the approximate actuarial mid-point of the range continues to be the best estimate within the range of the PSN's ultimate liability. 26 --------------------------------------------------------------------------------Operating Expenses
The following table provides information regarding the various items which comprise operating expenses (dollar amounts in thousands).
Three Months Ended September 30, % 2012 2011 Increase Change Payroll, payroll taxes and benefits $ 8,688 $ 4,078 $ 4,610 113.0% Percentage of total revenue 4.5 % 4.4 % General and administrative 4,604 2,048 2,556 124.8% Percentage of total revenue 2.4 % 2.2 % Marketing and advertising 387 336 51 15.2% Percentage of total revenue 0.2 % 0.4 % Amortization of intangible assets 3,186 96 3,090 3218.8% Percentage of total revenue 1.7 % 0.1 % Total operating expenses $ 16,865 $ 6,558 $ 10,307 157.2%Payroll, Payroll Taxes and Benefits
Payroll, payroll taxes and benefits include salary and related costs associated with our corporate level executives, administrative, transportation and call center personnel. The increase in 2012 is primarily a result of the inclusion ofContinucare's executive, administrative, transportation and call center payroll, payroll taxes and benefits of$3.7 million and an increase in payroll expense of$0.7 million for the three months endedSeptember 30, 2012 compared to the same period in 2011. General and Administrative This increase in general and administrative expenses for the third quarter of 2012 is primarily a result of the inclusion of$1.7 million ofContinucare's general and administrative costs. Legal and accounting fees increased by$0.5 million for the third quarter of 2012 compared to the third quarter of 2011 primarily as a result of increased professional fees associated with the larger combined organization. Marketing and Advertising Marketing and advertising costs increased for the third quarter of 2012 compared to the third quarter of 2011 due primarily to the inclusion ofContinucare's marketing and advertising costs.Amortization of Intangibles
The increase in amortization is a result of the intangible assets acquired in connection with the acquisition of
Continucare .Other Expense
We recognized other expense of$8.1 million for the third quarter of 2012 compared to other expense of$2.0 million for the same period in 2011. For the third quarter of 2012, we incurred$8.1 million of interest expense related to the debt incurred in connection with theContinucare acquisition. For the third quarter of 2011, we recorded transaction costs associated with theContinucare transaction of$2.1 million .Income taxes
Our estimated effective income tax rate was 32.6% and 38.6% for the third quarter of 2012 and 2011, respectively. In the third quarter of 2012, we realized the tax benefits related to the elimination of$0.8 million of prior years' accrued uncertain tax positions for years that are no longer subject to audit, which lowered our effective income tax rate. 27 --------------------------------------------------------------------------------COMPARISON OF RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED
SEPTEMBER 30, 2012 ANDSEPTEMBER 30, 2011 Summary Net income for the nine months endedSeptember 30, 2012 was$20.1 million compared to$19.9 million for the nine months endedSeptember 30, 2011 . Net income for 2012 was positively impacted by the elimination of$0.8 million of prior years' accrued uncertain tax positions for years that are no longer subject to audit. Net income for the nine months endedSeptember 30, 2012 was negatively impacted by the$5.0 million pre-tax loss from the Contracting HMO Agreement. Net income in 2011 was reduced by CNU pre-tax transaction costs of$3.1 million . For the nine months endedSeptember 30, 2012 , our loss under the Contracting HMO Agreement was$5.0 million which included a premium deficiency of$1.1 million recorded in the third quarter as described below. OnNovember 6, 2012 , we provided written notice to the Contracting HMO terminating this agreement effectiveMarch 5, 2013 as we were unable to reach more favorable contract terms with the Contracting HMO. As a result, we recorded in medical claims expense in the third quarter of 2012 a premium deficiency of$1.1 million , which is our estimate of the loss that we will incur under the Contracting HMO Agreement throughMarch 5, 2013 . Basic and diluted earnings per share were$0.46 and$0.44 , respectively, for the nine months endedSeptember 30, 2012 as compared to$0.50 and$0.47 , respectively, for the same period in 2011. Basic and diluted earnings from continuing operations for the nine months endedSeptember 30, 2012 were$0.45 and$0.43 per share, respectively. The after tax impact of the$5.0 million loss from the Contracting HMO Agreement reduced basic and diluted earnings per share in 2012 by$0.06 . The after tax impact of theContinucare transaction costs reduced basic and diluted earnings per share by$0.05 in 2011. Basic and diluted earnings from discontinued operations for the nine months endedSeptember 30, 2012 were$0.01 per share. Revenue for the nine months endedSeptember 30, 2012 was$579.8 million compared to$284.7 million for the nine months endedSeptember 30, 2011 , an increase of$295.1 million or 103.7%. The increase in revenue was primarily attributable to Participating Customers added with the acquisition ofContinucare , the net addition of new Participating Customers under risk arrangements in 2012 and an increase in the average risk scores of our Participating Customers. Revenue in 2011 was reduced by the final estimated retroactive MRA premium receivable for 2010 being$1.2 million lower than had been estimated. Total medical expense for the nine months endedSeptember 30, 2012 was$475.2 million compared to$230.6 million for the nine months endedSeptember 30, 2011 , an increase of$244.6 million or 106.1%. This increase is primarily attributable to the medical costs associated with the net addition of new Participating Customers under risk arrangements in 2012, the higher than expected medical claims expense under the Contracting HMO Agreement, the addition of the 19Continucare medical practices and an increase in benefits, utilization and medical cost inflation.Gross profit was
$104.7 million for the nine months endedSeptember 30, 2012 as compared to$54.1 million for the same period in 2011, an increase of$50.6 million or 93.5%.Our MER was 82.0% for the nine months endedSeptember 30, 2012 , as compared to MER of 81.0% for the nine months endedSeptember 30, 2011 . Excluding the revenue and medical costs associated with the Contracting HMO Agreement, our MER for the first nine months of 2012 would have been 79.6%. 28 --------------------------------------------------------------------------------Operating expenses increased to
$49.6 million for the nine months endedSeptember 30, 2012 as compared to$19.2 million for the same period in 2011, an increase of$30.4 million or 158.3%. The increase in operating expenses is primarily due to the additional expenses ofContinucare and an increase in amortization expense of$9.3 million related to the amortizable intangible assets recorded in theContinucare acquisition.Other expense increased by$21.9 million due primarily to an increase in interest expense of$24.4 million for the nine months endedSeptember 30, 2012 related to the debt used to finance theContinucare acquisition. We expensed$3.1 million of transaction costs in the nine months endedSeptember 30, 2011 that were associated with our acquisition ofContinucare .Income before income taxes from continuing operations for the nine months ended
September 30, 2012 and 2011 was$30.7 million and$32.4 million , respectively. The primary reasons for the decrease are discussed above.In the third quarter of 2012, we realized the tax benefits related to the elimination of$0.8 million of prior years' accrued uncertain tax positions for years that are no longer subject to audit, which lowered our effective income tax rate.Income from discontinued operations was
$0.5 million for the nine months endedSeptember 30, 2012 . This amount represents income realized by the sleep diagnostic business during the nine months endedSeptember 30, 2012 , net of income tax expense.Customer Information
The table set forth below provides (i) the total number of customers to whom we were providing healthcare services as ofSeptember 30, 2012 and 2011 and (ii) the aggregate customer months for the nine months endedSeptember 30 , both 2012 and 2011. Customer months are the aggregate number of months of healthcare services we have provided to customers during a period of time. Participating Customer Months Percentage Increase Participating Customers at For The Nine Months Ended In Participating September 30, September 30, Customer Months 2012 2011 2012 2011 Risk arrangements 70,400 34,400 630,700 307,600 105.0% Non-risk arrangements 17,100 - 148,400 - N/A 87,500 34,400 779,100 307,600 153.3% The increase in total customer months under risk arrangements for the nine months endedSeptember 30, 2012 as compared to the same period in 2011 is primarily a result of the Participating Customers added with theContinucare acquisition and the net addition of new Participating Customers under risk arrangements in 2012. Changes in our customer base are also a result of new enrollments and/or transfers from other physician's practices, and individuals aging intoMedicare and becoming a Participating Customer, reduced by disenrollments, deaths, Participating Customers moving from the covered areas, Participating Customers transferring to another physician practice or Participating Customers making other insurance selections. The increase in customer months under non-risk arrangements is a result of theContinucare acquisition and the addition of theCincinnati andIndianapolis contracts with Humana. The Participating Customer months for the nine months endedSeptember 30, 2012 include the retroactive impact on customer months as a result of the retroactive effective date of theCincinnati contract with Humana.Revenue
The most significant component of our revenue is the revenue generated fromMedicare Advantage risk arrangements with the Contracting HMOs.Medicare risk revenue increased by$266.6 million , or 94.1%, during the nine months endedSeptember 30, 2012 as compared to the same period in 2011. The increase in revenue is primarily attributable to Participating Customers added with the acquisition ofContinucare , the net addition of new Participating Customers under risk arrangements in 2012 and increased risk scores for our Participating Customers. Our PCPM Medicare risk revenue increased by$78 for the nine months endedSeptember 30, 2012 compared to the same period in 2011. The increase in our PCPM revenue is primarily generated by the acquisition ofContinucare , which realizes higher rates inMiami-Dade County, Florida than we realize in our other service areas, and increases in our capitation payments as a result of changes in theMedicare risk adjustment scores of our Participating Customers. 29 -------------------------------------------------------------------------------- There was no material difference between the estimated final settlement for 2011 of$2.7 million and the final settlement that was received in the third quarter of 2012. AtDecember 31, 2010 , we recorded a$2.2 million receivable representing our estimate of the final retroactive MRA capitation fee for 2010. InAugust 2011 , we were notified that the final settlement was$1.0 million . The difference of$1.2 million reduced revenue in the third quarter of 2011. Fee-for-service revenue represents amounts earned from medical services provided to non-Participating Customers in our owned medical practices. Fee-for-service revenue represented less than 0.5% of our total revenue for the nine months endedSeptember 30, 2012 andSeptember 30, 2011 .Total Medical Expense
Total medical expense and the MER are as follows (in thousands):
Nine Months EndedSeptember 30,
20122011
Estimated medical expense for the period, excluding prior period claims development $ 477,337 $ 233,862 (Favorable) prior period medical claims development in current period based on actual claims submitted (2,183 ) (3,281 ) Total medical expense for period $ 475,154$ 230,581
Medical Expense Ratio for period 82.0 % 81.0 %Favorable claims development is a result of actual medical claim cost for prior periods developing lower than the original estimated cost which reduces the reported medical expense and the MER in the reporting period.
Total medical expense for the nine months endedSeptember 30, 2012 increased by$244.6 million , or 106.1%, to$475.2 million from$230.6 million for the nine months endedSeptember 30, 2011 . Medical claims expense, which is the largest component of medical services expense, increased by$215.1 million , or 99.3%, to$431.7 million for the nine months endedSeptember 30, 2012 from$216.6 million for the same period in 2011, primarily due to the acquisition ofContinucare , the net addition of new Participating Customers under risk arrangements added in 2012 and the higher than expected medical claims expense under the Contracting HMO Agreement. Our PCPM Medicare risk expense increased by$45 for the nine months endedSeptember 30, 2012 compared to the same period in 2011. The increase in our PCPM expense was primarily generated by the acquisition ofContinucare and the higher than expected medical claims expense under the Contracting HMO Agreement. The counties in whichContinucare operates, particularlyMiami-Dade County, Florida , have higher costs than those in most of the counties in which we had operated prior to the acquisition ofContinucare . The MER for the nine months endedSeptember 30, 2012 was 82.0%, compared to MER of 81.0% for the nine months endedSeptember 30, 2011 . Excluding the revenue and medical costs associated with the Contracting HMO Agreement our MER for the first nine months of 2012 would have been 79.6%. Medical practice costs include the salaries, taxes and benefits of the PSN's employed health professionals and staff providing primary care services, and the costs associated with the operations of our wholly-owned medical practices. Medical practice costs increased by$29.5 million , or 210.7%, to$43.5 million for the nine months endedSeptember 30, 2012 from$14.0 million for the nine months endedSeptember 30, 2011 . The increase in medical practice costs was primarily a result of our acquisition ofContinucare , which has 19 wholly-owned centers. 30--------------------------------------------------------------------------------Operating Expenses
The following table provides information regarding the various items which comprise operating expenses (dollar amounts in thousands).
Nine Months Ended September 30, % 2012 2011 Increase Change Payroll, payroll taxes and benefits $ 25,546 $ 12,039 $ 13,507 112.2 % Percentage of total revenue 4.4 % 4.2 % General and administrative 13,686 6,389 7,297 114.2 % Percentage of total revenue 2.4 % 2.2 % Marketing and advertising 771 456 315 69.1 % Percentage of total revenue 0.1 % 0.2 % Amortization of intangible assets 9,560 289 9,271 3208.0 % Percentage of total revenue 1.6 % 0.1 % Total operating expenses $ 49,563 $ 19,173 $ 30,390 158.5 %Payroll, Payroll Taxes and Benefits
Payroll, payroll taxes and benefits include salary and related costs associated with our corporate level executives, administrative, transportation and call center personnel. The increase in 2012 is primarily a result of the inclusion ofContinucare's executive, administrative, transportation and call center payroll, payroll taxes and benefits of$11.1 million . We also realized an increase in share-based compensation of$0.8 million , primarily due to the addition of certainContinucare employees to the plan and an increase in payroll expense of$1.5 million for the nine months endedSeptember 30, 2012 compared to the same period in 2011. General and Administrative This increase in general and administrative expenses for the nine months endedSeptember 30, 2012 is primarily a result of the inclusion of$4.9 million ofContinucare's general and administrative costs. Legal and accounting fees increased by$1.8 million for the nine months endedSeptember 30, 2012 when compared to the same period in 2011 primarily as a result of the preparation and filing of a "shelf" registration statement and related materials, non-recurring projects and increased professional fees associated with the larger combined organization. Marketing and Advertising Marketing and advertising costs increased in the nine months endedSeptember 30, 2012 compared to the nine months endedSeptember 30, 2011 due primarily to the inclusion ofContinucare's marketing and advertising costs.Amortization of Intangibles
The increase in amortization is a result of the intangible assets acquired in connection with the acquisition of
Continucare .Other Expense
We recognized other expense of$24.4 million and$2.5 million for the nine months endedSeptember 30, 2012 and 2011, respectively. The increase in other expense is primarily due to$24.4 million of interest expense related to the debt incurred in connection with theContinucare acquisition. For the nine months endedSeptember 30, 2011 we recorded transaction costs associated with theContinucare transaction of$3.1 million .Income taxes
Our estimated effective income tax rate was 36.0% for the nine months endedSeptember 30, 2012 and 38.5% for the nine months endedSeptember 30, 2011 . In the third quarter of 2012, we realized the tax benefits related to the elimination of$0.8 million of prior years' accrued uncertain tax positions for years that are no longer subject to audit, which lowered our effective income tax rate. 31--------------------------------------------------------------------------------LIQUIDITY AND CAPITAL RESOURCES
Cash and Cash Equivalents
Cash, cash equivalents and short-term investments atSeptember 30, 2012 totaled$54.8 million as compared to$18.3 million atDecember 31, 2011 , an increase of$36.5 million . As ofSeptember 30, 2012 , we had working capital of$59.5 million as compared to working capital of$43.2 million atDecember 31, 2011 , an increase of$18.0 million or 41.7%. Our total stockholders' equity was$128.3 million atSeptember 30, 2012 and$104.6 million atDecember 31, 2011 . Net cash provided by operating activities during the nine months endedSeptember 30, 2012 was$52.9 million . The most significant sources of cash from operating activities were: ? net income, including non-cash items, of$39.0 million ; ? a decrease in due from HMOs, net, of$9.9 million ; ? an increase in due to HMO, net, of$7.3 million ; and ? an increase in accrued interest payable of$4.3 million . These sources of cash were partially offset by a decrease in accrued payroll and payroll taxes of$1.4 million as a result of the payment in 2012 of the employee bonuses which were accrued atDecember 31, 2011 .Net cash used in investing activities for the nine months ended
September 30, 2012 was$3.6 million which primarily related to capital expenditures.Net cash used by financing activities for the nine months endedSeptember 30, 2012 was$12.8 million . This was primarily a result of the repayment of the$5.0 million of borrowings under the revolving loan facility and principal payments made of$8.4 million under our First Lien Term Loan Facility (see below). These uses were partially offset by the excess tax benefits from stock based compensation of$1.5 million .Redemption of Series A Preferred Stock
OnNovember 2, 2012 , we delivered a notice of redemption to the holder (the "Series A Holder") of all 5,000 of the outstanding shares of our Series A Preferred Stock. Pursuant to the notice of redemption, we notified the Series A Holder that we are exercising our right to redeem all of the outstanding shares of Series A Preferred Stock held by him at a redemption price of$105 per share($525,000) in accordance with the provisions of our Articles of Incorporation, as amended to date. Subject to certain conditions, the redemption of the Series A Preferred Stock is expected to occur onNovember 16, 2012 Adjusted EBITDA From Continuing Operations
The following table presents our Adjusted EBITDA from continuing operations (Non-GAAP measure) for the nine months endedSeptember 30, 2012 and 2011, as well as a reconciliation of Adjusted EBITDA from continuing operations to the reported income from continuing operations for such periods (in thousands): Three Months EndedSeptember 30 ,Nine Months Ended September 30,
2012 2011 2012 2011 Income from continuing operations $ 9,024 $ 5,996 $ 19,618 $ 19,889 Income tax expense 4,367 3,767 11,045 12,464 Net interest expense (income) 8,069 (96 ) 24,425 (559 ) Depreciation and amortization 4,142 320 12,310 1,062 Share-based compensation 850 613 2,749 1,941 Adjusted EBITDA from continuing operations $ 26,452 $ 10,600 $ 70,147 $ 34,797 Adjusted EBITDA from continuing operations is not defined under U.S. GAAP and it may not be comparable to similarly titled measures reported by other companies. We use Adjusted EBITDA from continuing operations, along with other U.S. GAAP measures, as a measure of profitability because Adjusted EBITDA from continuing operations helps us to compare our performance on a consistent basis by removing from our operating results from continuing operations the impact of our capital structure, the accounting methods used to compute depreciation and amortization and the effect of non-cash share-based compensation expense. We believe Adjusted EBITDA from continuing operations is useful to investors as it is a widely used measure of performance and the adjustments we make to Adjusted EBITDA from continuing operations provide further clarity on our profitability. We remove the effect of non-cash share-based compensation from our income which can vary based on share price, share price volatility and expected life of the equity instruments we grant. In addition, this share-based compensation expense does not result in cash payments by us. Adjusted EBITDA from continuing operations has limitations as a profitability measure in that it does not include the interest expense on our debt, our provisions for income taxes, the effect of our expenditures for capital assets, and the effect of non-cash share-based compensation expense. 32 --------------------------------------------------------------------------------Credit Facilities
We entered into a senior secured First Lien Credit Agreement and a secured Second Lien Credit Agreement onOctober 4, 2011 . These facilities are guaranteed jointly and severally by substantially all of our existing and future subsidiaries (the "Guarantors") and are secured by a first-priority and second-priority security interest, respectively, in substantially all of our and the Guarantors' existing and future assetsFirst Lien Credit Agreement
The First Lien Credit Agreement provides for a$240.0 million first lien term loan facility and a$40.0 million revolving loan facility (including subfacilities for up to$15.0 million for letters of credit and$5.0 million for same day, "swingline," borrowings). These loans bear interest at a variable rate that is currently equal to 7.0% for term loan borrowings and 6.5% for revolving loan borrowings. As ofSeptember 30, 2012 , we had$231.6 million outstanding under our first lien term loan facility. While no amount was outstanding under our revolving loan facility, letters of credit against the revolving loan facility atSeptember 30, 2012 reduced our available borrowing capacity under the revolving loan facility to$34.3 million . Borrowings under the First Lien Term Loan Facility are subject to quarterly principal amortization at the following rates: 5.0% of the$240.0 million principal amount the first year, 7.5% the third year, 10.0% the third year, and 12.5% for each of the fourth and fifth years. The balance of all borrowings under the first lien term loan facility is due and payable on the maturity date ofOctober 4, 2016 . We may prepay the term loans or permanently reduce the revolver commitment under the First Lien Facilities at any time without penalty. Commencing for the year endedDecember 31, 2012 , we will also be required to make prepayments on an annual basis (subject to certain basket amounts and exceptions), in an amount equal to 75.0% of our excess cash flow (defined as cash flow less scheduled principal and interest payments, cash taxes, and any increase in working capital, plus any decrease in working capital) less any voluntary prepayments made during the applicable year, with a reduction to 50.0% based on achievement of a total leverage ratio (defined as the ratio of our aggregate outstanding indebtedness to our adjusted income before share-based compensation, interest, taxes, depreciation and amortization) not exceeding 2.00x as of the last day of each year. We also must make prepayments of 25-50% of the net proceeds from publicly offered equity issuances as well as 100% of the net proceeds from asset sales, debt issuances (other than to the extent permitted under the First Lien Credit Agreement) and extraordinary receipts, as defined. The First Lien Credit Agreement includes customary restrictive covenants, subject to certain basket amounts and exceptions, including covenants limiting our ability to incur or amend certain types of indebtedness and liens; merge with, make an investment in or acquire any property or assets of another company; make capital expenditures; pay cash dividends; repurchase shares of our outstanding stock; make loans; dispose of assets (including the equity securities of our subsidiaries); or prepay the principal on any subordinate indebtedness. Subject to certain terms and conditions, we have the right to make up to$15.0 million of stock repurchases during the term of the credit facilities, generally not to exceed$5.0 million in any year, and make up to$100.0 million of acquisitions, generally not to exceed$50.0 million in any one year. The First Lien Credit Agreement also requires us to maintain certain total leverage ratios (defined above), senior leverage ratios (defined above) and fixed charge coverage ratios (defined as the ratio of our free cash flow to our fixed charges (interest, scheduled principal payments, earnout, stock repurchases from officers, directors and employees) during the term of the agreement, tested quarterly.Second Lien Credit Agreement
The Second Lien Credit Agreement provides for a$75.0 million second lien term loan facility. This loan bears interest at a variable rate that is currently equal to 13.5%. As ofSeptember 30, 2012 , we had$75.0 million outstanding under our second lien term loan facility. Borrowings under the Second Lien Credit Agreement are generally due and payable on the maturity date,October 4, 2017 . Prior to the repayment of all borrowings under the First Lien Credit Agreement, we may not prepay any borrowings under the Second Lien Credit Agreement without the prior consent of the First Lien Lenders. To the extent a prepayment of borrowings under the Second Lien Credit Agreement is permitted, we will be required to pay prepayment penalties of 2-5% and, if the prepayment is made prior toMay 4, 2013 , we will be required to pay a make-whole payment equal to the estimated, discounted net present value of any interest payments that would have been made on or prior to such date but are avoided as a result of the prepayment. 33 -------------------------------------------------------------------------------- AfterMay 4, 2013 , and provided all borrowings under the First Lien Credit Agreement have been repaid and the facility has been terminated, we will, subject to certain basket amounts and exceptions, be required to make mandatory prepayments to the Second Lien Lenders on substantially the same terms and conditions as mandatory prepayments are required under the First Lien Credit Agreement. Mandatory prepayments as a result of asset sales or debt or equity issuances will be subject to the prepayment charges described in the preceding paragraph. The Second Lien Credit Agreement contains substantially the same negative covenants and financial covenants (other than the senior leverage ratio) as the First Lien Credit Agreement, except that the permitted basket amounts in the Second Lien Credit Agreement are generally higher than under the First Lien Credit Agreement and the financial covenants ratios are 10-15% less restrictive than under the First Lien Credit Agreement.Interest Rate Cap
EffectiveDecember 4, 2011 , we entered into an interest rate cap agreement pursuant to which we will be entitled to receive certain payments in the event the LIBOR rate on the First and Second Lien Credit Agreements exceeds 1.5%. The notional amount of the interest rate cap, which expires onSeptember 30, 2014 , is$153.3 million atSeptember 30, 2012 and will decrease to$134.1 million over the life of the agreement. The effect of this interest rate cap is to hedge our risk of a rise in the LIBOR rate above 1.5% with respect to a portion of the outstanding indebtedness under the First Lien Credit Agreement and the Second Lien Credit Agreement equal to the notional amount of the cap.OFF-BALANCE SHEET ARRANGEMENTS
We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.
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