MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This Management's Discussion and Analysis of Financial Condition and Results of Operations may include certain 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 operating and financial performance, growth and acquisition opportunities and other similar forecasts and statements of expectation. Words such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates" and "should" and variations of these words and similar expressions, are intended to identify these forward-looking statements. Forward-looking statements made by the Company and its management are based on estimates, projections, beliefs and assumptions of management at the time of such statements and are not guarantees of future performance.
The Company disclaims any obligations to update or revise any forward-looking statement based on the occurrence of future events, the receipt of new information or otherwise. Actual future performance, outcomes and results may differ materially from those expressed in forward-looking statements made by the Company and its management as a result of a number of risks, uncertainties and assumptions. Representative examples of these factors include (without limitation) general industry and economic conditions; cost of capital and capital requirements; competition from other managed care companies; the ability to expand certain areas of the Company's business; shifts in customer demands; the ability of the Company to produce market-competitive software; changes in operating expenses including employee wages, benefits and medical inflation; governmental and public policy changes; dependence on key personnel; possible litigation and legal liability in the course of operations; and the continued availability of financing in the amounts and at the terms necessary to support the Company's future business.
CorVel Corporation is an independent nationwide provider of medical cost containment and managed care services designed to address the escalating medical costs of workers' compensation and auto policies. The Company's services are provided to insurance companies, third-party administrators ("TPA's"), and self-administered employers to assist them in managing the medical costs and monitoring the quality of care associated with healthcare claims.
Network Solutions Services
The Company's Network Solutions services are designed to reduce the price paid by its customers for medical services rendered in workers' compensation cases, and auto policies and, to a lesser extent, group health policies. The network solutions network solutions offered by the Company include automated medical fee auditing, preferred provider services, retrospective utilization review, independent medical examinations, MRI examinations, and inpatient bill review.
Patient Management Services
In addition to its network solutions services, the Company offers a range of patient management services, which involve working on a one-on-one basis with injured employees and their various healthcare professionals, employers and insurance company adjusters. The services designed to monitor the medical necessity and appropriateness of healthcare services provided to workers' compensation and other healthcare claimants and to expedite return to work. The Company offers these services on a stand-alone basis, or as an integrated component of its medical cost containment services.
The Company's management is structured geographically with regional vice-presidents who report to the President of the Company. Each of these regional vice-presidents is responsible for all services provided by the Company in his or her particular region and responsible for the operating results of the Company in multiple states. These regional vice presidents have area and district managers who are also responsible for all services provided by the Company in their given area and district.
Business Enterprise Segments
We operate in one reportable operating segment, managed care. The Company's services are delivered to its customers through its local offices in each region and financial information for the Company's operations follows this service delivery model. All regions provide the Company's patient management and network solutions services. Statement of Financial Accounting Standards, or SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," establishes standards for the way that public business enterprises report information about operating segments in annual consolidated financial statements. The Company's internal financial reporting is segmented geographically, as discussed above, and managed on a geographic rather than service line basis, with virtually all of the Company's operating revenue generated within the United States.
Under SFAS 131, two or more operating segments may be aggregated into a single operating segment for financial reporting purposes if aggregation is consistent with the objective and basic principles of SFAS 131, if the segments have similar economic characteristics, and if the segments are similar in each of the following areas: 1) the nature of products and services, 2) the nature of the production processes; 3) the type or class of customer for their products and services; and 4) the methods used to distribute their products or provide their services. We believe each of the Company's regions meet these criteria as they provide the similar services to similar customers using similar methods of productions and similar methods to distribute their services.
Because we believe we meet each of the criteria set forth above and each of our regions have similar economic characteristics, we aggregate our results of operations in one reportable operating segment.
Summary of Annual Results
The Company reported record revenues of $305 million for fiscal year ended March 31, 2004, an increase of $22.5 million over fiscal year ended March 31, 2003. However, the Company's sequential revenue increases for the past five quarters have been lower than the Company has historically experienced. The Company's quarterly sequential revenue growth was 1.2% in the March 2003 quarter compared to the December 2002 quarter, followed by quarterly sequential revenue increases of 2.6%, 1.4%, a decrease of 1.7% in the December 2003 quarter, and 1.5% increase in March 2004 quarter compared to the December 2003 quarter. If the revenues from the acquisition of Scan One are eliminated from this calculation, the quarterly sequential revenue increases were 1.2%, 2.5%, 0.5%, a decrease of 1.7% in the December 2003 quarter and an increase of 1.5%, respectively, for the five quarters ended March 31, 2004.
Although the revenues in the quarter ended March 31, 2004 were within $220,000 of a record for quarter for the Company, the sequential revenue increases reflect the more challenging market conditions and there is no guarantee that the Company will either post revenue growth similar to all previous years or increase revenues. The decline in the manufacturing employment, the decline in workers' compensation claims, the considerable price competition given the flat-to-declining overall market, the increase in competition, changes and the potential changes in state workers' compensation and auto managed care laws which can reduce demand for the Company's services, have created an environment where revenue and margin growth is more difficult to attain and where revenue growth is less certain than historically experienced. Additionally, the Company's technology and preferred provider network competes against other companies, some of which have more resources available. Also, some customers may handle their managed care services in-house and may reduce the amount of services which are outsourced to managed care companies such as CorVel Corporation.
During the fiscal year ended March 31, 2004, the Company achieved a revenue increase of $22.5 million; however, the Company's expenses increased $23.9 million. With a challenging revenue environment, the Company will need to keep cost growth at a rate below the revenue growth.
Business Acquisitions During the Three Years Ended March 31, 2004
In May 2002, the Company acquired AnciCare, PPO, Inc., a Florida-based national provider of diagnostic imaging services. The Company paid approximately $3.4 million ($2.9 million during fiscal 2003 and $475,000 during fiscal 2004) and recorded approximately $3.3 million for goodwill. If the results of the AnciCare operations attain certain revenue during each of the three years after the date of acquisition, the Company will pay an additional amount for the purchase, which is expected to be funded from future earnings generated by the acquisition. Any additional amounts paid will increase the goodwill related to the acquisition. The Company did not attain these revenue milestones during the fiscal 2004 year. As a result, no additional amounts were paid.
In June 2003, the Company expanded its existing office automation service line with the acquisition of Scan One, a provider of scanning, optical character recognition and document management services. The Company expects that this acquisition will provide the opportunity to sell scanning and document management, the services of Scan One, through a number of the Company's larger offices. The Company believes these services are synergistic with the Company's medical bill review processing.
Results of Operations
The Company derives its revenues from providing patient management and network solutions services to payors of workers' compensation benefits, auto insurance claims and health insurance benefits. Patient management services include utilization review, medical case management, and vocational rehabilitation. Network solutions revenues include fee schedule auditing, hospital bill auditing, independent medical examinations, diagnostic imaging review services and preferred provider referral services. In the prior fiscal years, the Company included the revenue from utilization review with network solutions revenues. The Company determined it was more appropriate to include these revenues with patient management. The revenue mix percentages shown below have been adjusted to include utilization review with the patient management services revenue. This change did not affect the trend of the past few years of slow growth in the patient management services causing this service to represent a lesser portion of the Company's revenues. The percentages of revenues attributable to patient management and network solutions services for the fiscal years ended March 31, 2002, 2003, and 2004 are listed below.
Income Statement Percentages
The following table sets forth, for the periods indicated, the percentage of revenues represented by certain items reflected in the Company's consolidated statements of income. The Company's past operating results are not necessarily indicative of future operating results.
Change in Revenue
2003 Compared to 2002
Revenues for fiscal 2003 increased by 20% to $283 million from $236 million in fiscal 2002, an increase of $47 million. The majority of this growth came from network solutions services, which grew 38% from $104 million in fiscal year 2002 to $144 million in fiscal 2003, primarily due to an increase in the number of bills reviewed along with an increase in the number of providers included in the Company's PPO network. Of this $40 million increase, $12 million was due to the aforementioned acquisition of Ancicare, a national provider of diagnostic imaging services, in May 2003. Patient management services increased 5%, by $7 million from $132 million in fiscal 2002 to $139 million in fiscal 2003. This increase was due primarily to an increase in pricing along with a nominal increase in the case referral volume.
Change in Revenue
2004 Compared to 2003
Revenues for fiscal year 2004 increased by 8% to $305 million, from $283 million in fiscal year 2003, an increase of $23 million. The majority of this growth came from network solutions services, which grew 17% from $144 million in fiscal year 2003 to $167 million in fiscal year 2004. Approximately half of this increase was due to an increase in the CorcareRx services which increased from $3 million to $15 million. The CorcareRx service margins are the lowest amongst the network solutions services which contributed to the decrease in the Company's gross profit margin.
Additionally, $2 million of the revenue increase was due to the acquisition of Scan One, a document imaging company, which is integrated with the bill review services. Revenue from patient management services decreased less than 1% from fiscal 2003 to fiscal 2004.
COST OF REVENUE
The Company's cost of revenues consist of direct expenses, costs directly attributable to the generation of revenue, and field indirect costs which are incurred in the field to support the operations in the field offices which generate the revenue. Direct costs are primarily case manager salaries, bill review analysts, related payroll taxes and fringe benefits, and costs for IME (independent medical examination) and MRI providers. Most of the Company's revenues are generated in offices which provide both patient management services and network solutions services. The largest of the field indirect costs are manager salaries and bonus, account executive base pay and commissions, administrative and clerical support, field systems personnel, PPO network developers, related payroll taxes and fringe benefits, office rent, and telephone expense. Approximately 40% of the costs incurred in the field are field indirect costs which support both the patient management services and network solutions operations of the Company's field operations.
Change in Cost of Revenue
2003 Compared to 2002
Cost of revenues increased from $193 million to $231 million, an increase of $38 million or 19.5% compared to revenue growth of 19.9%. The largest components of the direct costs are direct salaries for case managers and bill review analysts which increased by $5 million, or 8%, from $67 million to $73 million and IME and MRI provider costs which increased by $14 million, or 82%, from $17 million to $30 million.
The largest components of the field indirect costs and the changes from fiscal 2002 to fiscal 2003 are: manager salaries, which increased by $2 million, or 13%, from $16 million to $18 million; clerical salaries, which increased by $3 million, from $15 million to $18 million; and rent which increased by $1 million from $9 million to $10 million.
Change in Cost of Revenue
2004 Compared to 2003
Cost of revenues increased from $231 million to $254 million, an increase of $23 million or 10% compared to revenue growth of 8%. Revenues increase by a greater actual dollar and greater percentage than revenue. This increase in cost of revenues exceeded the increase in revenues on a percentage and absolute dollar basis because approximately half of the revenue growth in fiscal 2004 is from CorcareRX which has low gross margins. The largest components of the direct costs are direct salaries for case managers and bill review analysts which increased by $1 million, or 1%, from $73 million to $74 million because of the limited increase in bill volume processed and lack of growth in case management referrals. IME and MRI provider costs increased by $6 million, or 20%, from $30 million to $36 million. CorcareRX provider costs increased by $11 million, from $3 million to $14 million, due to the increase in revenues noted above.
The largest components of the field indirect costs and the changes from fiscal 2003 to fiscal 2004 are: manager salaries, which remained relatively unchanged at approximately $18.5 million for both fiscal 2003 and 2004; and clerical salaries, which increased by $1 million, from $18 million to $19 million. The growth in the field salary costs was nominal as the Company reduced the field headcount (excluding the acquisition of Scan One) by over 200 employees from December 2002 to March 2004.
GENERAL AND ADMINISTRATIVE COSTS
Change in General and Administrative Costs
2003 Compared to 2002
General and administrative costs consist primarily of corporate systems costs which include national support, software development and implementation, software training, the Company's national wide area network and other systems related costs. The rest of the general and administrative costs consist of national marketing, national sales support, corporate legal, insurance, human resources, accounting and other general corporate matters.
General and administrative expense increased from $19 million in fiscal 2002 to $25 million in fiscal 2003. General and administrative costs were 8% and 9% of revenues for these years, respectively. Most of this increase was due to increase in systems costs from $10 million in fiscal 2002 to $15 million in fiscal 2003. This increase from fiscal 2002 to fiscal 2003 was primarily due to increased MIS staff to support the Company's implementation of CareMC and further electronic data interface capabilities as required by customer needs. Systems costs were 4% and 5% of revenues for fiscal 2002 and 2003, respectively. Other general and administrative costs increased from $9 million to $10 million, and were 4% of revenues in each of fiscal 2002 and 2003.
Change in General and Administrative Costs
2004 Compared to 2003
General and administrative expense increased from $25 million in fiscal 2003 and to $26 million in fiscal 2004. General and administrative costs were 9% for each of revenues for each these two years. Almost all of this increase was due to increase in systems costs from $15 million in fiscal 2002 to $16 million in fiscal 2003. This increase from fiscal 2003 to fiscal 2004 was primarily due to increased staff for field support and for customer needs. Systems costs were approximately 5% of revenues for fiscal 2003 and 2004, respectively. Other general and administrative costs remained unchanged at $10 million from fiscal 2003 to fiscal 2004.
Income Tax Provision
The Company's income tax expense for fiscal 2002, fiscal 2003, and fiscal 2004 were $9 million, $10 million, and $9 million, respectively. The increase in the income tax expense for fiscal 2003 and subsequent decrease in fiscal 2004 resulted primarily from an increase in income before income taxes in fiscal 2003 and a decrease in income before income taxes from fiscal 2003 to fiscal 2004. The effective income tax rates for fiscal 2002, fiscal 2003, and fiscal 2004 were 38%, 38% and 37%, respectively. This rate differed from the statutory federal tax rate of 35.0% primarily due to state income taxes and certain non-deductible expenses.
Liquidity and Capital Resources
The Company has funded its operations and capital expenditures primarily from cash flow from operations, and to a lesser extent, option exercises. Net working capital increased from $38 million to $41 million, primarily due to an increase in cash from $6 million to $9 million. This increase in cash is primarily due to an increase in cash provided by operating activities from $22 million in fiscal 2003 to $28 million in fiscal 2004 along with a reduction in the amount spent to repurchase the Company's common stock from $15 million in fiscal 2003 to $12 million in fiscal 2004.
The Company believes that cash from operations, existing working capital, line of credit, and funds from exercise of stock options granted to employees are adequate to fund existing obligations, repurchase shares of the Company's common stock, introduce new services, and continue to develop healthcare related businesses. The Company regularly evaluates cash requirements for current operations and commitments, and for capital acquisitions and other strategic transactions. The Company may elect to raise additional funds for these purposes, either through debt or additional equity, the sale of investment securities or otherwise, as appropriate.
As of March 31, 2004, the Company had $9 million in cash and cash equivalents, invested primarily in short-term, highly liquid investments with maturities of 90 days or less.
In April 2003, the Company entered into a credit agreement with a financial institution to provide borrowing capacity of up to $5 million. This agreement expires in September 2004. Borrowings under this agreement bear interest, at the Company's option, at a fluctuating LIBOR-based rate plus 1.25% or at the financial institution's prime lending rate. There were no outstanding borrowings against this line of credit at either March 31, 2003 or March 31, 2004. The loan covenants require the Company to maintain a quick ratio of at least 2:1, a tangible net equity of at least $45 million and have positive net income.
The Company has historically required substantial capital to fund the growth of its operations, particularly working capital to fund the growth in accounts receivable and capital expenditures. The Company believes, however, that the cash balance at March 31, 2004 along with anticipated internally generated funds and the available line of credit would be sufficient to meet the Company's expected cash requirements for at least the next twelve months.
The following table set forth our contractual obligations at March 31, 2004, which are future minimum lease payments due under noncancelable operating leases:
Operating Cash Flows
2003 Compared to 2002
Net cash provided by operating activities was $27 million in 2002 compared to $21 million in 2003. The decrease in operating cash flows of $6 million was primarily due to the increase in the number of days sales outstanding (DSO) in accounts receivable from 50 days at March 31, 2002 from 56 days at March 31, 2003 which was partially caused by the Company's transition of its accounts receivable from its legacy system to a Peoplesoft system. The migration effort between these two systems distracted from the Company's ongoing collection efforts. Of the $10 million increase in accounts receivable from fiscal 2002 to fiscal 2003, $5 million was due to the increase in revenues and $5 million was due to the increase in days sales outstanding. Net income increased from $15 million in 2002 to $17 million in 2003.
Operating Cash Flows
2004 Compared to 2003
Net cash provided by operating activities was $21 million in 2003 compared to $26 million in 2004. The improvement in cash flow from operations of $6 million was primarily due to the improvement in the accounts receivable days sales outstanding from 56 days at March 31, 2003 to 54 days at March 31, 2004. During the prior fiscal year, an increase in accounts receivable created a $10 million use in cash from operating activities. Because the fiscal year 2004 revenue increase was less than the fiscal year 2003 revenue increase and the days sales outstanding decreased, accounts receivable, excluding the accounts receivable acquired in the Scan One acquisition decreased from fiscal 2003 to fiscal 2004. Additionally, the tax benefits from stock option exercises increased from $1 million in fiscal 2003 to $2 million in fiscal 2004 due to an increase in the number of options exercised from 205,000 to 277,000, respectively, along with a higher average stock price which increased the amount of tax deduction from the exercise of the stock options.
2003 Compared to 2002
Net cash flow used in investing activities was $11 million in fiscal 2002 compared to $17 million in fiscal 2003. The increase in cash flow used in investing activities was primarily due to the $3 million investment in the acquisition of Ancicare, noted above, and an increase in purchases of property and equipment from $11 million in fiscal 2002 to $14 million in fiscal 2003.
2004 Compared to 2003
Net cash flow used in investing activities was $17 million both fiscal 2003 and fiscal 2004 in both business acquisitions and property additions. The Company paid $4 million for acquired businesses, including an additional $.5 million payment for the Ancicare acquisition, noted above, along with $3.7 in disbursements to acquire the stock of Scan One, as noted above, and to pay off the outstanding notes payable of Scan One. Purchases of property and equipment decreased from $14 million in fiscal 2003 to $13 million in fiscal 2004 partially due to the reduction in the growth in the Company's revenues.
2003 Compared to 2002
Net cash flow used in financing activities was $13 million in 2002 compared to $10 million in 2003. The decrease in cash flow used in financing activities was primarily due to an increase in the amount of cash generated from the proceeds from the exercise of employee stock options and the employee stock purchase plan from $2 million in 2002 to $3 million in 2003, and an increase in the tax benefit from the exercise of stock options.
During both fiscal 2002 and fiscal 2003, the Company used $15 million in repurchasing its common stock. The Company repurchased 557,870 shares in fiscal 2002 and 461,527 shares in fiscal 2003. In 1996, the Company's Board of Directors authorized the repurchase of the Company's common stock. Including an expansion authorized in April 2002, the total number of shares authorized to repurchase has now been increased to 6,100,000 shares.
2004 Compared to 2003
Net cash flow used in financing activities was $10 million in 2003 compared to $6 million in 2004. The decrease in cash flow used in financing activities was primarily due to a $1 million increase in the amount of cash generated from the proceeds from the exercise of options in common stock and an increase in the tax benefit from the exercise of stock options from $1 million in fiscal 2003 to $2 million in fiscal 2004 along with a decrease in the amount spent by the Company to repurchase its common stock from $15 million in fiscal 2003 to $12 million in fiscal 2004. Additionally, the tax benefits from stock option exercises increased due to an increase in the number of options exercised from 205,000 to 277,000, respectively, along with a higher average stock price which increased the amount of tax deduction from the exercise of the stock options. The Company repurchased 461,527 shares in fiscal 2003 and 342,121 shares in fiscal 2004.
Critical Accounting Policies
The SEC defines critical accounting policies as those that require application of management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods.
The following is not intended to be a comprehensive list of our accounting policies. Our significant accounting policies are more fully described in Note 1 to the Consolidated Financial Statements. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States of America, with no need for management's judgment in their application. There are also areas in which management's judgment in selecting an available alternative would not produce a materially different result.
We have identified the following accounting policies as critical to us: 1) revenue recognition, 2) allowance for uncollectible accounts, 3) valuation of long-lived assets, 4) accrual for self-insured costs, and 5) accounting for income taxes.
Revenue recognition: The Company's revenues are recognized primarily as services are rendered based on time and expenses incurred. A certain portion of the Company's revenues are derived from fee schedule auditing which is based on the number of provider charges audited and, to a lesser extent, on a percentage of savings achieved for the Company's clients.
Allowance for uncollectible accounts: The Company determines its allowance by considering a number of factors, including the length of time trade accounts receivable are past due, the Company's previous loss history, the customers' current ability to pay its obligation to the Company, and the condition of the general economy and the industry as a whole. The Company writes off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts.
Valuation of long-lived assets: We assess the impairment of identifiable intangibles, property, plant and equipment, goodwill and investments whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:
significant underperformance relative to expected historical or projected future operating results;
significant changes in the manner of our use of the acquired assets or the strategy for our overall business;
significant negative industry or economic trends;
significant decline in our stock price for a sustained period; and our market capitalization relative to net book value.
When we determine that the carrying value of intangibles, long-lived assets and related goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, impairments are recognized when the expected future undiscounted cash flows derived from such assets are less than their carrying value, except for investments. We generally measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. A loss in the value of an investment will be recognized when it is determined that the decline in value is other than temporary.
Accrual for self-insurance costs: The Company self-insures for the group medical costs and workers' compensation costs of its employees. The Company purchases stop loss insurance for large claims. Management believes that the self-insurance reserves are appropriate; however, actual claims costs may differ from the original estimates requiring adjustments to the reserves.
Accounting for income taxes: As part of the process of preparing our consolidated financial statements we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our actual current tax expense together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. If the Company was to establish a valuation allowance or increase this allowance in a period, the Company must include an expense within the tax provision in the consolidated statement of income. Significant management judgment is required in determining our provision for income taxes and our deferred tax assets and liabilities.
Recently Issued Accounting Standards
In May of 2003, the Financial Accounting Standards Board (the Board), issued SFAS 150 Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity (SFAS 150). This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments would previously have been classified as equity. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatorily redeemable financial instruments of nonpublic entities. The Company has reviewed the provisions of SFAS 150, and believes that it does not have any financial instruments requiring reclassifications under SFAS 150.
In January 2003, the Board issued FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities - an Interpretation of ARB No. 51, Consolidated Financial Statements. The Interpretation addresses how variable interest entities are to be identified and how an enterprise assesses its interests in a variable interest entity to decide whether to consolidate that entity. The Interpretation also requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among the parties involved. FIN 46 is effective in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which a company holds a variable interest that is acquired before February 1, 2003. The provisions of FIN 46 have been reviewed, and the Company does not believe that it has any entities requiring consolidation.