Consolidated Financial Statements (With Independent Auditors Report Thereon)
KPMG LLP Suite 1400 55 Second Street San Francisco, CA 94105 Independent Auditors Report To the Board of Directors Hill Physicians Medical Group, Inc.: We have audited the accompanying consolidated financial statements of Hill Physicians Medical Group, Inc. and subsidiaries, which comprise the consolidated balance sheets as of, and the related consolidated statements of operations, changes in shareholders equity, and cash flows for the years then ended, and the related notes to the consolidated financial statements. Management s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with U.S. generally accepted accounting principles; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditors Responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditors judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audits opinion. Opinion In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hill Physicians Medical Group, Inc. and subsidiaries as of December 31, 2017 and 2016, and the results of their operations and their cash flows for the years then ended, in accordance with U.S. generally accepted accounting principles. San Francisco, California May 8, 2018 KPMG LLP is a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity.
Consolidated Balance Sheets (In thousands) Assets Current assets: Cash and cash equivalents $ 35,771 33,106 Marketable securities 52,435 42,550 Accounts receivable: Shared risk and pay for performance 1,896 3,676 Capitation and other receivables, net 12,446 18,979 Prepaid expenses and other 7,009 7,866 Total current assets 109,557 106,177 Property and equipment, net 75,210 62,490 Goodwill 2,816 3,238 Deferred taxes 1,486 2,364 Other assets 2,669 2,388 Total assets $ 191,738 176,657 Liabilities and Shareholders Equity Current liabilities: Claims payable $ 28,512 26,035 Supplemental provider payments 10,117 14,486 Accounts payable and accrued liabilities 21,964 13,582 Accrued employee benefit liabilities 12,493 9,417 Short term portion of loans payable 166 110 Total current liabilities 73,252 63,630 Deferred rent 2,047 2,326 Deferred taxes 1,720 Other long term liabilities 1,547 1,446 Loans payable 5,834 5,890 Total liabilities 84,400 73,292 Shareholders equity: Common stock 1 1 Additional paid-in capital 265 278 Retained earnings 109,263 103,702 Total shareholders equity attributable to Hill 109,529 103,981 Noncontrolling interest (2,191) (616) Total shareholders equity 107,338 103,365 Total liabilities and shareholders equity $ 191,738 176,657 See accompanying notes to consolidated financial statements. 2
Consolidated Statements of Operations Years ended (In thousands) Revenue: Health plan capitation revenue $ 421,897 450,458 Health plan and other revenue 44,867 47,602 Investment income 5,269 3,219 Total revenue 472,033 501,279 Expenses for physician and other contracted services 349,488 373,785 Gross margin 122,545 127,494 Administrative and other expenses: Salaries and benefits 69,436 73,044 Physician administrative services 2,255 2,470 Software maintenance and support 9,068 8,269 Other purchased services 17,487 16,816 Rent 3,750 4,217 Depreciation and amortization 11,200 7,859 Other 3,408 3,687 Total administrative and other expenses 116,604 116,362 Net income before provision for income taxes 5,941 11,132 Provision for income taxes 1,955 5,097 Net loss attributable to noncontrolling interest (1,575) (3,391) Net income $ 5,561 9,426 See accompanying notes to consolidated financial statements. 3
Consolidated Statements of Changes in Shareholders Equity Years ended (In thousands of dollars) Common stock Additional Total Shares Par paid-in Retained Noncontrolling shareholders Authorized Issued amount capital earnings interest equity Balance at December 31, 2015 1,000 287 $ 1 290 94,276 2,775 97,342 Comprehensive income: Net income 9,426 9,426 Change in noncontrolling interest (3,391) (3,391) Issuance of common stock 1 2 2 Repurchase of common stock (16) (14) (14) Balance at December 31, 2016 1,000 272 1 278 103,702 (616) 103,365 Comprehensive income: Net income 5,561 5,561 Change in noncontrolling interest (1,575) (1,575) Repurchase of common stock (17) (13) (13) Balance at December 31, 2017 1,000 255 $ 1 265 109,263 (2,191) 107,338 See accompanying notes to consolidated financial statements. 4
Consolidated Statements of Cash Flows Years ended (In thousands) Cash flows from operating activities: Net income $ 5,561 9,426 Net change in noncontrolling interest (1,575) (3,391) Net change due to consolidation of Hill Health 1,089 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 11,200 7,859 Recognized gain on marketable securities (3,973) (1,867) Deferred taxes 2,598 (465) Deferred rent (279) 1,582 Allowance for doubtful accounts 155 389 Changes in current assets and liabilities: Accounts receivable 8,158 (14,663) Prepaid expenses and other 857 (4,634) Other assets (447) (153) Claims payable 2,477 (2,719) Supplemental provider payments (4,369) (3,284) Accounts payable and accrued liabilities 7,741 5,493 Accrued employee benefit liabilities and other 3,177 693 Net cash provided by (used in) operating activities 31,281 (4,645) Cash flows from investing activities: Investment in healthcare venture 166 (799) Proceeds from sales of marketable securities 30,263 53,305 Purchases of marketable securities (36,175) (48,125) Purchases of property and equipment (22,857) (19,343) Cash acquired through consolidation of Hill Health 2,911 Net cash used in investing activities (28,603) (12,051) Cash flows from financing activities: Issuance of common stock 2 Repurchase of common stock (13) (14) Proceeds from loans 3,000 Net cash provided by (used in) financing activities (13) 2,988 Net increase (decrease) in cash and cash equivalents 2,665 (13,708) Cash and cash equivalents beginning of year 33,106 46,814 Cash and cash equivalents end of year $ 35,771 33,106 Supplemental cash flow information: Income taxes paid (received) $ (1,034) 7,509 Change in accrued purchases of property and equipment (641) 499 See accompanying notes to consolidated financial statements. 5
(1) Organization and Purpose Hill Physicians Medical Group, Inc. (Hill Physicians or the Company) is an independent practice association delivering medical care to health plan enrollees. Hill Physicians mission is to control medical cost while delivering quality medical care and a high level of service through effective management and efficient operations. Hill Physicians is owned by 255 physicians and contracts with 4,441 member-physician providers. Hill Physicians has a management services agreement with PriMed Management Consulting Services, Inc. (PriMed), which extends through 2033. Under terms of the agreement, PriMed provides strategic direction, contract negotiation, claims processing, utilization review, quality assurance, physician credentialing, accounting, and marketing services. PriMed is compensated based on its cost plus incentives related to revenue growth, operating results, and administrative efficiency. Hill Physicians has an ownership interest in PriMed, which is considered a variable interest due to the management agreement terms. Hill Physicians has been determined to be the primary beneficiary of PriMed. Accordingly, the financial statements of PriMed are included in the accompanying consolidated financial statements. Hill Physicians owns preferred stock in PriMed, which results in a 36% ownership interest. This ownership interest is eliminated in the accompanying consolidated financial statements. The non-controlling interest represents 64% outside ownership interest in the common and preferred stocks of PriMed. Hill Health, Inc. (Hill Health) was formed in July 2015 and began operating in December 2015. Hill Health is a California for-profit professional corporation and its purpose is to employ physicians to provide medical services in Northern California. Hill Physicians provided loans of $500,000, $3,000,000 and $4,000,000 to Hill Health during 2017, 2016 and 2015, respectively, which are considered a variable interest in Hill Health. Hill Physicians received $6,000,000 of financing from health plans to fund loans for Hill Health. Hill Physicians has been determined to be the primary beneficiary of Hill Health. The financial statements of Hill Health are included in the accompanying consolidated financial statements as of and for the year ended December 31, 2017. (2) Summary of Significant Accounting Policies (a) Basis of Consolidation The consolidated financial statements include PriMed and Hill Health. Significant intercompany accounts and transactions among consolidated entities have been eliminated. (b) Use of Estimates The preparation of the consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. 6 (Continued)
(c) Revenue Recognition Hill Physicians contracts with HMOs to provide physician and other defined medical services for their enrollees. Five HMOs in 2017 and 2016 comprise 83% and 86% of capitation revenue, respectively, with each HMO accounting for between 9% and 24% of capitation revenue in 2017 and between 9% and 26% of capitation revenue in 2016. Hill Physicians is paid for the majority of its contracted services on a capitated basis. Capitation revenue is recognized corresponding to the periods in which services are rendered. Hill Physicians is paid for certain services on a fee for service basis. These payments are included in health plan and other revenue, and are estimated and recognized in the year in which services are performed. Hill Physicians participates in hospital utilization, pharmacy utilization, and quality incentive programs. Revenue from these programs is recognized when it is estimable and deemed probable of receipt. These programs are subject to periodic settlements based upon information from the HMOs. Hill Health is paid for the majority of its contracted services on a fee-for-service basis. These payments are included in health plan and other revenue, and are estimated and recognized in the year in which services are performed. The provision for doubtful accounts is based upon management s assessment of historical and expected net collections considering historical business and economic conditions, trends in healthcare coverage, and other collection indicators. Periodically throughout the year, management assesses the adequacy of the allowance for doubtful accounts based upon historical write-off experience by payor category. The results of this review are then used to make modifications to the provision for doubtful accounts to establish an appropriate allowance for doubtful accounts. The allowance for bad debts was $303,000 and $255,000 as of, respectively. (d) Cash and Cash Equivalents Cash comprises of cash in bank checking and money market accounts. Cash equivalents include all highly liquid investments with maturity of three months or less when purchased. The Company holds the majority of its cash at a single bank. Consequently, the Company s bank balances may exceed federal deposit insurance limits. (e) Marketable Securities Marketable securities consist principally of domestic debt and equity securities. The Company accounts for its marketable securities under the fair value method of accounting. Under this method, unrealized gains and losses are recorded in investment income in the accompanying consolidated statements of operations. Purchases and sales of marketable securities are recorded on a trade date basis. Interest income is recorded on the accrual basis. Dividends are recorded on the ex-dividend date. 7 (Continued)
(f) Property and Equipment Property and equipment are stated at cost, and the related depreciation is calculated using the straight-line method of depreciation using estimated useful lives ranging from three to ten years for furniture and equipment, and application software, and the shorter of the life of the lease or the assets useful life for leasehold improvements. (g) Goodwill In 2014, Hill Physicians increased its ownership interest in PriMed by purchasing additional shares of PriMed common and preferred stock. Goodwill was recorded to reflect the excess of the amount paid over the book value of the shares purchased. Goodwill is being amortized on a straight-line basis over ten years. (h) Claims Payable The cost of professional medical services rendered to members through the end of the year, but not yet paid, is accrued as claims payable. A portion of the claims payable represents an estimate of claims incurred but not yet reported. Because of the degree of estimation involved in determining the claims payable liability, the actual amount paid in subsequent periods is likely to differ from the recorded liability. (i) Supplemental Provider Payments Supplemental provider payments represent accruals for performance compensation awards to providers that are earned by the providers during a given year but paid in the succeeding year. (j) Income Taxes The asset-and-liability method is used to recognize future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recorded if the realizability of deferred tax assets is uncertain. The Company recognizes the benefit of uncertain tax positions only if those positions are more likely than not of being sustained. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs. The Company, PriMed, and Hill Health file separate Federal and State of California income tax returns. (k) Reclassification Certain reclassifications have been made in these consolidated financial statements to conform 2016 information to the 2017 presentation. 8 (Continued)
(l) Recent Accounting Pronouncements In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606). Subsequent to May 2014, several supplementary pronouncements were issued to provide additional clarification and implementation guidance on ASU 2014-09. Topic 606 provides a framework that replaces existing revenue recognition guidance. The amendments on these updates are effective for fiscal years beginning after December 15, 2018, and early adoption is permitted. The Company has identified its major revenue streams and is in the process of completing formal contract review. While the Company continues to assess all of the potential impacts of Topic 606, the Company does not believe these pronouncements will have a significant impact on the Company s financial statements. In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842), aimed at making leasing activities more transparent and comparable. The new standard requires substantially all leases, including operating leases, be recognized by lessees on their balance sheet as a right-of-use asset and corresponding lease liability. ASU No. 2016-02 is effective for the Company on January 1, 2020, and early adoption is permitted. The Company has reviewed its leases and in the process of assessing the impact of Topic 842. At the time of adoption the Company will record a significant right of use asset and a corresponding lease liability. In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230), Classification of Certain Cash Receipts and Cash Payments. The amendments in this update address eight specific cash flow issues with the objective of reducing the existing diversity in practice. The new standard is effective for the Company on January 1, 2019. Early application is permitted. The standard requires the use of the retrospective transition method. The Company is assessing the potential impact of Topic 230. (3) Fair Value of Financial Instruments The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, accounts receivable, claims payable, supplemental provider payments, accounts payable and accrued liabilities, and accrued employee benefit liabilities approximate fair value due to the short maturities of these financial instruments. Marketable securities are reported at fair value. The fair values of marketable securities are based on quoted market prices, if available, or are estimated using quoted market prices for similar investments. The Company utilizes a three level hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to measurements involving significant unobservable inputs (Level 3 measurements). The three levels of fair value hierarchy are as follows: Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. 9 (Continued)
Level 3 inputs are unobservable inputs for the asset or liability. The level of the fair value hierarchy for an asset class is based on the lowest level input that is significant to the fair value measurement of the asset class. (4) Marketable Securities The following table presents the fair value measurements of investments by level at December 31, 2017 and 2016 (in thousands): Level 1 Level 2 Total Level 1 Level 2 Total Asset class: Fixed income securities: Municipal securities $ 25,291 25,291 15,553 15,553 Equity securities: U.S. common stock 11,869 11,869 16,648 16,648 Foreign common stock 4,186 4,186 3,052 3,052 Mutual funds 4,909 4,909 5,747 5,747 Exchange traded funds 6,180 6,180 1,550 1,550 Total $ 27,144 25,291 52,435 26,997 15,553 42,550 Transfers between fair value input levels, if any, are recorded at the end of the reporting period. During the years ended, there were no transfers between Level 1 and Level 2 investments. Maturities of fixed income securities are as follows at (in thousands): Fair value Fair value Adjusted and carrying Adjusted and carrying cost amount cost amount Fixed income securities: 0 to 5 years maturity $ 14,313 14,313 8,088 8,005 5 to 10 years maturity 6,248 6,283 4,027 3,989 Over 10 years maturity 4,712 4,695 3,596 3,559 Total $ 25,273 25,291 15,711 15,553 10 (Continued)
Investment income comprises the following for the years ended (in thousands): Interest and dividends $ 1,296 1,352 Realized gains 1,149 674 Unrealized gain 2,824 1,193 Total $ 5,269 3,219 (5) Property and Equipment Property and equipment consists of the following at (in thousands): Leasehold improvements $ 972 972 Furniture and equipment 14,874 14,907 Application software 103,915 77,787 Technology projects in progress 8,326 10,938 Total 128,087 104,604 Less accumulated depreciation and amortization (52,877) (42,114) Property and equipment net $ 75,210 62,490 (6) Loans Payable As part of a coordinated plan to provide funding for and to support the formation and development of Hill Health, Hill Physicians entered into loan agreements with two health plans to borrow up to $4,000,000 from each, for a total of $8,000,000. The loans accrue interest at a rate of 3.25% per annum with respect to all amounts outstanding and unpaid, and are due 10 years from their effective dates. As of December 31, 2017 and 2016, the outstanding balance of the loans payable to the health plans is $6,000,000 and $6,000,000, respectively. Accrued interest payable as of, is $151,000 and $54,000, respectively. Up to $3,000,000 of the December 31, 2017 loan payable balance to the health plans are forgivable upon Hill Health s achievement of certain milestones and performance standards. Hill Physicians is only responsible for making payments on the loans payable to the health plans from payments received on the loan receivable from Hill Health. 11 (Continued)
Future scheduled principal payments on the loans payable as of December 31, 2017 are as follows (in thousands): Loans payable 2018 $ 166 2019 477 2020 689 2021 712 2022 735 Thereafter 3,221 Total $ 6,000 (7) Employee Benefit Plan PriMed and Hill Health both offer 401(k) tax deferred savings plans (the Plans) through The Principal Financial Group under which eligible employees, subject to certain limitations, may elect to have up to 50% and 80% for PriMed and Hill Health, respectively, of their salary deferred and contributed to the Plans. Employees become eligible to participate in the Plans in the quarter following their hire date. The amount of salary deferred is not subject to federal income tax at the time of deferral. PriMed and Hill Health matches 100% of the employees contributions up to 6.5% and 6.0%, respectively, of their salary. PriMed contributed $2,858,266 and $2,648,000 to the Plan in 2017 and 2016, respectively. Hill Health contributed $85,262 and $88,000 to the Plan in 2017 and 2016, respectively. (8) Income Taxes The provision (benefit) for income taxes consists of the following for the years ended December 31, 2017 and 2016 (in thousands): Current federal taxes $ (680) 4,262 Current state taxes 37 1,300 Deferred 2,598 (465) Total $ 1,955 5,097 12 (Continued)
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities are presented below at (in thousands): Deferred tax assets (liabilities): Vacation accrual $ 1,002 1,430 Depreciation (5,986) (2,987) Deferred rent 611 997 State taxes (102) 202 Tax effect of unrealized gains on securities (1,074) (581) Prepaid expenses (916) (839) Accrued payroll 1,352 Nonqualified deferred compensation 462 541 Long-term incentive plan 703 671 Net operating loss 4,590 1,691 Research and development credit 3,280 2,288 Alternative minimum tax 147 106 Other 99 217 Total gross deferred tax asset 2,816 5,088 Less valuation allowance (3,050) (2,724) Net deferred tax asset (liability) $ (234) 2,364 As of December 31, 2017, the Company has federal and California research and development tax credits of $2,151,000 and $1,128,000, respectively. The federal research credits will begin to expire in the year 2037, and the California research credits have no expiration date. In assessing the realizability of the deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. Based upon the projected future operating trends and the expected reversal of deferred tax liabilities, management believes it is more likely than not that the Company will be unable to realize a portion of these deductible differences. Accordingly, a valuation allowance of $3,050,000 and $2,724,000 is recorded as of December 31, 2017 and 2016, respectively. On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (the Tax Act) was signed into law. The Tax Act reduces the corporate tax rate from a top marginal rate of 35% to a flat rate of 21%. Although the Tax Act is generally effective January 1, 2018, generally accepted accounting standards requires recognition of the tax effects of new legislation during the reporting period that includes the enactment date, which was December 22, 2017. The primary impact of the Tax Act resulted from the re-measurement of deferred tax assets and liabilities due to the change in the corporate tax rate, reducing the net deferred tax liability by $1,099,000, which had (84%) effect on the effective tax rate. 13 (Continued)
The Company has estimated the impact of the Tax Act by incorporating assumptions made based upon the current interpretation and analysis to date of the law. The actual impact of the Tax Act may differ from the estimates during 2018 due to, among other things, further refinement of the calculations, changes in interpretations and assumptions, guidance that may be issued and actions the Company may take as a result of the new legislation. Income tax expense for 2017 differed from the amount computed by applying the U.S. federal tax rate of 34% primarily due to state income taxes, tax-exempt dividends and interest on the Company s marketable securities, amortization of goodwill, and change in federal rates. Income tax expense for 2016 differed from the amount computed by applying the U.S. federal tax rate of 35% primarily due to state income taxes, tax-exempt dividends and interest on the Company s marketable securities, and amortization of goodwill. The Company files income tax returns in the U.S. Federal and in the State of California tax jurisdictions. The Company is currently open to audit under the statute of limitations by the Internal Revenue Service for tax years 2013 and forward and under the statute of limitations by the State of California Franchise Tax Board for tax years 2012 and forward. (9) Commitments and Contingencies From time to time, the Company may be a defendant in various actions arising from its healthcare services. No such actions that may have a material adverse effect on the Company s financial position are currently pending. The Company is required to periodically file financial statements and other information with the California Department of Managed Health Care and is in compliance with regulatory requirements. (10) Operating Leases The Company, PriMed, and Hill Health have entered into certain operating leases for office space. Rent expense in connection with these leases is recognized on a straight-line basis over the life of the lease. Accrued but unpaid rent is $2,047,000 and $2,326,000 at, respectively. Future rental commitments, including office leases, are as follows (in thousands): 2018 $ 3,957 2019 4,003 2020 4,078 2021 3,556 2022 383 Thereafter 1,488 Total $ 17,465 (11) Subsequent Events The Company has evaluated the subsequent events from the consolidated balance sheet date through May 8, 2018, the date at which the consolidated financial statements were available to be issued, and determined there are no other items to disclose. 14