COBALT CORP - 10-Q Quarterly Report

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United States
Securities and Exchange Commission
Washington, D.C. 20549

FORM 10-Q

Quarterly Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934

For the Period Ended June 30, 2002

Commission File Number 1-14177

COBALT CORPORATION
(Exact name of registrant as specified in its charter)

Wisconsin (State of incorporation)	39-1931212 (I.R.S. Employer Identification No.)
401 West Michigan Street, Milwaukee, Wisconsin (Address of principal executive offices)	53203-2896 (Zip Code)

(414) 226-6900
(Registrant's telephone number, including area code)

Indicate by check mark whether registrant (1) has filed all documents and reports required to be filed by Section 13, or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes ý No o

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date:

Common stock outstanding as of July 31, 2002 was 41,106,890

COBALT CORPORATION

INDEX TO
QUARTERLY REPORT ON FORM 10-Q

For the Period Ended June 30, 2002

PART I
Financial Statements and Supplementary Data		3
Management's Discussion and Analysis of Financial Condition and Results of Operations		17
Quantitative and Qualitative Disclosures about Market Risk		28
PART II
Other Information		29
Signature Page		32

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

COBALT CORPORATION
CONSOLIDATED BALANCE SHEETS

			June 30, 2002		December 31, 2001
			(Unaudited)
			(In thousands)
ASSETS
Current assets:
	Cash and cash equivalents		$	67,478	$	51,669
	Investments—available-for-sale, at fair value			306,270		180,692
	Due from affiliates			5,859		5,091
	Premium receivables			33,989		33,486
	Due from clinics and providers			7,265		11,922
	Other receivables			47,067		49,138
	Prepaid expenses and other current assets			33,827		30,150

		Total current assets		501,755		362,148
Noncurrent assets:
	Investments—held-to-maturity, at amortized cost			12,591		11,007
	Investments in affiliates, net			418		79,466
	Property and equipment, net			31,537		31,411
	Goodwill, net			89,594		92,066
	Prepaid pension			56,750		53,837
	Deferred income taxes			33,088		29,385
	Other noncurrent assets			68,914		48,685
Assets from discontinued operations				—		19,317

Total assets			$	794,647	$	727,322

See Notes to Interim Consolidated Financial Statements.

COBALT CORPORATION
CONSOLIDATED BALANCE SHEETS

			June 30, 2002		December 31, 2001
			(Unaudited)
			(In thousands)
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
	Medical and other benefits payable		$	194,562	$	220,038
	Advance premiums			85,975		88,495
	Due to affiliates			33		59
	Payables and accrued expenses			72,527		49,582
	Short-term debt			8,516		12,369
	Other current liabilities			34,821		29,521

		Total current liabilities		396,434		400,064
Noncurrent liabilities:
	Other benefits payable			50,094		47,282
	Deferred income taxes			33,088		29,259
	Postretirement benefits other than pension			17,626		18,005
	Other noncurrent liabilities			15,819		19,421
Liabilities from discontinued operations				—		5,069

		Total liabilities		513,061		519,100
Shareholders' equity (see Note H):
	Common stock			255,006		249,566
	Retained earnings (deficit)			4,529		(41,979	)
	Accumulated other comprehensive income			22,051		635

		Total shareholders' equity		281,586		208,222

Total liabilities and shareholders' equity			$	794,647	$	727,322

See Notes to Interim Consolidated Financial Statements.

COBALT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

			Three months ended June 30,						Six months ended June 30,
			2002			2001			2002			2001
			(In thousands, except share data)
Revenues:
	Health services revenue:
		Premium	$	339,129		$	366,883		$	677,095		$	516,905
		Government contract fees		27,971			29,107			56,780			56,010
		Other		12,150			11,541			23,414			19,243
	Investment results			3,631			3,490			6,562			5,554

		Total revenues		382,881			411,021			763,851			597,712
Expenses:
	Medical and other benefits			290,808			332,750			583,166			461,190
	Selling, general, administrative and other			80,581			81,115			157,449			136,050
	Interest			71			207			243			207
	Amortization of goodwill			—			1,520			—			1,701

		Total expenses		371,460			415,592			740,858			599,148

Operating income (loss) from continuing operations				11,421			(4,571	)		22,993			(1,436	)
Income (loss) from investment in affiliates, net of tax				12,465			658			15,317			(1,193	)

Pretax income (loss) from continuing operations				23,886			(3,913	)		38,310			(2,629	)
Income tax expense				1,124			18			2,304			18

Income (loss) from continuing operations				22,762			(3,931	)		36,006			(2,647	)
Income from discontinued operations:
	Income (loss) from discontinued operations, net of tax			—			135			(550	)		135
	Gain (loss) on sale of discontinued operations, net of tax			(250	)		—			9,659			—

Net income (loss)			$	22,512		$	(3,796	)	$	45,115		$	(2,512	)

Earnings (loss) per share (EPS):
	Basic EPS from continuing operations		$	0.56		$	(0.09	)	$	0.88		$	(0.07	)
	Basic EPS from discontinued operations			(0.01	)		—			0.23			—

		Total basic EPS	$	0.55		$	(0.09	)	$	1.11		$	(0.07	)

	Diluted EPS from continuing operations		$	0.54		$	(0.09	)	$	0.86		$	(0.07	)
	Diluted EPS from discontinued operations			(0.01	)		—			0.22			—

		Total diluted EPS	$	0.53		$	(0.09	)	$	1.08		$	(0.07	)

See Notes to Interim Consolidated Financial Statements.

COBALT CORPORATION
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)

				Common Shares Outstanding	Common Stock		Retained Earnings (Deficit)			Accumulated Other Comprehensive Income (Loss)			Total Shareholders' Equity
				(In thousands, except share data)
Balance at December 31, 2000				—	$	—	$	170,907		$	(1,964	)	$	168,943
		Capitalization of Wisconsin United for Health Foundation, Inc.		31,313,390		192,577		(192,577	)		—			—
	Issuance of common stock—acquisition			9,096,303		55,938		—			—			55,938
	Issuance of common stock—options			11,250		51		—			—			51
	Issuance of common stock—401(k)			172,100		1,000		—			—			1,000
	Adjustments as a result of purchase accounting			—		—		82			—			82
	Change in ownership of affiliates			—		—		1,320			—			1,320
	Conversion of SAR's to options			—		—		594			—			594
	Comprehensive loss:
		Net loss		—		—		(22,305	)		—			(22,305	)
		Change in unrealized gains/losses on investments, net of tax		—		—		—			2,599			2,599

			Comprehensive loss											(19,706	)

Balance at December 31, 2001				40,593,043	$	249,566	$	(41,979	)	$	635		$	208,222
	Issuance of common stock—options			448,967		4,990		—			—			4,990
	Issuance of common stock—401(k)			64,880		450		—			—			450
	Change in ownership of affiliates			—		—		1,304			—			1,304
	Conversion of SAR's to options—vesting			—		—		89			—			89
	Comprehensive income:
		Net income		—		—		45,115			—			45,115
		Change in unrealized gains/losses on investments, net of tax		—		—		—			21,416			21,416

			Comprehensive income											66,531

Balance at June 30, 2002				41,106,890	$	255,006	$	4,529		$	22,051		$	281,586

See Notes to Interim Consolidated Financial Statements.

COBALT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

					Six months ended June 30,
					2002			2001
					(In thousands)
Operating activities:
	Income (loss) from continuing operations				$	36,006		$	(2,647	)
	Adjustments to reconcile income (loss) from continuing operations to net cash provided by (used in) operating activities:
		Depreciation and amortization				5,510			7,563
		(Income) loss from investment in affiliates, net of tax				(15,317	)		1,193
		Realized investment gains, net				(27	)		(80	)
		Deferred income taxes				38			602
		Changes in operating accounts, net of discontinued operations, acquisitions and conversion/combination related activity:
			Premium receivables			(503	)		6,845
			Other receivables			6,198			(5,420	)
			Due from clinics and providers			4,657			1,642
			Medical and other benefits payable			(22,664	)		(14,211	)
			Advance premiums			(2,520	)		2,582
			Due to/from affiliates, net			(794	)		(9,890	)
			Other, net			(8,877	)		4,418

				Net cash provided by (used in) continuing operations		1,707			(7,403	)
Investing activities:
	Acquisitions and Combination activity					—			49,538
	Proceeds from sale of investment in affiliate					68,436			—
	Proceeds from sale of discontinued operations					17,000			—
	Purchases of available-for-sale investments					(96,529	)		(75,921	)
	Purchases of held-to-maturity investments					—			(1,303	)
	Proceeds from maturity of held-to-maturity investments					245			250
	Proceeds from sale and maturity of available-for-sale investments					32,130			63,430
	Additions to property and equipment, net					(5,321	)		(2,561	)
	Dividends from affiliate					552			—

				Net cash provided by investing activities		16,513			33,433
Financing activities:
	Proceeds from issuance of common stock					3,963			38
	Net (repayments) borrowings of debt					(6,853	)		4,335

				Net cash provided by (used in) financing activities		(2,890	)		4,373
Discontinued Operations:
	Cash flows from discontinued operations					479			(314	)

				Net cash provided by (used in) discontinued operations		479			(314	)
Cash and cash equivalents:
	Increase during the period					15,809			30,089
	Balance at beginning of year					51,669			1,305

				Balance at end of period	$	67,478		$	31,394

See Notes to Interim Consolidated Financial Statements.

COBALT CORPORATION
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

June 30, 2002

Note A. Basis of Presentation

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States ("GAAP") for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 30, 2002 are not necessarily indicative of the results that may be expected for the year ending December 31, 2002. These interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2001 and footnotes thereto included in the Cobalt Corporation ("Cobalt" or the "Company") Annual Report on Form 10-K for the year ended December 31, 2001, as filed with the Securities and Exchange Commission ("SEC").

Cobalt (formerly known as United Wisconsin Services, Inc. ("UWS")) was created as a result of the combination of UWS and Blue Cross & Blue Shield United of Wisconsin ("BCBSUW") on March 23, 2001 (the "Combination"). On that date, BCBSUW converted from a service insurance corporation to a stockholder owned corporation. Upon conversion, BCBSUW became a wholly-owned subsidiary of UWS through the combination of the two companies. At the time of conversion and the Combination, BCBSUW owned approximately 46.6% of UWS' outstanding common stock. In exchange for the ownership of BCBSUW, Cobalt issued 31,313,390 shares of newly issued Company common stock to Wisconsin United for Health Foundation, Inc. (the "Foundation"). The Foundation was established for the sole purpose of benefiting public health in Wisconsin from its earnings in the investment in Cobalt.

The Combination was accounted for as a purchase by BCBSUW of the remaining 9,096,303 shares of UWS that it did not already own at a market price of $6.15 per share on the closing date. In accordance with GAAP, goodwill was recorded representing the excess of the market price over the adjusted book value of UWS for the 53.4% of UWS that BCBSUW did not already own. For reporting purposes, the Combination is treated as a reverse purchase transaction, whereby BCBSUW becomes the acquirer and reporting entity for public company reporting. The consolidated statements of operations, cash flows, and changes in shareholders' equity and comprehensive income (loss) for the three and six month periods ended June 30, 2002 reflect the operations of the combined UWS and BCBSUW entities. Results for the three month period ended March 31, 2001, which are reflected in the consolidated financial statements for the six months ended June 30, 2001, include only the operations of BCBSUW and its wholly-owned subsidiary, United Government Services, LLC ("UGS") and minority interest in UWS and American Medical Security Group, Inc. ("AMSG"). Results for the three month period ended June 30, 2001, included in the consolidated financial statements for the six months ended June 30, 2001, reflect the operations of the combined UWS and BCBSUW entities. For purposes of calculating earnings per common share ("EPS") of the Company, the 7,949,904 shares of Cobalt common stock owned by BCBSUW are accounted for as treasury stock. The pro forma statement of operations for the six months ended June 30, 2001 for Cobalt presented in Note E, includes the operations of the former UWS and BCBSUW with elimination of intracompany transactions, the recording of purchase accounting adjustments and the amortization of goodwill calculated as if the transaction was completed at the beginning of the reporting period.

Continuing operations in the consolidated financial statements subsequent to the Combination include the accounts of the Company's majority owned insurance subsidiaries (BCBSUW, Compcare Health Services Insurance Corporation ("CompcareBlue"), Unity Health Plans Insurance Corporation ("Unity"), Valley Health Plan, Inc. ("Valley"), United Wisconsin Insurance Company ("UWIC"), and United Heartland Life Insurance Company ("UHLIC")) and other non-insurance subsidiaries (UGS, Meridian Resource Company, LLC ("MRC"), Comprehensive Receivables Group, Inc. ("CRG"), United Wisconsin Proservices, Inc. ("Proservices"), United Heartland, Inc. ("UHI") and C.C. Holdings, LLC ("CC Holdings")). All intracompany transactions after March 31, 2001 have been eliminated in consolidation.

Note B. Discontinued Operations

On March 29, 2002, Cobalt and certain affiliates sold 100% of the membership interest of its subsidiary, Innovative Resource Group, LLC ("IRG"), for $27.0 million ($17.0 million in cash and $10.0 million in a three-year note). IRG was one of Cobalt's specialty companies, which provided behavioral health and medical management services. Accordingly, IRG is accounted for as a discontinued operation for all periods presented. The purchase agreement also provides for certain bonuses/penalties to be received/paid between IRG and Cobalt based on revenues generated from Cobalt and affiliated entities in future years. In addition, the agreement requires certain subsidiaries of Cobalt to enter into seven-year service agreements for the provision of services by IRG.

The net gain on disposition of discontinued operations was $9.1 million, which includes a realized gain on the sale of $9.6 million, offset by a $0.5 million loss on IRG's operations for the six months ended June 30, 2002. During the second quarter of 2002, additional expenses of $0.3 million, related to the sale, were recorded adjusting the original gain down to $9.6 million from $9.9 million. The net gain on the sale could be adjusted further, based on any payments made in future periods in accordance with the purchase and sale agreement. Income from discontinued operations amounted to $0.1 million for the three and six month periods ended June 30, 2001. This reflects activity for the second quarter of 2001 only, since IRG was not considered part of Cobalt for financial reporting purposes prior to the Combination.

Note C. Net Income (Loss) Per Share

		Three months ended June 30,					Six months ended June 30,
		2002		2001			2002		2001
		(unaudited)
Numerator (in thousands):
	Net income (loss)	$	22,512	$	(3,796	)	$	45,115	$	(2,512	)

Denominator:
	Denominator for basic EPS—weighted average shares		40,904,010		40,415,278			40,771,339		36,341,914
	Effect of dilutive securities—employee stock options		1,509,543		—			988,952		—

Denominator for diluted EPS			42,413,553		40,415,278			41,760,291		36,341,914

Earnings (loss) per common share: