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EX-32 - EX-32, SECTION 906 CEO AND CFO CERTIFICATION - TIVITY HEALTH, INC.ex32.htm
EX-23 - EX-23, CONSENT OF ERNST & YOUNG LLP - TIVITY HEALTH, INC.ex23.htm
EX-21 - EX-21, SUBSIDIARY LIST - TIVITY HEALTH, INC.ex21.htm
EX-31.1 - EX-31.1, SECTION 302 CEO CERTIFICATION - TIVITY HEALTH, INC.ex31-1.htm
EX-31.2 - EX-31.2, SECTION 302 CFO CERTIFICATION - TIVITY HEALTH, INC.ex31-2.htm
EX-10.18 - EX-10.18, EMPLOYMENT AGREEMENT DATED JANUARY 7, 2009 BETWEEN THE COMPANY AND R. CLAIBORNE RICHARDS, JR. - TIVITY HEALTH, INC.ex10-18.htm
EX-10.17 - EX-10.17, EMPLOYMENT AGREEMENT DATED JANUARY 7, 2009 BETWEEN THE COMPANY AND CHRIS CIGARRAN - TIVITY HEALTH, INC.ex10-17.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-K

[X]  Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 
For the Fiscal Year Ended December 31, 2009

or

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

Commission file number 000-19364
 
 
GRAPHIC
 
HEALTHWAYS, INC.
(Exact name of registrant as specified in its charter)

Delaware
 
62-1117144
(State or other jurisdiction of
 
(I.R.S. Employer
incorporation or organization)
 
Identification No.)

701 Cool Springs Boulevard, Franklin, TN  37067
(Address of principal executive offices) (Zip code)

(615) 614-4929
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class
 
Name of each exchange on which registered
Common Stock - $.001 par value, and
 
The NASDAQ Stock Market LLC
 
related Preferred Stock Purchase Rights
   
   
 

Securities registered pursuant to Section 12(g) of the Act:
None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes  ¨   No  x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.
Yes  ¨   No  x

 
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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.
Yes  x   No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes   ¨   No   ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.                   x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non- accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  ¨ Accelerated filer  x   Non-accelerated filer  ¨    Smaller reporting company  ¨


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

Yes  ¨   No  x

As of June 30, 2009, the last business day of the registrant’s most recently completed second fiscal quarter, the aggregate market value of the shares held by non-affiliates of the registrant was approximately $443.0 million based on the price at which the shares were last sold for such date on The NASDAQ Stock Market.

As of March 5, 2010, 34,023,510 shares of Common Stock were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s Proxy Statement for the Annual Meeting of Stockholders to be held May 28, 2010 are incorporated by reference into Part III of this Form 10-K.

 
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Healthways, Inc.
Form 10-K
Table of Contents


     
Page
Part I
     
 
Item 1.
 
Item 1A.
 
Item 1B.
 
Item 2.
 
Item 3.
 
Item 4.
Part II
     
 
Item 5.
 
   
 
Item 6.
 
Item 7.
 
   
 
Item 7A.
 
Item 8.
 
Item 9.
 
   
 
Item 9A.
 
Item 9B.
Part III
     
 
Item 10.
 
Item 11.
 
Item 12.
 
Item 13.
 
Item 14.
Part IV
     
 
Item 15.


 
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PART I.

Item 1. Business

Founded in 1981, Healthways, Inc. provides specialized, comprehensive solutions to help people improve physical, emotional and social well-being, reducing both direct healthcare costs and costs associated with the loss of health-related employee productivity.

We provide highly specific and personalized interventions for each individual in a population, irrespective of health status, age or payor.  Our evidence-based health, prevention and well-being services are made available to consumers via phone, direct mail, the Internet, face-to-face consultations and venue-based interactions.

In North America, our customers include health plans, governments, employers, pharmacy benefit managers, and hospitals in all 50 states, the District of Columbia and Puerto Rico. We also provide health improvement programs and services in Germany, Brazil and Australia.  We operate care enhancement and coaching centers worldwide staffed with licensed health professionals.  Our fitness center network encompasses more than 15,000 U.S. locations.  We also maintain an extensive network of over 37,000 complementary and alternative medicine and chiropractic practitioners, which offers convenient access to the significant number of individuals who seek health services outside of the traditional healthcare system.

Our guiding philosophy and approach to market is predicated on the fundamental belief that healthier people cost less and are more productive.  As described more fully below, our programs are designed to help keep healthy individuals healthy, mitigate and delay the progression to disease associated with family or lifestyle risk factors, and optimize care for those who are already affected by health conditions or disease.

First, our programs are designed to help keep healthy people healthy by:

 
·
fostering wellness and disease prevention through total population screening, health risk assessments and supportive interventions; and
 
·
providing access to health improvement programs, such as fitness, weight management, and complementary and alternative medicine.

Our prevention programs focus on education, physical fitness, health coaching, behavior change techniques and support, and evidence-based interventions to drive adherence to proven standards of care, medication regimens and physicians’ plans of care.  We believe this approach optimizes the health status of member populations and reduces the short- and long-term direct healthcare costs for participants, including costs associated with the loss of health-related employee productivity.

Second, our programs are designed to drive healthy behaviors and mitigate lifestyle risk by:

 
·
promoting the reduction of lifestyle behaviors that lead to poor health or chronic conditions; and
 
·
providing educational materials and personal interactions with highly trained nurses and other healthcare professionals to create and sustain healthier behaviors for those individuals at-risk or in the early stages of chronic conditions.

 
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We enable our customers to engage everyone in their covered populations through specific interventions that are sensitive to each individual’s health risks and needs. Our products are designed to motivate people to make positive lifestyle changes and accomplish individual goals, such as increasing physical activity for seniors through the Healthways SilverSneakers® fitness program or overcoming nicotine addiction through the QuitNet® on-line smoking cessation community.

Finally, our programs are designed to optimize care for those with existing conditions or disease by:

 
·
incorporating the latest, evidence-based clinical guidelines into interventions to optimize patient health outcomes;
 
·
developing care support plans and motivating members to set attainable goals for themselves;
 
·
providing local market resources to address acute episodic interventions;
 
·
coordinating members’ care with their healthcare providers;
 
·
providing software licensing and management consulting in support of well-being improvement services; and
·      providing high-risk care management for members at risk for hospitalization due to complex conditions.

Our approach is to use proprietary, analytic models to identify individuals who are likely to incur future high costs without intervention, including those who have specific gaps in care that can be addressed to reduce disease progression and medical spending.

We recognize that each individual plays a variety of roles in his or her pursuit of health, often simultaneously.  By providing the full spectrum of services to meet each individual’s needs, we believe our interventions can be delivered at scale and in a manner that reflects those unique needs over time.  We believe creating real and sustainable behavior change generates measurable, long-term cost savings and improved business performance.

Change in Fiscal Year

In August 2008, our Board of Directors approved a change in our fiscal year-end from August 31 to December 31.  Accordingly, our 2009 fiscal year began on January 1, 2009 following a four-month transition period ended December 31, 2008.  References herein to fiscal 2009 refer to the year ended December 31, 2009; references herein to fiscal 2008 and fiscal 2007 refer to the years ended August 31, 2008 and 2007, respectively.

Customer Contracts

Contract Terms

We generally determine our contract fees by multiplying a contractually negotiated rate per member per month (“PMPM”) by the number of members covered by our services during the month.  We typically set the PMPM rates during contract negotiations with customers based on the value we expect our programs to create and a sharing of that value between the customer and the Company.  In addition, some of our services, such as the SilverSneakers fitness program, are billed on a fee for service basis.

Our contracts with health plans generally range from three to five years with provisions for subsequent renewal; contracts with self-insured employers, either directly or through their health plans or pharmacy benefit manager, typically have one to three-year terms.  Some of our contracts allow the customer to terminate early.

 
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Some of our contracts provide that a portion (up to 100%) of our fees may be refundable to the customer (“performance-based”) if our programs do not achieve, when compared to a baseline year, a targeted percentage reduction in the customer’s healthcare costs and selected clinical and/or other criteria that focus on improving the health of the members.  Approximately 4% of revenues recorded during fiscal 2009 were performance-based and were subject to final reconciliation as of December 31, 2009.  We anticipate that this percentage will fluctuate due to the level of performance-based fees in new contracts and the timing and amount of revenue recognition associated with performance-based fees.  Some contracts also provide opportunities for us to receive incentive bonuses in excess of the contractual PMPM rate if we exceed contractual performance targets.

Technology

Our solutions require sophisticated analytical, data management, Internet and computer-telephony solutions based on state-of-the-art technology. These solutions help us deliver our services to large populations within our customer base. Our predictive modeling capabilities allow us to identify and stratify those participants who are most at risk for an adverse health event. We incorporate behavior-change science with consumer-friendly interactions such as face-to-face, telephonic, print materials and web portals to facilitate consumer preferences for engagement and convenience. We use sophisticated data analytical and reporting solutions to validate the impact of our programs on clinical and financial outcomes. We continue to invest heavily in technology and are continually expanding and improving our proprietary clinical, data management, and reporting systems to continue to meet the information management requirements of our services.  The behavior change techniques incorporated in our technology identify an individual’s readiness to change and provide personalized support through appropriate messaging and convenient venues to motivate and sustain healthy behaviors.

Domestic Commercial Billed Lives and Domestic Commercial Available Lives

The number of domestic commercial available lives and domestic commercial billed lives as of December 31, 2009 and August 31, 2008 were as follows:

       
December 31,
 
August 31,
   
   
(In 000s)
 
2009
 
2008
   
   
Available lives(1)
 
196,700
 
192,500
   
   
Billed lives
 
36,000
 
31,700
   

(1) Estimated based on the Atlantic Information Services, Inc. (AIS) Directory of Health Plans and publicly available information.

Backlog

Backlog represents the estimated annualized revenue at target performance for business awarded but not yet started at December 31, 2009.  Annualized revenue in backlog as of December 31, 2009 and August 31, 2008 was as follows:

       
December 31,
 
August 31,
 
   
(In 000s)
 
2009
 
2008
 
   
Annualized revenue in backlog
 
$
32,400
 
$
13,600
 

    Demand for our services from self-insured employer accounts, which generally begin their benefit year on January 1, has historically resulted in a disproportionate amount of our new business beginning on this date.

 
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Business Strategy

 The World Health Organization defines health as “…not only the absence of infirmity and disease, but also a state of physical, mental, and social well-being.”

Our business strategy reflects our passion to enhance health and well-being, and as a result, reduce overall costs and improve workforce engagement, yielding better business performance for our customers.  Our programs are designed to:

 
·
keep healthy individuals healthy;
 
·
mitigate and delay the progression of disease associated with family or lifestyle risk factors; and
 
·
optimize care for those who are already affected by health conditions or disease.

Through our solutions, we work to optimize the health and well-being of entire populations, one person at a time, domestically and internationally, thereby creating value by reducing overall costs and improving productivity for individuals, families, health plans, governments and employers.

We believe it is critical to impact an entire population’s underlying health status and well-being in a long-term, cost effective way.  Believing that what gets measured gets acted upon, in January 2008, we entered into an exclusive, 25-year relationship with Gallup to provide a national, daily pulse of individual and collective well-being.  The Gallup-Healthways Well-Being IndexTM is the result of a unique partnership in well-being measurement and research that is based on surveys of 1,000 Americans every day, seven days a week.  Under the agreement, Gallup evaluates and reports on the well-being of individuals of countries, states and communities; Healthways provides similar services for companies, families and individuals.

To improve measurements like the Well-Being Index and thus enhance health and well-being within their respective populations, our current and prospective customers require solutions that focus on the underlying drivers of healthcare demand, address worsening health status, reverse or slow unsustainable cost trends, foster healthy behaviors, mitigate health risks, and manage chronic conditions.  Our strategy is to deliver programs that engage individuals and help them enhance their health status and well-being regardless of their starting point.  We believe we can achieve health and well-being improvements in a population and generate significant cost savings and increases in productivity by providing effective programs that support the individual throughout his or her health journey.

We are adding and enhancing solutions to extend our reach and effectiveness and to meet increasing demand for integrated solutions.  The flexibility of our programs allows customers to provide those services they deem appropriate for their organizations.  Customers may select from certain single program options up to a total-population approach, in which all members of a customer’s population are eligible to receive benefits.

Our strategy includes as a priority the ongoing development of an order-of-magnitude increase in our value proposition through, most recently, the introduction of our WholeHealth solution.  This solution, in addition to improving health and reducing direct healthcare costs, targets a much larger improvement in employer profitability by lowering the costs of lost productivity due to health-related reasons.  With the success of our WholeHealth solution, we expect to gain an even greater competitive advantage in responding to employers’ needs for a healthier, higher-performing and less costly workforce.

Our strategy also includes the further enhancement of our proprietary next generation technology platform known as Embrace.  This platform, which is essential to our WholeHealth solution, enables us to integrate data from all the healthcare and other entities interacting with an individual.  Embrace enables the

 
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delivery of our integrated solutions and ongoing communications between the individual and his/her medical and health experts, using any method desired, including venue-based face-to-face; print; phone; mobile and remote devices; on-line; emerging modalities; and any combination thereof.

We plan to increase our competitive advantage in delivering our services by leveraging our scalable, state-of-the-art call centers, medical information content, behavior change processes and techniques, strategic relationships, health provider networks, fitness center relationships, and proprietary technologies and techniques.  We anticipate we will continue to enhance, expand and further integrate capabilities, pursue opportunities in domestic government and international markets, and enhance our information technology support.  We may add some of these new capabilities and technologies through internal development, strategic alliances with other entities and/or through selective acquisitions or investments.

Segment and Major Customer Information

We have one reportable segment, well-being improvement services.  During fiscal 2009, CIGNA HealthCare, Inc. comprised approximately 19% of our revenues.  No other customer accounted for 10% or more of our revenues in fiscal 2009.

Competition

The healthcare industry is highly competitive and subject to continual change in the manner in which services are provided.  Other entities, whose financial, research, staff, and marketing resources may exceed our resources, are marketing a variety of well-being improvement services and other services to health plans and self-insured employers, or have announced an intention to offer such services.  These entities include disease management companies, health and wellness companies, retail drug stores, major pharmaceutical companies, health plans, healthcare organizations, providers, pharmacy benefit management companies, medical device and diagnostic companies, healthcare information technology companies, web-based medical content companies, and other entities that provide services to health plans and self-insured employers.

We believe we have advantages over our competitors because of the breadth and depth of our well-being improvement capabilities, state-of-the-art call center technology linked to our proprietary information technology, predictive modeling capabilities, behavior-change techniques, the comprehensive recruitment, pre-testing and training of our clinical colleagues, our experienced management team, the comprehensive clinical nature of our product offerings, our established reputation for providing well-being improvement services to members with health risks or chronic diseases, and the proven financial and clinical outcomes of our programs; however, we cannot assure you that we can compete effectively with other companies such as those noted above.

Consolidation has been, and may continue to be, an important factor in all aspects of the healthcare industry, including the well-being and health management sector.  While we believe the size of our membership base provides us with the economies of scale to compete even in a consolidating market, we cannot assure you that we can effectively compete with companies formed as a result of industry consolidation or that we can retain existing health plan customers if they are acquired by other health plans which already have or are not interested in our programs.

Governmental Regulation

Governmental regulation impacts us in a number of ways in addition to those regulatory risks presented under the “Risk Factors” below.

While many of the governmental and regulatory requirements affecting healthcare delivery generally do not directly affect us, our customers must comply with a variety of regulations including the licensing and

 
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reimbursement requirements of federal, state and local agencies and the requirements of municipal building codes and health codes.  Certain of our services, including health service utilization management and certain claims payment functions, require licensure by government agencies.  We are subject to a variety of legal requirements in order to obtain and maintain such licenses.

Certain of our professional healthcare employees, such as nurses, must comply with individual licensing requirements.  All of our healthcare professionals who are subject to licensing requirements are licensed in the state in which they are physically present, such as the professionals located at a call center.  Multiple state licensing requirements for healthcare professionals who provide services telephonically over state lines may require some of our healthcare professionals to be licensed in more than one state.  We continually monitor legislative, regulatory and judicial developments in telemedicine in order to stay in compliance with state and federal laws; however, new agency interpretations, federal or state legislation or regulations, or judicial decisions could increase the requirement for multi-state licensing of all call center health professionals, which would increase our costs of services.

Changes in laws governing reimbursement to health plans providing services under governmental programs such as Medicare and Medicaid may affect us.  Legislative and regulatory bodies may continue to reduce the funding of the Medicare and Medicaid programs in an effort to reduce overall federal healthcare spending.  These changes, healthcare reform efforts, future legislative initiatives, and/or government regulation could adversely affect our operations or reduce the demand for our services.

Federal privacy regulations issued pursuant to the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) extensively restrict the use and disclosure of individually-identifiable health information by health plans, most healthcare providers, and certain other entities (collectively, “covered entities”).  Federal security regulations issued pursuant to HIPAA require covered entities to implement and maintain administrative, physical and technical safeguards to protect the confidentiality, integrity and availability of electronic individually-identifiable health information.  We are required to comply with certain aspects of the HIPAA privacy and security regulations as a result of the American Recovery and Reinvestment Act of 2009 (“ARRA”) and our customer contracts.  Under ARRA we may be subject to civil and criminal penalties for violations of the regulations.  In addition ARRA significantly increased the civil penalties for violations, with penalties of up to $50,000 per violation for a maximum civil penalty of $1.5 million in a calendar year for violations of the same requirement.  In addition, we are contractually obligated to comply with any applicable state laws or regulations related to privacy that are more restrictive than the federal privacy regulations.  We may also be directly subject to state requirements related to the confidentiality and security of confidential personal information.  In the event of a data breach involving individually identifiable information, we are subject to contractual obligations and state and federal requirements that may require us to notify our customers or individuals affected by the breach.  These requirements may also require us or our customers to notify regulatory agencies and the media of the data breach.

Further, the healthcare industry is highly regulated at the federal and state levels. For example, federal law contains various prohibitions related to false statements and false claims, some of which apply to private payors as well as federal programs.  Actions may be brought under the federal False Claims Act by the government as well as by private individuals, known as “whistle blowers,” who are permitted to share in any settlement or judgment.

When a private party brings an action under the whistleblower provisions of the False Claims Act, the defendant will generally not be aware of the lawsuit until the government makes a determination of whether it will intervene and take a lead in the litigation. There are many potential bases for liability under the False Claims Act. Although liability under the False Claims Act arises when an entity knowingly submits a false claim for reimbursement to the federal government, the False Claims Act defines the term “knowingly” broadly. Thus, although simple negligence generally will not give rise to liability under the False Claims Act,

 
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submitting a claim with reckless disregard for its truth or falsity can constitute “knowingly” submitting a claim. In some cases, whistleblowers, the federal government, and some courts have taken the position that entities who allegedly have violated other statutes, such as the “fraud and abuse” provisions of the Social Security Act, have thereby submitted false claims under the False Claims Act.  The Fraud Enforcement and Recovery Act of 2009 expanded the scope of the False Claims Act by, among other things, creating liability for knowingly or improperly avoiding repayment of an overpayment received from the government and broadening protections for whistleblowers.  From time to time, participants in the healthcare industry, including our company, may be subject to actions under the False Claims Act, and it is not possible to predict the impact of such actions.  As discussed under Item 3: “Legal Proceedings”, we were subject to a “whistle blower” action filed in June 1994 on behalf of the United States government by a former employee whom we dismissed in February 1994.  This lawsuit was settled effective April 1, 2009.

Employees

As of March 8, 2010, we had approximately 3,000 employees.  Our employees are not subject to any collective bargaining agreements.  We believe we have a good relationship with our employees.

Available Information

Our Internet address is www.healthways.com.  We make available free of charge, on or through our Internet website, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.


In the execution of our business strategy, our operations and financial condition are subject to certain risks.  A summary of certain material risks is provided below, and you should take such risks into account in evaluating any investment decision involving our company.  This section does not describe all risks applicable to us and is intended only as a summary of certain material factors that could impact our operations in the industry in which we operate.  Other sections of this Annual Report on Form 10-K contain additional information concerning these and other risks.

We depend on payments from customers, and cost reduction pressure on these entities may adversely affect our business and results of operations.

The healthcare industry in which we operate currently faces significant cost reduction pressures as a result of increased competition, constrained revenues from governmental and private revenue sources, increasing underlying medical care costs, and general economic conditions.  We believe that these pressures will continue and possibly intensify.

We believe that our solutions, which are geared to foster wellness and disease prevention and provide access to health improvement programs, specifically assist our customers in controlling the high costs of healthcare; however, the pressures to reduce costs in the short term may negatively affect our ability to sign and/or retain contracts under existing terms or to restructure these contracts on terms that would not have a material negative impact on our results of operations.  These financial pressures could have a negative impact on our results of operations.




 
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A significant percentage of our revenues is derived from health plan customers.

A significant percentage of our revenues is derived from health plan customers.  The health plan industry continues to undergo a period of consolidation, and we cannot assure you that we will be able to retain health plan customers if they are acquired by other health plans which already have or are not interested in our programs.  In addition, a reduction in the number of covered lives enrolled with our health plan customers or a decision by our health plan customers to take programs in-house could adversely affect our results of operations.  As discussed below, the uncertainty surrounding healthcare reform may cause our health plan customers or prospective customers to reduce or delay the purchase of our services.

We currently derive a large percentage of our revenues from one customer.  The loss of, or the restructuring of a contract with, this or other large customers could have a material adverse effect on our business and results of operations.

Because of the size of its membership and the number of programs purchased from us, CIGNA HealthCare, Inc. comprised approximately 19% of our revenues in fiscal 2009.  Our contract with CIGNA continues into 2013.  No other customer accounted for 10% or more of our revenues in fiscal 2009.

Our industry is a continually evolving segment of the healthcare industry.

The rapidly growing industry in which we operate is a continually evolving segment of the overall healthcare industry with many entrants marketing various services and products labeled as wellness and prevention, disease management, health management, health support and care support.  Companies have used the generic labels of wellness, prevention, disease management and/or health management to characterize a wide range of activities, from the sale of medical supplies and drugs to demand management services.  Because the industry is continually evolving, purchasers of these services have not had significant experience purchasing, evaluating or monitoring the new products and services which are being developed, which generally results in a lengthy sales cycle for new contracts.  As the industry matures, the number of programs that customers have been purchasing has generally expanded from one or two programs to a more comprehensive suite of programs.  These changes result in a sizable contract commitment that generally requires approval from the customer’s executive management, thus elongating the sales process in some cases.

Our business strategy is dependent in part on developing new and additional products to complement our existing services, as well as establishing additional distribution channels through which we may offer our products and services.

           Our strategy focuses on keeping healthy people healthy, mitigating and delaying the progression of disease associated with family or lifestyle risk factors, and optimizing care for those who are already affected by health conditions or disease.  While we have considerable experience in solutions with a broad range of medical conditions, any new or modified programs will involve inherent risks of execution, such as our ability to implement our programs within expected timelines or cost estimates; our ability to obtain adequate financing to provide the capital that may be necessary to support our operations and to support or guarantee our performance under new contracts; and our ability to deliver outcomes on any new products or services.  In addition, as part of our business strategy, we may enter into relationships, such as our strategic relationship with Medco Health Solutions, Inc., to establish additional distribution channels through which we may offer our products and services.  As we offer products through new or alternative distribution channels, we may face difficulties, such as potential customer overlap that may lead to pricing conflicts, which may adversely affect our business.

 
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Our inability to meet or exceed the targets under our customer contracts could have a material adverse effect on our business and results of operations.

Our ability to grow and expand our business is contingent upon our ability to achieve desired financial savings, clinical performance targets, and productivity improvement under our existing contracts and to favorably resolve contract billing and interpretation issues with our customers.  Unusual and unforeseen patterns of healthcare utilization by individuals with diabetes, cardiac, respiratory and/or other diseases or conditions for which we provide services could adversely affect our ability to achieve desired financial savings and clinical outcomes.

We depend on the timely receipt of accurate data from our customers and our accurate analysis of such data.

Identifying which members are eligible to receive our services and measuring our performance under our contracts are highly dependent upon the timely receipt of accurate data from our customers and our accurate analysis of such data.  Data acquisition, data quality control and data analysis are complex processes that carry a risk of untimely, incomplete or inaccurate data from our customers or flawed analysis of such data, which could have a material adverse impact on our ability to recognize revenues.

Certain customer contracts are performance-based, and all or a portion of our fees may be refundable if certain performance targets are not achieved.

Certain customer contracts provide that all or a portion of our fees may be refundable to the customer if our programs do not achieve targeted savings performance.  There is no guarantee that we will effect the necessary cost savings and clinical outcomes improvements under our contracts within the time frames contemplated and reach mutual agreement with customers with respect to cost savings.  In addition, our ability to provide financial guidance with respect to performance-based contracts is contingent upon our ability to accurately forecast performance and the timing of revenue recognition under the terms of our contracts ahead of data collection and reconciliation.

Our ability to recognize estimated annualized revenue in backlog is based on certain estimates.

Our ability to recognize estimated annualized revenue in backlog in the manner and within the timeframe we expect is based on certain estimates regarding the implementation of our services.  We cannot assure you that the amounts in backlog will ultimately result in revenues in the manner and within the timeframe we expect.

Changes in macroeconomic conditions may adversely affect our business.

Economic difficulties in the credit markets and other macroeconomic conditions, such as the current recession, have reduced the demand and/or the timing of purchases for certain of our services from customers and potential customers.  A loss of a customer or a reduction in a customer’s enrolled lives could have a material adverse effect on our business and results of operations.  In addition, current economic conditions have created liquidity and credit constraints in the markets.  We cannot assure you that we would be able to secure additional financing if needed and, if such funds were available, whether the terms or conditions would be acceptable to us.

 
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The expansion of our services into international markets subjects us to additional business, regulatory and financial risks.

We intend to continue expanding our international operations as part of our business strategy.  We have incurred and expect to continue to incur costs in connection with pursuing business opportunities in international markets.  Our success in the international markets will depend in part on our ability to anticipate the rate of market acceptance of our solutions and the individual market dynamics and regulatory requirements in potential international markets.  Because the international market for our services is relatively immature with varied healthcare delivery systems and involves many first-time purchasers of our services, there is no guarantee that we will be able to effect the necessary cost savings and clinical outcomes improvements under our contracts with international customers within the time frames contemplated and reach mutual agreement with customers with respect to those outcomes.  The failure to accurately forecast the costs necessary to implement our strategy of establishing a presence in these markets could have a material adverse effect on our business.

In addition, as a result of doing business in foreign markets, we are subject to a variety of risks which are different from or additional to the risks we face within the United States. Our future operating results in these countries or in other countries or regions throughout the world could be negatively affected by a variety of factors, most of which are beyond our control.  These factors include political conditions, economic conditions, legal and regulatory constraints, currency regulations, and other matters in any of the countries or regions in which we operate, now or in the future.  In addition, foreign currency exchange rates and fluctuations may have an impact on our future costs or on future cash flows from our international operations, and could adversely affect our financial performance.  Other factors which may impact our international operations include foreign trade, monetary and fiscal policies both of the United States and of other countries, laws, regulations and other activities of foreign governments, agencies and similar organizations. Additional risks inherent in our international operations generally include, among others, the costs and difficulties of managing international operations, adverse tax consequences and greater difficulty in enforcing intellectual property rights in countries other than the United States.

We may experience difficulties associated with the implementation and/or integration of new businesses or technologies.

We may face substantial difficulties, costs and delays in effectively implementing and/or integrating new businesses and technologies into our platform.  Implementing internally-developed solutions and/or integrating newly acquired organizations and technologies could be costly and time-consuming and may strain our resources.  Consequently, we may not be successful in implementing and/or integrating these new businesses or technologies and may not achieve anticipated revenue and cost benefits.

Our level of indebtedness could adversely affect our future financial condition.

On December 1, 2006, we entered into a Third Amended and Restated Revolving Credit and Term Loan Agreement (the “Third Amended Credit Agreement”) in conjunction with the acquisition of Axia.  The Third Amended Credit Agreement contains various financial covenants, restricts the payment of dividends, and limits the amount of repurchases of our common stock.  As of December 31, 2009, our total long-term debt, including the current portion, was $256.5 million.

Our indebtedness could have a material adverse effect on our financial condition by, among other things:

·  
increasing our vulnerability to a downturn in general economic conditions or to increases in interest rates, particularly with respect to the portion of our outstanding debt that is subject to variable interest rates;

 
13

 
 
·  
potentially limiting our ability to obtain additional financing or to obtain such financing on favorable terms;
·  
causing us to dedicate a portion of future cash flow from operations to service or pay down our debt, which reduces the cash available for other purposes, such as operations, capital expenditures, and future business opportunities; and
·  
possibly limiting our ability to adjust to changing market conditions and placing us at a competitive disadvantage compared to our competitors who may be less leveraged.

Our ability to service our indebtedness will depend on our ability to generate cash in the future.  We cannot assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available in an amount sufficient to enable us to service our indebtedness or to fund other liquidity needs.

Current economic conditions, including turmoil and uncertainty in the financial services industry, have created constraints on liquidity and the ability of some entities to obtain credit from banks or in the capital markets.  We cannot assure you that we would always be able to obtain additional financing, if needed, and, if such funds were available, whether the terms or conditions would be acceptable to us.

We are exposed to risks related to counterparty creditworthiness and non-performance by counterparties of their contractual obligations.

In order to manage our exposure to market risks from changes in interest rates on our variable rate indebtedness under the Third Amended Credit Agreement, we have entered into eight interest rate swap agreements.  Consequently, we are exposed to potential fluctuations in the fair value of the interest rate swaps in the event of a change in the creditworthiness of a counterparty or the non-performance by a counterparty to the interest rate swap agreements, which could negatively impact our results of operations.

We have a significant amount of goodwill and intangible assets, the value of which could become impaired.

We have recorded significant portions of the purchase price of certain acquisitions as goodwill and/or intangible assets.  At December 31, 2009, we had approximately $496.4 million and $101.0 million of goodwill and intangible assets, respectively.  On an ongoing basis, we evaluate whether the carrying values of goodwill and intangible assets are impaired.  If we determine that the carrying values of our goodwill and/or intangible assets are impaired, we may incur a non-cash charge to earnings which could have a material adverse effect on our results of operations for the period in which the impairment occurs and/or could impact our compliance with the covenant requirements of the Third Amended Credit Agreement.

A failure of our information systems could adversely affect our business.

Our ability to deliver our services depends on effectively using information technology.  We believe that our state-of-the-art electronic health record and call center technology provides us with a competitive advantage in the industry; however, we expect to continually invest in updating and expanding our information technology.  In some cases, we may have to make systems investments before we generate revenues from contracts with new customers.  In addition, these system requirements expose us to technology obsolescence risks.
 
 
In addition, the nature of our business involves the receipt and storage of a significant amount of health information about the participants in our programs.  If we experience a data security breach, we could be exposed to government enforcement actions and private litigation.  In addition, our customers could lose confidence in our ability to protect the health information of their members, which could cause them to discontinue usage of our services.

 
14

 

Our revenues are subject to seasonal pressure from the disenrollment processes of employer customers of our contracted health plans.  In addition, some of our contracts with employers, either direct or through their health plans, are one year in length, often beginning on January 1.

Employers typically make decisions on which health insurance carriers they will offer to their employees and also may allow employees to switch between health plans on an annual basis.  These annual membership disenrollment and re-enrollment processes of employers (whose employees are the health plan members) from health plans can result in a seasonal reduction in billed lives in January of each year.

Another seasonal impact on billed lives could occur if a health plan decided to withdraw coverage altogether for a specific line of business, such as Medicare Advantage, or in a specific geographic area, thereby automatically disenrolling previously covered members.

We face competition for staffing, which may increase our labor costs and reduce profitability.

We compete with other healthcare and services providers in recruiting qualified management and staff personnel for the day-to-day operations of our business and call centers, including nurses and other healthcare professionals.  In some markets, the scarcity of nurses and other medical support personnel has become a significant operating issue to healthcare businesses.  This shortage may require us to enhance wages and benefits to recruit and retain qualified nurses and other healthcare professionals.  A failure to recruit and retain qualified management, nurses and other healthcare professionals, or to control labor costs, could have a material adverse effect on profitability.

We are party to litigation that could force us to pay significant damages and/or harm our reputation.

We are subject to certain legal proceedings, which potentially involve large claims and significant defense costs (see Item 3: “Legal Proceedings”).  These legal proceedings and any other claims that we may face, whether with or without merit, could result in costly litigation, and divert the time, attention, and resources of our management.  Although we currently maintain liability insurance, there can be no assurance that the coverage limits of such insurance policies will be adequate or that all such claims will be covered by insurance.  Although we believe that we have conducted our operations in full compliance with applicable statutory and contractual requirements and that we have meritorious defenses to outstanding claims, it is possible that resolution of these legal matters could have a material adverse effect on our consolidated results of operations.  In addition, legal expenses associated with the defense of these matters may be material to our consolidated results of operations in a particular financial reporting period.

Compliance with new federal and state legislative and regulatory initiatives could adversely affect our results of operations or may require us to spend substantial amounts acquiring and implementing new information systems or modifying existing systems.

Our customers are subject to considerable state and federal government regulation.  Many of these regulations are vaguely written and subject to differing interpretations that may, in certain cases, result in unintended consequences that could impact our ability to effectively deliver services.  The ARRA legislation strengthening the privacy and security requirements of HIPAA is one such example.

We believe that federal requirements governing the confidentiality of individually-identifiable health information permit us to obtain individually-identifiable health information for well-being improvement purposes from a covered entity; however, state legislation or regulation could preempt federal legislation if it is more restrictive.  We are required by contract and ARRA to comply with certain aspects of these confidentiality and security regulations.

 
15

 
 
Although we continually monitor the extent to which federal and state legislation or regulations may govern our operations, new federal or state legislation or regulation in this area that restricts our ability to obtain and handle individually-identifiable health information or that otherwise restricts our operations would have a material negative impact on our results of operations.

Government regulators may interpret current regulations or adopt new legislation governing our operations in a manner that subjects us to penalties or negatively impacts our ability to provide services.

Broadly written Medicare fraud and abuse laws and regulations that are subject to varying interpretations may expose us to potential civil and criminal litigation regarding the structure of current and past contracts entered into with our customers, such as the civil lawsuit filed against us in 1994 as discussed under Item 3: “Legal Proceedings.”

Expanding the well-being and health management industry to Medicare beneficiaries enrolled in Medicare Advantage plans could lead to increased direct regulation of well-being and health management services.  Further, providing services to Medicare Advantage beneficiaries may result in our being subject directly to various federal laws and regulations, including provisions related to fraud and abuse, false claims and billing and reimbursement for services, and the federal False Claims Act.

In addition, certain of our services, including health utilization management and certain claims payment functions, require licensure by government agencies.  We are subject to a variety of legal requirements in order to obtain and maintain such licenses.  Little guidance is available to determine the scope of some of these aforementioned requirements.  Failure to obtain and maintain any required licenses or failure to comply with other laws and regulations applicable to our business could have a material negative impact on our operations.

Healthcare reform may reduce our revenues and/or require us to revise our operations.
 
National healthcare reform is a focus at the federal level.  In the final months of 2009, both houses of the U.S. Congress passed separate bills intended to reform the healthcare system through, among other things, decreasing or eliminating the number of uninsured individuals, improving quality of care, and reducing healthcare costs.  Both bills included reductions in payments that could have a material adverse impact on Medicare Advantage plans, from whom we derive a significant portion of our revenues.  While neither of these bills has yet to become law, the uncertainty surrounding healthcare reform may cause our customers or prospective customers to reduce or delay the purchase of our services. We are unable to predict what provisions, if any, will be enacted, and it is unclear whether healthcare reform will adversely affect our operations, require us to revise our operations or reduce the demand for our services.

Certain of our professional healthcare employees, such as nurses, must comply with individual licensing requirements.

All of our healthcare professionals who are subject to licensing requirements, such as the professionals located at a call center, are licensed in the state in which they are physically present.  Multiple state licensing requirements for healthcare professionals who provide services telephonically over state lines may require us to license some of our healthcare professionals in more than one state.  We continually monitor legislative, regulatory and judicial developments in telemedicine; however, new agency interpretations, federal or state legislation or regulations, or judicial decisions could increase the requirement for multi-state licensing of all call center health professionals, which would increase our costs of services.


 
16

 

Not applicable.


We lease approximately 264,000 square feet of office space in Franklin, Tennessee, which contains our corporate headquarters and one of our call centers, pursuant to an agreement that expires in February 2023.

We also lease office space for our 12 other call center locations for an aggregate of approximately 294,000 square feet of space with lease terms expiring on various dates from 2010 to 2015.  Our operations support and training offices contain approximately 130,000 square feet in aggregate and have lease terms expiring from 2010 to 2016.
 

Former Employee Action

In June 1994, a former employee whom we dismissed in February 1994 filed a “whistle blower” action on behalf of the United States government.  Subsequent to its review of this case, the federal government determined not to intervene in the litigation.  The employee sued Healthways, Inc. and our wholly-owned subsidiary, American Healthways Services, Inc. (“AHSI”), as well as certain named and unnamed medical directors and one named client hospital, West Paces Medical Center (“WPMC”), and other unnamed client hospitals.

Healthways, Inc. was subsequently dismissed as a defendant.  In addition, WPMC settled claims filed against it as part of a larger settlement agreement that WPMC’s parent organization, HCA Inc., reached within the United States government.  The plaintiff dismissed his claims against the medical directors with prejudice, and on February 7, 2007 the court granted the plaintiff’s motion and dismissed all claims against all named medical directors.

Effective as of April 1, 2009, the Company and AHSI entered into a settlement agreement with the United States of America, acting through the United States Department of Justice and on behalf of the Department of Health and Human Services (collectively, the “United States”), and the former employee in connection with the settlement of the lawsuit.  Pursuant to the settlement agreement, we paid $28 million to the United States in settlement of the litigation.  Additionally, we paid an additional $12 million for other costs and fees related to the settlement, including the estimated legal costs and expenses of the plaintiff’s attorneys.  As a result of the settlement, the court has dismissed the lawsuit with prejudice.

In a related matter, we have settled the arbitration claim filed against us by WPMC and the arbitration counter-claim we filed against WPMC in February 2006, both of which sought indemnification for certain costs and expenses incurred in connection with the qui tam case.  The arbitration has been dismissed with prejudice.
 
Securities Class Action Litigation

Beginning on June 5, 2008, Healthways and certain of its present and former officers and/or directors were named as defendants in two putative securities class actions filed in the U.S. District Court for the Middle District of Tennessee, Nashville Division. On August 8, 2008, the court ordered the consolidation of the two related cases, appointed lead plaintiff and lead plaintiff’s counsel, and granted lead plaintiff leave to file a consolidated amended complaint. 

 
17

 
 
The amended complaint, filed on September 22, 2008, alleges that the Company and the individual defendants violated Sections 10(b) of the Securities Exchange Act of 1934 (the “Act”) and that the individual defendants violated Section 20(a) of the Act as “control persons” of Healthways.  The amended complaint further alleges that certain of the individual defendants also violated Section 20A of the Act based on their stock sales.  The plaintiff purports to bring these claims for unspecified monetary damages on behalf of a class of investors who purchased Healthways stock between July 5, 2007 and August 25, 2008. 
 
 
In support of these claims, the lead plaintiff alleges generally that, during the proposed class period, the Company made misleading statements and omitted material information regarding (1) the purported loss or restructuring of certain contracts with customers, (2) the Company’s participation in the Medicare Health Support (“MHS”) pilot program for the Centers for Medicare & Medicaid Services, and (3) the Company’s guidance for fiscal year 2008.  The defendants filed a motion to dismiss the amended complaint on November 13, 2008.  On March 9, 2009, the Court denied the defendants’ motion to dismiss.  The parties have exchanged discovery requests, and the discovery phase of the lawsuit is presently underway.  

Shareholder Derivative Lawsuits

Also, on June 27, 2008 and July 24, 2008, respectively, two shareholders filed putative derivative actions purportedly on behalf of Healthways in the Chancery Court for the State of Tennessee, Twentieth Judicial District, Davidson County, against certain directors and officers of the Company.  These actions are based upon substantially the same facts alleged in the securities class action litigation described above.  The plaintiffs are seeking to recover damages in an unspecified amount and equitable and/or injunctive relief. 

On August 13, 2008, the Court consolidated these two lawsuits and appointed lead counsel.  On October 3, 2008, the Court ordered that the consolidated action be stayed until the motion to dismiss in the securities class action had been resolved by the District Court.  By stipulation of the parties, the plaintiffs filed their consolidated complaint on May 9, 2009.  On June 19, 2009, the defendants filed a motion to dismiss the consolidated complaint.  The Court granted the defendants’ motion to dismiss on October 14, 2009.  The plaintiffs filed a notice of appeal on November 12, 2009.
 
 
ERISA Lawsuits

Additionally, on July 31, 2008, a purported class action alleging violations of the Employee Retirement Income Security Act (“ERISA”) was filed in the U.S. District Court for the Middle District of Tennessee, Nashville Division against Healthways, Inc. and certain of its directors and officers alleging breaches of fiduciary duties to participants in the Company’s 401(k) plan.  The central allegation is that Company stock was an imprudent investment option for the 401(k) plan. 

An amended complaint was filed on September 29, 2008, naming as defendants the Company, the Board of Directors, certain officers, and members of the Investment Committee charged with administering the 401(k) plan.  The amended complaint alleged that the defendants violated ERISA by failing to remove the Company stock fund from the 401(k) plan when it allegedly became an imprudent investment, by failing to disclose adequately the risks and results of the MHS pilot program to 401(k) plan participants, and by failing to seek independent advice as to whether to continue to permit the plan to hold Company stock.  It further alleged that the Company and its directors should have been more closely monitoring the Investment Committee and other plan fiduciaries.  The amended complaint sought damages in an undisclosed amount and other equitable relief.  The defendants filed a motion to dismiss on October 29, 2008.   On January 28, 2009, the Court granted the defendants’ motion to dismiss the plaintiff’s claims for breach of the duty to disclose with regard to any non-public information and information beyond the specific disclosure requirements of

 
18

 

ERISA and denied Defendants’ motion to dismiss as to the remainder of the plaintiff’s claims.  A period of discovery ensued.

 On May 12, 2009, the plaintiff filed a motion for class certification.  After the plaintiff failed, without explanation, to appear for his scheduled deposition, the Court issued an Order on July 10, 2009 warning the plaintiff that his failure to participate in the lawsuit could result in sanctions, including but not limited to dismissal.  After the plaintiff’s failure to participate continued, on July 23, 2009, the defendants filed a motion to dismiss for failure to prosecute the action.  On August 6, 2009, the parties filed a stipulation of dismissal with prejudice as to the named plaintiff but otherwise without prejudice, and the Court entered an Order to that effect on the same date.  

On February 1, 2010, a new named plaintiff filed another putative class action complaint in the United States District Court for the Middle District of Tennessee, Nashville Division, alleging ERISA violations in the administration of the Company’s 401(k) plan.  The new complaint is identical to the original complaint, including the allegations and the requests for relief.  Defendants’ answer to this complaint is due to be filed on or about March 22, 2010.


Not applicable.

Executive Officers of the Registrant

The following table sets forth certain information regarding our executive officers as of December 31, 2009.  Executive officers of the Company serve at the pleasure of the Board of Directors.

Officer
Age
Position
     
Ben R. Leedle, Jr.
48
Chief Executive Officer and director of the Company since September 2003, President from May 2002 through October 2008, Executive Vice President and Chief Operating Officer of the Health Plan Group from 2000 until May 2002.  Senior Vice President from 1996 until 2000.
     
Stefen F. Brueckner
60
President and Chief Operating Officer of the Company since October 2008.  Vice President, Senior Products, for Humana Inc., from 2005 to 2008 and Vice President, Market Operations and Large Group Underwriting, from 2001 to 2005.
     
Mary A. Chaput
59
Chief Financial Officer and Secretary of the Company since October 2001.
     
Matthew E. Kelliher
54
President, International Business, of the Company since September 2004.
     
Alfred Lumsdaine
44
Chief Accounting Officer since February 2002.
     
Anne M. Wilkins
43
Vice President, Marketing and Strategy, of the Company since May 2008.  Partner and Managing Director and lead of the North America Payer practice of the Boston Consulting Group from 2003 to 2008.


 
19

 

PART II

 

Market Information

Our common stock is traded over-the-counter on The NASDAQ Stock Market (“NASDAQ”) under the symbol HWAY.

The following table sets forth the high and low sales prices per share of Common Stock as reported by NASDAQ for the relevant periods.

       
High
   
Low
   
   
Year ended December 31, 2009
             
   
First quarter
 
$
15.52
 
$
7.01
 
   
Second quarter
   
14.78
   
8.27
 
   
Third quarter
   
16.86
   
12.03
 
   
Fourth quarter
   
19.44
   
13.31
 
                   
   
Four months ended December 31, 2008
 
$
19.96
 
$
5.35
 
                   
   
Year ended August 31, 2008
             
   
First quarter
 
$
60.88
 
$
48.99
 
   
Second quarter
   
71.22
   
28.43
 
   
Third quarter
   
37.79
   
29.68
 
   
Fourth quarter
   
34.60
   
18.57
 

Holders

At March 5, 2010, there were approximately 16,500 holders of our Common Stock, including 191 stockholders of record.

Dividends

We have never declared or paid a cash dividend on our common stock.  We intend to retain our earnings to finance the growth and development of our business and do not expect to declare or pay any cash dividends in the foreseeable future.  Our Board of Directors will review our dividend policy from time to time and may declare dividends at its discretion.  Our Third Amended Credit Agreement restricts the payment of dividends.  For further discussion of the Third Amended Credit Agreement, see “Management’s Discussion and Analysis of Financial Condition and Results of Operation - Liquidity and Capital Resources.”




 
20

 



(In thousands, except per share data)
                                             
     
Year Ended December 31,
   
Four Months Ended December 31,
     
Year Ended August 31,
 
     
2009
 
 
2008
 
 
 
 2008
 
 
 
2007
 
 
 
2006
 
 
 
2005
 
     
(1) (2)
   
(1) (2)
     
(1) (2)
     
(1) (2)
     
(1)
         
Operating Results:
                                                       
Revenues
 
$
717,426
   
$
244,737
     
$
736,243
     
$
615,586
     
$
412,308
     
$
312,504
 
Cost of services (exclusive of depreciation and amortization included below)
   
522,999
     
177,651
       
503,940
       
417,721
       
281,161
       
205,253
 
Selling, general and administrative expenses
   
71,535
     
27,790
       
71,342
       
67,352
       
44,417
       
28,418
 
Depreciation and amortization
   
49,289
     
16,188
       
47,479
       
37,044
       
24,517
       
22,408
 
Impairment loss
   
     
4,344
       
       
       
       
 
Restructuring and related charges
   
     
10,264
       
       
       
       
 
Operating income
 
$
73,603
   
$
8,500
     
$
113,482
     
$
93,469
     
$
62,213
     
$
56,425
 
Gain on sale of investment
   
(2,581
)
   
       
       
       
       
 
Interest expense
   
15,717
     
6,757
       
20,927
       
18,185
       
1,053
       
1,630
 
Legal settlement and related costs
   
39,956
     
       
       
       
       
 
                                                         
Income before income taxes
 
$
20,511
   
$
1,743
     
$
92,555
     
$
75,284
     
$
61,160
     
$
54,795
 
Income tax expense
   
10,137
     
1,009
       
37,741
       
30,163
       
24,009
       
21,711
 
Net income
 
$
10,374
   
$
734
     
$
54,814
     
$
45,121
     
$
37,151
     
$
33,084
 
                                                         
Basic income per share: (1)
 
$
0.31
   
$
0.02
     
$
1.57
     
$
1.29
     
$
1.08
     
$
1.00
 
                                                         
Diluted income per share: (1)
 
$
0.30
   
$
0.02
     
$
1.50
     
$
1.22
     
$
1.02
     
$
0.93
 
                                                         
Weighted average common shares and
                                                       
equivalents:
                                                       
Basic
   
33,730
     
33,616
       
34,977
       
35,049
       
34,348
       
33,241
 
Diluted
   
34,359
     
34,038
       
36,597
       
37,002
       
36,379
       
35,691
 
                                                         
Balance Sheet Data:
                                                       
Cash and cash equivalents
 
$
2,356
   
$
5,157
     
$
35,242
     
$
47,655
     
$
154,792
     
$
63,467
 
Working capital (deficit)
   
(44,296
)
   
(6,034
)
     
21,276
       
10,792
       
124,469
       
70,644
 
Total assets
   
882,366
     
883,090
       
906,813
       
828,845
       
382,386
       
270,954
 
Long-term debt
   
254,345
     
304,372
       
345,395
       
297,059
       
236
       
416
 
Other long-term liabilities
   
42,615
     
39,533
       
31,227
       
14,388
       
10,853
       
9,055
 
Stockholders’ equity
   
377,277
     
357,036
       
354,334
       
362,750
       
274,873
       
206,930
 
                                                         
Other Operating Data:
                                                       
Billed lives
   
36,000
     
32,900
       
31,700
       
27,400
       
2,426
       
1,883
 
Annualized revenue in backlog
 
$
32,400
   
$
35,900
     
$
13,600
     
$
39,900
     
$
6,625
     
$
32,578
 

(1)
Includes $13.9 million, $14.7 million, $18.1 million, $21.0 million, and $15.3 million during fiscal 2009, the four months ended December 31, 2008, and fiscal 2008, 2007, and 2006, respectively, of costs related to equity-based awards expensed under accounting principles generally accepted in the United States of America (“U.S. GAAP”) and cash-based awards issued in lieu of equity-based awards that were historically granted to certain levels of management.  These cash-based awards are a result of changes in the design of the Company's long-term incentive compensation program in preparation for adopting a new accounting pronouncement governing stock-based compensation on September 1, 2005.
(2)
Includes operating results, balance sheet data, and other operating data of Axia Health Management, Inc. since the date of the acquisition, which was December 1, 2006.


 
21

 

Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operation

Overview

 Founded in 1981, Healthways, Inc. provides specialized, comprehensive solutions to help people improve physical, emotional and social well-being, reducing both direct healthcare costs and costs associated with the loss of health-related employee productivity.

We provide highly specific and personalized interventions for each individual in a population, irrespective of health status, age or payor.  Our evidence-based health, prevention and well-being services are made available to consumers via phone, direct mail, the Internet, face-to-face consultations and venue-based interactions.

In North America, our customers include health plans, governments, employers, pharmacy benefit managers, and hospitals in all 50 states, the District of Columbia and Puerto Rico. We also provide health improvement programs and services in Germany, Brazil and Australia.  We operate care enhancement and coaching centers worldwide staffed with licensed health professionals.  Our fitness center network encompasses more than 15,000 U.S. locations.  We also maintain an extensive network of over 37,000 complementary and alternative medicine and chiropractic practitioners, which offers convenient access to the significant number of individuals who seek health services outside of the traditional healthcare system.

Our guiding philosophy and approach to market is predicated on the fundamental belief that healthier people cost less and are more productive.  As described more fully below, our programs are designed to help keep healthy individuals healthy, mitigate and delay the progression to disease associated with family or lifestyle risk factors, and optimize care for those who are already affected by health conditions or disease.

First, our programs are designed to help keep healthy people healthy by:

 
·
fostering wellness and disease prevention through total population screening, health risk assessments and supportive interventions; and
 
·
providing access to health improvement programs, such as fitness, weight management, and complementary and alternative medicine.

Our prevention programs focus on education, physical fitness, health coaching, behavior change techniques and support, and evidence-based interventions to drive adherence to proven standards of care, medication regimens and physicians’ plans of care.  We believe this approach optimizes the health status of member populations and reduces the short- and long-term direct healthcare costs for participants, including costs associated with the loss of health-related employee productivity.

Second, our programs are designed to drive healthy behaviors and mitigate lifestyle risk by:

 
·
promoting the reduction of lifestyle behaviors that lead to poor health or chronic conditions; and
 
·
providing educational materials and personal interactions with highly trained nurses and other healthcare professionals to create and sustain healthier behaviors for those individuals at-risk or in the early stages of chronic conditions.

 
22

 

We enable our customers to engage everyone in their covered populations through specific interventions that are sensitive to each individual’s health risks and needs. Our products are designed to motivate people to make positive lifestyle changes and accomplish individual goals, such as increasing physical activity for seniors through the Healthways SilverSneakers® fitness program or overcoming nicotine addiction through the QuitNet® on-line smoking cessation community.

Finally, our programs are designed to optimize care for those with existing conditions or disease by:

 
·
incorporating the latest, evidence-based clinical guidelines into interventions to optimize patient health outcomes;
 
·
developing care support plans and motivating members to set attainable goals for themselves;
 
·
providing local market resources to address acute episodic interventions;
 
·
coordinating members’ care with their healthcare providers;
 
·
providing software licensing and management consulting in support of well-being improvement services; and
 
·
providing high-risk care management for members at risk for hospitalization due to complex conditions.

Our approach is to use proprietary, analytic models to identify individuals who are likely to incur future high costs without intervention, including those who have specific gaps in care that can be addressed to reduce disease progression and medical spending.

We recognize that each individual plays a variety of roles in his or her pursuit of health, often simultaneously.  By providing the full spectrum of services to meet each individual’s needs, we believe our interventions can be delivered at scale and in a manner that reflects those unique needs over time.  We believe creating real and sustainable behavior change generates measurable, long-term cost savings and improved business performance.

Change in Fiscal Year

In August 2008, our Board of Directors approved a change in our fiscal year-end from August 31 to December 31.  Accordingly, our 2009 fiscal year began on January 1, 2009 following a four-month transition period ended December 31, 2008.  References herein to fiscal 2009 refer to the year ended December 31, 2009; references herein to fiscal 2008 and fiscal 2007 refer to the years ended August 31, 2008 and 2007, respectively.

Forward-Looking Statements

Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements, which are based upon current expectations and involve a number of risks and uncertainties.  Forward-looking statements include all statements that do not relate solely to historical or current facts, and can be identified by the use of words like “may,” “believe,” “will,” “expect,” “project,” “estimate,” “anticipate,” “plan,” or “continue.”  In order for us to use the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, we caution you that the following important factors, among others, may affect these forward-looking statements.  Consequently, actual operations and results may differ materially from those expressed in the forward-looking statements.  The important factors include but are not limited to:

 
 
·
our ability to sign and implement new contracts for our solutions;
 
·
our ability to retain existing customers and to renew or maintain contracts with our customers under existing terms or restructure these contracts on terms that would not have a material negative impact on our results of operations;

 
23

 
 
 
·
our ability to accurately forecast performance and the timing of revenue recognition under the terms of our customer contracts ahead of data collection and reconciliation in order to provide forward-looking guidance;
 
·
the impact of national healthcare reform proposals and the potential impact of healthcare reform legislation, if enacted, on our operations and/or the demand for our services;
 
·
the impact of any new or proposed legislation, regulations and interpretations relating to the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, including the potential expansion to Phase II for Medicare Health Support programs and any legislative or regulatory changes with respect to Medicare Advantage;
 
·
our ability to reach mutual agreement with the Centers for Medicare & Medicaid Services (“CMS”) with respect to results under Phase I of Medicare Health Support;
 
·
our ability to anticipate the rate of market acceptance of our solutions in potential international markets;
 
·
our ability to accurately forecast the costs necessary to implement our strategy of establishing a presence in international markets;
 
·
the risks associated with foreign currency exchange rate fluctuations and our ability to hedge against such fluctuations;
 
·
the risks associated with a significant concentration of our revenues with a limited number of customers;
 
·
our ability to effect cost savings and clinical outcomes improvements under our contracts and reach mutual agreement with customers with respect to cost savings, or to effect such savings and improvements within the time frames contemplated by us;
 
·
our ability to achieve estimated annualized revenue in backlog in the manner and within the timeframe we expect, which is based on certain estimates regarding the implementation of our services;
 
·
our ability and/or the ability of our customers to enroll participants in our programs in a manner and within the timeframe anticipated by us;
 
 
·
the ability of our customers to provide timely and accurate data that is essential to the operation and measurement of our performance under the terms of our contracts;
 
·
our ability to favorably resolve contract billing and interpretation issues with our customers;
 
·
our ability to service our debt and make principal and interest payments as those payments become due;
 
·
the risks associated with changes in macroeconomic conditions, which may reduce the demand and/or the timing of purchases for our services from customers or potential customers, reduce the number of covered lives of our existing customers, restrict our ability to obtain additional financing, or impact the availability of credit under our Third Amended Credit Agreement;
 
·
counterparty risk associated with our interest rate swap agreements and foreign currency exchange contracts;
 
·
our ability to integrate acquired businesses or technologies into our business;
 
·
the impact of any impairment of our goodwill or other intangible assets;
 
·
our ability to develop new products and deliver outcomes on those products;
 
·
our ability to implement our new integrated data and technology solutions platform within the timeframe and cost estimates that we expect;
 
·
our ability to obtain adequate financing to provide the capital that may be necessary to support our operations and to support or guarantee our performance under new contracts;
 
·
unusual and unforeseen patterns of healthcare utilization by individuals with diabetes, cardiac, respiratory and/or other diseases or conditions for which we provide services;
 
·
the ability of our customers to maintain the number of covered lives enrolled in the plans during the terms of our agreements;
 
·
the impact of litigation involving us and/or our subsidiaries;

 
24

 
 
 
·
the impact of future state, federal, and international healthcare and other applicable legislation and regulations on our ability to deliver our services and on the financial health of our customers and their willingness to purchase our services;
 
·
current geopolitical turmoil, the continuing threat of domestic or international terrorism, and the potential emergence of a health pandemic; and
·      other risks detailed in this Annual Report on Form 10-K, including those set forth in Item 1A.

We undertake no obligation to update or revise any such forward-looking statements.

Critical Accounting Policies

We describe our accounting policies in Note 1 of the Notes to the Consolidated Financial Statements.  We prepare the consolidated financial statements in conformity with U.S. GAAP, which requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and related disclosures at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results may differ from those estimates.

We believe the following accounting policies are the most critical in understanding the estimates and judgments that are involved in preparing our financial statements and the uncertainties that could impact our results of operations, financial condition and cash flows.

Revenue Recognition

We generally determine our contract fees by multiplying a contractually negotiated rate per member per month (“PMPM”) by the number of members covered by our services during the month.  We typically set the PMPM rates during contract negotiations with customers based on the value we expect our programs to create and a sharing of that value between the customer and the Company.  In addition, some of our services, such as the SilverSneakers fitness program, are billed on a fee for service basis.

Our contracts with health plans generally range from three to five years with provisions for subsequent renewal; contracts with self-insured employers, either directly or through their health plans or pharmacy benefit manager, typically have one to three-year terms. Some of our contracts allow the customer to terminate early.

Some of our contracts provide that a portion (up to 100%) of our fees may be refundable to the customer (“performance-based”) if our programs do not achieve, when compared to a baseline year, a targeted percentage reduction in the customer’s healthcare costs and selected clinical and/or other criteria that focus on improving the health of the members.  Approximately 4% of revenues recorded during fiscal 2009 were performance-based and were subject to final reconciliation as of December 31, 2009.  We anticipate that this percentage will fluctuate due to the level of performance-based fees in new contracts and the timing and amount of revenue recognition associated with performance-based fees.  Some contracts also provide opportunities for us to receive incentive bonuses in excess of the contractual PMPM rate if we exceed contractual performance targets.

We generally bill our customers each month for the entire amount of the fees contractually due for the prior month’s enrollment, which typically includes the amount, if any, that is performance-based and may be subject to refund should we not meet performance targets.  Deferred revenues arise from contracts which permit upfront billing and collection of fees covering the entire contractual service period, generally 12 months.  Contractually, we cannot bill for any incentive bonus until after contract settlement.  Fees for service are typically billed in the month after the services are provided.

 
25

 
 
We recognize revenue as follows: 1) we recognize the fixed portion of PMPM fees and fees for service as revenue during the period we perform our services; 2) we recognize the performance-based portion of the monthly fees based on the most recent assessment of our performance, which represents the amount that the customer would legally be obligated to pay if the contract were terminated as of the latest balance sheet date; and 3) we recognize additional incentive bonuses based on the most recent assessment of our performance, to the extent we consider such amounts collectible.

We assess our level of performance for our contracts based on medical claims and other data that the customer is contractually required to supply.  A minimum of four to six months’ data is typically required for us to measure performance.  In assessing our performance, we may include estimates such as medical claims incurred but not reported and a medical cost trend compared to a baseline year.  In addition, we may also provide contractual allowances for billing adjustments (such as data reconciliation differences) as appropriate.

In 2005, we began participating in two Medicare Health Support pilots, which concluded in January 2008 and July 2008, respectively.  Substantially all of the fees under these pilots were performance-based.  Our original cooperative agreements required that, by the end of the third year, we achieve a cumulative net savings (total savings for the intervention population as compared to the control group less fees received from CMS) of 5.0%.  Under an amendment to our agreement for our stand-alone Medicare Health Support pilot in Maryland and the District of Columbia, we began serving a “refresh population” of approximately 4,500 beneficiaries on August 1, 2006, which was measured as a separate cohort for two years, by the end of which the program was required to achieve a 2.5% cumulative net savings when compared to a new control cohort.  In April 2008, we signed an amendment to our Medicare Health Support protocol with CMS, which changed the financial performance target for both the initial and the refresh populations to budget neutrality.  In late April 2009, we received the final reconciliation report from CMS’ independent financial reconciliation contractor.  Based upon this final reconciliation report as well as our performance over the term of the pilots, we have recognized $9.5 million of cumulative performance-based fees related to these pilots and $12.2 million of fixed fees.  At December 31, 2009, approximately $57.8 million of performance-based fees related to these pilots was recorded in contract billings in excess of earned revenue, $50.3 million of which related to fees collected, and the remaining $7.5 million of which related to fees billed but not collected due to CMS withholding payment of these fees.  We submitted our objections to the final reconciliation report and engaged in discussions with CMS regarding our objections.   We, along with several other participating organizations in the Medicare Health Support pilots, have submitted a proposal to CMS to resolve the issues related to the reconciliation; however, such proposal remains subject to approval by the United States government.

If data is insufficient or incomplete to measure performance, or interim performance measures indicate that we are not meeting performance targets, we do not recognize performance-based fees subject to refund as revenues but instead record them in a current liability account entitled “contract billings in excess of earned revenue.”  Only in the event we do not meet performance levels by the end of the measurement period, typically one year, are we contractually obligated to refund some or all of the performance-based fees.  We would only reverse revenues that we had already recognized if performance to date in the measurement period, previously above targeted levels, subsequently dropped below targeted levels.  Historically, any such adjustments have been immaterial to our financial condition and results of operations.

During the settlement process under a contract, which generally occurs six to eight months after the end of a contract year, we settle any performance-based fees and reconcile healthcare claims and clinical data.  As of December 31, 2009, performance-based fees that have not yet been settled with our customers but that have been recognized as revenue in the current and prior years totaled approximately $46.4 million, all of which was based on actual data received from our customers.  Data reconciliation differences, for which we provide contractual allowances until we reach agreement with respect to identified issues, can arise between the customer and us due to customer data deficiencies, omissions, and/or data discrepancies.

 
26

 
 
Performance-related adjustments (including any amounts recorded as revenue that were ultimately refunded), changes in estimates, data reconciliation differences, or adjustments to incentive bonuses may cause us to recognize or reverse revenue in a current fiscal year that pertains to services provided during a prior fiscal year.  During fiscal 2009, we recognized a net increase in revenue of $8.6 million that related to services provided prior to fiscal 2009.

Impairment of Intangible Assets and Goodwill

We review goodwill for impairment on an annual basis (during the fourth quarter of our fiscal year) or more frequently whenever events or circumstances indicate that the carrying value may not be recoverable.

We completed an annual goodwill impairment test as of June 30, 2009 and concluded that no impairment of goodwill exists.  Due to the recent change in our fiscal year-end from August 31 to December 31, the date of our annual impairment test changed to October 31 beginning on October 31, 2009.  We completed an annual goodwill impairment test as of October 31, 2009 and concluded that no impairment of goodwill exists.

We estimate the fair value of each reporting unit using a discounted cash flow model and reconcile the aggregate fair value of our reporting units to our consolidated market capitalization.  The discounted cash flow model requires significant judgments, including management’s estimate of future cash flows, which is dependent on internal forecasts, estimation of the long-term growth rate for our business, the useful life over which cash flows will occur, and determination of our weighted average cost of capital.  Changes in these estimates and assumptions could materially affect the estimate of fair value and goodwill impairment for each reporting unit.

If we determined that the carrying value of goodwill was impaired based upon an impairment review, we would calculate any impairment using a fair-value-based goodwill impairment test as required by U.S. GAAP.  The fair value of a reporting unit is the price that would be received to sell the unit as a whole in an orderly transaction between market participants at the measurement date.

Except for a trade name which has an indefinite life and is not subject to amortization, we amortize identifiable intangible assets, such as acquired technologies and customer contracts, using the straight-line method over their estimated useful lives.  We assess the potential impairment of intangible assets subject to amortization whenever events or changes in circumstances indicate that the carrying values may not be recoverable.

We review intangible assets not subject to amortization on an annual basis or more frequently whenever events or circumstances indicate that the assets might be impaired.  We estimate the fair value of the trade name using a present value technique, which requires management’s estimate of future revenues attributable to this trade name, estimation of the long-term growth rate for these revenues, and determination of our weighted average cost of capital.  Changes in these estimates and assumptions could materially affect the estimate of fair value for the trade name.

If we determine that the carrying value of other identifiable intangible assets may not be recoverable, we calculate any impairment using an estimate of the asset’s fair value based on the estimated price that would be received to sell the asset in an orderly transaction between market participants.

Future events could cause us to conclude that impairment indicators exist and that goodwill and/or other intangible assets associated with our acquired businesses are impaired. Any resulting impairment loss could have a material adverse impact on our financial condition and results of operations.

 
27

 

Income Taxes

The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns.  Accounting for income taxes requires significant judgment in determining income tax provisions, including determination of deferred tax assets, deferred tax liabilities, and any valuation allowances that might be required against deferred tax assets, and in evaluating tax positions.

We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement.  U.S. GAAP also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures.  Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our financial position, results of operations, or cash flows.
 
 
Share-Based Compensation

We measure and recognize compensation expense for all share-based payment awards based on estimated fair values at the date of grant.  Determining the fair value of share-based awards at the grant date requires judgment in developing assumptions, which involve a number of variables.  These variables include, but are not limited to, the expected stock price volatility over the term of the awards and expected stock option exercise behavior.  In addition, we also use judgment in estimating the number of share-based awards that are expected to be forfeited.

Business Strategy

The World Health Organization defines health as “…not only the absence of infirmity and disease, but also a state of physical, mental, and social well-being.”

Our business strategy reflects our passion to enhance health and well-being, and as a result, reduce overall costs and improve workforce engagement, yielding better business performance for our customers.  Our programs are designed to:

·
keep healthy individuals healthy;
·
mitigate and delay the progression of disease associated with family or lifestyle risk factors; and
·
optimize care for those who are already affected by health conditions or disease.

Through our solutions, we work to optimize the health and well-being of entire populations, one person at a time, domestically and internationally, thereby creating value by reducing overall costs and improving productivity for individuals, families, health plans, governments and employers.

We believe it is critical to impact an entire population’s underlying health status and well-being in a long-term, cost effective way.  Believing that what gets measured gets acted upon, in January 2008, we entered into an exclusive, 25-year relationship with Gallup to provide a national, daily pulse of individual and collective well-being.  The Gallup-Healthways Well-Being IndexTM is a unique partnership in well-being

 
28

 

measurement and research that is based on surveys of 1,000 Americans every day, seven days a week.  Under the agreement, Gallup evaluates and reports on the well-being of individuals of countries, states and communities; Healthways provides similar services for companies, families and individuals.

To improve measurements like the Well-Being Index and thus enhance health and well-being within their respective populations, our current and prospective customers require solutions that focus on the underlying drivers of healthcare demand, address worsening health status, reverse or slow unsustainable cost trends, foster healthy behaviors, mitigate health risks, and manage chronic conditions.  Our strategy is to deliver programs that engage individuals and help them enhance their health status and well-being regardless of their starting point.  We believe we can achieve health and well-being improvements in a population and generate significant cost savings and increases in productivity by providing effective programs that support the individual throughout his or her health journey.

We are adding and enhancing solutions to extend our reach and effectiveness and to meet increasing demand for integrated solutions.  The flexibility of our programs allows customers to provide those services they deem appropriate for their organizations.  Customers may select from certain single program options up to a total-population approach, in which all members of a customer’s population are eligible to receive benefits.

Our strategy includes as a priority the ongoing development of an order-of-magnitude increase in our value proposition through introducing our WholeHealth solution.  This solution, in addition to improving health and reducing direct healthcare costs, targets a much larger impact on employer profitability by lowering the costs of lost productivity due to health-related reasons.  With the success of our WholeHealth solution, we expect to gain a significant competitive advantage in responding to employers’ needs for a healthier, higher-performing and less costly workforce.

Our strategy also includes the further enhancement of our proprietary next generation technology platform known as Embrace.  This platform, which is essential to our WholeHealth solution, enables us to integrate data from all the healthcare entities interacting with an individual.  Embrace enables the delivery of our integrated solutions and ongoing communications between the individual and his/her medical and health experts, using any method desired, including venue-based face-to-face; print; phone; mobile and remote devices; on-line; emerging modalities; and any combination thereof.

We plan to increase our competitive advantage in delivering our services by leveraging our scalable, state-of-the-art call centers, medical information content, behavior change processes and techniques, strategic relationships, health provider networks, fitness center relationships, and proprietary technologies and techniques.  We anticipate we will continue to enhance, expand and further integrate capabilities, pursue opportunities in domestic government and international markets, and enhance our information technology support.  We may add some of these new capabilities and technologies through internal development, strategic alliances with other entities and/or through selective acquisitions or investments.

Results of Operations
 
 
The following table shows the components of the statements of operations for the fiscal year ended December 31, 2009, the four months ended December 31, 2008 and 2007, and the fiscal years ended August 31, 2008 and 2007 expressed as a percentage of revenues.

 
29

 


     
Year Ended December 31,
 
Four Months Ended
 
Year Ended
 
       
December 31,
 
December 31,
 
August 31,
 
     
2009
 
2008
 
2007
 
2008
 
2007
 
                         
 
Revenues
 
100.0
%
100.0
%
100.0
%
100.0
%
100.0
%
 
Cost of services (exclusive of depreciation
                     
 
and amortization included below)
 
72.9
%
72.6
%
69.9
%
68.4
%
67.9
%
 
Selling, general and administrative expenses
 
10.0
%
11.4
%
9.3
%
9.7
%
10.9
%
 
Depreciation and amortization
 
6.9
%
6.6
%
5.8
%
6.4
%
6.0
%
 
Impairment loss
 
 
1.8
%
 
 
 
 
Restructuring and related charges
 
 
4.2
%
 
 
 
 
Operating income (1)
 
10.3
%
3.5
%
15.0
%
15.4
%
15.2
%
                         
 
Gain on sale of investment
 
(0.4
)%
 
 
 
 
 
Interest expense
 
2.2
%
2.8
%
3.0
%
2.8
%
3.0
%
 
Legal settlement
 
5.6
%
 
 
 
 
                         
 
Income before income taxes
 
2.9
%
0.7
%
11.9
%
12.6
%
12.2
%
 
Income tax expense
 
1.4
%
0.4
%
4.9
%
5.1
%
4.9
%
                         
 
Net income (1)
 
1.4
%
0.3
%
7.0
%
7.4
%
7.3
%
(1) Figures may not add due to rounding.

Revenues

Revenues for fiscal 2009 decreased $18.8 million, or 2.6%, over fiscal 2008, primarily due to the following:

 
·
contract restructurings and terminations with certain customers; and
 
·
decreased revenues related to our Medicare Health Support pilots, which ended in January and July 2008, respectively.

These decreases were somewhat offset by increases in revenues primarily due to the following:

 
·
the commencement of contracts with new customers;
 
·
increased revenues from fitness center programs, primarily due to an increase in participation in these programs as well as in the number of members eligible for them;

 
30

 
 
 
·
growth in the number of self-insured employer lives under existing customer contracts;
 
·
increased performance-based revenues due to our ability to measure and achieve performance targets on certain contracts during fiscal 2009; and
 
·
increased membership in customers’ existing programs.

Revenues for the four months ended December 31, 2008 increased $10.5 million, or 4.5%, over revenues for the four months ended December 31, 2007, primarily due to the following:

 
·
the commencement of new contracts;
 
·
growth in the number of self-insured employers on behalf of our health plan customers; and
 
·
the addition of new programs or the expansion of existing programs into additional populations with existing customers.

These increases were partially offset by decreases in revenues primarily due to contract restructurings and terminations with certain customers, program terminations by certain customers, and the loss by some of our health plan customers of their administrative services only (“ASO”) employer accounts.

Revenues for fiscal 2008 increased $120.7 million, or 19.6%, over fiscal 2007 primarily due to the acquisition of Axia on December 1, 2006.  The remainder of the increase is primarily due to the following:

 
·
the addition of new customers, new programs with existing customers, or the expansion of existing programs into additional populations with existing customers since the beginning of fiscal 2007; and
 
·
increased membership in customers’ existing programs.

These increases were partially offset by decreases in revenues related to contract terminations and restructurings with certain customers.
 
 
Cost of Services

Cost of services (excluding depreciation and amortization) as a percentage of revenues for fiscal 2009 increased to 72.9% compared to 68.4% for fiscal 2008, primarily due to the following:

 
·
an increased portion of our revenue generated by fitness center and certain health improvement programs, which typically have a higher cost of services as a percentage of revenue than our other programs;
 
·
the addition of certain participating locations to our fitness center network that have a higher cost of services as a percentage of revenue;
 
·
contract restructurings with certain customers that resulted in either decreased revenues or lower per member fees without a proportional corresponding decrease in costs; and
 
·
an increase in the level of employee bonus provision based on the Company’s financial performance against established internal targets during these periods.

These increases were somewhat offset by the following decreases in cost of services as a percentage of revenues:

 
·
a decrease in salaries and benefits expense, primarily due to a restructuring of the Company that was largely completed during the fourth calendar quarter of 2008 and a decrease in health insurance costs related to changes in employee medical plan design in fiscal 2009, which included a number of wellness initiatives aimed at improving employee health; and

 
31

 
 
 
·
cost savings related to certain cost management initiatives.

During the three months ended December 31, 2009, there were no material changes in cost of services (excluding depreciation and amortization) as a percentage of revenues from previous quarters during 2009, except for a decrease in the level of employee bonus provision based on the Company’s year-to-date financial performance against established internal targets.

Cost of services (excluding depreciation and amortization) as a percentage of revenues increased to 72.6% for the four months ended December 31, 2008 compared to 69.9% for the four months ended December 31, 2007, primarily due to the following:

 
·
the completion of an offer to purchase from our employees, excluding the chief executive officer and Board of Directors, outstanding options to acquire shares of common stock of the Company that were granted between September 1, 2004 and August 15, 2008 under our shareholder-approved stock option plans (the “Tender Offer”) on December 30, 2008.  The Tender Offer resulted in additional stock-based compensation expense within cost of services of $7.4 million, representing the remaining compensation cost for these options as measured at the grant date but not yet recognized prior to the completion of the Tender Offer;
 
·
increased member utilization of fitness centers for contracts for which we receive a fixed fee per member;
 
·
contract restructurings with certain customers, as noted above, that resulted in decreased revenues without a proportional corresponding decrease in costs; and
 
·
increased costs related to information technology hosting security and storage for the four months ended December 31, 2008.

These increases were somewhat offset by the following decreases in cost of services as a percentage of revenues:

 
·
decreased costs related to the two Medicare Health Support pilots in which we participated, which ended in January 2008 and July 2008, respectively; and
 
·
cost savings related to certain cost management initiatives.

Cost of services (excluding depreciation and amortization) as a percentage of revenues for fiscal 2008 increased to 68.4% compared to 67.9% for fiscal 2007, primarily due to the following:

 
·
an increased portion of our revenue growth generated by fitness center programs, which typically have a higher cost of services as a percentage of revenue than our other programs; and
 
·
an increase in the level of employee bonus provision during fiscal 2008 compared to fiscal 2007 based on the Company’s financial performance against established internal targets during these periods.

These increases were partially offset by a decrease in cost of services as a percentage of revenues due to decreased costs during fiscal 2008 related to the two Medicare Health Support pilots in which we participated, which ended in January 2008 and July 2008, respectively.

Selling, General and Administrative Expenses

Selling, general and administrative expenses as a percentage of revenues increased to 10.0% for fiscal 2009 compared to 9.7% for fiscal 2008, primarily due to the following:

 
32

 
 
 
·
a net increase in salaries and benefits expense, primarily due to the Company restructuring in the fourth calendar quarter of 2008, which included an increased focus on research and development activities, resulting in an increase in personnel dedicated to these activities that more than offset the reduction in headcount resulting from this restructuring and other workforce reductions; and
 
·
an increase in the level of employee bonus provision based on the Company’s financial performance against established internal targets during these periods.

These increases were partially offset by a decrease in professional consulting fees primarily related to product innovation and strategic and organizational design initiatives in fiscal 2008.

Selling, general and administrative expenses as a percentage of revenues increased to 11.4% for the four months ended December 31, 2008 compared to 9.3% for the four months ended December 31, 2007, primarily due to the completion of the Tender Offer on December 30, 2008, which resulted in additional stock-based compensation expense within selling, general and administrative expenses of $4.1 million, representing the remaining compensation cost for these options as measured at the grant date but not yet recognized prior to the completion of the Tender Offer.

Selling, general and administrative expenses as a percentage of revenues decreased to 9.7% for fiscal 2008 compared to 10.9% for fiscal 2007, primarily due to the following:

 
·
efficiencies from the integration of the Axia acquisition; and
 
·
our ability to more effectively leverage our selling, general and administrative expenses as a result of growth in our operations.

These decreases were somewhat offset by an increase in selling, general and administrative expenses as a percentage of revenues for fiscal 2008 compared to fiscal 2007 related to relocating to and operating our new corporate headquarters during fiscal 2008.

Depreciation and Amortization

Depreciation and amortization expense increased 3.8% for fiscal 2009 compared to fiscal 2008, primarily due to increased depreciation expense resulting from capital expenditures of computer software, which we made to enhance our information technology capabilities, somewhat offset by a decrease in amortization expense related to certain intangible assets that became fully amortized in September 2008.

Depreciation and amortization expense increased 18.3% for the four months ended December 31, 2008 compared to the four months ended December 31, 2007, primarily due to increased depreciation expense resulting from capital expenditures of computer software and hardware, which we made to enhance our information technology capabilities, and capital expenditures related to our new corporate headquarters. This increase was partially offset by a decrease in amortization expense related to certain intangible assets that became fully amortized in September 2008.

Depreciation and amortization expense increased 28.2% for fiscal 2008 compared to fiscal 2007, primarily due to the following:

 
·
increased depreciation expense resulting from capital expenditures on computer software development, which we made to enhance our information technology capabilities;
 
·
depreciation and amortization expense associated with the depreciable assets and identifiable intangible assets recorded in connection with the Axia acquisition on December 1, 2006; and
 
·
increased amortization expense associated with patents which were acquired in August 2007.

 
33

 
 
Restructuring and Related Charges and Impairment Loss
 
During the four months ended December 31, 2008, we incurred net charges of $10.3 million related to a restructuring of the Company announced in October 2008, which primarily consisted of severance costs, net of equity forfeitures, and costs associated with capacity consolidation.
 
In December 2008, we decided to discontinue offering one of our products as a standalone program. As a result of this decision we did not renew the expiring trade name associated with this product and recorded an impairment loss of $4.3 million during the four months ended December 31, 2008 to write off this intangible asset.
 
Gain on Sale of Investment

In January 2009, a private company in which we held preferred stock was acquired by a third party.  As part of this sale, we received two payments totaling $11.6 million in January and February 2009 and recorded a gain of $2.6 million during the first quarter of 2009.

Interest Expense

Interest expense for fiscal 2009 decreased $5.2 million compared to fiscal 2008, primarily as a result of a decrease in floating interest rates on outstanding borrowings under the Third Amended Credit Agreement during fiscal 2009 compared to fiscal 2008.

Interest expense for the four months ended December 31, 2008 decreased $0.4 million compared to the four months ended December 31, 2007, primarily as a result of a decrease in interest rates on outstanding borrowings somewhat offset by a higher average level of outstanding borrowings under the Third Amended Credit Agreement during the four months ended December 31, 2008 compared to the four months ended December 31, 2007. 

Interest expense for fiscal 2008 increased $2.7 million compared to fiscal 2007, primarily related to increased interest expense during the three months ended November 30, 2007 compared to the three months ended November 30, 2006 due to borrowings under the Third Amended Credit Agreement related to the acquisition of Axia on December 1, 2006.  This increase was somewhat offset by a decrease in interest expense from lower average interest rates during fiscal 2008 compared to fiscal 2007.

Legal Settlement and Related Costs

In March 2009, our Board of Directors approved a settlement of a qui tam lawsuit filed in 1994 on behalf of the United States government related to the Company’s former Diabetes Treatment Center of America business.  As a result of the settlement, which was effective as of April 1, 2009, we incurred a charge of approximately $40 million, including a $28 million payment to the United States government and payment of approximately $12 million for other costs and fees related to the settlement, including the estimated legal costs and expenses of the plaintiff’s attorneys. 

Income Tax Expense

Our effective tax rate increased to 49.4% for fiscal 2009 compared to 40.8% for fiscal 2008, primarily due to a relatively small base of pretax income for fiscal 2009 in relation to both the lack of tax benefit on

 
34

 

certain expenses incurred in international initiatives and certain non-deductible expenses.  The differences between the statutory federal income tax rate of 35.0% and our effective tax rate are due primarily to the impact of state income taxes, the lack of tax benefit on certain expenses incurred in international initiatives, and certain non-deductible expenses for income tax purposes.

Our effective tax rate increased to 57.9% for the four months ended December 31, 2008 compared to 41.1% for the four months ended December 31, 2007, primarily due to a relatively small base of pretax income for the four months ended December 31, 2008 in relation to the lack of tax benefit on certain expenses incurred in international initiatives, the impact of tax interest accruals, and the impact of certain non-deductible expenses for income tax purposes.

Our effective tax rate increased to 40.8% for fiscal 2008 compared to 40.1% for fiscal 2007, primarily due to the impact of interest accruals related to unrecognized tax benefits included in our income tax provision for fiscal 2008.  The differences between the statutory federal income tax rate of 35.0% and our effective tax rate are due primarily to the impact of state income taxes, the lack of tax benefit on certain expenses incurred in international initiatives, the tax interest accruals described above, and certain non-deductible expenses for income tax purposes.

Outlook

We anticipate that revenues for fiscal 2010 will likely decrease slightly compared to fiscal 2009 primarily due to contract restructurings and terminations with certain customers, program terminations by certain customers, and the loss by some of our health plan customers of their ASO employer accounts, which will likely more than offset increases in revenue from higher fitness center participation and from new or existing customers.

Notwithstanding the anticipated decrease in revenues in fiscal 2010, we expect cost of services and selling, general and administrative expenses as a percentage of revenues for fiscal 2010 to decrease compared to fiscal 2009 due to continuing operational efficiencies.  We anticipate depreciation and amortization expense for fiscal 2010 to increase over fiscal 2009, primarily due to amortization of capitalized software costs related to our new integrated data and technology solutions platform.

As discussed in “Liquidity and Capital Resources” below, a significant portion of our long-term debt is subject to fixed interest rate swap agreements; however, we cannot predict the potential for changes in interest rates, which would impact our variable rate debt, especially in light of current economic conditions that have created uncertainty and credit constraints in the markets.  We anticipate that our effective tax rate for fiscal 2010 will decrease to a level consistent with that incurred during fiscal 2008; however, we continue to evaluate the impact on our effective tax rate of both international operations and any future adjustments related to uncertain tax positions.

Liquidity and Capital Resources

Operating activities for the year ended December 31, 2009 generated cash of $112.9 million compared to $105.3 million for the year ended August 31, 2008.  The increase in operating cash flow resulted primarily from the following:

 
·
a decrease in income tax payments during fiscal 2009 primarily related to a smaller base of pretax income in fiscal 2009;
 
·
an increase in cash collections on accounts receivable for fiscal 2009 compared to fiscal 2008 due to the timing of cash receipts as well as an improvement in days’ sales outstanding; and
 
·
a decrease in interest payments during fiscal 2009, primarily as a result of a decrease in floating interest rates on outstanding borrowings under the Third Amended Credit Agreement.

 
35

 

These increases were somewhat offset by decreases in operating cash flow primarily related to the following:

 
·
payments during fiscal 2009 related to the aforementioned legal settlement and related costs and fees;
 
·
payments during fiscal 2009 related to a restructuring of the Company that was largely completed during the fourth quarter of calendar 2008, which primarily consisted of severance costs and costs associated with capacity consolidation; and
 
·
a higher amount of lease incentives received during fiscal 2008 compared to fiscal 2009, primarily related to our new corporate headquarters in fiscal 2008.

Investing activities during fiscal 2009 used $62.4 million in cash, which primarily consisted of costs associated with software development, purchases of property and equipment associated with relocating one of our regional offices, and business acquisitions and investments, slightly offset by proceeds from the sale of an investment, described above.

Financing activities during fiscal 2009 used $53.4 million in cash primarily due to net payments on borrowings under the Third Amended Credit Agreement.

On December 1, 2006, we entered into the Third Amended Credit Agreement. The Third Amended Credit Agreement provides us with a $400.0 million revolving credit facility, including a swingline sub facility of $10.0 million and a $75.0 million sub facility for letters of credit, a $200.0 million term loan facility, and an uncommitted incremental accordion facility of $200.0 million.  As of December 31, 2009, availability under our revolving credit facility totaled $147.7 million.

Revolving advances under the Third Amended Credit Agreement generally bear interest, at our option, at 1) LIBOR plus a spread of 0.875% to 1.750% or 2) the greater of the federal funds rate plus 0.5%, or the prime rate, plus a spread of 0.000% to 0.250%.  Term loan borrowings bear interest, at our option, at 1) LIBOR plus 1.50% or 2) the greater of the federal funds rate plus 0.5%, or the prime rate.  The Third Amended Credit Agreement also provides for a fee ranging between 0.150% and 0.300% of unused commitments. The Third Amended Credit Agreement is secured by guarantees from most of the Company’s domestic subsidiaries and by security interests in substantially all of the Company’s and such subsidiaries’ assets.
 
We are required to repay outstanding revolving loans on the revolving commitment termination date, which is December 1, 2011.  We are required to repay term loans in quarterly principal installments aggregating $0.5 million each, which commenced on March 31, 2007, and the entire unpaid principal balance of the term loans is due and payable at maturity on December 1, 2013.

The Third Amended Credit Agreement contains various financial covenants, which require us to maintain, as defined, ratios or levels of 1) total funded debt to EBITDA, 2) fixed charge coverage, and 3) net worth.  In connection with the legal settlement described above, in March 2009 we entered into a sixth amendment to the Third Amended Credit Agreement to expressly exclude up to $40 million of expenses attributable to this settlement from the calculation of earnings before interest, taxes, depreciation and amortization, or EBITDA, for purposes of covenant calculations.  The Third Amended Credit Agreement also restricts the payment of dividends and limits the amount of repurchases of the Company’s common stock.  As of December 31, 2009, we were in compliance with all of the covenant requirements of the Third Amended Credit Agreement.

 
36

 


As of December 31, 2009, we are a party to the following interest rate swap agreements for which we receive a variable rate of interest based on LIBOR and for which we pay the following fixed rates of interest plus a spread of 0.875% to 1.750% on revolving advances and a spread of 1.50% on term loan borrowings:

   
 
Swap #
 
Original Notional
Amount (in $000s)
 
Fixed Interest
Rate
 
Termination Date
         
   
1
 
$184,000
 
4.995
%
March 31, 2010
(1)
       
   
2
 
46,000
 
4.995
%
March 31, 2010
(2)
       
   
3
 
40,000
 
3.433
%
December 30, 2011
         
   
4
 
50,000
 
3.688
%
December 30, 2011
         
   
5
 
40,000
 
3.855
%
December 30, 2011
(3)
       
   
6
 
30,000
 
3.760
%
March 30, 2011
(4)
       
   
7
 
57,500
 
3.385
%
December 31, 2013
(5)
       
   
8
 
57,500
 
3.375
%
December 31, 2013
(6)
       

(1) The principal value of this swap agreement amortizes over a 39-month period.  During the three months ended December 31, 2009, the notional amount of this swap was $16 million.
(2) The principal value of this swap agreement amortizes over a 39-month period.  During the three months ended December 31, 2009, the notional amount of this swap was $4 million.
(3) This swap agreement became effective October 1, 2009.
(4) This swap agreement became effective January 2, 2010.
(5) This swap agreement becomes effective January 1, 2012.  The principal value of this swap agreement will amortize over a 24-month period.
(6) This swap agreement becomes effective January 3, 2012.  The principal value of this swap agreement will amortize over a 24-month period.

We currently meet the hedge accounting criteria under U.S. GAAP in accounting for these interest rate swap agreements.

We believe that cash flows from operating activities, our available cash, and our expected available credit under the Third Amended Credit Agreement will continue to enable us to meet our contractual obligations and to fund our current operations for the foreseeable future.  However, if our operations require significant additional financing resources, such as capital expenditures for technology improvements, additional call centers and/or letters of credit or other forms of financial assurance to guarantee our performance under the terms of new contracts, or if we are required to refund performance-based fees pursuant to contract terms, we may need to raise additional capital by expanding our existing credit facility and/or issuing debt or equity.  If we face a limited ability to arrange such financing, it may restrict our ability to effectively operate our business.  Current economic conditions, including turmoil and uncertainty in the financial services industry, have created constraints on liquidity and the ability of some entities to obtain credit from banks or in the capital markets.  We cannot assure you that we would always be able to secure additional financing if needed and, if such funds were available, whether the terms or conditions would be acceptable to us.

If contract development accelerates or acquisition opportunities arise, we may need to issue additional debt or equity to provide the funding for these increased growth opportunities.  We may also issue equity in connection with future acquisitions or strategic alliances.  We cannot assure you that we would be able to issue additional debt or equity on terms that would be acceptable to us.

 
37

 
 
Contractual Obligations

The following schedule summarizes our contractual cash obligations by the indicated period as of December 31, 2009:

     
Payments Due By Year Ended December 31,
 
 
(In $000s)
     
2011 -
 
2013 -
 
2015 and
     
 
 
 
2010
 
2012
 
2014
 
After
 
Total
 
 
Deferred compensation plan payments (1)
 
$
2,752
 
$
5,161
 
$
799
 
$
5,646
 
$
14,358
 
 
Long-term debt (2)
   
14,763
   
85,494
   
193,926
   
   
294,183
 
 
Operating lease obligations (3)
   
14,933
   
26,755
   
20,398
   
55,982
   
118,068
 
 
Purchase obligations
   
4,610
   
   
   
   
4,610
 
 
Other long-term liabilities (4)
   
419
   
2,624
   
   
   
3,043
 
 
Other contractual cash obligations (5)
   
11,547
   
19,739
   
2,013
   
18,000
   
51,299
 
 
Total contractual cash obligations
 
$
49,024
 
$
139,773
 
$
217,136
 
$
79,628
 
$
485,561
 

(1) Includes scheduled payments under a non-qualified deferred compensation plan and long-term performance awards earned by certain employees.

(2) Includes scheduled principal payments, repayment of outstanding revolving loans, and estimated interest payments on outstanding borrowings under the Third Amended Credit Agreement.  Estimated interest payments are as follows: $12.8 million for fiscal 2010, $19.5 million for fiscal 2011 and 2012, and $5.9 million for fiscal 2013 and 2014.

(3) Excludes total sublease income of $2.4 million.

(4) Includes estimated earnout payments related to the acquisition of HealthHonors in October 2009.  We have excluded long-term liabilities of $1.1 million related to uncertain tax positions as we are unable to reasonably estimate the timing of these payments in individual years due to uncertainties in the timing of effective settlement of tax positions.

(5) Other contractual cash obligations primarily represent a perpetual license agreement and 25-year strategic relationship agreement that we entered into in January 2008.  We have remaining contractual cash obligations of $35.0 million related to these agreements, $15.0 million of which will occur ratably during the next three years, and the remaining $20.0 million of which will occur ratably over the following 20 years.

Recently Issued Accounting Standards

 In April 2009, the FASB issued authoritative guidance requiring disclosures about fair value of financial instruments in both interim reporting periods of publicly traded companies as well as in annual financial statements, beginning with interim reporting periods ending after June 15, 2009.  The implementation of this guidance resulted in increased disclosures in our interim periods but did not have an impact on our financial position or results of operations.

In May 2009, the FASB issued guidance which establishes accounting and disclosure requirements for subsequent events.  The guidance defines subsequent events as events that occur after the balance sheet date but before the financial statements are issued for public entities.  It requires companies to disclose the date through which they have evaluated subsequent events and to designate subsequent events as either recognized or non-recognized.  In February 2010, the FASB issued revised guidance, effectively immediately for all financial statements that had not yet been issued, to remove the requirement for SEC filers to disclose the date

 
38

 

through which they have evaluated subsequent events.  The original guidance became effective for interim or annual periods ending after June 15, 2009.  The implementation of this guidance, as revised, resulted in increased disclosures but did not have an impact on our financial position or results of operations.
 
In June 2009, the FASB approved the FASB Accounting Standards Codification (the “Codification”).  Effective July 1, 2009, the Codification is the single source of authoritative nongovernmental U.S. GAAP, superseding existing FASB, American Institute of Certified Public Accountants (“AICPA”), Emerging Issues Task Force (“EITF”), and related accounting literature.  The Codification reorganizes the thousands of U.S. GAAP pronouncements into approximately 90 accounting topics and displays them using a consistent structure.  Also included is relevant Securities and Exchange Commission guidance organized using the same topical structure in separate sections.  
 
In December 2007, the FASB issued guidance regarding business combinations.  This guidance expands the definition of a business and a business combination and generally requires the acquiring entity to recognize all of the assets and liabilities of the acquired business, regardless of the percentage ownership acquired, at their fair values. It also requires that contingent consideration and certain acquired contingencies be recorded at fair value on the acquisition date and that acquisition costs generally be expensed as incurred.  The guidance was effective for fiscal years beginning after December 15, 2008.  The adoption of this guidance did not materially impact our financial position or results of operations when it became effective on January 1, 2009.
 
Item 7A. Quantitative and Qualitative Disclosures About Market Risk

We are subject to market risk related to interest rate changes, primarily as a result of the Third Amended Credit Agreement, which bears interest based on floating rates. Revolving advances under the Third Amended Credit Agreement generally bear interest, at our option, at 1) LIBOR plus a spread of 0.875% to 1.750% or 2) the greater of the federal funds rate plus 0.5%, or the prime rate, plus a spread of 0.000% to 0.250%. Term loan borrowings bear interest, at our option, at 1) LIBOR plus 1.50% or 2) the greater of the federal funds rate plus 0.5%, or the prime rate.

In order to manage our interest rate exposure under the Third Amended Credit Agreement, we have entered into eight interest rate swap agreements effectively converting our floating rate debt to fixed obligations with interest rates ranging from 3.375% to 4.995%.

A one-point interest rate change would have resulted in interest expense fluctuating approximately $1.0 million for fiscal 2009.

As a result of our investment in international initiatives, as of December 31, 2009 we are also exposed to foreign currency exchange rate risks. Because a significant portion of these risks is economically hedged with currency options and forwards contracts and because our international initiatives are not yet material to our consolidated results of operations, a 10% change in foreign currency exchange rates would not have had a material impact on our results of operations or financial position for fiscal 2009.  We do not execute transactions or hold derivative financial instruments for trading purposes.

 
39

 

Report of Independent Registered Public Accounting Firm

 
The Board of Directors and Stockholders of Healthways, Inc.

We have audited the accompanying consolidated balance sheets of Healthways, Inc. as of December 31, 2009 and August 31, 2008, and the related consolidated statements of operations, stockholders' equity, and cash flows for the years ended December 31, 2009, August 31, 2008 and August 31, 2007, and the four months ended December 31, 2008.  These financial statements are the responsibility of the Company's management.  Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Healthways, Inc. at December 31, 2009 and August 31, 2008, and the consolidated results of its operations and its cash flows for the years ended December 31, 2009, August 31, 2008 and August 31, 2007, and the four months ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.

As discussed in Note 5 to the consolidated financial statements, the Company changed its method of accounting for income tax contingencies with the adoption of the guidance originally issued in FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-An Interpretation of FASB Statement No. 109 (codified in FASB ASC Topic 740, Income Taxes) effective September 1, 2007.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Healthways, Inc.’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 16, 2010 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Nashville, Tennessee
March 16, 2010


 
40

 

Item 8.  Financial Statements and Supplementary Data


 HEALTHWAYS, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands)

ASSETS

   
December 31,
     
August 31,
 
   
2009
     
2008
 
Current assets:
                 
Cash and cash equivalents
 
$
2,356
     
$
35,242
 
Accounts receivable, net
   
100,833
       
113,312
 
Prepaid expenses
   
10,433
       
8,992
 
Other current assets
   
4,945
       
5,275
 
Income taxes receivable
   
6,452
       
 
Deferred tax asset
   
24,197
       
24,948
 
Total current assets
   
149,216
       
187,769
 
                   
Property and equipment:
                 
Leasehold improvements
   
40,609
       
37,475
 
Computer equipment and related software
   
166,448
       
131,296
 
Furniture and office equipment
   
28,096
       
29,209
 
Capital projects in process
   
23,052
       
12,052
 
     
258,205
       
210,032
 
Less accumulated depreciation
   
(134,046
)
     
(98,971
)
     
124,159
       
111,061
 
                   
Other assets
   
11,498
       
16,575
 
                   
Customer contracts, net
   
29,343
       
34,521
 
Other intangible assets, net
   
71,704
       
72,582
 
Goodwill, net
   
496,446
       
484,305
 
                   
Total assets
 
$
882,366
     
$
906,813
 
                   
See accompanying notes to the consolidated financial statements.
           



 
41

 

 HEALTHWAYS, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)

LIABILITIES AND STOCKHOLDERS’ EQUITY

   
December 31,
     
August 31,
 
   
2009
     
2008
 
Current liabilities:
             
Accounts payable
$
29,171
   
$
18,753
 
Accrued salaries and benefits
 
58,212
     
31,612
 
Accrued liabilities
 
25,004
     
23,555
 
Deferred revenue
 
4,639
     
6,422
 
Contract billings in excess of earned revenue
 
70,440
     
75,454
 
Income taxes payable
 
     
3,984
 
Current portion of long-term debt
 
2,192
     
2,837
 
Current portion of long-term liabilities
 
3,854
     
3,876
 
Total current liabilities
 
193,512
     
166,493
 
               
Long-term debt
 
254,345
     
345,395
 
Long-term deferred tax liability
 
14,617
     
9,364
 
Other long-term liabilities
 
42,615
     
31,227
 
               
Stockholders’ equity:
             
Preferred stock
             
$.001 par value, 5,000,000 shares
             
authorized, none outstanding
 
 —
     
 —
 
Common stock
             
$.001 par value, 120,000,000 and 75,000,000 shares authorized,
             
33,858,917 and 33,603,320 shares outstanding
 
34
     
34
 
Additional paid-in capital
 
222,472
     
207,918
 
Retained earnings
 
158,880
     
147,772
 
Accumulated other comprehensive loss
 
(4,109
)
   
(1,390
)
Total stockholders’ equity
 
377,277
     
354,334
 
               
Total liabilities and stockholders’ equity
$
882,366
   
$
906,813
 
               
See accompanying notes to the consolidated financial statements.
         


 
42

 

 HEALTHWAYS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except earnings per share data)


         
Year Ended December 31,
   
Four Months Ended December 31,
       
Year Ended August 31,
 
         
2009
   
2008
       
2008
       
2007
 
Revenues
     
$
717,426
 
$
244,737
     
$
736,243
     
$
615,586
 
Cost of services (exclusive of depreciation and amortization of $35,433, $11,805, $34,105, and $27,677, respectively, included below)
       
522,999
   
177,651
       
503,940
       
417,721
 
Selling, general and administrative expenses
       
71,535
   
27,790
       
71,342
       
67,352
 
Depreciation and amortization
       
49,289
   
16,188
       
47,479
       
37,044
 
Impairment loss
       
   
4,344
       
       
 
Restructuring and related charges
       
   
10,264
       
       
 
                                       
Operating income
       
73,603
   
8,500
       
113,482
       
93,469
 
Gain on sale of investment
       
(2,581
)
 
       
 —
       
 —
 
Interest expense
       
15,717
   
6,757
       
20,927
       
18,185
 
Legal settlement and related costs
       
39,956
   
       
       
 
                                       
Income before income taxes
       
20,511
   
1,743
       
92,555
       
75,284
 
Income tax expense
       
10,137
   
1,009
       
37,740
       
30,163
 
                                       
Net income
     
$
10,374
 
$
734
     
$
54,815
     
$
45,121
 
                                       
Earnings per share:
                                     
Basic
     
$
0.31
 
$
0.02
     
$
1.57
     
$
1.29
 
                                       
Diluted
     
$
0.30
 
$
0.02
     
$
1.50
     
$
1.22
 
                                       
                                       
Weighted average common shares and equivalents
                                     
Basic
       
33,730
   
33,616
       
34,977
       
35,049
 
Diluted
       
34,359
   
34,038
       
36,597
       
37,002
 
                                       
See accompanying notes to the consolidated financial statements.
                     




 
43

 

 HEALTHWAYS, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY
(In thousands)

                   
Accumulated
     
           
Additional
     
Other
     
   
Preferred
 
Common
 
Paid-in
 
Retained
 
Comprehensive
     
   
Stock
 
Stock
 
Capital
 
Earnings
 
Income (Loss)
 
Total
 
Balance, August 31, 2006
   
$—
   
$35
   
$140,200
   
$134,622
   
$16
   
$274,873
 
Comprehensive income:
                                     
Net income
   
 —
   
 —
   
 —
   
45,121
   
 —
   
45,121
 
Net change in fair value of interest rate
                                     
 swap, net of income tax benefit of $133
   
 —
   
 —
   
 —
   
 —
   
(205
)
 
(205
)
Foreign currency translation adjustment
   
 —
   
 —
   
 —
   
   
137
   
137
 
Total comprehensive income
                                 
45,053
 
Sale of unregistered common stock
   
 —
   
 —
   
5,000
   
 —
   
 —
   
5,000
 
Repurchases of common stock
   
   
   
(552
)
 
(5,102
)
 
   
(5,654
)
Exercise of stock options and other
   
 —
   
 —
   
11,221
   
 —
   
 —
   
11,221
 
Tax benefit of option exercises
   
 —
   
 —
   
13,421
   
 —
   
 —
   
13,421
 
Share-based employee compensation expense
   
 —
   
 —
   
18,836
   
 —
   
 —
   
18,836
 
Balance, August 31, 2007
   
$—
   
$35
   
$188,126
   
$174,641
   
$(52
)
 
$362,750
 
Cumulative effect of a change in accounting
                                     
principle – adoption of FIN 48
   
         
   
(687
)
 
   
(687
)
Comprehensive income:
                                     
Net income
   
   
 —
   
 —
   
54,815
   
 —
   
54,815
 
Net change in fair value of interest rate
                                     
swap, net of income tax benefit of $1,064
   
   
 —
   
 —
   
 —
   
(1,510
)
 
(1,510
)
Foreign currency translation adjustment
   
   
 —
   
 —
   
   
172
   
172
 
Total comprehensive income
                                 
53,477
 
Repurchases of common stock
   
 —
   
(2
)
 
(13,341
)
 
(80,997
)
 
   
(94,340
)
Exercise of stock options and other
   
 —
   
 1
   
6,710
   
 —
   
 —
   
6,711
 
Tax benefit of option exercises
   
 —
   
 —
   
9,893
   
 —
   
 —
   
9,893
 
Share-based employee compensation expense
   
 —
   
 —
   
16,530
   
 —
   
 —
   
16,530
 
Balance, August 31, 2008
   
$—
   
$34
   
$207,918
   
$147,772
   
 $(1,390
)
 
$354,334
 
Comprehensive income:
                                     
Net income
   
   
   
   
734
   
   
734
 
Net change in fair value of interest rate
                                     
swaps, net of income tax benefit of $3,371
   
   
   
   
   
(5,007
)
 
(5,007
)
Change in fair value of investment, net of
                                     
income taxes of $1,094
   
   
   
   
   
1,607
   
1,607
 
Foreign currency translation adjustment
   
   
   
   
   
(175
)
 
(175
)
Total comprehensive loss
                                 
(2,841
)
Write-off of deferred tax assets related to the
                                     
   repurchase of stock options
   
   
   
(9,088
)
 
   
   
(9,088
)
Exercise of stock options
   
   
   
56
   
   
   
56
 
Tax effect of option exercises
   
   
   
(340
)
 
   
   
(340
)
Share-based employee compensation expense
   
   
   
14,915
   
   
   
14,915
 
Balance, December 31, 2008
   
$—
   
$34
   
$213,461
   
$148,506
   
 $(4,965
)
 
$357,036
 
Comprehensive income:
                                     
Net income
   
   
   
   
10,374
   
   
10,374
 
Net change in fair value of interest rate
                                     
swaps, net of income taxes of $1,783
   
   
   
   
   
2,418
   
2,418
 
Change in fair value of investment, net of
                                     
income tax benefit of $49
   
   
   
   
   
(71
)
 
(71
)
Sale of investment, net of income taxes of
                                     
$1,045
   
   
   
   
   
(1,536
)
 
(1,536
)
Foreign currency translation adjustment
   
   
   
   
   
45
   
45
 
Total comprehensive income
                                 
11,230
 
Repurchase of stock options
   
   
   
(736
)
 
   
   
(736
)
Exercise of stock options
   
 —
   
   
727
   
 —
   
 —
   
727
 
Tax effect of option exercises
   
 —
   
 —
   
(1,193
)
 
 —
   
 —
   
(1,193
)
Share-based employee compensation expense
   
 —
   
 —
   
10,213
   
 —
   
 —
   
10,213
 
                                       
Balance, December 31, 2009
   
$—
   
$34
   
$222,472
   
$158,880
   
 $(4,109
)
 
$377,277
 

See accompanying notes to the consolidated financial statements.



 
44

 

 HEALTHWAYS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

     
Year Ended December 31,
 
Four Months Ended December 31,
 
Year Ended August 31,
     
2009
 
2008
 
2008
 
2007
                           
 
Cash flows from operating activities:
                       
 
Net income
 
$
10,374
 
$
734
 
$
54,815
 
$
45,121
 
Adjustments to reconcile net income to net cash   provided by operating activities, net of business acquisitions:
                       
 
Depreciation and amortization
   
49,289
   
16,188
   
47,479
   
37,044
 
Gain on sale of investment
   
(2,581
 
                     -
   
                   -
   
                    -
 
Loss on disposal of property and equipment
   
1,584
   
1,568
   
                   -
   
                    -
 
Impairment loss
   
                  -
   
4,344
   
                   -
   
                    -
 
Amortization of deferred loan costs
   
1,518
   
415
   
1,168
   
991
 
Share-based employee compensation expense
   
10,213
   
14,915
   
16,530
   
18,836
 
Excess tax benefits from share-based payment arrangements
   
(381)
   
(68)
   
(9,480)
   
(12,152)
 
Decrease (increase) in accounts receivable, net
   
14,352
   
(1,796)
   
(33,131)
   
(2,749)
 
(Increase) decrease in other current assets
   
(1,972)
   
(3,011)
   
3,927
   
(3,299)
 
Increase (decrease) in accounts payable
   
6,565
   
(3,620)
   
2,516
   
(1,143)
 
Increase (decrease) in accrued salaries and benefits
   
24,991
   
1,549
   
12,652
   
(21,362)
 
(Decrease) increase in other current liabilities
   
(11,067)
   
3,374
   
11,491
   
52,227
 
Deferred income taxes
   
8,076
   
(14,133)
   
(10,835)
   
(10,866)
 
Other
   
6,049
   
1,672
   
11,761
   
5,092
 
(Increase) decrease in other assets
   
(172)
   
540
   
(1,367)
   
834
 
Payments on other long-term liabilities
   
(3,970)
   
(504)
   
(2,220)
   
(1,247)
 
Net cash flows provided by operating activities
   
112,868
   
22,167
   
105,306
   
107,327
                           
 
Cash flows from investing activities:
                       
 
Acquisition of property and equipment
   
(49,110)
   
(13,753)
   
(82,521)
   
(29,507)
 
Sale of investment
   
11,626
   
                     -
   
                   -
   
                    -
 
Business acquisitions, net of cash acquired, and equity investments
   
(19,486)
   
(449)
   
                   -
   
                    -
 
Change in restricted cash
   
(538)
   
                     -
   
(452)
   
(493,071)
 
Purchase of investment
   
                  -
   
                     -
   
                   -
   
(9,045)
 
Other
   
(4,918)
   
(2,208)
   
(3,690)
   
(13)
 
Net cash flows used in investing activities
   
(62,426)
   
(16,410)
   
(86,663)
   
(531,636)
                           
 
Cash flows from financing activities:
                       
 
Proceeds from issuance of long-term debt
   
405,400
   
55,000
   
85,420
   
350,000
 
Deferred loan costs
   
(784)
   
(290)
   
                   -
   
(4,357)
 
Proceeds from sale of unregistered common stock
   
                  -
   
                     -
   
                   -
   
5,000
 
Repurchases of common stock
   
                  -
   
                     -
   
(94,340)
   
(5,654)
 
Repurchase of stock options
   
(736)
   
                     -
   
                   -
   
                    -
 
Excess tax benefits from share-based payment arrangements
   
381
   
68
   
9,480
   
12,152
 
Exercise of stock options
   
727
   
56
   
6,711
   
11,221
 
Payments of long-term debt
   
(457,303)
   
(96,825)
   
(38,327)
   
(51,190)
 
Change in outstanding checks and other
   
(1,113)
   
6,149
   
                   -
   
                    -
 
Net cash flows (used in) provided by financing activities
   
(53,428)
   
(35,842)
   
(31,056)
   
317,172
                           
 
Effect of exchange rate changes on cash
   
185
   
                     -
   
                   -
   
                    -
                           
 
Net decrease in cash and cash equivalents
   
(2,801)
   
(30,085)
   
(12,413)
   
(107,137)
                           
 
Cash and cash equivalents, beginning of period
   
5,157
   
35,242
   
47,655
   
154,792
                           
 
Cash and cash equivalents, end of period
 
$
2,356
   
5,157
   
35,242
   
47,655
                           
 
Supplemental disclosure of cash flow information:
                       
 
Cash paid during the period for interest
 
$
12,717
   
8,297
   
19,117
   
14,042
 
Cash paid during the period for income taxes
 
$
18,390
   
10,914
   
41,249
   
38,580
                           
 
See accompanying notes to the consolidated financial statements.
                       
                           


 
45

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Year Ended December 31, 2009, Four Months Ended December 31, 2008, and Years Ended August 31, 2008 and 2007

1.           Summary of Significant Accounting Policies

Healthways, Inc. and its wholly-owned subsidiaries provide specialized, comprehensive solutions to help people improve physical, emotional and social well-being, reducing both direct healthcare costs and the costs associated with the loss of health-related employee productivity.  In North America, our customers include health plans, governments, employers, pharmacy benefit managers, and hospitals in all 50 states, the District of Columbia and Puerto Rico. We also provide health improvement programs and services in Germany, Brazil and Australia.  

a.  Principles of Consolidation - The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are wholly-owned.  We have eliminated all intercompany profits, transactions and balances.

b.  Cash and Cash Equivalents - Cash and cash equivalents primarily include tax-exempt debt instruments, commercial paper, and other short-term investments with original maturities of less than three months.

c.  Accounts Receivable, net - Billed receivables primarily represent fees that are contractually due in the ordinary course of providing our services, net of contractual adjustments and allowances for doubtful accounts.  Unbilled receivables primarily represent fees for services based on the estimated utilization of fitness facilities and are generally billed in the following month.  Historically, we have experienced minimal instances of customer non-payment and therefore consider our accounts receivable to be collectible, but we may provide reserves, when appropriate, for doubtful accounts and for billing adjustments (such as data reconciliation differences) on a specific identification basis.

d.  Property and Equipment - Property and equipment is carried at cost and includes expenditures that increase value or extend useful lives.  We recognize depreciation using the straight-line method over useful lives of three to seven years for computer software and hardware and four to seven years for furniture and other office equipment.  Leasehold improvements are depreciated over the shorter of the estimated life of the asset or the life of the lease, which ranges from two to fifteen years.  Depreciation expense for the year ended December 31, 2009, the four months ended December 31, 2008, and the years ended August 31, 2008 and 2007 was $36.6 million, $12.1 million, $31.5 million, and $25.6 million, respectively, including amortization of assets recorded under capital leases.

e.  Other Assets - Other assets consist primarily of long-term investments and deferred loan costs net of accumulated amortization.

f.  Intangible Assets - Intangible assets are initially recognized and measured at cost.  Intangible assets subject to amortization primarily include customer contracts, acquired technology, patents, distributor and provider networks, and other intangible assets which we amortize on a straight-line basis over estimated useful lives ranging from three to 25 years.  We assess the potential impairment of intangible assets subject to amortization whenever events or changes in circumstances indicate that the carrying values may not be recoverable.

Intangible assets not subject to amortization at December 31, 2009 and August 31, 2008 consist of trade names of $29.9 million and $33.4 million, respectively.  We review intangible assets not subject to

 
46

 

amortization on an annual basis or more frequently whenever events or circumstances indicate that the assets might be impaired.  See Note 4 for further information on intangible assets.

g.  Goodwill - We recognize goodwill for the excess of the purchase price over the fair value of tangible and identifiable intangible net assets of businesses that we acquire.

We review goodwill at the reporting unit level (operating segment or one level below an operating segment) on an annual basis or more frequently whenever events or circumstances indicate that the carrying value may not be recoverable.  We estimate the fair value of each reporting unit using a discounted cash flow model and reconcile the aggregate fair value of our reporting units to our consolidated market capitalization. We allocate goodwill to reporting units based on the reporting unit expected to benefit from the combination.  We completed our annual impairment test during our fourth quarter and concluded that no impairment of goodwill exists.
 
 
h. Contract Billings in Excess of Earned Revenue - Contract billings in excess of earned revenue primarily represent performance-based fees subject to refund that we have not recognized as revenues because either 1) data from the customer is insufficient or incomplete to measure performance; or 2) interim performance measures indicate that we are not meeting performance targets.

i. Income Taxes - We file a consolidated federal income tax return that includes all of our domestic wholly-owned subsidiaries.  U.S. GAAP generally requires that we record deferred income taxes for the tax effect of differences between the book and tax bases of our assets and liabilities.  We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position.  The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement.

j. Revenue Recognition - We generally determine our contract fees by multiplying a contractually negotiated rate per member per month (“PMPM”) by the number of members covered by our services during the month.  We typically set the PMPM rates during contract negotiations with customers based on the value we expect our programs to create and a sharing of that value between the customer and the Company.  In addition, some of our services, such as the SilverSneakers fitness program, are billed on a fee for service basis.

 Some of our contracts provide that a portion (up to 100%) of our fees may be refundable to the customer (“performance-based”) if our programs do not achieve, when compared to a baseline year, a targeted percentage reduction in the customer’s healthcare costs and selected clinical and/or other criteria that focus on improving the health of the members.  Approximately 4% of revenues recorded during fiscal 2009 were performance-based and were subject to final reconciliation as of December 31, 2009.  We anticipate that this percentage will fluctuate due to the level of performance-based fees in new contracts and the timing and amount of revenue recognition associated with performance-based fees.  Some contracts also provide opportunities for us to receive incentive bonuses in excess of the contractual PMPM rate if we exceed contractual performance targets.

We generally bill our customers each month for the entire amount of the fees contractually due for the prior month’s enrollment, which typically includes the amount, if any, that is performance-based and may be subject to refund should we not meet performance targets.  Deferred revenues can arise from contracts which permit upfront billing and collection of fees covering the entire contractual service period, generally 12 months.  Contractually, we cannot bill for any incentive bonus until after contract settlement.  Fees for service are typically billed in the month after the services are provided.

We recognize revenue as follows: 1) we recognize the fixed portion of PMPM fees and fees for service as revenue during the period we perform our services; 2) we recognize the performance-based portion of the

 
47

 

monthly fees based on the most recent assessment of our performance, which represents the amount that the customer would legally be obligated to pay if the contract were terminated as of the latest balance sheet date; and 3) we recognize additional incentive bonuses based on the most recent assessment of our performance, to the extent we consider such amounts collectible.

We assess our level of performance for our contracts based on medical claims and other data that the customer is contractually required to supply.  A minimum of four to six months’ data is typically required for us to measure performance.  In assessing our performance, we may include estimates such as medical claims incurred but not reported and a medical cost trend compared to a baseline year.  In addition, we may also provide contractual allowances for billing adjustments (such as data reconciliation differences) as appropriate.

In 2005, we began participating in two Medicare Health Support pilots, which concluded in January 2008 and July 2008, respectively.  Substantially all of the fees under these pilots were performance-based.  Our original cooperative agreements required that, by the end of the third year, we achieve a cumulative net savings (total savings for the intervention population as compared to the control group less fees received from the Centers for Medicare & Medicaid Services (“CMS”)) of 5.0%.  Under an amendment to our agreement for our stand-alone Medicare Health Support pilot in Maryland and the District of Columbia, we began serving a “refresh population” of approximately 4,500 beneficiaries on August 1, 2006, which was measured as a separate cohort for two years, by the end of which the program was required to achieve a 2.5% cumulative net savings when compared to a new control cohort.  In April 2008, we signed an amendment to our Medicare Health Support protocol with CMS, which changed the financial performance target for both the initial and the refresh populations to budget neutrality.  In late April 2009, we received the final reconciliation report from CMS’ independent financial reconciliation contractor.  Based upon this final reconciliation report as well as our performance over the term of the pilots, we have recognized $9.5 million of cumulative performance-based fees related to these pilots and $12.2 million of fixed fees.  At December 31, 2009, approximately $57.8 million of performance-based fees related to these pilots was recorded in contract billings in excess of earned revenue, $50.3 million of which related to fees collected, and the remaining $7.5 million of which related to fees billed but not collected due to CMS withholding payment of these fees.  We submitted our objections to the final reconciliation report and engaged in discussions with CMS regarding our objections.   We, along with several other participating organizations in the Medicare Health Support pilots, have submitted a proposal to CMS to resolve the issues related to the reconciliation; however, such proposal remains subject to approval by the United States government.

If data is insufficient or incomplete to measure performance, or interim performance measures indicate that we are not meeting performance targets, we do not recognize performance-based fees subject to refund as revenues but instead record them in a current liability account entitled “contract billings in excess of earned revenue.”  Only in the event we do not meet performance levels by the end of the measurement period, typically one year, are we contractually obligated to refund some or all of the performance-based fees.  We would only reverse revenues that we had already recognized if performance to date in the measurement period, previously above targeted levels, subsequently dropped below targeted levels.  Historically, any such adjustments have been immaterial to our financial condition and results of operations.

During the settlement process under a contract, which generally occurs six to eight months after the end of a contract year, we settle any performance-based fees and reconcile healthcare claims and clinical data.  As of December 31, 2009, performance-based fees that have not yet been settled with our customers but that have been recognized as revenue in the current and prior years totaled approximately $46.4 million, all of which was based on actual data received from our customers.  Data reconciliation differences, for which we provide contractual allowances until we reach agreement with respect to identified issues, can arise between the customer and us due to customer data deficiencies, omissions, and/or data discrepancies.

Performance-related adjustments (including any amounts recorded as revenue that were ultimately refunded), changes in estimates, data reconciliation differences, or adjustments to incentive bonuses may cause

 
48

 

us to recognize or reverse revenue in a current fiscal year that pertains to services provided during a prior fiscal year.  During fiscal 2009, we recognized a net increase in revenue of approximately $8.6 million that related to services provided prior to fiscal 2009.

k.  Earnings Per Share – We calculate basic earnings per share using weighted average common shares outstanding during the period.  We calculate diluted earnings per share using weighted average common shares outstanding during the period plus the effect of all dilutive potential common shares outstanding during the period.  See Note 16 for a reconciliation of earnings per share.

l.  Share-Based CompensationWe recognize all share-based payments to employees, including grants of employee stock options, in the statement of operations based on their fair values.  See Note 13 for further information on share-based compensation.

m. Derivative Instruments and Hedging Activities – We record all derivatives at estimated fair value as either assets or liabilities on the balance sheet and recognize the unrealized gains and losses in either the balance sheet or statement of operations, depending on whether the derivative is designated as a hedging instrument.  As permitted under our master netting arrangements, beginning September 30, 2009, the fair value amounts of our derivative instruments are presented on a net basis by counterparty in the consolidated balance sheet.  See Note 6 for further information.

n. Management Estimates – In preparing our consolidated financial statements in conformity with generally accepted accounting principles, management must make estimates and assumptions that affect: 1) the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements; and 2) the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

o. Fiscal Year - In August 2008, our Board of Directors approved a change in our fiscal year-end from August 31 to December 31.  Accordingly, our 2009 fiscal year began on January 1, 2009 following a four-month transition period ended December 31, 2008.  References herein to fiscal 2009 refer to the year ended December 31, 2009; references herein to fiscal 2008 and fiscal 2007 refer to the years ended August 31, 2008 and 2007, respectively.

2.           Recently Issued Accounting Standards

In April 2009, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance requiring disclosures about fair value of financial instruments in both interim reporting periods of publicly traded companies as well as in annual financial statements, beginning with interim reporting periods ending after June 15, 2009.  The implementation of this guidance resulted in increased disclosures in our interim periods but did not have an impact on our financial position or results of operations.

In May 2009, the FASB issued guidance which establishes accounting and disclosure requirements for subsequent events.  The guidance defines subsequent events as events that occur after the balance sheet date but before the financial statements are issued for public entities.  It requires companies to disclose the date through which they have evaluated subsequent events and to designate subsequent events as either recognized or non-recognized.  In February 2010, the FASB issued revised guidance, effectively immediately for all financial statements that had not yet been issued, to remove the requirement for SEC filers to disclose the date through which they have evaluated subsequent events.  The original guidance became effective for interim or annual periods ending after June 15, 2009.  The implementation of this guidance, as revised, resulted in increased disclosures but did not have an impact on our financial position or results of operations.

In June 2009, the FASB approved the FASB Accounting Standards Codification (the “Codification”).  Effective July 1, 2009, the Codification is the single source of authoritative nongovernmental

 
49

 

U.S. GAAP, superseding existing FASB, American Institute of Certified Public Accountants (“AICPA”), Emerging Issues Task Force (“EITF”), and related accounting literature.  The Codification reorganizes the thousands of U.S. GAAP pronouncements into approximately 90 accounting topics and displays them using a consistent structure.  Also included is relevant Securities and Exchange Commission guidance organized using the same topical structure in separate sections.  
 
In December 2007, the FASB issued guidance regarding business combinations.  This guidance expands the definition of a business and a business combination and generally requires the acquiring entity to recognize all of the assets and liabilities of the acquired business, regardless of the percentage ownership acquired, at their fair values. It also requires that contingent consideration and certain acquired contingencies be recorded at fair value on the acquisition date and that acquisition costs generally be expensed as incurred. The guidance was effective for fiscal years beginning after December 15, 2008.  The adoption of this guidance did not materially impact our financial position or results of operations when it became effective on January 1, 2009.
 
3.           Goodwill

The change in carrying amount of goodwill during the year ended August 31, 2008, four months ended December 31, 2008, and year ended December 31, 2009 is shown below:

 
(In $000s)
       
 
Balance, August 31, 2007
   
$
483,584
 
 
Health IQ purchase price adjustment
     
475
 
 
Axia purchase price adjustment and other
     
246
 
 
Balance, August 31, 2008
   
$
484,305
 
 
Earn-out payments
     
291
 
 
Balance, December 31, 2008
   
$
484,596
 
 
HealthHonors purchase
     
11,850
 
 
Balance, December 31, 2009
   
$
496,446
 

In October 2009, we acquired HealthHonors, a behavioral economics company that specializes in behavior change science and optimized use of incentives, for a net cash payment of $14.5 million and a multi-year earn-out arrangement with an acquisition date fair value of $3.0 million.

4.           Intangible Assets

Intangible assets subject to amortization at December 31, 2009 consisted of the following:

     
Gross Carrying
   
Accumulated
       
 
(In $000s)
 
Amount
   
Amortization
   
Net
 
                     
 
Customer contracts
 
$
55,240
   
$
25,897
   
$
29,343
 
 
Acquired technology
   
26,757
     
19,009
     
7,748
 
 
Patents
   
23,405
     
5,419
     
17,986
 
 
Distributor and provider networks
   
8,709
     
3,765
     
4,944
 
 
Other
   
12,486
     
1,410
     
11,076
 
 
Total
 
$
126,597
   
$
55,500
   
$
71,097
 



 
50

 
 
Intangible assets subject to amortization at August 31, 2008 consisted of the following:

     
Gross Carrying
   
Accumulated
       
 
(In $000s)
 
Amount
   
Amortization
   
Net
 
                     
 
Customer contracts
 
$
53,140
   
$
18,619
   
$
34,521
 
 
Acquired technology
   
22,657
     
15,115
     
7,542
 
 
Patents
   
22,840
     
2,397
     
20,443
 
 
Distributor and provider networks
   
8,709
     
2,137
     
6,572
 
 
Other
   
5,470
     
838
     
4,632
 
 
Total
 
$
112,816
   
$
39,106
   
$
73,710
 

Intangible assets subject to amortization are being amortized over estimated useful lives ranging from three to 25 years.  Total amortization expense for the year ended December 31, 2009, four months ended December 31, 2008 and years ended August 31, 2008 and 2007 was $12.7 million, $4.0 million, $16.0 million, and $11.5 million, respectively.  The following table summarizes the estimated amortization expense for each of the next five years and thereafter:

 
(In $000s)
   
 
Year ending December 31,
   
 
2010
 
12,316
 
 
2011
 
12,376
 
 
2012
 
10,472
 
 
2013
 
10,404
 
 
2014
 
10,404
 
 
2015 and thereafter
 
15,125
 
 
Total
$
71,097
 
 
 
Intangible assets not subject to amortization at December 31, 2009 and August 31, 2008 consist of trade names of $29.9 million and $33.4 million, respectively.

5.           Income Taxes

Income tax expense (benefit) is comprised of the following:

 
(In $000s)
 
Year Ended December 31,
 
Four Months Ended December 31,
 
Year Ended August 31,
 
   
2009
 
2008
 
2008
 
2007
 
                     
 
Current taxes
                       
 
Federal
$
835
 
$
11,946
 
$
47,147
 
$
34,187
 
 
State
 
754
   
2,827
   
9,569
   
6,465
 
 
Deferred taxes
                       
 
Federal
 
7,638
   
(11,308
)
 
(15,500
)
 
(8,618
)
 
State
 
910
   
(2,456
)
 
(3,476
)
 
(1,871
)
 
Total
$
10,137
 
$
1,009
 
$
37,740
 
$
30,163
 

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax

 
51

 

purposes.  The following table shows the significant components of our net deferred tax asset (liability) as of December 31, 2009 and August 31, 2008:

 
(In $000s)
 
December 31,
     
August 31,
 
     
2009
     
2008
 
                 
 
Deferred tax asset:
                 
 
Accruals and reserves
 
$
10,710
     
$
9,537
 
 
Deferred compensation
   
9,253
       
8,270
 
 
Share-based payments
   
15,877
       
17,644
 
 
Net operating loss carryforwards
   
8,344
       
7,936
 
 
Other assets and liabilities
   
3,381
       
2,341
 
 
Advance receipts
   
14,220
       
16,381
 
       
61,785
       
62,109
 
 
Valuation allowance
   
(1,648
)
     
(1,239
)
       
60,137
       
60,870
 
 
Deferred tax liability:
                 
 
Property and equipment
   
(22,668
)
     
(13,895
)
 
Intangible assets
   
(27,805
)
     
(31,316
)
 
Other assets and liabilities
   
(84
)
     
(75
)
       
(50,557
)
     
(45,286
)
 
Net deferred tax asset
 
$
9,580
     
$
15,584
 
                     
 
Net current deferred tax asset
 
$
24,197
     
$
24,948
 
 
Net long-term deferred tax liability
   
(14,617
)
     
(9,364
)
     
$
9,580
     
$
15,584
 

The valuation allowance increased by $0.4 million from August 31, 2008 to December 31, 2009 due to an increase in the valuation allowance against deferred tax assets in non-U.S. jurisdictions with a recent history of losses.  Based on the Company’s historical and expected future taxable earnings, and a consideration of available tax planning strategies, management believes it is more likely than not that the Company will realize the benefit of the existing deferred tax assets, net of the valuation allowance, at December 31, 2009.

For fiscal 2009, 2008, and 2007, the tax benefit of stock option compensation, excluding the tax benefit related to the deferred tax asset for share-based payments, was recorded as additional paid-in capital.  We recorded a tax effect of $1.8 million in fiscal 2009, a tax benefit of $1.1 million in fiscal 2008, and a tax benefit of $0.1 million in fiscal 2007 related to our interest rate swap agreements (see Note 6) to stockholders’ equity as a component of other comprehensive income (loss).

At December 31, 2009, we had foreign net operating loss carryforwards, before valuation allowances, of approximately $5.9 million with an indefinite carryforward period and approximately $17.7 million of federal loss carryforwards originating from acquired entities.  The federal loss carryforwards are subject to an annual limitation under Internal Revenue Code Section 382 and also have expiration dates ranging from 2011 until 2025.

The difference between income tax expense computed using the statutory federal income tax rate and the effective rate is as follows:

 
52

 

 
 
(In $000s)
 
Year Ended December 31,
 
Four Months Ended December 31,
 
Year Ended August 31,
 
     
2009
 
2008
 
2008
 
2007
 
                       
 
Statutory federal income tax
 
$
7,179
 
$
610
 
$
32,394
 
$
26,349
 
 
State income taxes, less federal income tax benefit
   
970
   
62
   
3,910
   
3,133
 
 
Other
   
1,988
   
337
   
1,436
   
681
 
 
Income tax expense
 
$
10,137
 
$
1,009
 
$
37,740
 
$
30,163
 

Uncertain Tax Positions

As of December 31, 2009 and August 31, 2008, we had $1.1 million and $0.3 million, respectively, of unrecognized tax benefits that, if recognized, would affect our effective tax rate.  Our policy is to include interest and penalties related to unrecognized tax benefits in income tax expense.  As of December 31, 2009 and August 31, 2008, we had accrued interest related to uncertain tax positions of $0 and $1.5 million, respectively, on our balance sheet.  During fiscal 2009, the four months ended December 31, 2008, and fiscal 2008, we included approximately $0.2 million, $0.1 million, and $0.5 million, respectively, of net interest related to uncertain tax positions as a component of income tax expense.

The aggregate changes in the balance of unrecognized tax benefits were as follows:

 
(In $000s)
       
           
 
Unrecognized tax benefits at September 1, 2007
$
11,050
   
 
Decreases based on tax positions related to fiscal 2008
 
(8,534
)
 
 
Lapse of statutes of limitation
 
(140
)
 
 
Unrecognized tax benefits at August 31, 2008 and December 31, 2008
 
2,376
   
 
Change based upon settlements with taxing authorities
 
(2,376
)
 
 
Increases based upon tax positions related to fiscal 2009
 
1,072
   
 
Unrecognized tax benefits at December 31, 2009
$
1,072
   

We file income tax returns in the U.S. Federal jurisdiction and in various state and foreign jurisdictions.  During 2009, the Internal Revenue Service completed an audit of our 2005 and 2006 tax years, the resolution of which did not result in a material adjustment to our financial statements.

6.           Derivative Instruments and Hedging Activities

We use derivative instruments to manage risks related to interest rates and foreign currencies.  We record all derivatives at estimated fair value as either assets or liabilities on the balance sheet and recognize the unrealized gains and losses in either the balance sheet or statement of operations, depending on whether the derivative is designated as a hedging instrument.  As permitted under our master netting arrangements, at December 31, 2009, the fair value amounts of our derivative instruments are presented on a net basis by counterparty in the consolidated balance sheet.

 
53

 
 
Interest Rate

We currently maintain eight interest rate swap agreements to reduce our exposure to interest rate fluctuations on our floating rate debt commitments (see Note 8 for further information).  These interest rate swap agreements effectively modify our exposure to interest rate risk by converting a portion of our floating rate debt to fixed obligations with interest rates ranging from 3.375% to 4.995%, thus reducing the impact of interest rate changes on future interest expense.  Under these agreements, we receive a variable rate of interest based on LIBOR, and we pay a fixed rate of interest plus a spread of 0.875% to 1.750% on revolving advances and a spread of 1.50% on term loan borrowings.  We have designated these interest rate swap agreements as qualifying cash flow hedges.

Foreign Currency

We enter into foreign currency options and/or forward contracts in order to minimize our earnings exposure to fluctuations in foreign currency exchange rates.  Our foreign currency exchange contracts do not qualify for hedge accounting treatment under U.S. GAAP.  We routinely monitor our foreign currency exposures to maximize the overall effectiveness of our foreign currency hedge positions.  We do not execute transactions or hold derivative financial instruments for trading or other purposes.

The estimated gross fair values of derivative instruments at December 31, 2009, excluding the impact of netting derivative assets and liabilities when a legally enforceable master netting agreement exists, were as follows:

 
(In $000s)
 
Foreign currency exchange contracts
 
Interest rate swap agreements
   
 
Assets:
           
               
 
 Derivatives designated as hedging instruments:
           
 
     Other assets
 
$—
 
$88
   
 
Total assets
 
$—
 
$88
   
               
 
 Liabilities:
           
 
  Derivatives not designated as hedging instruments:
           
 
     Accrued liabilities
 
$12
 
$—
   
 
 
           
 
  Derivatives designated as hedging instruments:
           
 
     Accrued liabilities
 
 
236
   
 
     Other long-term liabilities
 
 
6,942
   
 
Total liabilities
 
$12
 
$7,178
   
               
See also Note 7.

Cash Flow Hedges

Derivative instruments that are designated and qualify as cash flow hedges are recorded at estimated fair value in the balance sheet, with the effective portion of the gains and losses being reported in other comprehensive income (“OCI”) or loss.  These gains and losses are reclassified into earnings in the same period during which the hedged transaction affects earnings or the period in which all or a portion of the hedge

 
54

 

becomes ineffective.  As of December 31, 2009, we expect to reclassify $5.2 million of net losses on interest rate swap agreements from accumulated OCI to interest expense within the next 12 months due to the scheduled payment of interest associated with floating rate debt.

As of December 31, 2009, we are a party to the following interest rate swap agreements for which we receive a variable rate of interest based on LIBOR and for which we pay the following fixed rates of interest plus a spread of 0.875% to 1.750% on revolving advances and a spread of 1.50% on term loan borrowings:

   
 
Swap #
 
Original Notional
Amount (in $000s)
 
Fixed Interest
Rate
 
Termination Date
         
   
1
 
$184,000
 
4.995
%
March 31, 2010
(1)
       
   
2
 
46,000
 
4.995
%
March 31, 2010
(2)
       
   
3
 
40,000
 
3.433
%
December 30, 2011
         
   
4
 
50,000
 
3.688
%
December 30, 2011
         
   
5
 
40,000
 
3.855
%
December 30, 2011
(3)
       
   
6
 
30,000
 
3.760
%
March 30, 2011
(4)
       
   
7
 
57,500
 
3.385
%
December 31, 2013
(5)
       
   
8
 
57,500
 
3.375
%
December 31, 2013
(6)
       

(1) The principal value of this swap agreement amortizes over a 39-month period.  During the
three months ended December 31, 2009, the notional amount of this swap was $16 million.
(2) The principal value of this swap agreement amortizes over a 39-month period.  During the three months ended December 31, 2009, the notional amount of this swap was $4 million.
(3) This swap agreement became effective October 1, 2009.
(4) This swap agreement became effective January 2, 2010.
(5) This swap agreement becomes effective January 1, 2012.  The principal value of this swap agreement will amortize over a 24-month period.
(6) This swap agreement becomes effective January 3, 2012.  The principal value of this swap agreement will amortize over a 24-month period.

We currently meet the hedge accounting criteria under U.S. GAAP in accounting for these interest rate swap agreements.

Gains and losses representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized in current earnings.  The following table shows the effect of our cash flow hedges on the consolidated statement of operations (or when applicable, the consolidated balance sheet) during the year ended December 31, 2009:

   
Year Ended December 31, 2009
 
 
 
 
Derivatives in
Cash Flow Hedging Relationships
 
 
Amount of Gain (Loss) Recognized in OCI on Derivatives (Effective Portion)
 
Location of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)
 
 
Amount of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)
Interest rate swap agreements, gross of tax effect
 
$(2,541)
 
Interest expense
 
$(6,742) 

During the year ended December 31, 2009, there were no gains or losses on cash flow hedges recognized in income resulting from hedge ineffectiveness.

 
55

 
 
Derivative Instruments Not Designated as Hedging Instruments

Our foreign currency exchange contracts require current period mark-to-market accounting, with any change in fair value being recorded each period in the statement of operations in selling, general and administrative expenses.  As of December 31, 2009, we had the following outstanding net foreign currency forward contract that was entered into to hedge forecasted foreign net income (loss) and intercompany debt.


       
Notional
   
   
Foreign Currency
 
Amount (000s)
   
   
Australian Dollar
 
AUD 1,180
   

Our forward contracts did not have a material effect on our consolidated statement of operations during the year ended December 31, 2009.

7.           Fair Value Measurements

We account for certain assets and liabilities at fair value.  Fair value is defined as the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date, assuming the transaction occurs in the principal or most advantageous market for that asset or liability.
 
Fair Value Hierarchy

The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are:

 
Level 1:  Quoted prices in active markets for identical assets or liabilities;
 
 
 
Level 2:  Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-based valuation techniques in which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities; and
 
 
 
Level 3:  Unobservable inputs that are supported by little or no market activity and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability.
 

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following table presents our assets and liabilities measured at fair value on a recurring basis at December 31, 2009:

 
56

 

 
 
(In 000s)
   
 
 
 
Level 2
   
 
 
 
Level 3
   
 
Gross Fair Value
   
 
 
 
Netting (1)
   
 
 
Net Fair Value
     
 
Assets:
                                   
 
Interest rate swap agreements
 
$
88
 
$
 
$
88
 
$
 
$
88
     
 
Liabilities:
                                   
 
Foreign currency exchange contracts
 
$
12
 
$
 
$
12
 
$
 
$
12
     
 
Interest rate swap agreements
   
7,178
   
   
7,178
   
   
7,178
     
 
Contingent consideration liability
   
   
3,043
   
3,043
   
   
3,043
     
 
(1) This column reflects the impact of netting derivative assets and liabilities by counterparty when a legally enforceable master netting agreement exists.

The fair values of forward foreign currency exchange contracts are valued using broker quotations of similar assets or liabilities in active markets.  The fair values of interest rate swap agreements are primarily determined based on the present value of future cash flows using internal models and third-party pricing services with observable inputs, including interest rates, yield curves and applicable credit spreads.  The contingent consideration liability represents the fair value of a multi-year earn-out arrangement in connection with a business combination entered into during the fourth quarter of 2009.  The fair value was determined using a discounted cash flow model based on management’s estimate of future cash flows.

The change in the contingent consideration liability during the year ended December 31, 2009 was as follows:

 
(In $000s)
     
Contingent
Consideration Liability 
   
 
Balance, January 1, 2009
   
$
   
 
Initial recognition of liability
     
3,043
   
 
Balance, December 31, 2009
   
$
3,043
   

Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis

We measure certain assets at fair value on a nonrecurring basis in the fourth quarter of our fiscal year, including the following:

·  
reporting units measured at fair value in the first step of a goodwill impairment test; and
·  
indefinite-lived intangible assets measured at fair value for impairment assessment.

Each of the assets above is classified as Level 3 within the fair value hierarchy.  Based on their estimated fair values, we did not record any impairment losses during the three months ended December 31, 2009.

We estimate the fair value of each reporting unit using a discounted cash flow model and reconcile the aggregate fair value of our reporting units to our consolidated market capitalization.  The discounted cash flow model requires significant judgments, including management’s estimate of future cash flows, which is dependent on internal forecasts, estimation of the long-term growth rate for our business, the useful life over which cash flows will occur, and determination of our weighted average cost of capital.  Changes in these estimates and assumptions could materially affect the estimate of fair value and goodwill impairment for each reporting unit.

 
57

 
 
We estimate the fair value of indefinite-lived intangible assets, which consist of a trade name, using a present value technique, which requires management’s estimate of future revenues attributable to this trade name, estimation of the long-term growth rate for these revenues, and determination of our weighted average cost of capital.  Changes in these estimates and assumptions could materially affect the estimate of fair value for the trade name.

Fair Value of Other Financial Instruments

In addition to foreign currency exchange contracts and interest rate swap agreements, the estimated fair values of which are disclosed above, the estimated fair value of each class of financial instruments at December 31, 2009 was as follows:
 
 
·
Cash and cash equivalents – The carrying amount of $2.4 million approximates fair value because of the short maturity of those instruments (less than three months).
 
 
·
Long-term debt –The estimated fair value of outstanding borrowings under the Third Amended Credit Agreement is based on the average of the prices set by the issuing bank given current market conditions and is not necessarily indicative of the amount we could realize in a current market exchange. The estimated fair value and carrying amount of outstanding borrowings under the Third Amended Credit Agreement at December 31, 2009 are $239.8 million and $256.0 million, respectively.

8.           Long-Term Debt

On December 1, 2006, we entered into a Third Amended and Restated Revolving Credit and Term Loan Agreement (the “Third Amended Credit Agreement”).  The Third Amended Credit Agreement provides us with a $400.0 million revolving credit facility, including a swingline sub facility of $10.0 million and a $75.0 million sub facility for letters of credit, a $200.0 million term loan facility, and an uncommitted incremental accordion facility of $200.0 million.

Revolving advances under the Third Amended Credit Agreement generally bear interest, at our option, at 1) LIBOR plus a spread of 0.875% to 1.750% or 2) the greater of the federal funds rate plus 0.5%, or the prime rate, plus a spread of 0.000% to 0.250%.  Term loan borrowings bear interest, at our option, at 1) LIBOR plus 1.50% or 2) the greater of the federal funds rate plus 0.5%, or the prime rate.  See Note 6 for a description of our interest rate swap agreements.  The Third Amended Credit Agreement also provides for a fee ranging between 0.150% and 0.300% of unused commitments.  The Third Amended Credit Agreement is secured by guarantees from most of the Company’s domestic subsidiaries and by security interests in substantially all of the Company’s and such subsidiaries’ assets.

We are required to repay outstanding revolving loans on the revolving commitment termination date, which is December 1, 2011. We are required to repay term loans in quarterly principal installments aggregating $0.5 million each, which commenced on March 31, 2007, and the entire unpaid principal balance of the term loans is due and payable at maturity on December 1, 2013.

The following table summarizes the minimum annual principal payments and repayments of the revolving advances under the Third Amended Credit Agreement for each of the next five years and thereafter:

 
58

 
 
 
(In $000s)
       
 
Year ending December 31,
       
 
2010
   
2,000
 
 
2011
   
64,000
 
 
2012
   
2,000
 
 
2013
   
188,000
 
 
2014
   
 
 
2015 and thereafter
   
 
 
Total
 
$
256,000
 

The Third Amended Credit Agreement contains various financial covenants, which require us to maintain, as defined, ratios or levels of 1) total funded debt to EBITDA, 2) fixed charge coverage, and 3) net worth.  In connection with a legal settlement (see Note 11), in March 2009 we entered into a sixth amendment to the Third Amended Credit Agreement to expressly exclude up to $40 million of expenses attributable to this settlement from the calculation of earnings before interest, taxes, depreciation and amortization, or EBITDA, for purposes of covenant calculations.  The Third Amended Credit Agreement also restricts the payment of dividends and limits the amount of repurchases of the Company’s common stock.  As of December 31, 2009, we were in compliance with all of the covenant requirements of the Third Amended Credit Agreement.

As described in Note 6 above, as of December 31, 2009, we are a party to eight interest rate swap agreements for which we receive a variable rate of interest based on LIBOR and for which we pay a fixed rate of interest plus a spread of 0.875% to 1.750% on revolving advances and a spread of 1.50% on term loan borrowings.

9.           Other Long-Term Liabilities

We have a non-qualified deferred compensation plan under which our officers may defer a portion of their salaries and receive a Company matching contribution plus a contribution based on our performance.  Company contributions vest at 25% per year.  We do not fund the plan and carry it as an unsecured obligation.  Participants in the plan elect payout dates for their account balances, which can be no earlier than four years from the period of the deferral.

As of December 31, 2009, and August 31, 2008, other long-term liabilities included vested amounts under the non-qualified deferred compensation plan of $7.8 million and $7.9 million, respectively, net of the current portions of $2.7 million.  For the next five years ended December 31, we must make estimated plan payments of $2.7 million, $0.3 million, $1.0 million, $0.8 million, and $0.1 million, respectively.

10.           Restructuring and Related Charges and Impairment Loss

In 2008, we began a restructuring of the Company primarily focused on streamlining management and better positioning the Company to deliver fully integrated solutions, which was largely completed by the end of calendar 2008.  Through December 31, 2009, we had incurred cumulative net charges of approximately $9.2 million.  These restructuring charges primarily consisted of severance costs, net of equity forfeitures, and costs associated with capacity consolidation.  For the four months ended December 31, 2008, these charges were presented in a separate line on the consolidated statement of operations.

During the year ended December 31, 2009, we recorded net credits of approximately ($1.0) million related to this restructuring, which are included in cost of services and selling, general, and administrative expenses.  We do not expect to incur significant additional costs or adjustments related to this restructuring.

 
59

 
 
The change in accrued restructuring and related charges during the year ended December 31, 2009 was as follows:

   
(In 000s)
             
                   
   
Accrued restructuring and related charges at January 1, 2009
$
10,460
         
   
Additions
 
191
         
   
Payments
 
(8,082
)
       
   
Adjustments (1)
 
(1,162
)
       
   
Accrued restructuring and related charges at December 31, 2009
$
1,407
         
                   
(1) Adjustments for the year ended December 31, 2009 resulted from actual severance amounts differing from initial estimates due to employees who were expected to be terminated but were instead transitioned to new roles, as well as a favorable adjustment to lease termination costs due to unanticipated demand for certain unused office space.
 
In December 2008, we decided to discontinue offering one of our products as a standalone program. As a result of this decision we did not renew the expiring trade name associated with this product and recorded an impairment loss of $4.3 million in December 2008 to write off this intangible asset.

11.           Commitments and Contingencies

Former Employee Action

In June 1994, a former employee whom we dismissed in February 1994 filed a “whistle blower” action on behalf of the United States government.  Subsequent to its review of this case, the federal government determined not to intervene in the litigation.  The employee sued Healthways, Inc. and our wholly-owned subsidiary, American Healthways Services, Inc. (“AHSI”), as well as certain named and unnamed medical directors and one named client hospital, West Paces Medical Center (“WPMC”), and other unnamed client hospitals.

Healthways, Inc. was subsequently dismissed as a defendant.  In addition, WPMC settled claims filed against it as part of a larger settlement agreement that WPMC’s parent organization, HCA Inc., reached within the United States government.  The plaintiff dismissed his claims against the medical directors with prejudice, and on February 7, 2007 the court granted the plaintiff’s motion and dismissed all claims against all named medical directors.

Effective as of April 1, 2009, the Company and AHSI entered into a settlement agreement with the United States of America, acting through the United States Department of Justice and on behalf of the Department of Health and Human Services (collectively, the “United States”), and the former employee in connection with the settlement of the lawsuit.  Pursuant to the settlement agreement, we paid $28 million to the United States in settlement of the litigation.  Additionally, we paid an additional $12 million for other costs and fees related to the settlement, including the estimated legal costs and expenses of the plaintiff’s attorneys.  As a result of the settlement, the court has dismissed the lawsuit with prejudice.

In a related matter, we have settled the arbitration claim filed against us by WPMC and the arbitration counter-claim we filed against WPMC in February 2006, both of which sought indemnification for certain costs and expenses incurred in connection with the qui tam case.  The arbitration has been dismissed with prejudice.

 
60

 
 
Securities Class Action Litigation

Beginning on June 5, 2008, Healthways and certain of its present and former officers and/or directors were named as defendants in two putative securities class actions filed in the U.S. District Court for the Middle District of Tennessee, Nashville Division. On August 8, 2008, the court ordered the consolidation of the two related cases, appointed lead plaintiff and lead plaintiff’s counsel, and granted lead plaintiff leave to file a consolidated amended complaint. 

The amended complaint, filed on September 22, 2008, alleges that the Company and the individual defendants violated Sections 10(b) of the Securities Exchange Act of 1934 (the “Act”) and that the individual defendants violated Section 20(a) of the Act as “control persons” of Healthways.  The amended complaint further alleges that certain of the individual defendants also violated Section 20A of the Act based on their stock sales.  The plaintiff purports to bring these claims for unspecified monetary damages on behalf of a class of investors who purchased Healthways stock between July 5, 2007 and August 25, 2008. 
 
 
In support of these claims, the lead plaintiff alleges generally that, during the proposed class period, the Company made misleading statements and omitted material information regarding (1) the purported loss or restructuring of certain contracts with customers, (2) the Company’s participation in the Medicare Health Support (“MHS”) pilot program for the Centers for Medicare & Medicaid Services, and (3) the Company’s guidance for fiscal year 2008.  The defendants filed a motion to dismiss the amended complaint on November 13, 2008.  On March 9, 2009, the Court denied the defendants’ motion to dismiss.  The parties have exchanged discovery requests, and the discovery phase of the lawsuit is presently underway.  

Shareholder Derivative Lawsuits

Also, on June 27, 2008 and July 24, 2008, respectively, two shareholders filed putative derivative actions purportedly on behalf of Healthways in the Chancery Court for the State of Tennessee, Twentieth Judicial District, Davidson County, against certain directors and officers of the Company.  These actions are based upon substantially the same facts alleged in the securities class action litigation described above.  The plaintiffs are seeking to recover damages in an unspecified amount and equitable and/or injunctive relief. 

On August 13, 2008, the Court consolidated these two lawsuits and appointed lead counsel.  On October 3, 2008, the Court ordered that the consolidated action be stayed until the motion to dismiss in the securities class action had been resolved by the District Court.  By stipulation of the parties, the plaintiffs filed their consolidated complaint on May 9, 2009.  On June 19, 2009, the defendants filed a motion to dismiss the consolidated complaint.  The Court granted the defendants’ motion to dismiss on October 14, 2009.  The plaintiffs filed a notice of appeal on November 12, 2009.
 
 
ERISA Lawsuits

Additionally, on July 31, 2008, a purported class action alleging violations of the Employee Retirement Income Security Act (“ERISA”) was filed in the U.S. District Court for the Middle District of Tennessee, Nashville Division against Healthways, Inc. and certain of its directors and officers alleging breaches of fiduciary duties to participants in the Company’s 401(k) plan.  The central allegation is that Company stock was an imprudent investment option for the 401(k) plan. 

An amended complaint was filed on September 29, 2008, naming as defendants the Company, the Board of Directors, certain officers, and members of the Investment Committee charged with administering the 401(k) plan.  The amended complaint alleged that the defendants violated ERISA by failing to remove the Company stock fund from the 401(k) plan when it allegedly became an imprudent investment, by failing to

 
61

 

disclose adequately the risks and results of the MHS pilot program to 401(k) plan participants, and by failing to seek independent advice as to whether to continue to permit the plan to hold Company stock.  It further alleged that the Company and its directors should have been more closely monitoring the Investment Committee and other plan fiduciaries.  The amended complaint sought damages in an undisclosed amount and other equitable relief.  The defendants filed a motion to dismiss on October 29, 2008.   On January 28, 2009, the Court granted the defendants’ motion to dismiss the plaintiff’s claims for breach of the duty to disclose with regard to any non-public information and information beyond the specific disclosure requirements of ERISA and denied Defendants’ motion to dismiss as to the remainder of the plaintiff’s claims.  A period of discovery ensued.

 On May 12, 2009, the plaintiff filed a motion for class certification.  After the plaintiff failed, without explanation, to appear for his scheduled deposition, the Court issued an Order on July 10, 2009 warning the plaintiff that his failure to participate in the lawsuit could result in sanctions, including but not limited to dismissal.  After the plaintiff’s failure to participate continued, on July 23, 2009, the defendants filed a motion to dismiss for failure to prosecute the action.  On August 6, 2009, the parties filed a stipulation of dismissal with prejudice as to the named plaintiff but otherwise without prejudice, and the Court entered an Order to that effect on the same date.  

On February 1, 2010, a new named plaintiff filed another putative class action complaint in the United States District Court for the Middle District of Tennessee, Nashville Division, alleging ERISA violations in the administration of the Company’s 401(k) plan.  The new complaint is identical to the original complaint, including the allegations and the requests for relief.  Defendants’ answer to this complaint is due to be filed on or about March 22, 2010.

Outlook

We are also subject to other contractual disputes, claims and legal proceedings that arise from time to time in the ordinary course of our business.  We currently are involved in a contractual dispute with a customer regarding fees paid to us as part of a former contractual relationship.  We believe we performed our services in compliance with the contractual requirements and the customer’s assertions are without merit.   In the event the parties are unable to resolve the dispute, the parties will proceed to arbitration as specified in the applicable agreement.  While we are unable to estimate a range of potential losses, we do not believe that the contractual disputes or any of the legal proceedings pending against us as of the date of this report will have a material adverse effect on our liquidity or financial condition; however, we may settle disputes, claims, sustain judgments or incur expenses relating to these matters in a particular fiscal quarter which may adversely affect our results of operations.  As these matters are subject to inherent uncertainties, our view of these matters may change in the future.

Contractual Commitment

In January 2008, we entered into a perpetual license agreement and 25-year strategic relationship agreement.  We have remaining contractual cash obligations of $35.0 million related to these agreements, $15.0 million of which will occur ratably during the next three years, and the remaining $20.0 million of which will occur ratably over the following 20 years.

12.           Leases

We maintain operating lease agreements principally for our corporate office space, our call centers, and our operations support and training offices.  We lease approximately 264,000 square feet of office space in Franklin, Tennessee, which contains our corporate headquarters and one of our call centers.  This lease commenced in March 2008 and expires in February 2023.  We also lease office space for our 12 other call center locations for an aggregate of approximately 294,000 square feet of space with lease terms expiring on

 
62

 

various dates from 2010 to 2015.  Our operations support and training offices contain approximately 130,000 square feet in aggregate and have lease terms expiring from 2010 to 2016.

Our corporate office lease agreement contains escalation clauses and provides for two renewal options of five years each at then prevailing market rates.  The base rent for the initial 15-year term will range from $4.2 million to $6.3 million per year over the term of the lease.  The landlord provided a tenant improvement allowance equal to $39.20 per square foot.  We record leasehold improvement incentives as deferred rent and amortize them as reductions to rent expense over the lease term.  We recognize rent expense on a straight-line basis over the lease term.
 
 
Most of our operating leases include escalation clauses, some of which are fixed amounts, and some of which reflect changes in price indices.  Certain operating leases contain renewal options to extend the lease for additional periods.  For the year ended December 31, 2009, four months ended December 31, 2008, and years ended August 31, 2008 and 2007, rent expense under lease agreements was approximately $14.5 million, $5.0 million, $16.9 million, and $10.6 million, respectively.  Our capital lease obligations are included in long-term debt and the current portion of long-term debt.

The following table summarizes our future minimum lease payments, net of total sublease income of $2.4 million, under all non-cancelable operating leases for each of the next five years:


 
(In $000s)
Operating
 
 
Year ending December 31,
Leases
 
 
2010
$
14,380
 
 
2011
 
13,593
 
 
2012
 
11,931
 
 
2013
 
10,363
 
 
2014
 
9,385
 
 
2015 and thereafter
 
55,982
 
 
Total minimum lease payments
$
115,634
 

13.        Share-Based Compensation

We have several shareholder-approved stock incentive plans for employees and directors.  We currently have three types of share-based awards outstanding under these plans: stock options, restricted stock, and restricted stock units.  We believe that such awards align the interests of our employees and directors with those of our stockholders.

We grant options under these plans at market value on the date of grant.  The options generally vest over or at the end of four years based on service conditions and expire seven or ten years from the date of grant.  Restricted share awards generally vest over or at the end of four years.  We recognize share-based compensation expense on a straight-line basis over the vesting period.  Certain option and restricted share awards generally provide for accelerated vesting upon a change in control or normal or early retirement (as defined in the plans).  At December 31, 2009, we have reserved approximately 0.9 million shares for future equity grants under our stock incentive plans.

On December 30, 2008, we completed an offer to purchase from our employees, excluding the chief executive officer and Board of Directors, outstanding options to acquire shares of common stock of the Company that were granted between September 1, 2004 and August 15, 2008 under our shareholder-approved stock option plans (the “Tender Offer”). We purchased stock options representing the right to acquire 1.1 million shares of the Company’s common stock in exchange for $0.7 million in cash. We also recognized

 
63

 

$11.5 million of additional stock-based compensation expense in December 2008, which represented the remaining compensation cost for these options as measured at the grant date but not yet recognized prior to the completion of the Tender Offer on December 30, 2008.

Following are certain amounts recognized in the statement of operations for share-based compensation arrangements for the year ended December 31, 2009, four months ended December 31, 2008, and years ended August 31, 2008 and 2007.  We did not capitalize any share-based compensation costs during these periods.

     
Year Ended
 
Four Months Ended
 
Year Ended
   
     
December 31,
 
December 31,
 
August 31,
 
August 31,
   
 
(In millions)
 
2009
 
2008
 
2008
 
2007
   
 
Total share-based compensation
 
$
10.2
 
$
14.9
(1)
$
16.5
 
$
18.8
   
 
Share-based compensation included in cost of services
   
4.4
   
9.1
   
8.0
   
8.4
   
 
Share-based compensation included in selling, general and administrative expenses
   
5.8
   
5.8
   
8.5
   
10.4
   
 
Total income tax benefit recognized
   
4.0
   
5.9
   
6.5
   
7.4
   

(1) Includes $11.5 million of additional expense related to the Tender Offer described above.

As of December 31, 2009, there was $19.9 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the stock incentive plans.  That cost is expected to be recognized over a weighted average period of 1.9 years.

Stock Options

We use a lattice-based binomial option valuation model (“lattice binomial model”) to estimate the fair values of stock options.  During fiscal 2007, we based expected volatility on both historical volatility and implied volatility from traded options on the Company’s stock.  Beginning in fiscal 2008, we based expected volatility on historical volatility due to the low volume of traded options on our stock.  The expected term of options granted is derived from the output of the lattice binomial model and represents the period of time that options granted are expected to be outstanding.  We used historical data to estimate expected option exercise and post-vesting employment termination behavior within the lattice binomial model.

The following table shows the weighted average grant-date fair values of options and the weighted average assumptions we used to develop the fair value estimates under each of the option valuation models for the year ended December 31, 2009, four months ended December 31, 2008, and years ended August 31, 2008 and 2007:

     
Year Ended December 31,
   
Four Months Ended December 31,
     
Year Ended August 31,
     
2009
   
2008
     
2008
     
2007
 
 
Weighted average grant-date fair value of options
 
$
6.72
   
$
4.97
     
$
22.16
     
$
22.08
 
                                       
 
Assumptions:
                                   
 
Expected volatility
   
51.6
%
   
46.5
%
     
37.8
%
     
48.7
%
 
Expected dividends
   
     
       
       
 
 
Expected term (in years)
   
6.1
     
5.1
       
6.6
       
5.5
 
 
Risk-free rate
   
2.5
%
   
3.6
%
     
4.2
%
     
5.1
%

 
64

 
A summary of option activity as of December 31, 2009 and the changes during the year then ended is presented below:

 
Options
 
Shares (000s)
 
 
 
Weighted
Average Exercise
Price
 
 
 
Weighted Average
Remaining
Contractual
 Term
 
 
 
Aggregate Intrinsic Value ($000s)
 
 
Outstanding at January 1, 2009
 
4,124
     
$
20.20
                   
 
Granted
 
1,153
       
11.69
                   
 
Exercised
 
(115
)
     
6.50
                   
 
Forfeited or expired
 
(226
)
     
21.73
                   
 
Outstanding at December 31, 2009
 
4,936
       
18.46
     
4.8
     
$
22,763
 
 
Exercisable at December 31, 2009
 
3,433
       
19.45
     
3.3
     
$
13,702
 
 
The total intrinsic value, which represents the difference between the underlying stock’s market price and the option’s exercise price, of options exercised during the year ended 2009, four months ended December 31, 2008, and years ended 2008 and 2007 was $1.0 million, $0.2 million, $27.5 million, and $35.9 million, respectively.

Cash received from option exercises under all share-based payment arrangements during fiscal 2009 was $0.7 million.  The actual tax benefit realized during fiscal 2009 for the tax deductions from option exercises totaled $0.9 million.  We issue new shares of common stock upon exercise of stock options.

Restricted Stock and Restricted Stock Units

The fair value of restricted stock and restricted stock units (“nonvested shares”) is determined based on the closing bid price of the Company’s common stock on the grant date.  The weighted average grant-date fair value of nonvested shares granted during the year ended December 31, 2009, four months ended December 31, 2008, and years ended August 31, 2008 and 2007 was $11.10, $9.20, $43.17 and $43.76, respectively.

The following table shows a summary of our nonvested shares as of December 31, 2009 as well as activity during the year then ended.  The total fair value of shares vested during the year ended December 31, 2009, four months ended December 31, 2008, and years ended 2008 and 2007 was $3.9 million, $1.5 million, $0.8 million, and $0.5 million, respectively.
 
 
 
Nonvested Shares
 
Shares (000s)
 
Weighted Average Grant Date Fair Value
 
 
Nonvested at January 1, 2009
 
501
 
$
41.01
 
 
Granted
 
666
   
11.10
 
 
Vested
 
(88
)
 
44.19
 
 
Forfeited
 
(64
)
 
23.24
 
 
Nonvested at December 31, 2009
 
1,015
   
22.21
 

14.           Sale of Investment

In January 2009, a private company in which we held preferred stock (recorded in “other assets”) was acquired by a third party.  As part of this sale, we received two payments totaling $11.6 million in January and February 2009 and recorded a gain of $2.6 million during the first quarter of 2009.

 
65

 
 
15.           Comprehensive Income

Comprehensive income (loss), net of income taxes, was $11.2 million, ($2.8) million, $53.5 million, and $45.1 million for the year ended December 31, 2009, four months ended December 31, 2008, and years ended August 31, 2008 and 2007, respectively.

16.           Earnings Per Share

The following is a reconciliation of the numerator and denominator of basic and diluted earnings per share for the year ended December 31, 2009, four months ended December 31, 2008, and years ended August 31, 2008 and 2007:
 
 
 
 
(In 000s except per share data)
 
 
       Year Ended
        December 31,
 
Four Months Ended December 31,
   
Year Ended August 31,
 
 
Numerator:
2009
 
2008
   
2008
     
2007
 
 
Net income - numerator for basic earnings per share
$
10,374
 
$
734
   
$
54,815
     
$
45,121
 
                                 
 
Denominator:
                             
 
Shares used for basic earnings per share
 
33,730
   
33,616
     
34,977
       
35,049
 
 
Effect of dilutive stock options and restricted stock units outstanding:
                             
 
Non-qualified stock options
 
336
   
270
     
1,477
       
1,887
 
 
Restricted stock units
 
293
   
152
     
143
       
66
 
 
Shares used for diluted earnings per share
 
34,359
   
34,038
     
36,597
       
37,002
 
                                 
 
Earnings per share:
                             
 
Basic
$
0.31
 
$
0.02
   
$
1.57
     
$
1.29
 
 
Diluted
$
0.30
 
$
0.02
   
$
1.50
     
$
1.22
 
                                 
 
Dilutive securities outstanding not included in the computation
                             
 
of earnings per share because their effect is antidilutive:
 
3,707
   
3,088
     
1,658
       
1,117
 

 
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17.           Unaudited Financial Information

Below are the unaudited statement of operations and statement of cash flows for the four months ended December 31, 2007:
 
 
(In 000s except per share data)
   
Four Months Ended December 31, 2007
   
 
Revenues
 
$
234,277
   
 
Cost of services (exclusive of depreciation and amortization)
   
163,750
   
 
Selling, general and administrative expenses
   
21,741
   
 
Depreciation and amortization
   
13,682
   
             
 
Operating income
   
35,104
   
 
Interest expense
   
7,118
   
             
 
Income before income taxes
   
27,986
   
 
Income tax expense
   
11,506
   
             
 
Net income
 
$
16,480
   
             
 
Earnings per share:
         
 
Basic
 
$
0.46
   
             
 
Diluted
 
$
0.44
   
             
 
Weighted average common shares and equivalents
         
 
Basic
   
35,770
   
 
Diluted
   
37,739
   


 
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(In 000s)
Four Months Ended December 31, 2007
 
         
 
Cash flows from operating activities:
     
 
Net income
$
16,480
 
 
Adjustments to reconcile net income to net cash provided by
     
 
operating activities, net of business acquisitions:
     
 
Depreciation and amortization
 
13,682
 
 
Loss on disposal of property and equipment
 
221
 
 
Amortization of deferred loan costs
 
389
 
 
Share-based employee compensation expense
 
5,057
 
 
Excess tax benefits from share-based payment arrangements
 
(6,072
)
 
Increase in accounts receivable, net
 
(12,084
)
 
Decrease in other current assets
 
1,513
 
 
Decrease in accounts payable
 
(2,429
)
 
Increase in accrued salaries and benefits
 
1,848
 
 
Increase  in other current liabilities
 
10,257
 
 
Deferred income taxes
 
(3,025
)
 
Other
 
3,951
 
 
Decrease in other assets
 
303
 
 
Payments on other long-term liabilities
 
(111
)
 
Net cash flows provided by operating activities
 
29,980
 
         
 
Cash flows from investing activities:
     
 
Acquisition of property and equipment
 
(25,045
)
 
Acquisitions, net of cash acquired
 
(15
)
 
Net cash flows used in investing activities
 
(25,060
)
         
 
Cash flows from financing activities:
     
 
Repurchases of common stock
 
(132
)
 
Excess tax benefits from share-based payment arrangements
 
6,072
 
 
Exercise of stock options
 
3,070
 
 
Payments of long-term debt
 
(21,070
)
 
Net cash flows used in financing activities
 
(12,060
)
         
 
Net decrease in cash and cash equivalents
 
(7,140
)
         
 
Cash and cash equivalents, beginning of period
 
47,655
 
         
 
Cash and cash equivalents, end of period
$
40,515
 

 

 
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18.           Stockholder Rights Plan

On June 19, 2000, the Board of Directors adopted a stockholder rights plan under which holders of common stock as of June 30, 2000 received preferred stock purchase rights as a dividend at the rate of one right per share.  As amended in June 2004 and July 2006, each right initially entitles its holder to purchase one one-hundredth of a Series A preferred share at $175.00, subject to adjustment.  Upon becoming exercisable, each right will allow the holder (other than the person or group whose actions have triggered the exercisability of the rights), under alternative circumstances, to buy either securities of the Company or securities of the acquiring company (depending on the form of the transaction) having a value of twice the then current exercise price of the rights.

With certain exceptions, each right will become exercisable only when a person or group acquires, or commences a tender or exchange offer for, 15% or more of our outstanding common stock.  Rights will also become exercisable in the event of certain mergers or asset sales involving more than 50% of our assets or earning power.  The rights will expire on June 15, 2014.  The Board of Directors of the Company reviews the plan at least once every three years to determine if the maintenance and continuance of the plan is still in the best interests of the Company and its stockholders.

19.           Employee Benefits

We have a 401(k) Retirement Savings Plan (the “Plan”) available to substantially all of our employees.  Employees can contribute up to a certain percentage of their base compensation as defined in the Plan.  The Company matching contributions are subject to vesting requirements.  Company contributions under the Plan totaled $3.9 million, $1.3 million, $4.3 million, and $3.8 million for the year ended December 31, 2009, four months ended December 31, 2008, and years ended August 31, 2008 and 2007, respectively.

20.           Segment Disclosures

We have aggregated our operating segments into one reportable segment, well-being improvement services.  Our integrated well-being improvement product line includes programs for various diseases, conditions, and wellness programs.  It is impracticable for us to report revenues by program.  Further, we report revenues from our external customers on a consolidated basis since well-being improvement is the only service that we provide.

During fiscal 2009 as well as the four months ended December 31, 2008, we derived approximately 19% of our revenues from one customer, with no other customer comprising 10% or more of our revenues.  In fiscal 2008, two customers each comprised 10% or more of our revenues.  Revenues from each of these customers individually totaled approximately 20% and 10%, respectively, of fiscal 2008 revenues.  In fiscal 2007, we derived approximately 22% of our revenues from one customer, with no other customer comprising 10% or more of our revenues.

 

 
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21.           Quarterly Financial Information (unaudited)
 
                         
(In thousands, except per share data)
                                 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Twelve Months Ended
December 31, 2009
 
 
 
First
 
 
 
Second
 
 
 
Third
 
 
 
Fourth
 
         
(1)
                               
Revenues
     
$
182,736
     
$
177,836
     
$
181,642
     
$
175,212
 
Gross margin
     
$
41,112
     
$
41,534
     
$
40,627
     
$
35,720
 
Income (loss) before income taxes
     
$
(22,572
)
   
$
15,534
     
$
15,484
     
$
12,065
 
Net income (loss)
     
$
(14,813
)
   
$
8,876
     
$
8,802
     
$
7,509
 
                                           
Basic earnings (loss) per share (2)
     
$
(0.44
)
   
$
0.26
     
$
0.26
     
$
0.22
 
Diluted earnings (loss) per share (2)
     
$
(0.44
)(3)
   
$
0.26
     
$
0.26
     
$
0.22
 
                                           
Twelve Months Ended
December 31, 2008
       
First
       
Second
       
Third
       
Fourth
 
                                       
(4)
 
Revenues
     
$
180,940
     
$
193,044
     
$
187,448
     
$
185,272
 
Gross margin
     
$
44,324
     
$
55,604
     
$
52,504
     
$
40,438
 
Income (loss) before income taxes
     
$
17,366
     
$
27,673
     
$
26,012
     
$
(4,744
)
Net income (loss)
     
$
10,203
     
$
16,325
     
$
15,623
     
$
(3,087
)
                                           
Basic earnings (loss) per share (2)
     
$
0.28
     
$
0.48
     
$
0.46
     
$
(0.09
)
Diluted earnings (loss) per share (2)
     
$
0.27
     
$
0.46
     
$
0.45
     
$
(0.09
) (3)

(1)  
Includes a legal settlement of approximately $40.0 million.
(2)  
We calculated earnings per share for each of the quarters based on the weighted average number of shares and dilutive options outstanding for each period.  Accordingly, the sum of the quarters may not necessarily be equal to the full year income per share.
(3)  
The assumed exercise of stock-based compensation awards for this period was not considered because the impact would have been anti-dilutive.
(4)  
Includes restructuring and impairment charges of approximately $14.6 million.

 
70

 


 
Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders of Healthways, Inc.

We have audited Healthways, Inc.’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria).   Healthways, Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, Healthways, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Healthways, Inc. as of December 31, 2009 and August 31, 2008, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the years ended December 31, 2009, August 31, 2008 and August 31, 2007, and the four months ended December 31, 2008 of Healthways, Inc. and our report dated March 16, 2010 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Nashville, Tennessee
March 16, 2010


 
71

 

Item 9.  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

  Not applicable.
 
Item 9A.  Controls and Procedures
 

Management’s Annual Report on Internal Control over Financial Reporting
 
Management, including the principal executive officer and principal financial officer, is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
 
 
                   Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies and procedures may deteriorate.
 
 
                   Management has performed an assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2009 based on criteria established by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”), Internal Controls - Integrated Framework, and believes that the COSO framework is a suitable framework for such an evaluation. Management has concluded that the Company’s internal control over financial reporting was effective as of December 31, 2009.
 
 
                   Ernst & Young LLP, the independent registered public accounting firm that audited the Company’s consolidated financial statements for the year ended December 31, 2009, has issued an attestation report on the Company’s internal control over financial reporting which is included in this Annual Report on Form 10-K.
 
 
                   Our chief executive officer and chief financial officer have reviewed and evaluated the effectiveness of our “disclosure controls and procedures” (as defined in Rule 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”)) as of December 31, 2009.  Based on that evaluation, the chief executive officer and chief financial officer have concluded that our disclosure controls and procedures are effective.  They are designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specific in the Commission’s rules and forms and to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is accumulated and communicated to management, including our chief executive officer and chief financial officer, to allow timely decision regarding required disclosure.
 
 
                   There have been no changes in our internal controls over financial reporting during the quarter ended December 31, 2009 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 

 
72

 
 
Item 9B.  Other Information
 

Not applicable.
PART III

Item 10.  Directors, Executive Officers and Corporate Governance

Information concerning our directors, audit committee, audit committee financial experts, code of ethics, and compliance with Section 16(a) of the Exchange Act will be included in our Proxy Statement for the Annual Meeting of Stockholders to be held May 28, 2010, to be filed with the Securities and Exchange Commission pursuant to Rule 14a-6(c), and is incorporated herein by reference.

Pursuant to General Instruction G(3), information concerning our executive officers is included in Part I of this Annual Report on Form 10-K, under the caption “Executive Officers of the Registrant.”

Item 11.  Executive Compensation

Information required by this item will be contained in our Proxy Statement for the Annual Meeting of Stockholders to be held May 28, 2010, to be filed with the Securities and Exchange Commission pursuant to Rule 14a-6(c), and is incorporated herein by reference.

Item 12.  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Except as set forth below, information required by this item will be contained in our Proxy Statement for the Annual Meeting of Stockholders to be held May 28, 2010, to be filed with the Securities and Exchange Commission pursuant to Rule 14a-6(c), and is incorporated herein by reference.

Item 13.  Certain Relationships and Related Transactions, and Director Independence

Information required by this item will be contained in our Proxy Statement for the Annual Meeting of Stockholders to be held May 28, 2010, to be filed with the Securities and Exchange Commission pursuant to Rule 14a-6(c), and is incorporated herein by reference.

Item 14.  Principal Accountant Fees and Services

Information required by this item will be contained in our Proxy Statement for the Annual Meeting of Stockholders to be held May 28, 2010, to be filed with the Securities and Exchange Commission pursuant to Rule 14a-6(c), and is incorporated herein by reference.

PART IV

Item 15.  Exhibits, Financial Statement Schedules

(a)
The following documents are filed as part of this Annual Report on Form 10-K:

1.           The financial statements filed as part of this report are included in Part II, Item 8 of this Annual Report on Form 10-K.

2.           We have omitted all Financial Statement Schedules because they are not required under the instructions to the applicable accounting regulations of the Securities and Exchange Commission or the information to be set forth therein is included in the financial statements or in the notes thereto.

 
73

 
 
3.           Exhibits

2.1
 
Stock Purchase Agreement dated October 11, 2006 among Healthways, Inc., Axia Health Management, Inc., and Axia Health Management LLC [incorporated herein by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K dated December 1, 2006]
     
3.1
 
Restated Certificate of Incorporation for Healthways, Inc., as amended [incorporated by reference to Exhibit 3.1 to Form 10-Q of the Company’s fiscal quarter ended February 29, 2008]
     
3.2
 
Bylaws, as amended [incorporated by reference to Exhibit 3.1 to Form 10-Q of the Company’s fiscal quarter ended February 29, 2004]
     
3.3
 
Amendment to bylaws, as amended [incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K dated November 15, 2007]
     
3.4
 
Amendment No. 2 to bylaws, as amended [incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K dated September 3, 2008]
     
4.1
 
Article IV of the Company's Restated Certificate of Incorporation (included in Exhibit 3.1)
     
4.2
 
Rights Agreement, dated June 19, 2000, between American Healthways, Inc. and SunTrust Bank, including the Form of Rights Certificate (Exhibit A), the Form of Summary of Rights (Exhibit B) and the Form of Certificate of Amendment to the Restated Certificate of Incorporation of American Healthways, Inc. (Exhibit C) [incorporated herein by reference to Exhibit 4 to the Company’s Current Report on Form 8-K dated June 21, 2000]
     
4.3
 
Amendment No. 1 to Rights Agreement, dated June 15, 2004, between American Healthways, Inc. and SunTrust Bank [incorporated herein by reference to Exhibit 4 to the Company’s Current Report on Form 8-K dated June 17, 2004]
     
4.4
 
Amendment No. 2 to Rights Agreement, dated July 19, 2006, between Healthways, Inc. and SunTrust Bank [incorporated herein by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K dated July 19, 2006]
     
10.1
 
Third Amended and Restated Revolving Credit and Term Loan Agreement (“Third Amended Credit Agreement”) between the Company and SunTrust Bank as Administrative Agent, U.S. Bank National Association and Regions Bank as Co-Documentation Agents, and JPMorgan Chase Bank, N.A., and Fifth Third Bank, N.A. as Co-Syndication Agents dated December 1, 2006 [incorporated by reference to Exhibit 10.1 to Form 10-Q of the Company’s fiscal quarter ended November 30, 2006]

 
74

 
 
     
10.2
 
First Amendment to Third Amended Credit Agreement, dated February 20, 2007 by and among the Company, various lenders, and SunTrust Bank, as Administrative Agent, Issuing Bank and Swingline Lender [incorporated by reference to Exhibit 10.1 to Form 10-Q of the Company’s fiscal quarter ended February 28, 2007]
     
10.3
 
Second Amendment to Third Amended Credit Agreement, dated April 11, 2007 by and among the Company, various lenders, and SunTrust Bank, as Administrative Agent, Issuing Bank and Swingline Lender [incorporated by reference to Exhibit 10.1 to Form 10-Q of the Company’s fiscal quarter ended May 31, 2007]
     
10.4
 
Third Amendment to Third Amended Credit Agreement, dated July 16, 2007 by and among the Company, various lenders, and SunTrust Bank, as Administrative Agent, Issuing Bank and Swingline Lender [incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated July 18, 2007]
     
10.5
 
Fourth Amendment to Third Amended Credit Agreement, dated August 15, 2008 by and among the Company, various lenders, and SunTrust Bank, as Administrative Agent, Issuing Bank and Swingline Lender [incorporated by reference to Exhibit 10.5 to Form 10-K of the Company’s fiscal year ended August 31, 2008]
     
10.6
 
Fifth Amendment to Third Amended Credit Agreement, dated August 22, 2008 by and among the Company, various lenders, and SunTrust Bank, as Administrative Agent, Issuing Bank and Swingline Lender [incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated August 25, 2008]
     
10.7
 
Sixth Amendment to Third Amended Credit Agreement, dated March 5, 2009 by and among the Company, various lenders, and SunTrust Bank, as Administrative Agent, Issuing Bank and Swingline Lender [incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated March 13, 2009]
     
10.8
 
Office Lease by and between Healthways, Inc. and Highwoods/Tennessee Holdings, L.P., dated as of May 4, 2006 [incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated May 5, 2006]
     
10.9
 
Consulting Agreement between the Company and Rincon Advisors, LLC dated October 11, 2006 [incorporated by reference to Exhibit 10.2 to Form 10-Q of the Company’s fiscal quarter ended November 30, 2006]
     
10.10
 
Subscription Agreement between the Company, L. Ben Lytle, and the L. Ben Lytle Amended and Restated Revocable Living Trust, U/A dated October 11, 2006 [incorporated by reference to Exhibit 10.3 to Form 10-Q of the Company’s fiscal quarter ended November 30, 2006]

 
75

 
 
     
Management Contracts and Compensatory Plans
     
10.11
 
Employment Agreement dated December 19, 2008 between the Company and Ben R. Leedle [incorporated by reference to Exhibit 10.1 to the Company’s Form 10-QT of the Company’s transition period ended December 31, 2008]
     
10.12
 
Employment Agreement dated December 19, 2008 between the Company and Mary A. Chaput [incorporated by reference to Exhibit 10.2 to the Company’s Form 10-QT of the Company’s transition period ended December 31, 2008]
     
10.13
 
Employment Agreement dated December 19, 2008 between the Company and Anne Wilkins [incorporated by reference to Exhibit 10.3 to Form 10-QT of the Company’s transition period ended December 31, 2008]
     
10.14
 
Employment Agreement dated December 10, 2008 between the Company and Matthew Kelliher [incorporated by reference to Exhibit 10.4 to Form 10-QT of the Company’s transition period ended December 31, 2008]
     
10.15
 
Employment Agreement dated October 11, 2008 between the Company and Stefen F. Brueckner [incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated October 16, 2008]
     
10.16
 
Employment Agreement dated January 7, 2009 between the Company and Alfred Lumsdaine [incorporated by reference to Exhibit 10.5 to Form 10-QT of the Company’s transition period ended December 31, 2008]
     
10.17
 
Employment Agreement dated January 7, 2009 between the Company and Chris Cigarran
     
10.18
 
Employment Agreement dated January 7, 2009 between the Company and R. Claiborne Richards, Jr.
     
10.19
 
Long-term performance award agreement dated September 28, 2006 between the Company and Matthew E. Kelliher [incorporated by reference to Exhibit 10.2 to Form 10-Q of the Company’s fiscal quarter ended February 28, 2007]
     
10.20
 
Capital Accumulation Plan, as amended and restated [incorporated by reference to Exhibit 10.1 to Form 10-Q of the Company’s fiscal quarter ended November 30, 2008]
     
10.21
 
Form of Indemnification Agreement by and among the Company and the Company's directors [incorporated by reference to Exhibit 10.15 to Registration Statement on Form S-1 (Registration No. 33-41119)]
     
10.22
 
2007 Stock Incentive Plan [incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated February 8, 2007]

 
76

 
 
     
10.23
 
1996 Stock Incentive Plan, as amended  [incorporated by reference to Exhibit 10.20 to Form 10-K of the Company’s fiscal year ended August 31, 2006]
     
10.24
 
2001 Amended and Restated Stock Option Plan, as amended  [incorporated by reference to Exhibit 10.21 to Form 10-K of the Company’s fiscal year ended August 31, 2006]
     
10.25
 
Form of Non-Qualified Stock Option Agreement under the Company’s 2007 Stock Incentive Plan [incorporated by reference to Exhibit 10.24 to Form 10-K of the Company’s fiscal year ended August 31, 2007]
     
10.26
 
Form of Restricted Stock Unit Award Agreement under the Company’s 2007 Stock Incentive Plan [incorporated by reference to Exhibit 10.25 to Form 10-K of the Company’s fiscal year ended August 31, 2007]
     
10.27
 
Form of Non-Qualified Stock Option Agreement (for Directors) under the Company’s 2007 Stock Incentive Plan [incorporated by reference to Exhibit 10.30 to Form 10-K of the Company’s fiscal year ended August 31, 2008]
     
10.28
 
2007 Stock Incentive Plan Performance Cash Award Agreement Company’s [incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated March 4, 2009]
     
21
 
Subsidiary List
     
23
 
Consent of Ernst & Young LLP
     
31.1
 
Certification pursuant to section 302 of the Sarbanes-Oxley Act of 2002 made by Ben R. Leedle, Jr., Chief Executive Officer
     
31.2
 
Certification pursuant to section 302 of the Sarbanes-Oxley Act of 2002 made by Mary A. Chaput, Chief Financial Officer
     
32
 
Certification Pursuant to 18 U.S.C section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 made by Ben R. Leedle, Jr., Chief Executive Officer and Mary A. Chaput, Chief Financial Officer

(b)
Exhibits

 
Refer to Item 15(a)(3) above.

(c)
Not applicable

 
77

 

SIGNATURES

Pursuant to the requirements of section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

   
HEALTHWAYS, INC
 
March 16, 2010
  By:   /s/ Ben R. Leedle, Jr.
 
 
Ben R. Leedle, Jr.
Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

Signature
 
Title
 
Date
         
/s/ Ben R. Leedle, Jr.
 
Chief Executive Officer and Director (Principal
 
 March 16, 2010
    Ben R. Leedle, Jr.
 
Executive Officer)
   
 
/s/ Mary A. Chaput
 
 
Chief Financial Officer (Principal Financial Officer)
 
 
 March 16, 2010
    Mary A. Chaput
       
 
/s/ Alfred Lumsdaine
 
 
Chief Accounting Officer (Principal Accounting Officer)
 
 
March 16, 2010
    Alfred Lumsdaine
 
/s/ Thomas G. Cigarran
 
 
 
Chairman of the Board and Director
 
 
 
March 16, 2010
    Thomas G. Cigarran
       
         
/s/ John A. Wickens
 
Director
 
 March 16, 2010
    John A. Wickens
       
         
/s/ William D. Novelli
 
Director
 
March 16, 2010
    William D. Novelli
       
         
/s/ William C. O’Neil, Jr.
 
Director
 
 March 16, 2010
    William C. O'Neil, Jr.
       
         
/s/ John W. Ballantine
 
Director
 
 March 16, 2010
   John W. Ballantine
       
         
/s/ Mary Jane England, M.D.
 
Director
 
 March 16, 2010
   Mary Jane England, M.D.
       
         
/s/ Alison Taunton-Rigby
 
Director
 
 March 16, 2010
   Alison Taunton-Rigby
       
         
/s/ J. Cris Bisgard, M.D.
 
Director
 
 March 16, 2010
    J. Cris Bisgard, M.D.
       
         
/s/ C. Warren Neel
 
Director
 
 March 16, 2010
   C. Warren Neel
       
         
/s/ L. Ben Lytle
 
Director
 
 March 16, 2010
   L. Ben Lytle
       
         


 
78