NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Business description and basis of presentation
The Advisory Board Company (individually and collectively with its subsidiaries, the “Company”) provides best practices research and insight, technology, data-enabled services, and consulting services through discrete programs to hospitals, health systems, independent medical groups, pharmaceutical and biotechnology companies, health care insurers, medical device companies, and colleges, universities, and other health care-focused organizations and educational institutions. Members of each subscription-based membership program are typically charged a separate fixed annual fee and have access to an integrated set of services that may include best practices research studies, executive education, proprietary content databases and online tools, daily online executive briefings, original executive inquiry services, cloud-based software applications, data-enabled services, and consulting and management services.
Sale Transactions
Merger Agreement.
On August 28, 2017, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with OptumInsight, Inc. (“Optum”), a wholly owned subsidiary of UnitedHealth Group Incorporated, and Apollo Merger Sub, Inc., a wholly owned subsidiary of Optum (“Merger Sub”), pursuant to which, after the closing of the Education Transaction (as defined below), Merger Sub will merge with and into the Company, with the Company surviving as a wholly owned subsidiary of Optum (the “Merger”).
Upon the terms and subject to the conditions set forth in the Merger Agreement, at the effective time of the Merger, each issued and outstanding share of common stock of the Company will be converted into the right to receive the following, without interest: (i)
$52.65
in cash, plus (ii) an additional cash amount based on the after-tax value of the Company’s ownership interest in Evolent Health, Inc. (“Evolent Inc.”) and Evolent Health LLC ("Evolent LLC"), which additional cash amount will be determined pursuant to the formula set forth in the Merger Agreement (the “Evolent Proceeds Amount”). Pursuant to the formula set forth in the Merger Agreement, the Evolent Proceeds Amount will consist of a per-share amount of (i) the after-tax value of any shares of Evolent Inc.’s Class A and Class B common stock held by the Company as of the close of business on the third business day prior to the closing, plus (ii) the after-tax net proceeds of any sales by the Company of shares of Evolent Inc.’s Class A and Class B common stock following the date of the Merger Agreement and ending on and including the third business day prior to the Merger closing. The Evolent Proceeds Amount is not fixed and will fluctuate prior to the closing based on changes in the trading price of Evolent Inc.’s Class A common stock, which trading price may be influenced by market conditions, among other things.
The closing of the Merger is subject to customary and other conditions, including the adoption of the Merger Agreement by the Company’s stockholders and the occurrence of the closing of the Education Transaction.
The Merger Agreement contains certain termination rights for the Company and Optum. Upon termination of the Merger Agreement under specified circumstances, the Company may be required to pay Optum a termination fee of
$42 million
.
For the three and nine months ended
September 30, 2017
, the Company incurred
$7.8 million
and
$17.2 million
, respectively, of costs related to the Merger Agreement, which are included on the Consolidated Statement of Operations.
Education Purchase Agreement.
Concurrently with the execution of the Merger Agreement, the Company entered into a Stock and Asset Purchase Agreement (the “Education Purchase Agreement”) with Avatar Holdco, LLC and Avatar Purchaser, Inc. (collectively, “Education Buyer”), pursuant to which the Company will sell its education business to Education Buyer (the “Education Transaction”). Avatar Holdco, LLC and Avatar Purchaser, Inc. were formed by Vista Equity Partners Fund VI, L.P.
Upon the terms and subject to the conditions set forth in the Education Purchase Agreement, at the closing of the Education Transaction, the Company will sell to Education Buyer the stock of Royall Acquisition Co., a wholly-owned subsidiary of the Company (“Royall”), and certain of the Company’s assets related to the Company’s education business for
$1.55 billion
in cash, subject to certain adjustments. Education Buyer will also assume certain of the Company’s liabilities related to the Company’s education business.
The closing of the Education Transaction is subject to customary and other conditions, including satisfaction of all conditions to close the Merger.
The Education Purchase Agreement contains certain termination rights for the Company and Education Buyer. Upon termination of the Education Purchase Agreement under specified circumstances, the Company may be required to pay Education Buyer a termination fee of
$42 million
or
$47 million
. The Transaction is expected to close in 2017.
Basis of Presentation
The unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”) for reporting on Form 10-Q. Accordingly, certain information and footnote disclosures required for complete financial statements are not included herein. These unaudited consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes as reported in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.
The unaudited consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. The Company uses the equity method to account for equity investments in instances in which it owns common stock and has the ability to exercise significant influence, but not control, over the investee and for all investments in partnerships or limited liability companies where the investee maintains separate capital accounts for each investor. All significant intercompany transactions and balances have been eliminated. Certain items in the prior period financial statements have been reclassified for comparative purposes to conform to the current period presentation.
In the opinion of management, all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation of the consolidated financial position, results of operations, and cash flows as of the dates and for the periods presented have been included. The consolidated balance sheet presented as of December 31, 2016 has been derived from the financial statements that have been audited by the Company’s independent registered public accounting firm. The consolidated results of operations for the three and nine months ended
September 30, 2017
may not be indicative of the results that may be expected for the Company’s fiscal year ending December 31, 2017, or any other period.
Note 2. Recent accounting pronouncements
Recently adopted
In March 2016, the Financial Accounting Standards Board ("FASB") issued accounting guidance relating to stock-based compensation. The guidance simplifies various aspects of the accounting for share-based payments. The amendments impact net income, earnings per share, and the statement of cash flows. The guidance is effective for annual reporting and interim periods beginning after December 15, 2016, with early adoption permitted. The Company adopted this standard as of January 1, 2017 using a modified retrospective approach, which requires the cumulative effect of initially applying the standard to be recorded as an adjustment to the opening balance of retained earnings of the annual reporting period that includes the date of initial application. In connection with the adoption of this guidance, the Company elected to no longer calculate an estimate of expected forfeitures and began recognizing forfeitures as they occur, which resulted in a cumulative-effect net decrease of
$0.7 million
to retained earnings with an offset of
$1.2 million
to additional paid-in capital and an increase of
$0.5 million
in deferred tax assets. Upon adoption, all excess tax benefits and tax deficiencies are recognized as income tax expense or benefit in the consolidated statements of operations. In addition, excess tax benefits are no longer presented within cash flows from financing activities but instead are presented in cash flows from operating activities in the consolidated statements of cash flows. Prior to adoption, the excess tax benefits and tax deficiencies were recorded to additional paid-in capital and excess tax benefits were not recorded until they were able to be utilized.
Recently issued
In May 2014, the FASB issued accounting guidance related to revenue recognition. The new standard supersedes most of the existing revenue recognition guidance under GAAP, and requires revenue to be recognized when goods or services are transferred to a customer in an amount that reflects the consideration a company expects to receive. The new standard may require more judgment and estimates relating to the recognition of revenue, which could result in additional disclosures to the financial statements. The new standard will be effective for annual and interim reporting periods beginning after December 15, 2017, with an option that permits companies to adopt the standard as early as the original effective date of December 31, 2016. Early application prior to the original effective date is not permitted. The Company will adopt the standard on January 1, 2018 using the modified retrospective approach. While the potential impacts of the new standard are still being assessed, the Company currently believes the new standard will affect the Company's accounting for contract acquisition costs and arrangements that include variable consideration. The Company is currently evaluating the effect that the standard will have on its remaining revenue. The Company continues to update its assessment of the impact of the standard and related updates to the consolidated financial statements, and will disclose material impacts when known.
In January 2016, the FASB issued accounting guidance related to the recognition and measurement of financial assets and liabilities. The guidance requires, among other things, that entities measure equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) at fair value, with changes in fair value recognized in net income. Under the new guidance, entities will no longer be able to recognize unrealized holding gains and losses on available-for-sale equity securities in other comprehensive income, and will no longer be able to use the cost
method of accounting for equity securities that do not have readily determinable fair values. The guidance for classifying and measuring investments in debt securities and loans is not affected. The guidance eliminates certain disclosure requirements related to financial instruments measured at amortized cost and adds disclosures related to the measurement categories of financial assets and financial liabilities. The guidance is effective for annual periods beginning after December 15, 2017. Early adoption is permitted only for certain portions of the guidance. The adoption of this guidance by the Company is not expected to have a material impact on its consolidated financial statements.
In February 2016, the FASB issued accounting guidance related to leases. The guidance requires that lessees recognize assets and liabilities on the balance sheet for the rights and obligations created by all leases with terms of more than twelve months. The new guidance also requires disclosures designed to give financial statement users information on the amount, timing, and uncertainty of cash flows arising from leases. These disclosures include qualitative and quantitative information. The guidance is effective for annual reporting and interim periods beginning after December 15, 2018, with early adoption permitted. The Company is currently evaluating the impact of this guidance on its consolidated financial statements.
In August 2016, the FASB issued accounting guidance relating to the statement of cash flows. The guidance clarifies how certain cash receipts and cash payments are presented in the statement of cash flows. The guidance is effective for annual reporting and interim periods beginning after December 15, 2017, with early adoption permitted. The Company is currently evaluating the impact of this guidance on its consolidated financial statements.
In January 2017, the FASB issued accounting guidance which clarifies the definition of a business in order to assist entities in evaluating whether transactions should be accounted for as acquisitions (or dispositions) of assets or businesses. The guidance is effective for annual reporting and interim periods beginning after December 15, 2017. The Company is currently evaluating the impact of this guidance on its consolidated financial statements.
In January 2017, the FASB issued accounting guidance simplifying the test of goodwill impairment. The guidance eliminates Step 2 of the goodwill impairment test, which calculates the implied fair value of goodwill to measure a goodwill impairment charge. Instead, entities will be required to record an impairment charge based on the excess of a reporting unit’s carrying amount over its fair value (i.e. Step 1). The guidance is effective for annual and interim reporting periods beginning after December 15, 2019, with early adoption permitted. The adoption of this guidance by the Company is not expected to have a material impact on its consolidated financial statements.
In February 2017, the FASB issued accounting guidance related to gains and losses from the derecognition of nonfinancial assets which clarifies the scope of asset derecognition guidance and accounting for partial sales of nonfinancial assets. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017, with early adoption permitted. The Company is currently evaluating the impact of this guidance on its consolidated financial statements.
In May 2017, the FASB issued accounting guidance related to changes to the terms or conditions of a share-based payment award that require an entity to apply modification accounting in Topic 718. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017, with early adoption permitted. The adoption of this guidance by the Company is not expected to have a material impact on its consolidated financial statements.
In August 2017, the FASB issued targeted improvements to accounting for hedging activities. This standard enables entities to better portray the economics of their risk management activities in the financial statements and enhances the transparency and understandability of hedge results through improved disclosures. The amendments are effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years, with early adoption permitted. The adoption of this guidance by the Company is not expected to have a material impact on its consolidated financial statements.
Note 3. Fair value measurements
Financial assets and liabilities
The estimated fair values of financial instruments are determined based on relevant market information. These estimates involve uncertainty and cannot be determined with precision. The Company’s financial instruments consist primarily of cash, cash equivalents, and interest rate swaps. In addition, contingent earn-out liabilities resulting from business combinations are recorded at fair value. The following methods and assumptions are used to estimate the fair value of each class of financial assets or liabilities that is valued on a recurring basis.
Cash and cash equivalents
. This class of financial assets includes all cash and liquid investments with an original maturity of three months or less from the date acquired. The carrying amount approximates fair value because of the short maturity of these instruments. Cash equivalents also consist of money market funds with fair values based on quoted market prices. The Company’s cash and cash equivalents are held at major commercial banks.
Contingent earn-out liabilities
. This class of financial liabilities represents the Company’s estimated fair value of the contingent earn-out liabilities related to acquisitions based on probability assessments of certain performance achievements during the earn-out periods. The performance targets are specific to the operation of the acquired company subsequent to the acquisition. These inputs are considered key estimates made by the Company that are unobservable because there are no active markets to support them. Contingent earn-out liabilities are included in accounts payable and accrued liabilities and other long-term liabilities on the consolidated balance sheets.
Interest rate swaps
. The Company uses interest rate swaps to manage interest rate risk. The fair values of interest rate swaps are determined using the market standard methodology of discounting the future variable cash payments, or receipts, over the life of the agreements. The variable interest rates used in the calculation of projected receipts are based on observable market interest rate curves. See Note 7, "Debt."
Measurements
The following table presents information about the Company's financial assets and liabilities that are measured at fair value on a recurring basis as of September 30, 2017 and December 31, 2016 and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value. In general, fair values determined by Level 1 inputs utilize quoted prices in active markets for identical assets or liabilities, and fair values determined by Level 2 inputs utilize quoted prices in inactive markets for identical assets or liabilities obtained from readily available pricing sources for similar instruments. The fair values determined by Level 3 inputs are unobservable values which are supported by little or no market activity, such as discounted cash flow methodologies. Assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurements. The Company reviews the fair value hierarchy classification on a quarterly basis. Changes in the observability of valuation inputs may result in a reclassification of levels for certain securities within the fair value hierarchy. It is the Company's policy to recognize transfers between levels of the fair value hierarchy, if any, at the end of the reporting period. There have been
no
such transfers during any of the periods presented.
The Company’s financial assets and liabilities subject to fair value measurements on a recurring basis and the related classifications are as follows (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fair value
as of September 30,
|
|
Fair value measurement as of September 30, 2017
using fair value hierarchy
|
|
2017
|
|
Level 1
|
|
Level 2
|
|
Level 3
|
Financial assets
|
|
|
|
|
|
|
|
Cash and cash equivalents (1)
|
$
|
151,458
|
|
|
$
|
151,458
|
|
|
$
|
—
|
|
|
$
|
—
|
|
Interest rate swaps (2)
|
1,694
|
|
|
—
|
|
|
1,694
|
|
|
—
|
|
Financial liabilities
|
|
|
|
|
|
|
|
Contingent earn-out liabilities (3)
|
237
|
|
|
—
|
|
|
—
|
|
|
237
|
|
|
|
|
|
|
|
|
|
|
Fair value
as of December 31,
|
|
Fair value measurement as of December 31, 2016
using fair value hierarchy
|
|
2016
|
|
Level 1
|
|
Level 2
|
|
Level 3
|
Financial assets
|
|
|
|
|
|
|
|
Cash and cash equivalents (1)
|
$
|
91,151
|
|
|
$
|
91,151
|
|
|
$
|
—
|
|
|
$
|
—
|
|
Interest rate swaps (2)
|
1,044
|
|
|
—
|
|
|
1,044
|
|
|
—
|
|
Financial liabilities
|
|
|
|
|
|
|
|
|
Contingent earn-out liabilities (3)
|
1,164
|
|
|
—
|
|
|
—
|
|
|
1,164
|
|
—————————————
|
|
(1)
|
Fair value is based on quoted market prices.
|
|
|
(2)
|
Fair value is determined using market standard models with observable inputs.
|
|
|
(3)
|
This fair value measurement is based on unobservable inputs that are supported by little or no market activity and reflect the Company’s own assumptions in measuring fair value using the income approach. In developing these estimates, the Company considered certain performance projections, historical results, and general macroeconomic environment and industry trends.
|
Contingent earn-out liabilities
The Company's fair value estimate of the earn-out liability related to the Company’s acquisition of Clinovations, LLC (“Clinovations”) in November 2014 was
$4.5 million
as of the date of acquisition. The Clinovations earn-out liability is affected by changes in estimates regarding expected operating results through the evaluation periods, which will end on December 31, 2017 with payments extending through April 2018. During the three months ended
September 30, 2017
,
17,317
shares were issued to pay a portion of the earn-out liability. As of
September 30, 2017
, a total of
79,586
shares have been issued to pay a portion of the earn-out liability under the terms of the acquisition agreement. The maximum payout of the earn-out liability is
$9.5 million
, while the minimum payment is
$0
. Based on the results of Clinovations’ operating results, there was
no
estimated remaining fair value contingent obligation for Clinovations as of
September 30, 2017
.
The Company's fair value estimate of the earn-out liability related to the Company’s acquisition of ThoughtWright, LLC d/b/a GradesFirst (“GradesFirst”) in December 2014 was
$3.6 million
as of the date of acquisition. The Company paid
$4.0 million
during the nine months ended September 30, 2016 in satisfaction of its remaining obligation.
The Company entered into an earn-out agreement in connection with its acquisition of Southwind Health Partners, L.L.C. and Southwind Navigator, LLC (together, “Southwind”) in December 2009. The Company paid
$1.0 million
during the nine months ended September 30, 2016 in satisfaction of its remaining obligation.
Changes in the fair value of the contingent earn-out liabilities subsequent to the acquisition date, including changes arising from events that occurred after the acquisition date, such as changes in the Company’s estimate of performance achievements, discount rates, and stock price, are recognized in earnings in the periods during which the estimated fair value changes.
The following table represents a reconciliation of the change in the contingent earn-out liabilities for the three and
nine
months ended
September 30, 2017
and
2016
(in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
2017
|
|
2016
|
|
2017
|
|
2016
|
Beginning balance
|
$
|
1,235
|
|
|
$
|
3,280
|
|
|
$
|
1,164
|
|
|
$
|
7,250
|
|
Addition due to acquisition
|
—
|
|
|
—
|
|
|
—
|
|
|
357
|
|
Fair value change in Clinovations contingent earn-out liability (1)
|
32
|
|
|
647
|
|
|
308
|
|
|
1,327
|
|
Fair value change in other contingent earn-out liabilities (1)
|
(105
|
)
|
|
141
|
|
|
71
|
|
|
166
|
|
Southwind earn-out payments
|
—
|
|
|
—
|
|
|
—
|
|
|
(1,032
|
)
|
Clinovations earn-out payments
|
(925
|
)
|
|
(2,703
|
)
|
|
(925
|
)
|
|
(2,703
|
)
|
Other earn-out payments
|
—
|
|
|
—
|
|
|
(381
|
)
|
|
—
|
|
GradesFirst earn-out payments
|
—
|
|
|
—
|
|
|
—
|
|
|
(4,000
|
)
|
Ending balance
|
$
|
237
|
|
|
$
|
1,365
|
|
|
$
|
237
|
|
|
$
|
1,365
|
|
—————————————
|
|
(1)
|
Amounts were recognized in cost of services on the consolidated statements of operations.
|
Financial instruments not recorded at fair value on a recurring basis
Equity method investments
. The Company's equity method investments represent the Company's ownership interest in Evolent Inc. and its subsidiary, Evolent LLC. The fair value of the Company's ownership interest in Evolent Inc. and its subsidiary prior to any discount was
$105.0 million
as of
September 30, 2017
based on the closing price of the Class A common stock of Evolent Inc. on that date as reported on the New York Stock Exchange. For further information, see Note 6, "Equity method investments." The fair value of the Company's equity method investments is measured quarterly for disclosure purposes. The Company's equity method investments are recorded at fair value only if an impairment charge is recognized.
Credit facilities
. The Company estimates that the fair value of its credit facilities was
$493.2
million as of
September 30, 2017
. The fair value was determined based on discounting the future expected variable cash payments over the life of the loan. The variable interest rates used in the calculation are based on observable market interest rates. The credit facilities would be classified as Level 2 within the fair value hierarchy if they were measured at fair value.
Non-financial assets and liabilities
Certain assets and liabilities are not measured at fair value on an ongoing basis, but instead are measured at fair value on a non-recurring basis, so that such assets and liabilities are subject to fair value adjustments in certain circumstances (such as
when there is evidence of impairment). During the
nine
months ended
September 30, 2017
and
2016
,
no
fair value adjustments or material fair value measurements were required for non-financial assets or liabilities.
Note 4. Property and equipment
Property and equipment consists of leasehold improvements, furniture, fixtures, equipment, capitalized internal-use software development, and acquired developed technology. Property and equipment is stated at cost, less accumulated depreciation and amortization. In certain membership programs, the Company provides software applications under a hosting arrangement where the software application resides on the Company’s or its service providers’ hardware. The members do not take delivery of the software and only receive access to the software during the term of their membership agreement. Software development costs that are incurred in the preliminary project stage are expensed as incurred. During the development stage, direct consulting costs and payroll and payroll-related costs for employees that are directly associated with each project are capitalized and amortized over the estimated useful life of the software once placed into operation. Capitalized software is amortized using the straight-line method over its estimated useful life, which is generally
five
years. Replacements and major improvements are capitalized, while maintenance and repairs are charged to expense as incurred.
The acquired developed technology, which includes acquired software, databases, and analytics, is classified as software within property and equipment because the developed software application, database, or analytic resides on the Company’s or its service providers’ hardware. Amortization of acquired developed technology is included in depreciation and amortization on the Company’s consolidated statements of operations. Developed technology obtained through acquisitions is amortized using the straight-line method over the estimated useful life used in determining the fair value of the assets at acquisition. As of
September 30, 2017
, the weighted average useful life of existing acquired developed technology was approximately
seven
years. The amount of acquired developed technology amortization included in depreciation and amortization for the
three
months ended
September 30, 2017
and
2016
was approximately
$2.3 million
and
$2.1 million
, respectively. The amount of acquired developed technology amortization included in depreciation and amortization for the
nine
months ended
September 30, 2017
and
2016
was approximately
$7.0 million
and
$6.7 million
, respectively.
Furniture, fixtures, and equipment are depreciated using the straight-line method over the estimated useful lives of the assets, which range from
three
to
seven
years. Leasehold improvements are depreciated using the straight-line method over the shorter of the estimated useful lives of the assets or the lease term. There are
no
capitalized leases included in property and equipment, net for the periods presented. The amount of depreciation expense recognized with respect to furniture, fixtures, and equipment during the
three
months ended
September 30, 2017
and
2016
was
$5.5 million
and
$5.7 million
, respectively. The amount of depreciation expense recognized with respect to furniture, fixtures, and equipment during the
nine
months ended
September 30, 2017
and
2016
was
$16.4 million
and
$16.6 million
, respectively.
Internally developed capitalized software related to the Company's hosted software is classified as software within property and equipment and has an estimated useful life of
five
years. As of
September 30, 2017
and December 31, 2016, the carrying value of internally developed capitalized software was
$73.0 million
and
$75.2 million
, respectively. Amortization expense for internally developed capitalized software for the
three
months ended
September 30, 2017
and
2016
recorded in depreciation and amortization on the consolidated statements of operations was approximately
$7.0 million
and
$5.6 million
, respectively. Amortization expense for internally developed capitalized software for the
nine
months ended
September 30, 2017
and
2016
recorded in depreciation and amortization on the consolidated statements of operations was approximately
$20.8 million
and
$17.5 million
, respectively.
Property and equipment consists of the following (in thousands):
|
|
|
|
|
|
|
|
|
|
As of
|
|
September 30, 2017
|
|
December 31, 2016
|
Leasehold improvements
|
$
|
69,717
|
|
|
$
|
69,465
|
|
Furniture, fixtures, and equipment
|
71,087
|
|
|
70,362
|
|
Software
|
251,107
|
|
|
231,952
|
|
Property and equipment, gross
|
391,911
|
|
|
371,779
|
|
Accumulated depreciation and amortization
|
(244,730
|
)
|
|
(200,498
|
)
|
Property and equipment, net
|
$
|
147,181
|
|
|
$
|
171,281
|
|
The Company evaluates its long-lived assets for impairment when changes in circumstances exist that suggest the carrying value of a long-lived asset may not be fully recoverable. If an indication of impairment exists, and the Company’s net book value of the related assets is not fully recoverable based upon an analysis of its estimated undiscounted future cash flows, the assets are written down to their estimated fair value. The Company recognized a
$0.8 million
loss on the disposal of property and equipment during the nine months ended
September 30, 2017
related to the restructuring plan described in Note 13, "Costs of exit or disposal." There was
no
material impairment loss recognized on long-lived assets during the three and
nine
months ended
September 30, 2017
or
2016
.
Construction in progress
. In December 2015, the Company entered into a lease for its new corporate headquarters, which is currently being constructed in Washington D.C. The lease has an anticipated start date of mid-2019, with a
16
-year initial term and
$446.1 million
of lease payments. The Company has concluded that it is the deemed owner of the building (for accounting purposes only) during the construction period and that the lease qualifies for build-to-suit accounting. Accordingly, the Company has recorded a construction-in-progress asset, net of
$148.0 million
for which there is a corresponding construction financing obligation of
$148.0 million
recorded in the consolidated balance sheet as of
September 30, 2017
. The Company will continue to increase the construction-in-progress asset and corresponding long-term liability as additional building costs are incurred by the landlord during the construction period. Upon completion of the construction, the Company will evaluate whether this arrangement meets the criteria for sale-leaseback accounting treatment.
Note 5. Goodwill and intangibles
Included in the Company’s goodwill and intangibles balances are goodwill and acquired intangibles, as well as internally developed capitalized software for sale. Goodwill is not amortized because it has an estimated indefinite life. Goodwill is reviewed for impairment at least annually as of October 1, or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company believes that
no
such impairment indicators existed during the
nine
months ended
September 30, 2017
or
2016
. There was
no
impairment of goodwill recorded in the
nine
months ended
September 30, 2017
or
2016
.
The following illustrates the change in the goodwill balance for the
nine
months ended
September 30, 2017
(in thousands):
|
|
|
|
|
Balance as of December 31, 2016
|
$
|
739,507
|
|
Acquisitions
|
—
|
|
Adjustment related to Royall acquisition (1)
|
(2,484
|
)
|
Balance as of September 30, 2017
|
$
|
737,023
|
|
—————————————
|
|
(1)
|
Represents an immaterial adjustment to the blended state tax rate used in the purchase price allocation resulting in a reduction to deferred tax liabilities and a reduction of goodwill.
|
Intangible assets with finite lives are amortized on a straight-line basis over their estimated useful lives, which range from
2
years to
17
years. As of
September 30, 2017
, the weighted average remaining useful life of acquired intangibles was approximately
12.8
years. As of
September 30, 2017
, the weighted average remaining useful life of internally developed intangibles was approximately
2.9
years.
The gross and net carrying balances and accumulated amortization of intangibles are as follows (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of September 30, 2017
|
|
As of December 31, 2016
|
|
Weighted
average
useful life
|
|
Gross
carrying
amount
|
|
Accumulated
amortization
|
|
Net
carrying
amount
|
|
Gross
carrying
amount
|
|
Accumulated
amortization
|
|
Net
carrying
amount
|
Intangibles
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Internally developed software for sale:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Capitalized software
|
5.0
|
|
$
|
21,860
|
|
|
$
|
(12,629
|
)
|
|
$
|
9,231
|
|
|
$
|
20,034
|
|
|
$
|
(9,998
|
)
|
|
$
|
10,036
|
|
Acquired intangibles:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Developed software
|
5.2
|
|
9,450
|
|
|
(8,950
|
)
|
|
500
|
|
|
9,450
|
|
|
(8,575
|
)
|
|
875
|
|
Customer relationships
|
16.2
|
|
277,710
|
|
|
(55,924
|
)
|
|
221,786
|
|
|
277,710
|
|
|
(42,978
|
)
|
|
234,732
|
|
Trademarks
|
8.6
|
|
14,900
|
|
|
(6,800
|
)
|
|
8,100
|
|
|
14,900
|
|
|
(5,923
|
)
|
|
8,977
|
|
Customer contracts
|
4.7
|
|
6,449
|
|
|
(6,321
|
)
|
|
128
|
|
|
6,449
|
|
|
(6,016
|
)
|
|
433
|
|
Total intangibles
|
|
|
$
|
330,369
|
|
|
$
|
(90,624
|
)
|
|
$
|
239,745
|
|
|
$
|
328,543
|
|
|
$
|
(73,490
|
)
|
|
$
|
255,053
|
|
Amortization expense for intangible assets for the three months ended
September 30, 2017
and
2016
, recorded in depreciation and amortization on the consolidated statements of operations, was approximately
$5.7 million
. Amortization expense for intangible assets for the nine months ended
September 30, 2017
and
2016
, recorded in depreciation and amortization on the consolidated statements of operations, was approximately
$17.1 million
. The following approximates the aggregate amortization expense to be recorded in depreciation and amortization on the consolidated statements of operations for the remaining three months of the fiscal year ending
December 31, 2017
, for each of the following fiscal years ending December 31, 2018 through 2021, and thereafter:
$5.6 million
,
$21.9 million
,
$20.3 million
,
$19.0 million
, and
$18.0 million
, respectively, and
$154.9 million
thereafter.
Note 6. Equity method investments
As of
September 30, 2017
, the Company held a
2.3%
equity interest in Evolent LLC and a
5.5%
equity ownership interest in Evolent Inc., which had no material operations outside of its
96.6%
ownership interest in Evolent LLC. These investments are accounted for under the equity method, with the Company’s proportionate share of the investees’ losses recognized in the consolidated statements of operations. The Company has the right to designate
two
individuals to Evolent Inc.'s board of directors, who were the Company’s Chief Financial Officer and an unaffiliated designee of the Company as of
September 30, 2017
.
Evolent Inc.
During the three months ended
September 30, 2017
, the Company recognized
$0.6 million
for its proportionate share of the losses of Evolent Inc. and a
$5.3 million
post-tax dilution gain due to Evolent Inc.'s primary offering in the consolidated statements of operations. During the three months ended
September 30, 2016
, the Company sold a portion of its interest in Evolent Inc. Total cash received from the transaction was
$48.6 million
and resulted in the recognition of an after-tax gain of
$29.7 million
in the three and nine months ended September 30, 2016. The Company's proportionate share of the losses of Evolent Inc. was
$1.2 million
for the three months ended
September 30, 2016
. These losses were not recorded as they exceeded the Company's investment balance.
During the nine months ended
September 30, 2017
, the Company's proportionate share of the losses of Evolent Inc. recognized in the consolidated statements of operations was
$2.9 million
and the Company recognized a
$5.3 million
post-tax dilution gain due to Evolent Inc.'s primary offering. During the nine months ended
September 30, 2016
, the Company's proportionate shares of the losses of Evolent Inc. was
$3.5 million
, of which
$1.5 million
was recognized in the consolidated statements of operations.
The carrying balance of the Company’s investment in Evolent Inc. was
$15.3 million
and
$10.3 million
as of
September 30, 2017
and December 31, 2016, respectively. The Company had no unrecorded losses related to its investment in Evolent Inc. as of
September 30, 2017
.
Evolent LLC
During the three months ended
September 30, 2017
, the Company recognized
$0.3 million
for its proportionate share of the losses of Evolent LLC and a
$2.3 million
post-tax dilution gain due to Evolent Inc.'s primary offering in the consolidated
statements of operations. During the three months ended
September 30, 2016
, the Company's proportionate share of the losses of Evolent LLC was
$1.3 million
. These losses were not recorded as they exceeded the Company's investment balance.
The Company's proportionate share of the losses of Evolent LLC was
$2.7 million
during the nine months ended
September 30, 2017
. During nine months ended
September 30, 2017
, the Company received total cash of
$71.9 million
from the sale of shares of Evolent Inc. Class A common stock which the Company received in exchange, on a
one
-for-one basis, for Evolent LLC Class B common units and shares of Evolent Inc. Class B common stock. The transactions resulted in post-tax gains of
$42.3 million
for the nine months ended
September 30, 2017
. In addition, the Company recognized a
$2.3 million
post-tax dilution gain due to Evolent Inc.'s primary offering during the nine months ended
September 30, 2017
. During the nine months ended
September 30, 2016
, the Company's proportionate share of the losses of Evolent LLC was
$3.5 million
, of which
$1.2 million
was recognized in the consolidated statements of operations.
The carrying balance of the Company’s investment in Evolent LLC was
$5.4 million
and
$9.6 million
as of
September 30, 2017
and December 31, 2016, respectively. The Company had
no
unrecorded losses related to its investment in Evolent LLC as of
September 30, 2017
.
At the time of Evolent Inc.'s initial public offering and related reorganization, the Company carried over its basis in the investment, resulting in a significant difference between its basis and its proportionate share in the equity of Evolent Inc. As of
September 30, 2017
, the basis difference totaled
$37.8 million
and will decrease over time through amortization and upon any sale or dilutive transactions. Evolent Inc. gained control of Evolent LLC in the transaction and applied purchase and push down accounting. The Company has excluded the effects of this accounting in its determination of the equity in Evolent LLC losses, thereby reducing its share of losses from Evolent LLC for the affected periods.
Because of Evolent LLC's treatment as a partnership for federal income tax purposes, the losses of Evolent LLC pass through to the Company and the other members. The Company's proportionate share of the losses of Evolent LLC is recorded net of the estimated tax benefit the Company believes will be realized from the equity in loss of equity method investments on the consolidated statements of operations. Historically, the Company had provided a full valuation allowance against the deferred tax asset resulting from these benefits. In the three and nine months ended September 30, 2016, tax benefits of
$5.1 million
and
$5.4 million
, respectively, were recorded for the tax effects of the current year losses received from Evolent LLC. The provision for income taxes from gains (losses) from equity method investments recorded for current year dilution gains and the allocated share of losses from Evolent LLC and Evolent, Inc. for the three months ended September 30, 2017 was
$3.6 million
, representing an effective tax rate of
33.9%
. The provision for income taxes from gains (losses) from equity method investments for the nine months ended September 30, 2017 was $
26.4 million
, representing an effective tax rate of
36.4%
. Tax expense of
$24.6 million
was recorded for the tax effect of the current period gain on sale of shares in Evolent LLC and tax expense of
$1.8 million
was recorded for the tax effect of the current year dilution gains and the allocated share of losses from Evolent LLC and Evolent, Inc.
The gains from equity method investments on the consolidated statement of operations for the combined Evolent entities consisted of the following (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
2017
|
|
2016
|
|
2017
|
|
2016
|
Dilution gain
|
$
|
11,455
|
|
|
$
|
—
|
|
|
$
|
11,455
|
|
|
$
|
2,026
|
|
Gain on partial sale of investment
|
—
|
|
|
48,565
|
|
|
66,853
|
|
|
48,565
|
|
Allocated share of losses
|
(935
|
)
|
|
—
|
|
|
(5,596
|
)
|
|
(2,732
|
)
|
Tax (expense) benefit
|
(3,564
|
)
|
|
(13,836
|
)
|
|
(26,443
|
)
|
|
(13,575
|
)
|
Gains (losses) from equity method investments
|
$
|
6,956
|
|
|
$
|
34,729
|
|
|
$
|
46,269
|
|
|
$
|
34,284
|
|
In connection with Evolent Inc.'s initial public offering and the related reorganization, the Company and certain investors in Evolent LLC entered into a tax receivables agreement with Evolent Inc. Under the terms of that agreement, Evolent Inc. will make cash payments to the Company and certain investors in amounts equal to
85%
of Evolent Inc.'s actual tax benefit realized from various tax attributes related to activity before the initial public offering. Interest will be included on the tax savings at the applicable London interbank offered rate plus 100 basis points. The tax receivables agreement will generally apply to Evolent Inc.'s taxable years up to and including the
15
th anniversary date of the transaction. As of
September 30, 2017
, the Company had not received any payments pursuant to the tax receivables agreement. As the amount the Company will receive pursuant to the tax receivables agreement is unknown, the Company will recognize payments, if any, associated with this agreement when such payments are received.
The following is a summary of the financial position of Evolent LLC as of the dates presented (in thousands):
|
|
|
|
|
|
|
|
|
|
As of
|
|
September 30, 2017
|
|
December 31, 2016
|
Assets:
|
|
|
|
Current assets
|
$
|
509,520
|
|
|
$
|
154,555
|
|
Non-current assets
|
932,068
|
|
|
921,556
|
|
Total assets
|
$
|
1,441,588
|
|
|
$
|
1,076,111
|
|
Liabilities and members’ equity:
|
|
|
|
Current liabilities
|
$
|
263,558
|
|
|
$
|
131,926
|
|
Non-current liabilities
|
131,147
|
|
|
24,654
|
|
Total liabilities
|
394,705
|
|
|
156,580
|
|
Members’ equity
|
1,046,883
|
|
|
919,531
|
|
Total liabilities and members’ equity
|
$
|
1,441,588
|
|
|
$
|
1,076,111
|
|
The following is a summary of the operating results of Evolent LLC for the periods presented (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended September 30,
|
|
Nine Months Ended September 30,
|
|
2017
|
|
2016
|
|
2017
|
|
2016
|
Revenue
|
$
|
107,912
|
|
|
$
|
60,210
|
|
|
$
|
321,222
|
|
|
$
|
166,177
|
|
Cost of revenue (exclusive of depreciation and amortization)
|
68,281
|
|
|
33,905
|
|
|
203,802
|
|
|
95,295
|
|
Gross profit
|
$
|
39,631
|
|
|
$
|
26,305
|
|
|
$
|
117,420
|
|
|
$
|
70,882
|
|
|
|
|
|
|
|
|
|
Net loss
|
$
|
(14,740
|
)
|
|
$
|
(16,029
|
)
|
|
$
|
(57,756
|
)
|
|
$
|
(203,199
|
)
|
The following is a summary of the consolidated financial position of Evolent Inc. as of the dates presented (in thousands):
|
|
|
|
|
|
|
|
|
|
As of
|
|
September 30, 2017
|
|
December 31, 2016
|
Assets:
|
|
|
|
Current assets
|
$
|
352,329
|
|
|
$
|
264,966
|
|
Non-current assets
|
946,701
|
|
|
934,873
|
|
Total assets
|
$
|
1,299,030
|
|
|
$
|
1,199,839
|
|
Liabilities and shareholders' equity:
|
|
|
|
Current liabilities
|
$
|
105,467
|
|
|
$
|
131,941
|
|
Non-current liabilities
|
137,784
|
|
|
155,784
|
|
Total liabilities
|
243,251
|
|
|
287,725
|
|
Total shareholders' equity attributable to Evolent Health, Inc.
|
1,019,847
|
|
|
702,526
|
|
Non-controlling interests
|
35,932
|
|
|
209,588
|
|
Total liabilities and shareholders’ equity
|
$
|
1,299,030
|
|
|
$
|
1,199,839
|
|
The following is a summary of the consolidated operating results of Evolent Inc. for the periods presented (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended September 30,
|
|
Nine Months Ended September 30,
|
|
|
2017
|
|
2016
|
|
2017
|
|
2016
|
Revenue
|
|
$
|
107,912
|
|
|
$
|
60,210
|
|
|
$
|
321,221
|
|
|
$
|
166,177
|
|
Cost of revenue (exclusive of depreciation and amortization)
|
|
68,281
|
|
|
33,905
|
|
|
203,804
|
|
|
95,294
|
|
Gross profit
|
|
$
|
39,631
|
|
|
$
|
26,305
|
|
|
$
|
117,417
|
|
|
$
|
70,883
|
|
|
|
|
|
|
|
|
|
|
Loss before income taxes and non-controlling interests
|
|
$
|
(14,843
|
)
|
|
$
|
(16,031
|
)
|
|
$
|
(57,986
|
)
|
|
$
|
(203,199
|
)
|
Net loss
|
|
$
|
(13,129
|
)
|
|
$
|
(15,775
|
)
|
|
$
|
(55,977
|
)
|
|
$
|
(201,585
|
)
|
Loss attributable to Evolent Health, Inc.
|
|
$
|
(12,588
|
)
|
|
$
|
(11,208
|
)
|
|
$
|
(47,506
|
)
|
|
$
|
(142,335
|
)
|
Evolent LLC is in the early stages of its business plan and, as a result, the Company expects both Evolent Inc. and Evolent LLC to continue to incur losses. The Company’s investments are evaluated for impairment whenever events or changes in circumstances indicate that there may be an other-than-temporary decline in value. As of
September 30, 2017
, the Company believes that
no
impairment charge is necessary. For additional information on the fair value of the Company’s investment in the Evolent entities, see Note 3, “Fair value measurements.”
Note 7. Debt
The Company's credit facilities consist of (a) a
five
-year senior secured term loan facility in the principal amount of
$475 million
(“term facility”) and (b) a
five
-year senior secured revolving credit facility (“revolving credit facility”) under which up to
$200 million
principal amount of borrowings and other credit extensions may be outstanding at any time. Amounts drawn under the term facility and revolving credit facilities bear interest, payable quarterly, at an annual rate calculated, at the Company’s option, on the basis of either (a) an alternate base rate plus an initial margin of
1.25%
or (b) the applicable London interbank offered rate ("LIBOR") plus an initial margin of
2.25%
, subject in each case to margin reductions based on the Company’s total leverage ratio from time to time. As of
September 30, 2017
, based on the Company's historical leverage ratio, the interest rate margin was
2.00%
and the stated annual interest rate on outstanding borrowings was
3.24%
.
As of
September 30, 2017
, there was
$100.0 million
outstanding under the revolving credit facility and
$80.9 million
available for future borrowings. As of
September 30, 2017
,
$19.1 million
of standby letters of credit had been issued under the revolving credit facility.
Long-term debt is summarized as follows (in thousands):
|
|
|
|
|
|
As of
September 30, 2017
|
3.24% term facility due fiscal 2020 ($388,750 face value less unamortized discount of $1,870)
|
$
|
386,880
|
|
Revolving credit facility
|
100,000
|
|
Less: Amounts due in next twelve months ($71,875 face value less unamortized discount of $897)
|
(70,978
|
)
|
Total long-term debt
|
$
|
415,902
|
|
The credit agreement contains customary representations and warranties, events of default and financial and other covenants, including covenants that require the Company to maintain a maximum total leverage ratio and a minimum interest coverage ratio. The Company's compliance with the
two
financial covenants is measured as of the end of each fiscal quarter. The Company was in compliance with these financial covenants as of
September 30, 2017
.
Interest expense for the three months ended
September 30, 2017
and
2016
was
$4.6 million
and
$4.5 million
, respectively, inclusive of
$0.3 million
and
$0.3 million
, respectively, of amortization of debt issuance costs. In addition, interest expense is inclusive of an immaterial amount and
$0.5 million
of payments related to the interest rate swaps, described below, during the three months ended
September 30, 2017
and
2016
, respectively. Interest expense for the nine months ended
September 30, 2017
and
2016
was
$13.9 million
and
$13.7 million
, respectively, inclusive of
$0.8 million
and
$0.9 million
, respectively, of amortization of debt issuance costs, and
$0.5 million
and
$1.7 million
, respectively, of payments related to the interest rate swaps described below.
Swap agreements
Through its term facility, the Company is exposed to interest rate risk. In April 2015, to minimize the impact of changes in interest rates on its interest payments, the Company entered into
three
interest rate swap agreements with financial institutions to swap a portion of its variable-rate interest payments for fixed-rate interest payments. The interest rate swap derivative financial instruments are recorded on the consolidated balance sheets at fair value, which is based on observable market-based expectations of future interest rates.
At hedge inception, the Company entered into interest rate swap arrangements with notional amounts totaling
$287.5 million
. The swap was structured to have a declining notional amount which matches the amortization schedule of the term facility. As of
September 30, 2017
, the principal amount hedged was
$244.4 million
. Consistent with the terms of the Company's term facility, the interest rate swap agreements mature in February 2020 and have periodic interest settlements. Under the agreements, the Company is entitled to receive a floating rate based on the 1-month LIBOR and obligated to pay an average fixed rate of
1.282%
on the outstanding notional amount. The Company has designated the interest rate swap as a cash flow hedge of the variability of interest payments under its term facility due to changes in the LIBOR benchmark interest rate. The difference between cash paid and received is recorded within interest expense on the consolidated statements of operations.
As of
September 30, 2017
and
2016
, the fair value of the interest rate swaps was an asset of
$1.7 million
and a liability of
$3.1 million
, respectively, and was recorded within prepaid expenses and other current assets and other long-term liabilities, respectively, on the Company's consolidated balance sheets. For the three months ended
September 30, 2017
and
2016
, the change in fair value of the swaps, net of tax, was an increase of
$0.1 million
and an increase of
$0.8 million
, respectively, and was reported as a component of accumulated other comprehensive income on the consolidated statements of operations. For the nine months ended
September 30, 2017
and
2016
, the change in fair value of the swaps, net of tax, was an increase of
$0.3 million
and a decrease of
$2.1 million
, respectively. For the three months and nine months ended
September 30, 2017
and
2016
, there was no material hedge ineffectiveness recorded within the consolidated statements of operations. Changes in fair value are reclassified from accumulated other comprehensive income into earnings in the same period in which the hedged item affects earnings.
If, at any time, the swap is determined to be ineffective, in whole or in part, due to changes in the interest rate swap or underlying debt agreements, the fair value of the portion of the swap determined to be ineffective will be recognized as a gain or loss on the consolidated statements of operations for the applicable period.
Note 8. Stockholders’ equity
The Company is authorized to purchase up to
$550 million
of the Company's common stock in its cumulative share repurchase program. The Company did
no
t repurchase any shares of its common stock in the three and nine months ended
September 30, 2017
. The Company repurchased
211,011
and
1,951,258
shares of its common stock at a total cost of approximately
$8.0 million
and
$61.6 million
, respectively, in the
three
and nine months ended
September 30, 2016
, respectively, pursuant to its share repurchase program. The total amount of common stock purchased from inception under the program through
September 30, 2017
was
19,778,800
shares at a total cost of
$513.5 million
. All such repurchases have been made in the open market, and all repurchased shares have been retired as of
September 30, 2017
.
No
minimum number of shares subject to repurchase has been fixed, and the share repurchase authorization has no expiration date. As of
September 30, 2017
, the remaining authorized repurchase amount was
$36.5 million
.
Note 9. Stock-based compensation
Stock incentive plans
The Company issues awards, including stock options and restricted stock units ("RSUs"), under the Company's 2009 Stock Incentive Plan (the "2009 Plan"). On May 31, 2017, the Company's stockholders approved an amendment to the “2009 Plan” that increased the number of shares of common stock issuable under the plan by
1,000,000
shares. After giving effect to the amendment, the aggregate number of shares of the Company’s common stock available for issuance under the 2009 Plan may not e
xceed
11,535,000
. As of
September 30, 2017
, there were
2,404,057
shares available for issuance under the 2009 Plan.
Performance-based RSU grant.
On March 28, 2017, the Compensation Committee of the Board of Directors approved a grant of
106,870
RSUs under the 2009 Plan to certain executive officers of the Company. These awards are subject to performance
conditions. Awards will vest based on the achievement of adjusted earnings per share targets during the performance periods, which extend through December 31, 2019, with all awards vesting if the highest performance levels are achieved. The Company has concluded that it is probable that all awards will vest at the highest level of performance. The awards are reflected in the table below.
Royall inducement plan
During the nine months ended
September 30, 2017
, the first vesting tranche of the awards issued under the Royall inducement plan vested in full. As of
September 30, 2017
, the Company continues to expect that
70%
to
99%
of the remaining performance targets will be achieved based on performance of the Royall programs and services through December 31, 2017, which would result in an additional vesting of
10%
of the performance-based stock options and
10%
of the performance-based RSUs eligible to vest, subject to forfeitures. During the three months ended March 31, 2017, the Company determined that it was no longer probable that the January 2019 and January 2020 vesting tranches, representing
20%
of the awards, would vest. As a result,
$0.9 million
in compensation expense related to these tranches was reversed in the nine months ended
September 30, 2017
. The amount of stock-based compensation expense may increase or decrease over time based upon changes in expectations regarding whether the applicable performance conditions will be met. The actual amount of expense that the Company will recognize is based upon Royall's actual results. The option and RSU award activity related to these awards is reflected in the tables and related disclosure below.
Stock option activity
During the nine months ended
September 30, 2017
and
2016
, participants exercised
371,572
and
251,458
options, respectively, for a total intrinsic value of
$3.9 million
and
$3.8 million
, respectively. Intrinsic value is calculated as the number of shares exercised times the Company’s stock price on the exercise date reported on the NASDAQ Global Select Market less the exercise price of the option.
The following table summarizes the changes in common stock options outstanding under the Company’s stock incentive plans during the
nine
months ended
September 30, 2017
and
2016
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Number of
performance-based options
|
|
Weighted
average
exercise
price
|
|
Number of
service-based options
|
|
Weighted
average
exercise
price
|
Outstanding, as of December 31, 2015
|
2,013,325
|
|
|
$
|
50.42
|
|
|
1,843,110
|
|
|
$
|
41.73
|
|
Granted
|
319,900
|
|
|
28.20
|
|
|
1,025,100
|
|
|
28.52
|
|
Exercised
|
—
|
|
|
—
|
|
|
(251,458
|
)
|
|
15.36
|
|
Forfeited
|
(215,370
|
)
|
|
49.92
|
|
|
(22,195
|
)
|
|
53.38
|
|
Expired
|
—
|
|
|
—
|
|
|
(17,347
|
)
|
|
51.77
|
|
Outstanding, as of September 30, 2016
|
2,117,855
|
|
|
$
|
47.11
|
|
|
2,577,210
|
|
|
$
|
38.88
|
|
|
|
|
|
|
|
|
|
|
Number of
performance-based options
|
|
Weighted
average
exercise
price
|
|
Number of
service-based options
|
|
Weighted
average
exercise
price
|
Outstanding, as of December 31, 2016
|
2,117,855
|
|
|
$
|
47.11
|
|
|
2,525,178
|
|
|
$
|
39.28
|
|
Granted
|
—
|
|
|
—
|
|
|
200,324
|
|
|
46.95
|
|
Exercised
|
(38,300
|
)
|
|
39.30
|
|
|
(333,272
|
)
|
|
37.12
|
|
Forfeited
|
(115,044
|
)
|
|
51.19
|
|
|
(153,737
|
)
|
|
42.62
|
|
Expired
|
—
|
|
|
—
|
|
|
—
|
|
|
—
|
|
Outstanding, as of September 30, 2017
|
1,964,511
|
|
|
$
|
47.02
|
|
|
2,238,493
|
|
|
$
|
40.06
|
|
Exercisable, as of September 30, 2017
|
485,836
|
|
|
$
|
35.64
|
|
|
1,108,864
|
|
|
$
|
43.49
|
|
The fair value of the service-based options granted during the
nine
months ended
September 30, 2017
was estimated at
$16.80
per share on the date of grant valued using a Black-Scholes model utilizing the following weighted average assumptions: risk-free interest rate of
2.0%
; an expected term of approximately
5.0
years; expected volatility of
37.50%
; and dividend yield of
0.0%
over the expected life of the option.
During the
nine
months ended
September 30, 2017
and 2016,
483,520
and
6,872
options, respectively, with market and/or
performance-based conditions vested.
Restricted stock unit activity
During the nine months ended
September 30, 2017
and
2016
, participants vested in
372,324
and
315,446
RSUs, respectively, for a total intrinsic value of
$18.0 million
and
$10.4 million
, respectively. Intrinsic value is calculated as the number of shares vested times the Company’s closing stock price as reported on the NASDAQ Global Select Market at the vesting date. Of the RSUs vested in the nine months ended
September 30, 2017
and
2016
,
116,234
and
107,083
shares, respectively, were withheld to satisfy minimum employee tax withholding.
The following table summarizes the changes in RSUs granted under the Company’s stock incentive plans during the
nine
months ended
September 30, 2017
and
2016
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Number of
performance-based RSUs
|
|
Weighted average
grant date
fair value
|
|
Number of
service-based RSUs
|
|
Weighted average
grant date
fair value
|
Non-vested, December 31, 2015
|
301,032
|
|
|
$
|
39.10
|
|
|
839,613
|
|
|
$
|
52.82
|
|
Granted
|
23,580
|
|
|
32.28
|
|
|
490,165
|
|
|
30.92
|
|
Forfeited
|
(66,139
|
)
|
|
51.15
|
|
|
(56,067
|
)
|
|
47.36
|
|
Vested
|
(893
|
)
|
|
50.41
|
|
|
(314,553
|
)
|
|
51.47
|
|
Non-vested, September 30, 2016
|
257,580
|
|
|
$
|
35.34
|
|
|
959,158
|
|
|
$
|
42.39
|
|
|
|
|
|
|
|
|
|
|
Number of
performance-based RSUs
|
|
Weighted average
grant date
fair value
|
|
Number of
service-based RSUs
|
|
Weighted average
grant date
fair value
|
Non-vested, December 31, 2016
|
257,580
|
|
|
$
|
35.34
|
|
|
968,084
|
|
|
$
|
42.13
|
|
Granted
|
106,870
|
|
|
46.95
|
|
|
266,203
|
|
|
47.76
|
|
Forfeited
|
(38,740
|
)
|
|
51.48
|
|
|
(81,950
|
)
|
|
44.79
|
|
Vested
|
(16,356
|
)
|
|
49.97
|
|
|
(355,968
|
)
|
|
45.79
|
|
Non-vested, September 30, 2017
|
309,354
|
|
|
$
|
36.56
|
|
|
796,369
|
|
|
$
|
42.10
|
|
The Company recognized stock-based compensation expense in the following consolidated statements of operations line items for stock options and RSUs for the three and
nine
months ended
September 30, 2017
and
2016
(in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
2017
|
|
2016
|
|
2017
|
|
2016
|
Stock-based compensation expense included in:
|
|
|
|
|
|
|
|
Costs and expenses:
|
|
|
|
|
|
|
|
Cost of services
|
$
|
1,743
|
|
|
$
|
2,443
|
|
|
$
|
4,830
|
|
|
$
|
7,123
|
|
Member relations and marketing
|
1,122
|
|
|
1,342
|
|
|
3,403
|
|
|
3,843
|
|
General and administrative
|
2,741
|
|
|
4,182
|
|
|
8,699
|
|
|
11,948
|
|
Total costs and expenses
|
$
|
5,606
|
|
|
$
|
7,967
|
|
|
$
|
16,932
|
|
|
$
|
22,914
|
|
There are
no
stock-based compensation costs capitalized as part of the cost of an asset.
As of
September 30, 2017
,
$42.8 million
of total unrecognized compensation cost related to outstanding options and non-vested RSUs was expected to be recognized over a weighted average period of
2.4
years.
Note 10. Income taxes
The Company's effective tax rates were
38.4%
and
53.9%
for the three months ended
September 30, 2017
and
2016
. The decrease is primarily attributable to the recording of non-recurring one-time unfavorable items and the impact of the federal return-to-provision during the three months ended September 30, 2016.
The Company's effective tax rates remained consistent at
39.5%
and
39.6%
for the nine months ended
September 30, 2017
and
2016
, respectively.
The Company uses a more-likely-than-not recognition threshold based on the technical merits of the tax position taken for the financial statement recognition and measurement of a tax position. If a tax position does not meet the more-likely-than-not initial recognition threshold, no benefit is recorded in the financial statements. The Company does not expect that the total amounts of unrecognized tax benefits will significantly change within the next 12 months. The Company classifies interest and penalties on any unrecognized tax benefits as a component of the provision for income taxes. The Company recognized an immaterial amount of interest in the consolidated statements of operations in the three and
nine
months ended
September 30, 2017
and
2016
, respectively.
The Company files income tax returns in U.S. federal and state and foreign jurisdictions. With limited exceptions, the Company is no longer subject to U.S. federal, state, and local tax examinations for filings in major tax jurisdictions before 2014.
Note 11. Earnings per share
Basic earnings per share is computed by dividing net income by the number of weighted average common shares outstanding during the period. Diluted earnings per share is computed by dividing net income by the number of weighted average common shares and potentially dilutive common shares outstanding during the period. The number of potential common shares outstanding is determined in accordance with the treasury stock method. Certain potential common share equivalents were not included in the computation because their effect was anti-dilutive.
A reconciliation of basic to diluted weighted average common shares outstanding is as follows (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
2017
|
|
2016
|
|
2017
|
|
2016
|
Basic weighted average common shares outstanding
|
40,706
|
|
|
40,102
|
|
|
40,517
|
|
|
40,651
|
|
Effect of dilutive outstanding stock-based awards
|
928
|
|
|
390
|
|
|
864
|
|
|
326
|
|
Diluted weighted average common shares outstanding
|
41,634
|
|
|
40,492
|
|
|
41,381
|
|
|
40,977
|
|
In the
three
months ended
September 30, 2017
and
2016
,
0.7 million
and
1.6 million
shares, respectively, related to share-based compensation awards have been excluded from the calculation of the effect of dilutive outstanding stock-based awards shown above because their effect was anti-dilutive. In the
nine
months ended
September 30, 2017
and
2016
,
0.9 million
and
1.7 million
shares, respectively, related to share-based compensation awards have been excluded from the calculation of the effect of dilutive outstanding stock-based awards shown above because their effect was anti-dilutive.
As of
September 30, 2017
, the Company had
1.5
million nonqualified stock options and
0.3
million RSUs that contained either performance or market conditions, or both, and therefore were treated as contingently issuable awards. As of
September 30, 2016
, the Company had
1.8
million nonqualified stock options and
0.2
million RSUs that contained either performance or market conditions and were treated as contingently issuable awards. These awards are excluded from diluted earnings per share until the reporting period in which the necessary conditions are achieved. To the extent all necessary conditions have not yet been satisfied, the number of contingently issuable shares included in diluted earnings per share will be based on the number of shares, if any, that would be issuable if the end of the reporting period were the end of the contingency period. A total of
170,580
and
137,589
incremental shares related to contingently issuable awards were included within the diluted earnings per share calculations for the
three
and
nine
months ended
September 30, 2017
, respectively, as the related performance goals were met as of the balance sheet date. A total of
42,585
and
11,532
contingently issuable shares were included within the diluted earnings per share calculations for the
three
and
nine
months ended
September 30, 2016
, respectively, as the related performance goals were met as of
September 30, 2016
.
Note 12. Related parties
In June 2009, the Company invested in the convertible preferred stock of a private company that provides technology tools and support services to health care providers, including the Company’s members, and entered into a reseller licensing agreement with that company. As disclosed in Note 2, "Summary of significant accounting policies," of the Company's consolidated financial statements included in its Annual Report on Form 10-K for the year ended
December 31, 2016
, the private company is considered to be a related party.
The Company made payments to the private company under the reseller agreement of $
1.6 million
and $
1.2 million
for the
three
months ended
September 30, 2017
and
2016
, respectively, and
$4.2 million
and
$3.4 million
for the
nine
months ended
September 30, 2017
and
2016
, respectively. The payments are included in cost of services on the consolidated statements of operations.
Note 13. Costs of exit or disposal
In January 2017, the Company announced a restructuring plan. In connection with the plan, the Company is reducing its workforce as a part of a broader effort to more closely align operating expenses with its long-term strategic initiatives. Additionally, the Company closed
four
offices and is completing a gradual wind-down process, to be completed by the end of the year ending December 31, 2017, for several products.
As a result of the restructuring plan, the Company incurred one-time severance and other employee benefit costs of
$1.5 million
and
$9.0 million
during the three and nine months ended
September 30, 2017
, respectively. For the three and nine months ended
September 30, 2017
, the Company recorded
$0.8 million
and
$1.6 million
, respectively, of these amounts in cost of services,
$0.2 million
and
$0.3 million
, respectively, of these amounts in member relations and marketing expense, and
$0.5 million
and
$7.1 million
, respectively, of these amounts in general and administrative expense on the consolidated statements of operations. The Company expects to recognize approximately
$1.3 million
of additional one-time severance and other employee benefit costs through the remainder of the year ending December 31, 2017. Lease exit costs of
0.7 million
and
$3.9 million
were incurred during the three and nine months ended
September 30, 2017
, respectively. The Company does not have any material accruals recorded on the consolidated balance sheets as of
September 30, 2017
related to the restructuring plan.
No
exit or disposal costs were incurred in the three and nine months ended
September 30, 2016
.
Note 14. Supplemental cash flow
A summary of supplemental cash flow information for the three and nine months ended
September 30, 2017
and
2016
is presented below (in thousands):
|
|
|
|
|
|
|
|
|
|
Nine Months Ended
September 30,
|
|
2017
|
|
2016
|
Cash paid (received) for:
|
|
|
|
Income taxes
|
$
|
18,548
|
|
|
$
|
10,324
|
|
Interest
|
$
|
11,745
|
|
|
$
|
10,648
|
|
|
|
|
|
Non-cash activities:
|
|
|
|
Increase in estimated cost of construction of a building under a build-to-suit lease
|
$
|
84,651
|
|
|
$
|
30,486
|
|
Clinovations earn-out liability share-based payment
|
$
|
925
|
|
|
$
|
2,703
|
|
Note 15. Commitments and Contingencies
The Company is involved in various claims, assessments, and legal proceedings that arise from time to time in the ordinary course of its business, including the legal proceeding identified below. The Company accrues a liability when it believes that it is both probable that a liability has been incurred and that it can reasonably estimate the amount of the loss. The Company reviews these accruals at least quarterly and adjusts them to reflect ongoing negotiations, settlements, rulings, advice of legal counsel, and other relevant information. To the extent new information is obtained and the Company’s views on the probable outcomes of claims, assessments, or legal proceedings change, changes in the Company’s accrued liabilities would be recorded in the period in which such a determination is made. For some matters, the amount of liability is not probable or the amount cannot be reasonably estimated and therefore accruals have not been made.
On August 3, 2017 and September 22, 2017, two purported class-action lawsuits were filed in U.S. District Courts for the Southern District of New York and the District of Columbia, respectively, naming as defendants the Company and
two
of its executive officers,
one
of whom is a director. In both complaints, plaintiffs allege that the Company’s public statements about its business and operations between January 21, 2015 and February 23, 2016 contained material misstatements and omissions in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder which artificially inflated the Company’s stock price. In addition to compensatory damages in an unspecified amount and attorneys’ fees, both actions seek such relief as the district court deems just and proper. On October 27, 2017, judges in both actions appointed lead plaintiffs and lead plaintiffs’ counsel after the only competing putative lead plaintiff withdrew itself from consideration. The Company believes these claims are without merit and intends to vigorously defend the actions.
Note 16. Subsequent events
On November 2, 2017, Evolent Inc. entered into a Stock Purchase Agreement, pursuant to which Evolent Inc. will acquire all of the stock of Premier Health Plan for a combination of cash and shares of Evolent Inc.’s Class A common stock. When closed, this transaction is expected to reduce the Company’s ownership in Evolent Inc. and Evolent LLC. The Company is currently evaluating the effect that this dilution has on its investment and will finalize its accounting for this transaction once the transaction closes and the final valuation report is available.