Magellan Health 10Q 2001 Q2 Quarterly report

QuickLinks -- Click here to rapidly navigate through this document

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

FORM 10-Q

(Mark One)

/x/	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2001

/ /	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File No. 1-6639

MAGELLAN HEALTH SERVICES, INC.
(Exact name of registrant as specified in its charter)

Delaware (State of other jurisdiction of incorporation or organization)		58-1076937 (IRS Employer Identification No.)
6950 Columbia Gateway Drive Suite 400 Columbia, Maryland (Address of principal executive offices)		21046 (Zip code)

(410) 953-1000
(Registrant's telephone number, including area code)

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 / /

The number of shares of the registrant's common stock outstanding as of July 31, 2001 was 34,437,897.

FORM 10-Q

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

INDEX

		Page No.
PART I—Financial Information:
	Item 1: Financial Statements
	Condensed Consolidated Balance Sheets— September 30, 2000 and June 30, 2001	1
	Condensed Consolidated Statements of Operations— For the Three Months and Nine Months ended June 30, 2000 and 2001	2
	Condensed Consolidated Statements of Cash Flows— For the Nine Months ended June 30, 2000 and 2001	3
	Notes to Condensed Consolidated Financial Statements	4
	Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations	16
PART II—Other Information:
	Item 1: Legal Proceedings	25
	Item 6: Exhibits and Reports on Form 8-K	26
	Signatures	27

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(In thousands, except per share amounts)

					September 30, 2000			June 30, 2001
ASSETS
Current assets:
	Cash and cash equivalents				$	41,628		$	29,100
	Accounts receivable, net					137,224			120,772
	Restricted cash and investments					117,723			78,985
	Refundable income taxes					4,416			1,934
	Other current assets					18,662			15,066

			Total current assets			319,653			245,857
Property and equipment, net of accumulated depreciation of $95,101 at September 30, 2000 and $90,297 at June 30, 2001						112,612			89,003
Deferred income taxes						121,782			80,679
Investments in unconsolidated subsidiaries						12,746			10,524
Other long-term assets						10,235			32,980
Goodwill, net						1,074,753			1,044,636
Other intangible assets, net						152,006			151,836

					$	1,803,787		$	1,655,515

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
	Accounts payable				$	40,687		$	24,148
	Accrued liabilities					175,698			178,892
	Medical claims payable					219,375			210,265
	Current maturities of long-term debt and capital lease obligations					34,119			2,680

			Total current liabilities			469,879			415,985

Long-term debt and capital lease obligations						1,063,928			1,001,668

Deferred credits and other long-term liabilities						83,226			18,619

Minority interest						456			550

Commitments and contingencies:
Redeemable preferred stock						57,834			61,534

Stockholders' equity:
	Preferred stock, without par value
		Authorized—9,793 shares at September 30, 2000 and June 30, 2001
				Issued and outstanding—none		—			—
	Common stock, par value $0.25 per share
		Authorized—80,000 shares
				Issued 34,936 shares and outstanding 32,647 shares as of September 30, 2000 and issued 36,595 shares and outstanding 34,306 shares as of June 30, 2001		8,733			9,148
	Other stockholders' equity
		Additional paid-in capital				349,541			352,950
		Accumulated deficit				(210,358	)		(185,419	)
		Warrants outstanding				25,050			25,050
		Common stock in treasury, 2,289 shares at September 30, 2000 and June 30, 2001				(44,309	)		(44,309	)
		Cumulative foreign currency adjustments included in other comprehensive income				(193	)		(261	)

			Total stockholders' equity			128,464			157,159

					$	1,803,787		$	1,655,515

The accompanying Notes to Unaudited Condensed Consolidated Financial Statements
are an integral part of these statements.

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share amounts)

		For the Three Months Ended June 30,						For the Nine Months Ended June 30,
		2000			2001			2000			2001
Net revenue		$	418,683		$	432,875		$	1,208,564		$	1,322,950

Cost and expenses:
	Salaries, cost of care and other operating expenses		368,167			382,427			1,063,576			1,165,547
	Equity in earnings of unconsolidated subsidiaries		(2,465	)		(5,013	)		(8,847	)		(33,236	)
	Depreciation and amortization		17,387			17,071			50,890			50,259
	Interest, net		23,956			22,023			72,201			70,920
	Special charges		—			—			—			3,340

			407,045			416,508			1,177,820			1,256,830

Income from continuing operations before income taxes and minority interest			11,638			16,367			30,744			66,120
Provision for income taxes			7,842			8,987			20,127			33,364

Income from continuing operations before minority interest			3,796			7,380			10,617			32,756
Minority interest			74			19			105			71

Income from continuing operations			3,722			7,361			10,512			32,685
Discontinued operations:
	Income (loss) from discontinued operations(1)		1,236			467			(48,424	)		5,634
	Gain (loss) on disposal of discontinued operations, including income tax provision of $1,457 and $10,761		—			2,707			—			(9,396	)

			1,236			3,174			(48,424	)		(3,762	)

Income (loss) before extraordinary item			4,958			10,535			(37,912	)		28,923
Extraordinary item—net loss on early extinguishment of debt, net of tax benefit			—			(3,984	)		—			(3,984	)

Net income (loss)			4,958			6,551			(37,912	)		24,939
Preferred dividend requirement and amortization of redeemable preferred stock issuance costs			1,195			1,266			2,499			3,747

Income (loss) available to common stockholders			3,763			5,285			(40,411	)		21,192
Other comprehensive income (loss)			(41	)		—			(67	)		(68	)

Comprehensive income (loss)		$	3,722		$	5,285		$	(40,478	)	$	21,124

Weighted average number of common shares outstanding—basic			32,166			33,696			32,067			33,081

Weighted average number of common shares outstanding—diluted			32,578			36,315			32,398			41,229

Income (loss) per common share available to common stockholders—basic:
	Income from continuing operations	$	0.08		$	0.18		$	0.25		$	0.87

	Income (loss) from discontinued operations	$	0.04		$	0.10		$	(1.51	)	$	(0.11	)

	Extraordinary (loss) on early extinguishment of debt	$	—		$	(0.12	)	$	—		$	(0.12	)

Net income (loss)		$	0.12		$	0.16		$	(1.26	)	$	0.64

Income (loss) per common share available to common stockholders—diluted:
	Income from continuing operations	$	0.08		$	0.17		$	0.25		$	0.79

	Income (loss) from discontinued operations	$	0.04		$	0.09		$	(1.50	)	$	(0.09	)

	Extraordinary (loss) on early extinguishment of debt	$	—		$	(0.11	)	$	—		$	(0.10	)

Net income (loss)		$	0.12		$	0.15		$	(1.25	)	$	0.60

(1): Net of income tax (benefit) provision of $(491) and $218 for the three months ended June 30, 2000, and 2001, respectively, and $(33,010) and $3,464 for the nine months ended June 30, 2000, and 2001, respectively.
The accompanying Notes to Unaudited Condensed Consolidated Financial Statements
are an integral part of these statements.

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)

				For the Nine Months Ended June 30,
				2000			2001
Cash flows from operating activities:
	Net (loss) income			$	(37,912	)	$	24,939
	Adjustments to reconcile net (loss) income to net cash provided by operating activities:
		(Gain) loss on sale of assets, net			(610	)		1,575
		Depreciation and amortization			59,274			52,242
		Impairment of long-lived assets			58,783			—
		Equity in earnings of unconsolidated subsidiaries			(8,847	)		(33,236	)
		Stock option expense			—			636
		Non-cash interest expense			3,278			3,887
		Extraordinary loss on early extinguishment of debt			—			3,984
	Cash flows from changes in assets and liabilities, net of effects from sales and acquisitions of businesses:
		Accounts receivable, net			36,669			(23,816	)
		Restricted cash and investments			1,647			38,738
		Distributions received from unconsolidated subsidiaries			10,524			35,399
		Other assets			(2,937	)		548
		Accounts payable and other accrued liabilities			(38,607	)		(52,868	)
		Medical claims payable			17,677			(10,259	)
		Income taxes payable and deferred income taxes			(15,592	)		43,585
		Reserve for unpaid claims			(78	)		—
		Other liabilities			(1,791	)		(3,477	)
		Minority interest, net of dividends paid			262			117
		Other			(114	)		1,021

			Total adjustments		119,538			58,076

		Net cash provided by operating activities			81,626			83,015

Cash flows from investing activities:
	Capital expenditures				(24,846	)		(17,962	)
	Acquisitions and investments in businesses, net of cash acquired				(68,597	)		(84,000	)
	Decrease in assets restricted for settlement of unpaid claims				591			—
	Proceeds from sale of assets, net of transaction costs				(777	)		103,428

		Net cash (used in) provided by investing activities			(93,629	)		1,466

Cash flows from financing activities:
	Payments on debt and capital lease obligations				(86,926	)		(457,372	)
	Proceeds from issuance of debt, net of issuance costs				59,642			353,791
	Proceeds from issuance of redeemable preferred stock, net of issuance costs				54,765			—
	Proceeds from exercise of stock options and warrants				968			6,572

		Net cash provided by (used in) financing activities			28,449			(97,009	)

Net increase (decrease) in cash and cash equivalents					16,446			(12,528	)
Cash and cash equivalents at beginning of period					37,440			41,628

Cash and cash equivalents at end of period				$	53,886		$	29,100

The accompanying Notes to Unaudited Condensed Consolidated Financial Statements
are an integral part of these statements.

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2001
(Unaudited)

NOTE A—Basis of Presentation

The accompanying unaudited condensed consolidated interim financial statements of Magellan Health Services, Inc. and Subsidiaries ("Magellan" or the "Company") have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments considered necessary for a fair presentation, have been included.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

The Company previously operated five business segments, four of which have been discontinued. Since March 2001, the Company operates only in the behavioral managed healthcare business.

On September 2, 1999, the Company's Board of Directors approved a formal plan to dispose of the businesses and interests that comprised the Company's healthcare provider and healthcare franchising business segments (the "Disposal Plan"). On October 4, 2000, the Company adopted a formal plan to dispose of the business and interest that comprised the Company's specialty managed healthcare business segment. On January 18, 2001, the Company's Board of Directors approved and the Company entered into a definitive agreement for the sale of National Mentor, Inc. ("Mentor"), which represented the business and interest that comprised the Company's human services business segment. On March 9, 2001, the Company consummated the sale of the stock of Mentor to an entity formed by the management of Mentor and Madison Dearborn Partners, a private equity investment firm. Accordingly, the results of operations of the healthcare provider, healthcare franchising, specialty managed healthcare and human services business segments have been reported in the unaudited condensed consolidated interim financial statements as discontinued operations for all periods presented.

All references to fiscal years contained herein refer to periods of twelve consecutive months ending on September 30. Certain reclassifications have been made to fiscal 2000 amounts to conform to fiscal 2001 presentation.

These financial statements should be read in conjunction with the Company's audited consolidated financial statements for the fiscal year ended September 30, 2000 and the notes thereto, which are included in the Company's Form 8-K filed May 21, 2001. APB 30 requires that the results of continuing operations be reported separately from those of discontinued operations for all periods presented and that any gain or loss from disposal of a segment of a business be reported in conjunction with the related results of discontinued operations. Accordingly, the Company has restated its results of operations for all prior periods related to the healthcare provider, healthcare franchising, specialty managed healthcare and human services business segments.

NOTE B—Supplemental Cash Flow Information

Below is supplemental cash flow information related to the nine months ended June 30, 2000 and 2001 (in thousands):

	Nine Months Ended June 30,
	2000		2001
Income taxes paid, net of refunds received	$	2,639	$	3,957

Interest paid	$	61,404	$	59,985

NOTE C—Long-Term Debt and Leases

Information with regard to the Company's long-term debt and capital lease obligations at September 30, 2000 and June 30, 2001 is as follows (in thousands):

		September 30, 2000		June 30, 2001
Credit Agreement:
	Revolving Facility due through 2004	$	30,000	$	—
	Term Loan Facility (7.5625% to 7.8125% at June 30, 2001) due through 2006		436,612		119,656
	9.375% Senior Notes due 2007		—		250,000
	9.0% Senior Subordinated Notes due 2008		625,000		625,000
	11.5% notes payable due 2005		35		35
	Capital lease obligations due through 2014 (2.70% to 9.27% at June 30, 2001)		6,400		9,657

			1,098,047		1,004,348
Less amounts due within one year			34,119		2,680

		$	1,063,928	$	1,001,668

The Company recognized a net extraordinary loss from the early extinguishment of debt of approximately $4.0 million, net of income tax benefit, during the quarter and the nine months ended June 30, 2001, to write-off unamortized deferred financing costs related to repayment of indebtedness outstanding under the Company's Term Loan Facilities.

NOTE D—Accrued Liabilities

Accrued liabilities consist of the following (in thousands):

	September 30, 2000		June 30, 2001
Salaries, wages and other benefits	$	21,411	$	11,946
TRICARE adjustments		22,603		3,502
Contingent purchase price		—		60,000
Accrued interest		7,590		23,382
Other		124,094		80,062

	$	175,698	$	178,892

NOTE E—Income per Common Share

The following tables reconcile income (numerator) and shares (denominator) used in the Company's computations of income from continuing operations per common share (in thousands):

		Three Months Ended June 30,						Nine Months Ended June 30,
		2000			2001			2000			2001
Numerator:
Income from continuing operations		$	3,722		$	7,361		$	10,512		$	32,685
	Less: preferred dividend requirement and amortization of redeemable preferred stock issuance costs		(1,195	)		(1,266	)		(2,499	)		(3,747	)

Income from continuing operations—basic			2,527			6,095			8,013			28,938
	Add: presumed conversion of redeemable preferred stock		—			—			—			3,747

Income from continuing operations—diluted		$	2,527		$	6,095		$	8,013		$	32,685

Denominator:
Average number of common shares outstanding—basic			32,166			33,696			32,067			33,081
Common stock equivalents-stock options			52			1,772			155			1,181
Common stock equivalents-warrants			—			9			—			6
Common stock equivalents-redeemable preferred stock			360			505			176			6,920
Common stock equivalents-redeemable preferred stock option			—			333			—			111

Average number of common shares outstanding—diluted			32,578			36,315			32,398			41,299

Income from continuing operations per common share:
Basic (basic numerator/basic denominator)		$	0.08		$	0.18		$	0.25		$	0.87

Diluted (diluted numerator/diluted denominator)		$	0.08		$	0.17		$	0.25		$	0.79

Conversion of the redeemable preferred stock (see Note K "Redeemable Preferred Stock") was presumed for the nine months ended June 30, 2001. Conversion of the redeemable preferred stock was not presumed for the three months ended June 30, 2000 and 2001 and for the nine months ended June 30, 2000 due to the anti-dilutive effect. Certain stock options and warrants which were outstanding during the three months and nine months ended June 30, 2000 and 2001 were not included in the computation of diluted earnings per share because of their anti-dilutive effect.

NOTE F—Investments in Unconsolidated Subsidiaries

Choice Behavioral Health Partnership. The Company is a 50% partner with Value Options, Inc. in Choice Behavioral Health Partnership ("Choice"), a general partnership. Choice is a managed

behavioral healthcare company which derives all of its revenues from a contract with TRICARE, the successor to the Civilian Health and Medical Program of the Uniformed Services ("CHAMPUS"). The Company accounts for its investment in Choice using the equity method.

A summary of financial information for the Company's investment in Choice is as follows
(in thousands):

		September 30, 2000		June 30, 2001
Current assets		$	19,144	$	28,029
Property and equipment, net			132		158

	Total assets	$	19,276	$	28,187

Current liabilities		$	16,212	$	26,684
Long-term liabilities			—		2,775
Partners' capital			3,064		(1,272	)

	Total liabilities and partners' capital	$	19,276	$	28,187

Company investment in Choice		$	1,532	$	(636	)

	Three Months Ended June 30,						Nine Months Ended June 30,
	2000			2001			2000			2001
Net revenue	$	13,995		$	17,842		$	42,069		$	90,188
Operating expenses		(8,327	)		(9,263	)		(23,968	)		(24,476	)

Net income	$	5,668		$	8,579		$	18,101		$	65,712

Company equity income	$	2,834		$	4,289		$	9,051		$	32,858

Cash distributions from Choice	$	4,137		$	25,931		$	10,337		$	35,024

During the three months ended March 31, 2001, Choice recognized income related to the settlement of certain issues under its TRICARE contract some of which related to prior periods. See Note H—"Commitments and Contingencies".

Premier Behavioral Systems, LLC. The Company owns a 50% interest in Premier Behavioral Systems of Tennessee, LLC ("Premier"). Premier was formed to manage behavioral healthcare benefits for the State of Tennessee's TennCare program. The Company accounts for its investment in Premier using the equity method. The Company's investment in Premier at September 30, 2000 and June 30, 2001 was $8.1 million and $6.4 million, respectively. The Company's equity in earnings (losses) of Premier for the three months ended June 30, 2000 and 2001 was $(1.1) million and $0.1 million, respectively, and for the nine months ended June 30, 2000 and 2001 was $(1.2) million and $(1.7) million, respectively. The Company has not received a partnership distribution from Premier in fiscal years 2000 and 2001.

NOTE G—Discontinued Operations

Healthcare Provider and Franchising Segments

During fiscal 1997, the Company sold substantially all of its domestic acute-care psychiatric hospitals and residential treatment facilities (collectively, the "Psychiatric Hospital Facilities") to Crescent Real Estate Equities ("Crescent") for $417.2 million in cash and certain other consideration (the "Crescent Transactions"). Simultaneously with the sale of the Psychiatric Hospital Facilities, the Company and Crescent Operating, Inc. ("COI"), an affiliate of Crescent, formed Charter Behavioral Health Systems, LLC ("CBHS") to conduct the operations of the Psychiatric Hospital Facilities and

certain other facilities transferred to CBHS by the Company. The Company obtained a 50% ownership of CBHS; the other 50% ownership interest of CBHS was owned by COI.

On September 10, 1999, the Company consummated the transfer of assets and other interests pursuant to a Letter Agreement dated August 10, 1999 with Crescent, COI and CBHS that effected the Company's exit from its healthcare provider and healthcare franchising businesses (the "CBHS Transactions"). As part of this transaction, the Company agreed to provide CBHS with the net economic value of five hospital-based joint ventures ("Provider JVs") and agreed to transfer to CBHS its interests in the Provider JVs and related real estate as soon as practicable. In addition, the Company became obligated to pay $2.0 million to CBHS in 12 equal monthly installments beginning on the first anniversary of the closing date (the "CBHS Note").

The CBHS Transactions, together with the formal plan of disposal authorized by the Company's Board of Directors on September 2, 1999, represented the disposal of the Company's healthcare provider and healthcare franchising business segments.

The Company's original plan of disposal contemplated that the disposition of all provider joint venture interests would take place within twelve months of the measurement date. The Company, with the cooperation of its joint venture partners and CBHS, has closed two of the five hospital-based joint ventures, sold the assets and operations of three of the joint ventures during fiscal 2001 and is currently negotiating to sell its interest in the remaining joint ventures.

On February 16, 2000, CBHS filed a voluntary petition for relief of indebtedness under Chapter 11 of the United States Bankruptcy Code. In connection with the bankruptcy proceedings, CBHS indicated that it believed that it had certain claims against the Company regarding certain previous transactions. During April of 2001, the Company entered into an agreement with CBHS that provided the Company with a full release of all claims. The agreement was approved by the bankruptcy court in April 2001. Under the agreement, (i) the Company was released of all obligations to CBHS; (ii) the Company obtained the economic value of the five Provider JVs that was previously conveyed to CBHS; and (iii) the Company agreed to pay CBHS approximately $26 million over a 9 month period. The amounts due under the agreement are anticipated to be funded primarily through proceeds from the sale of the Company's interest in the Provider JVs, and from amounts previously withheld from CBHS for services provided.

Specialty Managed Healthcare Segment

On December 5, 1997, the Company purchased the assets of Allied Health Group, Inc. and certain affiliates ("Allied"). Allied provided specialty managed care services, including risk-based products and administrative services to a variety of insurance companies and other customers. Allied's products included, among other things, claims authorization, analysis, adjudication and payment, comprised of multiple clinical specialties. The Company paid approximately $50.0 million for Allied, with cash on hand. During the quarter ended December 31, 1998, the Company and the former owners of Allied amended the Allied purchase agreement (the "Allied Amendments"). The Allied Amendments resulted in the Company paying the former owners of Allied $4.5 million additional consideration, which was recorded as goodwill. On February 29, 2000, the Company consummated the purchase of the outstanding stock of Vivra, Inc. ("Vivra"), which also provided specialty managed care services. The initial purchase price of Vivra was $10.25 million, excluding transaction costs. Allied and Vivra, as well as certain other related assets, comprised the Company's specialty managed healthcare segment. The Company accounted for the Allied and Vivra acquisitions using the purchase method of accounting.

On October 4, 2000, the Company adopted a formal plan to dispose of the business and interests that comprise the Company's specialty managed healthcare segment. The Company is exiting the specialty managed healthcare business via sale and/or abandonment of businesses and related assets, certain of which activities had already occurred in the normal course prior to October 4, 2000. The Company does not expect to receive significant proceeds from the sale of these assets. Further, the

Company is actively exiting all significant contracts entered into by Allied and Vivra. This effort is expected to be completed by September 30, 2001.

Human Services Segment

On January 18, 2001, the Company's Board of Directors approved and the Company entered into a definitive agreement for the sale of Mentor, which represented the business and interest that comprised the Company's human services business segment. On March 9, 2001, the Company consummated the sale of the stock of Mentor to an entity formed by the management of Mentor and Madison Dearborn Partners, a private equity investment firm. The Company received approximately $113 million in consideration, net of approximately $2 million of transaction costs. The Company's consideration consisted of approximately $103 million of cash and $10 million in the form of an interest-bearing note. The Company also retained certain liabilities approximating $3 million.

Accounting for Discontinued Operations

The Company has accounted for the disposal of the discontinued segments under Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB 30"). APB 30 requires that the results of continuing operations be reported separately from those of discontinued operations for all periods presented and that any gain or loss from disposal of a segment of a business be reported in conjunction with the related results of discontinued operations. Accordingly, the Company has restated its results of operations for all prior periods.

The summarized results of discontinued operations segments are as follows (in thousands):

		Three Months Ended June 30, 2000			Three Months Ended June 30, 2001		Nine Months Ended June 30, 2000			Nine Months Ended June 30, 2001
Healthcare Provider and Healthcare Franchising Segments
	Net revenue(1)	$	—		$	1,381	$	—		$	5,645

	Salaries, cost of care and other operating expenses(1)		—			696		—			4,534
	Depreciation and amortization		—			—		—			—
	Other expenses(2)(3)		—			218		—			388

	Net income	$	—		$	467	$	—		$	723

Speciality Managed Healthcare Segment
	Net revenue	$	36,600		$	1,447	$	117,412		$	16,846

	Salaries, cost of care and other operating expenses(4)		39,360			1,447		149,900			11,984
	Impairment of long-lived assets		—			—		58,173			—
	Depreciation and amortization		960			—		3,326			—
	Other expenses (income)(2)(3)		(2,441	)		—		(38,361	)		1,702

	Net income (loss)(5)	$	(1,279	)	$	—	$	(55,626	)	$	3,160

Human Services Segment
	Net revenue	$	56,743		$	—	$	162,406		$	91,654

	Salaries, cost of care and other operating expenses		50,494					144,795			86,546
	Depreciation and amortization		1,784			—		5,058			1,983
	Other expenses(2)(3)(6)		1,950			—		5,351			1,374

	Net income (loss)(7)	$	2,515		$	—	$	7,202		$	1,751

Discontinued Operations—Combined
	Net revenue	$	93,343		$	2,828	$	279,818		$	114,145

	Salaries, cost of care and other operating expenses		89,854			2,143		294,695			103,064
	Impairment of Long-Lived Assets		—			—		58,173			—
	Depreciation and amortization		2,744			—		8,384			1,983
	Other expenses (income)		(491	)		218		(33,010	)		3,464

	Net income (loss)	$	1,236		$	467	$	(48,424	)	$	5,634

(1): Fiscal 2001 amounts reflect settlements of certain outstanding Medicare and Medicaid cost reports, collection of certain receivables previously written off, cost of collection and settlement of other liabilities.
(2): Interest expense has not been allocated to discontinued operations.
(3): Includes provision (benefit) for income taxes and minority interest.
(4): The nine months ended June 30, 2001 amounts include a $4.9 million favorable change in estimate regarding settlement of an obligation.
(5): Fiscal 2001 amounts exclude losses of $4.5 million from the operations of the specialty managed healthcare segments that were provided for during the fourth quarter of fiscal 2000. See "Remaining Assets and Liabilities—Specialty Managed Healthcare Segment" elsewhere herein.
(6): Fiscal 2001 amounts exclude an estimated loss on disposal of approximately $12.1 million. See "Loss on Disposal of Human Services Segment" below.
(7): Fiscal 2001 amounts exclude income of $1.9 million from the operations of the human services segment provided for in the estimated loss on sale during the first quarter of fiscal 2001.

Loss on Disposal of Human Services Segment

The summary of the estimated loss on disposal recorded during fiscal 2001 related to the disposal of the Company's human services segment is as follows (in thousands):

Estimated net proceeds from sale(1)	$	110,469
Less: Estimated net book value of assets		113,269

Estimated loss before taxes		(2,800	)
Income tax provision(2)		(9,303	)

Total estimated loss(3)	$	(12,103	)

(1): Net of certain assumed liabilities.

(2): Amount includes provision for income taxes related to $26.1 million of goodwill which has no tax basis.
(3): The estimated loss may change based upon a working capital settlement provided for in the sale agreement.

Remaining Assets and Liabilities

Healthcare Provider and Healthcare Franchising Segments

The remaining assets and liabilities of the discontinued healthcare provider business at June 30, 2001 include, among other things, (i) hospital-based real estate of $4.6 million, (ii) interest in provider joint ventures of $10.8 million (iii) long-term debt of $6.4 million related to the hospital-based real estate, and (iv) accrued liabilities of $21.7 million. The Company is also subject to inquiries and investigations from governmental agencies related to its operating and business practices prior to consummation of the Crescent Transactions (as defined) on June 17, 1997. See Note H—"Commitments and Contingencies."

The following table provides a roll-forward of the reserves established in connection with the discontinuance of the healthcare provider and healthcare franchising segments (in thousands):

Type of Cost	Balance September 30, 2000		Payments			Adjustments			Balance June 30, 2001
Transaction costs and legal fees	$	1,749	$	(1,722	)	$	(27	)	$	—
Provider JV working capital		3,116		—			(3,116	)		—
Other		905		—			(905	)		—

	$	5,770	$	(1,722	)	$	(4,048	)	$	—

In conjunction with the CBHS settlement, the Company was released from certain liabilities and therefore has determined that certain liabilities recorded as a result of the CBHS Transactions during fiscal 1999 are no longer required. The reversal of these liabilities, net of tax, has been recorded during the third quarter of fiscal 2001, resulting in a change in estimate related to the loss on disposal of the healthcare provider and franchising segments of $2.7 million.

Specialty Managed Healthcare Segment

The remaining assets and liabilities of the discontinued specialty managed healthcare segment at June 30, 2001 include, among other things, (i) cash and accounts receivable of $1.7 million, (ii) medical claims payable of $0.9 million, (iii) reserve for discontinued operations of $4.1 million and (iv) accounts payable and accrued liabilities of $3.5 million.

The following table provides a roll-forward of reserves related to the discontinuance of the specialty managed healthcare segment (in thousands):

Type of Cost	Balance September 30, 2000		Additions		Payments			Balance June 30, 2001
Accrued losses	$	3,531	$	—	$	(3,531	)	$	—
Estimated lease exit costs		5,051		—		(919	)		4,132

	$	8,582	$	—	$	(4,450	)	$	4,132

Impairment of Long-Lived Assets—Allied

The Company recorded a charge of approximately $58.2 million in the second quarter of fiscal 2000, related to the impairment of certain of Allied's long-lived assets in accordance with Statement of Financial Accounting Standards No. 121 "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("FAS 121"). This amount included certain goodwill, certain property and equipment and identifiable intangible assets of Allied which, prior to the Vivra acquisition, was the principal component of the Company's specialty managed healthcare business segment. During the second quarter of fiscal 2000, Allied recorded significant losses associated primarily with the termination or restructuring of various customer contracts. These events and the resulting expectation of lower future earnings and cash flows from Allied represented a change in circumstances with respect to the business of Allied. At that time the Company estimated that the future undiscounted cash flows expected to be generated by Allied were insufficient to fully recover the recorded cost of the long-lived assets. The Company recorded the impairment charge to write these assets down to their estimated fair value.

NOTE H—Commitments and Contingencies

The Company is self-insured for a portion of its general and professional liability risks. The reserves for self-insured general and professional liability losses, including loss adjustment expenses, were included in reserve for unpaid claims in the Company's consolidated balance sheet and were based on actuarial estimates that were discounted at an average rate of 6% to their present value based on the Company's historical claims experience adjusted for current industry trends. These reserves related primarily to the professional liability risks of the Company's healthcare provider segment prior to the Crescent Transactions. On July 2, 1999, the Company transferred its remaining medical malpractice claims portfolio (the "Loss Portfolio Transfer") to a third-party insurer for approximately $22.3 million. The Loss Portfolio Transfer was funded from assets restricted for settlement of unpaid claims. The insurance limit obtained through the Loss Portfolio Transfer for future medical malpractice claims is $26.3 million. The Company continually evaluates the adequacy of these insured limits and Management believes that these amounts are sufficient.

The healthcare industry is subject to numerous laws and regulations. The subjects of such laws and regulations include, but are not limited to, matters such as licensure, accreditation, government healthcare program participation requirements, reimbursement for patient services, and Medicare and Medicaid fraud and abuse. Over the past several years, government activity has increased with respect to investigations and/or allegations concerning possible violations of fraud and abuse and false claims statutes and/or regulations by healthcare providers. Entities that are found to have violated these laws and regulations may be excluded from participating in government healthcare programs, subjected to fines or penalties or required to repay amounts received from the government for previously billed patient services. The Office of the Inspector General of the Department of Health and Human Services and the United States Department of Justice ("Department of Justice") and certain other governmental agencies are currently conducting inquiries and/or investigations regarding the compliance by the Company and certain of its subsidiaries with such laws and regulations. Certain of the inquiries relate to the operations and business practices of the Psychiatric Hospital Facilities prior to the consummation of the Crescent Transactions in June 1997. The Department of Justice has indicated that its inquiries are based on its belief that the federal government has certain civil and administrative causes of action under the Civil False Claims Act, the Civil Monetary Penalties Law, other federal statutes and the common law arising from the participation in federal health benefit programs of CBHS psychiatric facilities nationwide. The Department of Justice inquiries relate to the following matters: (i) Medicare cost reports; (ii) Medicaid cost statements; (iii) supplemental applications to CHAMPUS/TRICARE based on Medicare cost reports; (iv) medical necessity of services to patients and admissions; (v) failure to provide medically necessary treatment or admissions; and (vi) submission of claims to government

payors for inpatient and outpatient psychiatric services. No amounts related to such proposed causes of action have yet been specified. The Company cannot reasonably estimate the settlement amount, if any, associated with the Department of Justice inquiries. Accordingly, no reserve has been recorded related to this matter.

On or about August 4, 2000, the Company was served with a lawsuit filed by Wachovia Bank, N.A. ("Wachovia") in the Court of Common Pleas of Richland County, South Carolina, seeking recovery under the indemnification provisions of an Engagement Letter between South Carolina National Bank (now Wachovia) and the Company and the ESOP Trust Agreement between South Carolina National Bank (now Wachovia) and the Company for losses sustained in a settlement entered into by Wachovia with the United States Department of Labor in connection with the ESOP's purchase of stock of the Company in 1991 while Wachovia served as ESOP Trustee. Wachovia also alleged fraud, negligent misrepresentation and other claims and asserts its losses exceed $30 million. During the second and third quarters of fiscal 2001, the court entered orders dismissing all of the claims asserted by Wachovia, with the exception of one of the two contractual indemnification claims. While an outcome cannot be determined, the Company believes the claim of Wachovia is without merit and is defending it vigorously. The Company has not recorded any reserves related to this matter.

On October 26, 2000, two class action complaints (the "Class Actions") were filed against Magellan Health Services, Inc. and Magellan Behavioral Health, Inc. (the "Defendants") in the United States District Court for the Eastern District of Missouri under the Racketeer Influenced and Corrupt Organizations Act ("RICO") and the Employment Retirement Income Security Act of 1974 ("ERISA"). On May 1, 2001, the Missouri court granted the Company's request to transfer the venue of the case to the United States District Court for the District Court of Maryland. The class representatives purport to bring the actions on behalf of a nationwide class of individuals whose behavioral health benefits have been provided, underwritten and/or arranged by the Defendants since 1996. The complaints allege violations of RICO and ERISA arising out of the Defendants' alleged misrepresentations with respect to and failure to disclose its claims practices, the extent of the benefits coverage and other matters that cause the value of benefits to be less than the amount of premium paid. The complaints seek unspecified compensatory damages, treble damages under RICO, and an injunction barring the alleged improper practices, plus interest, costs and attorneys' fees. While the claims are in the initial stages and an outcome cannot be determined, the Company believes that the claims are without merit and intends to defend them vigorously.

The Company is also subject to or party to other litigation, claims and civil suits, relating to its operations and business practices. Certain of the Company's managed care litigation matters involve class action lawsuits, which allege (i) the Company inappropriately denied and/or failed to authorize benefits for mental health treatment under insurance policies with a customer of the Company and (ii) a provider at a Company facility violated privacy rights of certain patients. In the opinion of management, the Company has recorded reserves that are adequate to cover litigation, claims or assessments that have been or may be asserted against the Company, and for which the outcome is probable and reasonably estimable, arising out of such other litigation, claims and civil suits. Furthermore, management believes that the resolution of such litigation, claims and civil suits will not have a material adverse effect on the Company's financial position or results of operations; however, there can be no assurance in this regard.

The Company provides mental health and substance abuse services, as a subcontractor, to beneficiaries of TRICARE (formerly CHAMPUS) under two separate contracts. The fixed monthly amounts that the Company receives for medical costs under TRICARE contracts are subject to retroactive adjustment ("TRICARE Adjustments") based upon actual healthcare utilization during the period known as the "data collection period". The Company recorded reserves of approximately $22.6 million and $3.5 million as of September 30, 2000 and June 30, 2001, respectively, for TRICARE Adjustments. During the first quarter of fiscal 2000, the Company reached a settlement agreement with

a contractor under one of its TRICARE contracts whereby the Company agreed to pay approximately $38.1 million to the contractor during the quarter ended December 31, 1999. During the first two quarters of fiscal 2001, the Company and the contractors under its TRICARE contracts agreed to positive settlements of their joint appeals of the Department of Defense's retroactive adjustments and other contractual issues in the amount of approximately $30.3 million. While management believes that the present reserve for TRICARE adjustments is reasonable, ultimate settlement resulting from adjustments and available appeal processes may vary from the amounts provided. Choice, one of the Company's 50% joint ventures, also participates as a subcontractor to TRICARE. During the second quarter of fiscal 2001, Choice and its contractor also agreed to a positive settlement of a joint appeal to the Department of Defense's retroactive adjustment, in the amount of approximately $50 million. As of June 30, 2001, $5.5 million of the adjustment relates to future periods.

NOTE I—Special Charges

In December 2000, the Company sold its Canadian behavioral managed care operations to Family Guidance Group, Inc. for approximately $9.7 million net of transaction costs of $0.3 million. The sale of the Canadian operations resulted in a non-recurring loss of approximately $3.3 million before provision for income taxes. The Company received net proceeds of approximately $8.5 million and will receive an additional $1.3 million in two installments payable in December 2001 and 2002. Proceeds received from the sale were used to reduce debt.

During the fourth quarter of fiscal 2000, the Company incurred special charges of $9.6 million, net of the $1.9 million non-recurring gain on the sale of the corporate aircraft, related to the closure of certain provider offices and restructuring of the corporate function and certain behavioral managed healthcare office sites. The following table provides a roll-forward of liabilities resulting from these special charges (in thousands):

Type of Cost	Balance September 30, 2000		Payments			Adjustments(1)			Balance June 30, 2001
Employee severance and termination benefits	$	5,866	$	(5,536	)	$	876		$	1,206
Lease termination and other costs		5,578		(2,364	)		(876	)		2,338

	$	11,444	$	(7,900	)	$	—		$	3,544

(1): The adjustments represent reclassification of certain amounts based upon the Company's evaluation at June 30, 2001.

NOTE J—Business Segment Information

As of March 2001, the Company is operating only in the behavioral managed healthcare business. The Company provides behavioral managed healthcare services to health plans, insurance companies, corporations, labor unions and various governmental agencies. In conjunction with the discontinuance of its other segments, the Company is evaluating its remaining business to determine if additional segment disclosure is warranted. The Company anticipates completion of the evaluation during fiscal 2001.

NOTE K—Redeemable Preferred Stock

TPG Investment. On December 14, 1999, the Company entered into an agreement with TPG Magellan ("TPG") pursuant to which TPG agreed to purchase 59,063 shares of the Company's Series A Preferred Stock, and the Option to purchase an additional 21,000 shares of Series A Preferred Stock (the "TPG Investment").

TPG assigned its right to purchase the 59,063 shares of the Company's Series A Preferred Stock to TPG Partners II and its affiliates, who purchased the Series A Preferred Stock on December 15, 1999. Net cash proceeds from the issuance of the Series A Preferred Stock were $54.0 million. Approximately 50% of the net proceeds received from the issuance of the Series A Preferred Stock was used to reduce debt outstanding under the Term Loan Facility, with the remaining 50% of the proceeds being used for general corporate purposes. The Series A Preferred Stock carries a dividend rate of 6.5% per annum, payable in quarterly installments in cash or common stock, subject to certain conditions. Dividends not paid in cash or common stock will accumulate. Dividends are currently accumulating. The Series A Preferred Stock is convertible at any time into the Company's common stock at a conversion price of $9.375 per share, subject to customary antidilution provisions, (which would initially result in approximately 6.3 million shares of common stock if all of the currently issued Series A Preferred Stock were to convert) and carries "as converted" voting rights. The Company may, under certain circumstances, require the holders of the Series A Preferred Stock to convert such stock into common stock. The Series A Preferred Stock, plus accrued and unpaid dividends thereon, must be redeemed by us on December 15, 2009. The Option may be exercised in whole and not in part at any time on or prior to August 17, 2002. The Company may, under certain circumstances, require TPG Magellan to exercise the Option. In certain circumstances, the exercise period could be extended, but in any event the Option will expire not later than August 17, 2004. The terms of the shares of Series A Preferred Stock issuable pursuant to the Options are identical to the terms of the shares of Series A Preferred Stock issued to TPG Magellan at the closing of the TPG investment.

TPG has three representatives on the Company's twelve-member Board of Directors.

The TPG Investment is reflected under the caption "redeemable preferred stock" in the Company's condensed consolidated balance sheet as follows (in thousands):

	June 30, 2001
Redeemable convertible preferred stock:
Series A—stated value $1, 87 shares authorized, 59 shares issued and outstanding	$	59,063
Series B—stated value $1, 60 shares authorized, none issued and outstanding		—
Series C—stated value $1, 60 shares authorized, none issued and outstanding		—

		59,063
Less: Fair value of Series A Option at issuance		(3,366	)

Total redeemable convertible preferred stock		55,697
Accretion and accumulated unpaid dividends on Series A Preferred Stock		6,771
Fair value of Series A Option at issuance		3,366
Issuance costs, net of amortization of $778		(4,300	)

	$	61,534

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

Overview

The Company has been executing a strategy to dispose of non-core businesses and focus on its core behavioral managed healthcare business.

On September 10, 1999, the Company consummated the CBHS Transactions (as defined). The CBHS Transactions, together with the formal plan of disposal authorized by the Company's Board of Directors on September 2, 1999, represented the disposal of the Company's healthcare provider and healthcare franchising business segments.

On October 4, 2000, the Company adopted a formal plan to dispose of the businesses included in the Company's specialty managed healthcare segment through the sale and/or abandonment of these businesses and related assets. The specialty managed healthcare segment includes the businesses acquired in conjunction with the purchase of Vivra which was consummated February 29, 2000 and Allied which was consummated on December 5, 1997. The initial purchase price for Vivra was $10.25 million. The Company paid approximately $54.5 million for Allied.

On January 18, 2001, the Company's Board of Directors approved and the Company entered into a definitive agreement for the sale of the stock of National Mentor, Inc. (Mentor), which represents the business and interests that comprise the Company's human services segment. On March 9, 2001, the Company consummated the sale of Mentor. The sale of Mentor represents the disposal of the Company's human services segment.

APB 30 requires that the results of continuing operations be reported separately from those of discontinued operations for all periods presented and that any gain or loss from disposal of a segment of a business be reported in conjunction with the related results of discontinued operations. Accordingly, the Company has restated its results of operations for all prior periods related to the healthcare provider, healthcare franchising, specialty managed healthcare and human services business segments.

The Company currently is engaged in the behavioral managed healthcare business. The Company coordinates and manages the delivery of behavioral healthcare treatment services through its network of providers, which includes psychiatrists, psychologists and other medical professionals. The treatment services provided through these provider networks include outpatient programs (such as counseling or therapy), intermediate care programs (such as intensive outpatient programs and partial hospitalization services), inpatient treatment and crisis intervention services. The Company provides these services primarily through: (i) risk-based products, where the Company assumes all or a portion of the responsibility for the cost of providing treatment services in exchange for a fixed per member per month fee, (ii) Administrative Services Only ("ASO") products, where the Company provides services such as utilization review, claims administration or provider network management, (iii) Employee Assistance Programs ("EAP") and (iv) products which combine features of some or all of the Company's risk-based, ASO, or EAP products. At June 30, 2001, the Company managed the behavioral healthcare benefits of approximately 69.4 million individuals.

This Form 10-Q and other statements issued or made from time to time by Magellan Health Services, Inc. or its representatives contain statements which may constitute "forward-looking statements" under the Private Securities Litigation Reform Act of 1995. Those statements include statements regarding the intent, belief or current expectations of Magellan and members of its management team, as well as the assumptions on which such statements are based. Words or phrases such as "should result," "are expected to," "anticipate," "estimate", "project" or similar expressions are intended to identify forward-looking statements. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and

uncertainties and that actual results may differ materially from those comtemplated by such forward-looking statements. Important factors currently known to management that could cause actual results to differ materially from those in forward-looking statements are set forth under the heading "Cautionary Statements" in Item 1 of Magellan's Annual Report on Form 10-K/A for the fiscal year ended September 30, 2000, which information is hereby incorporated by reference in this Form 10-Q. Magellan undertakes no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results over time.

Results of Operations

Quarter ended June 30, 2001 ("Current Year Quarter"), compared to the same period of fiscal 2000 ("Prior Year Quarter")

Net Revenue. Net revenue increased 3.4% or $14.2 million, to $432.9 million for the Current Year Quarter. The increase was primarily due to membership growth in existing and new accounts, shifts in membership between benefit products in certain select accounts and increases in rates, partially offset by contracts and businesses the Company exited and terminated.

Salaries, Cost of Care and Other Operating Expenses. Salaries, cost of care and other operating expenses increased 3.9% or $14.3 million, to $382.4 million for the Current Year Quarter. The 2001 quarter increase was due to increased care costs under certain select contracts, membership growth, and new contracts as compared to the Prior Year Quarter.

Equity in Earning of Unconsolidated Subsidiaries. Equity in earnings from unconsolidated subsidiaries increased 103.4% or $2.5 million, to $5.0 million for the Current Year Quarter. Earnings from the Choice partnership increased $1.5 million or 51.3% to $4.3 million in the Current Year Quarter. This increase is primarily due to additional earnings resulting from the the settlement of certain issues with TRICARE that occurred during the second quarter of 2001. Earnings from the Premier partnership increased $1.1 million to $0.1 million in the Current Year Quarter due to decreased care costs incurred during the Current Year Quarter.

Depreciation and Amortization. Depreciation and amortization decreased 1.8%, or $0.3 million, to $17.1 million for the Current Year Quarter. The decrease is primarily attributable to assets fully depreciated during the Current Year Quarter and the write-off and sale of certain assets subsequent to the Prior Year Quarter, partially offset by fixed asset additions.

Interest, net. Interest expense, net, decreased 8.1%, or $1.9 million, to $22.0 million for the Current Year Quarter. The decrease from the Prior Year Quarter is primarily due to lower borrowing rates and lower borrowings outstanding. See "Historical Liquidity and Capital Resources—Financing Activities" for further discussion of the Company's repayment of indebtedness during fiscal 2001.

Income Taxes. The Company's effective income tax rate decreased to 54.9% for the Current Year Quarter from 67.4% for the Prior Year Quarter. The decrease is primarily attributable to the Company's increased level of earnings in the Current Year Quarter relative to the amount of non-deductible goodwill amortization expense associated with certain acquisitions.

Extraordinary Item. The Company recorded an extraordinary loss on early extinguishment of debt of approximately $4.0 million, net of income tax benefit, during the Current Year Quarter to write-off unamortized deferred financing costs related to repayment of certain indebtedness outstanding under the Company's Term Loan Facilities.

Discontinued Operations. The following table summarizes income (loss) from discontinued operations, net of tax for the three months ended June 30, (in thousands):

	2000			2001
Healthcare provider segment	$	—		$	467
Specialty managed healthcare segment		(1,279	)		—
Human services segment		2,515			—

	$	1,236		$	467

Income from the healthcare provider segment for the Current Year Quarter is a result of collection of certain receivables previously written off net of cost of collection and provision for income taxes. During the Current Year Quarter, the Company finalized an agreement with CBHS (the "CBHS Agreement") that provided, (i) the Company is released of all obligations to CBHS; (ii) the Company obtained the economic value of the five Provider JVs that was previously conveyed to CBHS; and (iii) the Company agreed to pay CBHS approximately $26 million over a 9 month period. In conjunction with the CBHS settlement, the Company was released from certain liabilities and therefore has determined that certain liabilities recorded as a result of the CBHS Transactions during fiscal 1999 are no longer needed. The reversal of these liabilities, net of tax, has been recorded during the third quarter of fiscal 2001, resulting in a change in estimate related to the loss on disposal of the healthcare provider and franchising segments of $2.7 million.

Income (loss) from the specialty managed healthcare segment was $0 in the Current Year Quarter due to accruals previously provided for operating losses in conjunction with the plan of disposal. See Note G—"Discontinued Operations" to the Company's unaudited condensed consolidated financial statements set forth elsewhere herein.

Income from the human services segment was $0 in the Current Year Quarter as compared to $2.5 million in the Prior Year Quarter. The Company sold its human services segment during the second quarter of fiscal 2001. See Note G—"Discontinued Operations" to the Company's condensed consolidated financial statements set forth elsewhere herein.

Nine Months ended June 30, 2001 ("Current Year Period"), compared to the same period in fiscal 2000 ("Prior Year Period")

Net Revenue. Net revenue increased 9.5% or $114.4 million, to $1,323.0 million for the Current Year Period. The increase in net revenue was primarily due to increased membership from existing and new contracts, shifts in membership between benefit products in certain select accounts and increases in rates, partially offset by contracts and businesses the Company exited and terminated. Total covered lives increased 2.2% or 1.5 million, to 69.4 million at June 30, 2001 compared to June 30, 2000. The increase in total covered lives excludes 2.2 million lives which were transferred in conjunction with the sale of the Company's Canadian and provider businesses.

Salaries, Cost of Care and Other Operating Expenses. Salaries, cost of care and other operating expenses increased 9.6% or $102.0 million, to $1,165.5 million for the Current Year Period. The Current Year Period was impacted by an adjustment of approximately $15.0 million to the Company's estimate of the estimated claims incurred in prior years based on the results of the Company's reduction in claims inventory and other claims processing improvements. The increase was also due to increased care costs resulting from shifts in membership between benefit products in certain select contracts, membership growth, new contracts and an increase in employee incentive compensation accruals resulting from increased earnings of the Company as compared to the Prior Year Period.

Equity in Earnings of Unconsolidated Subsidiaries. Equity in earnings of unconsolidated subsidiaries increased 275.7% or $24.4 million, to $33.2 million in the Current Year Period. During the

Current Year Period, the Company recorded approximately $22.3 million in connection with the favorable settlement of certain issues related to the Choice partnership's contract with TRICARE. The remaining increase is primarily attributable to increased earnings in Choice offset by decreased earnings in Premier, which resulted primarily from an increase in legal accruals related to certain litigation in the Current Year Period.

Depreciation and Amortization. Depreciation and amortization decreased 1.2%, or $0.6 million, to $50.3 million for the Current Year Period. The decrease is primarily attributable to assets fully depreciated during the Current Year Period and the write-off and sale of certain assets subsequent to the Prior Year Period.

Interest, net. Interest expense, net, decreased 1.8%, or $1.3 million, to $70.9 million for Current Year Period, primarily due to lower borrowing rates in the Current Year Period and lower borrowings outstanding. See "Historical Liquidity and Capital Resources—Financing Activities" for further discussion of the Company's repayment of indebtedness during fiscal 2001.

Other Items. The Company recorded special charges of $3.3 million in the Current Year Period related to the loss on the sale of the Company's Canadian subsidiary. See Note I—"Special Charges" to the Company's condensed consolidated financial statements set forth elsewhere herein.

Income Taxes. The Company's effective income tax rate decreased to 50.5% for the Current Year Period, from 65.5% for Prior Year Period. The decrease is primarily attributable to the Company's increased level of earnings in the Current Year Period relative to the amount of non-deductible goodwill amortization expense associated with certain acquisitions.

Extraordinary Item. The Company recorded an extraordinary loss on early extinguishment of debt of approximately $4.0 million, net of income tax benefit, during the Current Year Period to write-off unamortized deferred financing costs related to repayment of certain indebtedness outstanding under the Company's Term Loan Facilities.

Discontinued Operations. The following table summarizes income (loss) from discontinued operations, net of tax, for the nine months ended June 30 (in thousands):

	2000			2001
Healthcare provider segment	$	—		$	723
Specialty managed healthcare segment		(55,626	)		3,160
Human services segment		7,202			1,751

	$	(48,424	)	$	5,634

Income from the healthcare provider segment for the Current Year Period is a result of the positive settlement of outstanding Medicare and Medicaid cost reports and collection of certain receivables previously written off, offset by the cost of collections and settlement of other liabilities. See Note G—"Discontinued Operations" to the Company's unaudited condensed consolidated financial statements set forth elsewhere herein.

Income from the specialty managed healthcare segment for the Current Year Period represents the settlement of obligations for less than the amount previously estimated. During the Prior Year Period, the Company recorded a $58.2 million impairment of long-lived assets which adversely affected the segment's profitability. See Note G—"Discontinued Operations" to the Company's unaudited condensed consolidated financial statements set forth elsewhere herein.

Income from the human services segment was $1.8 million for the Current Year Period compared to $7.2 million in the Prior Year Period. The decrease is primarily a result of accrual of operating

results in conjunction with recordation of the loss on disposal and approval of the plan of disposal. See Note G—"Discontinued Operations" to the Company's unaudited condensed consolidated financial statements set forth elsewhere herein.

The following table summarizes the gain (loss) on disposal of discontinued operations, net of tax, for the nine months ended June 30 (in thousands):

	2000		2001
Healthcare provider segment	$	—	$	2,707
Human services segment		—		(12,103	)

	$	—	$	(9,396	)

In conjunction with the CBHS settlement, the Company was released from certain liabilities and therefore has determined that certain liabilities recorded as a result of the CBHS Transactions during fiscal 1999 are no longer needed. The reversal of these liabilities, net of tax, has been recorded during the third quarter of fiscal 2001, resulting in a change in estimate related to the loss on disposal of the healthcare provider and franchising segments of $2.7 million. See Note G—"Discontinued Operations" to the Company's unaudited condensed consolidated financial statements set forth elsewhere herein.

The Company recorded an estimated loss on disposal of the human service segment of approximately $12.1 million during the Current Year Period. This loss is comprised of an estimated pre-tax loss of $2.8 million and tax provision of $9.3 million. The tax provision results from a lower tax basis, primarily due to approximately $26.1 million of goodwill that has no tax basis. The loss may change based upon a potential adjustment to working capital as provided for in the sale agreement to be determined during the Company's fourth quarter. See Note G—"Discontinued Operations" to the Company's unaudited condensed consolidated financial statements set forth elsewhere herein.

Historical Liquidity and Capital Resources

Operating Activities. The Company's net cash provided by operating activities was $83.0 million for the Current Year Period and $81.6 million for the Prior Year Period. During the Current Year Period, operating cash flows were: (i) negatively impacted by approximately $29.7 million of cash outflows associated with the settlement of obligations and medical claims previously provided for in conjunction with the disposal of the specialty managed healthcare segment; (ii) negatively impacted by approximately $7.5 million of net cash outflows from the healthcare provider segment associated with the payment of the first installment of CBHS liability offset by net cash collected related to receivables previously written off; (iii) negatively impacted by approximately $7.5 million related to severance and other exit costs accrued for during the fourth quarter of fiscal 2000; (iv) benefited by approximately $30.0 million related to settlement of certain contract issues under its TRICARE contracts; (v) benefited by approximately $24.7 million of additional distributions from the Choice partnership, which was the result of a favorable settlement under its TRICARE contract in the second quarter of fiscal 2001; and (vi) unfavorably affected by increased medical claims payments resulting from the reduction of claims inventory in connection with improved customer service initiatives. During the Prior Year Period, non-recurring cash inflows of approximately $24.0 million related to healthcare provider cost report settlements and non-recurring cash payments totaling $38.1 million related to TRICARE Adjustments were incurred.

Investing Activities. Capital expenditures decreased 27.7%, or $6.9 million, to $18.0 million for the Current Year Period. The decrease was primarily due to approximately $5.6 million of capital expenditures related to specialty managed healthcare and human services segments incurred in the Prior Year Period that were not required in the Current Year Period as a result of the planned disposal of these two segments. During the Current Year Period, the Company had net cash proceeds of:

(i) $8.5 million related to the sale of the Company's Canadian subsidiary; (ii) $91.9 million related to the sale of National Mentor Inc. (net of cash conveyed) and (iii) $3.0 million from the sale of other assets, including a hospital based joint venture.

During both the Prior Year Period and the Current Year Period, the Company paid contingent purchase consideration to Aetna related to previously acquired businesses. During the Current Year Quarter, the Company paid the remaining contingent purchase price to the shareholders of CMG Health, Inc., a managed behavioral healthcare company acquired by Merit in September 1997.

Financing Activities. The Company made net repayments of $457.4 million of indebtedness outstanding under the Revolving Facility (as defined herein) and the Term Loan Facility (as defined herein) during the Current Year Period. The Company used the proceeds of the $250 million Senior Notes issuance (see below) and approximately $100.3 million of the proceeds of the Mentor sale to reduce debt outstanding. As of June 30, 2001, the Company had $115.7 million of availability under the Revolving Facility, excluding $34.3 million of availability reserved for certain letters of credit.

On May 31, 2001, the Company issued $250 million of 9.375% Senior Notes (the "Senior Notes") which mature on November 15, 2007 and are general senior unsecured obligations of the Company. Interest on the Senior Notes is payable semi-annually on each May 15 and November 15, commencing on November 15, 2001. The gross proceeds of $250 million from the issuance and sale of the Senior Notes, together with cash on hand, were used to pay the initial purchasers' fees and other expenses related to the offering and to repay indebtedness outstanding under the Company's Term Loan Facilities as follows: $99.6 million under the Tranche A Term Loans, $75.2 million under the Tranche B Term Loans, and $75.2 million under the Tranche C Term Loans. The Company recognized a net extraordinary loss from the early extinguishment of debt of approximately $4.0 million, net of income tax benefit, during the quarter and the nine months ended June 30, 2001, to write-off unamortized deferred financing costs related to repayment of indebtedness outstanding under the Company's Term Loan Facilities. See Note C—"Long-Term Debt and Leases" to the Company's unaudited condensed consolidated financial statements set forth elsewhere herein.

The Company completed the sale of 59,063 shares of Series A Redeemable Preferred Stock to TPG during fiscal 2000, for a total price of approximately $54.0 million, net of issuance costs. Approximately 50% of the net proceeds were used to reduce debt outstanding under the Term Loan Facility with the remaining 50% being used for general corporate purposes. See Note K—"Redeemable Preferred Stock" to the Company's unaudited condensed consolidated financial statements set forth elsewhere herein.

Outlook—Liquidity and Capital Resources

Debt Service Obligations. The interest payments on the Company's $625.0 million 9% Series A Senior Subordinated Notes due 2008 (the "Senior Subordinated Notes"), the $250.0 million 9.375% Senior Notes due 2007 (the "Senior Notes"), and interest and principal payments on indebtedness outstanding pursuant to the Company's $700.0 million senior secured bank credit agreement (the "Credit Agreement") represent significant liquidity requirements for the Company. Borrowings under the Credit Agreement bear interest at floating rates and require interest payments on varying dates depending on the interest rate option selected by the Company. Borrowings pursuant to the Credit Agreement include $119.7 million, as of June 30, 2001, under a term loan facility (the "Term Loan Facility") and up to $150.0 million under a revolving facility (the "Revolving Facility"). The Company is required to repay the principal amount of borrowings outstanding under the Term Loan Facility, the

principal amount of the Senior Subordinated Notes, and the principal amount of the Senior Notes in the years and amounts set forth in the following table (in millions):

Fiscal Year	Remaining Principal Amount
2001	$	0.4
2002		1.5
2003		14.8
2004		48.9
2005		44.3
2006 and beyond		884.8

In addition, any amounts outstanding under the Revolving Facility mature in February 2004. The Company had no outstanding borrowings and $34.3 million in letters of credit under the Revolving Facility as of June 30, 2001.

Potential Purchase Price Adjustments. In December 1997, the Company purchased HAI from Aetna for approximately $122.1 million, excluding transaction costs. In addition, the Company incurred the obligation to make contingent payments to Aetna which may total up to $60.0 million annually over the five-year period subsequent to closing. The Company may be obligated to make the contingent payments under two separate calculations, which are primarily based upon membership levels during the contract year (as defined) and are calculated at the end of the contractual year. "Contract Year" means each of the twelve-month periods ending on the last day of December in 1998, 1999, 2000, 2001, and 2002.

The Company paid $60.0 million to Aetna for each of the Contract Years ended December 31, 1998, 1999, and 2000. The full $60.0 million payment related to Contract Year 3 (2000) was paid during the second quarter of fiscal 2001. In addition, based upon actual and projected membership levels of Contract Year 4 (2001), the Company has recorded the full $60.0 million payment related to that year. This amount is included in accrued liablities on the balance sheet at June 30, 2001. The Company anticipates it will make the payment during the second quarter of fiscal 2002.

By virtue of acquiring Merit, the Company was required to make certain payments to the former shareholders of CMG Health, Inc. ("CMG"), a managed behavioral healthcare company that was acquired by Merit, in September 1997. Such contingent payments and other related contingencies amounted to approximately $24.0 million, representing additional purchase price. The Company paid this amount during the third quarter of fiscal 2001.

Revolving Facility and Liquidity. The Revolving Facility provides the Company with revolving loans and letters of credit in an aggregate principal amount at any time not to exceed $150.0 million. At June 30, 2001, the Company had approximately $115.7 million of availability under the Revolving Facility. The Company has spent approximately $18.0 million for capital expenditures in the first nine months of fiscal 2001. The Company estimates that it will spend approximately $10.0 million for capital expenditures in the remainder of fiscal 2001. The majority of the Company's anticipated capital expenditures relate to management information systems and related equipment. In conjunction with the Company's on-going integration plan and efforts to comply with the Health Insurance Portability and Accountability Act ("HIPAA"), the Company expects to incur expenditures to improve its computer systems. The Company expects to fund these expenditures from its regular capital expenditures budget. The Company believes that the cash flows generated from its operations, together with amounts available for borrowing under the Revolving Facility and anticipated proceeds from sale of the Provider JVs, will be sufficient to fund its debt service requirements, anticipated capital expenditures, payments with respect to HAI, payments under the CBHS Agreement, and other investing and financing activities over the next year.

Restrictive Financing Covenants. The Credit Agreement imposes restrictions on the Company's ability to make capital expenditures, and the Credit Agreement, the Senior Subordinated Notes Indenture and the Senior Notes Indenture limit the Company's ability to incur additional indebtedness. Such restrictions, together with the highly leveraged financial condition of the Company, may limit the Company's ability to respond to market opportunities. The covenants contained in the Credit Agreement also, among other things, restrict the ability of the Company to dispose of assets, repay other indebtedness, amend other debt instruments (including the Senior Subordinated Notes Indenture and the Senior Notes Indenture), pay dividends, create liens on assets, enter into sale and leaseback transactions, make investments, loans or advances, redeem or repurchase common stock, and make acquisitions.

Strategic Alternatives to Reduce Long-Term Debt and Improve Liquidity. The Company continually evaluates strategic alternatives to reduce debt and improve liquidity, including issuance of equity or debt, refinancing of existing debt and disposition of other assets. There can be no assurance that the Company will be able to implement such alternatives in the future.

On December 15, 1999, the Company received approximately $54.0 million of net proceeds (after transaction costs) upon issuance of Series A Preferred Stock to TPG. Approximately 50% of the net proceeds received from the issuance of the Series A Preferred Stock was used to reduce debt outstanding under the Term Loan Facility with the remaining 50% of the proceeds being used for general corporate purposes.

On March 9, 2001, the Company consummated the sale of National Mentor, Inc. ("Mentor"), the Company's human services business to an entity formed by the management of Mentor and Madison Dearborn Partners, a private equity investment firm. The Company received approximately $113 million in consideration, net of approximately $2 million in transaction costs. The Company's consideration consisted of approximately $103 million in cash and $10 million in the form of an interest-bearing note. The Company also assumed liabilities approximating $3 million. Approximately $50 million of the proceeds were used to retire Term Loans as required by the Company's Credit Agreement, with the remainder used to reduce amounts outstanding under the Revolving Facility.

Net Operating Loss Carryforwards. During fiscal 2000, the Company reached an agreement (the "IRS Agreement") with the Internal Revenue Service ("IRS") related to its federal income tax returns for the fiscal years ended September 30, 1992 and 1993. The IRS had originally proposed to disallow approximately $162 million of deductions related primarily to interest expense in fiscal 1992. Under the IRS Agreement, the Company paid approximately $1 million in taxes and interest to the IRS in the second quarter of fiscal 2001 to resolve the assessment relating to taxes due for these open years, although no concession was made by either party as to the Company's ability to utilize these deductions through net operating loss carryforwards. As a result of the IRS Agreement, the Company recorded a reduction in deferred tax reserves of approximately $9.1 million as a change in estimate during the fourth quarter of fiscal 2000. While any IRS assessment related to these deductions is not expected to result in a material cash payment for income taxes related to prior years, the Company's net operating loss carryforwards for federal income tax could be reduced if the IRS later successfully challenges these deductions.

Recent Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board ("FASB") finalized Statements of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 requires all business combinations initiated after June 30, 2001, to be accounted for using the purchase method. With the adoption of SFAS No. 142, goodwill is no longer subject to amortization over its estimated useful life. Rather, goodwill will be subject to at least an annual assessment for impairment by applying a fair-value-based test.

Similarly, goodwill associated with equity-method investments is no longer amortized. Equity-method goodwill is not, however, subject to the new impairment rules; the impairment guidance in existing rules for equity-method investments continues to apply. Under the new rules, an acquired intangible asset should be separately recognized (and amortized over its useful life) if the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented, or exchanged, regardless of the acquirer's intent to do so. The new rules are effective for fiscal years beginning after December 15, 2001 although early adoption is permitted in certain circumstances. The Company is assessing the effects, if any, of the new pronouncements on the Company's financial statements.

PART II—OTHER INFORMATION

Item 1—Legal Proceedings

On October 26, 2000, two class action complaints (the "Class Actions") were filed against Magellan Health Services, Inc. and Magellan Behavioral Health, Inc. (the "Defendants") in the United States District Court for the Eastern District of Missouri under the Racketeer Influenced and Corrupt Organizations Act ("RICO") and the Employment Retirement Income Security Act of 1974 ("ERISA"). On May 1, 2001, the Missouri court granted the Company's request to transfer the venue of the case to the United States District Court for the District Court of Maryland. The class representatives purport to bring the actions on behalf of a nationwide class of individuals whose behavioral health benefits have been provided, underwritten and/or arranged by the Defendants since 1996. The complaints allege violations of RICO and ERISA arising out of the Defendant's alleged misrepresentations with respect to and failure to disclose its claims practices, the extent of the benefits coverage and other matters that cause the value of benefits to be less than the amount of premium paid. The complaints seek unspecified compensatory damages, treble damages under RICO, and an injunction barring the alleged improper practices, plus interest, costs and attorneys' fees. While the claims are in the initial stages and an outcome cannot be determined, the Company believes that the claims are without merit and intends to defend them vigorously.

On February 16, 2000, CBHS filed a voluntary petition for relief of indebtedness under Chapter 11 of the United States Bankruptcy Code. In connection with the bankruptcy proceedings, CBHS indicated that it believed that it had certain claims against the Company regarding certain previous transactions. During April of 2001, the Company entered into an agreement with CBHS that would provide the Company with a full release of all claims. The agreement was approved by the bankruptcy court in April 2001. Under the agreement, (i) the Company is released of all obligations to CBHS; (ii) the Company obtained the economic value of the five Provider JVs that was previously conveyed to CBHS; and (iii) the Company is to pay CBHS approximately $26 million over the next 9 months. The amounts due under the agreement are anticipated to be funded primarily through proceeds from the sale of the Company's interest in the Provider JVs, and from amounts previously withheld from CBHS for services provided.

Item 6.—Exhibits and Reports on Form 8-K

(a): Exhibits

Exhibit No.		Description of Exhibit
None.

(b): Reports on Form 8-K

The Company filed the following current reports on Form 8-K with the Securities and Exchange Commission during the Quarter ended June 30, 2001.

Date of Report	Item Reported and Description	Financial Statement as filed
May 21, 2001	Financial Information restated to present the human services segment as discontinued operations.	yes(1)
May 21, 2001	Regulation FD Disclosure	no
May 22, 2001	Registrant's press release dated May 22, 2001	no
May 24, 2001	Registrant's press release dated May 24, 2001	no

(1): Unaudited Pro Forma Condensed Consolidated Balance Sheet at March 31, 2001; Unaudited Pro Forma Condensed Statement of Operations for the six months ended March 31, 2001 and the twelve months ended September 30, 2000.

SIGNATURES

Pursuant to the requirements 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.

	MAGELLAN HEALTH SERVICES, INC. (Registrant)
Date: August 8, 2001	/s/ MARK S. DEMILIO Mark S. Demilio Executive Vice President, Finance and Legal
Date: August 8, 2001	/s/ THOMAS C. HOFMEISTER Thomas C. Hofmeister Senior Vice President and Chief Accounting Officer

QuickLinks

FORM 10-Q MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES INDEX
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited) (In thousands, except per share amounts)
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (In thousands, except per share amounts)
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (In thousands)
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS June 30, 2001 (Unaudited)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
PART II—OTHER INFORMATION
SIGNATURES

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	8th grade Bad

Magellan Health (MGLN) 10-Q2001 Q2 Quarterly report

Content analysis