1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 1999
COMMISSION FILE NUMBER 000-23343
NOVACARE EMPLOYEE SERVICES, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 23-2866146
(State of incorporation) (I.R.S. Employer Identification No.)
VALLEY FORGE CORPORATE CENTER
2621 VAN BUREN AVENUE
NORRISTOWN, PA 19403
(Address of principal executive office) (Zip code)
Registrant's telephone number: (610) 650-4700
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
--- ---
As of April 30, 1999, NovaCare Employee Services, Inc. had 29,021,245 shares of
common stock, $.01 par value, outstanding.
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NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
FORM 10-Q - QUARTER ENDED MARCH 31, 1999
INDEX
PART NO. ITEM NO. DESCRIPTION PAGE NO.
- -------- -------- ----------- --------
I FINANCIAL INFORMATION
1 Financial Statements
- Condensed Consolidated Balance Sheets as of
March 31, 1999 and June 30, 1998 1
- Condensed Consolidated Statements of Operations
for the Three Months Ended March 31, 1999 and 1998 2
- Condensed Consolidated Statements of Operations
for the Nine Months Ended March 31, 1999 and 1998 3
- Condensed Consolidated Statements of Cash Flows
for the Nine Months Ended March 31, 1999 and 1998 4
Notes to Condensed Consolidated Financial Statements 5-11
2 Management's Discussion and Analysis of Financial
Condition and Results of Operations 12-20
II OTHER INFORMATION
6 Exhibits and Reports on Form 8-K 21
Signature 22
i
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NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
MARCH 31, June 30,
1999 1998
--------- ---------
ASSETS (UNAUDITED) (See Note 1)
Current assets:
Cash and cash equivalents ........................................... $ 4,509 $ 5,926
Accounts receivable:
Related party .................................................... 16,295 45,083
Unbilled ......................................................... 18,166 13,903
Third parties, net of allowance for doubtful accounts at March 31,
1999 and June 30, 1998 of $432, and $318, respectively ....... 9,243 7,660
Prepaid assets ...................................................... 2,266 1,948
Deferred income taxes ............................................... 1,688 1,688
Other current assets ................................................ 416 324
--------- ---------
Total current assets ..................................... 52,583 76,532
Property and equipment, net ......................................... 5,585 4,490
Excess cost of net assets acquired, net ............................. 83,674 75,570
Other assets, net ................................................... 1,528 829
--------- ---------
$ 143,370 $ 157,421
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current portion of financing arrangements ........................... $ 231 $ 217
Accounts payable and accrued expenses ............................... 5,765 3,748
Accrued salaries, wages and payroll taxes ........................... 38,464 59,759
Current portion of accrued workers' compensation and health claims .. 12,954 17,948
Current portion of deferred purchase price obligations .............. 750 750
Income taxes payable ................................................ 2,678 2,009
--------- ---------
Total current liabilities ................................. 60,842 84,431
Financing arrangements, net of current portion ......................... 507 739
Accrued workers' compensation and health claims, net of current portion 3,221 4,466
Deferred purchase price obligations, net of current portion ............ 805 5,456
Other .................................................................. 436 523
--------- ---------
Total liabilities ......................................... 65,811 95,615
Commitments and contingencies .......................................... -- --
Shareholders' equity:
Preferred stock, $.01 par value; authorized 1,000 shares; no shares
issued or outstanding ............................................. -- --
Common stock, $.01 par value; authorized 60,000 shares; issued 29,045
shares at March 31, 1999, and 27,349 shares at June 30, 1998 ...... 290 273
Additional paid-in capital .......................................... 66,205 57,365
Retained earnings ................................................... 11,215 4,271
--------- ---------
77,710 61,909
Less:Common stock in treasury (at cost), 24 shares at March 31, 1999 (67) --
Deferred compensation, net ..................................... (84) (103)
--------- ---------
Total shareholders' equity ................................ 77,559 61,806
--------- ---------
$ 143,370 $ 157,421
========= =========
The accompanying Notes to Condensed Consolidated Financial Statements are an
integral part of these statements
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NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
FOR THE THREE MONTHS ENDED
MARCH 31,
--------------------------
1999 1998
--------- ---------
Revenues:
Related party ........................................................ $ 160,910 $ 193,837
Third parties ........................................................ 223,119 144,530
--------- ---------
Total revenues ................................................... 384,029 338,367
Direct costs:
Related party:
Salaries, wages and employment taxes of worksite employees ....... 137,096 171,931
Healthcare and workers' compensation, state unemployment and other 15,712 16,642
Third parties:
Salaries, wages and employment taxes of worksite employees ....... 201,835 128,280
Healthcare and workers' compensation, state unemployment and other 12,669 10,212
--------- ---------
Gross profit ................................................... 16,717 11,302
Selling, general and administrative expenses ............................ 10,958 7,685
Amortization of excess cost of net assets acquired ...................... 887 777
--------- ---------
Income from operations ........................................... 4,872 2,840
Investment income ....................................................... 17 46
Interest expense ........................................................ (123) (121)
--------- ---------
Income before income taxes ...................................... 4,766 2,765
Income taxes ............................................................ 2,193 1,286
--------- ---------
Net income ....................................................... $ 2,573 $ 1,479
========= =========
Net income per share:
Basic ............................................................ $ .09 $ .05
========= =========
Assuming dilution ................................................ $ .09 $ .05
========= =========
The accompanying Notes to Condensed Consolidated Financial Statements are an
integral part of these statements
2
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NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
FOR THE NINE MONTHS ENDED
MARCH 31,
------------------------------
1999 1998
----------- -----------
Revenues:
Related party ........................................................ $ 552,385 $ 570,821
Third parties ........................................................ 617,843 337,054
----------- -----------
Total revenues ................................................... 1,170,228 907,875
Direct costs:
Related party:
Salaries, wages and employment taxes of worksite employees ....... 479,123 511,506
Healthcare and workers' compensation, state unemployment and other 49,789 44,102
Third parties:
Salaries, wages and employment taxes of worksite employees ....... 559,251 300,776
Healthcare and workers' compensation, state unemployment and other 34,686 22,449
----------- -----------
Gross profit ................................................... 47,379 29,042
Selling, general and administrative expenses ............................ 31,570 19,801
Amortization of excess cost of net assets acquired ...................... 2,681 1,988
----------- -----------
Income from operations ........................................... 13,128 7,253
Investment income ....................................................... 85 163
Interest expense ........................................................ (353) (197)
Interest expense -- related party ....................................... -- (611)
----------- -----------
Income before income taxes ....................................... 12,860 6,608
Income taxes ............................................................ 5,916 3,073
----------- -----------
Net income ....................................................... $ 6,944 $ 3,535
=========== ===========
Historical information, after accretion adjustment (Note 4):
Net income applicable to common stockholders ..................... $ 6,944 $ 2,350
=========== ===========
Net income per share:
Basic ............................................................ $ .24 $ .10
=========== ===========
Assuming dilution ................................................ $ .24 $ .10
=========== ===========
Pro forma information, excluding accretion adjustment (Note 4):
Net income ....................................................... $ 6,944 $ 3,535
=========== ===========
Net income per share:
Basic ............................................................ $ .24 $ .15
=========== ===========
Assuming dilution ................................................ $ .24 $ .15
=========== ===========
The accompanying Notes to Condensed Consolidated Financial Statements are an
integral part of these statements
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NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
FOR THE NINE MONTHS ENDED
MARCH 31,
------------------------
1999 1998
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income ................................................................ $ 6,944 $ 3,535
Adjustments to reconcile net income to net cash flows provided by operating
activities:
Depreciation and amortization .......................................... 3,901 2,736
Provision for uncollectible accounts ................................... 114 123
Changes in assets and liabilities, net of effects from acquisitions:
Accounts receivable -- related party ............................... 29,619 2,520
Accounts receivable -- third parties ............................... (6,596) (3,875)
Other current assets ............................................... (250) (1,489)
Accounts payable and accrued expenses .............................. 161 (2,725)
Accrued salaries, wages, and payroll taxes ......................... (21,998) 4,589
Accrued workers' compensation and health claims .................... (7,413) 9,090
Income taxes payable ............................................... 669 705
Other, net ......................................................... (804) 796
-------- --------
Net cash flows provided by operating activities ................. 4,347 16,005
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Payments for businesses acquired, net of cash acquired .................... (3,433) (7,821)
Payments of deferred purchase price obligation ............................ -- (17,172)
Additions to property and equipment ....................................... (2,033) (2,404)
Other, net ................................................................ -- (515)
-------- --------
Net cash flows used in investing activities ..................... (5,466) (27,912)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from financing arrangements ...................................... 8,500 4,750
Net proceeds from the initial public offering of common stock ............. -- 45,709
Payment of financing arrangements ......................................... (8,803) (5,874)
Payment of financing arrangements with related party ...................... -- (28,382)
Proceeds from common stock issued ......................................... 5 6
-------- --------
Net cash flows (used in) provided by financing activities ....... (298) 16,209
-------- --------
Net (decrease) increase in cash and cash equivalents ...................... (1,417) 4,302
Cash and cash equivalents, beginning of period ............................ 5,926 1,782
-------- --------
Cash and cash equivalents, end of period .................................. $ 4,509 $ 6,084
======== ========
Supplemental disclosures of cash flow information:
Interest paid .......................................................... $ 138 $ 687
======== ========
Income taxes paid ...................................................... $ 2,056 $ 2,273
======== ========
The accompanying Notes to Condensed Consolidated Financial Statements are an
integral part of these statements.
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NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1999
(In thousands, except per share data)
(Unaudited)
1. BASIS OF PRESENTATION
NovaCare Employee Services, Inc. (the "Company") is a national
professional employer organization ("PEO") providing small-to medium-sized
businesses with comprehensive, fully integrated outsourcing solutions to
human resource needs, including payroll management, workers' compensation
risk management, health care and other employee benefits management,
unemployment services, rehabilitation temporary staffing and human
resource consulting services.
The condensed consolidated financial statements include the
operations of NovaCare Employee Services, Inc., and its wholly owned
subsidiaries. Intercompany accounts and transactions have been eliminated
in consolidation.
The accompanying condensed consolidated financial statements of the
Company are unaudited. The balance sheet as of June 30, 1998 is condensed
from the audited balance sheet of the Company at that date. These
statements have been prepared in accordance with the rules and regulations
of the Securities and Exchange Commission and should be read in
conjunction with the Company's consolidated financial statements and notes
thereto for the year ended June 30, 1998. Certain information and footnote
disclosures normally in the financial statements prepared in accordance
with generally accepted accounting principles have been condensed or
omitted pursuant to such rules and regulations. In the opinion of Company
management, the condensed consolidated financial statements for the
unaudited interim periods presented include all adjustments (consisting of
only normal recurring adjustments) necessary for a fair presentation of
the Company's financial position and results of operations for the interim
periods presented. Certain amounts in the fiscal 1998 condensed
consolidated financial statements have been reclassified to conform with
the fiscal 1999 presentation.
Operating results for the three and nine month periods ended March
31, 1999 are not necessarily indicative of the results that may be
expected for a full year or any portion thereof.
2. INITIAL PUBLIC OFFERING
On November 14, 1997, the Company completed an initial public
offering of 5,000 shares of its common stock (the "Offering"). Subsequent
to the Offering, the Company issued an additional 750 shares pursuant to
the exercise of an over-allotment provision, for a total issuance of 5,750
shares. The net proceeds from the Offering (including the exercise of the
over-allotment provision), after deducting offering costs of $6,041,
amounted to $45,709 and were used by the Company to pay: (i) the Company's
outstanding revolving credit loan of $28,382 from NovaCare, Inc. (the
"Parent"), (ii) $1,000 to an affiliate of the Company who is a former
owner of a business acquired by the Company, and (iii) $16,172 to retire
deferred purchase obligations. The remaining proceeds were allocated for
general corporate purposes. Simultaneously with the completion of the
Offering, the Company's mandatorily redeemable common stock was converted
into 813 shares of the Company's common stock.
5
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NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
(In thousands, except per share data)
(Unaudited)
3. ACQUISITIONS
On October 1, 1998, the Company acquired all of the outstanding
stock of Payday Professional Employer ("Payday"), a PEO headquartered in
Albuquerque, New Mexico. The purchase price was comprised of cash, shares
of the Company's common stock, the assumption of certain liabilities and
future contingent payments. The cash portion of the purchase price was
partially funded through borrowings from the Company's revolving credit
facility.
On August 1, 1998, the Company acquired all of the outstanding stock
of Pay America, Inc. ("Pay America"), a PEO headquartered in Salt Lake
City, Utah. The purchase price was comprised of cash, shares of the
Company's common stock, the assumption of certain liabilities and future
contingent payments. The cash portion of the purchase price was partially
funded through borrowings from the Company's revolving credit facility
with the remainder generated from operations.
During the nine months ended March 31, 1998, the Company completed
two acquisitions - NovaPro, a rehabilitation temporary staffing business
acquired from the Parent on July 1, 1997 and AmeriCare Employers Group,
Inc. ("AmeriCare"), a PEO based in Arizona, acquired on December 1, 1997.
The above acquisitions have been accounted for as a purchase, and
accordingly, the aggregate purchase price was allocated to assets and
liabilities based on their fair values at the date of acquisition.
The following unaudited pro forma consolidated results of the
Company give effect to the acquisitions as if they occurred as of July 1,
1997:
FOR THE NINE MONTHS ENDED
MARCH 31,
---------------------------
1999 1998
----------- -----------
Net revenues .................................. $ 1,179,522 $ 1,018,024
Net income .................................... 7,061 3,666
Net income per share - basic .................. $ .24 $ .15
Net income per share - assuming dilution ...... $ .24 $ .15
The above pro forma information is not necessarily indicative of the
results of operations that would have occurred had the acquisition been
made as of July 1, 1997, or the results which may occur in the future.
Information with respect to the businesses acquired in purchase
transactions for the nine months ended March 31, 1999 was as follows:
Cash paid (net of $767 cash acquired) ......................... $2,833
Common stock issued ........................................... 3,600
Deferred purchase price obligations ........................... 1,200
Other consideration ........................................... 600
------
8,233
Liabilities assumed ........................................... 1,699
------
9,932
Fair value of assets acquired ................................. 1,047
------
Cost in excess of fair value of net assets acquired ........... $8,885
======
6
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NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
(In thousands, except per share data)
(Unaudited)
In addition during the nine month period ended March 31, 1999, the
Company paid $600 of guaranteed earnout payments to the former owners of a
business acquired in fiscal 1997.
The operating results with respect to the businesses acquired have
been included in the consolidated results of the Company from the
effective date of acquisition.
4. NET INCOME PER SHARE
The Company adopted the provisions of Statement of Financial
Accounting Standards No. 128, "Earnings per Share" (SFAS 128) during the
second quarter of fiscal 1998. This statement revised the calculation of
earnings per share from the "primary" and "fully diluted" methods
previously employed to the "basic" and "assuming dilution" methods. Under
this new statement, earnings per share-basic represents net income divided
by the weighted average number of shares outstanding during the period.
Earnings per share-assuming dilution represents the basic weighted average
shares outstanding adjusted for the effects of dilutive stock options and
contingently issuable shares under certain acquisition agreements.
The following table sets forth the computation and reconciliation of
net income per share-basic and net income per share-assuming dilution:
FOR THE THREE MONTHS
ENDED MARCH 31,
-----------------------
1999 1998
------- -------
NET INCOME ..................................... $ 2,573 $ 1,479
======= =======
WEIGHTED AVERAGE SHARES OUTSTANDING:
Weighted average shares outstanding -
basic ...................................... 29,185 27,544
Stock options .............................. 125 130
Contingently issuable shares ............... 576 --
------- -------
Weighted average shares outstanding -
assuming dilution .......................... 29,886 27,674
======= =======
NET INCOME PER SHARE:
Basic ........................................ $ .09 $ .05
======= =======
Assuming dilution ............................ $ .09 $ .05
======= =======
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NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
(In thousands, except per share data)
(Unaudited)
4. NET INCOME PER SHARE (CONTINUED)
FOR THE NINE MONTHS ENDED
MARCH 31,
---------------------------------------
1999 1998
-------- ------------------------
HISTORICAL PRO FORMA
-------- -------- --------
NET INCOME .............................................. $ 6,944 $ 3,535 $ 3,535
ADJUSTMENT TO NET INCOME:
Deduct - accretion of mandatorily
redeemable common stock ............................. -- (1,185) --
-------- -------- --------
Net income attributable to common stock ............... $ 6,944 $ 2,350 $ 3,535
======== ======== ========
WEIGHTED AVERAGE SHARES OUTSTANDING:
Weighted average shares outstanding - basic ........... 29,080 24,134 24,134
Stock options ....................................... 97 140 140
Contingently issuable shares ........................ 232 -- --
-------- -------- --------
Weighted average shares outstanding - assuming dilution 29,409 24,274 24,274
======== ======== ========
NET INCOME PER SHARE:
Basic ................................................. $ .24 $ .10 $ .15
======== ======== ========
Assuming dilution ..................................... $ .24 $ .10 $ .15
======== ======== ========
Historical net income per share is computed by dividing net income,
net of the accretion of mandatorily redeemable common stock, by the
weighted average number of shares outstanding.
Pro forma net income per share is computed by dividing net income,
without consideration to the accretion of mandatorily redeemable common
stock, by the weighted average number of shares outstanding.
Options to purchase 15 and 1,101 shares of common stock for the
three and nine months ended March 31, 1999, respectively, were not
included in the computation of net income per share-assuming dilution
because the effect would be antidilutive. As part of certain purchase
agreements, the former owners of acquired companies are eligible to
receive additional shares of the Company's common stock contingent upon
the acquired companies achieving certain financial and operating criteria
over multiple reporting periods. Approximately 2,003 contingently issuable
shares were not included in the computation of net income per
share-assuming dilution because the specified financial and operating
conditions have not been satisfied. There were no transactions occurring
subsequent to March 31, 1999 that would have materially changed the number
of shares used in computing net income per share-basic or net income per
share-assuming dilution.
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NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
(In thousands, except per share data)
(Unaudited)
5. FINANCING ARRANGEMENTS
Financing arrangements consisted of the following:
MARCH 31, June 30,
1999 1998
------ ------
$25,000 revolving credit facility, due November 17, 2000 . $ -- $ --
Subordinated promissory notes (6% to 10%), through 2002 .. 553 678
Capitalized lease obligations, payable through 2001 ...... 185 278
------ ------
738 956
Less: current portion .................................... 231 217
------ ------
$ 507 $ 739
====== ======
In November 1997, the Company entered into a three-year revolving
credit facility with a syndicate of lenders. The credit facility provides
for interest at a variable rate, depending on certain financial ratios,
equal to (a) the EuroDollar rate plus a range of 1.375% to 2.50% or (b)
the lead lender's prime rate plus a range of 0.125% to 1.25%. In addition,
the Company has agreed to pay a commitment fee ranging from 0.30% to 0.50%
per annum on the unused portion of the commitment. Loans made under the
credit facility are collateralized by a pledge of all of the: (i)
Company's interest in the common stock of its subsidiaries; (ii) assets of
the Company and its subsidiaries; and (iii) Parent's interest in the
common stock of the Company. The revolving credit facility requires the
maintenance of minimum capitalization and net worth amounts, capital
expenditure thresholds as well as certain financial ratios. At March 31,
1999, the Company was in compliance with these requirements. The unused
portion of the credit facility at March 31, 1999 was $25,000.
6. ACCRUED WORKERS' COMPENSATION AND HEALTH CLAIMS
The Company's accruals for claims are summarized as follows:
MARCH 31, June 30,
1999 1998
------- -------
Accrued health benefit premiums payable and claims reserves ...... $10,806 $16,638
Accrued workers' compensation premiums payable and claims reserves 5,369 5,776
------- -------
16,175 22,414
Less: workers' compensation and health claims expected to be
settled in less than one year ................................ 12,954 17,948
------- -------
$ 3,221 $ 4,466
======= =======
7. MANDATORILY REDEEMABLE COMMON STOCK
Mandatorily redeemable common stock was issued in fiscal 1997 in
connection with certain acquisitions which provided certain registration
and valuation rights. The mandatorily redeemable common stock was recorded
at the fair value at the date of issuance. The excess of the put price
over the carrying value was accreted by periodic charges to retained
earnings or additional paid-in capital, as applicable, over a two-year
period. During the nine months ended March 31, 1998, the Company recorded
$1,185 of accretion to retained earnings. On November 11, 1997, all 813
shares of mandatorily redeemable stock were converted into common stock.
9
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NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
(In thousands, except per share data)
(Unaudited)
8. COMMITMENTS AND CONTINGENCIES
The Company is subject to legal proceedings and claims which arise
in the ordinary course of its business. In the opinion of management, the
amount of ultimate liability, if any, with respect to these actions will
not have a materially adverse effect on the financial position or results
of operations of the Company.
The Company's operations are subject to numerous federal, state and
local laws related to employment, taxes and benefit plan matters.
Generally, these regulations affect all companies in the United States.
However, the regulatory environment for PEOs is an evolving area due to
uncertainties resulting from the non-traditional employment relationship
created by PEOs. Many federal and state laws relating to tax and
employment matters were enacted prior to the development of PEO companies
and do not specifically address the obligations and responsibilities of
these co-employer relationships. The Internal Revenue Service (the "IRS")
has conducted a market segment study of the PEO industry (the "Market
Segment Study") focusing on selected PEOs (not including the Company) for
the purpose of examining the relationship among PEOs, their clients,
worksite employees, and the worksite owners. IRS officials indicate that
the Market Segment Study is near completion and suggest that an
announcement of the IRS' position with respect to PEOs has been delayed
pending the outcome of legislation that has been proposed by the PEO
industry. If the IRS concludes that PEOs are not "employers" of certain
worksite employees for purposes of the Internal Revenue Code, the
Company's benefit plans (including cafeteria, health and welfare, and
retirement plans) may lose their favorable tax status, and the Company may
no longer be able to assume its clients' Federal employment tax
withholding obligations. The Company believes that, although unfavorable
to the Company, a prospective application by the IRS of an adverse
conclusion would not have a material effect on its financial position and
results of operations. A retrospective application by the IRS could have a
material adverse effect on the Company's business, financial position,
results of operations and liquidity. While the Company believes that a
retrospective disqualification is unlikely, there can be no assurance as
to the ultimate resolution of these issues.
In February 1997, the Company entered into a contract with the
Parent to co-employ substantially all of the Parent's workforce (the
"NovaCare Contract"). Under the NovaCare Contract, the Company provides
traditional PEO services such as payroll and benefits management, worksite
safety evaluation, employment-related risk management and compensation and
benefits consultation. Effective July 1, 1998, the Company and the Parent
amended the NovaCare Contract to provide the existing PEO services and a
broader array of services, including recruiting, employee training and
orientation, outplacement and human resource consulting. The amended
contract is for four years and is principally a fee-for-service contract,
with the fees negotiated annually. This replaced the previous contract
which was priced as a percentage of payroll. The Parent may not terminate
the NovaCare Contract except in the event of: (i) the breach of any of the
Company's agreements, duties, or performance standards under the NovaCare
Contract; (ii) the making of false or misleading representations,
warranties, or statements of material fact in documents submitted by or on
behalf of the Company to the Parent; or (iii) the insolvency, bankruptcy,
or receivership of the Company.
On March 31, 1999, the Parent announced that due to continuing
declines in rehabilitation caseloads at customer long-term care
facilities, resulting from the new reimbursement structure for therapy
under the Medicare program, and to a lesser extent, contract
cancellations, the Parent will be forced to exit selected long-term care
markets and facilities, and will continue to lower expenses by reducing
labor costs. In addition, the Parent has announced a definitive agreement
to sell its orthotics and prosthetics services business. Based on these
announcements, the Company and the Parent are negotiating new contract
terms to reflect changes in the Parent's ongoing service needs. The
Company expects that the new contract terms will be effective July 1,
1999.
10
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NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
(In thousands, except per share data)
(Unaudited)
8. COMMITMENTS AND CONTINGENCIES (CONTINUED)
The Company anticipates that the events described above will have an
adverse impact on the future operating results of the NovaCare Contract
and the Company's rehabilitation temporary staffing services business. The
Company is evaluating the implications these events will have on its
organizational structure, and expects to record a provision for
restructure in the fourth quarter of fiscal 1999. The provision will
consist principally of employee severance costs, which represent the
accumulation of termination benefits as set forth in the Company's
severance policy, and facility lease costs.
In addition to the sale of its orthotics and prosthetics services
business, the Parent continues to evaluate its strategic alternatives for
obtaining capital to fund its ongoing working capital needs, satisfy its
remaining debt obligations and maximize the Parent's shareholder value.
Such alternatives include the evaluation of the Parent's long-term
care services segment, replacing the Parent's current debt with long-term
financing through a high-yield debt offering or private placement or the
sale of one or more of the Parent's remaining businesses. The feasibility
and timing of these alternatives will depend on a variety of capital
markets, tax, regulatory and operational issues. The ultimate impact of
these alternatives on the NovaCare Contract and on the future operating
results and financial position of the Company is not presently
determinable.
In response to the Parent's recent announcements to reduce the scale
of its long-term care services segment by exiting selected markets, and
that it had reached a definitive agreement to sell its orthotics and
prosthetics services business, the Company has engaged two investment
banking firms to assist the Company in exploring strategic alternatives,
which may include the sale of the Company.
The assessment of strategic alternatives by the Company will
complement the Parent's continued evaluation of strategic alternatives for
its remaining businesses. The feasibility and timing of the Company's
alternatives will depend on a variety of capital markets, tax, regulatory
and operational issues. The impact of these strategic alternatives on the
future operating results and financial position of the Company, in the
event the Company executes a sale or separation from the Parent, is not
presently determinable.
11
14
NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
OVERVIEW
NovaCare Employee Services, Inc. (the "Company") is the third largest
(measured by number of worksite employees) professional employer organization
("PEO") in the United States. The Company provides small-to medium-sized
businesses with comprehensive, fully integrated outsourcing solutions to human
resource needs, including payroll management, workers' compensation risk
management, health care and other employee benefits management, unemployment
services, rehabilitation temporary staffing and human resource consulting
services. The Company was established by NovaCare, Inc. (the "Parent"), in
September 1996, as a subsidiary and commenced operations on October 1, 1996,
concurrent with the acquisition of one PEO business. In February 1997, the
Company acquired three additional PEO businesses and entered into a contract
with the Parent to provide traditional PEO services to principally all of the
Parent's worksite employees (the "NovaCare Contract"). During fiscal 1998, the
Company completed three additional acquisitions - NovaPro, a rehabilitation
temporary staffing business acquired from the Parent on July 1, 1997; AmeriCare
Employers Group, Inc. ("AmeriCare"), a PEO based in Arizona, acquired on
December 1, 1997; and Staff Leasing Systems, Inc. ("SLS"), a PEO based in
Maryland, acquired on May 1, 1998. In addition, in November 1997 and June 1998,
the Company expanded via start-up operations into two new markets, Atlanta and
Philadelphia, respectively. Effective July 1, 1998, the Company amended the
NovaCare Contract to provide the existing traditional PEO services and a broader
array of services, including recruiting, employee training and orientation,
outplacement and human resource consulting to the Parent. The Company acquired
Pay America, Inc. ("Pay America"), a PEO based in Utah, effective August 1, 1998
and Payday Professional Employer ("Payday"), a PEO based in New Mexico,
effective October 1, 1998. At March 31, 1999, the Company served 3,896 client
organizations with 56,106 employees at over 5,000 worksites in 46 states,
principally in nine different industries.
CONTRACTUAL ARRANGEMENT WITH PARENT
The Parent and the Company entered into the NovaCare Contract in February
1997, whereby principally all of the Parent's employees are co-employed by the
Company. Under the NovaCare Contract, the Company provides traditional PEO
services such as payroll and benefits management, worksite safety evaluation,
employment-related risk management and compensation and benefits consultation.
In January 1998, the Parent initiated a restructuring plan to favorably position
one of its operating divisions for recent changes in the Medicare reimbursement
system as mandated by the Balanced Budget Act of 1997. The intent of the plan
was to substantially reduce the cost of its workforce by transitioning to an
operating model which relies on lower cost quality services. In support of this
transition and to address the increased demand from the Parent for additional
human resource services, the Company and the Parent amended the NovaCare
Contract. The amended contract is a four-year agreement which became effective
July 1, 1998. It provides the existing PEO services and a broader array of
services, including recruiting, employee training and orientation, outplacement
and human resource consulting. The amended contract is principally a
fee-for-service contract. The Parent may not terminate the NovaCare Contract
except in the event of: (i) the breach of any of the Company's agreements,
duties or performance standards under the NovaCare Contract; (ii) the making of
false or misleading representations, warranties, or statements of material fact
in documents submitted by or on behalf of the Company to the Parent; or (iii)
the insolvency, bankruptcy, or receivership of the Company.
12
15
NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (CONTINUED)
CONTRACTUAL ARRANGEMENT WITH PARENT (CONTINUED)
On March 31, 1999, the Parent announced that due to continuing declines in
rehabilitation caseloads at customer long-term care facilities, resulting from
the new reimbursement structure for therapy under the Medicare program, and to a
lesser extent, contract cancellations, the Parent will be forced to exit
selected long-term care markets and facilities, and will continue to lower
expenses by reducing labor costs. In addition, the Parent has announced a
definitive agreement to sell its orthotics and prosthetics services business.
Based on these announcements, the Company and the Parent are negotiating new
contract terms to reflect changes in the Parent's ongoing service needs. The
Company expects that the new contract terms will be effective July 1, 1999.
The Company anticipates that the events described above will have an
adverse impact on the future operating results of the NovaCare Contract and the
Company's rehabilitation temporary staffing services business. The Company is
evaluating the implications these events will have on its organizational
structure, and expects to record a provision for restructure in the fourth
quarter of fiscal 1999. The provision will consist principally of employee
severance costs, which represent the accumulation of termination benefits as set
forth in the Company's severance policy, and facility lease costs.
In addition to the sale of its orthotics and prosthetics services
business, the Parent continues to evaluate its strategic alternatives for
obtaining capital to fund its ongoing working capital needs, satisfy its
remaining debt obligations and maximize the Parent's shareholder value. Such
alternatives include the evaluation of the Parent's long-term care services
segment, replacing the Parent's current debt with long-term financing through a
high-yield debt offering or private placement or the sale of one or more of the
Parent's remaining businesses. The feasibility and timing of these alternatives
will depend on a variety of capital markets, tax, regulatory and operational
issues. The ultimate impact of these alternatives on the NovaCare Contract and
on the future operating results and financial position of the Company is not
presently determinable.
In response to the Parent's recent announcements to reduce the scale of
its long-term care services segment by exiting selected markets, and that it
had reached a definitive agreement to sell its orthotics and prosthetics
services business, the Company has engaged two investment banking firms to
assist the Company in exploring strategic alternatives, which may include the
sale of the Company.
The assessment of strategic alternatives by the Company will complement
the Parent's continued evaluation of strategic alternatives for its remaining
businesses. The feasibility and timing of the Company's alternatives will depend
on a variety of capital markets, tax, regulatory and operational issues. The
impact of these strategic alternatives on the future operating results and
financial position of the Company, in the event the Company executes a sale or
separation from the Parent, is not presently determinable.
13
16
NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (CONTINUED)
RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 1999
The following table sets forth certain income statement and statistical data for
the three months ended March 31, 1999 and 1998.
FOR THE THREE MONTHS ENDED
MARCH 31,
-----------------------------------------------------
(TABLE IN THOUSANDS, EXCEPT PERCENTAGES) 1999 1998
---------------------- ----------------------
OPERATING RESULTS: $ % $ %
--------- --------- --------- ---------
Revenues .............................. $ 384,029 100.0% $ 338,367 100.0%
Direct costs:
Salaries, wages and employment taxes of
worksite employees .................. 338,931 88.2 300,211 88.7
Health care, workers' compensation,
state unemployment and other ........ 28,381 7.4 26,854 7.9
--------- --------- --------- ---------
Gross profit ........................ 16,717 4.4 11,302 3.3
Selling, general and administrative
expenses .......................... 10,958 2.9 7,685 2.3
Amortization of excess cost of net
assets acquired ..................... 887 0.2 777 0.2
--------- --------- --------- ---------
Income from operations .............. 4,872 1.3 2,840 0.8
Interest expense, net ................. (106) (0.1) (75) --
--------- --------- --------- ---------
Income before income taxes .......... 4,766 1.2 2,765 0.8
Income tax expense .................... 2,193 0.5 1,286 0.4
--------- --------- --------- ---------
Net income .......................... $ 2,573 0.7% $ 1,479 0.4%
========= ========= ========= =========
FOR THE THREE MONTHS
ENDED MARCH 31,
------------------------
1999 1998
--------- ---------
STATISTICAL DATA:
EBITDA (in thousands) (1) ................. $ 6,187 $ 3,881
Number of clients at period end ........... 3,896 2,650
Worksite employees at period end:
Third parties ........................... 41,676 28,535
Related party ........................... 14,430 18,626
--------- ---------
Total ................................... 56,106 47,161
========= =========
Weighted average worksite employees paid
during the period:
Third parties ........................... 41,294 27,873
Related party ........................... 15,234 18,490
--------- ---------
Total ................................... 56,528 46,363
========= =========
Quarterly gross profit per weighted
average worksite employee (in whole $'s):
Third parties ........................... $ 209 $ 217
Related party ........................... 532 285
Weighted average ........................ 296 244
(1) EBITDA is defined as earnings before interest, income taxes, depreciation
and amortization. EBITDA is presented because it is a widely accepted
financial indicator of a company's ability to incur and service debt.
However, EBITDA should not be considered in isolation or as a substitute
for net income or cash flow data prepared in accordance with generally
accepted accounting principles or as a measure of a company's
profitability or liquidity. Also, the EBITDA definition used herein may
not be comparable to similarly titled measures reported by other
companies.
14
17
NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (CONTINUED)
RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 1999
Revenues totaled $384 million for the three months ended March 31, 1999,
compared to $338.3 million for the three months ended March 31, 1998,
representing an increase of $45.7 million or 13%. During this period, third
party revenues increased $78.6 million or 54%, while related party revenues
declined $32.9 million or 17%. The overall increase in revenue is attributable
to an increased number of clients and worksite employees served. From March 31,
1998 to March 31, 1999, the number of clients increased 47% from 2,650 to 3,896
while the number of weighted average worksite employees increased 22% from
46,363 to 56,528. The increases are attributable to: (i) additions from
businesses acquired; (ii) internal growth in existing markets; and (iii)
start-up of new markets.
Gross profit was $16.7 million for the three months ended March 31, 1999,
compared to $11.3 million for the three months ended March 31, 1998,
representing an increase of $5.4 million or 48%. The increase in gross profit is
attributable to: (i) additional higher margin services provided to the Parent
under the amended NovaCare Contract; (ii) gross profit from newly acquired
businesses; (iii) internal growth resulting from increased clients and worksite
employees in the Company's existing markets; and (iv) growth from the start-up
of new markets. Gross profit as a percentage of revenues increased to 4.4% for
the three months ended March 31, 1999, compared to 3.3% for the same period in
the prior year. The improvement is attributable to: (i) additional higher margin
services provided under the amended NovaCare Contract; (ii) third party
business, which has a higher gross profit margin, comprising a larger portion of
the Company's operations compared to the same period in the prior year; and
(iii) the provision of higher margin temporary staffing services provided to the
Parent. The gross profit per third party weighted average worksite employee
decreased to $209 for the three months ended March 31, 1999 from $217 for the
comparable period in the prior year. The decrease is attributable to a decline
in the provision of temporary staffing services, which have higher margins
compared to standard PEO services. The gross profit per related party weighted
average worksite employee increased to $532 for the three months ended March 31,
1999 from $285 for the comparable period in the prior year due to: (i) the
higher margin services provided under the amended NovaCare Contract; and (ii)
the provision of higher margin temporary staffing services.
Selling, general and administrative expenses increased to $11.0 million
for the three months ended March 31, 1999 from $7.7 million for the three months
ended March 31, 1998, representing an increase of $3.3 million or 43%. The
increase results from increased staffing and other expenses associated with: (i)
the timing of acquisitions; (ii) new services provided under the amended
NovaCare Contract; (iii) executing the Company's internal growth strategy; and
(iv) opening new markets. As a percentage of revenue, selling, general and
administrative expenses were 2.9% for the three months ended March 31, 1999,
compared to 2.3% for the same period in the prior year. The increase in selling,
general and administrative expenses as a percentage of revenues is due primarily
to: (i) the additional services provided under the amended NovaCare Contract;
(ii) an increase in costs to support the Company's expanding infrastructure; and
(iii) third party operations, which have higher selling, general and
administrative expenses as a percentage of revenue, comprising a larger portion
of the current period's expenses.
Amortization of excess cost of net assets acquired increased to $887,000
for the three months ended March 31, 1999 from $777,000 for the comparable
period in the prior year. The increase is primarily attributable to the
acquisitions of SLS, Pay America and Payday discussed above.
Interest expense, net of investment income, increased to $106,000 for the
three months ended March 31, 1999 from $75,000 for the comparable period in the
prior year. The increase is due primarily to an increase in the Company's
average borrowings from the revolving credit facility during the three months
ended March 31, 1999 compared to the prior year. The increase in the average
borrowings is primarily due to the increased number of acquisitions made
subsequent to March 31, 1998.
Income tax expense as a percentage of pretax income decreased to 46.0%
from 46.5%. The principal reason for the reduction in the tax rate was the
relative impact of non-deductible amortization of excess costs of net assets
acquired on pre-tax income for the three months ended March 31, 1999 compared
with the prior year.
15
18
NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (CONTINUED)
RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED MARCH 31, 1999
The following table sets forth certain income statement and statistical data for
the nine months ended March 31, 1999 and 1998.
FOR THE NINE MONTHS ENDED
MARCH 31,
--------------------------------------------------------------
(TABLE IN THOUSANDS, EXCEPT PERCENTAGES) 1999 1998
---------------------------- ----------------------------
OPERATING RESULTS: ....................... $ % $ %
----------- ----------- ----------- -----------
Revenues .............................. $ 1,170,228 100.0% $ 907,875 100.0%
Direct costs:
Salaries, wages and employment taxes of
worksite employees .................. 1,038,374 88.8 812,282 89.5
Health care, workers' compensation,
state unemployment and other ........ 84,475 7.2 66,551 7.3
----------- ----------- ----------- -----------
Gross profit ........................ 47,379 4.0 29,042 3.2
Selling, general and administrative
expenses ......................... 31,570 2.7 19,801 2.2
Amortization of excess cost of net
assets acquired ..................... 2,681 0.2 1,988 0.2
----------- ----------- ----------- -----------
Income from operations .............. 13,128 1.1 7,253 0.8
Interest expense, net ................. (268) -- (645) (0.1)
----------- ----------- ----------- -----------
Income before income taxes .......... 12,860 1.1 6,608 0.7
Income tax expense .................... 5,916 0.5 3,073 0.3
----------- ----------- ----------- -----------
Net income .......................... $ 6,944 0.6% $ 3,535 0.4%
=========== =========== =========== ===========
FOR THE NINE MONTHS
ENDED MARCH 31,
----------------------------
1999 1998
----------- -----------
STATISTICAL DATA:
EBITDA (in thousands) (1) ................. $ 17,029 $ 9,990
Number of clients at period end ........... 3,896 2,650
Worksite employees at period end:
Third parties ........................... 41,676 28,535
Related party ........................... 14,430 18,626
----------- -----------
Total ................................... 56,106 47,161
=========== ===========
Weighted average worksite employees paid
during the period:
Third parties ........................... 39,026 23,388
Related party ........................... 17,562 17,354
----------- -----------
Total ................................... 56,588 40,742
=========== ===========
Quarterly gross profit per weighted
average worksite employee (in whole $'s):
Third parties ........................... $ 613 $ 591
Related party ........................... 1,337 877
Weighted average ........................ 837 713
(1) EBITDA is defined as earnings before interest, income taxes, depreciation
and amortization. EBITDA is presented because it is a widely accepted
financial indicator of a company's ability to incur and service debt.
However, EBITDA should not be considered in isolation or as a substitute
for net income or cash flow data prepared in accordance with generally
accepted accounting principles or as a measure of a company's
profitability or liquidity. Also, the EBITDA definition used herein may
not be comparable to similarly titled measures reported by other
companies.
16
19
NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (CONTINUED)
RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED MARCH 31, 1999
Revenues totaled $1.170 billion for the nine months ended March 31, 1999,
compared to $908 million for the nine months ended March 31, 1998, representing
an increase of $262 million or 29%. During this period, third party revenues
increased $280.8 million or 83%, while related party revenues decreased $18.4
million or 3%. The overall increase is attributable to an increased number of
clients and worksite employees served. From March 31, 1998 to March 31, 1999,
the number of clients increased 47% from 2,650 to 3,896, while the number of
weighted average worksite employees increased 39% from 40,742 to 56,588. The
increases are attributable to: (i) additions from businesses acquired; (ii)
internal growth in existing markets; and (iii) start-up of new markets.
Gross profit was $47.4 million for the nine months ended March 31, 1999,
compared to $29.0 million for the nine months ended March 31, 1998, representing
an increase of $18.4 million or 63%. The increase in gross profit is
attributable to: (i) additional higher margin services provided to the Parent
under the amended NovaCare Contract; (ii) gross profit from newly acquired
businesses; (iii) internal growth resulting from increased clients and worksite
employees in the Company's existing markets; and (iv) growth from the start-up
of new markets. Gross profit as a percentage of revenues increased to 4.0% for
the nine months ended March 31, 1999, compared to 3.2% for the same period in
the prior year. The improvement is attributable to: (i) additional higher margin
services provided under the amended NovaCare Contract; (ii) third party
business, which has a higher gross profit margin, comprising a larger portion of
the Company's operations compared to the same period in the prior year; and
(iii) the provision of higher margin temporary staffing services provided to the
Parent. The gross profit per third party weighted average worksite employee
increased to $613 for the nine months ended March 31, 1999 from $591 for the
comparable period in the prior year. The increase is attributable to improved
same market gross profit per worksite employee and the impact of newly acquired
businesses. The gross profit per related party weighted average worksite
employee increased to $1,337 for the nine months ended March 31, 1999 from $877
for the comparable period in the prior year due to: (i) the higher margin
services provided under the amended NovaCare Contract; and (ii) the provision of
higher margin temporary staffing services.
Selling, general and administrative expenses increased to $31.6 million
for the nine months ended March 31, 1999 from $19.8 million for the nine months
ended March 31, 1998, representing an increase of $11.8 million or 59%. The
increase results from increased staffing and other expenses associated with: (i)
the timing of acquisitions; (ii) new services provided under the amended
NovaCare Contract; (iii) executing the Company's internal growth strategy; and
(iv) opening new markets. As a percentage of revenue, selling, general and
administrative expenses were 2.7% for the nine months ended March 31, 1999,
compared to 2.2% for the same period in the prior year. The increase in selling,
general and administrative expenses as a percentage of revenues is due primarily
to: (i) the additional services provided under the amended NovaCare Contract;
(ii) an increase in costs to support the Company's expanding infrastructure; and
(iii) third party operations, which have higher selling, general and
administrative expenses as a percentage of revenue, comprising a larger portion
of the current period's expenses.
Amortization of excess cost of net assets acquired increased to $2.7
million for the nine months ended March 31, 1999 from $2.0 million for the
comparable period in the prior year. The increase is primarily attributable to
the acquisitions of AmeriCare, SLS, Pay America and Payday discussed above.
Interest expense, net of investment income, decreased to $268,000 for the
nine months ended March 31, 1999 from $645,000 for the comparable period in the
prior year. The decrease is due primarily to a reduction in related party
interest expense. During the second quarter of fiscal 1998, the Company repaid
all outstanding indebtedness to the Parent with a portion of the net proceeds
available from the Offering completed November 14, 1997.
Income tax expense as a percentage of pretax income decreased to 46.0%
from 46.5%. The principal reason for the reduction in the tax rate was the
relative impact of non-deductible amortization of excess costs of net assets
acquired on pre-tax income for the nine months ended March 31, 1999 compared
with the prior year.
17
20
NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (CONTINUED)
LIQUIDITY AND CAPITAL RESOURCES
The Company had $4.5 million of cash and cash equivalents at March 31,
1999. As of the same date, the Company had a working capital deficit of $8.3
million compared to a working capital deficit of $7.9 million at June 30, 1998.
Cash flows from operating activities were $4.3 million for the nine months
ended March 31, 1999, representing a decrease of $11.7 million from the nine
months ended March 31, 1998. The decrease results principally from a $16.5
million decrease in cash flows related to workers' compensation and health claim
liabilities, caused primarily from the timing of benefits payments related to
the NovaCare Contract and third party clients; partially offset by a $3.4
million increase in net income and a $1.2 million increase in non-cash charges
consisting of amortization, depreciation and provision for uncollectible
accounts. Accounts receivable, accrued salaries, wages, payroll taxes, and
health benefit premiums payable are subject to fluctuations depending on the
correlation between the financial reporting cycle versus the payroll cycle.
Cash expended for investing activities was $5.5 million for the nine
months ended March 31, 1999 compared to $27.9 million for the comparable period
in the prior year. During the first nine months of fiscal 1999, the Company
expended $3.4 million in net cash payments to complete the August 1998 and
October 1998 acquisitions of Pay America and Payday, respectively, along with
$2.0 million for capital expenditures related primarily to computer equipment,
software and furniture. During the first nine months of fiscal 1998, the Company
retired $17.2 million of deferred purchase obligations related to fiscal 1997
acquisitions and paid $7.8 million of net cash to complete the December 1997
acquisition of AmeriCare. Capital expenditures in the prior year of $2.4 million
related primarily to furniture, leasehold improvements and computer equipment
associated with the Company's relocation to new corporate headquarters.
Net cash flows from financing activities decreased by $16.5 million to a
net cash flow use of $298,000 for the nine months ended March 31, 1999 when
compared to the same period in the prior year. In the first nine months of
fiscal 1998, the Company completed the Offering of 5.8 million shares of common
stock and received net proceeds of $45.7 million. A portion of the proceeds was
used to retire $28.4 million of outstanding indebtedness due to the Parent.
In November 1997, the Company entered into a $25.0 million three-year
revolving credit facility with a syndicate of lenders. The credit facility
provides for interest at a variable rate, depending on certain financial ratios,
equal to (a) the EuroDollar rate plus a range of 1.375% to 2.50% or (b) the lead
lender's prime rate plus a range of 0.125% to 1.25%. In addition, the Company
has agreed to pay a commitment fee ranging from 0.30% to 0.50% per annum on the
unused portion of the commitment. Loans made under the Credit Facility are
collateralized by a pledge of all of the (i) Company's interest in the common
stock of its subsidiaries, (ii) assets of the Company and its subsidiaries, and
(iii) Parent's interest in the common stock of the Company. The unused portion
of the credit facility at March 31, 1999 was $25.0 million.
The Company's primary short-term liquidity requirements relate to the
payment of accrued payroll and payroll taxes of its worksite and internal core
employees, accounts payable and the payment of accrued workers' compensation
expense and health benefit plan premiums. The Company anticipates additional
short-term requirements for the remainder of fiscal 1999 related to cash
payments for potential acquisitions, capital expenditures to support the
Company's internal growth strategy and expansion into new markets. The Company
believes the cash flows generated by the Company's operations, together with its
existing cash and availability of credit under the credit facility will be
sufficient to meet the Company's short and long-term cash needs.
18
21
NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (CONTINUED)
YEAR 2000 READINESS
The "Year 2000 issue" is the result of historical computer programming of
date sensitive software. Many existing computer programs have been written using
only two digits to define an applicable year (e.g. 98 for 1998), rather than
four digits. On January 1, 2000, any date recording mechanism, including date
sensitive software, may recognize a date using "00" as the year 1900 rather than
the year 2000. This could result in systems failures or create erroneous
results, including among other things, a temporary inability to process
transactions.
Generally, the scope of the Company's exposure to the Year 2000 issue is
limited to its core business systems (payroll, human resources and financial
reporting systems) and the computer systems used by third party service
providers and suppliers. The Company has completed its initial assessment and
believes that all internal Year 2000 issues will be addressed timely to ensure
that the core business systems are in the appropriate state of readiness.
In January 1998, the Company launched a Year 2000-review program, which
included a dedicated Year 2000 project team, review process and internal and
external communication activities. At March 31, 1999 all of the core business
systems have been identified, evaluated and risk assessed for Year 2000
readiness. All significant external suppliers, comprised primarily of financial
institutions, third party insurers and service providers and information
technology suppliers, have been contacted to determine the extent to which the
Company is vulnerable to any external Year 2000 issues. While the Company is not
currently aware of any significant Year 2000 issues related to its business with
service providers and suppliers, there can be no guarantee that the Company will
not be adversely affected by the failure of its primary vendors to remediate
their own Year 2000 issues.
The Company expects to complete Year 2000 testing and remediation by June
30, 1999. Remediation activities consist of developing new programs to enhance
or provide additional functionality to the Company's core business systems. The
next phase of the Company's Year 2000 review program, testing and validation of
external supplier Year 2000 readiness, is expected to be completed by September
15, 1999. Given the Company's current state of readiness and limited exposure,
the cost of remediation activities should approximate $150,000. As of March 31,
1999 the Company's incurred costs related to Year 2000 readiness have been
limited to salary and benefits costs of internal information systems personnel,
and are included as an expense in the fiscal 1998 and 1999 operating results. If
the Company is unsuccessful in completing remediation of non-compliant systems
or third party vendors are not capable of rectifying Year 2000 issues, the
Company could be subjected to the following risks: (i) disruption of payroll,
benefits and compensation administration; (ii) information from internal
management control and reporting systems may lack integrity; (iii) the quality
of service to clients could decline, resulting in higher attrition and loss of
business; and (iv) eligibility information from third party insurers could be
compromised resulting in denial of benefits to health plan participants.
In the event the Company would be subject to the above risks, an
appropriate contingency plan would be implemented. At March 31, 1999, the
Company's contingency plan includes: (i) a dedicated internal group of
information systems professionals that is primarily focused on system or process
disruption; (ii) the creation of a partnership with external service providers
and suppliers to respond to a disruption; (iii) labor intensive efforts in place
of core business system processing; and (iv) on a selective basis engaging
external consultants.
19
22
NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (CONTINUED)
MARKETING AGREEMENT
In fiscal 1998, the Company implemented a strategy to identify and
evaluate potential marketing alliances to augment other opportunities for
growth. In March 1999, the Company entered into a three-year marketing agreement
with AFLAC, Inc., the leading writer of supplemental insurance in the United
States, to cross-sell products between the two companies' respective client
bases. The marketing agreement will give the Company access to AFLAC's
substantial customer base across the country and will broaden the Company's
reach to prospective customers through AFLAC's national sales organization. In
addition, the Company's existing worksite employees will be offered an enhanced
employee benefits package through AFLAC's wide array of supplemental insurance
products.
The Company believes that the agreement with AFLAC will enhance its
ability to increase the growth of worksite employees and clients in existing and
new markets. However, there can be no assurance of these results in the future.
The Company intends to continue developing other alliance opportunities as an
extension of its marketing and sales capability.
STRATEGIC ALTERNATIVES
In response to the Parent's recent announcements to reduce the scale of
its long-term care services segment by exiting selected markets, and that it
had reached a definitive agreement to sell its orthotics and prosthetics
services business, the Company has engaged two investment banking firms to
assist the Company in exploring strategic alternatives, which may include the
sale of the Company.
The assessment of strategic alternatives by the Company will complement
the Parent's continued evaluation of strategic alternatives for its remaining
businesses. The feasibility and timing of the Company's alternatives will depend
on a variety of capital markets, tax, regulatory and operational issues. The
impact of these alternatives on the future operating results and financial
position of the Company, in the event the Company executes a sale or separation
from the Parent, is not presently determinable.
CAUTIONARY STATEMENT
Except for historical information, matters discussed above including, but
not limited to, statements concerning future growth and Year 2000 readiness, are
forward-looking statements that are based on management's estimates, assumptions
and projections. Important factors that could cause results to differ materially
from those expected by management include (i) management retention and
development; (ii) management's success in integrating acquired businesses, in
developing and introducing new products and lines of business and in entering
new markets; (iii) the ability of the Company, its customers and its suppliers
to complete assessment, testing and remediation of Year 2000 issues; (iv)
adverse Internal Revenue Service rulings and state regulations with respect to
the employer status of employee services businesses; (v) the Company's ability
to implement its employee services business model; and (vi) any adverse impact
on the operating results of the NovaCare Contract in the event the Parent
executes some form of a separation strategy, or the sale of one or more of its
businesses.
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NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
PART II - OTHER INFORMATION
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K
(A) Exhibit
Number Exhibit Description Page Number
------ ------------------- -----------
10 Employment Agreement dated as of December 8,
1998 between the Company and Andrew W. Stith.
27 Financial Data Schedule
(B) Reports on Form 8-K
The Company filed no reports on Form 8-K for the quarter ended March 31,
1999.
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NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES
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.
NOVACARE EMPLOYEE SERVICES, INC.
(REGISTRANT)
MAY 17, 1999 BY /s/ THOMAS D. SCHUBERT
-------------------------------------
THOMAS D. SCHUBERT
SENIOR VICE PRESIDENT,
CHIEF FINANCIAL OFFICER AND PRINCIPAL
ACCOUNTING OFFICER
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