- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-K
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1999
/ / 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 58-1076937
- --------------------------------------- -------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
6950 COLUMBIA GATEWAY DRIVE
SUITE 400
COLUMBIA, MARYLAND 21046
- --------------------------------------- -------------------
(Address of principal executive
offices) (Zip Code)
Registrant's telephone number, including area code: (410) 953-1000
--------------------------
Securities registered pursuant to Section 12(b) of the Act:
NAME OF EACH EXCHANGE ON
TITLE OF EACH CLASS WHICH REGISTERED
- ------------------- ------------------------
Common Stock ($0.25 par value) New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No / /
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. / /
The aggregate market value of the voting stock held by non-affiliates of the
registrant at November 30, 1999 was approximately $178 million.
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes / / No / /
The number of shares of the registrant's common stock outstanding as of
November 30, 1999 was 31,979,324.
DOCUMENTS INCORPORATED BY REFERENCE: The registrant's definitive proxy
materials on Schedule 14A relating to its annual meeting of stockholders on
February 17, 2000 are incorporated by reference into Part III as set forth
herein.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
MAGELLAN HEALTH SERVICES, INC.
ANNUAL REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1999
TABLE OF CONTENTS
PAGE
PART I --------
ITEM 1. Business.................................................... 2
ITEM 2. Properties.................................................. 27
ITEM 3. Legal Proceedings........................................... 27
ITEM 4. Submission of Matters to a Vote of Security Holders......... 29
PART II
ITEM 5. Market Price for Registrant's Common Equity and Related
Stockholder Matters......................................... 30
ITEM 6. Selected Financial Data..................................... 30
ITEM 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 32
ITEM 7A. Quantitative and Qualitative Disclosures About Market
Risk........................................................ 46
ITEM 8. Financial Statements and Supplementary Data................. 46
ITEM 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 46
PART III
ITEM 10. Directors and Executive Officers of the Registrant.......... 47
ITEM 11. Executive Compensation...................................... 47
ITEM 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 47
ITEM 13. Certain Relationships and Related Transactions.............. 47
PART IV
ITEM 14. Exhibits, Financial Statement Schedule and Reports on Form
8-K......................................................... 47
PART I
ITEM 1. BUSINESS
Magellan Health Services, Inc. (the "Company"), which was incorporated in
1969 under the laws of the State of Delaware, is a national healthcare company.
The Company operates through three principal segments engaging in (i) the
behavioral managed healthcare business, (ii) the human services business and
(iii) the specialty managed healthcare business. The Company's executive offices
are located at Suite 400, 6950 Columbia Gateway Drive, Columbia, Maryland 21046,
and its telephone number at that location is (410) 953-1000.
RECENT DEVELOPMENTS
SALE OF EUROPEAN PROVIDER OPERATIONS. On April 9, 1999, the Company sold
its European psychiatric provider operations to Investment AB Bure of Sweden for
approximately $57.0 million (before transaction costs of approximately
$2.5 million) which resulted in a non-recurring gain of approximately
$23.9 million before provision for income taxes.
The Company used approximately $38.2 million of the net proceeds to make a
mandatory unscheduled principal payment on indebtedness outstanding under the
Term Loan Facility (as defined). The remaining proceeds were used to reduce
borrowings outstanding under the Revolving Facility (as defined).
TPG INVESTMENT. On July 19, 1999, the Company entered into a definitive
agreement to issue approximately $75.4 million of cumulative convertible
preferred stock to TPG Magellan, LLC, an affiliate of the investment firm Texas
Pacific Group ("TPG") (the "TPG Investment"). On December 15, 1999, the Company
and TPG amended and restated the definitive agreement and consummated the TPG
Investment.
Pursuant to the amended and restated definitive agreement, TPG purchased
approximately $59.1 million of the Company's Series A Cumulative Convertible
Preferred Stock (the "Series A Preferred Stock") and an Option (the "Option") to
purchase an additional approximately $21.0 million of Series A Preferred Stock.
Net proceeds from 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 (as defined) with the remaining 50% of the proceeds being used for
general corporate purposes. The Series A Preferred Stock carries a dividend 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. The Series A Preferred Stock is convertible at any time into
approximately 6.3 million shares of the Company's common stock at a conversion
price of $9.375 per share 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 the Company on
December 15, 2009. The Options will expire unless exercised by June 15, 2002.
TPG may exercise the Options in whole or in part. The Company may, under certain
circumstances, require TPG to exercise the Options. 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 at the closing of
the TPG Investment.
TPG has three representatives on the Company's twelve-member Board of
Directors.
The issuance of common stock in respect of accrued and unpaid dividend
obligations on the Series A Preferred Stock and the issuance of common stock
underlying the Options are subject to approval by the Company's stockholders.
The Company intends to seek such approval no later than the next annual meeting
of its stockholders, which is expected to be held on February 17, 2000.
DISPOSITION OF HEALTHCARE PROVIDER AND FRANCHISING BUSINESSES. On
September 10, 1999, the Company consummated the transfer of certain assets and
other interests pursuant to a Letter Agreement dated
2
August 10, 1999 with Crescent Real Estate Equities ("Crescent"), Crescent
Operating, Inc. ("COI") and Charter Behavioral Health Systems, LLC ("CBHS"). The
transfer effected the Company's exit from its healthcare provider and healthcare
franchising businesses (the "CBHS Transactions"). The terms of the CBHS
Transactions are summarized as follows:
- CBHS redeemed 80% of the Company's CBHS common interest and all of its
CBHS preferred interest, leaving the Company with a 10% non-voting common
interest in CBHS.
- The Company agreed to transfer to CBHS its interests in five of its six
hospital-based joint ventures ("Provider JVs") and related real estate as
soon as practicable.
- The Company transferred to CBHS the right to receive approximately
$7.1 million from Crescent for the sale of two psychiatric hospitals that
were acquired by the Company (and leased to CBHS) in connection with CBHS'
acquisition of certain businesses from Ramsay Healthcare, Inc. in fiscal
1998.
- The Company forgave receivables due from CBHS of approximately
$3.3 million for payments received by CBHS for patient services prior to
the formation of CBHS on June 17, 1997. The receivables related primarily
to patient stays that "straddled" the formation date of CBHS.
- The Company agreed to pay $2.0 million to CBHS in 12 equal monthly
installments beginning on the first anniversary of the closing date.
- CBHS agreed to indemnify the Company for 20% of up to the first
$50 million (i.e., $10 million) for expenses, liabilities and settlements
related to government investigations for events that occurred prior to
June 17, 1997 (the "CBHS Indemnification"). CBHS will be required to pay
the Company a maximum of $500,000 per year under the CBHS Indemnification.
- Crescent, COI, CBHS and Magellan provided each other with mutual releases
of claims among all of the parties with respect to the original
transactions that effected the formation of CBHS and the operation of CBHS
since June 17, 1997 with certain specified exceptions.
- The Company transferred certain other real estate and interests related to
the healthcare provider business to CBHS.
- The Company transferred its healthcare franchising interests, which
included Charter Advantage, LLC, the Charter call center operation, the
Charter name and related intellectual property to CBHS. The Company has
been released from performing any further franchise services or incurring
future franchising expenses.
- The Company forgave prepaid call center management fees of approximately
$2.7 million.
- The Company forgave unpaid franchise fees of approximately $115 million.
The CBHS Transactions, together with the formal plan of disposal authorized
by the Company's Board of Directors on September 2, 1999, represents the
disposal of the Company's healthcare provider and healthcare franchising
business 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 Company recorded an after-tax loss on disposal of its
healthcare provider and healthcare franchising business segments of
approximately $47.4 million (primarily non-cash), in the fourth quarter of
fiscal 1999.
HISTORY
OVERVIEW Prior to June 1997, the Company derived the majority of its
revenue and earnings from providing behavioral healthcare services in an
inpatient setting. Payments from third-party payors are the principal source of
revenue for most healthcare providers. In the early 1990's, many third-party
payors
3
sought to control the cost of providing care to their patients by instituting
managed care programs or seeking the assistance of managed care companies.
Providers participating in managed care programs agree to provide services to
patients for a discount from established rates, which generally results in
pricing concessions by the providers and lower margins. Additionally, managed
care programs generally encourage alternatives to inpatient treatment settings
and reduce utilization of inpatient services. As a result, third-party payors
established managed care programs or engaged managed care companies in many
areas of healthcare, including behavioral healthcare. The Company, which, until
June 1997, was the largest operator of psychiatric hospitals in the United
States, was adversely affected by the adoption of managed care programs as the
principal cost control measure of third party payors.
Prior to the first quarter of fiscal 1996, the Company was not engaged in
the behavioral managed healthcare business. During the first quarter of fiscal
1996, the Company acquired a 61% ownership interest in Green Spring Health
Services, Inc. ("Green Spring"), a managed care company specializing in mental
health and substance abuse/dependence services. At that time, the Company
intended to become a fully integrated behavioral healthcare provider by
combining the behavioral managed healthcare products offered by Green Spring
with the direct treatment services offered by the Company's psychiatric
hospitals. The Company believed that an entity that participated in both the
managed care and provider segments of the behavioral healthcare industry could
more efficiently provide and manage behavioral healthcare for insured
populations than an entity that was solely a managed care company. The Company
also believed that earnings from its behavorial managed care business would
offset, in part, the negative impact on the financial performance of its
psychiatric hospitals caused by managed care.
Subsequent to the Company's acquisition of Green Spring, the growth of the
behavioral managed healthcare industry accelerated. Under the Company's majority
ownership, Green Spring increased its base of covered lives from 12.0 million at
the end of calendar 1995 to 21.1 million at the end of calendar 1997, a compound
annual growth rate of over 32%. While growth in the industry was accelerating,
the behavioral managed healthcare industry also began to consolidate. The
Company concluded that this consolidation presented an opportunity for it to
increase its participation in the behavioral managed healthcare industry, which
the Company believed offered growth and earnings prospects superior to those of
the psychiatric hospital industry. Therefore, the Company decided to sell its
domestic psychiatric facilities to obtain capital for expansion of its
behavioral managed healthcare business.
The Company took a significant step toward implementing this strategy during
fiscal 1997, when it sold substantially all of its domestic acute-care
psychiatric hospitals and residential treatment facilities (collectively, the
"Psychiatric Hospital Facilities") to Crescent for $417.2 million in cash
(before costs of approximately $16.0 million) and certain other consideration
(the "Crescent Transactions"). Simultaneously with the sale of the Psychiatric
Hospital Facilities, the Company and COI, an affiliate of Crescent, formed CBHS
to conduct the operations of the Psychiatric Hospital Facilities and certain
other facilities transfered to CBHS by the Company. The Company retained a 50%
ownership of CBHS; the other 50% of the equity of CBHS was owned by COI.
The Cresent Transactions provided the Company with approximately $200
million of net cash proceeds, after debt repayment, for use in implementing its
business strategy of expanding its managed care operations. The Company used the
proceeds to finance the acquisitions of HAI (as defined) and Allied (as defined)
in December 1997 and further implemented its business strategy through the Merit
(as defined) acquisition (collectively, the "Managed Care Acquisitions"). A
summary of the Managed Care Acquisitions and related transactions are as
follows:
HUMAN AFFAIRS INTERNATIONAL, INCORPORATED ACQUISITION. On December 4, 1997,
the Company consummated the purchase of Human Affairs International,
Incorporated ("HAI"), formerly a unit of Aetna/U.S. Healthcare ("Aetna"), for
approximately $122.1 million, which the Company funded from cash on hand. HAI
managed behavioral healthcare programs primarily through employee assistance
programs ("EAPs") and other behavioral managed healthcare plans. The Company may
be required to make additional contingent payments of up to $60.0 million
annually to Aetna over the five year period subsequent to closing. The amount
and timing of the payments will be contingent upon net increases in the number
of
4
HAI's covered lives in specified products. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Outlook--Liquidity
and Capital Resources."
ALLIED HEALTH GROUP, INC. ACQUISITION. On December 5, 1997, the Company
purchased the assets of Allied Health Group, Inc. and certain of its affiliates
("Allied"). Allied provides specialty managed care products, including
risk-based products and administrative services to a variety of insurance
companies and other customers, including Prudential and Cigna. The Company paid
approximately $54.5 million for Allied. The Company may be required to make
additional contingent payments to the former owners of Allied depending on
Allied's future performance. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Outlook--Liquidity and Capital
Resources."
MERIT ACQUISITION. On February 12, 1998, the Company consummated the
acquisition of Merit Behavioral Care Corporation ("Merit") for cash
consideration of approximately $448.9 million plus the repayment of Merit's
debt. Merit managed behavioral healthcare programs across all segments of the
healthcare industry, including health maintenance organizations ("HMO's"), Blue
Cross/Blue Shield organizations and other insurance companies, corporations and
labor unions, federal, state and local governmental agencies and various state
Medicaid programs.
In connection with the consummation of the Merit acquisition, the Company
consummated certain related transactions (together with the Merit acquisition,
collectively, the "Transactions"), as follows: (i) the Company terminated its
existing credit agreement (the "Magellan Existing Credit Agreement"); (ii) the
Company repaid all loans outstanding pursuant to and terminated Merit's existing
credit agreement (the "Merit Existing Credit Agreement") (the Magellan Existing
Credit Agreement and the Merit Existing Credit Agreement are hereinafter
referred to as the "Existing Credit Agreements"); (iii) the Company consummated
a tender offer for its 11 1/4% Series A Senior Subordinated Notes due 2004 (the
"Magellan Outstanding Notes"); (iv) Merit consummated a tender offer for its
11 1/2% Senior Subordinated Notes due 2005 (the "Merit Outstanding Notes") (the
Magellan Outstanding Notes and the Merit Outstanding Notes are hereinafter
referred to collectively as the "Outstanding Notes" and such tender offers are
hereinafter referred to collectively as the "Debt Tender Offers"); (v) the
Company entered into a new senior secured bank credit agreement (the "Credit
Agreement"), providing for a revolving credit facility (the "Revolving
Facility") and a term loan facility (the "Term Loan Facility") which provides
for borrowings of up to $700 million; and (vi) the Company issued the 9%
Series A Senior Subordinated Notes due 2008 (the "Notes") pursuant to an
indenture which governs the Notes ("Indenture").
The following table sets forth the sources and uses of funds for the
Transactions (in millions):
SOURCES:
Cash and cash equivalents................................... $ 59.3
Credit Agreement:
Revolving Facility(1)..................................... 20.0
Term Loan Facility........................................ 550.0
The Notes................................................... 625.0
--------
Total sources........................................... $1,254.3
========
USES:
Direct Cash Merger Consideration............................ $ 448.9
Repayment of Merit Existing Credit Agreement(2)............. 196.4
Purchase of Magellan Outstanding Notes(3)................... 432.1
Purchase of Merit Outstanding Notes(4)...................... 121.6
Transaction costs(5)........................................ 55.3
--------
Total uses.............................................. $1,254.3
========
-------------------------------
(1) The Revolving Facility provides for borrowings of up to
$150.0 million.
5
(2) Includes principal amount of $193.7 million and accrued interest of
$2.7 million.
(3) Includes principal amount of $375.0 million, tender premium of
$43.4 million and accrued interest of $13.7 million.
(4) Includes principal amount of $100.0 million, tender premium of
$18.8 million and accrued interest of $2.8 million.
(5) Transaction costs include, among other things, costs paid at closing
associated with the debt tender offers, the Notes offering, the Merit
acquisition and the Credit Agreement.
DISPOSITION OF PROVIDER AND FRANCHISE OPERATIONS. The Company completed its
exit from the healthcare provider and franchising businesses during fiscal 1999.
In April 1999, the Company sold its European psychiatric provider operations to
Investment AB Bure of Sweden for approximately $57.0 million and, in September
1999, the Company consummated the CBHS Transactions.
INDUSTRY
OVERVIEW
Behavioral healthcare costs have increased significantly in the United
States in recent years. According to industry sources, direct medical costs of
behavioral health problems, combined with certain indirect costs, were
conservatively estimated at more than $160.0 billion in 1990, the latest year
for which statistics are available. In addition, according to industry sources,
in 1994 (the most recent year for which such information was available), direct
behavioral healthcare services treatment costs amounted to approximately $82.0
billion, or approximately 8% of total healthcare industry spending. These direct
costs have grown, in part, as society has begun to recognize and address
behavioral health concerns and employers have realized that rehabilitation of
employees suffering from substance abuse and relatively mild mental health
problems can reduce losses due to absenteeism and decreased productivity.
In response to these escalating costs, behavioral managed healthcare
companies such as Green Spring, HAI and Merit were formed. Behavorial managed
healthcare companies focus on care management techniques with the goal of
arranging for the provision of an appropriate level of care in a cost-efficient
and effective manner by improving early access to care and assuring an effective
match between the patient and the behavioral healthcare provider's specialty. As
the growth of behavioral managed healthcare has increased, there has been a
significant decrease in occupancy rates and average lengths of stay for
inpatient psychiatric facilities and an increase in outpatient treatment and
alternative care services.
According to an industry trade publication entitled "Open Minds Year Book of
Managed Behavioral Health Market Share in the United States 1999-2000" published
by Open Minds, Gettysburg, Pennsylvania (hereinafter referred to as "OPEN
MINDS"), as of January 1999, approximately 176.8 million beneficiaries were
covered by some form of behavioral managed healthcare plan and an additional
18.8 million beneficiaries were enrolled in internally-managed behavioral
healthcare programs within HMOs. The number of covered beneficiaries has grown
from approximately 86.3 million beneficiaries in 1993 to approximately
176.8 million as of January 1999, representing an approximate 13% compound
annual growth rate since 1993. In addition, according to OPEN MINDS,
beneficiaries covered under risk-based programs are growing even more rapidly,
from approximately 13.6 million as of January 1993 to approximately
49.0 million as of January 1999, representing a compound annual growth rate of
over 25%. OPEN MINDS estimates that the revenues of behavioral managed
healthcare companies totaled approximately $4.4 billion in 1999.
6
OPEN MINDS divides the managed behavioral healthcare industry as of January
1999 into the following categories of care, based on services provided, extent
of care management and level of risk assumption:
BENEFICIARIES PERCENT
CATEGORY OF CARE (IN MILLIONS) OF TOTAL
- ---------------- ------------- --------
Utilization Review/Care Management Programs.............. 35.1 19.9%
Risk-Based Network Products.............................. 49.0 27.7
Non-Risk-Based Network Products.......................... 36.7 20.8
EAPs..................................................... 41.8 23.6
Integrated Programs...................................... 14.2 8.0
----- -----
Total............................................ 176.8 100.0%
===== =====
Management believes the current trends in the behavioral healthcare industry
include increased utilization of risk-based network managed care products and
the integration of EAPs with such managed care products. Management believes
that these trends have developed in response to the attempt by payors to reduce
rapidly escalating behavioral healthcare costs and to limit their risk
associated with such costs while continuing to provide access to high quality
care. According to OPEN MINDS, risk-based network products, integrated programs
and EAPs are the most rapidly growing segments of the behavioral managed
healthcare industry.
UTILIZATION REVIEW/CARE MANAGEMENT PRODUCTS. Under utilization review/care
management products, a managed behavioral healthcare company manages and often
arranges for treatment, but does not maintain a network of providers or assume
any of the responsibility for the cost of providing treatment services. The
Company categorizes its products within this segment of the managed behavioral
healthcare industry (as it is defined by OPEN MINDS) as administrative services
only ("ASO") products. The Company does not expect this segment of the industry
to experience significant growth.
NON-RISK-BASED NETWORK PRODUCTS. Under non-risk-based network products, the
behavioral managed healthcare company provides a full array of managed care
services, including selecting, credentialing and managing a network of providers
(such as psychiatrists, psychologists, social workers and hospitals), and
performs utilization review, claims administration and care management
functions. The third-party payor remains responsible for the cost of providing
the treatment services rendered. The Company categorizes its products within
this segment of the behavioral managed healthcare industry (as it is defined by
OPEN MINDS) as ASO products.
RISK-BASED NETWORK PRODUCTS. Under risk-based network products, the
behavioral managed healthcare company assumes all or a portion of the
responsibility for the cost of providing a full or specified range of behavioral
healthcare treatment services. Most of these programs have payment arrangements
in which the managed care company agrees to arrange for services in exchange for
a fixed fee per member per month that varies depending on the profile of the
beneficiary population or otherwise shares the responsibility for arranging for
all or some portion of the treatment services at a specific cost per person.
Under these products, the behavioral managed healthcare company not only reviews
and monitors a course of treatment, but also arranges and pays for the provision
of patient care. Therefore, the behavioral managed healthcare company must
contract with, credential and manage a network of specialized providers and
facilities that covers the complete continuum of care. The behavioral managed
healthcare company must also see that the appropriate level of care is delivered
in the appropriate setting. Given the ability of payors of behavioral healthcare
benefits to reduce their risk with respect to the cost of treatment services
through risk-based network products while continuing to provide access to high
quality care, this market segment has grown rapidly in recent years. In addition
to the expected growth in total beneficiaries covered under behavioral managed
healthcare products, this shift of beneficiaries into risk-based network
products should further contribute to revenue growth for the behavioral managed
healthcare industry because such contracts generate significantly higher revenue
than ASO contracts. The higher revenue is
7
intended to compensate the behavioral managed healthcare company for bearing the
financial responsibility for the cost of delivering care. The Company's
risk-based products are risk-based network products as defined by OPEN MINDS.
EMPLOYEE ASSISTANCE PROGRAMS. An EAP is a worksite-based program designed
to assist in the early identification and resolution of productivity problems
associated with behavioral conditions or other personal concerns of employees
and their dependants. Under an EAP, staff or network providers or other
affiliated clinicians provide assessment and referral services to employee
beneficiaries and their dependants. These services consist of evaluating a
patient's needs and, if indicated, providing limited counseling and/or
identifying an appropriate provider, treatment facility or other resource for
more intensive treatment services. The EAP industry developed largely out of
employers' efforts to combat alcoholism and substance abuse problems afflicting
workers. A 1990 industry survey estimated the total costs of this dependency at
approximately $98.6 billion per year. Many businesses have implemented
alcoholism and drug abuse treatment programs in the workplace, and in some cases
have expanded those services to cover a wider spectrum of personal problems
experienced by workers and their families. As a result, EAP products now
typically include consultation services, evaluation and referral services,
employee education and outreach services. The Company believes that federal and
state "drug-free workplace" measures and Federal Occupational Health and Safety
Act requirements, taken together with the growing public perception of increased
violence in the workplace, have prompted many companies to implement EAPs.
Although EAPs originated as a support tool to assist managers in dealing with
troubled employees, payors increasingly regard EAPs as an important component in
the continuum of behavioral healthcare services.
INTEGRATED EAP/MANAGED BEHAVIORAL HEALTHCARE PRODUCTS. EAPs are utilized in
a preventive role and in facilitating early intervention and brief treatment of
behavioral healthcare problems before more extensive treatment is required.
Consequently, EAPs often are marketed and sold in tandem with managed behavioral
healthcare programs through "integrated" product offerings. Integrated products
offer employers comprehensive management and treatment of all aspects of
behavioral healthcare. In an effort to both reduce costs and increase
accessibility and ease of treatment, employers are increasingly attempting to
consolidate EAP and behavioral managed healthcare services into a single
product. Although integrated EAP/managed behavioral healthcare products are
currently only a small component of the overall industry, the Company expects
this market segment to grow.
AREAS OF GROWTH
Management believes that the growth of the behavioral managed healthcare
industry will continue, as payors of behavioral healthcare benefits attempt to
reduce the costs of behavioral healthcare while maintaining high quality care.
Management also believes that a number of opportunities exist in the behavioral
managed healthcare industry for continued growth, primarily for risk-based
products. The following paragraphs discuss factors contributing to the growth of
risk-based products and the increase in the number of covered lives in certain
markets.
RISK-BASED PRODUCTS. According to OPEN MINDS, industry enrollment in
risk-based products has grown from approximately 13.6 million covered lives in
1993 to approximately 49.0 million covered lives in 1999, a compound annual
growth rate of over 25%. Despite this growth, only approximately 27.7% of total
managed behavioral healthcare covered lives were enrolled in risk-based products
as of January 1999. The Company believes that the market for risk-based products
has grown and will continue to grow as payors attempt to reduce their
responsibility for the cost of providing behavioral healthcare while ensuring an
appropriate level of access to care. Risk-based products can generate
significantly greater revenue per covered life than other non-risk product
types. According to the OPEN MINDS survey, risk-based products account for
approximately one-half of total managed behavioral healthcare industry revenue,
but, as stated above, accounted for only approximately 27.7% of total covered
lives as of January 1999. During fiscal 1999, risk-based products accounted for
approximately 75.2% of the Company's behavorial managed
8
healthcare revenue and represented approximately 28.9% of covered lives as of
September 30, 1999. See "Cautionary Statements--Risk-Based Products."
MEDICAID. Medicaid is a joint state and federal program to provide
healthcare benefits to low income individuals, including welfare recipients.
According to the Health Care Financing Administration of the United States
Department of Health and Human Services ("HCFA"), federal and state Medicaid
spending increased from $75.4 billion in 1990 to an estimated $159.9 billion in
1997, at an average annual rate almost twice as fast as the annual increase in
overall healthcare spending. Furthermore, according to HCFA, from 1991 to 1996
the number of Medicaid beneficiaries covered under full managed contracts grew
at a compound annual rate of approximately 40% per year. The Company expects
that the Balanced Budget Act of 1997 (the "Budget Act") will slow the growth of
Medicaid spending by accelerating the trend of state Medicaid programs toward
shifting beneficiaries into managed care programs in order to control rising
costs.
Despite the recent increase in managed care enrollment of Medicaid
beneficiaries, Medicaid managed care enrollment as a percentage of all Medicaid
beneficiaries remains small. As of June 1996, according to the National
Institute for Health Care Management, only approximately 35% of all Medicaid
beneficiaries were enrolled in some form of managed care program, and less than
7% were enrolled in risk-based programs. The Company expects the number of
Medicaid recipients enrolled in managed behavioral healthcare programs to
increase through two avenues: (i) subcontracts with HMOs and (ii) direct
contracts with state agencies. As HMOs increase their penetration of the
Medicaid market, the Company expects that many HMOs will continue to (or begin
to) subcontract with behavioral managed healthcare companies to provide services
for Medicaid beneficiaries. State agencies have also begun to contract directly
with behavioral managed healthcare companies to provide behavioral healthcare
services to their Medicaid beneficiaries. Iowa, Massachusetts, Nebraska,
Maryland, Pennsylvania, Tennessee and Montana are examples of states that have
decided to "carve out" behavioral healthcare from their overall Medicaid managed
care programs and have contracted or are expected to contract directly with
behavioral managed healthcare companies to provide such services. The Company
expects that the Budget Act will accelerate the trend of states contracting
directly with behavioral managed healthcare companies. During fiscal 1999,
Medicaid programs accounted for approximately 27.3% of the Company's behavorial
managed healthcare revenue and represented approximately 4.4% of covered lives
as of September 30, 1999. A majority of the Company's Medicaid contracts are
risk-based. See "Cautionary Statements--Dependence on Government Spending for
Managed Healthcare; Possible Impact of Healthcare Reform" and "--Risk-Based
Products" and "Business--Regulation--Budget Act."
9
COMPANY OVERVIEW
GENERAL
According to enrollment data reported in OPEN MINDS, the Company is the
nation's largest provider of behavioral managed healthcare services. As of
September 30, 1999, the Company had approximately 66.4 million covered lives
under behavioral managed healthcare contracts and managed behavioral healthcare
programs for approximately 3,500 customers. Through its current network of over
40,000 providers and 5,000 treatment facilities, the Company manages behavioral
healthcare programs for HMOs, Blue Cross/Blue Shield organizations and other
insurance companies, corporations, federal, state and local governmental
agencies, labor unions and various state Medicaid programs. The Company believes
it has the largest and most comprehensive behavioral healthcare provider network
in the United States. In addition to the Company's behavioral managed healthcare
segment, the Company offers specialty managed care products related to the
management of certain chronic medical conditions. The Company also offers a
broad continuum of human services to 6,444 individuals who receive healthcare
benefits funded by state and local governmental agencies through National
Mentor, Inc. ("Mentor"), its wholly-owned human services provider.
The Company's professional care managers coordinate and manage the delivery
of behavioral healthcare treatment services through the Company's network of
providers, which includes psychiatrists, psychologists, licensed clinical social
workers, marriage and family therapists and licensed clinical professional
counselors. The treatment services provided by the Company's behavioral provider
network include outpatient programs (such as counseling and therapy),
intermediate care programs (such as sub-acute emergency care, intensive
outpatient programs and partial hospitalization services), inpatient treatment
services and alternative care services (such as residential treatment, home and
community-based programs and rehabilitative and support services). The Company
provides these services through: (i) risk-based products, (ii) EAPs, (iii) ASO
products and (iv) products that combine features of some or all of these
products. Under risk-based products, the Company arranges for the provision of a
full range of behavioral healthcare services for beneficiaries of its customers'
healthcare benefit plans through fee arrangements under which the Company
assumes all or a portion of the responsibility for the cost of providing such
services in exchange for a fixed per member per month fee. Under EAPs, the
Company provides assessment services to employees and dependents of its
customers, and if required, referral services to the appropriate behavioral
healthcare service provider. Under ASO products, the Company provides services
such as utilization review, claims administration and provider network
management. The Company does not assume the responsibility for the cost of
providing healthcare services pursuant to its ASO products.
The Company conducts operations in three business segments: (i) behavioral
managed healthcare, (ii) human services and (iii) specialty managed healthcare.
The following describes the Company's three business segments:
BEHAVIORAL MANAGED HEALTHCARE. The behavioral managed healthcare segment is
the Company's primary operating segment. The Company's behavioral managed
healthcare operations are organized around three customer segments: (i) the
Health Plan Division, focusing on the needs of health insurance plans and HMO's
and their members; (ii) the Workplace Division, focusing on self-insured
employers and labor unions and their employees and dependants; and (iii) the
Public Sector Division, focusing on the needs of public purchasers of behavioral
healthcare services and their constituents.
HUMAN SERVICES. The Company's human services business provided specialty
home-based behavioral healthcare services through Mentor, to approximately 6,444
individuals in 181 programs in 22 states as of September 30, 1999. Mentor was
founded in 1983 and was acquired by the Company in January 1995. Mentor's
services include specialty home-based behavioral healthcare services, which
feature individualized home and community-based health and human services
delivered in highly structured and professionally monitored family environments
or "mentor" homes. The mentor homes serve clients with
10
chronic behavioral disorders and disabilities requiring long-term care,
including children and adolescents with behavioral problems, individuals with
mental retardation or developmental disabilities, and individuals with
neurological impairment or other medical and behavioral frailties. Mentor also
provides various residential and day services for individuals with acquired
brain injuries and for individuals with mental retardation and developmental
disabilities.
SPECIALTY MANAGED HEALTHCARE. The Company's specialty managed healthcare
business provides specialty risk-based products and administrative services to a
variety of health insurance companies and other customers, including Prudential,
Cigna and HIP of New York and Florida. The specialty managed healthcare
operations focus on the needs of health plans to manage their specialty care
networks and disease management programs in areas such as diabetes, asthma,
oncology and cardiology.
BUSINESS STRATEGY
INCREASE ENROLLMENT IN BEHAVIORAL MANAGED HEALTHCARE PRODUCTS. The Company
believes it has an opportunity to increase covered lives in all its behavioral
managed healthcare products. The Company believes it will increase ASO and EAP
covered lives with further penetration of large corporate, HMO and insurance
customers. The Company also believes that it has an opportunity to increase
revenues, earnings and cash flows from operations by increasing lives covered by
its risk-based products in all customer segments. The Company is the industry's
leading provider of risk-based products, according to data reported by OPEN
MINDS, and believes that it may benefit from the continuing shift to risk-based
products. According to OPEN MINDS, industry enrollment in risk-based products
has grown from approximately 13.6 million in 1993 to approximately 49.0 million
as of January 1999, representing a compound annual growth rate of over 25%.
Despite this growth, only approximately 27.7% of total behavioral managed
healthcare enrollees were in risk-based products as of January 1999. The Company
believes that the market for risk-based products has grown and will continue to
grow as payors attempt to reduce their cost of providing behavioral healthcare
while ensuring a high quality of care and an appropriate level of access to
care. The Company believes enrollment in its risk-based products will increase
through growth in new covered lives and through the transition of covered lives
in ASO and EAP products to higher revenue risk-based products. There are certain
risks associated with increased enrollment in risk-based products. See
"Cautionary Statements--Risk-Based Products."
PURSUE ADDITIONAL SPECIALTY MANAGED HEALTHCARE OPPORTUNITIES. The Company
believes that significant demand exists for specialty managed healthcare
products related to the management of certain chronic conditions. The Company
believes its large number of covered lives, information systems infrastructure
and experience in managing behavioral healthcare programs position the Company
to provide customers with specialty managed healthcare products. In addition,
the Company may attempt to expand its specialty managed care product offerings
by pursuing strategic acquisitions. The Company may be unable to fully execute
its acquisition strategy due to possible financial and liquidity concerns. See
"Cautionary Statements--Leverage and Debt Service Obligations" and "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Outlook--Liquidity and Capital Resources."
EXPANSION OF HUMAN SERVICES GEOGRAPHIC COVERAGE AND PRODUCT MIX. The human
services industry is a very fragmented, $100 billion industry that continues to
be consolidated by a few competitors. The Company believes continued growth will
result from its ability to increase its geographic coverage through strategic
acquisitions as well as leveraging its human services product offerings on a
nationwide basis. The Company may be unable to fully execute its acquisition
strategy due to possible financial and liquidity concerns. See "Cautionary
Statements--Leverage and Debt Service Obligations" and "Management's Discussion
and Analysis of Financial Condition and Results of
Operations--Outlook--Liquidity and Capital Resources."
11
BEHAVIORAL MANAGED HEALTHCARE PRODUCTS AND SERVICES
GENERAL. The following table sets forth the approximate number of covered
lives as of September 30, 1998 and 1999 and revenue for fiscal 1998 and 1999 for
the types of behavioral managed healthcare programs offered by the Company:
PROGRAMS COVERED LIVES PERCENT REVENUE PERCENT
- -------- ------------- -------- -------- --------
(IN MILLIONS, EXCEPT PERCENTAGES)
1998
Risk-Based Products.................................... 18.6 30.2% $ 773.3 75.4%
EAP, ASO and other products............................ 43.0 69.8 252.9 24.6
---- ----- -------- -----
Total.............................................. 61.6 100.0% $1,026.2 100.0%
==== ===== ======== =====
1999
Risk-Based Products.................................... 19.2 28.9% $1,115.3 75.2%
EAP, ASO and other products............................ 47.2 71.1 367.9 24.8
---- ----- -------- -----
Total.............................................. 66.4 100.0% $1,483.2 100.0%
==== ===== ======== =====
The number of the Company's covered lives fluctuates based on the number of the
Company's customer contracts and as employee, HMO and insurance company
subscriber and government program enrollee populations change from time to time.
RISK-BASED PRODUCTS. Under the Company's risk-based products, the Company
typically arranges for the provision of a full range of outpatient, intermediate
and inpatient treatment services to beneficiaries of its customers' healthcare
benefit plans, primarily through arrangements in which the Company assumes all
of the responsibility for the cost of providing such services in exchange for a
per member per month fee. The Company's experience with risk-based contracts
covering a large number of lives has given it a broad base of data from which to
analyze utilization rates. The Company believes that this broad database permits
it to estimate utilization trends and costs more accurately than many of its
competitors, which allows it to bid effectively. The Company believes that its
experience has also allowed it to develop effective measures for managing the
cost of providing a unit of care to its covered lives. The Company has developed
or acquired clinical protocols, which permit it to assist its network providers
to administer effective treatment in a cost efficient manner, and claims
management technology, which permits the Company to reduce the cost of
processing claims. The Company's care managers are an essential element in its
provision of cost-effective care. Care managers, in consultation with treating
professionals, and using the Company's clinical protocols, authorize an
appropriate level and intensity of services that can be delivered in a
cost-efficient manner.
EMPLOYEE ASSISTANCE PROGRAMS. The Company's EAP products typically provide
assessment and referral services to employees and dependents of the Company's
customers in an effort to assist in the early identification and resolution of
productivity problems associated with the employees who are impaired by
behavioral conditions or other personal concerns. For many EAP customers, the
Company also provides limited outpatient therapy (typically limited to eight or
fewer sessions) to patients requiring such services. For these services, the
Company typically is paid a fixed fee per member per month; however, the Company
is usually not responsible for the cost of providing care beyond these services.
If further services are necessary beyond limited outpatient therapy, the Company
will refer the beneficiary to an appropriate provider or treatment facility.
INTEGRATED PRODUCTS. Under its integrated products, the Company typically
establishes an EAP to function as the "front end" of a managed care program that
provides a full range of services, including more intensive treatment services
not covered by the EAP. The Company typically manages the EAP and accepts all or
some of the responsibility for the cost of any additional treatment required
upon referral out
12
of the EAP, thus integrating the two products and using both the Company's care
management and clinical care techniques to manage the provision of care.
ASO PRODUCTS. Under its ASO products, the Company provides services ranging
from utilization review and claims administration to the arrangement for and
management of a full range of patient treatment services, but does not assume
any of the responsibility for the cost of providing treatment services. Services
include member assistance, management reporting and claims processing in
addition to utilization review and care management.
BEHAVIORAL MANAGED HEALTHCARE CUSTOMERS
GENERAL. The following table sets forth the approximate number of covered
lives as of September 30, 1998 and 1999 and revenue for fiscal 1998 and 1999 in
each of the Company's market segments described below:
MARKET COVERED LIVES PERCENT REVENUE PERCENT
- ------ ------------- -------- -------- --------
(IN MILLIONS, EXCEPT PERCENTAGES)
1998
Workplace (Corporations and Labor Unions).............. 22.8 37.0% $ 165.3 16.1%
Health Plans........................................... 35.4 57.5 625.3 60.9
Public Sector (Primarily Medicaid)..................... 3.4 5.5 235.6 23.0
---- ----- -------- -----
Total.............................................. 61.6 100.0% $1,026.2 100.0%
==== ===== ======== =====
1999
Workplace (Corporations and Labor Unions).............. 27.0 40.7% $ 252.8 17.1%
Health Plans........................................... 36.5 54.9 824.9 55.6
Public Sector (Primarily Medicaid)..................... 2.9 4.4 405.5 27.3
---- ----- -------- -----
Total.............................................. 66.4 100.0% $1,483.2 100.0%
==== ===== ======== =====
CORPORATIONS AND LABOR UNIONS. Corporations and, to a lesser extent, labor
unions, account for a large number of the Company's contracts to provide
behavioral managed healthcare services and, in particular, EAP and integrated
EAP/managed care services. The Company has structured a variety of fee
arrangements with corporate customers to cover all or a portion of the
responsibility of the cost of providing treatment services. In addition, the
Company operates a number of programs for corporate customers on an ASO basis.
Management believes the corporate market is an area of potential growth for the
Company, as corporations are anticipated to increase their utilization of
behavioral managed healthcare services. In an effort to increase penetration of
the corporate market, the Company intends to build upon its experience in
managing programs for large corporate customers (such as IBM, Federal Express
and AT&T) and to market integrated programs to existing EAP customers and other
prospective corporate clients.
HEALTH PLANS. The Company is a leader in the HMO market, providing
behavioral managed healthcare services to HMO beneficiaries. HMO contracts are
full, limited or shared risk contracts in which the Company generally accepts a
fixed fee per member per month from the HMO in exchange for arranging for a full
or specified range of behavioral healthcare services for a specific portion of
the HMO's beneficiaries. Although certain large HMOs provide their own
behavioral managed healthcare services, many HMOs "carve out" behavioral
healthcare from their general healthcare services and subcontract such services
to behavioral managed healthcare companies such as the Company. The Company
anticipates that its business with HMOs will continue to grow. The Company is
also the nation's leading provider of behavioral managed healthcare services to
Blue Cross/Blue Shield organizations, serving 35 such organizations as of
September 30, 1999.
13
PUBLIC SECTOR. The Company provides behavioral managed healthcare services
to Medicaid recipients through both direct contracts with state and local
governmental agencies and through subcontracts with HMOs focused on Medicaid
beneficiary populations. In addition to the Medicaid population, other public
entitlement programs, such as Medicare and state insurance programs for the
uninsured, offer the Company areas of potential future growth. The Company
expects that governmental agencies will continue to implement a significant
number of managed care Medicaid programs through contracts with HMOs and that
many HMOs will subcontract with behavioral managed healthcare organizations,
such as the Company, for behavioral healthcare services. The Company also
expects that other states will continue the trend of "carving-out" behavioral
healthcare services from their general healthcare benefit plans and contracting
directly with behavioral managed healthcare companies such as the Company. See
"Industry--Areas of Growth," "Cautionary Statements--Dependence on Government
Spending for Managed Healthcare; Possible Impact of Healthcare Reform" and
"Cautionary Statements--Regulation--Other Proposed Legislation."
BEHAVIORAL MANAGED HEALTHCARE CONTRACTS
The Company's contracts with customers typically have terms of one to three
years, and in certain cases contain renewal provisions (at the customer's
option) for successive terms of between one and two years (unless terminated
earlier). Substantially all of these contracts are immediately terminable with
cause and many are terminable without cause by the customer or the Company
either upon the giving of requisite notice and the passage of a specified period
of time (typically between 60 and 180 days) or upon the occurrence of other
specified events. In addition, the Company's contracts with federal, state and
local governmental agencies, under both direct contract and subcontract
arrangements with HMOs, generally are conditioned on legislative appropriations.
These contracts, notwithstanding terms to the contrary, generally can be
terminated or modified by the customer if such appropriations are not made. See
"Cautionary Statements--Risk Based Programs" and "Cautionary
Statements--Reliance on Customer Contracts."
The specific terms of the Company's contracts are determined by whether the
contracts are for risk-based, EAP, integrated or ASO products. Risk-based, EAP
and ASO contracts provide for payment of a per member per month fee to the
Company. The Company's billing arrangements for integrated products vary on a
case by case basis.
BEHAVIORAL MANAGED HEALTHCARE NETWORK
The Company's behavioral managed healthcare and EAP treatment services are
provided by a network of third-party providers. The number and type of providers
in a particular area depend upon customer preference, site, geographic
concentration and demographic make-up of the beneficiary population in that
area. Network providers include a variety of specialized behavioral healthcare
personnel, such as psychiatrists, psychologists, licensed clinical social
workers, substance abuse counselors and other professionals.
As of September 30, 1999, the Company had contractual arrangements covering
over 40,000 individual third-party network providers. The Company's network
providers are independent contractors located throughout the local areas in
which the Company's customers' beneficiary populations reside. Network providers
work out of their own offices, although the Company's personnel are available to
assist them with consultation and other needs. Network providers include both
individual practitioners, as well as individuals who are members of group
practices or other licensed centers or programs. Network providers typically
execute standard contracts with the Company for which they are typically paid by
the Company on a fee-for-service basis. In some cases, network providers are
paid on a "case rate" basis, whereby the provider is paid a set rate for an
entire course of treatment, or through other risk sharing arrangements.
14
As of September 30, 1999, the Company's behavorial managed healthcare
network included contractual arrangements with approximately 5,000 third-party
treatment facilities, including inpatient psychiatric and substance abuse
hospitals, intensive outpatient facilities, partial hospitalization facilities,
community health centers and other community-based facilities, rehabilitative
and support facilities, and other intermediate care and alternative care
facilities or programs. This variety of facilities enables the Company to offer
patients a full continuum of care and to refer patients to the most appropriate
facility or program within that continuum. Typically, the Company contracts with
facilities on a per diem or fee-for-service basis and, in some cases, on a "case
rate" or capitated basis. The contracts between the Company and inpatient and
other facilities typically are for one year terms and, in some cases, are
automatically renewable at the Company's option. Facility contracts are usually
terminable by the Company or the facility owner upon 30 to 120 days notice.
COMPETITION
Each segment of the Company's business is highly competitive. With respect
to its managed care businesses, the Company competes with large insurance
companies, HMOs, PPOs, third-party administrators ("TPAs"), independent
practitioner associations ("IPAs"), multi-disciplinary medical groups and other
managed care companies. Many of the Company's competitors are significantly
larger and have greater financial, marketing and other resources than the
Company, and some of the Company's competitors provide a broader range of
services. The Company may also encounter substantial competition in the future
from new market entrants. Many of the Company's customers that are managed care
companies may, in the future, seek to provide behavioral managed healthcare and
EAP services to their employees or subscribers directly, rather than by
contracting with the Company for such services. Because of competition, the
Company does not expect to be able to rely on price increases to achieve revenue
growth and expects to continue experiencing pressure on direct operating
margins. See "Cautionary Statements--Highly Competitive Industry."
The Company's human services operations compete with various for profit and
not-for-profit entities, including, but not limited to: (i) behavioral managed
healthcare companies that have started managing human services for governmental
agencies; (ii) home health care organizations; (iii) proprietary nursing home
companies; and (iv) proprietary human services companies. The Company believes
that the most significant factors in a customer's selection of services include
price, quality of services and outcomes. The pricing aspect of such services is
especially important to attract public sector agencies looking to outsource
public services to the private sector as demand for quality services escalates
while budgeted dollars for healthcare services are reduced. The Company's
management believes that it competes effectively with respect to these factors.
The Company believes it benefits from the competitive strengths described
below:
INDUSTRY LEADERSHIP. The Company is the largest provider of behavioral
managed healthcare services in the United States, according to enrollment data
reported in OPEN MINDS. The Company believes, based on data reported in OPEN
MINDS, that it also now has the number one market position in each of the major
product markets in which it competes. The Company believes its position will
enhance its ability to: (i) provide a consistent level of high quality service
on a nationwide basis; (ii) enter into agreements with behavioral healthcare
providers that allow it to control healthcare costs for its customers; and
(iii) market its behavioral managed care products to large corporate, HMO and
health insurance customers, which, the Company believes, increasingly prefer to
be serviced by a single-source provider on a national basis. See "Cautionary
Statements--Highly Competitive Industry and --Reliance on Customer Contracts"
for a discussion of the risks associated with the highly competitive nature of
the behavioral managed healthcare industry and the Company's reliance on
contracts with payors of behavioral healthcare benefits, respectively.
15
BROAD PRODUCT OFFERING AND NATIONWIDE PROVIDER NETWORK. The Company offers
behavioral managed care products that can be designed to meet specific customer
needs, including risk-based and partial risk-based products, integrated EAPs,
stand-alone EAPs and ASO products. The Company's provider network encompasses
over 40,000 providers and nearly 5,000 treatment facilities in all 50 states.
The Company believes that the combination of its product offerings and its
provider network allows the Company to meet its customers needs for behavioral
managed healthcare on a nationwide basis, and positions the Company to capture
incremental revenue opportunities resulting from the continued growth of the
behavioral managed healthcare industry and the continued migration of its
customers from ASO and EAP products to higher revenue risk-based products. See
"Cautionary Statements--Risk-Based Products" for a discussion of the risks
associated with risk-based products, which are the Company's primary source of
revenue.
BROAD BASE OF CUSTOMER RELATIONSHIPS. The Company believes that the breadth
of its customer relationships are attributable to the Company's broad product
offerings, nationwide provider network, commitment to quality care and ability
to manage behavioral healthcare costs effectively. The Company's customers
include: (i) Blue Cross/Blue Shield organizations; (ii) national HMOs and other
large insurers, such as Aetna and Humana; (iii) large corporations, such as IBM,
Federal Express and AT&T; (iv) state and local governmental agencies through
commercial, Medicaid and other programs; and (v) the federal government through
contracts with CHAMPUS and the U.S. Postal Service. This broad base of customer
relationships provides the Company with stable and diverse sources of revenue,
earnings and cash flows and an established base from which to continue to
increase covered lives and revenue. See "Cautionary Statements--Reliance on
Customer Contracts" for a discussion of the risks associated with the Company's
reliance on certain contracts with payors of behavioral healthcare benefits.
PROVEN RISK MANAGEMENT EXPERIENCE. The Company had approximately
19.2 million covered lives under risk-based contracts at September 30, 1999,
making it the nation's industry leader in at-risk behavioral managed healthcare
products, based on data reported in OPEN MINDS. The Company's experience with
risk-based products covering a large number of lives has given it a broad base
of data from which to analyze utilization rates. The Company believes that this
broad database permits it to estimate utilization trends and costs more
accurately than many of its competitors, which allows it to bid effectively. The
Company believes that its experience has also allowed it to develop effective
measures for controlling the cost of providing a unit of care to its covered
lives. Among other cost control measures, the Company has developed or acquired
clinical protocols, which permit the Company to assist its network providers to
administer effective treatment in a cost efficient manner, and claims management
technology, which permits the Company to reduce the cost of processing claims.
INSURANCE
The Company maintains a general and professional liability insurance policy
with an unaffiliated insurer. The policy is written on an "occurrence" basis,
subject to a $250,000 per claim and $1.0 million annual aggregate self-insured
retention, for a three-year policy period ending June 2001.
16
REGULATION
GENERAL. The behavioral managed healthcare industry and the provision of
behavioral healthcare services are subject to extensive and evolving state and
federal regulation. The Company is subject to certain state laws and
regulations, including those governing: (i) the licensing of insurance
companies, HMOs, PPOs, TPAs and companies engaged in utilization review and
(ii) the licensing of healthcare professionals, including restrictions on
business corporations from practicing, controlling or exercising excessive
influence over behavioral healthcare services through the direct employment of
psychiatrists or, in a few states, psychologists and other behavioral healthcare
professionals. These laws and regulations vary considerably among states and the
Company may be subject to different types of laws and regulations depending on
the specific regulatory approach adopted by each state to regulate the managed
care business and the provision of behavioral healthcare treatment services. In
addition, the Company is subject to certain federal laws as a result of the role
the Company assumes in connection with managing its customers' employee benefit
plans. The regulatory scheme generally applicable to the Company's managed care
operations is described in this section.
The Company believes its operations are structured to comply with applicable
laws and regulations in all material respects and that it has received all
licenses and approvals that are material to the operation of its business.
However, regulation of the managed healthcare industry is evolving, with new
legislative enactments and regulatory initiatives at the state and federal
levels being implemented on a regular basis. Consequently, it is possible that a
court or regulatory agency may take a position under existing or future laws or
regulations, or as a result of a change in the interpretation thereof, that such
laws or regulations apply to the Company in a different manner than the Company
believes such laws or regulations apply. Moreover, any such position may require
significant alterations to the Company's business operations in order to comply
with such laws or regulations, or interpretations thereof. Expansion of the
Company's business to cover additional geographic areas, to serve different
types of customers, to provide new services or to commence new operations could
also subject the Company to additional licensure requirements and/ or
regulation.
LICENSURE. Certain regulatory agencies having jurisdiction over the Company
possess discretionary powers when issuing or renewing licenses or granting
approval of proposed actions such as mergers, a change in ownership, transfer or
assignment of licenses and certain intracorporate transactions. One or multiple
agencies may require as a condition of such licensure or approval that the
Company cease or modify certain of its operations in order to comply with
applicable regulatory requirements or policies. In addition, the time necessary
to obtain licensure or approval varies from state to state, and difficulties in
obtaining a necessary license or approval may result in delays in the Company's
plans to expand operations in a particular state and, in some cases, lost
business opportunities. Compliance activities, mandated changes in the Company's
operations, delays in the expansion of the Company's business or lost business
opportunities as a result of regulatory requirements or policies could have a
material adverse effect on the Company.
INSURANCE, HMO AND PPO ACTIVITIES. To the extent that the Company operates
or is deemed to operate in one or more states as an insurance company, HMO, PPO
or similar entity, it may be required to comply with certain laws and
regulations that, among other things, may require the Company to maintain
certain types of assets and minimum levels of deposits, capital, surplus,
reserves or net worth. In many states, entities that assume risk under contracts
with licensed insurance companies or HMOs have not been considered by state
regulators to be conducting an insurance or HMO business. As a result, the
Company has not sought licensure as either an insurer or HMO in certain states.
The National Association of Insurance Commissioners (the "NAIC") has undertaken
a comprehensive review of the regulatory status of entities arranging for the
provision of healthcare services through a network of providers that, like the
Company, may assume risk for the cost and quality of healthcare services, but
that are not currently licensed as an HMO or similar entity. As a result of this
review, the NAIC developed a "health organizations risk-based capital" formula,
designed specifically for managed care organizations, that
17
establishes a minimum amount of capital necessary for a managed care
organization to support its overall operations, allowing consideration for the
organization's size and risk profile. The NAIC initiative also may result in the
adoption of a model NAIC regulation in the area of health plan standards, which
could be adopted by individual states in whole or in part, and could result in
the Company being required to meet additional or new standards in connection
with its existing operations. Individual states have also recently adopted their
own regulatory initiatives that subject entities such as the Company to
regulation under state insurance laws. This includes, but is not limited to,
requiring licensure as an insurance company or HMO and requiring adherence to
specific financial solvency standards. State insurance laws and regulations may
limit the ability of the Company to pay dividends, make certain investments and
repay certain indebtedness. Licensure as an insurance company, HMO or similar
entity could also subject the Company to regulations governing reporting and
disclosure, mandated benefits, and other traditional insurance regulatory
requirements. PPO regulations to which the Company may be subject may require
the Company to register with a state authority and provide information
concerning its operations, particularly relating to provider and payor
contracting. The imposition of such requirements could increase the Company's
cost of doing business and could delay the Company's conduct or expansion of its
business in some areas. The licensure process under state insurance laws can be
lengthy and, unless the applicable state regulatory agency allows the Company to
continue to operate while the licensure process is ongoing, the Company could
experience a material adverse effect on its operating results and financial
condition while its licensure application is pending. In addition, failure by
the Company to obtain and maintain required licenses typically also constitutes
an event of default under the Company's contracts with its customers. The loss
of business from one or more of the Company's major customers as a result of
such an event of default or otherwise could have a material adverse effect on
the Company.
UTILIZATION REVIEW AND THIRD-PARTY ADMINISTRATOR ACTIVITIES. Numerous
states in which the Company does business have adopted, or are expected to
adopt, regulations governing entities engaging in utilization review and TPA
activities. Utilization review regulations typically impose requirements with
respect to the qualifications of personnel reviewing proposed treatment,
timeliness and notice of the review of proposed treatment, and other matters.
TPA regulations typically impose requirements regarding claims processing and
payments and the handling of customer funds. Utilization review and TPA
regulations may increase the Company's cost of doing business in the event that
compliance requires the Company to retain additional personnel to meet the
regulatory requirements and to take other required actions and make necessary
filings. Although compliance with utilization review regulations has not had a
material adverse effect on the Company, there can be no assurance that specific
regulations adopted in the future would not have such a result, particularly
since the nature, scope and specific requirements of such provisions vary
considerably among states that have adopted regulations of this type.
There is a trend among states to require licensure or certification of
entities performing utilization review or TPA activities; however, certain
federal courts have held that such licensure requirements are preempted by the
Employee Retirement Income Security Act of 1974, as amended, ("ERISA"). ERISA
preempts state laws that mandate employee benefit structures or their
administration, as well as those that provide alternative enforcement
mechanisms. The Company believes that its TPA activities performed for its
self-insured employee benefit plan customers are exempt from otherwise
applicable state licensing or registration requirements based upon federal
preemption under ERISA and has relied on this general principle in determining
not to seek licensure for certain of its activities in many states. Existing
case law is not uniform on the applicability of ERISA preemption with respect to
state regulation of utilization review or TPA activities. There can be no
assurance that additional licensure will not be required with respect to
utilization review or TPA activities in certain states.
"ANY WILLING PROVIDER" LAWS. Several states in which the Company does
business have adopted, or are expected to adopt, "any willing provider" laws.
Such laws typically impose upon insurance companies, PPOs, HMOs or other types
of third-party payors an obligation to contract with, or pay for the services
of, any healthcare provider willing to meet the terms of the payor's contracts
with similar providers.
18
Compliance with any willing provider laws could increase the Company's costs of
assembling and administering provider networks and could, therefore, have a
material adverse effect on its operations.
LICENSING OF HEALTHCARE PROFESSIONALS. The provision of behavioral
healthcare treatment services by psychiatrists, psychologists and other
providers is subject to state regulation with respect to the licensing of
healthcare professionals. The Company believes that the healthcare professionals
who provide behavioral healthcare treatment on behalf of or under contracts with
the Company are in compliance with the applicable state licensing requirements
and current interpretations thereof; however, there can be no assurance that
changes in such state licensing requirements or interpretations thereof will not
adversely affect the Company's existing operations or limit expansion. With
respect to the Company's crisis intervention program, additional licensure of
clinicians who provide telephonic assessment or stabilization services to
individuals who are calling from out-of-state may be required if such assessment
or stabilization services are deemed by regulatory agencies to be treatment
provided in the state of such individual's residence. The Company believes that
any such additional licensure could be obtained; however, there can be no
assurance that such licensing requirements will not adversely affect the
Company's existing operations or limit expansion.
PROHIBITION ON FEE SPLITTING AND CORPORATE PRACTICE OF PROFESSIONS. The
laws of some states limit the ability of a business corporation to directly
provide, control or exercise excessive influence over behavioral healthcare
services through the direct employment of psychiatrists, psychologists, or other
behavioral healthcare professionals. In addition, the laws of some states
prohibit psychiatrists, psychologists, or other healthcare professionals from
splitting fees with other persons or entities. These laws and their
interpretations vary from state to state and enforcement by the courts and
regulatory authorities may vary from state to state and may change over time.
The Company believes that its operations as currently conducted are in material
compliance with the applicable laws, however, there can be no assurance that the
Company's existing operations and its contractual arrangements with
psychiatrists, psychologists and other healthcare professionals will not be
successfully challenged under state laws prohibiting fee splitting or the
practice of a profession by an unlicensed entity, or that the enforceability of
such contractual arrangements will not be limited. The Company believes that it
could, if necessary, restructure its operations to comply with changes in the
interpretation or enforcement of such laws and regulations, and that such
restructuring would not have a material adverse effect on its operations.
DIRECT CONTRACTING WITH LICENSED INSURERS. Regulators in several states in
which the Company does business have adopted policies that require HMOs or, in
some instances, insurance companies, to contract directly with licensed
healthcare providers, entities or provider groups, such as IPAs, for the
provision of treatment services, rather than with unlicensed intermediary
companies. In such states, the Company's customary model of contracting directly
with its customers may need to be modified so that, for example, the IPAs
(rather than the Company) contract directly with the HMO or insurance company,
as appropriate, for the provision of treatment services. The Company intends to
work with a number of these HMO customers to restructure existing contractual
arrangements, upon contract renewal or in renegotiations, so that the entity
which contracts with the HMO directly is an IPA. The Company does not expect
this method of contracting to have a material adverse effect on its operations.
OTHER REGULATION OF HEALTHCARE PROVIDERS. The Company's business is
affected indirectly by regulations imposed upon healthcare providers.
Regulations imposed upon healthcare providers include provisions relating to the
conduct of, and ethical considerations involved in, the practice of psychiatry,
psychology, social work and related behavioral healthcare professions and, in
certain cases, the common law duty to warn others of danger or to prevent
patient self-injury. Confidentiality and patient privacy requirements are
particularly strict in the field of behavioral healthcare services, and
additional legislative initiatives relating to confidentiality are expected. The
Health Insurance Portability and Accountability Act of 1996 ("HIPAA") included a
provision that prohibits the wrongful disclosure of certain "individually
identifiable health information." HIPAA requires the Secretary of the Department
to adopt standards
19
relating to the transmission of such health information by healthcare providers
and healthcare plans. Although the Company believes that such regulations do not
at present materially impair the Company's operations, there can be no assurance
that such indirect regulation will not have a material adverse effect on the
Company in the future.
REGULATION OF CUSTOMERS. Regulations imposed upon the Company's customers
include, among other things, benefits mandated by statute, exclusions from
coverages prohibited by statute, procedures governing the payment and processing
of claims, record keeping and reporting requirements, requirements for and
payment rates applicable to coverage of Medicaid and Medicare beneficiaries,
provider contracting and enrollee rights, and confidentiality requirements.
Although the Company believes that such regulations do not at present materially
impair the Company's operations, there can be no assurance that such indirect
regulation will not have a material adverse effect on the Company in the future.
ERISA. Certain of the Company's services are subject to the provisions of
ERISA. ERISA governs certain aspects of the relationship between
employer-sponsored healthcare benefit plans and certain providers of services to
such plans through a series of complex laws and regulations that are subject to
periodic interpretation by the Internal Revenue Service and the Department of
Labor. In some circumstances, and under certain customer contracts, the Company
may be expressly named as a "fiduciary" under ERISA, or be deemed to have
assumed duties that make it an ERISA fiduciary, and thus be required to carry
out its operations in a manner that complies with ERISA requirements in all
material respects. Although the Company believes that it is in material
compliance with the applicable ERISA requirements and that such compliance does
not currently have a material adverse effect on the Company's operations, there
can be no assurance that continuing ERISA compliance efforts or any future
changes to the applicable ERISA requirements will not have a material adverse
effect on the Company.
OTHER PROPOSED LEGISLATION. In the last five years, legislation has
periodically been introduced at the state and federal level providing for new
healthcare regulatory programs and materially revising existing healthcare
regulatory programs. Any such legislation, if enacted, could materially
adversely affect the Company's business, financial condition or results of
operations. Such legislation could include both federal and state bills
affecting the Medicaid programs which may be pending in or recently passed by
state legislatures and which are not yet available for review and analysis. Such
legislation could also include proposals for national health insurance and other
forms of federal regulation of health insurance and healthcare delivery. It is
not possible at this time to predict whether any such legislation will be
adopted at the federal or state level, or the nature, scope or applicability to
the Company's business of any such legislation, or when any particular
legislation might be implemented. No assurance can be given that any such
federal or state legislation will not have a material adverse effect on the
Company.
CAUTIONARY STATEMENTS
This Form 10-K includes "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended (the "Securities Act")
Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange
Act"). Although the Company believes that its plans, intentions and expectations
reflected in such forward-looking statements are reasonable, it can give no
assurance that such plans, intentions or expectations will be achieved.
Important factors that could cause actual results to differ materially from the
Company's forward-looking statements are set forth below and elsewhere in this
Form 10-K. All forward-looking statements attributable to the Company or persons
acting on behalf of the Company are expressly qualified in their entirety by the
cautionary statements set forth below.
LEVERAGE AND DEBT SERVICE OBLIGATIONS The Company is currently highly
leveraged, with indebtedness that is substantial in relation to its
stockholders' equity. As of September 30, 1999, the Company's aggregate
outstanding indebtedness was approximately $1.14 billion and the Company's
stockholders' equity was approximately $196.7 million. The Credit Agreement and
the Indenture permit the Company to incur or guarantee certain additional
indebtedness, subject to certain limitations.
20
The Company's high degree of leverage could have important consequences to
the Company, including, but not limited to, the following: (i) the Company's
ability to obtain additional financing for working capital, capital
expenditures, acquisitions, general corporate purposes or other purposes may be
impaired in the future; (ii) a substantial portion of the Company's cash flows
from operations must be dedicated to the payment of principal and interest on
its indebtedness; (iii) the Company is substantially more leveraged than certain
of its competitors, which might place the Company at a competitive disadvantage;
(iv) the Company may be hindered in its ability to adjust rapidly to changing
market conditions and (v) the Company's high degree of leverage could make it
more vulnerable in the event of a downturn in general economic conditions or its
business or in the event of adverse changes in the regulatory environment or
other adverse circumstances applicable to the Company.
The Company's ability to repay or to refinance its indebtedness and to pay
interest on its indebtedness will depend on its financial and operating
performance, which, in turn, is subject to prevailing economic and competitive
conditions and to certain financial, business and other factors, many of which
are beyond the Company's control. These factors could include operating
difficulties, increased operating costs, the actions of competitors, regulatory
developments and delays in implementing strategic projects. The Company's
ability to meet its debt service and other obligations may depend in significant
part on the extent to which the Company can successfully implement its business
strategy. There can be no assurance that the Company will be able to implement
its strategy fully or that the anticipated results of its strategy will be
realized. See "Business--Business Strategy."
If the Company's cash flows and capital resources are insufficient to fund
its debt service obligations, the Company may be forced to reduce or delay
capital expenditures, sell assets or seek to obtain additional equity capital or
to restructure its debt. There can be no assurance that the Company's cash flows
and capital resources will be sufficient for payment of principal of and
interest on its indebtedness in the future, or that any such alternative
measures would be successful or would permit the Company to meet its scheduled
debt service obligations.
In addition, because the Company's obligations under the Credit Agreement
bear interest at floating rates, an increase in interest rates could adversely
affect, among other things, the Company's ability to meet its debt service
obligations. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations--Outlook--Results of Operations."
RESTRICTIVE FINANCING COVENANTS The Credit Agreement and the Indenture
contain a number of covenants that restrict the operations of the Company and
its subsidiaries. In addition, the Credit Agreement requires the Company to
comply with specified financial ratios and tests, including a minimum interest
coverage ratio, a maximum leverage ratio, a minimum net worth test, a maximum
senior debt ratio and a minimum "EBITDA" test (as defined in the Credit
Agreement, as amended). There can be no assurance that the Company will be able
to comply with such covenants, ratios and tests in the future. The Company's
ability to comply with such covenants, ratios and tests may be affected by
events beyond its control, including prevailing economic, financial and industry
conditions. The breach of any such covenants, ratios or tests could result in a
default under the Credit Agreement that would permit the lenders thereunder to
declare all amounts outstanding thereunder to be immediately due and payable,
together with accrued and unpaid interest, and to prevent the Company from
paying principal, premium, interest or other amounts due on any or all of the
Notes until the default is cured or all senior indebtedness is paid or satisfied
in full. Furthermore, the commitments of the lenders under the Credit Agreement
to make further extensions of credit thereunder could be terminated. If the
Company were unable to repay all amounts accelerated, the lenders could proceed
against the subsidiary guarantors and the collateral securing the Company's and
the subsidiary guarantors' obligations pursuant to the Credit Agreement. If the
indebtedness outstanding pursuant to the Credit Agreement were to be
accelerated, there can be no assurance that the assets of the Company would be
sufficient to repay such indebtedness and the other indebtedness of the Company.
The value of the Company's common stock would be adversely affected if the
Company were unable to repay such indebtedness.
21
RISK-BASED PRODUCTS Revenues under risk-based contracts are the primary
source of the Company's revenue from its behavioral managed healthcare business.
Such revenues accounted for approximately 59.6% of the Company's total revenue
and approximately 75.2% of its behavioral managed healthcare revenue in fiscal
1999. Under a risk-based contract, the Company assumes all or a portion of the
responsibility for the cost of providing a full or specified range of behavioral
healthcare treatment services to a specified beneficiary population in exchange,
generally, for a fixed fee per member per month. In order for such contracts to
be profitable, the Company must accurately estimate the rate of service
utilization by beneficiaries enrolled in programs managed by the Company and
control the unit cost of such services. If the aggregate cost of behavioral
healthcare treatment services provided to a given beneficiary population in a
given period exceeds the aggregate of the per member per month fees received by
the Company with respect to the beneficiary population in such period, the
Company will incur a loss with respect to such beneficiary population during
such period. Furthermore, the Company may be required to pay during any period
amounts with respect to behavioral healthcare treatment services provided to a
given beneficiary population that exceed per member per month fees received with
respect to such beneficiary population during the same period. There can be no
assurance that the Company's assumptions as to service utilization rates and
costs will accurately and adequately reflect actual utilization rates and costs,
nor can there be any assurance that increases in behavioral healthcare costs or
higher-than-anticipated utilization rates, significant aspects of which are
outside the Company's control, will not cause expenses associated with such
contracts to exceed the Company's revenue for such contracts. In addition, there
can be no assurance that adjustments will not be required to the estimates,
particularly those regarding cost of care, made in reporting historical
financial results. See Note 1 to the audited consolidated financial statements
of the Company included elsewhere herein. The Company expects to attempt to
increase membership in its risk-based products. If the Company is successful in
this regard, the Company's exposure to potential losses from its risk-based
products will also be increased. Furthermore, certain of such contracts and
certain state regulations limit the profits that may be earned by the Company on
risk-based business and may require refunds if the loss experience is more
favorable than that originally anticipated. Such contracts and regulations may
also require the Company or certain of its subsidiaries to reserve a specified
amount of cash as financial assurance that it can meet its obligations under
such contracts. As of September 30, 1999, the Company had restricted cash and
investments of $116.8 million pursuant to such contracts and regulations. Such
amounts will not be available to the Company for general corporate purposes.
Furthermore, certain state regulations restrict the ability of subsidiaries that
offer risk-based products to pay dividends to the Company. Certain state
regulations relating to the licensing of insurance companies may also adversely
affect the Company's risk-based business. See "--Regulation." Although
experience varies on a contract-by-contract basis, historically, the Company's
risk-based contracts have been profitable. However, the degree of profitability
varies significantly from contract to contract. For example, the Company's
Medicaid contracts with governmental entities generally tend to have direct
profit margins that are lower than the Company's other contracts. The most
significant factor affecting the profitability of risk-based contracts is the
ability to control direct service costs in relation to contract pricing.
RELIANCE ON CUSTOMER CONTRACTS Approximately 79.2% of the Company's revenue
in fiscal 1999 was derived from contracts with payors of behavioral healthcare
benefits. The Company's behavioral managed healthcare contracts typically have
terms of one to three years, and in certain cases contain renewal provisions
providing for successive terms of between one and two years (unless terminated
earlier). Substantially all of these contracts are immediately terminable with
cause and many, including some of the Company's most significant contracts, are
terminable without cause by the customer upon the provision of requisite notice
and the passage of a specified period of time (typically between 60 and 180
days), or upon the occurrence of certain other specified events. The Company's
ten largest behavioral managed healthcare customers accounted for approximately
57.5% of the Company's behavioral managed healthcare revenue for fiscal 1999.
The Company's contract with the State of Tennessee to manage the behavioral
healthcare benefits for the State's TennCare program represented approximately
14.4% of the Company's
22
behavioral managed healthcare revenue and approximately 11.4% of the Company's
consolidated revenue in fiscal 1999. The Company's managed behavioral contracts
and specialty managed care contracts with Aetna, including Nylcare and
Prudential, which were acquired by Aetna in July 1998 and August 1999,
respectively, represented approximately 15.9% and 29.3% of the Company's
behavioral managed healthcare revenue and specialty managed healthcare revenue,
respectively, and approximately 15.7% of the Company's consolidated revenue in
fiscal 1999. There can be no assurance that such contracts will be extended or
successfully renegotiated or that the terms of any new contracts will be
comparable to those of existing contracts. Loss of all of these contracts or
customers would, and loss of any one of these customers could, have a material
adverse effect on the Company. In addition, price competition in bidding for
contracts can significantly affect the financial terms of any new or
renegotiated contract.
DEPENDENCE ON GOVERNMENT SPENDING FOR MANAGED HEALTHCARE; POSSIBLE IMPACT OF
HEALTHCARE REFORM A significant portion of the Company's managed care revenue is
derived, directly or indirectly, from federal, state and local governmental
agencies, including state Medicaid programs. Reimbursement rates vary from state
to state, are subject to periodic negotiation and may limit the Company's
ability to maintain or increase rates. The Company is unable to predict the
impact on the Company's operations of future regulations or legislation
affecting Medicaid or Medicare programs, or the healthcare industry in general,
and there can be no assurance that future regulations or legislation will not
have a material adverse effect on the Company. Moreover, any reduction in
government spending for such programs could also have a material adverse effect
on the Company. In addition, the Company's contracts with federal, state and
local governmental agencies, under both direct contract and subcontract
arrangements, generally are conditioned upon financial appropriations by one or
more governmental agencies, especially with respect to state Medicaid programs.
These contracts generally can be terminated or modified by the customer if such
appropriations are not made. Finally, some of the Company's contracts with
federal, state and local governmental agencies, under both direct contract and
subcontract arrangements, require the Company to perform additional services if
federal, state or local laws or regulations imposed after the contract is signed
so require, in exchange for additional compensation to be negotiated by the
parties in good faith. Government and other third-party payors are generally
seeking to impose lower reimbursement rates and to renegotiate reduced contract
rates with service providers in a trend toward cost control. See "Industry--
Areas of Growth" and "Business--Business Strategy."
The House of Representatives of the U.S. Congress recently passed the
Norwood-Dingell bill which would (if it or similar legislation became law),
among other things, place limits on health care plans methods of operations,
limit employers' and health care plans' ability to define medical necessity and
permit employers and health care plans to be sued in state courts for coverage
determinations. It is uncertain whether the Company could recoup, through higher
premiums or other measures, the increased costs of federally mandated benefits
or other increased costs caused by such legislation or similar legislation. The
Company cannot predict the effect of this legislation, or other legislation that
may be adopted by Congress, and no assurance can be given that such legislation
will not have an adverse effect on the Company.
REGULATION The managed healthcare industry and the provision of behavioral
healthcare services are subject to extensive and evolving state and federal
regulation. The Company is subject to certain state laws and regulations,
including those governing: (i) the licensing of insurance companies, HMOs, PPOs,
TPAs and companies engaged in utilization review and (ii) the licensing of
healthcare professionals, including restrictions on business corporations from
practicing, controlling or exercising excessive influence over behavioral
healthcare services through the direct employment of psychiatrists or, in a few
states, psychologists and other behavioral healthcare professionals. In
addition, the Company is subject to certain federal laws as a result of the role
the Company assumes in connection with managing its customers' employee benefit
plans. The Company's managed care operations are also indirectly affected by
regulations applicable to the establishment and operation of behavioral
healthcare clinics and facilities.
23
In many states, entities that assume risk under contracts with licensed
insurance companies or HMOs have not been considered by state regulators to be
conducting an insurance or HMO business. As a result, the Company has not sought
licensure as either an insurer or HMO in certain states. Regulators in some
states, however, have determined that risk assuming activity by entities that
are not themselves providers of care is an activity that requires some form of
licensure. There can be no assurance that other states in which the Company
operates will not adopt a similar view, thus requiring the Company to obtain
additional licenses. Such additional licensure might require the Company to
maintain minimum levels of deposits, net worth, capital, surplus or reserves, or
limit the Company's ability to pay dividends, make investments or repay
indebtedness. The imposition of these additional licensure requirements could
increase the Company's cost of doing business or delay the Company's conduct or
expansion of its business.
Regulators may impose operational restrictions on entities granted licenses
to operate as insurance companies or HMOs. For example, the California
Department of Corporations ("DOC") imposed certain restrictions on the Company
in connection with its issuance of an approval of the Company's acquisitions of
HAI and Merit, including restrictions on the ability of the California
subsidiaries of HAI and Merit to fund the Company's operations in other states
and on the ability of the Company to make certain operational changes with
respect to HAI and Merit California subsidiaries.
In addition, utilization review and TPA activities conducted by the Company
are regulated by many states, which states impose requirements upon the Company
that increase its business costs. The Company believes that its TPA activities
performed for its self-insured employee benefit plan customers are exempt from
otherwise applicable state licensing or registration requirements based upon
federal preemption under ERISA, and has relied on this general principle in
determining not to seek licensure for certain of its activities in many states.
Existing case law is not uniform on the applicability of ERISA preemption with
respect to state regulation of utilization review or TPA activities. There can
be no assurance that additional licensure will not be required with respect to
utilization review or TPA activities in certain states. See
"Business--Regulation--Insurance, HMO, and PPO Activities" and "--Utilization
Review and Third-Party Administrator Activities."
State regulatory agencies responsible for the administration and enforcement
of the laws and regulations to which the Company's operations are subject have
broad discretionary powers. A regulatory agency or a court in a state in which
the Company operates could take a position under existing or future laws or
regulations, or change its interpretation or enforcement practices with respect
thereto, that such laws or regulations apply to the Company differently than the
Company believes such laws and regulations apply or should be enforced. The
resultant compliance with, or revocation of, or failure to obtain, required
licenses and governmental approvals could result in significant alteration to
the Company's business operations, delays in the expansion of the Company's
business and lost business opportunities, any of which, under certain
circumstances, could have a material adverse effect on the Company. See
"Business--Regulation--General," "--Licensure," "--Insurance, HMO and PPO
Activities" and "--Utilization Review and Third-Party Administrator Activities."
The laws of some states limit the ability of a business corporation to
directly provide, control or exercise excessive influence over behavioral
healthcare services through the direct employment of psychiatrists,
psychologists, or other behavioral healthcare professionals. In addition, the
laws of some states prohibit psychiatrists, psychologists, or other healthcare
professionals from splitting fees with other persons or entities. These laws and
their interpretations vary from state to state and enforcement by the courts and
regulatory authorities may vary from state to state and may change over time.
The Company believes that its operations as currently conducted are in material
compliance with the applicable laws, however there can be no assurance that the
Company's existing operations and its contractual arrangements with
psychiatrists, psychologists and other healthcare professionals will not be
successfully challenged under state laws prohibiting fee splitting or the
practice of a profession by an unlicensed entity, or that the enforceability of
such contractual arrangements will not be limited. The Company believes that it
24
could, if necessary, restructure its operations to comply with changes in the
interpretation or enforcement of such laws and regulations, and that such
restructuring would not have a material adverse effect on its operations.
Several states in which the Company does business have adopted, or are
expected to adopt, "any willing provider" laws. Such laws typically impose upon
insurance companies, PPOs, HMOs or other types of third-party payors an
obligation to contract with, or pay for the services of, any healthcare provider
willing to meet the terms of the payor's contracts with similar providers.
Compliance with any willing provider laws could increase the Company's costs of
assembling and administering provider networks and could, therefore, have a
material adverse effect on its operations.
HIGHLY COMPETITIVE INDUSTRY The industry in which the Company conducts its
managed care businesses is highly competitive. The Company competes with large
insurance companies, HMOs, PPOs, TPAs, provider groups and other managed care
companies. Many of the Company's competitors are significantly larger and have
greater financial, marketing and other resources than the Company, and some of
the Company's competitors provide a broader range of services. The Company may
also encounter substantial competition in the future from new market entrants.
Many of the Company's customers that are managed care companies may, in the
future, seek to provide behavioral managed healthcare services to their
employees or subscribers directly, rather than contracting with the Company for
such services. See "Business--Competition."
RISKS RELATED TO AMORTIZATION OF INTANGIBLE ASSETS The Company's total
assets at September 30, 1999 reflect intangible assets of approximately $1.27
billion. At September 30, 1999, net intangible assets were 67.3% of total assets
and 643.8% of total stockholders' equity. Intangible assets include goodwill of
approximately $1.11 billion, which is amortized over 25 to 40 years, and other
identifiable intangible assets (primarily customer lists, provider networks and
treatment protocols) of approximately $158.3 million that are amortized over 4
to 30 years. The amortization periods used by the Company may differ from those
used by other entities. In addition, the Company may be required to shorten the
amortization period for intangible assets in future periods based on the
prospects of acquired companies. There can be no assurance that the value of
such assets will ever be realized by the Company. The Company evaluates, on a
regular basis, whether events and circumstances have occurred that indicate that
all or a portion of the carrying value of intangible assets may no longer be
recoverable, in which case a charge to earnings for impairment losses could
become necessary. Any determination requiring the write-off of a significant
portion of unamortized intangible assets would adversely affect the Company's
results of operations. A write-off of intangible assets could become necessary
if the anticipated undiscounted cash flows of an acquired company do not support
the carrying value of long-lived assets, including intangible assets. At
present, no evidence exists that would indicate impairment losses may be
necessary in future periods.
PROFESSIONAL LIABILITY; INSURANCE The management and administration of the
delivery of behavioral and specialty managed healthcare services, like other
healthcare services, entail significant risks of liability. The Company is
regularly subject to lawsuits alleging malpractice and related legal theories,
some of which involve situations in which participants in the Company's
behavioral programs have committed suicide. The Company is also subject to
claims of professional liability for alleged negligence in performing
utilization review activities, as well as for acts and omissions of independent
contractors participating in the Company's third-party provider networks. The
Company is subject to claims for the costs of services for which payment was
denied. There can be no assurance that the Company's procedures for limiting
liability have been or will be effective, or that one or more lawsuits will not
have a material adverse effect on the Company in the future.
Recently, certain managed healthcare companies have been targeted as
defendants in several national class action lawsuits regarding their business
practices. These class action complaints include (i) inadequate disclosure of
provider compensation arrangements to members, (ii) misrepresentation and
omissions in advertising and health plan materials and (iii) concealment of
information from health plan
25
members used to determine what claims will be paid, procedures to determine
medical necessity and procedures to determine the extent and type of coverage.
The Company believes that these national class action lawsuits are part of a
trend targeting the healthcare industry, particularly managed care companies.
While the Company has received suits of a similar nature in the past, it has not
been named as a defendant in any of these new trend of national class action
lawsuits. However, there can be no assurance that the Company won't be named in
such class action lawsuits or that such lawsuits won't have a material adverse
effect on the Company.
The Company carries professional liability insurance, subject to certain
deductibles. There can be no assurance that such insurance will be sufficient to
cover any judgments, settlements or costs relating to present or future claims,
suits or complaints or that, upon expiration thereof, sufficient insurance will
be available on favorable terms, if at all. If the Company is unable to secure
adequate insurance in the future, or if the insurance carried by the Company is
not sufficient to cover any judgments, settlements or costs relating to any
present or future actions or claims, there can be no assurance that the Company
will not be subject to a liability that could have a material adverse effect on
the Company. See "Business-Insurance" and "Legal Proceedings."
The Company has certain potential liabilities relating to the self-insurance
program it maintained with respect to its provider business prior to the
Crescent Transactions. In addition, the Company continues to be subject to
governmental investigations and inquiries, civil suits and other claims and
assessments with respect to the provider business. See "Legal Proceedings" and
Note 11 to the Company's audited historical consolidated financial statements
included elsewhere herein.
EXECUTIVE OFFICERS OF THE REGISTRANT
NAME AGE POSITION
- ---- -------- --------
Henry T. Harbin M.D.................... 52 President, Chief Executive Officer and Director
Mark S. Demilio........................ 44 Executive Vice President and General Counsel
Clifford W. Donnelly................... 46 Executive Vice President and Chief Financial Officer
Clarissa C. Marques, Ph.D.............. 47 Executive Vice President of Clinical and Quality
Management
John J. Wider, Jr...................... 52 President and Chief Operating Officer of Magellan
Behavorial Health
HENRY T. HARBIN, M.D. became President, Chief Executive Officer and a
Director of the Company on March 18, 1998. Dr. Harbin served as President and
Chief Executive Officer of Green Spring from 1994 to 1998. Dr. Harbin served as
Executive Vice President of the Company from 1995 until becoming President and
Chief Executive Officer of the Company.
MARK S. DEMILIO became Executive Vice President and General Counsel of the
Company in July 1999. Prior thereto, Mr. Demilio was with Youth Services
International, Inc., a publicly traded company that managed facilities for
adjudicated youth, serving as Executive Vice President Business Development and
General Counsel from March 1997 and Acting Chief Financial Officer from June
1998. Mr. Demilio was a partner with Miles & Stockbridge, a Baltimore,
Maryland-based law firm, from 1994 to March 1997 and served as an associate with
that firm from 1989.
CLIFFORD W. DONNELLY became Executive Vice President and Chief Financial
Officer of the Company in March 1999. Mr. Donnelly was Chief Financial Officer
for Physicians Corporation of America ("PCA") from 1988 to September 1997 when
PCA was acquired by Humana, Inc. PCA was a publicly-held company specializing in
managed healthcare through HMO products and workers compensation products.
CLARISSA C. MARQUES, PH.D. has served as Executive Vice President of
Clinical and Quality Management since March 1998. Dr. Marques served as
Executive Vice President and Chief Clinical Officer of
26
Green Spring during 1997 and 1998. Dr. Marques served as Senior Vice President
of Green Spring from 1992 to 1997.
JOHN J. WIDER, JR. has served as President and Chief Operating Officer of
Magellan Behavorial Health ("MBH") since March 1998. Mr. Wider served as
Executive Vice President and Chief Operating Officer of Green Spring from 1997
to 1998. Mr. Wider was President and General Manager for Cigna Healthcare
Corporation's ("Cigna") Mid-Atlantic region from 1996 to 1997. Mr. Wider served
as Area Operations Officer for Cigna during 1995 and 1996 and as Vice President
of Sales of Cigna's Midwest region from 1993 to 1995.
EMPLOYEES OF THE REGISTRANT
At September 30, 1999, the Company had approximately 12,500 full-time and
part-time employees. The Company believes it has satisfactory relations with its
employees.
ITEM 2. PROPERTIES
GENERAL. The Company's principal executive offices are located in Columbia,
Maryland; the lease for the Company's headquarters expires in 2003.
BEHAVORIAL MANAGED CARE BUSINESS. Magellan Behavioral Health ("MBH") leases
its 172 offices with terms expiring between 1999 and 2008. MBH's headquarters
are leased and are co-located with the principal executive offices in Columbia,
Maryland.
HUMAN SERVICES BUSINESS. Mentor leases its 134 offices with terms expiring
between 1999 and 2005. Mentor's headquarters are leased and are located in
Boston, Massachusetts with the lease expiring in 2002.
SPECIALITY MANAGED CARE BUSINESS. Allied and Care Management Resources, Inc.
lease their 5 offices with terms expiring between 1999 and 2004.
ITEM 3. LEGAL PROCEEDINGS
The management and administration of the delivery of behavioral managed
healthcare services, and the direct provision of behavioral healthcare treatment
services, entail significant risks of liability. From time to time, the Company
is subject to various actions and claims arising from the acts or omissions of
its employees, network providers or other parties. In the normal course of
business, the Company receives reports relating to suicides and other serious
incidents involving patients enrolled in its programs. Such incidents
occasionally give rise to malpractice, professional negligence and other related
actions and claims against the Company or its network providers. As the number
of lives covered by the Company grows and the number of providers under contract
increases, actions and claims against the Company (and, in turn, possible legal
liability) predicated on malpractice, professional negligence or other related
legal theories can be expected to increase. See "Cautionary
Statements--Professional Liability; Insurance." Many of these actions and claims
received by the Company seek substantial damages and therefore require the
defendant to incur significant fees and costs related to their defense. To date,
claims and actions against the Company alleging professional negligence have not
resulted in material liabilities and the Company does not believe that any
pending action against it will have a material adverse effect on the Company.
There can be no assurance that pending or future actions or claims for
professional liability (including any judgments, settlements or costs associated
therewith) will not have a material adverse effect on the Company. See
"--Insurance" and "Cautionary Statements--Professional Liability; Insurance."
From time to time, the Company receives notifications from and engages in
discussions with various governmental agencies concerning its respective managed
care businesses and operations. As a result of these contacts with regulators,
the Company in many instances implements changes to its operations, revises its
filings with such agencies and/or seeks additional licenses to conduct its
business. In recent years,
27
in response to governmental agency inquiries or discussions with regulators, the
Company has determined to seek licensure as a single service HMO, TPA or
utilization review agent in one or more jurisdictions.
On May 26, 1998, a group of eleven plaintiffs purporting to represent an
uncertified class of psychiatrists, psychologists and social workers brought an
action under the federal antitrust laws in the United States District Court for
the District of New Jersey against nine behavioral health managed care
organizations, including Merit, CMG, Green Spring and HAI (collectively, the
"Defendants"). The complaint alleges that the Defendants violated Section I of
the Sherman Act by engaging in a conspiracy to fix the prices at which the
Defendants purchase services from mental healthcare providers such as the
plaintiffs. The complaint further alleges that the Defendants engaged in a group
boycott to exclude mental healthcare providers from the Defendants' networks in
order to further the goals of the alleged conspiracy. The complaint also
challenges the propriety of the Defendants' capitation arrangements with their
respective customers, although it is unclear from the complaint whether the
plaintiffs allege that the Defendants unlawfully conspired to enter into
capitation arrangements with their respective customers. The complaint seeks
treble damages against the Defendants in an unspecified amount and a permanent
injunction prohibiting the Defendants from engaging in the alleged conduct which
forms the basis of the complaint, plus costs and attorneys' fees. Upon joint
motion by the Defendants, the case was transferred to the United States District
Court for the Southern District of New York, the same court where a previous
similar case (the "Stephens Case") was dismissed for failure to state a claim
upon which relief can be granted. On March 15, 1999, the Defendants filed a
joint motion to dismiss the case for substantially the same reasons as in the
Stephens Case. On June 16, 1999, the court denied the motion to dismiss. The
case currently is in discovery. On October 14, 1999, the Plaintiffs filed a
motion seeking class certification for a class that would include approximately
200,000 providers. The court has not yet heard argument on that motion. The
Company does not believe this matter will have a material adverse effect on its
financial position or results of operations.
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. Recently, 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 and the compliance by CBHS 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.
28
The Company is also subject to or party to other litigation, claims, and
civil suits, relating to its operations and business practices. 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.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
29
PART II
ITEM 5. MARKET PRICE FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company has one class of common stock, $0.25 par value per share, which
is listed for trading on the New York Stock Exchange (ticker symbol "MGL"). As
of November 30, 1999, there were 9,354 holders of record of the Company's common
stock. The following table sets forth the high and low sales prices of the
Company's common stock from October 1, 1997 through the fiscal year ended
September 30, 1999 as reported by the New York Stock Exchange:
COMMON
STOCK SALES
PRICES
-------------------------
CALENDAR YEAR HIGH LOW
- ------------------------------------------------------------ ------------ ----------
1997
Fourth Quarter.......................................... 31 3/4 20 9/16
1998
First Quarter........................................... 26 18 5/8
Second Quarter.......................................... 28 7/16 24
Third Quarter........................................... 26 9 5/8
Fourth Quarter.......................................... 10 3/4 6 3/8
1999
First Quarter........................................... 11 1/8 4 3/16
Second Quarter.......................................... 10 3 9/16
Third Quarter........................................... 10 1/2 6 7/8
The Company did not declare any cash dividends during fiscal 1998 or 1999.
As of November 30, 1999, the Company was prohibited from paying dividends on its
common stock under the terms of the Credit Agreement, except in very limited
circumstances.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected historical consolidated financial
information of the Company for each of the five years in the period ended
September 30, 1999. On September 2, 1999, the Company's Board of Directors
approved a formal plan to dispose of the businesses included in the Company's
healthcare provider and healthcare franchising segments. On September 10, 1999,
the Company consummated the CBHS Transactions. Accordingly, the statement of
operations data has been restated to reflect the healthcare provider and
healthcare franchising segments as discontinued operations. Selected
consolidated financial information for the three years ended September 30, 1999
and as of September 30, 1998 and 1999, presented below, have been derived from,
and should be read in conjunction with, the Company's audited consolidated
financial statements and the notes thereto. Selected consolidated financial
information for the two years ended September 30, 1995 and 1996 and as of
September 30, 1995, 1996 and 1997 has been derived from the Company's unaudited
consolidated financial statements. The selected financial data set forth below
should be read in conjunction with the Company's audited consolidated financial
statements and the notes thereto and "Management's Discussion and Analysis of
Financial Condition and Results of Operations" appearing elsewhere herein.
30
FISCAL YEAR ENDED SEPTEMBER 30,
--------------------------------------------------------------
1995 1996 1997 1998 1999
---------- ---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
STATEMENT OF OPERATIONS DATA:
Net revenue.................................. $ 56,077 $ 302,573 $ 463,872 $1,310,778 $1,871,636
Salaries, cost of care and other operating
expenses................................... 77,499 299,855 438,472 1,183,626 1,663,626
Equity in (earnings) loss of unconsolidated
subsidiaries............................... -- 2,005 5,567 (12,795) (20,442)
Depreciation and amortization................ 3,664 14,290 19,683 49,264 73,531
Interest, net................................ 55,405 48,584 46,438 76,505 93,752
ESOP expense................................. 17,960 -- -- -- --
Stock option expense (credit)................ (467) 914 4,292 (5,623) 18
Managed care integration costs............... -- -- -- 16,962 6,238
Special charges, net......................... -- 1,221 -- -- 4,441
Income (loss) from continuing operations
before income taxes, minority interest and
extraordinary items........................ (97,984) (64,296) (50,580) 2,839 50,472
Provision for (benefit from) income taxes.... (39,194) (25,719) (20,232) 5,544 27,376
Income (loss) from continuing operations
before minority interest and extraordinary
items...................................... (58,790) (38,577) (30,348) (2,705) 23,096
Minority interest............................ -- 4,531 6,856 4,094 630
Income (loss) from continuing operations
before extraordinary items................. (58,790) (43,108) (37,204) (6,799) 22,466
Discontinued operations:
Income from discontinued operations........ 15,827 75,491 41,959 20,531 29,645
Loss on disposal of discontinued
operations............................... -- -- -- -- (47,423)
Income (loss) before extraordinary items..... (42,963) 32,383 4,755 13,732 4,688
Extraordinary items-losses on early
extinguishments of debt.................... -- -- (5,253) (33,015) --
Net income (loss)............................ $ (42,963) $ 32,383 $ (498) $ (19,283) $ 4,688
INCOME (LOSS) PER COMMON SHARE--BASIC:
Income (loss) from continuing operations
before extraordinary items................. $ (2.11) $ (1.39) $ (1.29) $ (0.22) $ 0.71
Income (loss) from discontinued operations... 0.57 2.43 1.46 0.67 (0.56)
Loss from extraordinary items................ -- -- (0.18) (1.07) --
Net income (loss)............................ $ (1.54) $ 1.04 $ (0.02) $ (0.63) $ 0.15
INCOME (LOSS) PER COMMON SHARE--DILUTED:
Income (loss) from continuing operations
before extraordinary items................. $ (2.11) $ (1.39) $ (1.29) $ (0.22) $ 0.70
Income (loss) from discontinued operations... 0.57 2.43 1.46 0.67 (0.56)
Loss from extraordinary items................ -- -- (0.18) (1.07) --
Net income (loss)............................ $ (1.54) $ 1.04 $ (0.02) $ (0.63) $ 0.15
BALANCE SHEET DATA (END OF PERIOD):
Current assets............................... $ 305,575 $ 338,150 $ 507,038 $ 399,724 $ 374,927
Current liabilities.......................... 214,162 274,316 219,376 454,766 474,268
Property and equipment, net.................. 488,767 495,390 109,214 177,169 120,667
Total assets................................. 983,558 1,140,137 896,868 1,917,088 1,881,615
Total debt and capital lease obligations..... 541,569 572,058 395,294 1,225,646 1,144,308
Stockholders' equity......................... 88,560 121,817 159,498 188,433 196,696
31
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
SEPTEMBER 30, 1999
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
Prior to June 1997, the Company derived the majority of its revenue from
providing behavioral healthcare services in an inpatient setting. Payments from
third-party payors are the principal source of revenue for most behavioral
healthcare providers. In the early 1990's, many third party payors sought to
control the cost of providing care to their patients by instituting managed care
programs or seeking the assistance of managed care companies. Providers
participating in managed care programs agree to provide services to patients for
a discount from established rates, which generally results in pricing
concessions by the providers and lower margins. Additionally, managed care
programs generally encourage alternatives to inpatient treatment settings and
reduce utilization of inpatient services. As a result, third-party payors
established managed care programs or engaged managed care companies in many
areas of healthcare, including behavioral healthcare. The Company, which until
June 1997, was the largest operator of psychiatric hospitals in the United
States, was adversely affected by the adoption of managed care programs as the
principal cost control measure of third-party payors.
Prior to the first quarter of fiscal 1996, the Company was not engaged in
the behavioral managed healthcare business. During the first quarter of fiscal
1996, the Company acquired a 61% ownership interest in Green Spring Health
Services, Inc. ("Green Spring"). At that time, the Company intended to become a
fully integrated behavioral healthcare provider by combining the behavorial
managed healthcare products offered by Green Spring with the direct treatment
services offered by the Company's psychiatric hospitals. The Company believed
that an entity that participated in both the managed care and the provider
segments of the behavioral healthcare industry could more efficiently provide
and manage behavioral healthcare for insured populations than an entity that was
solely a managed care company. The Company also believed that earnings from its
behavioral managed care business would offset, in part, the negative impact on
the financial performance of its psychiatric hospitals caused by managed care.
Green Spring was the Company's first significant involvement in behavioral
managed healthcare. During the second quarter of fiscal 1998, the minority
stockholders of Green Spring converted their 39% ownership interest in Green
Spring into an aggregate of 2,831,516 shares of Magellan common stock.
Subsequent to the Company's acquisition of Green Spring, the growth of the
behavioral managed healthcare industry accelerated. Under the Company's majority
ownership, Green Spring increased its base of covered lives from 12.0 million at
of the end of calendar year 1995 to 21.1 million at the end of calendar year
1997, a compound annual growth rate of over 32%. While growth in the industry
was accelerating, the behavioral managed healthcare industry also began to
consolidate. The Company concluded that this consolidation presented an
opportunity for it to increase its participation in the behavioral managed
healthcare industry, which the Company believed offered growth and earnings
prospects superior to those of the psychiatric hospital industry. Therefore, the
Company decided to sell its domestic psychiatric facilities to obtain capital
for expansion of its behavioral managed healthcare business.
On June 17, 1997, the Company consummated the Crescent Transactions which
provided the Company with approximately $200 million of net cash proceeds, after
debt repayment, for use in implementing its business strategy to increase its
participation in the managed healthcare industry. The Company used the net cash
proceeds of approximately $200 million, after debt repayment, to finance the
acquisitions of HAI and Allied in December 1997. The Company further implemented
its business strategy through the acquisition of Merit in February 1998.
32
On September 10, 1999, the Company consummated the CBHS Transactions. The
CBHS Transactions, together with the formal plan of disposal authorized by the
Company's Board of Directors on September 2, 1999, represents the disposal of
the Company's healthcare provider and healthcare franchising business segments
under 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 Company recorded an after-tax loss on disposal of its healthcare
provider and healthcare franchising business segments of approximately
$47.4 million (primarily non-cash), in fiscal 1999.
The Company currently operates through three principal business segments
which are engaged in:
- THE BEHAVIORAL MANAGED HEALTHCARE BUSINESS. The Company's MAGELLAN
BEHAVIORAL HEALTH division 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 alternative
care services (such as residential treatment and home or community-based
programs). 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) ASO products, where the Company
provides services such as utilization review, claims administration or
provider network management, (iii) EAPs and (iv) products which combine
features of some or all of the Company's risk-based, ASO, or EAP products.
- THE HUMAN SERVICES BUSINESS. The Company provides various human services
through Mentor. These human services include specialty home-based
healthcare services provided through "mentor" homes as well as residential
and day treatment services for individuals with acquired brain injuries
and for individuals with mental retardation and developmental
disabilities.
- THE SPECIALTY MANAGED HEALTHCARE BUSINESS. The Company's MAGELLAN
SPECIALTY HEALTH division provides specialty risk-based and ASO services
to a variety of health insurance companies and other customers.
At September 30, 1999, the Company's MAGELLAN BEHAVIORAL HEALTH division,
managed the behavioral healthcare benefits of approximately 66.4 million
individuals; Mentor, which provided community-based services to 6,444
individuals; and the Company's MAGELLAN SPECIALTY HEALTH division, which was
formed primarily through acquisitions completed in fiscal 1997 (Care Management
Resources, Inc.) and fiscal 1998 (Allied) managed specialty benefits for
approximately 3.5 million members of health plans.
33
RESULTS OF OPERATIONS
The following tables summarize, for the periods indicated, operating results
by continuing business segment (in thousands).
BEHAVIORAL SPECIALTY CORPORATE
MANAGED HUMAN MANAGED OVERHEAD
FISCAL 1997 HEALTHCARE SERVICES HEALTHCARE AND OTHER CONSOLIDATED
- ----------- ---------- -------- ---------- --------- ------------
Net revenue............................ $375,541 $88,331 $ -- $ -- $ 463,872
-------- ------- ------- -------- ----------
Salaries, cost of care and other
operating expenses................... 332,955 77,636 2,303 25,578 438,472
Equity in loss of unconsolidated
subsidiaries......................... 5,567 -- -- -- 5,567
-------- ------- ------- -------- ----------
338,522 77,636 2,303 25,578 444,039
-------- ------- ------- -------- ----------
Segment Profit(1).................... $ 37,019 $10,695 $(2,303) $(25,578) $ 19,833
======== ======= ======= ======== ==========
BEHAVIORAL SPECIALTY CORPORATE
MANAGED HUMAN MANAGED OVERHEAD
FISCAL 1998 HEALTHCARE SERVICES HEALTHCARE AND OTHER CONSOLIDATED
- ----------- ---------- -------- ---------- --------- ------------
Net revenue............................ $1,026,243 $141,032 $143,503 $ -- $1,310,778
---------- -------- -------- -------- ----------
Salaries, cost of care and other
operating expenses................... 901,846 125,539 140,375 15,866 1,183,626
Equity in earnings of unconsolidated
subsidiaries......................... (12,795) -- -- -- (12,795)
---------- -------- -------- -------- ----------
889,051 125,539 140,375 15,866 1,170,831
---------- -------- -------- -------- ----------
Segment Profit(1).................... $ 137,192 $ 15,493 $ 3,128 $(15,866) $ 139,947
========== ======== ======== ======== ==========
BEHAVIORAL SPECIALTY CORPORATE
MANAGED HUMAN MANAGED OVERHEAD
FISCAL 1999 HEALTHCARE SERVICES HEALTHCARE AND OTHER CONSOLIDATED
- ----------- ---------- -------- ---------- --------- ------------
Net revenue............................ $1,483,202 $191,277 $197,157 $ -- $1,871,636
---------- -------- -------- -------- ----------
Salaries, cost of care and other
operating expenses................... 1,285,391 169,549 194,747 13,939 1,663,626
Equity in earnings of unconsolidated
subsidiaries......................... (20,442) -- -- -- (20,442)
---------- -------- -------- -------- ----------
1,264,949 169,549 194,747 13,939 1,643,184
---------- -------- -------- -------- ----------
Segment Profit(1)...................... $ 218,253 $ 21,728 $ 2,410 $(13,939) $ 228,452
========== ======== ======== ======== ==========
(1) Segment Profit is the measure of profitability used by management to assess
the operating performance of each business segment. See Note 13, "Business
Segment Information", to the Company's audited consolidated financial
statements appearing elsewhere herein.
FISCAL 1998 COMPARED TO FISCAL 1999
BEHAVIORAL MANAGED HEALTHCARE. Revenue increased 44.5% or $457.0 million,
to $1.48 billion for fiscal 1999, from $1.03 billion in fiscal 1998. Salaries,
cost of care and other operating expenses increased 42.5%, or $383.5 million, to
$1.29 billion for fiscal 1999, from $901.8 million in fiscal 1998. Equity in
earnings of unconsolidated subsidiaries increased $7.6 million, to
$20.4 million for fiscal 1999, from $12.8 million for fiscal 1998. The increases
resulted primarily from (i) the HAI and Merit acquisitions in fiscal 1998,
(ii) increased enrollment related to existing customers, (iii) expanded services
and lives under
34
management with certain public sector customers, (iv) new business development
and (v) increases in retroactive customer settlements, offset by reductions in
general and administrative costs as a result of the integration of Green Spring,
HAI and Merit and the termination of one public sector contract (Montana
Medicaid) in fiscal 1999. Total covered lives increased 7.8% or 4.8 million to
66.4 million at September 30, 1999 from 61.6 million at September 30, 1998. The
Company frequently records retroactive customer settlements, which may be
favorable or unfavorable, under its commercial behavioral managed healthcare
contracts. Revenue and Segment Profit for fiscal 1999 reflect approximately $9.8
million of such favorable settlements compared to favorable settlements of $1.8
million during fiscal 1998. The Company recorded $3.7 million of favorable
retroactive customer settlements in the fourth quarter of fiscal 1999.
HUMAN SERVICES. Revenue increased 35.7%, or $50.3 million, to $191.3
million for fiscal 1999, from $141.0 million in fiscal 1998. Salaries, cost of
care and other operating expenses increased 35.1%, or $44.0 million, to $169.5
million for fiscal 1999 from $125.5 million in fiscal 1998. The increases were
attributable to acquisitions consummated in fiscal 1998 and fiscal 1999 and
internal growth, offset by reductions in revenue and Segment Profit at one
acquired business in fiscal 1999 as a result of rate and placement reductions
from a state agency. Total placements increased 9.5% to 6,444 at September 30,
1999, compared to 5,883 at September 30, 1998.
SPECIALTY MANAGED HEALTHCARE. Revenue increased 37.4%, or $53.7 million, to
$197.2 million for fiscal 1999, compared to $143.5 million in the same period in
fiscal 1998. Salaries, cost of care and other operating expenses increased
38.7%, or $54.3 million, to $194.7 million for fiscal 1999, compared to
$140.4 million in fiscal 1998. The increase in revenue and salaries, cost of
care and other operating expenses was primarily related to the Allied
acquisition in fiscal 1998 and a shift toward more risk-based business in fiscal
1999 offset by the loss of a significant customer at the end of fiscal 1998 and
increased administrative spending in fiscal 1999 to support future internal
growth.
CORPORATE OVERHEAD AND OTHER. Salaries and other operating expenses
decreased 12.1%, or $1.9 million, primarily as a result of ongoing integration
of corporate administrative functions with business unit administrative
functions.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased
49.1%, or $24.2 million, to $73.5 million for fiscal 1999, from $49.3 million in
fiscal 1998. The increase was primarily attributed to (i) the acquisition of
HAI, Allied and Merit in fiscal 1998, (ii) depreciation related to recent
capital expenditures and (iii) amortization related to the Aetna Payment (as
defined) made in fiscal 1999.
INTEREST, NET. Interest expense, net, increased 22.6%, or $17.3 million, to
$93.8 million for fiscal 1999, from $76.5 million in fiscal 1998. The increase
was primarily the result of interest expense incurred on borrowings used to fund
the Merit acquisition and related transactions in fiscal 1998.
OTHER ITEMS. Stock option expense for fiscal 1999 was not material compared
to a credit of $5.6 million in fiscal 1998 primarily due to fluctuations in the
market price of the Company's stock in fiscal 1998.
The Company recorded managed care integration costs of $6.2 million for
fiscal 1999, compared to $17.0 million in fiscal 1998. For a more complete
discussion of managed care integration costs, see Note 9, "Managed Care
Integration Plan and Costs and Special Charges" to the Company's audited
consolidated financial statements set forth elsewhere herein.
The Company recorded special charges of $4.4 million during fiscal 1999
related primarily to the loss on disposal of an office building, executive
severance and costs associated with moving the Company's corporate headquarters
from Atlanta, Georgia to Columbia, Maryland.
The Company's effective income tax rate was 54.2% for fiscal 1999. The
effective income tax rate exceeds statutory rates due primarily to
non-deductible goodwill amortization resulting from the Merit acquisition of
$18.0 million for fiscal 1999.
35
Minority interest decreased $3.5 million, to $0.6 million during fiscal 1999
primarily as a result of the Green Spring minority stockholder conversion in
fiscal 1998.
Income from discontinued operations, net of tax, increased 44.4% or
$9.1 million to $29.6 million for fiscal 1999 compared to $20.5 million for
fiscal 1998. Income from the healthcare provider segment increased 171.1%, or
$20.7 million to $32.8 million for fiscal 1999 compared to $12.1 million for
fiscal 1998. The increase is primarily attributable to (i) the net effect of the
Company's sale of its three European Hospitals in April 1999, which included a
gain on sale of $14.4 million, net of tax, (ii) increases in income of
$8.8 million, net of tax, from cost report settlements related primarily to the
resolution of Medicare cost report matters in the fourth quarter of fiscal 1999
associated with the Company's sale of the Psychiatric Hospital Facilities, and
(iii) increases in income of $4.8 million, net of tax, related to adjustments to
accounts receivable collection fee reserves recorded in connection with the
Crescent Transactions, offset by reductions in adjustments to income of
$2.5 million, net of tax, related to updated actuarial estimates of malpractice
claims. Income from the healthcare franchising segment decreased $11.6 million,
net of tax, to a loss of $3.2 million, net of tax, for fiscal 1999 compared to
income of $8.4 million, net of tax, for the same period in 1998. The decrease
was primarily attributable to the declining operating performance of CBHS, which
resulted in the Company recording and collecting no franchise fees from CBHS in
fiscal 1999. The Company recorded a loss on disposal of discontinued operations
of approximately $47.4 million, net of tax, during fiscal 1999 as a result of
the CBHS Transactions. See Note 3, "Discontinued Operations" to the Company's
audited consolidated financial statements set forth elsewhere herein.
The Company recorded an extraordinary loss on early extinguishment of debt
of approximately $33.0 million, net of tax, during fiscal 1998, related
primarily to refinancing the Company's long-term debt in connection with the
Merit acquisition.
FISCAL 1997 COMPARED TO FISCAL 1998
BEHAVIORAL MANAGED HEALTHCARE. Revenue increased 173.3%, or
$650.7 million, to $1,026.2 million for fiscal 1998 from $375.5 million in
fiscal 1997. Salaries, cost of care and other operating expenses increased
170.8%, or $568.8 million, to $901.8 million for fiscal 1998 from
$333.0 million in fiscal 1997. Equity in earnings of unconsolidated subsidiaries
increased $18.4 million to $12.8 million in fiscal 1998 compared to a loss of
$5.6 million in fiscal 1997. The increases resulted primarily from the
acquisitions of HAI and Merit in fiscal 1998 and internal growth at Green
Spring. Revenue and Segment Profit increased as a result of acquisitions, the
award of several new contracts in fiscal 1997 and 1998 and significant
improvements in negotiated rates and terms of the TennCare contract in fiscal
1998.
HUMAN SERVICES. Revenue increased 59.7%, or $52.7 million, to
$141.0 million for fiscal 1998 from $88.3 million in fiscal 1997. Salaries, cost
of care and other operating expenses increased 61.7%, or $47.9 million, to
$125.5 million in fiscal 1998 from $77.6 million in fiscal 1997. The increases
were attributable to seven acquisitions consummated in fiscal 1998 and internal
growth. Placements in Mentor homes increased 19.6% in fiscal 1998.
SPECIALTY MANAGED HEALTHCARE. Revenue was $143.5 million in fiscal 1998
compared to $0 in fiscal 1997. Salaries, cost of care and other operating
expenses were $140.4 million in fiscal 1998 compared to $2.3 million in fiscal
1997. The increase in revenues and salaries, cost of care and other operating
expenses were primarily related to the Allied acquisition. Fiscal 1997 salaries,
cost of care and other operating expenses represent start-up costs related to
the Company's initial involvement in the specialty managed care business.
CORPORATE OVERHEAD AND OTHER. Salaries and other operating expenses
decreased 38.0%, or $9.7 million, due primarily to the transfer of personnel and
overhead to CBHS and the healthcare franchising segment in fiscal 1997 as a
result of the Crescent Transactions.
36
DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased
150.3%, or $29.6 million, to $49.3 million in fiscal 1998 from $19.7 million
fiscal 1997. The increase was primarily attributable to increases in
depreciation and amortization resulting from the HAI, Allied and Merit
acquisitions.
INTEREST, NET. Interest expense, net, increased 64.9% or $30.1 million to
$76.5 million in fiscal 1998 from $46.4 million in fiscal 1997. The increase was
primarily the result of interest expense incurred on borrowings used to fund the
Merit acquisition and related transactions offset by lower interest expense due
to lower average borrowings and higher interest income from cash received in the
Crescent Transactions through December 5, 1997.
OTHER ITEMS. Stock option expense for fiscal 1998 decreased $9.9 million
compared to fiscal 1997 primarily due to fluctuations in the market price of the
Company's common stock.
The Company recorded managed care integration costs of $17.0 million for
fiscal 1998. See Note 9, "Managed Care Integration Plan and Costs, and Special
Charges" to the Company's audited consolidated financial statements set forth
elsewhere herein.
The Company's effective income tax rate was 195.3% for fiscal 1998 primarily
due to non-deductible goodwill amortization of approximately $11.0 million
resulting from the Merit acquisition in fiscal 1998.
Minority interest decreased $2.8 million during fiscal 1998, compared to
fiscal 1997. The decrease was primarily attributable to the Green Spring
minority stockholder conversion in January 1998 offset by Green Spring's net
income growth in fiscal 1998 through January 1998.
Income from discontinued operations, net of tax, decreased 51.2%, or
$21.5 million to $20.5 million in fiscal 1998 from $42.0 million in fiscal 1997.
Income from the healthcare provider segment decreased 65.9% or $23.4 million to
$12.1 million in fiscal 1998 from $35.5 million in fiscal 1997. The decrease
resulted primarily from (i) the effect of the Crescent Transactions which
included a $35.9 million loss in 1997, net of tax, (ii) decreases in income of
$12.3 million from settlements and adjustments related to reimbursement issues
("Cost Report Settlements"), net of tax, (iii) favorable adjustments to fiscal
1997 income of $3.8 million related to accounts receivable retained by the
Company that were generated by the hospitals operated by CBHS, net of tax, and
(iv) decreases in adjustments to income of $2.0 million related to updated
actuarial estimates of malpractice claim reserves, net of tax. Income from the
healthcare franchising segment increased 29.2%, or $1.9 million, to
$8.4 million in fiscal 1998 compared to $6.5 million in fiscal 1997. The
increase resulted primarily from the effect of the Crescent Transactions offset
by declining operating performance of CBHS in fiscal 1998. See Note 3,
"Discontinued Operations", to the Company's audited consolidated financial
statements included elsewhere herein.
The Company recorded extraordinary losses on early extinguishments of debt,
net of tax, of $5.3 million and $33.0 million during fiscal 1997 and 1998,
respectively, related primarily to the termination of its then existing credit
agreements in fiscal 1997 and 1998 and the extinguishment of the long-term debt
related to the Merit acquisition in fiscal 1998. See Note 5, "Long-Term Debt,
Capital Lease Obligations and Operating Leases," to the Company's audited
consolidated financial statements set forth elsewhere herein.
OUTLOOK--RESULTS OF OPERATIONS
BEHAVIORAL MANAGED HEALTHCARE RESULTS OF OPERATIONS. The Company's
behavioral managed healthcare Segment Profit is subject to significant
fluctuations on a quarterly basis. These fluctuations may result from: (i)
changes in utilization levels by enrolled members of the Company's risk-based
contracts, including seasonal utilization patterns; (ii) performance-based
contractual adjustments to revenue, reflecting utilization results or other
performance measures; (iii) retroactive contractual adjustments under commercial
contracts and CHAMPUS contracts; (iv) retrospective membership adjustments; (v)
timing of implementation of new contracts and enrollment changes, (vi) pricing
adjustments upon long-term
37
contract renewals and (vii) changes in estimates regarding medical costs and
incurred but not yet reported medical claims.
The Company's contract with the State of Tennessee to manage the behavioral
healthcare benefits for the State's TennCare program ("TennCare Contract")
represented approximately 14.4% of the Company's behavioral managed healthcare
revenue and approximately 11.4% of the Company's consolidated revenue in fiscal
1999. The TennCare Contract contains provisions that limit the Company's profit,
subject to the carryforward of losses incurred in prior periods. The Company's
profit under the TennCare Contract benefited from the carryforward of losses
incurred in prior periods during fiscal 1999. The Company's Segment Profit under
the TennCare Contract is expected to be up to $10 million lower in fiscal 2000
than fiscal 1999 as result of these contract provisions.
The Company performs provider network, care management and medical review
services for Independence Blue Cross ("IBC"), a health insurance company, under
a contract that was entered into on July 7, 1994, with terms of up to five
years. The Company is in the process of renegotiating the terms of its contract
with IBC. Based on preliminary discussions with IBC, the Company expects to
renew the IBC contract on a long-term basis. However, there can be no assurance
that the Company will be able to renew the IBC contract at existing pricing
levels.
INTEREST RATE RISK. The Company had $512.9 million of total debt
outstanding under the Credit Agreement at September 30, 1999. Debt under the
Credit Agreement bears interest at variable rates. Historically, the Company's
has elected the interest rate option under the Credit Agreement that is an
adjusted London inter-bank offer rate ("LIBOR") plus a borrowing margin. See
Note 5, "Long-Term Debt, Capital Lease Obligations and Operating Leases", to the
Company's audited consolidated financial statements appearing elsewhere herein.
Based on September 30, 1999 borrowing levels, a 25 basis point increase in
interest rates would cost the Company approximately $1.3 million per year in
additional interest expense. LIBOR-based Eurodollar borrowing rates have
increased since January 1999. One month and six month LIBOR-based Eurodollar
rates increased by approximately 45 basis points and 100 basis points,
respectively, between January 1999 and September 1999 and may continue to
increase during fiscal 2000. The Company's earnings could be adversely affected
by further increases in interest rates.
TPG INVESTMENT. On December 15, 1999, the Company consummated the TPG
Investment. See Note 15, "Subsequent Event" to the Company's audited
consolidated financial statements set forth elsewhere herein. The TPG Investment
will reduce fiscal 2000 diluted income from continuing operations per common
share.
HISTORICAL LIQUIDITY AND CAPITAL RESOURCES--FISCAL 1997-1999
OPERATING ACTIVITIES. The Company's net cash provided by (used in)
operating activities was $73.6 million, $(4.2) million and $41.9 million for
fiscal 1997, 1998 and 1999, respectively. The increase in cash provided by
operating activities in fiscal 1999 compared to fiscal 1998 was primarily the
result of reduction in income taxes paid, net of refunds received, of
$10.8 million, and increases in cash flows from operations as a result of the
HAI and Merit acquisitions, offset by reductions in franchise fees collected
from CBHS of $40.6 million, changes in reserve for unpaid claims of $11.0
million and increases in interest paid of $6.9 million. The decrease in cash
provided by operating activities in fiscal 1998 compared to fiscal 1997 was
primarily the result of: (i) higher interest payments ($54.4 million and
$95.2 million in fiscal 1997 and 1998, respectively,) as a result of the Merit
acquisition; (ii) reduced cash flows from the provider business, net of
franchise fees received and (iii) the funding of liabilities related to the
Merit acquisition.
INVESTING ACTIVITIES. The Company utilized $33.3 million, $44.2 million and
$48.1 million in funds during fiscal 1997, 1998 and 1999, respectively, for
capital expenditures. The increases were the result of the Company's transition
to the managed care business from the provider business.
The Company used $50.9 million, $1.05 billion and $69.5 million in funds
during fiscal 1997, 1998 and 1999, respectively, net of cash acquired, for
acquisitions and investments in businesses. This included
38
primarily equity investments in CBHS and Premier (as defined) and hospital
acquisitions in fiscal 1997, managed care acquisitions and human services
acquisitions in fiscal 1998 and contingent consideration paid related to managed
care acquisitions in fiscal 1999.
The Company received distributions from unconsolidated subsidiaries of
$11.4 million and $21.2 million in fiscal 1998 and 1999, respectively.
Distributions received from Choice (as defined) were $11.4 million and
$13.0 million in fiscal 1998 and 1999, respectively, with the remaining
distributions being received from the Provider JVs in fiscal 1999.
The Company received proceeds from the sale of assets of $398.7 million,
$11.9 million and $54.2 million in fiscal 1997, 1998 and 1999, respectively. The
sales proceeds were generated primarily from (i) the Crescent Transactions in
fiscal 1997, (ii) the sale of hospital real estate related to closed hospitals
retained by the Company and (iii) the sale of the European Hospitals in fiscal
1999.
FINANCING ACTIVITIES. The Company borrowed approximately $203.6 million,
$1.2 billion and $76.8 million during fiscal 1997, 1998 and 1999, respectively.
The fiscal 1997 borrowings primarily funded the repayment of variable rate
secured notes and other long-term debt (including the refinancing of a previous
revolving credit agreement), acquisitions and working capital needs. The fiscal
1998 borrowings primarily funded the Merit acquisition and related long-term
debt refinancing with the remaining amounts representing borrowings under the
Revolving Facility for short-term capital needs. The fiscal 1999 borrowings were
primarily draws under the Revolving Facility for short-term capital needs.
The Company repaid approximately $390.3 million, $438.6 million and
$156.0 million of debt and capital lease obligations during fiscal 1997, 1998
and 1999, respectively. The fiscal 1997 repayments related primarily to a
previous revolving credit agreement and repaying variable rate secured notes as
a result of the Crescent Transactions. The fiscal 1998 repayments related
primarily to the extinguishment of the Magellan Outstanding Notes as part of the
Merit acquisition. The fiscal 1999 payments were for Term Loan Facility
principal amortization, required Term Loan Facility principal payments related
to the sale of the European Hospitals and payments on balances outstanding under
the Revolving Facility.
The Company issued approximately 2.6 million warrants, in aggregate, to
Crescent and COI for $25.0 million in cash as part of the Crescent Transactions
during fiscal 1997.
On November 1, 1996, the Company announced that its board of directors had
approved the repurchase of an additional 3.0 million shares of common stock from
time to time subject to the terms of the Company's then current credit
agreements. During fiscal 1998, the Company repurchased approximately
0.7 million shares of its common stock for approximately $14.4 million.
As of September 30, 1999, the Company had approximately $112.4 million of
availability under the Revolving Facility, excluding approximately $17.6 million
of availability reserved for certain letters of credit. The Company was in
compliance with all debt covenants as of September 30, 1999.
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 and interest and
principal payments on indebtedness outstanding pursuant to the Company's
$700.0 million 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. As of September 30, 1999, borrowings
pursuant to the Credit Agreement included $492.9 million under the Term Loan
Facility and up to $150.0 million under the Revolving Facility. The Company had
$20.0 million of borrowings and $17.6 million of letters of credit outstanding
under the Revolving Facility at September 30, 1999. As of September 30, 1999,
the Company is required to repay the principal amount of borrowings
39
outstanding under the Term Loan Facility and the principal amount of the Notes
in the years and amounts set forth in the following table (in millions):
REMAINING
FISCAL YEAR PRINCIPAL AMOUNT
- ----------- ----------------
2000 $ 30.1
2001 36.2
2002 45.9
2003 85.5
2004 145.6
2005 122.5
2006 27.1
2007 --
2008 625.0
In addition, any amounts outstanding under the Revolving Facility mature in
February 2004.
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 is obligated to make
contingent payments under two separate calculations as follows: In respect of
each Contract Year (as defined), the Company may be required to pay to Aetna the
"Tranche 1 Payments" (as defined) and the "Tranche 2 Payments" (as defined).
"Contract Year" means each of the twelve-month periods ending on the last day of
December in 1998, 1999, 2000, 2001, and 2002.
Upon the expiration of each Contract Year, the Tranche 1 Payment shall vest
with respect to such Contract Year in an amount equal to the product of (i) the
Tranche 1 Cumulative Incremental Members (as defined) for such Contract Year and
(ii) the Tranche 1 Multiplier (as defined) for such Contract Year. The vested
amount of Tranche 1 Payment shall be zero with respect to any Contract Year in
which the Tranche 1 Cumulative Incremental Members is a negative number.
Furthermore, in the event that the number of Tranche 1 Cumulative Incremental
Members with respect to any Contract Year is a negative number due to a decrease
in the number of Tranche 1 Cumulative Incremental Members for such Contract Year
(as compared to the immediately preceding Contract Year), Aetna will forfeit the
right to receive a certain portion (which may be none or all) of the vested and
unpaid amounts of the Tranche 1 Payment relating to preceding Contract Years.
"Tranche 1 Cumulative Incremental Members" means, with respect to any
Contract Year, (i) the number of Equivalent Members (as defined) serviced by the
Company during such Contract Year for Tranche 1 Members, minus (ii)(A) for each
Contract Year other than the initial Contract Year, the number of Equivalent
Members serviced by the Company for Tranche 1 Members during the immediately
preceding Contract Year or (B) for the initial Contract Year, the number of
Tranche 1 Members as of September 30, 1997, subject to certain upward
adjustments. There were 3,761,253 Tranche 1 Members for the initial Contract
Year, prior to such upward adjustments. "Tranche 1 Members" are members of
managed behavioral healthcare plans for whom the Company provides services in
any of specified categories of products or services. "Equivalent Members" for
any Contract Year equals the aggregate Member Months for which the Company
provides services to a designated category or categories of members during the
applicable Contract Year divided by 12. "Member Months" means, for each member,
the number of months for which the Company provides services and is compensated.
The "Tranche 1 Multiplier" is $80, $50, $40, $25, and $20 for the Contract Years
1998, 1999, 2000, 2001, and 2002, respectively.
40
For each Contract Year, the Company is obligated to pay to Aetna the lesser
of (i) the vested portion of the Tranche 1 Payment for such Contract Year and
the vested and unpaid amount relating to prior Contract Years as of the end of
the immediately preceding Contract Year and (ii) $25.0 million. To the extent
that the vested and unpaid portion of the Tranche 1 Payment exceeds $25.0
million, the Tranche 1 Payment remitted to Aetna shall be deemed to have been
paid first from any vested but unpaid amounts from previous Contract Years in
order from the earliest Contract Year for which vested amounts remain unpaid to
the most recent Contract Year at the time of such calculation. Except with
respect to the Contract Year ending in 2002, any vested but unpaid portion of
the Tranche 1 Payment shall be available for payment to Aetna in future Contract
Years, subject to certain exceptions. All vested but unpaid amounts of
Tranche 1 Payments shall expire following the payment of the Tranche 1 Payment
in respect to the Contract Year ending in 2002, subject to certain exceptions.
In no event shall the aggregate Tranche 1 Payments to Aetna exceed $125.0
million.
Upon the expiration of each Contract Year, the Tranche 2 payment shall be an
amount equal to the lesser of: (a) (i) the product of (A) the Tranche 2
Cumulative Members (as defined) for such Contract Year and (B) the Tranche 2
Multiplier (as defined) applicable to such number of Tranche 2 Cumulative
Members, minus (ii) the aggregate of the Tranche 2 Payments paid to Aetna for
all previous Contract Years and (b) $35.0 million. The amount shall be zero with
respect to any Contract Year in which the Tranche 2 Cumulative Members is a
negative number.
"Tranche 2 Cumulative Members" means, with respect to any Contract Year,
(i) the Equivalent Members serviced by the Company during such Contract Year for
Tranche 2 Members, minus (ii) the Tranche 2 Members as of September 30, 1997,
subject to certain upward adjustments. There were 936,391 Tranche 2 Members
prior to such upward adjustments. "Tranche 2 Members" means Members for whom the
Company provides products or services in the HMO category. The "Tranche 2
Multiplier" with respect to each Contract Year is $65 in the event that the
Tranche 2 Cumulative Members are less than 2,100,000 and $70 if more than or
equal to 2,100,000.
For each Contract Year, the Company shall pay to Aetna the amount of
Tranche 2 Payment payable for such Contract Year. All rights to receive
Tranche 2 Payment shall expire following the payment of the Tranche 2 Payment in
respect to the Contract Year ending in 2002, subject to certain exceptions.
Notwithstanding anything herein to the contrary, in no event shall the aggregate
Tranche 2 Payment to Aetna exceed $175.0 million, subject to certain exceptions.
The Company paid $60.0 million to Aetna on March 26, 1999 for both the full
Tranche 1 Payment and the full Tranche 2 Payment for the Contract Year ended
December 31, 1998. Also, based upon the most recent membership enrollment data
related to the Contract Year to end December 31, 1999 ("Contract Year 2"), the
Company believes beyond a reasonable doubt that it will be required to make both
the full Tranche 1 Payment and the full Tranche 2 Payment ($60.0 million in
aggregate) related to Contract Year 2. Accordingly, the Company recorded
$120.0 million of goodwill and other intangible assets related to the purchase
of HAI during fiscal 1999. The Contract Year 2 liability of $60.0 million is
included in "Deferred credits and other long-term liabilities" in the Company's
consolidated balance sheet as of September 30, 1999. The Company intends to
borrow under the Revolving Facility to meet this obligation, which is expected
to be paid during the second quarter of fiscal 2000.
In December, 1997 the Company purchased Allied for $70.0 million, excluding
transaction costs. The purchase price the Company originally paid for Allied
consisted of a $50.0 million payment to the former owners of Allied and a $20.0
million deposit into an interest-bearing escrow account and was subject to
increase or decrease based on the operating performance of Allied during the
three years following the closing. The Company was required to pay up to $60.0
million, of which $20.0 million would have been distributed from the escrow
account, during the three years following the closing of the Allied acquisition
if Allied's performance exceeded certain earnings targets.
41
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 following changes to the
original terms of the Allied purchase agreement:
- The original $20.0 million placed in escrow by the Company at the
consummation of the Allied acquisition, plus accrued interest, was repaid
to the Company.
- The Company paid the former owners of Allied $4.5 million of additional
consideration, which was recorded as goodwill.
- The Company capped future obligations with respect to additional
contingent payments for the purchase of Allied at $3.0 million. The
earnings targets which must be met by Allied for this amount to be paid
were increased.
By virtue of acquiring Merit, the Company may be 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 are subject to an aggregate maximum of $23.5 million.
The Company has initiated legal proceedings against certain former owners of CMG
with respect to representations made by such former owners in conjunction with
Merit's acquisition of CMG. Whether any contingent payments will be made to the
former shareholders of CMG and the amount and timing of contingent payments, if
any, may be subject to the outcome of these proceedings.
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 September 30, 1999, the
Company had approximately $112.4 million of availability under the Revolving
Facility. The Company estimates that it will spend approximately $45.0 million
for capital expenditures in fiscal 2000. The majority of the Company's
anticipated capital expenditures relate to management information systems and
related equipment. The Company believes that the cash flows generated from its
operations, together with amounts available for borrowing under the Revolving
Facility, should be sufficient to fund its debt service requirements,
anticipated capital expenditures, contingent payments, if any, with respect to
HAI and CMG, and other investing and financing activities for the foreseeable
future. The Company expects to have significant liquidity needs during the first
and second fiscal quarters of fiscal 2000 including, but not limited to,
(i) CHAMPUS settlement payments of $38.1 million (first fiscal quarter),
(ii) 1999 short-term incentive plan payments of approximately $12.0 million
(second fiscal quarter), (iii) semi-annual interest payments on the Notes of
$28.1 million (second fiscal quarter) and (iv) contingent consideration payable
to Aetna of to $60.0 million (second fiscal quarter). The Company expects its
borrowing capacity under the Revolving Facility to decline to approximately
$30.0 million to $40.0 million by March 31, 2000 depending primarily on (i) the
timing and amount of contingent consideration paid related to HAI and CMG (if
any), (ii) operating and cash flow performance of the Company in fiscal 2000,
(iii) capital resources needed to pursue certain new risk-based managed care
business and (iv) the timing and amount of acquisition-related spending. If the
Company's borrowing capacity under the Revolving Facility is expected to fall
below the levels described above, management intends to delay or forego certain
investing activities, including capital expenditures and acquisitions, and
possibly forego certain new business opportunities. The Company's future
operating performance and ability to service or refinance the Notes or to extend
or refinance the indebtedness outstanding pursuant to the Credit Agreement will
be subject to future economic conditions and to financial, business, regulatory
and other factors, many of which are beyond the Company's control.
RESTRICTIVE FINANCING COVENANTS. The Credit Agreement imposes restrictions
on the Company's ability to make capital expenditures, and both the Credit
Agreement and the 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
42
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's sale of the European Hospitals in April 1999 was one of the steps in
the Company's exit from the healthcare provider and healthcare franchising
businesses in order to reduce long-term debt and improve liquidity. The Company
is currently involved in discussions with various parties to divest certain
other non-core businesses. There can be no assurance that the Company will be
able to divest any businesses or that the divestiture of such businesses would
result in significant reductions of long-term debt or improvements in liquidity.
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. The Company is also reviewing additional strategic alternatives to
improve its capital structure and liquidity. There can be no assurance that the
Company will be able to consummate any transaction that will improve its capital
structure and/or liquidity.
NET OPERATING LOSS CARRYFORWARDS. During June 1999, the Company received an
assessment from the Internal Revenue Service (the "IRS Assessment") related to
its federal income tax returns for the fiscal years ended September 30, 1992 and
1993. The IRS Assessment disallowed approximately $162 million of deductions
that relate primarily to interest expense in fiscal 1992. The Company filed an
appeal of the IRS Assessment during September 1999.
The Company had previously recorded a valuation allowance for the full
amount of the $162 million of deductions disallowed in the IRS Assessment. The
IRS Assessment is not expected to result in a material cash payment for income
taxes related to prior years; however, the Company's federal income tax net
operating loss carryforwards would be reduced if the Company's appeal is
unsuccessful.
RECENT ACCOUNTING PRONOUNCEMENTS
In April 1998, the AICPA issued Statement of Position 98-5, "Reporting on
the Costs of Start-up Activities" ("SOP 98-5"). SOP 98-5 requires all
nongovernmental entities to expense costs of start-up activities as those costs
are incurred. Start-up costs, as defined by SOP 98-5, include pre-operating
costs, pre-opening costs and organization costs.
SOP 98-5 becomes effective for financial statements for fiscal years
beginning after December 15, 1998. At adoption, a company must record a
cumulative effect of a change in accounting principle to write off any
unamortized start-up costs remaining on the balance sheet when SOP 98-5 is
adopted. Prior year financial statements cannot be restated. The Company adopted
SOP 98-5 effective October 1, 1998. The Company's adoption of SOP 98-5 had no
impact on its financial position or results of operations.
Emerging Issues Task Force Issue 96-16, "Investor's Accounting for an
Investee When the Investor Has a Majority of the Voting Interest but a Minority
Shareholder or Shareholders Have Certain Approval or Veto Rights" ("EITF 96-16")
supplements the guidance contained in AICPA Accounting Research Bulletin 51,
"Consolidated Financial Statements", and in Statement of Financial Accounting
Standards No. 94, "Consolidation of All Majority-Owned Subsidiaries" ("ARB
51/FAS 94"), about the conditions under which the Company's consolidated
financial statements should include the financial position, results of
operations and cash flows of subsidiaries which are less than wholly-owned along
with those of the Company and its subsidiaries.
In general, ARB 51/FAS 94 requires consolidation of all majority-owned
subsidiaries except those for which control is temporary or does not rest with
the majority owner. Under the ARB 51/FAS 94 approach, instances of control not
resting with the majority owner were generally regarded to arise from such
events
43
as the legal reorganization or bankruptcy of the majority-owned subsidiary. EITF
96-16 expands the definition of instances in which control does not rest with
the majority owner to include those where significant approval or veto rights,
other than those which are merely protective of the minority shareholder's
interest, are held by the minority shareholder or shareholders ("Substantive
Participating Rights"). Substantive Participating Rights include, but are not
limited to: (i) selecting, terminating and setting the compensation of
management responsible for implementing the majority-owned subsidiary's policies
and procedures and (ii) establishing operating and capital decisions of the
majority-owned subsidiary, including budgets, in the ordinary course of
business.
The provisions of EITF 96-16 apply to new investment agreements made after
July 24, 1997, and to existing agreements which are modified after such date.
The Company has made no new investments, and has modified no existing
investments, to which the provisions of EITF 96-16 would have applied.
In addition, the transition provisions of EITF 96-16 must be applied to
majority-owned subsidiaries previously consolidated under ARB 51/FAS 94 for
which the underlying agreements have not been modified in financial statements
issued for years ending after December 15, 1998 (fiscal 1999 for the Company).
The adoption of the transition provisions of EITF 96-16 on October 1, 1998 had
the following effect on the Company's consolidated financial position:
OCTOBER 1,
1998
----------
Increase (decrease) in:
Cash and cash equivalents................................. $(21,092)
Other current assets...................................... (9,538)
Long-term assets.......................................... (30,049)
Investment in unconsolidated subsidiaries................. 26,498
--------
Total Assets............................................ $(34,181)
========
Current liabilities....................................... $(10,381)
Minority interest......................................... (23,800)
--------
Total Liablities........................................ $(34,181)
========
POTENTIAL IMPACT OF YEAR 2000 COMPUTER ISSUES
OVERVIEW. The year 2000 computer problem is the inability of computer
systems which store dates by using the last two digits of the year (i.e. "98"
for "1998") to reliably recognize that dates after December 31, 1999 are later
than, and not before, 1999. For instance, the date January 1, 2000, may be
mistakenly interpreted as January 1, 1900, in calculations involving dates on
systems which are non-year 2000 compliant.
The Company relies on information technology ("IT") systems and other
systems and facilities such as telephones, building access control systems and
heating and ventilation equipment ("Embedded Systems") to conduct its business.
These systems are potentially vulnerable to year 2000 problems due to their use
of the date information.
The Company also has business relationships with customers and healthcare
providers and other critical vendors who are themselves reliant on IT and
Embedded Systems to conduct their businesses.
STATE OF READINESS. The Company's IT systems are largely decentralized,
with each major operating unit having its own standards for systems which
include both purchased and internally-developed software. The Company's IT
hardware infrastructure is built mainly around mid-range computers and IBM PC-
compatible servers and desktop systems.
The Company's principal means of ensuring year 2000 readiness for purchased
software has been the replacement, upgrade or repair of non-compliant systems.
This replacement process would have been
44
undertaken for business reasons irrespective of the year 2000 problem; however,
it would, more than likely, have been implemented over a longer period of time.
The Company's internally-developed software was either designed to be year 2000
ready from inception or have been modified to be year 2000 ready and has gone
through an independent verification and validation process. The Company believes
its mission critical systems have been remediated to a state of year 2000
readiness.
To successfully prepare for the Year 2000, a Program Management Office
"(PMO)" was established by the Company. The PMO's responsibility is to provide
oversight to the year 2000 project, develop plans, policies and procedures,
manage risk, as well as perform independent verification and validation for the
Company's year 2000 readiness.
Each of the Company's major operating units has a Chief Information Officer
who is responsible for ensuring that all year 2000 issues are addressed and
mitigated before any computational problems related to dates after December 31,
1999, occur.
The Company's plan for IT systems consists of several phases, primarily:
(i) Inventory--identifying all IT systems and the magnitude of year 2000
readiness risk of each according to its potential business impact;
(ii) Date assessment--identifying IT systems that use date functions and
assessing them for year 2000 functionality;
(iii) Remediation--reprogramming, replacing or upgrading where necessary,
inventoried items to ensure they are year 2000 ready; and
(iv) Testing and certification--testing the code modifications and new
inventory with other associated systems, including extensive date testing
and performing quality assurance testing to ensure successful operation
in the post-1999 environment.
The Company has completed the inventory and assessment phases for
substantially all of its IT systems. The Company has completed the remediation,
testing and certification of substantially all of its IT systems.
The Company leases most of the office space in which its reliance on
Embedded Systems presents a potential problem and has been working with the
respective lessors to identify any potential year 2000 problems related to these
Embedded Systems. Responses concerning year 2000 readiness have been received
and assessed from all facilities considered mission critical. Risk has been
determined for each facility and follow-up activities continue to ensure that
facilities remain a low risk for year 2000.
The Company believes that its year 2000 projects have been substantially
completed.
EXTERNAL RELATIONSHIPS. The Company also faces the risk that one or more of
its critical suppliers or customers ("External Relationships") will not be able
to interact with the Company due to the third party's inability to resolve its
own year 2000 issues, including those associated with its own External
Relationships. The Company has completed its inventory of External Relationships
and risk rated each External Relationship based upon the potential business
impact, available alternatives and cost of substitution. The Company determined
the overall year 2000 readiness of its External Relationships. In the case of
significant customers and mission critical suppliers such as banks,
telecommunications providers and other utilities and IT vendors, the Company has
been engaged in discussions with the third parties and has, in many cases,
obtainined detailed information as to those parties' year 2000 plans and state
of readiness.
YEAR 2000 COSTS. Total costs incurred solely for remediation of potential
year 2000 problems were approximately $4.3 million in fiscal 1999. A large
majority of these costs were incremental expenses that will not recur in
calendar 2000 or thereafter. The Company expenses these costs as incurred and
funds these costs through operating cash flows. In addition, the Company
estimates that it has accelerated
45
approximately $5.5 million of capital expenditures that would have been budgeted
for future periods into fiscal 1999 to ensure year 2000 readiness for outdated
systems.
Year 2000 readiness is critical to the Company. The Company has redeployed
some resources from non-critical system enhancements to address year 2000
issues. Due to the importance of IT systems to the Company's business,
management has deferred non-critical systems enhancements to become year 2000
ready. The Company does not expect these redeployments and deferrals to have a
material impact on the Company's financial condition or results of operations.
RISKS AND CONTINGENCY/RECOVERY PLANNING. If the Company's year 2000 issues
were unresolved, the most reasonably likely worst case scenario would include,
among other possibilities, the inability to accurately and timely authorize and
process benefits and claims, accurately bill customers, assess claims exposure,
determine liquidity requirements, report accurate data to management,
stockholders, customers, regulators and others, cause business interruptions or
shutdowns, financial losses, reputational harm, loss of significant customers,
increased scrutiny by regulators and litigation related to year 2000 issues. The
Company is attempting to limit the potential impact of the year 2000 by
monitoring the progress of its own year 2000 project and those of its critical
External Relationships and by developing contingency/recovery plans. The Company
cannot guarantee that it will be able to resolve all of its year 2000 issues.
Any critical unresolved year 2000 issues at the Company or its External
Relationships, however, could have a material adverse effect on the Company's
results of operations, liquidity or financial condition.
The Company has developed, or is developing, contingency/recovery plans
aimed at ensuring the continuity of critical business functions before and after
December 31, 1999. As part of that process, the Company has substantially
completed the development of manual work alternatives to automated processes
which should both ensure business continuity and provide a ready source of input
to affected systems when they are returned to an operational status. These
manual alternatives presume, however, that basic infrastructure such as
electrical power and telephone service, as well as purchased systems which are
advertised to be year 2000 ready by their manufacturers (primarily personal
computers and productivity software) will remain unaffected by the year 2000
problem. Contingency planning activities will continue through calendar
year-end. Activities consist of, but are not limited to, plan verification of
all key corporate functions, establishment of response teams and associated "war
rooms", testing of call centers telephone re-routing strategy and rehearsal for
year-end transition.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company has significant interest rate risk related to its variable rate
debt outstanding under the Credit Agreement. See "Cautionary
Statements--Leverage and Debt Service Obligations," "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Outlook--Results of
Operations and Outlook--Liquidity and Capital Resources" and Note 5, "Long-Term
Debt, Capital Lease Obligations and Operating Leases" to the Company's audited
consolidated financial statements set forth elsewhere herein.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Information with respect to this item is contained in the Company's audited
consolidated financial statements and financial statement schedule indicated in
the Index on Page F-1 of this Annual Report on Form 10-K and is incorporated
herein by reference.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
46
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information with respect to the Company's executive officers is contained
under "Item 1. Business--Executive Officers of the Registrant." Pursuant to
General Instruction G(3) to Form 10-K, the information required by this item
with respect to directors and compliance with Section 16(a) of the Exchange Act
has been omitted inasmuch as the Company files with the Securities and Exchange
Commission a definitive proxy statement not later than 120 days subsequent to
the end of its fiscal year. Such information is incorporated herein by
reference.
ITEM 11. EXECUTIVE COMPENSATION
Pursuant to General Instruction G(3) to Form 10-K, the information required
with respect to this item has been omitted inasmuch as the Company files with
the Securities and Exchange Commission a definitive proxy statement not later
than 120 days subsequent to the end of its fiscal year. Such information is
incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Pursuant to General Instruction G(3) to Form 10-K, the information required
with respect to this item has been omitted inasmuch as the Company files with
the Securities and Exchange Commission a definitive proxy statement not later
than 120 days subsequent to the end of its fiscal year. Such information is
incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Pursuant to General Instruction G(3) to Form 10-K, the information required
with respect to this item has been omitted inasmuch as the Company files with
the Securities and Exchange Commission a definitive proxy statement not later
than 120 days subsequent to the end of its fiscal year. Such information is
incorporated herein by reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(A) DOCUMENTS FILED AS PART OF THE REPORT:
1. FINANCIAL STATEMENTS
Information with respect to this item is contained on Pages F-1 to F-51 of
this Annual Report on Form 10-K.
2. FINANCIAL STATEMENT SCHEDULE
Information with respect to this item is contained on page S-1 of this
Annual Report on Form 10-K.
47
3. EXHIBITS
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- --------------------- ----------------------
2(a) Stock Purchase Agreement, dated November 14, 1995, among
Blue Cross and Blue Shield of New Jersey, Inc. Health Care
Service Corporation, Independence Blue Cross, Medical
Service Association of Pennsylvania, Pierce County Medical
Bureau, Inc., Veritus, Inc., Green Spring Health Services,
Inc. and the Company, which was filed as Exhibit 10(e) to
the Company's Quarterly Report on Form 10-Q for the
Quarterly period ended December 31, 1995, and is
incorporated herein by reference.
2(b) GPA Stock Exchange Agreement, dated November 14, 1995,
between Green Spring Health Services, Inc. and the Company,
which was filed as Exhibit 10(f) to the Company's Quarterly
Report on Form 10-Q for the Quarterly period ended December
31, 1995, and is incorporated herein by reference.
2(c) Real Estate Purchase and Sale Agreement, dated January 29,
1997, between the Company and Crescent Real Estate Equities
Limited Partnership, which was filed as Exhibit 2(a) to the
Company's current report on Form 8-K filed on April 23,
1997, and is incorporated herein by reference.
2(d) Amendment No. 1, dated February 28, 1997, to the Real Estate
Purchase and Sale Agreement, dated January 29, 1997, between
the Company and Crescent Real Estate Equities Limited
Partnership, which was filed as Exhibit 2(b) to the
Company's current report on Form 8-K filed on April 23,
1997, and is incorporated herein by reference.
2(e) Amendment No. 2, dated May 29, 1997, to the Real Estate
Purchase and Sale Agreement, dated January 29, 1997, between
the Company and Crescent Real Estate Equities Limited
Partnership, which was filed as Exhibit 2(c) to the
Company's current report on Form 8-K, which was filed on
June 30, 1997, and is incorporated herein by reference.
2(f) Contribution Agreement, dated June 16, 1997, between the
Company and Crescent Operating, Inc., which was filed as
Exhibit 2(d) to the Company's current report on Form 8-K
which was filed on June 30, 1997, and is incorporated herein
by reference.
2(g) Stock Purchase Agreement, dated August 5, 1997, between the
Company and Aetna Insurance Company of Connecticut, which
was filed as Exhibit 2(a) to the Company's current report on
Form 8-K, which was filed on December 17, 1997, and is
incorporated herein by reference.
2(h) Master Service Agreement, dated August 5, 1997, between the
Company, Aetna U.S. Healthcare, Inc. and Human Affairs
International, Incorporated, which was filed as Exhibit 2(b)
to the Company's current report on Form 8-K, which was filed
on December 17, 1997, and is incorporated herein by
reference.
2(i) First Amendment to Stock Purchase Agreement, dated December
4, 1997, between the Company and Aetna Insurance Company of
Connecticut, which was filed as Exhibit 2(c) to the
Company's current report on Form 8-K, which was filed on
December 17, 1997, and is incorporated herein by reference.
2(j) First Amendment to Master Services Agreement, dated December
4, 1997, between the Company, Aetna U.S. Healthcare, Inc.
and Human Affairs International, Incorporated, which was
filed as Exhibit 2(d) to the Company's current report on
Form 8-K, which was filed on December 17, 1997, and is
incorporated herein by reference.
2(k) Asset Purchase Agreement, dated October 16, 1997, among the
Company; Allied Health Group, Inc.; Gut Management, Inc.;
Sky Management Co,; Florida Specialty Network, LTD; Surgical
Associates of South Florida, Inc.; Surginet, Inc.; Jacob
Nudel, M.D.; David Russin, M.D. and Lawrence Schimmel, M.D.,
which was filed as Exhibit 2(e) to the Company's Quarterly
Report on Form 10-Q for the quarterly period ended December
31, 1997, and is incorporated herein by reference.
48
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- --------------------- ----------------------
2(l) First Amendment to Asset Purchase Agreement, dated December
5, 1997, among the Company; Allied Health Group, Inc.; Gut
Management, Inc.; Sky Management Co.; Florida Specialty
Network, LTD; Surgical Associates of South Florida, Inc.;
Surginet, Inc.; Jacob Nudel, M.D.; David Russin M.D.; and
Lawrence Schimmel, M.D., which was filed as Exhibit 2(f) to
the Company's Quarterly Report on Form 10-Q for the
quarterly period ended December 31, 1997, and is
incorporated herein by reference.
2(m) Second Amendment to Asset Purchase Agreement, dated November
18, 1998, among the Company; Allied Health Group, Inc.; Gut
Management, Inc.; Sky Management Co.; Florida Specialty
Network, LTD; Surgical Associates of South Florida, Inc.;
Surginet, Inc.; Jacob Nudel, M.D.; David Russin M.D.; and
Lawrence Schimmel, M.D., which was filed as Exhibit 2(m) to
the Company's Annual Report on Form 10-K for the fiscal year
ended September 30, 1998 and is incorporated herein by
reference.
2(n) Third Amendment to Asset Purchase agreement, dated
December 31, 1998, among the Company; Allied Health Group,
Inc.; Gut Management, Inc.; Sky Management Co.; Florida
Specialty Network, LTD; Surgical Associates of South
Florida, Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David
Russin, M.D.; and Lawrence Schimmel, M.D., which was filed
as Exhibit 2(b) to the Company's Quarterly on Form 10-Q for
the quarterly period ended December 31, 1998 and is
incorporated herein by reference.
2(o) Agreement and Plan of Merger, dated October 24, 1997, among
the Company, Merit Behavioral Care Corporation and MBC
Merger Corporation which was filed as Exhibit 2(g) to the
Company's Quarterly Report on Form 10-Q for the quarterly
period ended December 31, 1997, and is incorporated herein
by reference.
2(p) Share Purchase Agreement, dated April 2, 1999, by and among
the Company, Charter Medical International, S.A., Inc. (a
wholly owned subsidiary of the Company), Investment AB Bure,
and CMEL Holding Limited (a wholly owned subsidiary of
Investment AB Bure), filed as Exhibit 2(a) to the Company's
current report on Form 8-K, which was filed on April 12,
1999, and is incorporated herein by reference.
2(q) Stock Purchase Agreement, dated April 2, 1999, by and among
the Company, Charter Medical International S.A., Inc. (a
wholly owned subsidiary of the Company), Investment AB Bure
and Grodrunden 515 AB (a wholly owned subsidiary of
Investment AB Bure), filed as Exhibit 2(b) to the Company's
current report on Form 8-K, which was filed on April 12,
1999, and is incorporated herein by reference.
2(r) First Amendment to Share Purchase Agreement, dated April 8,
1999, by and among the Company, Charter Medical
International S.A., Inc. (a wholly owned subsidiary of the
Company), Investment AB Bure, and CMEL Holding Limited (a
wholly owned subsidiary of Investment AB Bure), filed as
Exhibit 2(c) to the Company's current report on Form 8-K,
which was filed on April 12, 1999, and is incorporated
herein by reference.
2(s) First Amendment to Stock Purchase Agreement, dated April 8,
1999, among the Company, Charter Medical International S.A.,
Inc. (a wholly owned subsidiary of the Company), Investment
AB Bure, and CMEL Holding Limited (a wholly owned subsidiary
of Investment AB Bure), filed as Exhibit 2(d) to the
Company's current report on Form 8-K, which was filed on
April 12, 1999, and is incorporated herein by reference.
2(t) Letter Agreement dated August 10, 1999 by and among the
Company, Charter Behavioral Health Systems, LLC, Crescent
Real Estate Equities Limited Partnership and Crescent
Operating, Inc., which was filed as Exhibit 2(a) to the
Company's current report on Form 8-K , which was filed on
September 24, 1999 and is incorporated herein by reference.
3(a) Restated Certificate of Incorporation of the Company, as
filed in Delaware on October 16, 1992, which was filed as
Exhibit 3(a) to the Company's Annual Report on Form 10-K for
the year ended September 30, 1992, and is incorporated
herein by reference.
49
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- --------------------- ----------------------
3(b) Bylaws of the Company.
3(c) Certificate of Ownership and Merger merging Magellan Health
Services, Inc. (a Delaware corporation) into Charter Medical
Corporation (a Delaware corporation), as filed in Delaware
on December 21, 1995, which was filed as Exhibit 3(c) to the
Company's Annual Report on Form 10-K for the year ended
September 30, 1995, and is incorporated herein by reference.
4(a) Stockholders' Agreement, dated December 13, 1995, among
Green Spring Health Services, Inc., Blue Cross and Blue
Shield of New Jersey, Inc., Health Care Service Corporation,
Independence Blue Cross, Pierce County Medical Bureau, Inc.
and the Company, which was filed as Exhibit 4(d) to the
Company's Quarterly Report on Form 10-Q for the quarterly
period ended December 31, 1995, and is incorporated herein
by reference.
4(b) First Amendment to Stockholders' Agreement, dated February
28, 1997, among Green Spring Health Services, Inc, Blue
Cross and Blue Shield of New Jersey, Inc., Health Care
Service Corporation, Independence Blue Cross, Pierce County
Medical Bureau, Inc. and the Company, which was filed as
Exhibit 4(af) to the Company's Annual Report on Form 10-K
for the year ended September 30, 1997, and is incorporated
herein by reference.
4(c) Exchange Agreement, dated December 13, 1995, among Blue
Cross and Blue Shield of New Jersey, Inc., Health Care
Service Corporation, Independence Blue Cross, Pierce County
Medical Bureau, Inc. and the Company, which was filed as
Exhibit 4(e) to the Company's Quarterly Report on Form 10-Q
for the quarterly period ended December 31, 1995, and is
incorporated herein by reference.
4(d) Stock and Warrant Purchase Agreement, dated December 22,
1995, between the Company and Richard E. Rainwater, which
was filed as Exhibit 4(f) to the Company's Quarterly Report
on Form 10-Q for the quarterly period ended December 31,
1995, and is incorporated herein by reference.
4(e) Amendment No. 1 to Stock and Warrant Purchase Agreement,
dated January 25, 1996, between the Company and
Rainwater-Magellan Holdings, L.P., which was filed as
Exhibit 4.7 to the Company's Registration Statement on Form
S-3 dated February 26, 1996, and is incorporated herein by
reference.
4(f) Warrant Purchase Agreement, dated January 29, 1997, between
the Company and Crescent Real Estate Equities Limited
Partnership which was filed as Exhibit 4(a) to the Company's
current report on Form 8-K, which was filed on April 23,
1997, and is incorporated herein by reference.
4(g) Amendment No. 1, dated June 17, 1997, to the Warrant
Purchase Agreement, dated January 29, 1997, between the
Company and Crescent Real Estate Equities Limited
Partnership, which was filed as Exhibit 4(b) to the
Company's current report on Form 8-K, which was filed on
June 30, 1997, and is incorporated herein by reference.
4(h) Indenture, dated as of February 12, 1998, between the
Company and Marine Midland Bank, as trustee, relating to the
9% Senior Subordinated Notes due February 15, 2008 of the
Company, which was filed as Exhibit 4(a) to the Company's
Current Report on Form 8-K, which was filed April 3, 1998,
and is incorporated herein by reference.
4(i) Purchase Agreement, dated February 5, 1998, between the
Company and Chase Securities Inc., which was filed as
Exhibit 4(b) to the Company's Current Report on Form 8-K,
which was filed April 3, 1998, and is incorporated herein by
reference.
4(j) Exchange and Registration Rights Agreement, dated February
12, 1998, between the Company and Chase Securities Inc.,
which was filed as Exhibit 4(c) to the Company's Current
Report on Form 8-K, which was filed on April 3, 1998, and is
incorporated herein by reference.
50
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- --------------------- ----------------------
4(k) Credit Agreement, dated February 12, 1998, among the
Company, certain of the Company's subsidiaries listed
therein and The Chase Manhattan Bank, as administrative
agent, which was filed as Exhibit 4(d) to the Company's
Current Report on Form 8-K, which was filed April 3, 1998,
and is incorporated herein by reference.
4(l) Amendment No. 1, dated as of September 30, 1998, to the
Credit Agreement, dated as of February 12, 1998, among the
Company, certain of the Company's subsidiaries listed
therein and The Chase Manhattan Bank, as administrative
agent, which was filed as Exhibit 4(e) to the Company's
Registration Statement Form S-4 (no. 333-49335), which was
filed on October 5, 1998, and is incorporated herein by
reference.
4(m) Amendment No. 2, dated as of April 30, 1999, to the Credit
Agreement dated as of February 12, 1998, among the Company
certain of the Company's subsidiaries listed therein and the
Chase Manhattan Bank, as administrative agent which was
filed as Exhibit 4(a) to the Company's Quarterly Report on
Form 10-Q for the quarterly period ended June 30, 1999 and
is incorporated herein by reference.
4(n) Amendment No. 3, dated as of July 29, 1999, to the Credit
Agreement dated as of February 12, 1998, among the Company's
subsidiaries listed therein and the Chase Manhattan Bank, as
administrative agent.
4(o) Amendment No. 4, dated as of September 8, 1999, to the
Credit Agreement dated as of February 12, 1998, among the
Company's subsidiaries listed therein and the Chase
Manhattan Bank, as administrative agent.
4(p) Investment Agreement dated as of July 19, 1999, between the
Company and TPG Magellan LLC together with the following
exhibits: (i) form of Certificate of Designations of Series
A Cumulative Convertible Preferred Stock; (ii) form of
Certificate of Designation of Series B Cumulative
Convertible Preferred Stock; (iii) form of Certificate of
Designations of Series C Junior Participating Preferred
Stock; and (iv) form of Escrow Agreement by and among The
Company, TPG Magellan LLC and SunTrust Bank, Atlanta, as
escrow agent, filed as Exhibit 4.1 to the Company's current
report on Form 8-K, which was filed on July 21, 1999, and is
incorporated herein by reference.
4(q) Registration Rights Agreement, dated as of July 19, 1999,
between the Company and TPG Magellan LLC, filed as Exhibit
4.2 to the Company's current report on Form 8-K, which was
filed on July 21, 1999, and is incorporated herein by
reference.
4(r) Amended and Restated Investment Agreement, dated
December 14, 1999, between the Company and TPG Magellan LLC
together with the following exhibits: (i) form of
Certificate of Designations of Series A Cumulative
Convertible Preferred Stock; (ii) form of Certificate of
Designation of Series B Cumulative Convertible Preferred
Stock; (iii) form of Certificate of Designations of Series C
Junior Participating Preferred Stock.
*10(a) 1992 Stock Option Plan of the Company, as amended, which was
filed as Exhibit 10(c) to the Company's Annual Report on
Form 10-K for the year ended September 30, 1994, and is
incorporated herein by reference.
*10(b) 1992 Directors' Stock Option Plan of the Company, as
amended, which was filed as Exhibit 10(d) to the Company's
Annual Report on Form 10-K for the year ended September 30,
1994, and is incorporated herein by reference.
*10(c) 1994 Stock Option Plan of the Company, as amended, which was
filed as Exhibit 10(e) to the Company's Annual Report on
Form 10-K for the year ended September 30, 1994, and is
incorporated herein by reference.
*10(d) Directors' Unit Award Plan of the Company, which was filed
as Exhibit 10(i) to the Company's Registration Statement on
Form S-4 (No. 33-53701) filed May 18, 1994, and is
incorporated herein by reference.
51
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- --------------------- ----------------------
*10(e) 1996 Stock Option Plan of the Company, which was filed as
Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q
for the quarterly period ended March 31, 1996 and is
incorporated herein by reference.
*10(f) 1996 Directors' Stock Option Plan of the Company, which was
filed as Exhibit 10(b) to the Company's Quarterly Report on
Form 10-Q for the quarterly period ended March 31, 1996 and
is incorporated herein by reference.
*10(g) 1997 Stock Option Plan of the Company, which was filed as
Exhibit 10(i) to the Company's Quarterly Report on Form 10-Q
for the quarterly period ended June 30, 1997, and is
incorporated herein by reference.
*10(h) Amendment to the Company's 1992 Directors' Stock Option
Plan, which was filed as Exhibit 10(d) to the Company's
Quarterly Report on Form 10-Q for the quarterly period ended
March 31, 1999 and is incorporated herein by reference.
*10(i) Amendment to the Company's Directors' 1996 Directors Stock
Option Plan, which was filed as Exhibit 10(e) to the
Company's Quarterly Report on Form 10-Q for the quarterly
period ended March 31, 1999 and is incorporated herein by
reference.
*10(j) Amendment to the Company's 1994 Stock Option Plan, which was
filed as Exhibit 10(f) to the Company's Quarterly Report on
Form 10-Q for the quarterly period ended March 31, 1999 and
is incorporated herein by reference.
*10(k) Amendment to the Company's 1996 Stock Option Plan, which was
filed as Exhibit 10(g) to the Company's Quarterly Report on
Form 10-Q for the quarterly period ended March 31, 1999 and
is incorporated herein by reference.
*10(l) Amendment to the Company's 1997 Stock Option Plan, which was
filed as Exhibit 10(h) to the Company's Quarterly Report on
Form 10-Q for the quarterly period ended March 31, 1999 and
is incorporated herein by reference.
*10(m) Amended 1998 Stock Option Plan of the Company, which was
filed as Exhibit 10(i) to the Company's Quarterly Report on
Form 10-Q for the quarterly period ended March 31, 1999 and
is incorporated herein by reference.
*10(n) Third Amendment to the Company's 1998 Stock Option Plan,
which was filed as Exhibit 10(j) to the Company's Quarterly
Report on Form 10-Q for the quarterly period ended
March 31, 1999 and is incorporated herein by reference.
*10(o) Employment Agreement, dated March 31, 1995, between the
Company and Craig L. McKnight, Executive Vice President and
Chief Financial Officer, which was filed as Exhibit 10(l) to
the Company's Annual Report on Form 10-K for the year ended
September 30, 1995, and is incorporated herein by reference.
*10(p) Letter Agreement, dated November 9, 1993, between Green
Spring Health Services, Inc. and Henry T. Harbin, M.D.,
Executive Vice President of the Company and President and
Chief Executive Officer of Green Spring Health Services,
Inc., which was filed as Exhibit 10(c) to the Company's
Quarterly Report on Form 10-Q for the quarterly period ended
December 31, 1995 and is incorporated herein by reference.
*10(q) Letter Agreement, dated September 19, 1994 between Green
Spring Health Services, Inc. and Henry T. Harbin, M.D.,
Executive Vice President of the Company and President and
Chief Executive Officer of Green Spring Health Services,
Inc., which was filed as Exhibit 10(d) to the Company's
Quarterly Report on Form 10-Q for the quarterly period ended
December 31, 1995 and is incorporated herein by reference.
*10(r) Employment Agreement dated February 28, 1996, between Green
Spring Health Services, Inc. and Henry T. Harbin, M.D.,
Executive Vice President of the Company and President and
Chief Executive Officer of Green Spring Health Services,
Inc., which was filed as Exhibit 10(t) to the Company's
Annual Report on Form 10-K for the year ended September 30,
1996, and is incorporated herein by reference.
52
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- --------------------- ----------------------
*10(s) Compensation Agreement dated September 30, 1996, between
Magellan Health Services, Inc. and Henry T. Harbin, M.D.,
Executive Vice President of the Company and President and
Chief Executive Officer of Green Spring Health Services,
Inc., which was filed as Exhibit 10(u) to the Company's
Annual Report on Form 10-K for the year ended September 30,
1996, and is incorporated herein by reference.
*10(t) Written description of the Green Spring Health Services,
Inc. Annual Incentive Plan for the period ended September
30, 1998, which was filed as Exhibit 10(s) to the Company's
Annual Report on Form 10-K for the year ended September 30,
1998 and is incorporated herein by reference.
*10(u) Magellan Corporate Short-Term Incentive Plan for the fiscal
year ended September 30, 1999, which was filed as Exhibit
10(a) to the Company's Quarterly Report on Form 10-Q for the
quarterly period ended March 31, 1999 and is incorporated
herein by reference.
*10(v) Magellan Behavioral Health Short-Term Incentive Plan for the
fiscal year ended September 30, 1999, which was filed as
Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q
for the quarterly period ended March 31, 1999 and is
incorporated herein by reference.
*10(w) Letter Agreement, dated March 2, 1999, between the Company
and Clifford W. Donnelly, Executive Vice President of the
Company.
*10(x) Letter Agreement, dated June 4, 1999, between the Company
and Mark S. Demilio, Executive Vice President of the
Company.
10(y) Master Lease Agreement, dated June 16, 1997, between
Crescent Real Estate Funding VII, L.P., as Landlord, and
Charter Behavioral Health Systems, LLC, as Tenant, which was
filed as Exhibit 99(b) to the Company's current report on
Form 8-K, which was filed on June 30, 1997, and is
incorporated herein by reference.
10(z) Master Franchise Agreement, dated June 17, 1997, between the
Company and Charter Behavioral Health Systems, LLC, which
was filed as Exhibit 99(c) to the Company's current report
on Form 8-K, which was filed on June 30, 1997, and is
incorporated herein by reference.
10(aa) Form of Franchise Agreement, dated June 17, 1997, between
the Company, as Franchisor, and Franchise Owners, which was
filed as Exhibit 99(d) to the Company's current report on
Form 8-K, which was filed on June 30, 1997, and is
incorporated herein by reference.
10(ab) Subordination Agreement, dated June 16, 1997, between the
Company, Charter Behavioral Health Systems, LLC and Crescent
Real Estate Equities Limited Partnership, which was filed as
Exhibit 99(e) to the Company's current report on Form 8-K,
which was filed on June 30, 1997, and is incorporated herein
by reference.
10(ac) Operating Agreement of Charter Behavioral Health Systems,
LLC, dated June 16, 1997, between the Company and Crescent
Operating, Inc., which was filed as Exhibit 99(f) to the
Company's current report on Form 8-K, which was filed on
June 30, 1997, and is incorporated herein by reference.
10(ad) Warrant Purchase Agreement, dated June 16, 1997, between the
Company and Crescent Operating, Inc., which was filed as
Exhibit 99(g) to the Company's current report on Form 8-K,
which was filed on June 30, 1997, and is incorporated herein
by reference.
*10(ae) 1998 Stock Option Plan of the Company which was filed as
Exhibit (ay) to the Company's Registration Statement on Form
S-4, which was filed on April 3, 1998, and is incorporated
herein by reference.
53
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- --------------------- ----------------------
*10(af) Letter Agreement, dated May 7, 1997, between Green Spring
Health Services, Inc. and John J. Wider, Jr., Executive Vice
President and Chief Operating Officer of Green Spring Health
Services, Inc., which was filed as Exhibit 10 (az) to the
Company's Registration Statement on Form S-4, which was
filed on April 3, 1998, and is incorporated herein by
reference.
*10(ag) Employment Agreement, dated December 9, 1998, between
Magellan Behavioral Health, Inc. and John Wider, President
and Chief Operating Officer of Magellan Behavioral Health,
Inc., which was filed as Exhibit 10 to the Company's Form
10-Q for the quarterly period ended December 31, 1998 and is
incorporated herein by reference.
*10(ah) Employment Agreement, dated March 12, 1997, between Green
Spring Health Services, Inc. and Clarissa C. Marques, Chief
Clinical Officer of Green Spring Health Services, Inc.,
which was filed as Exhibit 10 (ba) to the Company's
Registration Statement on Form S-4, which was filed on April
3, 1998, and is incorporated herein by reference.
*10(ai) Letter Agreement, dated February 2, 1995, between Green
Spring Health Services, Inc. and Clarissa C. Marques, Senior
Vice President of Green Spring Health Services, Inc., which
was filed as Exhibit 10 (bb) to the Company's Registration
Statement on Form S-4, which was filed on April 3, 1998, and
is incorporated herein by reference.
*10(aj) Employment Agreement, dated February 11, 1999, between the
Company and Clarissa C. Marques, Ph.D., Executive Vice
President of the Company, which was filed as Exhibit 10(c)
to the Company's Quarterly Report on Form 10-Q for the
quarterly period ended March 31, 1999 and is incorporated
herein by reference.
*10(ak) Employment Agreement, dated June 25, 1998, between the
Company and Henry T. Harbin, M.D., President, Chief
Executive Officer of the Company, which was filed as exhibit
10(a) to the Company's quarterly report on Form 10-Q for the
quarterly period ended June 30, 1998 and is incorporated
herein by reference.
10(al) Offer to Purchase and Consent Solicitation Statement, dated
January 12, 1998, by the Company for all of its 11 1/4%
Series A Senior Subordinated Notes due 2008, which was filed
as Exhibit 10(ad) to the Company's Registration Statement on
Form S-4, which was filed on April 3, 1998, and is
incorporated herein by reference.
10(am) Offer to Purchase and Consent Solicitation Statement, dated
January 12, 1998, by Merit Behavioral Care Corporation for
all of its 11 1/2% Senior Subordinated Notes due 2005, which
was filed as Exhibit 10(ad) to the Company's Registration
Statement on Form S-4, which was filed on April 3, 1998, and
is incorporated herein by reference.
10(an) Agreement and Plan of Merger by and among Merit Behavioral
Care Corporation, Merit Merger Corp., and CMG Health, Inc.
dated as of July 14, 1997, which was filed as Exhibit 10(ah)
to the Company's Annual Report on Form 10-K for the year
ended September 30, 1998 and is incorporated herein by
reference.
21 List of subsidiaries of the Company.
23 Consent of Arthur Andersen LLP.
27 Financial Data Schedule
- ------------------------
* Constitutes a management contract or compensatory plan arrangement.
54
(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 September 30,
1999.
FINANCIAL
STATEMENT
DATE OF REPORT ITEM REPORTED AND DESCRIPTION FILED
--------------------- ----------------------------------------------------------- ---------
July 19, 1999 Item 5. Other Events--TPG Investment No
September 24, 1999 Item 2. Disposition of Assets--CBHS Transactions Yes(1)
- ------------------------
(1) Unaudited Pro Forma Consolidated Balance Sheet at June 30, 1999;
Unaudited Pro Forma Consolidated Statement of Operations for fiscal 1996,
1997 and 1998 and for the nine months ended June 30, 1998 and 1999.
(C) EXHIBITS REQUIRED BY ITEM 601 OF REGULATION S-K:
Exhibits required to be filed by the Company pursuant to Item 601 of
Regulation S-K are contained in a separate volume.
(D) FINANCIAL STATEMENT AND SCHEDULES REQUIRED BY REGULATION S-X:
Information with respect to this item is contained on page S-1 of this
Annual Report on Form 10-K.
55
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned thereunto duly authorized.
MAGELLAN HEALTH SERVICES, INC.
(Registrant)
Date: December 23, 1999 /S/ CLIFFORD W. DONNELLY
------------------------------------------------
Clifford W. Donnelly
Executive Vice President and
Chief Financial Officer
Date: December 23, 1999 /S/ THOMAS C. HOFMEISTER
------------------------------------------------
Thomas C. Hofmeister
Senior Vice President and Chief Accounting
Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ HENRY T. HARBIN President, Chief Executive
------------------------------------------- Officer and Director December 23, 1999
Henry T. Harbin
/s/ DAVID BONDERMAN Director
------------------------------------------- December 23, 1999
David Bonderman
/s/ JONATHAN J. COSLET Director
------------------------------------------- December 23, 1999
Jonathan J. Coslet
/s/ G. FRED DIBONA, JR. Director
------------------------------------------- December 23, 1999
G. Fred DiBona, Jr.
/s/ ANDRE C. DIMITRIADIS Director
------------------------------------------- December 23, 1999
Andre C. Dimitriadis
/s/ A.D. FRAZIER, JR. Director
------------------------------------------- December 23, 1999
A.D. Frazier, Jr.
/s/ GERALD L. MCMANIS Director
------------------------------------------- December 23, 1999
Gerald L. McManis
56
SIGNATURE TITLE DATE
--------- ----- ----
/s/ DANIEL S. MESSINA Director
------------------------------------------- December 23, 1999
Daniel S. Messina
/s/ ROBERT W. MILLER Chairman of the Board of
------------------------------------------- Directors December 23, 1999
Robert W. Miller
/s/ DARLA D. MOORE Director
------------------------------------------- December 23, 1999
Darla D. Moore
/s/ JEFFREY A. SONNENFELD Director
------------------------------------------- December 23, 1999
Jeffrey A. Sonnenfeld
/s/ JAMES B. WILLIAMS Director
------------------------------------------- December 23, 1999
James B. Williams
57
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS
The following consolidated financial statements of the registrant and its
subsidiaries are submitted herewith in response to Item 8 and Item 14(a)1:
PAGE
--------
MAGELLAN HEALTH SERVICES, INC.
Audited Consolidated Financial Statements
Report of independent public accountants................ F-2
Consolidated balance sheets as of September 30, 1998 and
1999................................................... F-3
Consolidated statements of operations for the fiscal
years ended September 30, 1997, 1998 and 1999.......... F-4
Consolidated statements of changes in stockholders'
equity for the fiscal years ended September 30, 1997,
1998 and 1999.......................................... F-5
Consolidated statements of cash flows for the fiscal
years ended September 30, 1997, 1998 and 1999.......... F-6
Notes to consolidated financial statements.............. F-7
The following financial statement schedule of the registrant and its
subsidiaries is submitted herewith in response to Item 14(a)2:
PAGE
--------
Schedule II--Valuation and qualifying accounts.......... S-1
Financial statements in response to Item 14 (d)(1):
CHOICE BEHAVIORAL HEALTH PARTNERSHIP
The audited consolidated financial statements of Choice Behavioral Health
Partnership ("Choice") will be filed in an amendment to this Form 10-K no later
than March 30, 2000. Choice's fiscal year end is December 31, 1999.
F-1
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors of Magellan Health Services, Inc:
We have audited the accompanying consolidated balance sheets of Magellan
Health Services, Inc. (a Delaware corporation) and subsidiaries as of
September 30, 1998 and 1999, and the related consolidated statements of
operations, changes in stockholders' equity and cash flows for each of the three
years in the period ended September 30, 1999. These consolidated financial
statements and the schedule referred to below are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Magellan Health Services,
Inc. and subsidiaries as of September 30, 1998 and 1999 and the results of their
operations and their cash flows for each of the three years in the period ended
September 30, 1999 in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedule listed in the index to
financial statements is presented for purposes of complying with the Securities
and Exchange Commission's rules and is not part of the basic financial
statements. This schedule has been subjected to the auditing procedures applied
in the audits of the basic financial statements and, in our opinion, fairly
states, in all material respects, the financial data required to be set forth
therein in relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Baltimore, Maryland
November 30, 1999 (except
with respect to the
matter discussed in
Note 15, as to which the
date is December 15,
1999)
F-2
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
SEPTEMBER 30,
-----------------------
1998 1999
---------- ----------
ASSETS
Current Assets:
Cash, including cash equivalents of $14,185 at
September 30, 1998 and $10,147 at September 30, 1999 at
cost, which approximates market value.................. $ 92,050 $ 37,440
Accounts receivable, less allowance for doubtful
accounts of $34,867 at September 30, 1998 and $28,437
at September 30, 1999.................................. 174,846 198,646
Restricted cash and investments......................... 89,212 116,824
Refundable income taxes................................. 4,939 3,452
Other current assets.................................... 38,677 18,565
---------- ----------
Total Current Assets.................................. 399,724 374,927
Assets restricted for settlement of unpaid claims and other
long-term liabilities..................................... 37,910 --
Property and equipment, net................................. 177,169 120,667
Deferred income taxes....................................... 98,184 91,657
Investments in unconsolidated subsidiaries.................. 11,066 18,396
Other long-term assets...................................... 35,415 9,599
Goodwill, net of accumulated amortization of $32,785 at
September 30, 1998 and
$60,869 at September 30, 1999............................. 992,431 1,108,086
Other intangible assets, net of accumulated amortization of
$12,343 at September 30, 1998 and $26,457 at
September 30, 1999........................................ 165,189 158,283
---------- ----------
$1,917,088 $1,881,615
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable.......................................... $ 42,873 $ 44,425
Accrued liabilities....................................... 193,530 209,796
Medical claims payable.................................... 195,330 189,928
Current maturities of long-term debt and capital lease
obligations............................................. 23,033 30,119
---------- ----------
Total Current Liabilities........................... 454,766 474,268
Long-term debt and capital lease obligations................ 1,202,613 1,114,189
Reserve for unpaid claims................................... 30,280 --
Deferred credits and other long-term liabilities............ 14,011 92,948
Minority interest........................................... 26,985 3,514
Commitments and Contingencies
Stockholders' Equity:
Preferred stock, without par value
Authorized--10,000 shares
Issued and outstanding--none............................ -- --
Common stock, par value $.25 per share
Authorized--80,000 shares
Issued and outstanding--33,898 shares at September 30,
1998 and 34,268 shares at September 30, 1999............ 8,476 8,566
Other Stockholders' Equity:
Additional paid-in capital.............................. 349,651 352,030
Accumulated deficit..................................... (149,238) (144,550)
Warrants outstanding.................................... 25,050 25,050
Common stock in treasury, 2,289 shares at September 30,
1998 and September 30, 1999............................ (44,309) (44,309)
Cumulative foreign currency adjustments included in
other comprehensive income............................. (1,197) (91)
---------- ----------
Total Stockholders' Equity.......................... 188,433 196,696
---------- ----------
$1,917,088 $1,881,615
========== ==========
The accompanying Notes to Consolidated Financial Statements
are an integral part of these balance sheets.
F-3
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
FISCAL YEAR ENDED SEPTEMBER 30,
----------------------------------
1997 1998 1999
-------- ---------- ----------
Net revenue................................................. $463,872 $1,310,778 $1,871,636
-------- ---------- ----------
Costs and expenses:
Salaries, cost of care and other operating expenses....... 438,472 1,183,626 1,663,626
Equity in (earnings) losses of unconsolidated
subsidiaries.............................................. 5,567 (12,795) (20,442)
Depreciation and amortization............................. 19,683 49,264 73,531
Interest, net............................................. 46,438 76,505 93,752
Stock option expense (credit)............................. 4,292 (5,623) 18
Managed care integration costs............................ -- 16,962 6,238
Special charges........................................... -- -- 4,441
-------- ---------- ----------
514,452 1,307,939 1,821,164
-------- ---------- ----------
Income (loss) from continuing operations before income
taxes, minority interest and extraordinary items.......... (50,580) 2,839 50,472
Provision for (benefit from) income taxes................... (20,232) 5,544 27,376
-------- ---------- ----------
Income (loss) from continuing operations before minority
interest and extraordinary items.......................... (30,348) (2,705) 23,096
Minority interest........................................... 6,856 4,094 630
-------- ---------- ----------
Income (loss) from continuing operations before
extraordinary items....................................... (37,204) (6,799) 22,466
Discontinued operations:
Income from discontinued operations(1).................... 41,959 20,531 29,645
Loss on disposal of discontinued operations, net of income
tax benefit of $31,616.................................. -- -- (47,423)
-------- ---------- ----------
41,959 20,531 (17,778)
-------- ---------- ----------
Income before extraordinary items........................... 4,755 13,732 4,688
Extraordinary items--net losses on early extinguishments of
debt (net of income tax benefit of $3,503 in 1997 and
$22,010 in 1998).......................................... (5,253) (33,015) --
-------- ---------- ----------
Net income (loss)........................................... $ (498) $ (19,283) $ 4,688
Other comprehensive income (loss)........................... (683) 675 1,106
-------- ---------- ----------
Comprehensive income (loss)................................. $ (1,181) $ (18,608) $ 5,794
======== ========== ==========
Weighted average number of common shares
outstanding--basic........................................ 28,781 30,784 31,758
======== ========== ==========
Weighted average number of common shares
outstanding--diluted...................................... 28,781 30,784 31,916
======== ========== ==========
Income (loss) per common share--basic:
Income (loss) from continuing operations before
extraordinary items....................................... $ (1.29) $ (0.22) $ 0.71
======== ========== ==========
Income (loss) from discontinued operations................ $ 1.46 $ 0.67 $ (0.56)
======== ========== ==========
Extraordinary losses on early extinguishments of debt..... $ (0.18) $ (1.07) $ --
======== ========== ==========
Net income (loss)........................................... $ (0.02) $ (0.63) $ 0.15
======== ========== ==========
Income (loss) per common share--diluted:
Income (loss) from continuing operations before
extraordinary items....................................... $ (1.29) $ (0.22) $ 0.70
======== ========== ==========
Income (loss) from discontinued operations................ $ 1.46 $ 0.67 $ (0.56)
======== ========== ==========
Extraordinary losses on early extinguishments of debt..... $ (0.18) $ (1.07) $ --
======== ========== ==========
Net income (loss)........................................... $ (0.02) $ (0.63) $ 0.15
======== ========== ==========
- ------------------------------
(1) Net of income tax provision of $27,973, $13,687 and $19,763, for fiscal
1997, 1998 and 1999, respectively.
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
F-4
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(IN THOUSANDS)
FISCAL YEAR ENDED SEPTEMBER 30,
---------------------------------
1997 1998 1999
--------- --------- ---------
Common Stock:
Balance, beginning of period.............................. $ 8,252 $ 8,361 $ 8,476
Exercise of options and warrants.......................... 109 115 90
--------- --------- ---------
Balance, end of period.................................... 8,361 8,476 8,566
--------- --------- ---------
Additional paid-in capital:
Balance, beginning of period.............................. 327,681 340,645 349,651
Stock option expense (credit)............................. 4,292 (5,623) 18
Exercise of options and warrants.......................... 8,156 3,867 2,542
Green Spring Minority Stockholder Conversion.............. -- 10,722 --
Other..................................................... 516 40 (181)
--------- --------- ---------
Balance, end of period.................................... 340,645 349,651 352,030
--------- --------- ---------
Accumulated deficit:
Balance, beginning of period.............................. (129,457) (129,955) (149,238)
Net income (loss)......................................... (498) (19,283) 4,688
--------- --------- ---------
Balance, end of period.................................... (129,955) (149,238) (144,550)
--------- --------- ---------
Warrants outstanding:
Balance, beginning of period.............................. 54 25,050 25,050
Exercise of warrants...................................... (4) -- --
Issuance of warrants to Crescent and COI.................. 25,000 -- --
--------- --------- ---------
Balance, end of period.................................... 25,050 25,050 25,050
--------- --------- ---------
Common stock in treasury:
Balance, beginning of period.............................. (82,731) (82,731) (44,309)
Purchases of treasury stock............................... -- (14,352) --
Green Spring Minority Stockholder Conversion.............. -- 52,774 --
--------- --------- ---------
Balance, end of period.................................... (82,731) (44,309) (44,309)
--------- --------- ---------
Cumulative foreign currency adjustments included in other
comprehensive income:
Balance, beginning of period.............................. (1,189) (1,872) (1,197)
Components of other comprehensive income (loss):
Unrealized foreign currency translation gain (loss) (net
of reclassification adjustment related to sale of
European Hospitals of $1,678 in 1999)................... (1,138) 1,125 (230)
Sale of European Hospitals................................ -- -- 2,074
--------- --------- ---------
(1,138) 1,125 1,844
Provision for (benefit from) income taxes................. (455) 450 738
--------- --------- ---------
Other comprehensive income (loss)......................... (683) 675 1,106
--------- --------- ---------
Balance, end of period.................................... (1,872) (1,197) (91)
--------- --------- ---------
Total Stockholders' Equity.................................. $ 159,498 $ 188,433 $ 196,696
========= ========= =========
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
F-5
MAGELLAN HEALTH SERVICES, INC. SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
FISCAL YEAR ENDED SEPTEMBER 30,
---------------------------------------------
1997 1998 1999
---- ---- ----
Cash Flows From Operating Activities
Net income (loss)......................................... $ (498) $ (19,283) $ 4,688
--------- ----------- ----------
Adjustments to reconcile net income (loss) to net cash
provided by
(used in) operating activities:
Loss (gain) on sale of assets....................... 54,121 (3,001) (23,623)
Loss on CBHS Transactions........................... -- -- 79,039
Depreciation and amortization....................... 19,683 49,264 73,531
Impairment of long-lived assets..................... -- 2,507 --
Other non-cash portion of special charges and
discontinued operations............................. 33,300 37,499 (422)
Equity in (earnings) losses of unconsolidated
subsidiaries........................................ 5,567 (12,795) (20,442)
Stock option expense (credit)....................... 4,292 (5,623) 18
Non-cash interest expense........................... 1,710 2,935 3,843
Extraordinary losses on early extinguishments of
debt................................................ 8,756 55,025 --
Cash flows from changes in assets and liabilities, net
of effects from sales and acquisitions of businesses:
Accounts receivable, net.............................. 60,675 (1,585) (21,321)
Restricted cash and investments....................... -- (21,782) (22,130)
Other current assets.................................. 4,708 (3,010) 6,182
Other long-term assets................................ (2,411) 4,955 2,577
Accounts payable and accrued liabilities.............. (68,715) (50,082) (20,842)
Medical claims payable................................ 8,056 6,358 (22,202)
Income taxes payable and deferred income taxes........ (14,669) (14,489) 14,143
Reserve for unpaid claims............................. (26,553) (19,177) (30,196)
Other liabilities..................................... (23,038) (9,290) 17,224
Minority interest, net of dividends paid.............. 9,633 (929) 3,142
Other................................................. (1,018) (1,701) (1,333)
--------- ----------- ----------
Total adjustments..................................... 74,097 15,079 37,188
--------- ----------- ----------
Net cash provided by (used in) operating
activities.......................................... 73,599 (4,204) 41,876
--------- ----------- ----------
Cash Flows From Investing Activities:
Capital expenditures...................................... (33,348) (44,213) (48,119)
Acquisitions and investments in businesses, net of cash
acquired................................................ (50,876) (1,046,436) (69,457)
Conversion of joint ventures from consolidation to equity
method.................................................. -- -- (21,092)
Distributions received from unconsolidated subsidiaries... -- 11,441 21,970
Decrease in assets restricted for settlement of unpaid
claims and other long-term liabilities.................. 17,209 51,006 42,570
Proceeds from sale of assets.............................. 398,695 11,875 54,196
--------- ----------- ----------
Net cash provided by (used in) investing
activities.......................................... 331,680 (1,016,327) (19,932)
--------- ----------- ----------
Cash Flows From Financing Activities:
Payments on debt and capital lease obligations............ (390,254) (438,633) (156,004)
Proceeds from issuance of debt, net of issuance costs..... 203,643 1,188,706 76,818
Proceeds from exercise of stock options and warrants...... 8,265 3,982 2,632
Proceeds from issuance of warrants........................ 25,000 -- --
Purchases of treasury stock............................... -- (14,352) --
--------- ----------- ----------
Net cash provided by (used in) financing
activities.......................................... (153,346) 739,703 (76,554)
--------- ----------- ----------
Net increase (decrease) in cash and cash equivalents........ 251,933 (280,828) (54,610)
Cash and cash equivalents at beginning of period............ 120,945 372,878 92,050
--------- ----------- ----------
Cash and cash equivalents at end of period.................. $ 372,878 $ 92,050 $ 37,440
========= =========== ==========
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements
F-6
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1999
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements of Magellan Health Services, Inc., a
Delaware corporation, ("Magellan" or the "Company") include the accounts of the
Company and its subsidiaries. All significant intercompany accounts and
transactions have been eliminated in consolidation.
The Company's primary business segment, as of September 30, 1999, was its
behavioral managed healthcare business. The Company operates in two other
business segments, which are described in further detail in Note 13, "Business
Segment Information."
On September 2, 1999, the Company's Board of Directors approved a formal
plan to dispose of the businesses and interests that comprise the Company's
healthcare provider and healthcare franchising business segments (the "Disposal
Plan"). The results of operations of the healthcare provider and healthcare
franchising business segments have been reported in the accompanying financial
statements as discontinued operations for all periods presented.
The preparation of financial statements in conformity with generally
accepted accounting principles 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.
MANAGED CARE REVENUE
Managed care revenue is recognized over the applicable coverage period on a
per member basis for covered members and as earned and estimable for
performance-based revenues. Deferred revenue is recorded when premium payments
are received in advance of the applicable coverage period.
ADVERTISING COSTS
The production costs of advertising are expensed as incurred. The Company
does not consider any of its advertising costs to be direct-response and,
accordingly, does not capitalize such costs. Advertising costs consist primarily
of radio and television air time, which is amortized as utilized, and printed
media services. Advertising expense for continuing operations was approximately
$0.7 million, $2.4 million and $2.4 million for the fiscal years ended
September 30, 1997, 1998 and 1999, respectively. Advertising expense for
discontinued operations was approximately $18.5 million, $2.3 million and
$0.2 million for the years ended September 30, 1997, 1998, and 1999,
respectively.
INTEREST, NET
The Company records interest expense net of interest income. Interest income
for the fiscal years ended September 30, 1997, 1998, and 1999 was approximately
$9.0 million, $10.8 million and $10.4 million, respectively.
CASH AND CASH EQUIVALENTS
Cash equivalents are short-term, highly liquid interest-bearing investments
with a maturity of three months or less when purchased, consisting primarily of
money market instruments.
F-7
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
RESTRICTED CASH AND INVESTMENTS
Restricted cash and investments at September 30, 1998 and 1999 include
approximately $89.2 million and $116.8 million, respectively that is held for
the payment of claims under the terms of certain behavioral managed care
contracts and for regulatory purposes related to the payment of claims in
certain jurisdictions.
CONCENTRATION OF CREDIT RISK
Accounts receivable subject the Company to a concentration of credit risk
with third party payors that include health insurance companies, managed
healthcare organizations, healthcare providers and governmental entities. The
Company establishes an allowance for doubtful accounts based upon factors
surrounding the credit risk of specific payors, historical trends and other
information. Management believes the allowance for doubtful accounts is adequate
to provide for normal credit losses.
ASSETS RESTRICTED FOR THE SETTLEMENT OF UNPAID CLAIMS AND OTHER LONG-TERM
LIABILITIES
Assets restricted for the settlement of unpaid claims and other long-term
liabilities include investments which are carried at fair market value. Transfer
of such investments from the Company's insurance subsidiaries to Magellan or any
of its other subsidiaries is subject to approval by certain regulatory
authorities. As of September 30, 1998 and 1999, assets restricted for settlement
of unpaid claims and other long-term liabilities were approximately $37.9
million and $0, respectively. On July 2, 1999, the Company transferred its
remaining unpaid claims portfolio to a third party insurer for approximately
$22.3 million. This transfer was funded from assets restricted for the
settlement of unpaid claims.
The investments can be classified into three categories: (i) held to
maturity; (ii) available for sale; and (iii) trading. Unrealized holding gains
or losses are recorded for trading and available for sale securities. The
Company's investments are classified as available for sale. The unrealized gain
or loss on investments available for sale was not material at September 30,
1997, 1998 and 1999.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost, except for assets that have been
impaired, for which the carrying amount is reduced to estimated fair value.
Expenditures for renewals and improvements are charged to the property accounts.
Replacements and maintenance and repairs that do not improve or extend the life
of the respective assets are expensed as incurred. Internal-use software is
capitalized in accordance with AICPA Statement of Position 98-1. Amortization of
capital lease assets is included in depreciation expense. Depreciation is
provided on a straight-line basis over the estimated useful lives of the assets,
which is generally ten to forty years for buildings and improvements, three to
ten years for equipment and three to five years for capitalized internal-use
software. Depreciation expense for continuing operations was $9.6 million,
$18.6 million and $30.0 million for the fiscal years ended September 30, 1997,
1998 and 1999, respectively. Depreciation expense for discontinued operations
was $24.5 million, $5.4 million and $2.3 million for the fiscal years ended
September 30, 1997, 1998 and 1999, respectively.
F-8
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Property and equipment, net, consisted of the following at September 30,
1998 and 1999 (in thousands):
SEPTEMBER 30,
-------------------
1998 1999
-------- --------
Land........................................................ $ 11,607 $ 114
Buildings and improvements.................................. 78,886 12,079
Equipment................................................... 112,422 119,518
Capitalized internal-use software........................... 33,923 55,648
-------- --------
236,838 187,359
Accumulated depreciation.................................... (60,100) (66,692)
-------- --------
176,738 120,667
Construction in progress.................................... 431 --
-------- --------
Property and equipment, net............................... $177,169 $120,667
======== ========
INTANGIBLE ASSETS
Intangible assets are composed principally of (i) goodwill, (ii) customer
lists and relationships and (iii) deferred financing costs. Goodwill represents
the excess of the cost of businesses acquired over the fair value of the net
identifiable assets at the date of acquisition and is amortized using the
straight-line method over 25 to 40 years. Customer lists and relationships and
other intangible assets are amortized using the straight-line method over their
estimated useful lives of 4 to 30 years. Deferred financing costs are amortized
over the terms of the underlying agreements.
The Company continually monitors events and changes in circumstances which
could indicate that carrying amounts of intangible assets may not be
recoverable. When events or changes in circumstances are present that indicate
the carrying amount of intangible assets may not be recoverable, the Company
assesses the recoverability of intangible assets by determining whether the
carrying value of such intangible assets will be recovered through the future
cash flows expected from the use of the asset and its eventual disposition.
Impairment losses from continuing operations of approximately $2.4 million were
recorded in fiscal 1998 as a result of the Integration Plan (see Note 9),
including property and equipment.
MEDICAL CLAIMS PAYABLE
Medical claims payable represent the liability for healthcare claims
reported but not yet paid and claims incurred but not yet reported ("IBNR")
related to the Company's managed healthcare businesses. The IBNR portion of
medical claims payable is estimated based upon authorized healthcare services,
past claim payment experience for member groups, adjudication decisions,
enrollment data, utilization statistics and other factors. Although considerable
variability is inherent in such estimates, management believes the liability for
medical claims payable is adequate. Medical claims payable balances are
continually monitored and reviewed. Changes in assumptions for care costs caused
by changes in actual experience could cause these estimates to change in the
near term.
F-9
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
FOREIGN CURRENCY
Changes in the cumulative translation of foreign currency assets and
liabilities are presented as a separate component of stockholders' equity. Gains
and losses resulting from foreign currency transactions, which were not
material, are included in operations as incurred.
NET INCOME (LOSS) PER COMMON SHARE
Net income (loss) per common share is computed based on the weighted average
number of shares of common stock and common stock equivalents outstanding during
the period.
The Exchange Option (as defined), was classified as a potentially dilutive
security for fiscal 1997 and 1998 for the purpose of computing diluted income
per common share. The Exchange Option (as defined) was anti-dilutive for fiscal
1997 and 1998 and, therefore, was excluded from the diluted income per common
share calculations. The Exchange Option (as defined) was exercised in January
1998.
STOCK-BASED COMPENSATION
In October 1995, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation," ("FAS 123") which became effective for fiscal years beginning
after December 15, 1995 (fiscal 1997 for the Company). FAS 123 established new
financial accounting and reporting standards for stock-based compensation plans.
Entities are allowed to measure compensation cost for stock-based compensation
under FAS 123 or APB Opinion No. 25, "Accounting for Stock Issued to Employees"
("APB 25"). Entities electing to remain with the accounting in APB 25 are
required to make pro forma disclosures of net income and income per common share
as if the provisions of FAS 123 had been applied. The Company has adopted
FAS 123 on a pro forma disclosure basis. The Company continues to account for
stock-based compensation under APB 25. See Note 6, "Stockholders' Equity".
RECENT ACCOUNTING PRONOUNCEMENTS
In April 1998, the AICPA issued Statement of Position 98-5, "Reporting on
the Costs of Start-up Activities" ("SOP 98-5"). SOP 98-5 requires all
nongovernmental entities to expense costs of start-up activities as those costs
are incurred. Start-up costs, as defined by SOP 98-5, include pre-operating
costs, pre-opening costs and organizational costs. SOP 98-5 became effective for
financial statements for fiscal years beginning after December 15, 1998. At
adoption, a company must record a cumulative effect of a change in accounting
principle to write off any unamortized start-up costs remaining on the balance
sheet when SOP 98-5 is adopted. Prior year financial statements cannot be
restated. The Company adopted SOP 98-5 on October 1, 1998. The adoption of SOP
98-5 did not have any impact on the Company's financial position or results of
operations.
Emerging Issues Task Force Issue 96-16, "Investor's Accounting for an
Investee When the Investor Has a Majority of the Voting Interest but the
Minority Shareholder or Shareholders Have Certain Approval or Veto Rights"
("EITF 96-16") supplements the guidance contained in AICPA Accounting Research
Bulletin 51, "Consolidated Financial Statements", and in Statement of Financial
Accounting Standards No. 94, "Consolidation of All Majority-Owned Subsidiaries"
("ARB 51/FAS 94"), about the conditions under which the Company's consolidated
financial statements should include the financial
F-10
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
position, results of operations and cash flows of subsidiaries which are less
than wholly-owned along with those of the Company's wholly-owned subsidiaries.
In general, ARB 51/FAS 94 requires consolidation of all majority-owned
subsidiaries except those for which control is temporary or does not rest with
the majority owner. Under the ARB 51/FAS 94 approach, instances of control not
resting with the majority owner were generally regarded to arise from such
events as the legal reorganization or bankruptcy of the majority-owned
subsidiary. EITF 96-16 expands the definition of instances in which control does
not rest with the majority owner to include those where significant approval or
veto rights, other than those which are merely protective of the minority
shareholder's interest, are held by the minority shareholder or shareholders
("Substantive Participating Rights"). Substantive Participating Rights include,
but are not limited to: i) selecting, terminating and setting the compensation
of management responsible for implementing the majority-owned subsidiary's
policies and procedures, and ii) establishing operating and capital decisions of
the majority-owned subsidiary, including budgets, in the ordinary course of
business.
The provisions of EITF 96-16 apply to new investment agreements made after
July 24, 1997, and to existing investment agreements which are modified after
this date. The Company has made no new investments, and has modified no existing
investments, to which the provisions of EITF 96-16 would have applied.
In addition, the provisions of EITF 96-16 must be applied to majority-owned
subsidiaries previously consolidated under ARB 51/FAS 94 for which the
underlying agreements have not been modified in financial statements issued for
years ending after December 15, 1998 (fiscal 1999 for the Company). The adoption
of the provisions of EITF 96-16 on October 1, 1998, had the following effects on
the Company's consolidated financial position:
OCTOBER 1,
1998
----------
INCREASE (DECREASE) IN:
Cash and cash equivalents.................................. $(21,092)
Other current assets...................................... (9,538)
Long-term assets.......................................... (30,049)
Investment in unconsolidated subsidiaries................. 26,498
--------
Total Assets............................................ $(34,181)
========
Current liabilities....................................... $(10,381)
Minority interest......................................... (23,800)
--------
Total Liabilities....................................... $(34,181)
========
RECLASSIFICATIONS
Certain reclassifications have been made to fiscal 1997 and 1998 amounts to
conform to fiscal 1999 presentation.
F-11
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
2. ACQUISITIONS AND JOINT VENTURES
ACQUISITIONS
MERIT ACQUISITION. On February 12, 1998, the Company consummated the
acquisition of Merit Behavioral Care Corporation ("Merit") for cash
consideration of approximately $448.9 million plus the repayment of Merit's
debt. Merit manages behavioral healthcare programs across all segments of the
healthcare industry, including HMOs, Blue Cross/Blue Shield organizations and
other insurance companies, corporations and labor unions, federal, state and
local governmental agencies and various state Medicaid programs. The Company
accounted for the Merit acquisition using the purchase method of accounting. On
September 12, 1997, Merit completed the acquisition of CMG Health, Inc. ("CMG").
CMG was also a national behavioral managed healthcare company. Merit paid
approximately $48.7 million in cash and issued approximately 739,000 shares of
Merit common stock as consideration for CMG. The former owners of CMG may be
entitled to additional consideration, depending on the performance of three CMG
customer contracts. Such contingent payments are subject to an aggregate maximum
of $23.5 million. No contingent consideration will be payable to the former
shareholders of CMG based on the performance of two of the three CMG customer
contracts at September 30, 1999. The Company may still be required to pay
contingent consideration to the former shareholders of CMG depending on the
financial performance of CHOICE Behavioral Health Partnership ("Choice"). Choice
is a joint venture with Value Options, Inc. that services a contract with
CHAMPUS (as defined). The Company and Value Options, Inc. each own 50% of
Choice. The payment of contingent consideration, if any, to the former
shareholders of CMG, depends on the financial performance of Choice from
October 1, 1996 to June 30, 1997, which is subject to a CHAMPUS Adjustment (as
defined) the Company expects to receive in fiscal 2000. The Company has
initiated legal proceedings against certain former owners of CMG with respect to
representations made by such former owners in conjunction with Merit's
acquisition of CMG. Whether any contingent payments will be made to the former
shareholders of CMG and the amount and timing of contingent payments, if any,
may be subject to the outcome of these proceedings.
In connection with the acquisition of Merit, the Company (i) terminated its
existing credit agreement; (ii) repaid all loans outstanding pursuant to Merit's
existing credit agreement; (iii) completed a tender offer for its 11.25% Series
A Senior Subordinated Notes due 2004 (the "Old Notes"); (iv) completed a tender
offer for Merit's 11.50% Senior Subordinated notes due 2005 (the "Merit
Outstanding Notes"); (v) entered into a new senior secured bank credit agreement
(the "Credit Agreement") providing for a revolving credit facility (the
"Revolving Facility") and a term loan facility (the "Term Loan Facility") of up
to $700 million; and (vi) issued $625 million in 9.0% Senior Subordinated Notes
due 2008 (the "Notes").
F-12
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
The following table sets forth the sources and uses of funds for the Merit
acquisition and related transactions (the "Transactions") at closing (in
thousands):
SOURCES:
Cash and cash equivalents................................... $ 59,290
Credit Agreement:
Revolving Facility (1).................................... 20,000
Term Loan Facility........................................ 550,000
The Notes................................................... 625,000
----------
Total sources........................................... $1,254,290
==========
USES:
Cash paid to Merit Shareholders............................. $ 448,867
Repayment of Merit existing credit agreement (2)............ 196,357
Purchase of the Old Notes (3)............................... 432,102
Purchase of Merit Outstanding Notes (4)..................... 121,651
Transaction costs (5)....................................... 55,313
----------
Total uses.............................................. $1,254,290
==========
- ------------------------
(1) The Revolving Facility provides for borrowings of up to $150.0 million.
(2) Includes principal amount of $193.7 million and accrued interest of $2.7
million.
(3) Includes principal amount of $375.0 million, tender premium of $43.4 million
and accrued interest of $13.7 million.
(4) Includes principal amount of $100.0 million, tender premium of $18.8 million
and accrued interest of $2.8 million.
(5) Transaction costs include, among other things, expenses associated with the
debt tender offers, the Notes offering, the Merit acquisition and the Credit
Agreement.
HAI ACQUISITION. On December 4, 1997, the Company consummated the purchase
of Human Affairs International, Incorporated ("HAI"), formerly a unit of Aetna,
Inc. ("Aetna"), for approximately $122.1 million, which the Company funded from
cash on hand. HAI manages behavioral healthcare programs, primarily through EAPs
and other behavioral managed healthcare plans. The Company may be required to
make additional contingent payments of up to $60.0 million annually to Aetna
over the five year period subsequent to closing. The amount and timing of the
payments will be contingent upon net increases in the number of HAI's covered
lives in specified products. The Company accounted for the HAI acquisition using
the purchase method of accounting.
The Company may be required to make additional contingent payments of up to
$300 million to Aetna (the "Contingent Payments") over the five-year period
(each year a "Contract Year") subsequent to closing. The amount and timing of
the Contingent Payments will depend upon HAI's receipt of additional covered
lives as computed, under two separate calculations. Under the first calculation,
the Company may be required to pay up to $25.0 million per year for each of five
years following the acquisition based on the net annual growth in the number of
lives covered in specified HAI products. Under the second calculation,
F-13
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
the Company may be required to pay up to $35.0 million per Contract Year, based
on the net cumulative increase in lives covered by certain other HAI products.
The Company is obligated to make contingent payments under two separate
calculations (as previously described) as follows: In respect of each Contract
Year, the Company may be required to pay to Aetna the "Tranche 1 Payments" (as
defined) and the "Tranche 2 Payments" (as defined).
Upon the expiration of each Contract Year, the Tranche 1 Payment shall vest
with respect to such Contract Year in an amount equal to the product of (i) the
Tranche 1 Cumulative Incremental Members (as defined) for such Contract Year and
(ii) the Tranche 1 Multiplier (as defined) for such Contract Year. The vested
amount of Tranche 1 Payment shall be zero with respect to any Contract Year in
which the Tranche 1 Cumulative Incremental Members is a negative number.
Furthermore, in the event that the number of Tranche 1 Cumulative Incremental
Members with respect to any Contract Year is a negative number due to a decrease
in the number of Tranche 1 Cumulative Incremental Members for such Contract Year
(as compared to the immediately preceding Contract Year), Aetna will forfeit the
right to receive a certain portion (which may be none or all) of the vested and
unpaid amounts of the Tranche 1 Payment relating to preceding Contract Years.
"Tranche 1 Cumulative Incremental Members" means, with respect to any
Contract Year, (i) the number of Equivalent Members (as defined) serviced by the
Company during such Contract Year for Tranche 1 Members, minus (ii)(A) for each
Contract Year other than the Initial Contract Year, the number of Equivalent
Members serviced by the Company for Tranche 1 Members during the immediately
preceding Contract Year or (B) for the Initial Contract Year, the number of
Tranche 1 Members as of September 30, 1997, subject to certain upward
adjustments. There were 3,761,253 Tranche 1 Members for the initial Contract
Year, prior to such upward adjustments. "Tranche 1 Members" are members of
managed behavioral healthcare plans for whom the Company provides services in
any of specified categories of products or services. "Equivalent Members" for
any Contract Year equals the aggregate Member Months for which the Company
provides services to a designated category or categories of members during the
applicable Contract Year divided by 12. "Member Months" means, for each member,
the number of months for which the Company provides services and is compensated.
The "Tranche 1 Multiplier" is $80, $50, $40, $25, and $20 for the Contract Years
1998, 1999, 2000, 2001, and 2002, respectively.
For each Contract Year, the Company is obligated to pay to Aetna the lesser
of (i) the vested portion of the Tranche 1 Payment for such Contract Year and
the vested and unpaid amount relating to prior Contract Years as of the end of
the immediately preceding Contract Year and (ii) $25.0 million. To the extent
that the vested and unpaid portion of the Tranche 1 Payment exceeds
$25.0 million, the Tranche 1 Payment remitted to Aetna shall be deemed to have
been paid first from any vested but unpaid amounts from previous Contract Years
in order from the earliest Contract Year for which vested amounts remain unpaid
to the most recent Contract Year at the time of such calculation. Except with
respect to the Contract Year ending in 2002, any vested but unpaid portion of
the Tranche 1 Payment shall be available for payment to Aetna in future Contract
Years, subject to certain exceptions. All vested but unpaid amounts of Tranche 1
Payments shall expire following the payment of the Tranche 1 Payment in respect
to the Contract Year ending in 2002, subject to certain exceptions. In no event
shall the aggregate Tranche 1 Payments to Aetna exceed $125.0 million.
F-14
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
Upon the expiration of each Contract Year, the Tranche 2 Payment shall be an
amount equal to the lesser of: (a)(i) the product of (A) the Tranche 2
Cumulative Members (as defined) for such Contract Year and (B) the Tranche 2
Multiplier (as defined) applicable to such number of Tranche 2 Cumulative
Members, minus (ii) the aggregate of the Tranche 2 Payments paid to Aetna for
all previous Contract Years and (b) $35.0 million. The amount shall be zero with
respect to any Contract Year in which the Tranche 2 Cumulative Members is a
negative number.
"Tranche 2 Cumulative Members" means, with respect to any Contract Year; (i)
the Equivalent Members serviced by the Company during such Contract Year for
Tranche 2 Members, minus (ii) the Tranche 2 Members as of September 30, 1997,
subject to certain upward adjustments. There were 936,391 Tranche 2 Members
prior to such upward adjustments. "Tranche 2 Members" means Members for whom the
Company provides products or services in the HMO category. The "Tranche 2
Multiplier" with respect to each Contract Year is $85 in the event that the
Tranche 2 Cumulative Members are less than 2,100,000, and $70 if more than or
equal to 2,100,000.
For each Contract Year, the Company shall pay to Aetna the amount of Tranche
2 Payment payable for such Contract Year. All rights to receive Tranche 2
Payment shall expire following the payment of the Tranche 2 Payment in respect
to the Contract Year ending in 2002, subject to certain exceptions.
Notwithstanding anything herein to the contrary, in no event shall the aggregate
Tranche 2 payment to Aetna exceed $175.0 million, subject to certain exceptions.
The Company paid $60.0 million to Aetna on March 26, 1999 for both the full
Tranche 1 Payment and the full Tranche 2 Payment for the Contract Year ended
December 31, 1998. Also, based upon the most recent membership enrollment data
related to the Contract Year to end December 31, 1999 ("Contract Year 2"), the
Company believes beyond a reasonable doubt that it will be required to make both
the full Tranche 1 Payment and the full Tranche 2 Payment ($60.0 million in
aggregate) related to Contract Year 2. Accordingly, the Company recorded
$120.0 million of goodwill and other intangible assets related to the purchase
of HAI during fiscal 1999. The Contract Year 2 liability of $60.0 million is
included in "Deferred credits and other long-term liabilities" in the Company's
consolidated balance sheet as of September 30, 1999. The Company intends to
borrow under the Revolving Facility to meet this obligation, which is expected
to be paid during the second quarter of fiscal 2000.
The Company would record additional contingent consideration payable, if
any, as goodwill and identifiable intangible assets.
ALLIED ACQUISITION. On December 5, 1997, the Company purchased the assets of
Allied Health Group, Inc. and certain affiliates ("Allied"). Allied provides
specialty managed care services, including risk-based products and
administrative services to a variety of insurance companies and other customers.
Allied has over 80 physician networks across the eastern United States. Allied's
networks include physicians specializing in cardiology, oncology and diabetes.
The Company paid approximately $70.0 million for Allied, with cash on hand, of
which $50.0 million was paid to the seller at closing with the remaining
$20.0 million placed in escrow. The Company accounted for the Allied acquisition
using the purchase method of accounting. The escrowed amount was payable in
one-third increments if Allied achieved specified earnings targets during each
of the three years following the closing. Additionally, the purchase price could
have been increased during the three year period by up to $40.0 million if
Allied's performance exceeded specified earnings targets.
F-15
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
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 following changes to the
original terms of the Allied purchase agreement:
- The original $20.0 million placed in escrow by the Company at the
consummation of the Allied acquisition, plus accrued interest, was repaid
to the Company. This $20.0 million was included in the $70.0 million
originally paid for Allied.
- The Company paid the former owners of Allied $4.5 million additional
consideration which was recorded as goodwill.
- The Company capped future obligations with respect to additional
contingent payments for the purchase of Allied at $3.0 million. The
earnings targets which must be met by Allied for this amount to be paid
were increased.
The Company would record contingent consideration payable, if any, as
additional goodwill.
The following unaudited pro forma information for the fiscal years ended
September 30, 1998 and 1999 has been prepared assuming the Allied acquisition,
HAI acquisition, Merit acquisition, the Transactions, the Green Spring Minority
Stockholder Conversion (as defined), the Europe Sale (as defined) and the CBHS
Transactions (as defined), were consummated on October 1, 1997. The unaudited
pro forma information does not purport to be indicative of the results that
would have actually been obtained had such transactions been consummated on
October 1, 1997 or which may be attained in future periods (in thousands, except
per share data):
PRO FORMA
FOR THE FISCAL YEAR ENDED
-----------------------------
SEPTEMBER 30, SEPTEMBER 30,
1998 1999
------------- -------------
Net revenue................................................. $1,609,770 $1,871,636
Income (loss) from continuing operations before
extraordinary item(1)(2)................................... (1,152) 28,924
Income (loss) per common share--basic:
Income (loss) from continuing operations before
extraordinary item...................................... (0.04) 0.91
Income (loss) per common share--diluted:
Income (loss) from continuing operations before
extraordinary item...................................... (0.04) 0.91
- ------------------------
(1) Excludes expected unrealized cost savings related to the Integration Plan
(as defined) and managed care integration costs (See Note 9).
(2) Excludes the extraordinary losses on early extinguishment of debt for the
year ended September 30, 1998, that were directly attributable to the
consummation of the Transactions.
HUMAN SERVICES ACQUISITIONS During fiscal 1998 and 1999, the Company
acquired eight businesses, in aggregate, in its human services segment for an
initial aggregate purchase price of approximately $60 million (collectively, the
"Human Services Acquisitions"). The Human Services Acquisitions were accounted
for using the purchase method of accounting. The Human Services Acquisitions
provide various residential and day services for individuals with acquired brain
injuries and for individuals with mental retardation and developmental
disabilities.
F-16
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
GREEN SPRING ACQUISITION. On December 13, 1995, the Company acquired a 51%
ownership interest in Green Spring Health Services, Inc. ("Green Spring") for
approximately $68.9 million in cash, the issuance of 215,458 shares of common
stock valued at approximately $4.3 million and the contribution of Group
Practice Affiliates, Inc. ("GPA"), a wholly-owned subsidiary of the Company,
which became a wholly-owned subsidiary of Green Spring. In addition, the
minority stockholders of Green Spring were issued an option agreement whereby
they could exchange their interests in Green Spring for an equivalent of the
Company's common stock or subordinated notes (the "Exchange Option"). On
December 20, 1995, the Company acquired an additional 10% ownership interest in
Green Spring for approximately $16.7 million in cash as a result of an exercise
by a minority stockholder of its Exchange Option. In January 1998, the minority
stockholders of Green Spring converted their collective 39% interest in Green
Spring into an aggregate of 2,831,516 shares of the Company's common stock
through exercise of the Exchange Option (the "Green Spring Minority Stockholder
Conversion"). As a result of the Green Spring Minority Stockholder Conversion,
the Company owns 100% of Green Spring. The Company issued shares from treasury
to effect the Green Spring Minority Stockholder Conversion and accounted for it
as a purchase of minority interest at a fair value of consideration paid of
approximately $63.5 million.
The Company recorded the investments in Green Spring using the purchase
method of accounting. Green Spring's results of operations have been included in
the Company's consolidated financial statements since the acquisition date, less
minority interest through January, 1998, at which time the Company became the
sole owner of Green Spring.
At each reporting date through January 1998, the Company assessed the fair
value of the Exchange Option in relation to the redemption price available to
the minority stockholders. In any period that the fair value of the Exchange
Option was determined to be less than the redemption price, the difference would
have been recognized as an adjustment to minority interest. No losses were
recorded in fiscal 1997 and 1998 as a result of changes in the fair value of the
Exchange Option.
JOINT VENTURES
Through its acquisition of Merit, the Company became a 50% partner with
Value Options, Inc. in Choice, a managed behavioral healthcare company. Choice
derives all of its revenues from a contract with the Civilian Health and Medical
Program of the Uniformed Services ("CHAMPUS"), and with TriCare, the successor
to CHAMPUS. The Company accounts for its investment in Choice using the equity
method.
F-17
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
A summary of unaudited financial information for the Company's investment in
Choice is as follows (in thousands):
SEPTEMBER 30, 1998 SEPTEMBER 30, 1999
------------------ ------------------
Current assets.............................. $22,974 $19,572
Property and equipment, net................. 345 228
------- -------
Total assets.............................. $23,319 $19,800
======= =======
Current liabilities......................... $16,829 $12,673
Partners' capital........................... 6,490 7,127
------- -------
Total liabilities and partners' capital..... $23,319 $19,800
======= =======
Magellan investment in Choice............... $ 3,245 $ 3,563
======= =======
FOR THE 231 DAYS
ENDED FISCAL YEAR ENDED
SEPTEMBER 30, 1998 SEPTEMBER 30, 1999
------------------- -------------------
Net revenue................................. $38,676 $54,880
Operating expenses.......................... 22,914 28,124
------- -------
Net income................................ $15,762 $26,756
======= =======
Magellan equity income...................... $ 7,881 $13,378
======= =======
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, 1998 and 1999 was $5.8 million and $12.2 million,
respectively. The Company's equity in income (loss) of Premier for fiscal 1997,
1998 and 1999 was $(5.6) million, $4.7 million and $6.3 million, respectively.
3. DISCONTINUED OPERATIONS
GENERAL
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 Real Estate Equities ("Crescent"), Crescent Operating, Inc. ("COI") and
Charter Behavioral Health Systems, LLC ("CBHS") that effects the Company's exit
from its healthcare provider and healthcare franchising businesses (the "CBHS
Transactions"). The terms of the CBHS Transactions are summarized as follows:
HEALTHCARE PROVIDER INTERESTS
- The Company redeemed 80% of its CBHS common interest and all of its CBHS
preferred interest, leaving it with a 10% non-voting common interest in
CBHS.
- The Company agreed to transfer to CBHS its interests in five of its six
hospital-based joint ventures ("Provider JVs") and related real estate as
soon as practicable.
F-18
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
3. DISCONTINUED OPERATIONS (CONTINUED)
- The Company transferred to CBHS the right to receive approximately
$7.1 million from Crescent for the sale of two psychiatric hospitals that
were acquired by the Company (and leased to CBHS) in connection with CBHS'
acquisition of certain businesses from Ramsay Healthcare, Inc. in fiscal
1998.
- The Company forgave receivables due from CBHS of approximately
$3.3 million for payments received by CBHS for patient services prior to
the formation of CBHS on June 17, 1997. The receivables related primarily
to patient stays that "straddled" the formation date of CBHS.
- The Company will pay $2.0 million to CBHS in 12 equal monthly installments
beginning on the first anniversary of the closing date.
- CBHS will indemnify the Company for 20% of up to the first $50 million
(i.e., $10 million) for expenses, liabilities and settlements related to
government investigations for events that occurred prior to June 17, 1997
(the "CBHS Indemnification"). CBHS will be required to pay the Company a
maximum of $500,000 per year under the CBHS Indemnification.
- Crescent, COI, CBHS and Magellan have provided each other with mutual
releases of claims among all of the parties with respect to the original
transactions that effected the formation of CBHS and the operation of CBHS
since June 17, 1997 with certain specified exceptions.
- The Company transfered certain other real estate and interests related to
the healthcare provider business to CBHS.
HEALTHCARE FRANCHISING INTERESTS
- The Company transferred its healthcare franchising interests to CBHS,
which included Charter Advantage, LLC, the Charter call center operation,
the Charter name and related intellectual property. The Company has been
released from performing any further franchise services or incurring
future franchising expenses.
- The Company forgave prepaid call center management fees of approximately
$2.7 million.
- The Company forgave unpaid franchise fees of approximately $115 million.
The CBHS Transactions, together with the formal plan of disposal authorized
by the Company's Board of Directors on September 2, 1999, represents the
disposal of the Company's healthcare provider and healthcare franchising
business 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 Company recorded an after-tax loss on disposal of its
healthcare provider and healthcare franchising business segments of
approximately $47.4 million, (primarily non-cash) in the fourth quarter of
fiscal 1999. The Company expects to transfer the Provider JVs and related real
estate to CBHS and to sell its remaining joint venture interest and related real
estate by no later than August 31, 2000.
F-19
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
3. DISCONTINUED OPERATIONS (CONTINUED)
The summarized results of the operations of the healthcare provider and
healthcare franchising segments are as follows (in thousands):
FISCAL YEARS ENDED SEPTEMBER 30
---------------------------------
HEALTHCARE PROVIDER 1997 1998 1999
- ------------------------------------------------------------ -------- -------- --------
Net revenue(1).............................................. $729,652 $133,256 $ 74,860
-------- -------- --------
Salaries, cost of care and other operating expenses......... 582,609 106,760 53,952
Equity in earnings of unconsolidated subsidiaries........... -- -- (2,901)
Depreciation and amortization............................... 25,018 5,266 2,141
Interest income(2).......................................... (1,060) (1,130) (76)
Special charges(income), net................................ 60,225 135 (33,046)
Other expenses(3)........................................... 27,390 10,093 21,907
-------- -------- --------
Net income.................................................. $ 35,470 $ 12,132 $ 32,883
======== ======== ========
HEALTHCARE FRANCHISING
- ------------------------------------------------------------
Net revenue................................................. $ 22,739 $ 55,625 $ 563
-------- -------- --------
Salaries, cost of care and other operating expenses......... 3,643 9,072 5,623
Equity in loss of CBHS...................................... 8,122 31,878 --
Depreciation and amortization............................... 160 355 337
Special charges............................................. -- 323 --
Other expenses(3)........................................... 4,325 5,598 (2,159)
-------- -------- --------
Net income (loss)........................................... $ 6,489 $ 8,399 $ (3,238)
======== ======== ========
DISCONTINUED OPERATIONS--COMBINED
- ------------------------------------------------------------
Net revenue(1).............................................. $752,391 $188,881 $ 75,423
-------- -------- --------
Salaries, cost of care and other operating expenses......... 586,252 115,832 59,575
Equity in (earnings) losses of unconsolidated
subsidiaries.............................................. 8,122 31,878 (2,901)
Depreciation and amortization............................... 25,178 5,621 2,478
Interest income(2).......................................... (1,060) (1,130) (76)
Special charges (income), net............................... 60,225 458 (33,046)
Other expenses(3)........................................... 31,715 15,691 19,748
-------- -------- --------
Net income.................................................. $ 41,959 $ 20,531 $ 29,645
======== ======== ========
- ------------------------
(1) Includes $27.4 million, $7.0 million and $21.6 million in fiscal 1997, 1998
and 1999, respectively, related to the settlement and adjustment of
reimbursement issues related to prior periods ("Cost Report Settlements").
(2) Interest expense has not been allocated to discontinued operations.
(3) Includes income taxes and minority interest.
F-20
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
3. DISCONTINUED OPERATIONS (CONTINUED)
The summary of the loss on disposal of discontinued operations is as follows
(in thousands):
Basis in Provider JV's.................................. $ 44,598
Basis in Real Estate transferred to CBHS................ 13,969
Basis in Franchise and other operations................. 7,285
Working capital forgiveness............................. 5,565
Transaction costs and legal fees........................ 7,622
--------
Loss before income taxes................................ 79,039
Income tax benefit...................................... 31,616
--------
$ 47,423
========
Remaining assets and liabilities of the provider business at September 30,
1999 include, among other things, (i) net amounts receivable for Cost Report
Settlements of $16.2 million, (ii) hospital-based real estate of $7.0 million,
(iii) long-term debt of $6.4 million related to the hospital-based real estate
and (iv) reserve for discontinued operations of $11.4 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 11.
The following table provides a rollforward of liabilities resulting from the
CBHS Transactions (in thousands):
BALANCE BALANCE
SEPTEMBER 30, SEPTEMBER 30,
TYPE OF COST 1998 ADDITIONS PAYMENTS OTHER 1999
- ------------ ------------- --------- -------- -------- -------------
Transaction costs and legal fees.......... $ -- $ 7,622 $(69) $ -- $ 7,553
Provider JV working capital............... -- 2,931 -- 185 3,116
Other..................................... -- 755 -- -- 755
---- ------- ---- ---- -------
$ -- $11,308 $(69) $185 $11,424
==== ======= ==== ==== =======
CRESCENT TRANSACTIONS
On June 17, 1997, the Company consummated a series of transactions including
the sale of substantially all of its domestic hospital real estate and related
personal property (the "Psychiatric Hospital Facilities") to Crescent and the
sale of certain related assets to CBHS. In addition, CBHS was formed as a joint
venture to operate the domestic portion of the Company's provider business
segment. CBHS was initially owned equally by Magellan and COI. The Company
accounted for its 50% investment in CBHS under the equity method of accounting.
The Company received approximately $417.2 million in cash (before costs
estimated to be $16.0 million) and warrants in COI for the purchase of 2.5% of
COI's common stock at $18.32, which are exercisable over 12 years. The Company
also issued 1,283,311 warrants each to Crescent and COI (the "Crescent
Warrants") for the purchase of Magellan common stock at an exercise price of $30
per share.
F-21
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
3. DISCONTINUED OPERATIONS (CONTINUED)
In related agreements, (i) Crescent leased the hospital real estate and
related assets to CBHS for initial annual rent beginning at approximately $41.7
million with a 5% annual escalation clause compounded annually (the "Facilities
Lease") and (ii) CBHS was to pay Magellan approximately $78.3 million in annual
franchise fees, subject to increase, for the use of assets retained by Magellan
and for support in certain areas. The franchise fees to be paid by CBHS to the
Company were subordinated to the lease obligations in favor of Crescent. The
assets retained by Magellan included, but were not limited to, the "CHARTER"
name, intellectual property, protocols and procedures, clinical quality
management, operating processes and the "1-800-CHARTER" telephone call center.
Magellan provided CBHS ongoing support in areas including advertising and
marketing assistance, risk management services, outcomes monitoring, and
consultation on matters relating to reimbursement, government relations,
clinical strategies, regulatory matters, strategic planning and business
development.
The Company initially used approximately $200 million of the proceeds from
the Crescent Transactions to reduce its long-term debt, including borrowings
under its then existing credit agreement. In December 1997, the Company used the
remaining proceeds from the Crescent Transactions to acquire additional managed
healthcare businesses. See Note 2, "Acquisitions and Joint Ventures."
The Company recorded a loss before income taxes of approximately $59.9
million in fiscal 1997 as a result of the Crescent Transactions, which consisted
of the following (in thousands):
Accounts receivable collection fees......................... $21,400
Impairment losses on intangible assets...................... 14,408
Exit costs and construction obligation...................... 12,549
Loss on the sale of property and equipment.................. 11,511
-------
$59,868
=======
Accounts receivable collection fees represent the reduction in the net
realizable value of accounts receivable for estimated collection fees on
retained hospital-based receivables for CBHS pursuant to a contractual
obligation with CBHS, whereby CBHS received a fee equal to 5% of collections for
the first 120 days after consummation of the Crescent Transactions and estimated
bad debt agency fees of 40% for receivables collected subsequent to 120 days
after the consummation of the Crescent Transactions. The Company reduced the
accounts receivable collection fees reserve by $8.1 million during the fourth
quarter of fiscal 1999 as substantially all hospital-based receivables subject
to the collection fees had been collected at September 30, 1999.
INVESTMENT IN CBHS
The Company owned a 50% voting interest and 10% non-voting interest in CBHS
as of September 30, 1998 and 1999 respectively. The Company became a 50% owner
of CBHS upon consummation of the Crescent Transactions and reduced its ownership
interest to 10% as a result of the CBHS Transactions. The Company accounted for
its investment in CBHS using the equity method through September 10, 1999. The
Company's 10% investment in CBHS is valued at $0 at September 30, 1999.
HOSPITAL-BASED JOINT VENTURES. The Company was an owner in six and five
hospital-based joint ventures at September 30, 1998 and 1999, respectively. The
Company sold its interest in the Chicago, IL
F-22
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
3. DISCONTINUED OPERATIONS (CONTINUED)
joint venture to the minority owner in September 1999. Generally, each member of
the joint venture leased and/or contributed certain assets in each respective
market to the joint venture with the Company becoming the managing member.
On October 1, 1998, the Provider JVs, excluding Westwood/Pembroke, were
converted from consolidation to the equity method of accounting due to the
Company's implementation of the transition guidance set forth in EITF 96-16. See
Note 1, "Recent Accounting Pronouncements". A summary of the Provider JVs is as
follows:
OWNERSHIP
MARKET DATE PERCENTAGE MINORITY OWNER/S
------ ---- ---------- -----------------------------------
Chicago, IL (sold September June 1994 75% Naperville Health Ventures
1999).......................
Boston, MA.................... February 1995 97.5% Westwood/Pembroke Corp.,
Psychiatric Associates of Norfolk
County, Inc.
Albuquerque, NM............... May 1995 67% Columbia/HCA Healthcare Corporation
Raleigh, NC................... June 1995 50% Columbia/HCA Healthcare Corporation
Lafayette, LA................. October 1995 50% Columbia/HCA Healthcare Corporation
Anchorage, AK................. August 1996 57% Columbia/HCA Healthcare Corporation
The Provider JVs have been managed by CBHS for a fee equivalent to the
Company's portion of their earnings since June 17, 1997. The net proceeds from
the sale of the Chicago, IL joint venture were transferred to CBHS in September
1999.
SPECIAL CHARGES (INCOME)
GENERAL
The following table summarizes special charges (income) recorded during the
three years in the period ended September 30, 1999 in the Company's healthcare
provider and healthcare franchising businesses (in thousands):
FISCAL YEAR ENDED
SEPTEMBER 30,
------------------------------
1997 1998 1999
-------- -------- --------
Facility closures............................... $ 4,201 $ -- $ --
Gains on the sale of psychiatric hospitals,
net........................................... (5,388) (3,000) (24,974)
Loss on Crescent Transactions................... 59,868 -- (8,072)
Termination of CBHS sale transaction............ -- 3,458 --
Other........................................... 1,544 -- --
------- ------- --------
$60,225 $ 458 $(33,046)
======= ======= ========
F-23
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
3. DISCONTINUED OPERATIONS (CONTINUED)
FACILITY CLOSURES
During fiscal 1997, the Company consolidated, closed or sold three
psychiatric facilities and its one general hospital (the "Closed Facilities"),
respectively, exclusive of the Crescent Transactions. The three psychiatric
facilities closed in fiscal 1997 were sold as part of the Crescent Transactions.
The Company recorded charges of approximately $4.2 million related to
facility closures in fiscal 1997:
1997
--------
Severance and related benefits.............................. $2,976
Contract terminations and other............................. 1,225
------
$4,201
======
Approximately 700 employees were terminated at the facilities closed in
1997. The recorded amounts have been paid as of September 30, 1998.
GAINS ON SALE OF PSYCHIATRIC FACILITIES, NET AND OTHER
During fiscal 1997, 1998 and 1999, the Company recorded gains of
approximately $5.4 million, $3.0 million and $1.1 million, respectively, related
to the sales of psychiatric hospitals and other real estate. The Company also
recorded a charge of approximately $1.5 million during fiscal 1997 for costs
incurred related primarily to the expiration of its agreement to sell its three
European Hospitals.
EUROPEAN PSYCHIATRIC HOSPITALS. On April 9, 1999, the Company sold its
European psychiatric provider operations to Investment AB Bure of Sweden for
approximately $57.0 million (before transaction costs of approximately
$2.5 million) (the "Europe Sale"). The Europe Sale resulted in a non-recurring
gain of approximately $23.9 million before provision for income taxes which is
included in gain of sale of psychiatric hospitals.
The Company used approximately $38.2 million of the net proceeds from the
Europe Sale to make mandatory unscheduled principal payments on indebtedness
outstanding under the Term Loan Facility (as defined). The remaining proceeds
were used to reduce borrowings outstanding under the Revolving Facility (as
defined).
TERMINATION OF CBHS SALE TRANSACTION
On March 3, 1998, the Company and certain of its wholly owned subsidiaries
entered into definitive agreements with COI and CBHS pursuant to which the
Company would have, among other things, sold the Company's franchise operations,
certain domestic provider operations and certain other assets and operations. On
August 19, 1998, the Company announced that it had terminated discussions with
COI for the sale of its interest in CBHS.
F-24
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
3. DISCONTINUED OPERATIONS (CONTINUED)
In connection with the termination of the CBHS sale transaction, the Company
recorded a charge of approximately $3.5 million as follows (in thousands):
Severance(1)................................................ $ 488
Lease termination(1)........................................ 1,067
Impairment of long-lived assets............................. 153
Transaction costs and other................................. 1,750
------
$3,458
======
- ------------------------
(1) Relates to staffing reductions and lease terminations incurred in the
Company's franchising and outcomes monitoring subsidiaries.
4. BENEFIT PLANS
The Company currently has a defined contribution retirement plan (the
"401(k) Plan"), which is in the form of an amendment and restatement of the
Green Spring 401(k) Plan. Certain other 401(k) plans and assets, including the
Magellan 401(k) Plan, were merged into the Green Spring Plan effective
January 1, 1999. Employee participants can elect to voluntarily contribute up to
15% of their compensation to the 401(k) Plan. The Company makes contributions to
the 401(k) Plan based on employee compensation and contributions. Additionally,
the Company makes a discretionary contribution of 2% of each eligible employee's
compensation. The Company matches 50% of each employee's contribution up to 3%
of their compensation. The Company recognized $3.0 million of expense for the
year ended September 30, 1999 for the matching contribution to the 401(k) Plan.
The Company maintained a defined contribution plan (the "Magellan 401-K
Plan"). Participants could contribute up to 15% of their compensation to the
Magellan 401-K Plan. The Company made discretionary contributions of 2% of each
employee's compensation and matched 50% of each employee's contribution up to 3%
of their compensation. During the fiscal years ended September 30, 1997, 1998
and 1999, the Company made contributions of approximately $5.7 million,
$3.2 million and $1.2 million respectively, to the Magellan 401-K Plan.
Green Spring maintained a defined contribution plan (the "Green Spring 401-K
Plan"). Employee participants could elect to voluntarily contribute up to 6% or
12% of their compensation, depending upon each employee's compensation level, to
the Green Spring 401-K Plan. Green Spring matched up to 3% of each employee's
compensation. Employees vested in employer contributions over five years. During
the fiscal years ended September 30, 1997, 1998 and 1999 the Company contributed
approximately $1.3 million, $1.2 million and $2.9 million, respectively, to the
Green Spring 401-K Plan.
F-25
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
5. LONG-TERM DEBT, CAPITAL LEASE OBLIGATIONS AND OPERATING LEASES
Information with regard to the Company's long-term debt and capital lease
obligations at September 30, 1998 and 1999 is as follows (in thousands):
SEPTEMBER 30, SEPTEMBER 30,
1998 1999
------------- -------------
Credit Agreement:
Revolving Facility (7.63% at September 30, 1999)
due through 2004............................... $ 40,000 $ 20,000
Term Loan Facility (7.75% to 8.25% at
September 30, 1999) due through 2006........... 550,000 492,873
9.0% Senior Subordinated Notes due 2008............ 625,000 625,000
11.5% other notes payable through 2005............. 4,198 35
3.8% capital lease obligations due through 2014.... 6,448 6,400
---------- ----------
1,225,646 1,144,308
Less amounts due within one year................. 23,033 30,119
---------- ----------
$1,202,613 $1,114,189
========== ==========
The aggregate scheduled maturities of long-term debt and capital lease
obligations during the five fiscal years subsequent to September 30, 1999 are as
follows (in thousands): 2000--$30,119; 2001--$36,161; 2002--$45,922;
2003--$85,523 and 2004--$145,560.
The Notes, which are carried at cost, had a fair value of approximately $534
million at both September 30, 1998 and 1999, based on market quotes. The
Company's remaining debt is also carried at cost, which approximates fair market
value.
The Company recognized a net extraordinary loss from the early
extinguishment of debt of approximately $33.0 million, net of income tax
benefit, during fiscal 1998, to write off unamortized deferred financing costs
related to terminating the previous credit agreement and extinguishing the Old
Notes, to record the tender premium and related costs of extinguishing the Old
Notes and to record the gain on extinguishment of the Company's 7.5% Swiss
bonds. The Credit Agreement provides for a Term Loan Facility in an original
aggregate principal amount of $550 million, consisting of an approximately
$183.3 million Tranche A Term Loan (the "Tranche A Term Loan"), an approximately
$183.3 million Tranche B Term Loan (the "Tranche B Term Loan") and an
approximately $183.3 million Tranche C Term Loan (the "Tranche C Term Loan"),
and a Revolving Facility providing for revolving loans to the Company and the
"Subsidiary Borrowers" (as defined therein) and the issuance of letters of
credit for the account of the Company and the Subsidiary Borrowers in an
aggregate principal amount (including the aggregate stated amount of letters of
credit) of $150.0 million. Letters of credit outstanding were $17.6 million at
September 30, 1999.
The Tranche A Term Loan and the Revolving Facility mature on February 12,
2004. The Tranche B Term Loan matures on February 12, 2005 and the Tranche C
Term Loan matures on February 12, 2006. The Tranche A Term Loan amortizes in
installments in each fiscal year in amounts equal to $26.0 million in 2000,
$32.1 million in 2001, $41.8 million in 2002, $44.6 million in 2003 and
$10.5 million in 2004. The Tranche B Term Loan amortizes in installments in
amounts equal to $2.0 million in each of 2000 through 2002, $38.9 million in
2003, $96.2 million in 2004 and $27.7 million in 2005. The Tranche C Term Loan
F-26
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
5. LONG-TERM DEBT, CAPITAL LEASE OBLIGATIONS AND OPERATING LEASES (CONTINUED)
amortizes in installments in each fiscal year in amounts equal to $2.0 million
in each of 2000 through 2003, $38.9 million in 2004, $94.8 million in 2005 and
$27.1 million in 2006. In addition, the Credit Facilities are subject to
mandatory prepayment and reductions (to be applied first to the Term Loan
Facility) in an amount equal to (a) 75% of the net proceeds of certain offerings
of equity securities by the Company or any of its subsidiaries, (b) 100% of the
net proceeds of certain debt issues of the Company or any of its subsidiaries,
(c) 75% of the Company's excess cash flow, as defined, and (d) 100% of the net
proceeds of certain asset sales or other dispositions of property of the Company
and its subsidiaries, in each case subject to certain limited exceptions.
The Credit Agreement contains a number of covenants that, among other things
restrict the ability of the Company and its subsidiaries to dispose of assets,
incur additional indebtedness, incur or guarantee obligations, prepay other
indebtedness or amend other debt instruments (including the indenture for the
Notes (the "Indenture")), pay dividends, create liens on assets, make
investments, make loans or advances, redeem or repurchase common stock, make
acquisitions, engage in mergers or consolidations, change the business conducted
by the Company and its subsidiaries and make capital expenditures. In addition,
the Credit Agreement requires the Company to comply with specified financial
ratios and tests, including minimum coverage ratios, maximum leverage ratios,
maximum senior debt ratios and minimum "EBITDA" (as defined in the Credit
Agreement) and minimum net worth tests. As of September 30, 1999, the Company
was in compliance with its debt covenants.
At the Company's election, the interest rates per annum applicable to the
loans under the Credit Agreement are a fluctuating rate of interest measured by
reference to either (a) an adjusted London inter-bank offer rate ("LIBOR") plus
a borrowing margin or (b) an alternate base rate ("ABR") (equal to the higher of
the Chase Manhattan Bank's published prime rate or the Federal Funds effective
rate plus 1/2 of 1%) plus a borrowing margin. The borrowing margins applicable
to the Tranche A Term Loan and loans under the Revolving Facility are currently
1.25% for ABR loans and 2.25% for LIBOR loans, and are subject to reduction if
the Company's financial results satisfy certain leverage tests. The borrowing
margins applicable to the Tranche B Term Loan and the Tranche C Term Loan are
1.50% and 1.75%, respectively, for ABR loans and 2.50% and 2.75%, respectively,
for LIBOR loans, and are not subject to reduction. Amounts outstanding under the
credit facilities not paid when due bear interest at a default rate equal to
2.00% above the rates otherwise applicable to each of the loans under the Term
Loan Facility and the Revolving Facility.
The obligations of the Company and the Subsidiary Borrowers under the Credit
Agreement are unconditionally and irrevocably guaranteed by, subject to certain
exceptions, each wholly owned domestic subsidiary and, subject to certain
exceptions, each foreign subsidiary of the Company. In addition, the Revolving
Facility, the Term Loan Facility and the guarantees are secured by security
interests in and pledges of or liens on substantially all the material tangible
and intangible assets of the guarantors, subject to certain exceptions.
The Notes are general unsecured senior subordinated obligations of the
Company. The Notes are limited in aggregate principal amount to $625.0 million
and will mature on February 15, 2008. Interest on the Notes accrues at the rate
of 9.0% per annum and is payable semi-annually on each February 15 and
August 15, commencing on August 15, 1998. The Notes were originally issued as
unregistered securities and later exchanged for securities which were registered
with the Securities and Exchange Commission. Due to a delay in the registration
of the Notes to be exchanged, the Company was required to increase the
F-27
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
5. LONG-TERM DEBT, CAPITAL LEASE OBLIGATIONS AND OPERATING LEASES (CONTINUED)
interest rate on the Notes by 100 basis points per annum for the period from
July 13, 1998 through November 9, 1998, the date of issuance of the Notes to be
exchanged.
The Notes are redeemable at the option of the Company. The Notes may be
redeemed at the option of the Company, in whole or in part, at the redemption
prices (expressed as a percentage of the principal amount) set forth below, plus
accrued and unpaid interest, during the twelve-month period beginning on
February 15 of the years indicated below:
REDEMPTION
YEAR PRICES
---- ----------
2003............................................. 104.5%
2004............................................. 103.0%
2005............................................. 101.5%
2006 and thereafter.............................. 100.0%
In addition, at any time and from time to time prior to February 15, 2001,
the Company may, at its option, redeem up to 35% of the original aggregate
principal amount of the Notes at a redemption price (expressed as a percentage
of the principal amount) of 109%, plus accrued and unpaid interest with the net
cash proceeds of one or more equity offerings; provided that at least 65% of the
original aggregate principal amount of Notes remains outstanding immediately
after the occurrence of such redemption and that such redemption occurs within
60 days of the date of the closing of any such equity offering.
The Indenture limits, among other things: (i) the incurrence of additional
indebtedness by the Company and its restricted subsidiaries; (ii) the payment of
dividends on, and redemption or repurchase of, capital stock of the Company and
its restricted subsidiaries and the redemption of certain subordinated
obligations of the Company; (iii) certain other restricted payments, including
investments; (iv) sales of assets; (v) certain transactions with affiliates;
(vi) the creation of liens; and (vii) consolidations, mergers and transfers of
all or substantially all the Company's assets. The Indenture also prohibits
certain restrictions on distributions from restricted subsidiaries. However, all
such limitations and prohibitions are subject to certain qualifications and
exceptions.
The Company recorded extraordinary losses of approximately $5.3 million, net
of tax, during fiscal 1997 to write off unamortized deferred financing costs
related to its previous credit agreement and for costs related to paying off its
then existing variable rate secured notes.
F-28
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
The Company leases certain of its operating facilities. The leases, which
expire at various dates through 2008, generally require the Company to pay all
maintenance, property and tax insurance costs.
At September 30, 1999, aggregate amounts of future minimum payments under
operating leases were as follows: 2000--$34.5 million; 2001--$30.8 million;
2002--$26.7 million; 2003--$19.7 million; 2004--$11.1 million; subsequent to
2004--$15.2 million.
Rent expense for continuing operations was $10.3 million, $27.8 million and
$39.9 million, respectively for the years ended September 30, 1997, 1998 and
1999. Rent expense for discontinued operations was $8.9 million, $2.8 million
and $1.7 million, respectively for the fiscal years ended September 30, 1997,
1998 and 1999.
6. STOCKHOLDERS' EQUITY
Pursuant to the Company's Restated Certificate of Incorporation, the Company
is authorized to issue 80 million shares of common stock, $.25 par value per
share, and 10 million shares of preferred stock, without par value. No shares of
preferred stock have been issued as of September 30, 1999.
COMMON STOCK
The Company is prohibited from paying dividends on its common stock under
the terms of the Indenture and the Credit Agreement except under very limited
circumstances.
1992 STOCK OPTION PLAN
The 1992 Stock Option Plan provided for the issuance of approximately 3.4
million options to purchase shares of common stock. A summary of changes in
options outstanding and other related information is as follows:
FISCAL YEAR ENDED SEPTEMBER 30,
-----------------------------------
1997 1998 1999
------------ --------- --------
Balance, beginning of period............... 368,990 368,990 6,000
Canceled................................. -- -- (6,000)
Exercised................................ -- (362,990) --
------------ --------- -------
Balance, end of period..................... 368,990 6,000 --
============ ========= =======
Option prices, end of period............... $4.36-$22.75 $ 22.75 $ --
Price range of exercised options........... -- $ 4.36 $ --
Average exercise price..................... -- $ 4.36 $ --
The exercise price of certain options would have been reduced upon
termination of employment of a certain optionee without cause. The Company
recorded compensation expense for the difference between the exercise price of
these options and the fair value of the Company's common stock until the
measurement date was known. Such compensation expense was included in stock
option expense (credit) in the Company's statements of operations until such
options were exercised in August 1998.
F-29
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
6. STOCKHOLDERS' EQUITY (CONTINUED)
1994 STOCK OPTION PLAN
The 1994 Stock Option Plan (the "1994 Plan") provided for the issuance of
approximately 1.3 million options to purchase shares of common stock. Officers
and key employees of the Company are eligible to participate. The options have
an exercise price which approximates fair market value of the Common Stock at
the date of grant. A summary of changes in options outstanding and other related
information is as follows:
FISCAL YEAR ENDED SEPTEMBER 30,
--------------------------------------------------
1997 1998 1999
--------------- --------------- --------------
Balance, beginning of period.... 948,669 1,028,494 681,217
Granted....................... 341,166 -- --
Canceled...................... (87,498) (298,276) (152,057)
Exercised..................... (173,843) (49,001) (46,266)
--------------- --------------- --------------
Balance, end of period.......... 1,028,494 681,217 482,894
=============== =============== ==============
Option prices, end of period.... $15.687-$27.718 $15.687-$27.718 $8.406-$22.875
Price range of exercised
options..................... $15.687-$27.875 $16.125-$22.875 $ 8.406
Average exercise price........ $ 22.20 $ 19.903 $ 8.406
Options granted under the 1994 Plan are exercisable to the extent vested. An
option vests at the rate of 33 1/3% of the shares covered by the option on each
of the first three anniversary dates of the grant of the option if the optionee
is an employee of the Company on such dates. Options must be exercised no later
than ten years after the date of grant. As of September 30, 1999, 94.3% of the
options outstanding were vested.
1996 STOCK OPTION PLAN
The 1996 Stock Option Plan (the "1996 Plan") provides for the issuance of
1.75 million options to purchase shares of the Company's common stock. Options
must be granted on or before December 31, 1999. Officers and key employees of
the Company are eligible to participate. The options have an exercise price
which approximates fair market value of the common stock at the date of grant. A
summary of changes in options outstanding and other related information is as
follows:
FISCAL YEAR ENDED SEPTEMBER 30
--------------------------------------------------
1997 1998 1999
--------------- --------------- --------------
Balance, beginning of
period..................... 1,298,500 1,411,292 1,240,917
Granted.................... 310,667 50,000 548,803
Canceled................... (96,125) (42,000) (335,055)
Exercised.................. (101,750) (178,375) (2,000)
--------------- --------------- --------------
Balance, end of period....... 1,411,292 1,240,917 1,452,665
=============== =============== ==============
Option prices, end of
period..................... $ 15.75-$30.875 $ 15.75-$30.875 $4.188-$23.438
Price range of exercised
options.................... $18.125-$18.875 $ 15.75-$25.156 $ 8.406
Average exercise price....... $ 18.348 $ 18.568 $ 8.406
F-30
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
6. STOCKHOLDERS' EQUITY (CONTINUED)
Options granted under the 1996 Plan are exercisable to the extent vested. An
option vests at the rate of 25% of the shares covered by the option on each of
the four anniversary dates of the grant of the option if the optionee is an
employee of the Company on such dates. Options must be exercised no later than
November 30, 2005.
The 1996 Plan provides that the options granted thereunder, upon the
occurrence of certain events, vest and become fully exercisable upon the "sale,
lease, transfer of other disposition... of all or substantially all" of the
Company's assets. Based upon a review of relevant Delaware case law, the Company
believes that substantial uncertainty existed regarding whether the Crescent
Transactions, which are described in Note 3, constituted a "sale ... of all or
substantially all" of the Company's assets. Accordingly, the Company's Board of
Directors determined it should treat the Crescent Transactions as such an event
in order to eliminate the risk of a dispute. Options outstanding under the 1996
Plan immediately vested upon closing the Crescent Transactions. As of
September 30, 1999, 62.5% of the options outstanding under the 1996 Plan were
vested.
1997 STOCK OPTION PLAN
The 1997 Stock Option Plan (the "1997 Plan") provides for the issuance of
1.5 million options to purchase shares of the Company's common stock. Options
must be granted on or before December 31, 2000. Officers and key employees of
the Company are eligible to participate. The options have an exercise price
which approximates fair market value of the common stock at the date of grant. A
summary of changes in options outstanding and other related information is as
follows:
FISCAL YEAR ENDED SEPTEMBER 30,
-------------------------------------------------
1997 1998 1999
-------------- --------------- --------------
Balance, beginning of
period...................... -- 988,333 732,278
Granted....................... 988,333 396,000 801,500
Canceled...................... -- (652,055) (167,873)
-------------- --------------- --------------
Balance, end of period........ 988,333 732,278 $ 1,365,905
============== =============== ==============
Option prices, end of
period...................... $24.375-$31.00 $22.328-$31.063 $4.188-$24.375
Options granted under the 1997 Plan are exercisable to the extent vested. An
option vests at the rate of 33 1/3% of the shares covered by the option on each
of the three anniversary dates of the grant of the option if the optionee is an
employee of the Company on such dates. Options must be exercised no later than
February 28, 2007. As of September 30, 1999, 34.3% of the options outstanding
under the 1997 Plan were vested. Certain of the options granted under the 1997
stock option plan were granted prior to the stockholder approval date. The
measurement date for purposes of measuring compensation expense for such grants
under the 1997 Plan was the date of stockholder approval, which resulted in
compensation expense of approximately $0.5 million and $0.2 million in fiscal
1997 and 1998, respectively.
1998 STOCK OPTION PLAN
The 1998 Stock Option Plan (the "1998 Plan") provides for the issuance of
1.0 million options to purchase shares of the Company's common stock. Options
must be granted on or before December 31,
F-31
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
6. STOCKHOLDERS' EQUITY (CONTINUED)
2001. Officers and key employees of the Company are eligible to participate. The
options have an exercise price which approximates fair market value of the
common stock at the date of grant. A summary of changes in options outstanding
and other related information is as follows:
FISCAL YEAR ENDED
SEPTEMBER 30,
------------------------------
1998 1999
-------------- -------------
Balance, beginning of period................... -- 800,500
Granted........................................ 890,500 319,000
Canceled....................................... (90,000) (239,082)
-------------- -------------
Balance, end of period......................... 800,500 880,418
============== =============
Option prices, end of period................... $14.56-$22.875 $4.188-$8.406
Options granted under the 1998 Plan are exercisable to the extent vested. An
option vests over the period specified in each stock option grant. Options must
be exercised no later than December 31, 2008. As of September 30, 1999, 21.6% of
the options outstanding under the 1998 Plan were vested.
1997 EMPLOYEE STOCK PURCHASE PLAN
The 1997 Employee Stock Purchase Plan (the "1997 ESPP") covers 600,000
shares of common stock that can be purchased by eligible employees of the
Company. The 1997 ESPP offering periods will have a term not less than three
months and not more than 12 months. The first offering period under the 1997
ESPP began January 1, 1997 and the last offering period will end on or before
December 31, 1999. The option price of each offering period will be the lesser
of (i) 85% of the fair value of a share of common stock on the first day of the
offering period or (ii) 85% of the fair value of a share of common stock on the
last day of the offering period.
A summary of the 1997 ESPP is as follows:
OFFERING OPTIONS EXERCISE
PERIOD BEGAN ENDED EXERCISED PRICE
--------------------- --------------- ----------------- --------- --------
1 January 2, 1997 June 30, 1997 73,410 $ 19.125
2 August 1, 1997 December 31, 1997 26,774 $ 19.125
3 January 1, 1998 June 30, 1998 43,800 $18.4875
4 July 1, 1998 December 31, 1998 163,234 $ 7.0125
5 January 1, 1999 June 30, 1999 152,570 $ 7.0125
6 July 1, 1999 December 31, 1999 -- --
The number of options granted and the option price for the sixth offering
period will be determined on December 31, 1999 when the option price is known.
1992 DIRECTORS' STOCK OPTION PLAN AND DIRECTORS' UNIT AWARD PLAN
The 1992 Directors' Stock Option Plan (the "1992 Directors Plan") provides
for the grant of options to non-employee members of the Company's Board of
Directors to purchase up to 175,000 shares of the Company's common stock,
subject to adjustments to reflect certain changes in capitalization. The options
have an exercise price which approximates the fair market value of the common
stock on the date of grant. During fiscal 1997, 1998 and 1999, no options were
granted. As of September 30, 1999, 75,000 options were outstanding at $8.406. No
options were exercised during fiscal 1997, 1998 or 1999.
F-32
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
6. STOCKHOLDERS' EQUITY (CONTINUED)
Options granted can be exercised from the date of vesting until February 1,
2003. No options can be granted after December 31, 1995. Options vest 20% when
granted and an additional 20% on each successive February 1 for a period of four
years, if the optionee continues to serve as a non-employee director on the
applicable February 1. Unvested options vest in full in certain instances of
termination. As of September 30, 1999, all of the options outstanding were
vested.
In addition, during fiscal 1994, the Company approved the Directors' Unit
Award Plan (the "Unit Plan") which provides for the award of a maximum of 15,000
units (the "Units") that, upon vesting under the terms of the Unit Plan, would
result in the issuance of an aggregate of 15,000 shares of common stock in
settlement of Units.
The Unit Plan provides for the award to each director who is not an employee
of the Company of 2,500 Units. Upon vesting of the Units awarded to a director,
the Company will settle the Units by issuing to the director, with no exercise
price, a number of shares of the Company's common stock equal to the number of
vested Units.
1996 DIRECTORS' STOCK OPTION PLAN
The 1996 Directors' Stock Option Plan (the "1996 Directors Plan") provides
for the grant of options to non-employee members of the Company's Board of
Directors to purchase up to 250,000 shares of the Company's common stock,
subject to adjustments to reflect certain changes in capitalization. The options
have an exercise price which approximates the fair market value of a share of
the common stock on the date of grant. During fiscal 1997, 25,000 options were
granted at an exercise price of $30.812. During fiscal 1998, 50,000 options were
granted at an exercise prices ranging from $20.25 to $22.4375. During fiscal
1999, no options were granted. As of September 30, 1999, 150,000 options were
outstanding at $8.406. No options were exercised during fiscal 1997, 1998 or
1999.
Options granted can be exercised from the date of vesting until
November 30, 2005. No options can be granted after December 31, 1999. Options
vest at the rate of 25% of the shares covered on each of the four anniversary
dates of the grant of the option if the optionee continues to serve as a
non-employee director on such dates. Options vest in full in certain instances
of termination. As of September 30, 1999, 62.5% of the options outstanding were
vested.
STOCK OPTION REPRICING
On November 17, 1998, the Company's Board of Directors approved the
repricing of stock options outstanding under the Company's existing stock option
plans (the "Stock Option Repricing"). Each holder of 10,000 or more stock
options that was eligible to participate in the Stock Option Repricing was
required to forfeit a percentage of outstanding stock options as follows:
Directors, including the Chief Executive 40%
- - Officer.........................................
- - Named Executive Officers........................ 30%
- - Other holders of 50,000 or more stock options... 25%
- - Other holders of 10,000-49,999 stock options.... 15%
F-33
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
6. STOCKHOLDERS' EQUITY (CONTINUED)
The Stock Option Repricing was consummated on December 8, 1998 based on the
fair value of the Company's common stock on such date. Approximately
2.0 million outstanding stock options were repriced to $8.406 and approximately
0.7 million outstanding stock options were cancelled as a result of the Stock
Option Repricing. Each participant in the Stock Option Repricing was precluded
from exercising repriced stock options until June 8, 1999.
A summary of the Stock Option Repricing by stock option plan is as follows
(in thousands):
OPTIONS OPTIONS
REPRICED CANCELLED
-------- ---------
1994 Plan................................................... 319 65
1996 Plan................................................... 506 176
1997 Plan................................................... 378 54
1998 Plan................................................... 590 211
1992 Directors Plan......................................... 75 50
1996 Directors Plan......................................... 150 100
----- ---
2,018 656
===== ===
RIGHTS PLAN
The Company adopted a share purchase rights plan in fiscal 1992 (the "Rights
Plan"). Pursuant to the Rights Plan, each share of common stock also represents
one share purchase right (collectively, the "Rights"). The Rights trade
automatically with the underlying shares of common stock. Upon becoming
exercisable, but prior to the occurrence of certain events, each Right initially
entitles its holder to buy one share of common stock from the Company at an
exercise price of $60.00. The Rights will be distributed and become exercisable
only if a person or group acquires, or announces its intention to acquire,
common stock exceeding certain levels, as specified in the Rights Plan. Upon the
occurrence of such events, the exercise price of each Right reduces to one-half
of the then current market price. The Rights also give the holder certain rights
in an acquiring company's common stock. The Company is entitled to redeem the
Rights at a price of $.01 per Right at any time prior to the distribution of the
Rights. The Rights have no voting power until exercised.
COMMON STOCK WARRANTS
The Company issued 114,690 warrants in fiscal 1992 which expire on June 30,
2002 (the "2002 Warrants") to purchase one share each of the Company's common
stock. The 2002 Warrants have an exercise price of $5.24 per share. During
fiscal 1997 and 1998, 1,397 and 1,553 were issued, respectively, upon the
exercise of 2002 Warrants. At September 30, 1999, 18,920 of the 2002 Warrants
were outstanding.
The Company also has 146,791 warrants outstanding with an exercise price of
$38.70 per share which expire on September 1, 2006.
Crescent and COI each have the right to purchase 1,283,311 shares of common
stock (2,566,622 shares in aggregate; collectively the "Crescent Warrants") at a
warrant exercise price of $30.00 per share
F-34
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
6. STOCKHOLDERS' EQUITY (CONTINUED)
(subject to adjustment pursuant to antidilution provisions). The Crescent
Warrants will be exercisable at the following times and in the following
amounts:
NUMBER OF SHARES OF
DATE FIRST COMMON STOCK END OF
EXERCISABLE ISSUABLE UPON EXERCISE EXERCISE PERIOD
JUNE 17, OF WARRANTS JUNE 17,
- ------------------------ ------------------------ ------------------------
1998 30,000 2001
1999 62,325 2002
2000 97,114 2003
2001 134,513 2004
2002 174,678 2005
2003 217,770 2006
2004 263,961 2007
2005 313,433 2008
2006 366,376 2009
2007 422,961 2009
2008 483,491 2009
Crescent's and COI's rights with respect to the Crescent Warrants are not
contingent on or subject to the satisfaction or completion of any obligation
that Crescent or COI may have to CBHS, or that CBHS may have to the Company, or
by any subordination of fees otherwise payable to the Company by CBHS.
The Crescent Warrants contain provisions relating to adjustments in the
number of shares covered by the Crescent Warrants and the warrant exercise price
in the event of stock splits, stock dividends, mergers, reorganizations and
similar transactions.
The Crescent Warrants were recorded at $25.0 million upon issuance, which
was their approximate fair value upon execution of the Warrant Purchase
Agreement in January 1997.
TREASURY STOCK TRANSACTIONS
During fiscal 1998, the Company repurchased an aggregate of 696,600 shares
of its common stock in the open market for approximately $14.4 million. Those
transactions were funded with cash on hand.
In January 1998, the Company issued an aggregate of 2,831,516 shares of
treasury stock to the then existing minority stockholders of Green Spring to
effect the Green Spring Minority Stockholder Conversion. See Note 2,
"Acquisitions and Joint Ventures."
INCOME (LOSS) PER COMMON SHARE
The Company adopted Statement of Financial Accounting Standards No. 128,
"Earnings per Share" ("FAS 128"), effective October 1, 1997. Income per common
share for fiscal 1997 has been restated to conform to FAS 128 as required. The
effect of adopting FAS 128 was not material.
F-35
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
6. STOCKHOLDERS' EQUITY (CONTINUED)
The following table presents the components of weighted average common
shares outstanding--diluted:
YEAR ENDED SEPTEMBER 30,
------------------------------
1997 1998 1999
------ ------ ------
Weighted average common shares outstanding--basic........... 28,781 30,784 31,758
Common stock equivalents--stock options..................... -- -- 151
Common stock equivalents--warrants.......................... -- -- 7
------ ------ ------
Weighted average common shares outstanding--diluted......... 28,781 30,784 31,916
====== ====== ======
Options to purchase approximately 3,004,650 shares of common stock at $8.19
- -$31.00 per share were outstanding during fiscal 1999 but were not included in
the computation of diluted EPS because the options exercise price was greater
than the average market price of the common shares. Approximately 2,851,960 of
these options, which expire between fiscal 2004 and 2009, were still outstanding
at September 30, 1999.
Warrants to purchase approximately 4,713,000 shares of common stock at
$26.15 to $38.70 per share were outstanding during fiscal 1999 but were not
included in the computation of diluted EPS because the warrants exercise price
was greater than the average market price of the common shares. The warrants,
which expire between fiscal 2000 and 2009, were still outstanding at
September 30, 1999.
The Company owned a 61% equity interest in Green Spring Health Services,
Inc. ("Green Spring") during the periods presented above. The four minority
stockholders of Green Spring had the options to exchange their ownership
interests in Green Spring for 2,831,516 shares of the Company's common stock or
$65.1 million of subordinated notes. The Exchange Option was considered a
potentially dilutive security from the point in time the Company acquired Green
Spring in December 1995 for the purpose of computing diluted income per common
share. The Exchange Option was anti-dilutive for all periods presented and,
therefore, was excluded from the respective diluted income per common share
calculations.
Each of the minority stockholders of Green Spring exercised the Exchange
Option in January 1998, which resulted in the issuance of 2,831,516 shares of
the Company's common stock. See Note 2--"Acquisitions and Joint Ventures--Green
Spring."
On December 15, 1999, the Company consummated the TPG investment (as
defined). See Note 15, - "Subsequent Event."
Common stock equivalents of approximately 693,000 and 414,000 were excluded
from the diluted income per common share calculation for the years ended
September 30, 1997 and 1998, respectively, due to their anti-dilutive nature as
a result of the Company's loss from continuing operations before extraordinary
items for such periods.
STOCK-BASED COMPENSATION
Effective October 1, 1996, the Company adopted the disclosure requirements
of FAS 123. FAS 123 requires disclosure of pro forma net income and pro forma
net income per share as if the fair value-based method of accounting for stock
options had been applied in measuring compensation cost for stock-based
F-36
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
6. STOCKHOLDERS' EQUITY (CONTINUED)
awards granted in fiscal 1996, 1997, 1998 and 1999. Pro forma amounts are not
representative of the effects of stock-based awards on future pro forma net
income and pro forma net income per share because those pro forma amounts
exclude the pro forma compensation expense related to unvested stock options
granted before fiscal 1996.
Reported and pro forma net income and net income per share amounts are set
forth below (in thousands, except per share data):
FISCAL YEAR ENDED
SEPTEMBER 30,
------------------------------
1997 1998 1999
-------- -------- --------
Reported:
Income (loss) from continuing operations
before extraordinary items............... $(37,204) $ (6,799) $22,466
Net income (loss)............................ (498) (19,283) 4,688
Income (loss) per common share--basic:
Income (loss) from continuing operations
before extraordinary items............... (1.29) (0.22) 0.71
Net income (loss)............................ (0.02) (0.63) 0.15
Income (loss) per common share--diluted:
Income (loss) from continuing operations
before extraordinary items............... (1.29) (0.22) 0.70
Net income (loss)............................ (0.02) (0.63) 0.15
Pro Forma:
Income (loss) from continuing operations
before extraordinary items............... $(45,680) $(10,744) $15,443
Net loss..................................... (8,974) (23,228) (2,335)
Income (loss) per common share--basic:
Income (loss) from continuing operations
before extraordinary items............... (1.59) (0.35) 0.49
Net loss..................................... (0.31) (0.75) (0.07)
Income (loss) per common share--diluted:
Income (loss) from continuing operations
before extraordinary items............... (1.59) (0.35) 0.48
Net loss..................................... (0.31) (0.75) (0.07)
The fair values of the stock options and ESPP options granted were estimated
on the date of their grant using the Black-Scholes option pricing model based on
the following weighted average assumptions:
1997 1998 1999
--------- --------- ---------
Risk-free interest rate....................... 6.0% 4.5% 5.8%
Expected life................................. 5.5 years 4 years 3.8 years
Expected volatility........................... 30% 50% 50%
Expected dividend yield....................... 0% 0% 0%
F-37
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
6. STOCKHOLDERS' EQUITY (CONTINUED)
The weighted average fair value of options granted during fiscal 1997, 1998
and 1999 was $9.67, $9.53 and $2.21, respectively.
Stock option activity for all plans for 1997, 1998 and 1999 was as follows:
FISCAL YEAR ENDED SEPTEMBER 30,
---------------------------------------------------------------------
1997 1998 1999
-------------------- --------------------- ----------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE
--------- -------- ---------- -------- ----------- --------
Balance, beginning of period.... 2,916,159 $17.92 4,122,109 $20.13 3,835,912 $ 22.23
Granted......................... 1,665,166 24.24 1,386,500 24.22 1,669,303 5.730
Canceled........................ (183,623) 20.84 (1,082,331) 23.66 (1,050,067) 19.965
Exercised....................... (275,593) 20.26 (590,366) 9.90 (48,266) 7.992
--------- ---------- -----------
Balance, end of period.......... 4,122,109 20.13 3,835,912 22.23 4,406,882 10.149
--------- ---------- -----------
Exercisable, end of period...... 2,419,711 17.65 2,375,919 20.89 2,190,538 13.739
--------- ---------- -----------
Stock options outstanding on September 30, 1999:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
- -------------------------------------------------------------------- --------------------
WEIGHTED
AVERAGE WEIGHTED WEIGHTED
RANGE OF REMAINING AVERAGE AVERAGE
EXERCISE CONTRACTUAL EXERCISE EXERCISE
PRICE OPTIONS LIFE (YEARS) PRICE OPTIONS PRICE
- ------------------------------ --------- ------------ -------- --------- --------
$4.188 - $8.188 1,576,921 7.37 $ 5.628 52,843 $ 7.313
$8.406 1,863,739 6.89 8.406 1,223,973 8.406
$9.438 - $24.375 966,222 6.09 20.894 913,722 21.255
--------- ---------
4,406,882 6.89 10.149 2,190,538 13.739
========= =========
7. INCOME TAXES
The provision for income taxes consisted of the following (in thousands):
FISCAL YEAR ENDED SEPTEMBER 30,
---------------------------------
1997 1998 1999
-------- ------- -------
Income taxes currently payable:
Federal....................................... $ 10,685 $ 3,462 $ 555
State......................................... 2,740 589 2,800
Foreign....................................... -- -- 500
Deferred income taxes:
Federal....................................... (27,873) 1,857 22,583
State......................................... (5,784) (364) 938
Foreign....................................... -- -- --
-------- ------- -------
$(20,232) $ 5,544 $27,376
======== ======= =======
F-38
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
7. INCOME TAXES (CONTINUED)
A reconciliation of the Company's income tax provision (benefit) to that
computed by applying the statutory federal income tax rate is as follows (in
thousands):
FISCAL YEAR ENDED SEPTEMBER 30,
---------------------------------
1997 1998 1999
--------- --------- ---------
Income tax provision (benefit) at federal
statutory income tax rate.................... $(17,703) $ 993 $17,665
State income taxes, net of federal income tax
benefit...................................... (1,979) 147 2,430
Merit goodwill amortization.................... -- 4,410 7,187
Other--net..................................... (550) (6) 94
-------- -------- -------
Income tax provision (benefit)................. $(20,232) $ 5,544 $27,376
======== ======== =======
As of September 30, 1999, the Company has estimated tax net operating loss
("NOL") carryforwards of approximately $512 million available to reduce future
federal taxable income. These NOL carryforwards expire in 2006 through 2018 and
are subject to examination by the Internal Revenue Service. In addition, the
Company also has estimated tax NOL carryforwards of approximately $125 million
available to reduce the federal taxable income of Merit and its subsidiaries.
These NOL carryforwards expire in 2009 through 2018 and are subject to
examination by the Internal Revenue Service. Further, these NOL carryforwards
are subject to limitations on the taxable income of Merit and its subsidiaries.
The Company has recorded a valuation allowance against the portion of the total
NOL deferred tax asset and certain other deferred tax assets, that in
management's opinion, are not likely to be recovered.
Components of the net deferred income tax (assets) liabilities at
September 30, 1998 and 1999 are as follows (in thousands):
SEPTEMBER 30,
---------------------
1998 1999
--------- ---------
Deferred tax liabilities:
Property and depreciation........................... $ 8,670 $ 2,060
Long-term debt and interest......................... 20,388 19,735
ESOP................................................ 12,777 12,968
Intangibles......................................... -- 11,332
Other............................................... 9,556 15,209
--------- ---------
Total deferred tax liabilities.................... 51,391 61,304
--------- ---------
Deferred tax assets:
Intangible Assets................................... (8,992) --
Operating loss carryforwards........................ (250,512) (254,696)
Self-insurance reserves............................. (9,534) (2,220)
Restructuring costs................................. (4,071) (9,552)
Other............................................... (40,359) (51,953)
--------- ---------
Total deferred tax assets........................... (313,468) (318,421)
--------- ---------
Valuation allowance................................. 163,893 165,460
--------- ---------
Deferred tax assets after valuation allowance....... (149,575) (152,961)
--------- ---------
Net deferred tax assets............................. $ 98,184 $ 91,657
========= =========
F-39
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
7. INCOME TAXES (CONTINUED)
During June 1999, the Company received an assessment from the Internal
Revenue Service (the "IRS Assessment") related to its federal income tax returns
for the fiscal years ended September 30, 1992 and 1993. The IRS Assessment
disallowed approximately $162 million of deductions that relate primarily to
interest expense in fiscal 1992. The Company filed an appeal of the IRS
Assessment during September 1999.
The Company had previously recorded a valuation allowance for the full
amount of the $162 million of deductions disallowed in the IRS Assessment. The
IRS Assessment is not expected to result in a material cash payment for income
taxes related to prior years; however, the Company's federal income tax net
operating loss carryforwards would be reduced if the Company's appeal is
unsuccessful.
The Internal Revenue Service is currently examining Merit and CMG's income
tax returns for pre-acquisition periods. In management's opinion, adequate
provisions have been made for any adjustments which may result from these
examinations, including a potential reduction in the amount of NOL
carryforwards. The Company believes the examinations could result in a reduction
in NOL carryforwards available to offset future taxable income.
8. ACCRUED LIABILITIES
Accrued liabilities consist of the following (in thousands):
SEPTEMBER 30,
-------------------
1998 1999
-------- --------
Salaries, wages and other benefits.......................... $ 23,893 $ 22,318
CHAMPUS Adjustments......................................... 25,484 51,784
Due to Providers............................................ 17,576 35,918
Other....................................................... 126,577 99,776
-------- --------
$193,530 $209,796
======== ========
9. MANAGED CARE INTEGRATION PLAN AND COSTS AND SPECIAL CHARGES
INTEGRATION PLAN
The Company integrated three behavioral managed care organizations
("BMCOs"), Green Spring, HAI and Merit, as a result of acquisitions consummated
in fiscal 1996 (Green Spring) and fiscal 1998 (HAI and Merit). The Company also
integrated two specialty managed care organizations, Allied and Care Management
Resources, Inc. ("CMR"). During fiscal 1998, management committed the Company to
a plan to combine and integrate the operations of its BMCOs and specialty
managed care organizations (the "Integration Plan") that resulted in the
elimination of duplicative functions and standardized business practices and
information technology platforms.
The Integration Plan resulted in the elimination of approximately 1,000
positions during fiscal 1998 and fiscal 1999. Approximately 510 employees were
involuntarily terminated pursuant to the Integration Plan.
F-40
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
9. MANAGED CARE INTEGRATION PLAN AND COSTS AND SPECIAL CHARGES (CONTINUED)
The employee groups of the BMCOs that were primarily affected include
executive management, finance, human resources, information systems and legal
personnel at the various BMCOs corporate headquarters and regional offices and
credentialing, claims processing, contracting and marketing personnel at various
operating locations.
The Integration Plan has resulted in the closure and identified closure of
approximately 20 leased facilities at the BMCOs, Allied and CMR during fiscal
1998 and 1999.
The Company initially recorded approximately $21.3 million of liabilities
related to the Integration Plan, of which $12.4 million was recorded as part of
the Merit purchase price allocation and $8.9 million was recorded in the
statement of operations under "Managed care integration costs" in fiscal 1998.
During fiscal 1999, the Company recorded adjustments of approximately
$(0.3) million, net, to such liabilities, of which $(0.8) million was recorded
as part of the Merit purchase price allocation and $0.5 million was recorded in
the statement of operations under "Managed care integration costs." The Company
may record additional adjustments to such liabilities during the future periods
depending on its ability to sublease closed offices and upon determination of
the final amount of the Company's severance obligations.
The following table provides a rollforward of liabilities resulting from the
Integration Plan (in thousands):
BALANCE BALANCE
SEPTEMBER 30, SEPTEMBER 30,
TYPE OF COST 1997 ADDITIONS PAYMENTS 1998
- ------------ ------------- --------- ---------- -------------
Employee termination benefits......... $ -- $13,009 $(6,819) $ 6,190
Facility closing costs................ -- 8,008 (533) 7,475
Other................................. -- 244 (75) 169
---------- ------- ------- -------
$ -- $21,261 $(7,427) $13,834
========== ======= ======= =======
BALANCE BALANCE
SEPTEMBER 30, SEPTEMBER 30,
TYPE OF COST 1998 ADJUSTMENTS PAYMENTS 1999
- ------------ ------------- ----------- -------- -------------
Employee termination benefits.......... $ 6,190 $ 1,959 $(7,380) $ 769
Facility closing costs................. 7,475 (2,071) (2,310) 3,094
Other.................................. 169 (169) -- --
------- ------- ------- ------
$13,834 $ (281) $(9,690) $3,863
======= ======= ======= ======
OTHER INTEGRATION COSTS
The Integration Plan resulted in additional incremental costs that were
expensed as incurred in accordance with Emerging Issues Task Force Consensus
94-3, "Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)"
that are not described above and certain other charges. Other integration costs
include, but are not limited to, outside consultants, costs to relocate closed
office contents and long-lived asset
F-41
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
9. MANAGED CARE INTEGRATION PLAN AND COSTS AND SPECIAL CHARGES (CONTINUED)
impairments. Other integration costs are reflected in the statement of
operations under "Managed care integration costs".
During fiscal 1998, the Company incurred approximately $8.1 million, in
other integration costs, including long-lived asset impairments of approximately
$2.4 million, and outside consulting costs of approximately $4.1 million. The
asset impairments relate primarily to identifiable intangible assets and
leasehold improvements that no longer have value and have been written off as a
result of the Integration Plan.
During fiscal 1999, the Company incurred approximately $5.7 million in other
integration costs, primarily for outside consulting costs and employee and
office relocation costs.
SPECIAL CHARGES. During fiscal 1999, the Company recorded special charges
of approximately $4.4 million related primarily to the loss on disposal of an
office building, executive severance and relocation of its corporate
headquarters from Atlanta, Georgia to Columbia, Maryland.
10. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental cash flow information is as follows (in thousands):
YEAR ENDED SEPTEMBER 30,
------------------------------
1997 1998 1999
-------- -------- --------
Income taxes paid, net of refunds received.................. $18,406 $11,116 $ 347
Interest paid, net of amounts capitalized................... 54,378 95,153 102,094
Non-cash Transactions:
Initial capital contribution to CBHS, primarily property and
equipment, less assumed liabilities....................... 5,281 -- --
Common Stock in Treasury issued in connection with the
purchase of the remaining 39% interest in Green Spring
Health Services, Inc...................................... -- 63,496 --
F-42
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
11. 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 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. The undiscounted amount of the reserve for unpaid claims at
September 30, 1998 was approximately $34.6 million. The carrying amount of
accrued medical malpractice claims was $26.2 million at September 30, 1998. The
reserve for unpaid claims was adjusted periodically as such claims matured, to
reflect changes in actuarial estimates based on actual experience. During fiscal
1998, the Company recorded reductions in malpractice claim reserves of
approximately $4.1 million, respectively, as a result of updated actuarial
estimates which is included in discontinued operations. This reduction resulted
primarily from updates to actuarial assumptions regarding the Company's expected
losses for more recent policy years. This revision was based on changes in
expected values of ultimate losses resulting from the Company's claim
experience, and increased reliance on such claim experience. 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 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. Recently, 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 and the compliance by CBHS and
certain of its subsidiaries with such laws and regulations. Certain of the
inquiries relate to the operations and business practices of the Company's
psychiatric provider operations 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.
F-43
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
11. COMMITMENTS AND CONTINGENCIES (CONTINUED)
On August 1, 1996, the United States Department of Justice, Civil Division,
filed an Amended Complaint in a civil QUI TAM action initiated in November 1994
against the Company and its Orlando South hospital subsidiary ("Charter
Orlando") by two former employees. The First Amended Complaint alleges that
Charter Orlando violated the federal False Claims Act (the "Act") in billing for
inpatient treatment provided to elderly patients. The Court granted the
Company's motion to dismiss the government's First Amended Complaint yet granted
the government leave to amend its First Amended Complaint. The government filed
a Second Amended Complaint on December 12, 1996 which, similar to the First
Amended Complaint, alleges that the Company and its subsidiary violated the Act
in billing for the treatment of geriatric patients. Like the First Amended
Complaint, the Second Amended Complaint was based on disputed clinical and
factual issues which the Company believes do not constitute a violation of the
Act. On the Company's motion, the Court ordered the parties to participate in
mediation of the matter. As a result of the mediation, the parties reached a
settlement. Pursuant to the settlement, the Company paid approximately $4.8
million in August 1998. Furthermore, Charter Orlando (operated by CBHS) did not
seek reimbursement for services provided to patients covered under the Medicare
program for a period of up to fifteen months. The Company reimbursed CBHS for
the resulting loss of revenues through September 30, 1999.
On May 26, 1998, a group of eleven plaintiffs purporting to represent an
uncertified class of psychiatrists, psychologists and social workers brought an
action (the "Holstein Case") under the federal antitrust laws in the United
States District Court for the District of New Jersey against nine behavioral
health managed care organizations, including Merit, CMG, Green Spring and HAI
(collectively, the "Defendants"). The complaint alleges that the Defendants
violated Section I of the Sherman Act by engaging in a conspiracy to fix the
prices at which the Defendants purchase services from mental healthcare
providers such as the plaintiffs. The complaint further alleges that the
Defendants engaged in a group boycott to exclude mental healthcare providers
from the Defendants' networks in order to further the goals of the alleged
conspiracy. The complaint also challenges the propriety of the Defendants'
capitation arrangements with their respective customers, although it is unclear
from the complaint whether the plaintiffs allege that the Defendants unlawfully
conspired to enter into capitation arrangements with their respective customers.
The complaint seeks treble damages against the Defendants in an unspecified
amount and a permanent injunction prohibiting the Defendants from engaging in
the alleged conduct which forms the basis of the complaint, plus costs and
attorneys' fees. Upon joint motion by the Defendants, the case was transferred
to the United States District Court for the Southern District of New York, the
same court where a previous similar case (the "Stephens Case") was dismissed for
failure to state a claim upon which relief can be granted. On March 15, 1999,
the Defendants filed a joint motion to dismiss the case for substantially the
same reasons as in the Stephens Case. On June 16, 1999, the court denied the
motion to dismiss. The case currently is in discovery. On October 14, 1999, the
Plaintiffs filed a motion seeking class certification for a class of
approximately 200,000 providers. The court has not yet heard argument on that
motion. The Company does not believe this matter will have a material adverse
effect on its financial position or results of operations.
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,
including the Holstein Case, in which the Company has been named as a defendant.
Besides the Holstein Case, the Company has certain other class action lawsuits
which allege (i) the Company inappropriately denied and/or failed to authorize
benefits for mental health treatment under
F-44
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
11. COMMITMENTS AND CONTINGENCIES (CONTINUED)
insurance policies with a customer of the Company and (ii) the Company was party
to employee malpractice and professional negligence regarding a specific mental
health illness. 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 CHAMPUS. The fixed monthly amounts that the
Company receives for medical costs under CHAMPUS contracts are subject to
retroactive adjustment ("CHAMPUS Adjustments") based upon actual healthcare
utilization during the period known as the "data collection period". The Company
has recorded reserves of approximately $25.5 million and $51.8 million as of
September 30, 1998 and 1999, respectively for CHAMPUS Adjustments. During the
first quarter of fiscal 2000, the Company reached a settlement agreement with a
contractor under one of its CHAMPUS contracts whereby the Company agreed to pay
approximately $38.1 million to the contractor during the quarter ended
December 31, 1999. The Company and the contractor under this CHAMPUS contract
are in the process of appealing the department of defense's retroactive
adjustment. While management believes that the present reserve for CHAMPUS
Adjustments is reasonable, ultimate settlement resulting from the adjustment and
available appeal process may vary from the amount provided.
12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Gerald L. McManis, a director of the Company, is the President of McManis
Associates, Inc. ("MAI"), a healthcare development and management consulting
firm. During fiscal 1997, 1998 and 1999, MAI provided consulting services to the
Company with respect to the development of strategic plans and a review of the
Company's business processes. The Company incurred approximately $865,000 and
$85,000 in fees for such services and related expenses during fiscal 1997 and
1998, respectively.
G. Fred DiBona, Jr., a director of the Company, is a Director and the
President and Chief Executive Officer of Independence Blue Cross ("IBC"), a
health insurance company.
IBC owned 16.67% of Green Spring prior to December 13, 1995. On
December 13, 1995, IBC sold 4.42% of its ownership interest in Green Spring to
the Company for $5,376,000 in cash. IBC had a cost basis of $3,288,000 in the
4.42% ownership interest sold to the Company. The Exchange Option described
previously gave IBC the right to exchange its ownership interest in Green Spring
for a maximum of 889,456 shares of Common Stock or $20,460,000 in subordinated
notes through December 13, 1998. IBC exercised its Exchange Option in January
29, 1998 for Magellan Common Stock valued at approximately $17.9 million.
IBC and its affiliated entities contract with the Company for provider
network, care management and medical review services pursuant to contractual
relationships entered into on July 7, 1994 with terms of up to five years. The
Company's contract with IBC is in the process of being renegotiated. During
fiscal 1997, 1998 and 1999, IBC and its affiliated entities made payments to
Green Spring of approximately $48.0 million, $54.7 million and $71.3 million and
owed Green Spring approximately $13.5 million and $1.3 million
F-45
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (CONTINUED)
at September 30, 1998 and 1999, respectively. The Company recorded revenue of
approximately $47.4 million, $54.6 million and $59.1 million from IBC during
fiscal 1997, 1998 and 1999, respectively.
On July 7, 1994, IBC sold a subsidiary to Green Spring in exchange for a $15
million promissory note. As of September 30, 1999, such promissory note had been
repaid.
Darla D. Moore, a director of the Company since February 1996, is the spouse
of Richard E. Rainwater, Chairman of the Board of Crescent and one of the
largest stockholders of the Company (13.0% beneficial ownership as of
September 30, 1999). Because of her relationship to Mr. Rainwater, Ms. Moore did
not participate in any Board action taken with respect to the Crescent
Transactions.
Daniel S. Messina, a director of the Company, is the Chief Financial Officer
of Aetna U.S. Healthcare, a subsidiary of Aetna. Mr. Messina became a director
of the Company in December 1997. On December 4, 1997, the Company consummated
the purchase of HAI, formerly a unit of Aetna, for approximately $122.1 million
plus contingent consideration.
The Company may be required to make additional contingent payments of up to
$60.0 million annually to Aetna over the five-year period subsequent to closing.
The amount and timing of the payments will be contingent upon net increases in
the HAI's covered lives in specified products. The Company paid $60.0 million to
Aetna for both the full Tranche 1 Payment and the full Tranche 2 Payment for the
Contract Year ended December 31, 1998, on March 26, 1999. The consideration paid
for HAI was determined through arm's length negotiations that considered, among
other factors, the historical and projected income of HAI. The consideration
paid by the Company was determined by the Board with the advice of management
and the Company's investment bankers.
Aetna and its affiliated entities contract with the Company for various
behavioral and specialty managed care services pursuant to contractual
relationships, the most material of which is the Master Service Agreement, which
was entered into on December 4, 1997. During fiscal 1998 and 1999, Aetna and its
affiliated entities paid the Company approximately $72.3 million and $296.4
million, respectively for such services. As of September 30, 1998 and 1999,
Aetna and its affiliated entities owed the Company approximately $0.8 million
and $24.4 million, respectively. The Company recorded revenue of approximately
$69.2 million and $293.1 million, respectively from Aetna during fiscal 1998 and
1999.
13. BUSINESS SEGMENT INFORMATION
The Company operates through three reportable business segments engaging in
(i) the behavioral managed healthcare business, (ii) the human services business
and (iii) the specialty managed healthcare business. The behavioral managed
healthcare segment provides behavioral managed care services to health plans,
insurance companies, corporations, labor unions and various governmental
agencies. The human services segment provides therapeutic foster care services
and residential and day services to individuals with acquired brain injuries and
for individuals with mental retardation and developmental disabilities. The
speciality managed healthcare segment provides managed care services to health
plans and insurance companies for chronic medical conditions and other specialty
services.
The accounting policies of the segments are the same as those described in
the summary of significant accounting policies. The Company evaluates
performance of its segments based on profit or loss from continuing operations
before depreciation, amortization, interest, net, stock option expense (credit),
F-46
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
13. BUSINESS SEGMENT INFORMATION (CONTINUED)
managed care integration costs, special charges, net, income taxes and minority
interest ("Segment Profit"). Intersegment sales and transfers are not
significant.
The Company's reportable segments are strategic business units that offer
different services. They are managed separately because each business has (i)
different marketing strategies due to differences in types of customers and (ii)
different capital resource needs.
The following tables summarize, for the periods indicated, operating results
and other financial information, by business segment (in thousands):
BEHAVIORAL SPECIALTY CORPORATE
MANAGED HUMAN MANAGED OVERHEAD
HEALTHCARE SERVICES HEALTHCARE AND OTHER CONSOLIDATED
---------- -------- ---------- --------- ------------
1997
Net revenue.................................. $ 375,541 $ 88,331 $ -- $ -- $ 463,872
Segment profit (loss)........................ 37,019 10,695 (2,303) (25,578) 19,833
Equity in loss of unconsolidated
subsidiaries............................... (5,567) -- -- -- (5,567)
Capital expenditures......................... 9,548 1,880 567 21,353 33,348
1998
Net revenue.................................. $1,026,243 $141,032 $143,503 $ -- $1,310,778
Segment profit (loss)........................ 137,192 15,493 3,128 (15,866) 139,947
Equity in earnings of unconsolidated
subsidiaries............................... 12,795 -- -- -- 12,795
Investment in unconsolidated subsidiaries.... 10,125 -- -- 941 11,066
Capital expenditures......................... 27,535 8,391 3,937 4,350 44,213
Total assets................................. 1,356,259 119,356 78,062 363,411 1,917,088
1999
Net revenue.................................. $1,483,202 $191,277 $197,157 $ -- $1,871,636
Segment Profit (loss)........................ 218,253 21,728 2,410 (13,939) 228,452
Equity in earnings of unconsolidated
subsidiaries............................... 20,442 -- -- -- 20,442
Investment in unconsolidated subsidiaries.... 18,396 -- -- -- 18,396
Capital expenditures......................... 37,487 5,779 4,129 724 48,119
Total assets................................. 1,472,539 127,348 88,535 193,193 1,881,615
The following tables reconcile segment profit to consolidated income from
continuing operations before provision for income taxes, minority interest and
extraordinary items:
1997
Segment profit.............................................. $ 19,833
Depreciation and amortization............................... (19,683)
Interest, net............................................... (46,438)
Stock option expense........................................ (4,292)
--------
Loss from continuing operations before provision for
income taxes, minority interest and extraordinary
items................................................... $(50,580)
========
F-47
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
13. BUSINESS SEGMENT INFORMATION (CONTINUED)
1998
Segment profit.............................................. $139,947
Depreciation and amortization............................... (49,264)
Interest, net............................................... (76,505)
Stock option credit......................................... 5,623
Managed care integration costs.............................. (16,962)
--------
Income from continuing operations before provision for
income taxes, minority interest and extraordinary
items................................................... $ 2,839
========
1999
Segment Profit.............................................. $228,452
Depreciation and amortization............................... (73,531)
Interest, net............................................... (93,752)
Stock option (expense) credit............................... (18)
Managed care integration costs.............................. (6,238)
Special charges............................................. (4,441)
--------
Income from continuing operations before provision for
income taxes, minority interest and extraordinary item..... $ 50,472
========
Revenue generated and long-lived assets located in foreign countries are not
material. Revenues from one customer of the Company's behavioral managed
healthcare segment represented 11.4% of the Company's consolidated revenues for
fiscal 1999. Revenues from one customer served by both the Company's behavioral
managed healthcare segment and specialty managed healthcare segment represented
15.7% of the Company's consolidated revenues for fiscal 1999.
F-48
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
14. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of the quarterly results of operations for the
years ended September 30, 1998 and 1999.
FOR THE QUARTER ENDED
---------------------------------------------------
DECEMBER 31, MARCH 31, JUNE 30, SEPTEMBER 30,
1998 1999 1999 1999
------------ --------- -------- -------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
1999
Net Revenue........................................... $443,331 $479,703 $463,421 $485,181
-------- -------- -------- --------
Cost and expenses:
Salaries, cost of care and other operating
expenses.......................................... 392,313 429,602 412,315 429,396
Equity in earnings of unconsolidated subsidiaries... (3,783) (6,262) (8,196) (2,201)
-------- -------- -------- --------
Segment Profit...................................... 54,801 56,363 59,302 57,986
-------- -------- -------- --------
Depreciation and amortization....................... 17,513 18,129 19,801 18,088
Interest, net....................................... 24,122 24,229 22,662 22,739
Stock option expense................................ 12 6 -- --
Managed care integration costs...................... 1,750 2,119 522 1,847
Special charges, net................................ 1,084 2,252 -- 1,105
-------- -------- -------- --------
44,481 46,735 42,985 43,779
-------- -------- -------- --------
Income from continuing operations before income taxes
and minority interest............................... 10,320 9,628 16,317 14,207
Provision for income taxes............................ 5,915 5,658 8,323 7,480
-------- -------- -------- --------
Income from continuing operations before minority
interest............................................ 4,405 3,970 7,994 6,727
Minority interest..................................... 410 (34) 189 65
-------- -------- -------- --------
Income from continuing operations..................... 3,995 4,004 7,805 6,662
Discontinued operations:
Income (loss) from discontinued operations.......... 186 (47) 13,694 15,812
Loss on disposal of discontinued operations......... -- -- -- (47,423)
-------- -------- -------- --------
186 (47) 13,694 31,611
-------- -------- -------- --------
Net income (loss)..................................... $ 4,181 $ 3,957 $ 21,499 $(24,949)
======== ======== ======== ========
Income (loss) per common share -- basic:
Income from continuing operations................... $ 0.13 $ 0.13 $ 0.25 $ 0.21
======== ======== ======== ========
Income (loss) from discontinued operations.......... $ 0.01 $ -- $ 0.43 $ (0.99)
======== ======== ======== ========
Net income (loss)..................................... $ 0.13 $ 0.12 $ 0.68 $ (0.78)
======== ======== ======== ========
Income (loss) per common share -- diluted:
Income from continuing operations................... $ 0.13 $ 0.13 $ 0.24 $ 0.21
======== ======== ======== ========
Income (loss) from discontinued operations.......... $ 0.01 $ -- $ 0.43 $ (0.98)
======== ======== ======== ========
Net income (loss)..................................... $ 0.13 $ 0.12 $ 0.67 $ (0.77)
======== ======== ======== ========
F-49
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
14. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (CONTINUED)
FOR THE QUARTER ENDED
---------------------------------------------------
DECEMBER 31, MARCH 31, JUNE 30, SEPTEMBER 30,
1997 1998 1998 1998
------------ --------- -------- -------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
1998
Net Revenue........................................... $159,632 $321,256 $415,863 $414,027
-------- -------- -------- --------
Cost and expenses:
Salaries, cost of care and other operating
expenses.......................................... 146,078 294,513 375,943 367,092
Equity in (earnings) losses of unconsolidated
subsidiaries...................................... 634 (1,200) (6,750) (5,479)
-------- -------- -------- --------
Segment Profit...................................... 12,920 27,943 46,670 52,414
-------- -------- -------- --------
Depreciation and amortization....................... 5,568 11,489 16,326 15,881
Interest, net....................................... 7,685 17,799 24,693 26,328
Stock option expense (credit)....................... (3,959) 420 12 (2,096)
Managed care integration costs...................... -- 11,074 1,240 4,648
-------- -------- -------- --------
9,294 40,782 42,271 44,761
-------- -------- -------- --------
Income (loss) from continuing operations before income
taxes, minority interest and extraordinary items.... 3,626 (12,839) 4,399 7,653
Provision for (benefit from) income items............. 1,451 (4,278) 3,361 5,010
-------- -------- -------- --------
Income (loss) from continuing operations before
minority interest and extraordinary items........... 2,175 (8,561) 1,038 2,643
Minority interest..................................... 2,374 618 1,095 7
-------- -------- -------- --------
Income (loss) from continuing operations before
extraordinary items................................. (199) (9,179) (57) 2,636
Discontinued operations:
Income (loss) from discontinued operations.......... 7,827 6,887 7,467 (1,650)
-------- -------- -------- --------
Income (loss) before extraordinary items.............. 7,628 (2,292) 7,410 986
Extraordinary item -- net loss on early
extinguishments of debt............................. -- (33,015) -- --
-------- -------- -------- --------
Net income (loss)..................................... $ 7,628 $(35,307) $ 7,410 $ 986
======== ======== ======== ========
Income (loss) per common share -- basic:
Income (loss) from operations before extraordinary
items............................................. $ (0.01) $ (0.30) $ -- $ 0.08
======== ======== ======== ========
Income (loss) from discontinued operations.......... $ 0.27 $ 0.22 $ 0.24 $ (0.05)
======== ======== ======== ========
Extraordinary losses on early extinguishments of
debt.............................................. $ -- $ (1.06) $ -- $ --
======== ======== ======== ========
Net income (loss)..................................... $ 0.26 $ (1.14) $ 0.24 $ 0.03
======== ======== ======== ========
Income (loss) per common share -- diluted:
Income (loss) from continuing operations before
extraordinary items............................... $ (0.01) $ (0.30) $ -- $ 0.08
======== ======== ======== ========
Income (loss) from discontinued operations.......... $ 0.27 $ 0.22 $ 0.24 $ (0.05)
======== ======== ======== ========
Extraordinary losses on early extinguishments of
debt.............................................. $ -- $ (1.06) $ -- $ --
======== ======== ======== ========
Net income (loss)..................................... $ 0.26 $ (1.14) $ 0.24 $ 0.03
======== ======== ======== ========
F-50
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999
15. SUBSEQUENT EVENT
On July 19, 1999, the Company entered into a definitive agreement to issue
approximately $75.4 million of cumulative convertible preferred stock to TPG
Magellan, LLC, an affiliate of the investment firm Texas Pacific Group ("TPG")
(the "TPG Investment"). On December 15, 1999, the Company and TPG amended and
restated the definitive agreement and consummated the TPG Investment.
Pursuant to the amended and restated definitive agreement, TPG purchased
approximately $59.1 million of the Company's Series A Cumulative Convertible
Preferred Stock (the "Series A Preferred Stock") and an Option (the "Option") to
purchase an additional approximately $21.0 million of Series A Preferred Stock.
Net proceeds from issuance of 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 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. The
Series A Preferred Stock is convertible at any time by the holder into
approximately 6.3 million shares of the Company's common stock at a conversion
price of $9.375 per share 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 the Company on
December 15, 2009. The Options will expire unless exercised by June 15, 2002.
TPG may exercise the Options in whole or in part. The Company may, under certain
circumstances, require TPG to exercise the Options. 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 at the closing of
the TPG Investment.
TPG has three representatives on the Company's twelve-member Board of
Directors.
The issuance of common stock in respect of accrued and unpaid dividend
obligations on the Series A Preferred Stock and the issuance of common stock
underlying the Options are subject to approval by the Company's stockholders.
The Company intends to seek such stockholder approval no later than the next
annual meeting of its stockholders, which is expected to be held in
February 2000.
F-51
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS--MAGELLAN
(IN THOUSANDS)
CHARGED TO
BALANCE AT CHARGED TO OTHER BALANCE AT
BEGINNING COSTS AND ACCOUNTS-- DEDUCTIONS-- END OF
CLASSIFICATION OF PERIOD EXPENSES DESCRIBE DESCRIBE PERIOD
- -------------- ---------- ---------- ---------- ------------ ----------
Fiscal year ended September 30, 1997:
Allowance for doubtful accounts............ $50,548 $46,211 (D) $19,373(A) $ 89,114(B) $40,311
$21,400 (E) 5,164(F)
2,943(G)
------- ------- ------- -------- -------
$50,548 $67,611 $19,373 $ 97,221 $40,311
======= ======= ======= ======== =======
Fiscal year ended September 30, 1998:
Allowance for doubtful accounts............ $40,311 $ 4,977 (D) $15,031(A) $ 24,440(B) $34,867
4,376(C) 5,388(F)
------- ------- ------- -------- -------
$40,311 $ 4,977 $19,407 $ 29,828 $34,867
======= ======= ======= ======== =======
Fiscal year ended September 30, 1999:
Allowance for doubtful accounts............ $34,867 $ 3,277 (D) $ 2,362(A) $ 1,280(B) $28,437
(8,072)(E) 604(C) 672(F)
2,649(H)
------- ------- ------- -------- -------
$34,867 $(4,795) $ 2,966 $ 4,601 $28,437
======= ======= ======= ======== =======
- ------------------------
(A) Recoveries of accounts receivable previously written off.
(B) Accounts written off.
(C) Allowance for doubtful accounts (net) assumed or disposed of in acquisitions
or dispositions.
(D) Bad debt expense.
(E) Accounts receivable collection fees included in loss on Crescent
Transactions.
(F) Accounts receivable collection fees payable to CBHS and outside vendors.
(G) Amounts reclassified to contractual allowances.
(H) Conversion of Provider JVs from consolidation to equity method.
S-1