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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 8-K/A
CURRENT REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
DATE OF REPORT: APRIL 3, 1998
DATE OF EARLIEST EVENT
REPORTED: FEBRUARY 12, 1998
MAGELLAN HEALTH SERVICES, INC.
(Exact name of registrant as specified in its charter).
DELAWARE 1-6639 58-1076737
(State of incorporation) (Commission File Number) (IRS Employer Identification
No.)
3414 PEACHTREE ROAD, N.E., SUITE 1400, ATLANTA, 30326
GEORGIA
(Address of principal executive offices) (Zip Code)
(404) 841-9200
(Registrant's telephone number, including area code)
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ITEM 2. ACQUISITION OR DISPOSITION OF ASSETS
On February 12, 1998, a wholly-owned subsidiary of the Registrant, MBC
Merger Corporation, merged with Merit Behavioral Care Corporation ("Merit")
whereby Merit became a wholly-owned subsidiary of the the Registrant (the
"Company" or "Magellan").
The Company acquired all of the outstanding stock of Merit for approximately
$448.9 million in cash plus the repayment of Merit's debt. The Company will
account for the Merit acquisition using the purchase method of accounting. Merit
manages behavioral healthcare programs for approximately 21.0 million covered
lives 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 government 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
credit agreement; (ii) the Company repaid all loans outstanding pursuant to and
terminated Merit's existing credit agreement (the "Merit Existing Credit
Agreement"); (iii) the Company completed a tender offer for its 11 1/4% Series A
Senior Subordinated Notes due 2004 (the "Magellan Outstanding Notes"); (iv)
Merit completed a tender offer for its 11 1/2% Senior Subordinated Notes due
2005 (the "Merit Outstanding Notes"); (v) the Company entered into a new senior
secured bank credit agreement (the "New Credit Agreement") with The Chase
Manhattan Bank and a syndicate of financial institutions, providing for credit
facilities of up to $700.0 million; and (vi) the Company issued $625.0 million
in 9% Senior Subordinated Notes due 2008 (the "Notes") (collectively, the
"Transactions").
The following table sets forth the sources and uses of funds for the
Transactions (in millions):
SOURCES:
Cash and cash equivalents......................................... $ 59.3
New Credit Agreement:
Revolving Facility (1).......................................... 20.0
Term Loan Facility.............................................. 550.0
The Notes......................................................... 625.0
---------
Total sources................................................... $ 1,254.3
---------
---------
USES:
Cash paid to Merit shareholders................................... $ 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
---------
---------
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(1) The Revolving Facility provides for borrowings of up to $150.0 million. The
Company had approximately $112.5 million available for borrowing pursuant to
the Revolving Facility after consummating the Transactions, excluding
approximately $17.5 million of availability reserved for certain letters of
credit.
(2) Includes principal amount of $193.6 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.
2
(4) Includes principal amount of $100.0 million, tender premium of $18.9 million
and accrued interest of $2.8 million.
(5) Transaction costs include, among other things, costs paid at closing
associated with the tender offers for the Magellan Outstanding Notes and the
Merit Outstanding Notes, the Notes, the Merit acquisition and the New Credit
Agreement.
The total consideration in the Merit acquisition was determined through
arm's length negotiations between representatives of Magellan and Merit. No
directors or officers of Magellan and its affiliates or Merit and its affiliates
had any material relationship prior to the Merit acquisition.
Magellan and its provider business affiliates and Merit and its behavioral
managed care affiliates transacted business in the ordinary course prior to the
Merit acquisition.
ITEM 7. FINANCIAL STATEMENTS, PRO FORMA FINANCIAL INFORMATION AND EXHIBITS
FINANCIAL STATEMENTS
The following Merit Financial Statements, together with the independent
public accountants' reports thereon, are included herein:
1) Audited Consolidated Balance Sheets as of September 30, 1997 and 1996;
2) Audited Consolidated Statements of Operations for the years ended September
30, 1997, 1996 and 1995;
3) Audited Consolidated Statements of Stockholder's Equity for the years ended
September 30, 1997, 1996 and 1995;
4) Audited Consolidated Statements of Cash Flows for the years ended September
30, 1997, 1996 and 1995;
5) Unaudited Consolidated Balance Sheet as of December 31, 1997;
6) Unaudited Consolidated Statements of Operations for the three months ended
December 31, 1997 and 1996;
7) Unaudited Consolidated Statements of Cash Flows for the three months ended
December 31, 1997 and 1996.
3
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors of
Merit Behavioral Care Corporation
We have audited the accompanying consolidated balance sheets of Merit
Behavioral Care Corporation (the "Company") as of September 30, 1997 and 1996,
and the related consolidated statements of operations, stockholders' equity, and
cash flows for each of the three years in the period ended September 30, 1997.
These financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements based
on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits 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 Merit Behavioral Care
Corporation as of September 30, 1997 and 1996, and the results of its operations
and its cash flows for each of the three years in the period ended September 30,
1997, in conformity with generally accepted accounting principles.
As discussed in Note 4 to the financial statements, effective October 1,
1995, the Company changed its method of accounting for deferred contract
start-up costs related to new contracts or expansion of existing contracts.
Deloitte & Touche LLP
November 14, 1997
New York, New York
4
MERIT BEHAVIORAL CARE CORPORATION
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
DECEMBER
31, SEPTEMBER 30,
--------------------
1997 1997 1996
----------- --------- ---------
(UNAUDITED)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents................................ $ 75,827 $ 87,368 $ 47,375
Accounts receivable, net of allowance for doubtful
accounts of $1,711 at December 31, 1997 (unaudited) and
$2,603 and $1,996 at September 30, 1997 and 1996....... 49,917 41,884 28,383
Short-term marketable securities......................... 4,109 4,111 --
Deferred income taxes.................................... 6,616 6,616 2,296
Other current assets..................................... 7,300 13,129 2,481
----------- --------- ---------
Total current assets................................. 143,769 153,108 80,535
Property, plant and equipment, net....................... 82,427 83,312 67,880
Goodwill and other intangibles, net of accumulated
amortization of $89,047 at December 31, 1997
(unaudited) and $82,637 and $59,781 at September 30,
1997 and 1996.......................................... 187,597 195,192 162,849
Restricted cash and investments.......................... 3,880 3,727 5,668
Deferred financing costs, net of accumulated amortization
of $2,871 at December 31, 1997 (unaudited) and $2,484
and $1,142 at September 30, 1997 and 1996.............. 10,246 10,634 11,362
Other assets............................................. 23,552 22,772 16,507
----------- --------- ---------
Total assets............................................. $ 451,471 $ 468,745 $ 344,801
----------- --------- ---------
----------- --------- ---------
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable......................................... $ 7,217 $ 11,347 $ 5,888
Claims payable........................................... 106,957 102,834 57,611
Deferred revenue......................................... 8,747 8,131 6,577
Accrued interest......................................... 2,336 5,161 5,008
Current portion of long-term debt........................ 1,263 6,498 500
Other current liabilities................................ 15,307 18,386 13,079
----------- --------- ---------
Total current liabilities............................ 141,827 152,357 88,663
Long-term debt........................................... 318,002 323,002 253,500
Deferred income taxes.................................... 13,525 15,388 30,669
Other long-term liabilities.............................. 5,034 3,862 1,451
COMMITMENTS AND CONTINGENCIES (SEE NOTE 11)
STOCKHOLDERS' EQUITY:
Common stock (40,000,000 shares authorized, $0.01 par
value, 29,396,158 shares issued at December 31, 1997
(unaudited) and 29,396,158 and 28,398,800 shares issued
at September 30, 1997 and 1996)........................ 294 294 284
Additional paid in capital............................... 10,193 8,949 (9,756)
Accumulated deficit...................................... (30,979) (28,307) (14,435)
Notes receivable from officers........................... (6,425) (6,800) (5,470)
----------- --------- ---------
(26,917) (25,864) (29,377)
Less common stock in treasury (21,000 shares)............ -- -- (105)
----------- --------- ---------
Total stockholders' equity............................. (26,917) (25,864) (29,482)
----------- --------- ---------
Total liabilities and stockholders' equity............... $ 451,471 $ 468,745 $ 344,801
----------- --------- ---------
----------- --------- ---------
The accompanying notes are an integral part of these statements.
5
MERIT BEHAVIORAL CARE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN THOUSANDS)
THREE MONTHS ENDED
DECEMBER 31, YEARS ENDED SEPTEMBER 30,
-------------------------- -------------------------------------
1997 1996 1997 1996 1995
------------ ------------ ----------- ----------- -----------
(UNAUDITED) (UNAUDITED)
Revenue....................................... $ 177,217 $ 128,625 $ 555,717 $ 457,830 $ 361,549
Expenses:
Direct service costs........................ 145,997 102,932 449,563 361,684 286,001
Selling, general and administrative......... 22,091 16,579 67,450 64,523 49,823
Amortization of intangibles................. 7,231 6,799 26,897 25,869 21,373
Restructuring charge........................ -- -- -- 2,995 --
Income from joint ventures.................. (1,649) -- -- -- --
------------ ------------ ----------- ----------- -----------
173,670 126,310 543,910 455,071 357,197
Operating income.............................. 3,547 2,315 11,807 2,759 4,352
Other income (expense):
Interest income and other................... 1,074 780 3,497 2,838 1,498
Interest expense............................ (7,216) (6,186) (25,063) (23,826) --
Loss on disposal of subsidiary.............. -- -- (6,925) -- --
Merger costs and special charges............ (545) -- (1,314) (3,972) --
------------ ------------ ----------- ----------- -----------
(6,687) (5,406) (29,805) (24,960) 1,498
(Loss) income before income taxes and
cumulative effect of accounting change...... (3,140) (3,091) (17,998) (22,201) 5,850
(Benefit) provision for income taxes.......... (468) (219) (4,126) (5,332) 4,521
------------ ------------ ----------- ----------- -----------
(Loss) income before cumulative effect of
accounting change........................... (2,672) (2,872) (13,872) (16,869) 1,329
Cumulative effect of accounting change for
deferred contract start-up costs, net of tax
benefit of $757............................. -- -- -- (1,012) --
------------ ------------ ----------- ----------- -----------
Net (loss) income............................. $ (2,672) $ (2,872) $ (13,872) $ (17,881) $ 1,329
------------ ------------ ----------- ----------- -----------
------------ ------------ ----------- ----------- -----------
Pro forma net (loss) income assuming the new
method of accounting for deferred contract
start-up costs was applied retroactively.... $ (2,672) $ (2,872) $ (13,872) $ (16,869) $ 317
------------ ------------ ----------- ----------- -----------
------------ ------------ ----------- ----------- -----------
The accompanying notes are an integral part of these statements.
6
MERIT BEHAVIORAL CARE CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(DOLLARS IN THOUSANDS)
RETAINED NOTES
COMMON STOCK ADDITIONAL EARNINGS RECEIVABLE COMMON
-------------------------- PAID IN (ACCUMULATED FROM STOCK IN
SHARES AMOUNT CAPITAL DEFICIT) OFFICERS TREASURY
------------- ----------- ------------ -------------- ----------- -------------
BALANCE SEPTEMBER 30, 1994.............. 1,000,000 $ 10 $ 118,877 $ 2,117 $ -- $ --
Net income.............................. -- -- -- 1,329 -- --
------------- ----- ------------ -------------- ----------- -----
BALANCE SEPTEMBER 30, 1995.............. 1,000,000 10 118,877 3,446 -- --
Recapitalization from merger:
Redemption of common stock............ (915,754) (9) (258,129) -- -- --
Merger with MDC Acquisition Corp...... 415,023 4 104,996 -- -- --
Stock dividend........................ 24,763,531 247 (247) -- -- --
Issuance of stock to management....... 3,156,000 32 15,748 -- (5,800) --
Deferred taxes associated with
merger.............................. -- -- 7,594 -- -- --
Tax benefit from exercise of Merck stock
options............................... -- -- 1,505 -- -- --
Repayment of notes receivable........... -- -- -- -- 265 --
Cancellation of note receivable......... (20,000) -- (100) -- 100 --
Repurchase of common stock.............. -- -- -- -- -- (600)
Sale of common stock.................... -- -- -- -- (35) 495
Net loss................................ -- -- -- (17,881) -- --
------------- ----- ------------ -------------- ----------- -----
BALANCE SEPTEMBER 30, 1996.............. 28,398,800 284 (9,756) (14,435) (5,470) (105)
Issuance of stock for CMG acquisition... 739,358 7 5,538 -- -- --
Tax benefit from exercise of Merck stock
options............................... -- -- 11,630 -- -- --
Repayment of notes receivable........... -- -- -- -- 250 --
Repurchase of common stock.............. -- -- -- -- -- (30)
Sale of common stock.................... 258,000 3 1,537 -- (1,580) 135
Net loss................................ -- -- -- (13,872) -- --
------------- ----- ------------ -------------- ----------- -----
BALANCE SEPTEMBER 30, 1997.............. 29,396,158 $ 294 $ 8,949 $ (28,307) $ (6,800) $ --
------------- ----- ------------ -------------- ----------- -----
------------- ----- ------------ -------------- ----------- -----
The accompanying notes are an integral part of these statements.
7
MERIT BEHAVIORAL CARE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
THREE MONTHS ENDED
DECEMBER 31, YEARS ENDED SEPTEMBER 30,
-------------------------- -------------------------------
1997 1996 1997 1996 1995
------------ ------------ --------- --------- ---------
(UNAUDITED (UNAUDITED)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) income.................................... $ (2,672) $ (2,872) $ (13,872) $ (17,881) $ 1,329
Adjustments to reconcile net (loss) income to net
cash provided by (used for) operating activities:
Income from joint ventures....................... (1,649) -- -- -- --
Loss on sale of subsidiary....................... -- -- 6,925 -- --
Cumulative effect of accounting change........... -- -- -- 1,012 --
Depreciation and amortization.................... 11,028 9,907 39,400 36,527 28,150
Amortization of deferred financing costs......... 387 335 1,342 1,142 --
Deferred taxes and other......................... (619) (369) (4,409) (6,068) 379
Restructuring charge............................. -- -- -- 2,995 --
Changes in operating assets and liabilities, net of
the effect of acquisitions:
Accounts receivable.............................. (8,033) (6,492) (9,781) 265 (8,545)
Other current assets............................. 1,094 (1,336) (2,854) 536 (995)
Deferred contract start-up costs................. (335) (637) (6,067) (4,816) (6,231)
Accounts payable and accrued liabilities......... (5,295) (4,526) 16,224 14,864 11,982
------------ ------------ --------- --------- ---------
Net cash provided by (used for) operating
activities......................................... (6,094) (5,990) 26,908 28,576 26,069
------------ ------------ --------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property, plant and equipment....... (3,073) (5,554) (23,951) (23,808) (31,529)
Cash used for acquisitions, net of cash
acquired....................................... -- -- (35,645) (12,676) (9,580)
Investments in and advances to joint ventures.... (541) (850) (2,595) (2,931) (14,860)
Repayments of advances from joint ventures....... 1,859 180 675 420 --
Sales (purchases) of marketable securities....... -- -- (4,111) 1,143 3,533
Long-term restrictions removed from (placed on)
cash........................................... (153) 47 1,941 (2,183) (211)
Proceeds from sale of subsidiary and property,
plant and equipment............................ 4,867 -- -- -- --
Change in non-current assets and other........... 1,454 773 1,558 (1,282) (1,503)
------------ ------------ --------- --------- ---------
Net cash provided by (used for) investing
activities..................................... 4,413 (5,404) (62,128) (41,317) (54,150)
------------ ------------ --------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from capital contribution............... -- -- -- 114,980 --
Borrowings from parent........................... -- -- -- -- 32,882
Proceeds from bridge loan........................ -- -- -- 75,000 --
Proceeds from revolving credit facility.......... 25,000 40,000 187,500 163,500 --
Proceeds from senior term loans.................. -- -- 80,000 120,000 --
Proceeds from sale of notes...................... -- -- -- 100,000 --
Redemption of common stock....................... -- -- -- (258,138) --
Repayment of due to parent....................... -- -- -- (67,878) --
Repayment of bridge loan......................... -- -- -- (75,000) --
Repayment of senior term loans................... (5,235) (500) (500) -- --
Repayment of revolving credit facility........... (30,000) (35,000) (191,500) (129,500) --
Payment of financing costs....................... -- -- (602) (12,504) --
Other............................................ 375 250 315 125 --
------------ ------------ --------- --------- ---------
Net cash provided by (used for) financing
activities..................................... (9,860) 4,750 75,213 30,585 32,882
------------ ------------ --------- --------- ---------
INCREASE/(DECREASE) IN CASH AND CASH EQUIVALENTS..... (11,541) (6,644) 39,993 17,844 4,801
Cash and cash equivalents at beginning of year....... 87,368 47,375 47,375 29,531 24,730
------------ ------------ --------- --------- ---------
CASH AND CASH EQUIVALENTS AT END OF YEAR............. $ 75,827 $ 40,731 $ 87,368 $ 47,375 $ 29,531
------------ ------------ --------- --------- ---------
------------ ------------ --------- --------- ---------
The accompanying notes are an integral part of these statements.
8
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1997, 1996 AND 1995
(DOLLARS IN THOUSANDS)
1. ORGANIZATION
Merit Behavioral Care Corporation (the "Company") was incorporated in the
State of Delaware in March 1993 as a wholly-owned subsidiary of Medco
Containment Services, Inc. ("Medco"). The Company manages behavioral healthcare
programs for payors across all segments of the healthcare industry, including
health maintenance organizations, Blue Cross/Blue Shield organizations and other
insurance companies, corporations and labor unions, federal, state and local
governmental agencies, and various state Medicaid programs. Behavioral
healthcare involves the treatment of a variety of behavioral health conditions
such as emotional and mental health problems, substance abuse and other personal
concerns that require counseling, outpatient therapy or more intensive treatment
services.
On November 18, 1993, Merck & Co., Inc. ("Merck") acquired all of the
outstanding shares of Medco (See Note 3).
On October 6, 1995, the Company completed a merger (the "Merger") with MDC
Acquisition Corp. ("MDC"), a company formed by Kohlberg Kravis Roberts & Co.,
L.P. ("KKR"), whereby MDC was merged with and into the Company. In connection
with the Merger, the Company changed its name from Medco Behavioral Care
Corporation to Merit Behavioral Care Corporation (See Note 2).
2. MERGER
Prior to the Merger, the Company was a wholly-owned subsidiary of Merck &
Co., Inc. ("Merck"). As a result of the Merger, KKR and Company management and
related entities obtained approximately 85% of the post-Merger common stock of
the Company. In connection with the Merger, Merck received $326,016 in cash
(which reflects various final purchase price adjustments) and retained
approximately 15% of the common stock of the post-Merger Company. The Merger was
accounted for as a recapitalization which resulted in a charge to equity of
$258,138 to reflect the redemption of common stock. In conjunction with the
Merger, the Company paid a stock dividend of approximately 49.6 shares for each
share of the Company's stock then outstanding.
The Merger was financed with $114,980 of new cash equity, consisting of
$105,000 from affiliates of KKR and $9,980 from Company management and related
entities ("Management"). Management acquired an additional $5,800 of equity
which was funded by loans from the Company. The balance of the transaction was
funded with a $75,000 bridge loan (the "Bridge Loan") provided by an affiliate
of KKR and $155,000 of initial borrowings under a $205,000 senior credit
facility among the Company, The Chase Manhattan Bank, N.A. and Bankers Trust
Company (the "Senior Credit Facility"). The aforementioned proceeds were
utilized to redeem common stock for $258,138, repay amounts due Merck of
$67,878, and pay certain fees and expenses related to the Merger. Of the total
fees and expenses, $5,500 was paid to KKR.
3. BASIS OF PRESENTATION
On November 18, 1993, Merck acquired all the outstanding shares of Medco in
a transaction accounted for by the purchase method. As a result of this
acquisition, a new basis of accounting was established and as such, the
appraised value of the Company's assets and liabilities was recognized as of
November 18, 1993.
9
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. BASIS OF PRESENTATION (CONTINUED)
The appraisal determined that identified intangible assets, consisting
principally of customer contracts, had an appraised value of $112,000 and
related deferred taxes of $47,800 at the acquisition date. These identified
intangible assets are being amortized on a straight line basis over a weighted
average life of 12 years. Based on the allocation of the purchase price to the
net tangible and identified intangible assets and liabilities of the Company, an
excess of the allocated purchase price over the fair value of net assets
acquired of approximately $47,988 was recorded as goodwill. Such goodwill is
being amortized on a straight line basis over 40 years.
The unaudited consolidated financial statements of the Company as of
December 31, 1997 and for the three-month periods ended December 31, 1997 and
1996, were prepared by the Company without audit. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted. In the opinion of management, all necessary adjustments (consisting
only of normal recurring adjustments) have been made to present fairly the
consolidated financial position and results of operations and cash flows for
these periods. The results of operations for the period ended December 31, 1997
are not necessarily indicative of the expected results for the year ending
September 30, 1998.
Certain prior year amounts have been reclassified to conform to the current
year presentation.
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
USE OF ESTIMATES
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
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company
and its majority-owned subsidiaries. All significant intercompany balances and
transactions have been eliminated.
CASH AND CASH EQUIVALENTS
The Company considers all liquid investment instruments with an original
maturity of three months or less to be the equivalent of cash for purposes of
balance sheet presentation.
Included in cash and cash equivalents at September 30, 1997 and 1996 is
$11,020 and $11,713, respectively, of cash held under the terms of certain
customer contracts that require a claims fund to be established and segregated
for the purpose of paying customer behavioral healthcare claims. Under these
arrangements, a reconciliation process is typically conducted annually between
the customer and the Company to determine the amount of unexpended funds, if
any, accruing to the Company. This cash is unavailable to the Company for
purposes other than the payment of customer claims until such reconciliation
process has been completed. The amount of cash held under such arrangements in
excess of anticipated customer claims at September 30, 1997 and 1996 was $6,197
and $4,267, respectively.
10
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The Company held surplus cash balances of $29,325 and $13,715 as of
September 30, 1997 and 1996, respectively, as required by contracts with various
state and local governmental entities. In addition, at September 30, 1997 and
1996, the Company held surplus cash balances of $3,137 and $1,214, respectively,
as required by various other contracts. These contracts require the segregation
of such cash as financial assurance that the Company can meet its obligations
thereunder.
The Company has a subsidiary organized in the State of Missouri that is
licensed to do business as a foreign corporation in the State of California and
is subject to regulation by the Department of Corporations of the State of
California. Pursuant to these regulatory requirements, certain amounts of cash
are required to be retained for the use of this subsidiary. Included in cash and
cash equivalents at September 30, 1997 and 1996 is $0 and $900, respectively,
under such requirements.
SHORT-TERM MARKETABLE SECURITIES
Short-term marketable securities consist of treasury notes and certificates
of deposit, carried at amortized cost which approximates fair value. All of the
Company's short-term marketable securities are classified as held-to-maturity.
The Company held short-term marketable securities in the amount of $4,011 at
September 30, 1997 as required by the Company's contract with a governmental
entity.
RESTRICTED CASH
At September 30, 1997 and 1996, $6,623 and $7,168, respectively, of cash and
marketable securities were held by subsidiaries of the Company that are
organized and regulated under state law as insurance companies. Such insurance
companies are required to maintain certain minimum statutory deposits and
reserves with respect to the payment of future claims. The amount of cash in
excess of the liabilities of such subsidiaries and not available for dividend to
the Company without prior regulatory approval was $3,559 and $5,510 at September
30, 1997 and 1996, respectively. As a result, such amounts of cash held by these
subsidiaries have been classified as a long-term asset in the accompanying
consolidated balance sheets.
All of the Company's long-term marketable investments are classified as
held-to-maturity; in addition, such investments are carried at amortized cost
which approximates fair value.
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are stated at cost. For financial reporting
purposes, depreciation is provided principally on a straight line basis over the
estimated useful lives of the assets as follows:
Machinery and equipment....................................... 5 Years
Integrated managed care information system.................... 7 Years
Furniture and fixtures........................................ 15 Years
Life of
Leasehold improvements........................................ lease
Expenditures for maintenance, repairs and renewals of minor items are
charged to operations as incurred. Major betterments are capitalized.
The integrated managed care information system (the "System") represents
costs incurred in the development and adaptation of AMISYS software for use in
the Company's business. In addition to
11
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
purchased hardware and software costs, the payroll and related benefits of
employees who are exclusively engaged in the development and deployment of the
System are capitalized. The System was substantially complete in October 1995 at
which time the Company began installing the System in various area and regional
offices in the Company's service delivery system. As the System is installed in
an office, the office is allocated a ratable portion of the total cost of the
System, at which time the allocated cost is depreciated over an estimated useful
life of 7 years.
GOODWILL AND OTHER INTANGIBLES
The Company amortizes costs in excess of the net assets of businesses
acquired on a straight line basis over periods not to exceed 40 years.
Contingent consideration is charged to goodwill when paid and is amortized over
the remaining life of such goodwill, not to exceed 40 years. The Company
periodically reviews the carrying value of goodwill to assess recoverability and
other than temporary impairments.
Goodwill and intangible assets consisted of the following at September 30,
1997 and 1996:
1997 1996
----------- -----------
Customer Contracts.................................................. $ 88,074 $ 80,000
Provider Network.................................................... 12,000 12,000
Trade Names and other............................................... 20,000 20,000
Goodwill............................................................ 157,755 110,630
----------- -----------
$ 277,829 $ 222,630
----------- -----------
----------- -----------
DEFERRED CONTRACT START-UP COSTS
The Company defers contract start-up costs related to new contracts or
expansion of existing contracts that require the implementation of separate,
dedicated service delivery teams, provider networks and delivery systems or the
establishment of a local clinical organization in a new geographic area to
service the new program. The Company defers only costs which (i) are separately
identified, incremental and segregated from ordinary operating expenses; (ii)
provide a direct, quantifiable benefit to future periods; and (iii) are fully
recoverable from contract revenues directly attributable to such benefit. The
incremental costs deferred by the Company include, among other things,
consulting fees, salary costs, travel costs, office costs and network and
reporting system development costs. Consulting fees deferred by the Company
relate primarily to the recruitment, credentialling and contracting of the
particular customer's provider network. The salary costs relate primarily to
employees of the Company dedicated to clinical protocol design, network
development activities and program reporting and information systems
customization for the specific customer. These contract start-up costs are
capitalized and amortized on a straight line basis over the initial term of the
related contract. The amortization periods range from one to five years, with a
weighted-average life at September 30, 1997 and 1996 of 4.3 and 3.3 years,
respectively. Amortization of deferred contract start-up costs was $3,096,
$2,848, and $1,315 for the periods ended September 30, 1997, 1996, and 1995,
respectively. During the periods ended September 30, 1997, 1996, and 1995, the
Company deferred contract start-up costs of $6,067, $4,816, and $6,231,
respectively. Other non-current assets include $9,036 and $6,077 of unamortized
deferred contract start-up costs at September 30, 1997 and 1996, respectively.
12
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Effective October 1, 1995, the Company changed its method of accounting for
deferred start-up costs related to new contracts or expansion of existing
contracts (i) to expense costs relating to start-up activities incurred after
commencement of services under the contract, and (ii) to limit the amortization
period for deferred start-up costs to the initial contract period. Prior to
October 1, 1995, the Company capitalized start-up costs related to the
completion of the provider networks and reporting systems beyond commencement of
contracts and, in limited instances, amortized the start-up costs over a period
that included the initial renewal term associated with the contract. Under the
new policy, the Company does not defer contract start-up costs after contract
commencement, or amortize start-up costs beyond the initial contract period. The
change was made to increase the focus on controlling costs associated with
contract start-ups.
The pro forma effect of the change, had the Company adopted this new
accounting policy in prior years, is to decrease total assets by $1,769 and
decrease total liabilities by $757 as of September 30, 1995, and to increase
costs and expenses by $1,769 ($1,012 after taxes) for the year ended September
30, 1995. The effect of the change on fiscal 1996 and 1997 cannot be reasonably
estimated.
REVENUE RECOGNITION
Typically, the Company charges each of its customers a flat monthly
capitation fee for each beneficiary enrolled in such customer's behavioral
health managed care plan or Employee Assistance Program ("EAP"). This capitation
fee is generally paid to the Company in the current month. Contract revenue
billed in advance of performing related services is deferred and recognized
ratably over the period to which it applies. For a number of the Company's
behavioral health managed care programs, the capitation fee is divided into
outpatient and inpatient fees, which are recognized separately.
Outpatient revenue is recognized monthly as it is received; inpatient
revenue is recognized monthly and is in most cases (i) paid to the Company
monthly (in cases where the Company is responsible for the payment of inpatient
claims) or in certain cases (ii) retained by the customer for payment of
inpatient claims. When the customer retains the inpatient revenue, actual
inpatient costs are periodically reconciled to amounts retained and the Company
receives the excess of the amounts retained over the cost of services, or
reimburses the customer if the cost of services exceeds the amounts retained. In
certain instances, such excess or deficiency is shared between the Company and
the customer. A significant portion of the Company's revenue is derived from
capitated contracts.
DIRECT SERVICE COSTS
Direct service costs are comprised principally of expenses associated with
managing, supervising and providing the Company's services, including
third-party network provider charges, various charges associated with the
Company's staff offices, inpatient facility charges, costs associated with
members of management principally engaged in the Company's clinical operations
and their support staff, and rent for certain offices maintained by the Company
in connection with the delivery of services. Direct service costs are recognized
in the month in which services are expected to be rendered. Network provider and
facility charges for authorized services that have not been reported and billed
to the Company (known as incurred but not reported expenses, or "IBNR") are
estimated and accrued based on historical experience, current enrollment
statistics, patient census data, adjudication decisions and other information.
Such costs are included in the caption "Claims payable" in the accompanying
consolidated balance sheets.
13
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INCOME TAXES
Deferred taxes are provided for the expected future income tax consequences
of events that have been recognized in the Company's financial statements.
Deferred tax assets and liabilities are determined based on the temporary
differences between the financial statement carrying amounts and the tax bases
of assets and liabilities using enacted tax rates in effect in the years in
which the temporary differences are expected to reverse.
LONG-LIVED ASSETS
The Financial Accounting Standards Board issued SFAS No. 121, ACCOUNTING FOR
THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF,
in March 1995. The general requirements of this statement are applicable to the
properties and intangible assets of the Company and require impairment to be
considered whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. If the sum of expected
future cash flows (undiscounted and without interest charges) is less than the
carrying amount of the asset, an impairment loss is recognized. The Company
adopted this standard on October 1, 1996. No impairment losses have been
identified by the Company.
STOCK-BASED COMPENSATION PLANS
During fiscal 1997, the Company adopted SFAS No. 123, ACCOUNTING FOR
STOCK-BASED COMPENSATION ("SFAS 123"). The new standard defines a fair value
method of accounting for stock options and similar equity instruments. Under the
fair value method, compensation cost is measured at the grant date based on the
fair value of the award and is recognized over the service period, which is
usually the vesting period. As permitted by SFAS 123, however, the Company has
elected to continue to recognize and measure compensation for its stock rights
and stock option plans in accordance with the existing provisions of Accounting
Principles Board Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES ("APB
25"). See Note 16 for pro forma disclosures of net loss as if the fair
value-based method prescribed by SFAS No. 123 had been applied.
DISCLOSURE OF FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amount reported in the consolidated balance sheets for cash and
cash equivalents, accounts receivable, accounts payable and accrued liabilities
approximates fair value because of the immediate or short-term maturity of these
financial instruments. The Company's short-term marketable securities and
long-term marketable investments are carried at amortized cost which
approximates fair value. The carrying amount of loans made to certain joint
ventures engaged in the development of Medicaid programs (Note 9) approximates
fair value which was estimated by discounting future cash flows using rates at
which similar loans would be made to borrowers with similar credit ratings. The
carrying value for the variable rate debt outstanding under the Senior Credit
Facility (as described in Note 6) approximates the fair value. The fair value of
the Company's senior subordinated notes (see Note 6) is estimated to be $109,000
at September 30, 1997 (based on quoted market prices) which compares to the
carrying value of $100,000.
14
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
CONCENTRATIONS OF CREDIT RISK
Financial instruments that potentially subject the Company to concentrations
of credit risk consist principally of trade receivables. Concentrations of
credit risk with respect to trade receivables are limited due to the large
number of customers comprising the Company's customer base and the dispersion of
such customers across different businesses and geographic regions.
5. PROPERTY, PLANT, AND EQUIPMENT
Property, plant and equipment consisted of the following at September 30:
1997 1996
----------- ----------
Machinery and equipment............................................. $ 58,988 $ 44,896
Integrated managed care information system.......................... 38,914 28,349
Furniture and fixtures.............................................. 16,665 12,795
Leasehold improvements.............................................. 3,443 2,977
----------- ----------
118,010 89,017
Accumulated depreciation and amortization........................... (34,698) (21,137)
----------- ----------
$ 83,312 $ 67,880
----------- ----------
----------- ----------
Depreciation and amortization related to property, plant and equipment was
$12,503, $10,658, and $6,776 for the periods ended September 30, 1997, 1996, and
1995, respectively.
6. LONG TERM DEBT
Long-term debt consisted of the following at September 30:
1997 1996
----------- -----------
Revolving Loans..................................................... $ 30,000 $ 34,000
Senior Term Loan A.................................................. 70,000 70,000
Senior Term Loan B.................................................. 129,500 50,000
Notes............................................................... 100,000 100,000
----------- -----------
329,500 254,000
Less current portion................................................ (6,498) (500)
----------- -----------
$ 323,002 $ 253,500
----------- -----------
----------- -----------
SENIOR CREDIT FACILITY--In October 1995, the Company entered into a credit
agreement (the "Credit Agreement"), which provided for secured borrowings from a
syndicate of lenders. The Senior Credit Facility consisted initially of (i) a
six and one-half year revolving credit facility (the "Revolving Credit
Facility") providing for up to $85,000 in revolving loans, which includes
borrowing capacity available for letters of credit of up to $20,000, and (ii) a
term loan facility providing for up to $120,000 in term loans, consisting of a
$70,000 senior term loan with a maturity of six and one-half years ("Senior Term
Loan A"), and a $50,000 senior term loan with a maturity of eight years ("Senior
Term Loan B"). On September 12, 1997, the Senior Term Loan B was increased by
$80,000 to $130,000 with the maturity extended one and one-half years. The
additional borrowings from Senior Term Loan B were primarily obtained to fund
the
15
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. LONG TERM DEBT (CONTINUED)
acquisition of CMG Health, Inc. ("CMG"), as discussed in Note 8. At September
30, 1997, $30,000 of revolving loans and five letters of credit totaling $8,313
were outstanding under the Revolving Credit Facility, and approximately $46,687
was available for future borrowing. At September 30, 1996, $34,000 of revolving
loans and three letters of credit totaling $425 were outstanding under the
Revolving Credit Facility, and approximately $50,575 was available for future
borrowings.
In October 1996, a scheduled repayment of $500 was made on Senior Term Loan
B. The annual amortization schedule of the Senior Term Loans is $6,498 in 1998,
$10,000 in 1999, $12,500 in 2000, $20,000 in 2001, $25,000 in 2002 and $125,502
thereafter. The Senior Term Loans are subject to mandatory prepayment (i) with
the proceeds of certain asset sales and (ii) on an annual basis with 50% of the
Company's Excess Cash Flow (as defined in the Credit Agreement) for so long as
the ratio of the Company's Total Debt (as defined in the Credit Agreement) to
annual Earnings Before Interest, Taxes, Depreciation and Amortization ("EBITDA"
as defined in the Credit Agreement) is greater than 3.5 to 1.0. Proceeds in the
amount of $4,735 received in October 1997 as a result of the disposal of one of
the Company's subsidiaries (See Note 17) have been classified as current in
accordance with the mandatory prepayment loan provision. At September 30, 1997,
approximately $662 has been classified as current in accordance with mandatory
prepayment requirements for Excess Cash Flow.
The Company is charged a commitment fee calculated at an EBITDA-dependent
rate ranging from 0.250% to 0.500% per annum of the commitment under the
Revolving Credit Facility in effect on each day. The Company is charged a letter
of credit fee calculated at an EBITDA-dependent rate ranging from 0.375% to
1.750% per annum of the face amount of each letter of credit and a fronting fee
calculated at a rate equal to 0.250% per annum of the face amount of each letter
of credit. Loans under the Credit Agreement bear interest at EBITDA-dependent
floating rates, which are, at the Company's option, based upon (i) the higher of
the Federal funds rate plus 0.5%, or bank prime rates, or (ii) Eurodollar rates.
Rates on borrowing outstanding under the Senior Credit Facility averaged 8.1%
and 8.3% for the years ended September 30, 1997 and 1996, respectively.
NOTES--On November 22, 1995, the Company issued $100,000 aggregate principal
amount of 11 1/2% senior subordinated notes due 2005 (the "Private Notes"), the
net proceeds of which were applied to repay the Bridge Loan (including accrued
interest) and a portion of the Revolving Credit Facility. On March 20, 1996, the
Company exchanged the Private Notes for $100,000 aggregate principal amount of
11 1/2% Senior Subordinated Notes due 2005 that are registered under the
Securities Act of 1933 (the "Notes"). The Notes are senior subordinated,
unsecured obligations of the Company.
The Company may be obligated to purchase at the holders' option all or a
portion of the Notes upon a change of control or asset sale, as defined in the
indenture for the Notes (the "Notes Indenture"). The Notes are not redeemable at
the Company's option prior to November 15, 2000, except that at any time on or
prior to November 15, 1998, under certain conditions the Company may redeem up
to 35% of the initial principal amount of the Notes originally issued with the
net proceeds of a public offering of the common stock of the Company. The
redemption price is equal to 111.50% of the principal amount if the redemption
is on or prior to November 15, 1997, and 110.50% if the redemption is on or
prior to November 15, 1998. From and after November 15, 2000, the Notes will be
subject to redemption at the option of the Company, in whole or in part, at
various redemption prices, declining from 105.75% of the principal amount to par
on and after November 15, 2004. The Notes mature on November 15, 2005.
16
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. LONG TERM DEBT (CONTINUED)
The Credit Agreement and the Notes Indenture contain restrictive covenants
that, among other things and under certain conditions, limit the ability of the
Company to incur additional indebtedness, to acquire (including a limitation on
capital expenditures) or to dispose of assets or operations, to incur liens on
its property or assets, to make advances, investments and loans, and to pay any
dividends. The Company must also satisfy certain financial covenants and tests.
Borrowings under the Credit Agreement are secured by a first priority lien
on the capital stock of certain of the Company's subsidiaries.
7. NOTES RECEIVABLE FROM OFFICERS
In October 1995, the Company loaned several officers an aggregate of $5,800
for the purchase of common stock of the Company; subsequent to the Merger,
additional loans totaling $1,615 were made to officers for the purchase of
shares of common stock. Each loan is represented by a promissory note which
bears interest at a rate of 6.5% per annum.
These notes are full recourse obligations of the officers, are
collateralized by the pledge of common stock of the Company held by such
officers and may be prepaid in part or in full without notice or penalty. Notes
receivable totaling $250 and $265 were repaid during the periods ended September
30, 1997 and 1996, respectively. Also a note for $100 was canceled in January
1996 for receipt of shares of common stock. The remaining outstanding notes are
due as follows: $20 in 1998 and $6,780 in 2001. The notes are shown as a
reduction of stockholders' equity in the accompanying consolidated balance
sheets.
8. ACQUISITIONS
On September 12, 1997, the Company paid an initial $48,740 and issued
739,358 shares of Company common stock to acquire all of the capital stock of
CMG, a Maryland-based provider of managed behavioral healthcare services. The
acquisition was accounted for as a purchase transaction. The consolidated
financial statements of the Company include the operating results of CMG from
the date of the acquisition. The purchase price for CMG was allocated to the net
assets acquired based upon their estimated fair values. The Company common stock
issued in the acquisition was assigned a value of $7.50 per share based on a
valuation analysis performed by an independent third party. The excess of the
purchase price over the net tangible assets acquired amounted to $64,715 and is
being amortized over periods up to 40 years using the straight-line method. The
purchase price allocation was based on preliminary estimates and may be revised
upon final valuation. The Company is obligated to make contingent payments to
the former shareholders of CMG if the financial results of certain contracts
exceed specified base-line amounts. Such contingent payments are subject to an
aggregate maximum of $23,500. Any such additional payments will be recorded as
goodwill.
The following summary of the unaudited pro forma consolidated results of
operations of the Company for the years ended September 30, 1997 and 1996
assumes the CMG acquisition occurred as of the beginning of the respective
periods. The pro forma results include the combined historical results of the
Company and CMG, and pro forma adjustments to reflect (i) interest expense
associated with the debt incurred to finance the acquisition, (ii) changes to
depreciation and amortization related to the allocation of the cost of CMG to
the assets acquired and liabilities assumed and (iii) reductions of salaries,
benefits and certain other costs included in the historical results of CMG which
will be eliminated as a result of the acquisition. These pro forma results have
been prepared for comparative
17
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. ACQUISITIONS (CONTINUED)
purposes only and do not purport to be indicative of the results of operations
which actually would have resulted had the acquisition occurred at the beginning
of the respective periods, or which may result in the future.
UNAUDITED
------------------------
1997 1996
----------- -----------
Revenue............................................................. $ 653,477 $ 522,857
Net loss............................................................ (15,048) (16,939)
In August 1996, the Company paid approximately $340 to acquire Orion Life
Insurance Company ("Orion"), a Delaware life and health insurance company. Orion
holds insurance licenses in 17 states and provides the Company with the ability
to underwrite future business in those states should a customer require that a
licensed insurance entity underwrite its behavioral health program.
On December 19, 1995, the Company paid an initial $50 with a subsequent
payment of $2,950 in January 1996 to acquire ProPsych, Inc. ("ProPsych"), a
Florida-based behavioral health managed care company. As of September 30, 1996,
the Company recorded additional goodwill in the amount of $400 for a final
contingent payment made to the former shareholders of ProPsych in November 1996.
On October 5, 1995, the Company paid an initial $8,730 to acquire Choate
Health Management, Inc. and certain related entities ("Choate"), a
Massachusetts-based integrated behavioral healthcare organization. The Company
made a contingent consideration payment of $1,278 to the former shareholders of
Choate in July 1996; such payment was recorded as goodwill. In June 1997, the
Company and the former Choate shareholders signed an agreement which provided
for the settlement of the contingent consideration related to Choate. Such
agreement required no further payments by the Company. Choate was sold by the
Company in September 1997 (See Note 17).
In September 1995, a contingent payment of $8,550 was made to the former
shareholders of BenesYs, a subsidiary of the Company, in full settlement of any
and all contingent consideration due to such former shareholders. In April 1995,
a final payment of $650 was made related to the acquisition of the clinical
protocols of the Washton Institute.
9. JOINT VENTURES
CMG, which was acquired on September 12, 1997, is a 50% partner in CHOICE
Behavioral Health Partnership ("Choice"), a managed behavioral healthcare
company. The Company reports its investment in Choice using the equity method.
Although the Company reports its share of earnings from the joint venture, the
financial statements of Choice are not consolidated with those of the Company.
All revenue of the joint venture is from a contract for the Civilian Health and
Medical Program of the Uniformed Services ("CHAMPUS") with Humana, Inc.
18
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. JOINT VENTURES (CONTINUED)
Summarized financial information of the joint venture, representing 100% of
its business, as of September 30, 1997 and for the period from September 12,
1997 through September 30, 1997, is as follows:
Current Assets............. $ 38,286 Net Revenues............... $ 3,333
Cost of Providing
Non-Current Assets......... 700 Services................... 2,973
--------- ---------
Total Assets........... $ 38,986
---------
---------
Gross Profit............... 360
Total Liabilities.......... $ 37,141
Partners' Capital.......... 1,845 Other Expenses............. 106
--------- ---------
Total Liabilities & P.C.... $ 38,986 Net Income................. $ 254
--------- ---------
--------- ---------
In March 1994, the Company entered into a joint venture partnership with
Community Sector Systems, Inc. ("CSS"), a software development company, to
market a proprietary clinical information, communications and case documentation
software package. The Company contributed $125 in capital, loaned $1,375 to CSS
in 1994 and made an additional loan of $300 to CSS in 1995. In December 1996,
the Company converted the $1,375 loan and the accrued interest receivable on the
loan of $369 into an equity interest in CSS, and made an additional capital
contribution of $500. Additionally, in February 1997 the Company contributed
capital of $350 and loaned CSS $150. As of September 30, 1997, the Company has a
net loan receivable from CSS of $450 and an equity investment in CSS of $2,719.
In April 1995, the Company entered into a contractual arrangement with
Community Health Network of Connecticut, Inc. ("CHN"), an organization
consisting of 11 not-for-profit health centers in Connecticut, under which the
Company has agreed to provide CHN with up to a total of $4,000 in unsecured debt
to help finance CHN's Medicaid program development costs. As of September 30,
1997 and 1996, the Company had net advances to CHN outstanding of $1,732 and
$2,079, respectively.
Also, in April 1995, the Company entered into a joint venture with
Neighborhood Health Providers, LLC ("NHP"), an organization consisting of five
hospitals located in Brooklyn and Queens, New York, under which the Company
agreed to fund a portion of NHP's Medicaid program development costs in the form
of $1,500 in unsecured debt. As of September 30, 1997 and 1996, the Company had
net advances of $1,500 to NHP.
In September 1995, the Company paid $12,010 to Empire Blue Cross and Blue
Shield ("Empire") for the right to provide behavioral health managed care
services to approximately 750,000 Empire enrollees in the State of New York for
a period of eight years. In connection therewith, the Company formed a limited
liability company (the "Empire Joint Venture") with the Company and Empire
receiving ownership interests of 80% and 20%, respectively. The payment was
charged to goodwill and is being amortized over the life of the underlying
contract.
In January 1996, the Company formed a joint venture with the hospital
sponsors of NHP under the name Royal Health Care LLC ("Royal"), in which the
Company and NHP each holds a 50% equity interest. Royal has management services
contracts with certain organizations including NHP and Empire Community Delivery
Systems LLC ("ECDS"). During fiscal 1996, the Company made an equity
contribution and an unsecured working capital loan to Royal in the amounts of
$200 and $228, respectively. During fiscal 1997, the Company made an additional
capital contribution of $100 to Royal.
19
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. JOINT VENTURES (CONTINUED)
ECDS, which was formed in fiscal 1996, is a joint venture company in which
the Company, NHP and Empire hold interests of approximately 16.7%, 16.7%, and
66.6%, respectively. The Company made capital contributions to ECDS in 1997 and
1996 of $667 and $458, respectively. Also, in 1997 and 1996 the Company provided
loans to NHP, the proceeds of which were used to fund NHP's capital
contributions to ECDS, of $667 and $458, respectively. The loans to NHP are
secured by NHP's interest in ECDS. Empire and ECDS have entered into an
agreement under which ECDS will exclusively manage and operate, on behalf of
Empire, health care benefit programs (covering all services except behavioral
healthcare and vision care) in the five New York City boroughs for Medicaid
beneficiaries enrolled in Empire plans. Each of Empire and Royal will provide
specified administrative and management services to ECDS to support its delivery
of services to Empire under such agreement. Moreover, each of ECDS and Royal
will hold specified equity interests in certain independent practice
associations (IPAs) providing treatment services to the Empire Medicaid
beneficiaries. In addition, Empire has entered into an agreement with the Empire
Joint Venture to exclusively provide, on behalf of Empire, all behavioral
healthcare services in New York City to such Empire Medicaid enrollees. The
Royal and ECDS joint ventures and related agreements have five year terms, with
up to three five-year renewals (subject to applicable regulatory approvals).
Each such venture and agreement also contains customary termination provisions.
The receivables from, and the investments in, CSS, NHP, CHN, Royal and ECDS
are reflected in "other assets" in the accompanying balance sheets.
20
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. INCOME TAXES
Prior to the Merger, the Company filed a consolidated federal income tax
return with Merck. Though no formal tax sharing agreement existed between the
Company and Merck, the Company computed federal income taxes on a separate
return basis and recorded such taxes in the caption "Due to parent".
The components of income tax expense (benefit) for the periods ended
September 30, are as follows:
1997 1996 1995
--------- --------- ---------
Current:
Federal.................................................... $ -- $ -- $ 3,030
State...................................................... 283 736 1,112
--------- --------- ---------
283 736 4,142
--------- --------- ---------
Deferred:
Federal.................................................... (4,848) (5,495) 200
State...................................................... 439 (573) 179
--------- --------- ---------
(4,409) (6,068) 379
--------- --------- ---------
Total........................................................ $ (4,126) $ (5,332) $ 4,521
--------- --------- ---------
--------- --------- ---------
The differences between the U.S. federal statutory tax rate and the
Company's effective tax rate are as follows:
1997 1996 1995
--------- --------- ---------
U.S. federal statutory tax rate.................................. (35.0)% (35.0)% 35.0%
State income taxes (net of federal benefit)...................... 0.6 0.4 14.4
Capital loss..................................................... 6.9 -- --
Merger expenses.................................................. -- 5.8 --
Goodwill......................................................... 3.1 2.3 13.1
Expenses without tax benefit..................................... 1.6 2.0 13.9
Other............................................................ (0.1) 0.5 0.9
--------- --------- ---
Effective tax rate............................................... (22.9)% (24.0)% 77.3%
--------- --------- ---
--------- --------- ---
At September 30, 1997 and 1996, the Company had $46,733 and $23,707,
respectively, of deferred income tax assets and $55,505 and $52,080,
respectively, of deferred income tax liabilities which have
21
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. INCOME TAXES (CONTINUED)
been netted for presentation purposes. The significant components of these
amounts are shown on the balance sheet as follows:
1997 1996
---------------------- ----------------------
CURRENT NON CURRENT CURRENT NON CURRENT
ASSET LIABILITY ASSET LIABILITY
--------- ----------- --------- -----------
Provision for estimated expenses........ $ 7,023 $ 507 $ 2,630 $ 2,161
Capitalized expenses.................... (407) (1,224) (334) (1,436)
Net operating loss carryforwards........ -- 28,502 -- 9,170
Accelerated depreciation................ -- (20,194) -- (14,605)
Intangible asset differences............ -- (22,979) -- (25,959)
--------- ----------- --------- -----------
$ 6,616 $ (15,388) $ 2,296 $ (30,669)
--------- ----------- --------- -----------
--------- ----------- --------- -----------
Management believes that the deferred tax assets will be fully realized
based on future reversals of existing taxable temporary differences and
projected operating results of the Company. As a result, no valuation allowance
has been provided. At September 30, 1997, the Company had U.S. federal net
operating loss carryforwards of approximately $76,630 for tax purposes.
Approximately $5,920 of the carryforwards expire in 2010, $21,460 expire in 2011
and $49,250 expire in 2012.
11. COMMITMENTS AND CONTINGENCIES
A. LEASES
The Company leases office facilities and equipment under various
noncancelable operating leases.
At September 30, 1997, the minimum aggregate rental commitments under
noncancelable leases, excluding renewal options, are as follows:
1998.............................................................. $ 13,469
1999.............................................................. 11,606
2000.............................................................. 9,892
2001.............................................................. 8,699
2002.............................................................. 6,382
Thereafter........................................................ 18,219
---------
Minimum lease payments............................................ 68,267
Less amounts representing sublease income......................... (2,060)
---------
$ 66,207
---------
---------
Several of the leases contain escalation provisions due to increased
maintenance costs and taxes. Scheduled rent increases are amortized on a
straight-line basis over the lease term. Total rent expense for the periods
ended September 30, 1997, 1996 and 1995 amounted to $15,842, $13,059 and
$10,115, respectively.
22
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
11. COMMITMENTS AND CONTINGENCIES (CONTINUED)
B. EMPLOYMENT AGREEMENTS
The Company and certain of its subsidiaries have employment agreements with
various officers and certain other management personnel that provide for salary
continuation for a specified number of months under certain circumstances. The
aggregate commitment for future salaries at September 30, 1997, excluding
bonuses, was approximately $2,735.
C. LEGAL PROCEEDINGS
In October 1996, a group of eight plaintiffs purporting to represent an
uncertified class of psychiatrists and clinical social workers brought an action
under the federal antitrust laws in the United States District Court for the
Southern District of New York against nine behavioral health managed care
organizations, including the Company (collectively, "Defendants"). The complaint
alleges that Defendants violated section 1 of the Sherman Act by engaging in a
conspiracy to fix the prices at which Defendants purchase services from mental
healthcare providers such as plaintiffs. The complaint further alleges that
Defendants engaged in a group boycott to exclude mental healthcare providers
from Defendants' networks in order to further the goals of the alleged
conspiracy. The complaint also challenges the propriety of Defendents'
capitation arrangements with their respective customers, although it is unclear
from the complaint whether plaintiffs allege that Defendants unlawfully
conspired to enter into capitation arrangements with their respective customers.
The complaint seeks treble damages against Defendants in an unspecified amount
and a permanent injunction prohibiting Defendants from engaging in the alleged
conduct which forms the basis of the complaint, plus costs and attorneys' fees.
In January 1997, Defendants filed a motion to dismiss the complaint. On July 21,
1997, a court-appointed magistrate judge issued a report and recommendation to
the District Court recommending that Defendants' motion to dismiss the complaint
with prejudice be granted. On August 5, 1997, plaintiffs filed objections to the
magistrate judge's report and recommendation; such objections have not yet been
heard. The Company intends to vigorously defend itself in this litigation. No
amounts are recorded on the books of the Company in anticipation of a loss as a
result of this contingency.
The Company is engaged in various other legal proceedings that have arisen
in the ordinary course of its business. The Company believes that the ultimate
outcome of such proceedings will not have a material effect on the Company's
financial position, liquidity or results of operations.
D. INSURANCE
Under the Company's professional liability insurance policy, coverage is
limited to the period in which a claim is asserted, rather than when the
incident giving rise to such claim occurred. The Company has obtained
professional liability insurance through October 6, 1998; however, in the event
the Company was unable to obtain professional liability insurance at the
expiration of the current policy period, it is possible that the Company would
be uninsured for claims asserted after the expiration of the current policy
period. Historical experience of the Company does not indicate that losses, if
any, arising from claims asserted after the expiration of the current
professional liability policy period would have a material effect on the
Company's financial position, liquidity or results of operations.
23
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
11. COMMITMENTS AND CONTINGENCIES (CONTINUED)
E. CHAMPUS CONTRACT
On April 1, 1997, the Company began providing mental health and substance
abuse services, as a subcontractor, to beneficiaries of CHAMPUS in the
Southwestern and Midwestern United States, designated as CHAMPUS Regions 7 and
8. The fixed monthly amounts that the Company receives for medical costs and
records as revenue are subject to a one-time retroactive adjustment scheduled to
be determined in August 1998 based upon actual healthcare utilization during the
period known as the "data collection period". The data collection period is the
year ended March 31, 1997. Because of the inherent uncertainty surrounding
factors included in the determination of the final retroactive adjustment,
management has not been able to quantify a range of potential adjustment, and
accordingly no adjustments have been recorded as of September 30, 1997. As a
result, the amount of recorded revenue and income from the CHAMPUS contract may
differ significantly from the amount that would have been recorded had the
actual factors been known.
12. RELATED PARTY TRANSACTIONS
During the period ended September 30, 1997, the Company paid consulting fees
and board fees to KKR totaling approximately $500. During the period ended
September 30, 1996, the Company paid consulting fees and board fees to KKR
totaling approximately $5,900; of such amount, $5,500 related to the Merger and
associated financing transactions.
Prior to the merger, Medco disbursed funds on behalf of the Company for the
payment of certain of the Company's U.S. federal, state and local income taxes
and certain acquisition transactions described in Note 8.
Included in expense for the periods ended September 30, 1997, 1996 and 1995
are charges totaling $1,467, $1,218 and $703, respectively, related to a
prescription drug benefit program administered by Medco.
The average balance due to the parent (Medco) for fiscal 1995 was $40,996;
such balance was repaid in full on October 6, 1995 in connection with the
Merger. A summary of intercompany activity with the parent is as follows:
Due to parent, October 1, 1994................................... $ 37,931
Allocation of costs from parent.................................. 379
Intercompany purchases........................................... 659
Income taxes paid by parent...................................... 3,795
Cash transfer from parent........................................ 28,049
---------
Due to parent, September 30,1995................................. 70,813
Adjustment to income taxes paid by parent........................ (2,935)
Repayment made in connection with the Merger..................... (67,878)
---------
Due to parent, September 30,1996................................. $ --
---------
---------
13. RESTRUCTURING CHARGE
The Company recorded a pre-tax restructuring charge of $2,995 related to a
plan, adopted and approved in the fourth quarter of 1996, to restructure its
staff offices by exiting certain geographic
24
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
13. RESTRUCTURING CHARGE (CONTINUED)
markets and streamlining the field and administrative management organization of
Continuum Behavioral Healthcare Corporation, a subsidiary of the Company. This
decision was in response to the results of underperforming locations affected by
the lack of sufficient patient flow in the geographic areas serviced by these
offices and the Company's ability to purchase healthcare services at lower rates
from the network. In addition, it was determined that the Company would be able
to expand beneficiary access to specialists and other providers, thereby
achieving more cost-effective treatment, and to favorably shift a portion of the
economic risk, in some cases, of providing outpatient healthcare to the provider
through the use of case rates and other alternative reimbursement methods. The
restructuring charge was comprised primarily of accruals for employee severance,
real property lease terminations and write-off of certain assets in geographic
markets which were being exited. The restructuring plan was substantially
completed during fiscal 1997.
14. MAJOR CUSTOMERS
For fiscal 1997, revenue derived from a state Medicaid contract accounted
for approximately 12% of the Company's operating revenues. For fiscal 1996 and
1995, no customer accounted for more than 10% of the Company's operating
revenues.
15. EMPLOYEE BENEFIT PLAN
The Company has a 401(k) savings plan covering substantially all employees
who have completed one year of active employment during which 1,000 hours of
service has been credited. Under the plan, an employee may elect to contribute
on a pre-tax basis to a retirement account up to 15% of the employee's
compensation up to the maximum annual contributions permitted by the Internal
Revenue Code. The Company matches employee contributions at the rate of 50% (25%
for periods prior to January 1, 1997) of the employee's contributions to the
401(k) savings plan, up to a maximum of 6% of an employee's annual compensation.
The Company's 401(k) savings plan contribution recognized as expense for the
periods ended September 30, 1997, 1996 and 1995 was $1,289, $542 and $330,
respectively.
16. STOCK OPTIONS AND AWARDS
Effective October 1, 1996, the Company adopted SFAS No. 123. As permitted by
the standard, the Company has elected to continue following the guidance of APB
25 for measurement and recognition of stock-based transactions with employees.
Accordingly, no compensation cost has been recognized for the Company's option
plans. Had the determination of compensation cost for these plans been based on
the fair value as of the grant dates for awards under these plans, the Company's
net loss for the years ending September 30, 1997 and 1996 would have increased
to the pro forma amounts indicated below:
1997 1996
---------- ----------
Net loss:
As reported........................................................ $ (13,872) $ (17,881)
Pro forma (unaudited).............................................. (15,729) (19,428)
The resulting compensation expense may not be representative of compensation
expense to be incurred on a pro forma basis in future years.
25
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
16. STOCK OPTIONS AND AWARDS (CONTINUED)
In October 1995, the Company adopted the 1995 Stock Purchase and Option Plan
for Employees of Merit Behavioral Care Corporation and Subsidiaries (the "1995
Option Plan"). The 1995 Option Plan permits the issuance of common stock and the
grant of up to 8,561,000 non-qualified stock options (the "1995 Options") to
purchase shares of common stock to key employees of the Company. The exercise
price of 1995 Options will not be less than 50% of the fair market value per
share of common stock on the date of such grant. Such options vest at the rate
of 20% per year over a period of five years. An option's maximum term is 10
years.
In January 1996, the Company adopted a second stock option plan, the Merit
Behavioral Care Corporation Employee Stock Option Plan ("1996 Employee Option
Plan"). The 1996 Employee Option Plan covers all employees not included in the
1995 Option Plan whose employment commenced prior to January 1, 1997. The 1996
Employee Option Plan permits the grant of up to 1,000,000 non-qualified stock
options (the "1996 Employee Options") to purchase shares of common stock. The
1996 Employee Options vest on the fourth anniversary of the date of grant,
provided that the employee remains employed with the Company on such date. The
1996 Employee Options are exercisable after an initial public offering of common
stock of the Company meeting certain requirements. An option's maximum term is
10 years.
The fair value of each option grant is estimated on the date of grant by
using the Black-Scholes option-pricing model. The following weighted-average
assumptions were used for grants in the years ending September 30, 1997 and
1996:
1997 1996
--------- ---------
Expected dividend yield..................................................... 0.00% 0.00%
Expected volatility......................................................... 1.00% 1.00%
Risk-free interest rates.................................................... 6.44% 6.08%
Expected option lives (years)............................................... 7.0 7.0
Information regarding the Company's stock option plans is summarized below:
1995 OPTION PLAN 1996 EMPLOYEE OPTION PLAN
-------------------------------- -------------------------------
WEIGHTED AVERAGE WEIGHTED AVERAGE
SHARES EXERCISE PRICE SHARES EXERCISE PRICE
----------- ------------------- ---------- -------------------
Outstanding at October 1, 1995................. -- --
Granted........................................ 5,698,000 $ 5.00 835,175 $ 7.50
Canceled....................................... (585,000) $ 5.00 (119,625) $ 7.50
----------- ----------
Outstanding at September 30, 1996.............. 5,113,000 $ 5.00 715,550 $ 7.50
Granted........................................ 1,327,075 $ 7.22 254,400 $ 7.50
Exercised...................................... (3,000) $ 5.00 -- --
Canceled....................................... (202,000) $ 5.74 (212,300) $ 7.50
----------- ----------
Outstanding at September 30, 1997.............. 6,235,075 $ 5.45 757,650 $ 7.50
----------- ----------
----------- ----------
The weighted-average fair values of options granted during fiscal 1997 and
1996 for the 1995 Option Plan were $1.42 and $1.72, respectively. The
weighted-average fair values of options granted during fiscal 1997 and 1996 for
the 1996 Employee Option Plan were $0.87 and $0.01, respectively.
26
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
16. STOCK OPTIONS AND AWARDS (CONTINUED)
The following table summarizes information about stock options outstanding
as of September 30, 1997:
1995 OPTION PLAN 1996 EMPLOYEE OPTION PLAN
----------------- -----------------------------
Range of exercise price.......................................... $ 5.00-$7.50 $ 7.50
Weighted-average remaining contracted life (years)............... 8.38 8.51
As of September 30, 1997, 993,600 shares pertaining to the 1995 Option Plan
were exercisable with an exercise price of $5.00. No shares were exercisable for
the 1996 Employee Option Plan as of September 30, 1997.
Prior to the Merger, employees of the Company participated in stock option
plans administered by Merck. Pursuant to these plans, options were granted at
the fair market value of Merck common stock on the date of grant and generally
vest over a period of five years. The Company realizes an income tax benefit
when Company employees exercise either (a) nonqualified Merck stock options; or
(b) Merck incentive stock options, assuming the underlying common stock is sold
within one year from the date that the incentive stock option was exercised.
This benefit results in a decrease in tax liabilities and an increase in
additional paid in capital. During 1997 and 1996, the Company recorded tax
benefits of $11,630 and $1,505, respectively, from the exercise of Merck
options. Information regarding the options outstanding under these plans held by
employees of the Company at September 30, 1997 and 1996 is as follows:
SHARES OPTION PRICE PER SHARE
---------------------- ---------------------------------------
1997 1996 1997 1996
--------- ----------- ------------------- ------------------
Vested........................................ 497,353 905,504 $ 3.78 to $25.87 $ 3.78 to $35.75
Unvested...................................... 127,472 391,169 $ 21.93 to $22.24 $ 3.78 to $35.75
--------- -----------
Total......................................... 624,825 1,296,673
--------- -----------
--------- -----------
Through September 30, 1995, employees of the Company participated in an
Employee Stock Purchase Plan administered by Merck. The stock plan permitted
employees of the Company to purchase Merck common stock at the end of each
quarter at a price equal to 85% of the fair market value at that date.
17. DISPOSAL OF SUBSIDIARY
In September 1997, the Company sold Choate for approximately $4,775 ($4,735
of which was received in October 1997). The Company recognized a loss of
approximately $6,925 relating to the transaction.
18. MERGER COSTS AND SPECIAL CHARGES
In fiscal 1997, the Company recognized approximately $733 of expenses
associated with uncompleted acquisition transactions. Also, the Company incurred
other special charges of approximately $581 related to nonrecurring employee
benefit costs associated with the exercise of stock options by employees of the
Company under plans administered by Merck. A significant number of these stock
options, which were granted prior to the Merger, required exercise by September
30, 1997.
27
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
19. SUPPLEMENTAL INFORMATION
Supplemental cash flow information and noncash investing and financing
activities are as follows:
1997 1996 1995
----------- --------- ---------
Supplemental Cash Flow Information:
Cash (received) paid for income taxes........................................ $ (596) $ 1,100 $ 2,167
Cash paid for interest....................................................... 23,568 17,676 --
Supplemental Noncash Investing and Financing Activities:
Record deferred taxes associated with the Merger............................. -- 7,594 --
Exercise of Merck stock options.............................................. 11,630 1,505 --
Acquisitions:
Fair value of assets acquired, other than cash............................. 82,412 14,360 --
Liabilities assumed........................................................ (41,622) (2,962) --
----------- --------- ---------
Total consideration paid................................................... 40,790 11,398 --
Stock consideration paid................................................... (5,545) -- --
----------- --------- ---------
Cash consideration paid.................................................... 35,245 11,398 --
Contingent consideration................................................... 400 1,278 9,580
----------- --------- ---------
Cash used for acquisitions, net of cash acquired............................... $ 35,645 $ 12,676 $ 9,580
----------- --------- ---------
----------- --------- ---------
20. RECENTLY ISSUED ACCOUNTING STANDARD
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131,
DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION, which will
be effective for the Company beginning October 1, 1998. SFAS No. 131 redefines
how operating segments are determined and requires disclosure of certain
financial and descriptive information about a company's operating segments. The
Company has not yet completed its analysis with respect to which operating
segments of its business it will provide such information
21. SUBSEQUENT EVENT
On February 12, 1998, the Company's outstanding stock was aquired by
Magellan Health Services, Inc. for approximately $448.9 million in cash plus the
repayment of the Company's existing debt. In addition, all options outstanding
under the 1995 Option Plan and the 1996 Employee Option Plan vested upon closing
of the transaction.
28
UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION
The Unaudited Pro Forma Consolidated Financial Information set forth below
is based on the historical presentation of the consolidated financial statements
of Magellan, and the historical operating results of Human Affairs
International, Incorporated ("HAI"), Allied Health Group, Inc. ("Allied"), Merit
and CMG Health, Inc. ("CMG") and the historical financial position of Merit. The
Unaudited Pro Forma Consolidated Statements of Operations for the year ended
September 30, 1997 and the three months ended December 31, 1997 give effect to
the Crescent Transactions (as defined), the HAI acquisition, the Allied
acquisition, the Green Spring Minority Shareholder Conversion (as defined),
Merit's acquisition of CMG and the Transactions as if they had been consummated
on October 1, 1996. The Unaudited Pro Forma Consolidated Balance Sheet as of
December 31, 1997 gives effect to the Green Spring Minority Shareholder
Conversion and the Transactions as if they had been consummated on December 31,
1997.
The Unaudited Pro Forma Consolidated Statements of Operations do not give
effect to hospital acquisitions and closures during the year ended September 30,
1997 as such transactions and events are not considered material to the pro
forma presentation. The Unaudited Pro Forma Consolidated Statement of Operations
presentation assumes that the net proceeds from the Crescent Transactions, after
debt repayment of approximately $200 million, were fully utilized to fund the
HAI acquisition and the Allied acquisition. The Unaudited Pro Forma Consolidated
Statement of Operations for the year ended September 30, 1997 excludes the
non-recurring losses incurred by the Company as a result of the Crescent
Transactions.
The Unaudited Pro Forma Consolidated Financial Information does not purport
to be indicative of the results that actually would have been obtained if the
operations had been conducted as presented and they are not necessarily
indicative of operating results to be expected in future periods. The business
of the Company's 50% owned hospital business, Charter Behavioral Health Systems,
LLC ("CBHS"), is seasonal in nature with a reduced demand for certain services
generally occurring in the first fiscal quarter around major holidays, such as
Thanksgiving and Christmas, and during the summer months comprising the fourth
fiscal quarter. Accordingly, the Unaudited Pro Forma Statement of Operations for
the three months ended December 31, 1997 is not necessarily indicative of the
pro forma results expected for a full year. The Unaudited Pro Forma Statement of
Operations excludes approximately $60.0 million of cost savings on an annual
basis that the Company expects to achieve within eighteen months following
consummation of the Merit acquisition. The Unaudited Pro Forma Consolidated
Financial Information and notes thereto should be read in conjunction with the
historical consolidated financial statements and notes thereto of Magellan and
Merit, which appear elsewhere herein.
The following is a description of each of the transactions (other than the
Transactions, which are described elsewhere herein) reflected in the pro forma
presentation:
CRESCENT TRANSACTIONS. The Crescent Transactions, which were consummated on
June 17, 1997, resulted in, among other things: (i) the sale of substantially
all of the Company's domestic acute care psychiatric hospitals and residential
treatment facilities (the "Psychiatric Hospital Facilities") to Crescent Real
Estate Equities Limited Partnership ("Crescent") for $417.2 million (before
costs of approximately $16.0 million); (ii) the creation of CBHS; (iii) the
Company's entry into the healthcare franchising business; and (iv) the issuance
by Magellan of 2,566,622 warrants to Crescent and Crescent Operating, Inc.
("COI") (1,283,311 warrants each) with an exercise price of $30 per share. CBHS
leases the Psychiatric Hospital Facilities from Crescent under a twelve-year
operating lease (the "Facilities Lease") (subject to renewal) for $41.7 million
annually, subject to adjustment, with a 5% escalator, compounded annually plus
certain additional rent. The warrants issued to Crescent and COI have been
valued at $25.0 million in the Company's balance sheet. The Company accounts for
its 50% investment in CBHS under the equity method of accounting, which
significantly reduces the revenues and related operating expenses presented in
the Unaudited Pro Forma Consolidated Statements of Operations. "Divested
29
Operations--Crescent Transactions" in the Unaudited Pro Forma Consolidated
Statements of Operations represents the results of operations of the businesses
that are operated by CBHS.
The Company incurred a loss before income taxes, minority interest and
extraordinary items of approximately $59.9 million as a result of the Crescent
Transactions, which was recorded during fiscal 1997.
HAI ACQUISITION. On December 4, 1997, the Company consummated the purchase
of HAI, formerly a unit of Aetna U.S. Healthcare ("Aetna"), for approximately
$122.1 million. HAI manages the care of over 16.0 million covered lives,
primarily through EAPs and other managed behavioral healthcare plans. The
Company funded the acquisition of HAI with cash on hand and accounted for the
acquisition of HAI using the purchase method of accounting. The Company may be
required to make additional contingent payments of up to $60 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 maximum contingent payments are $300.0
million.
ALLIED ACQUISITION. On December 5, 1997, the Company purchased the assets
of Allied and certain affiliates for approximately $70.0 million, of which $50.0
million was paid to the seller at closing with the remaining $20.0 million
placed in escrow. Allied provides specialty risk-based products and
administrative services to a variety of insurance companies and other customers,
including Blue Cross of New Jersey, CIGNA and NYLCare, for its 3.4 million
members. Allied has over 80 physician networks across the eastern United States.
Allied's networks include physicians specializing in cardiology, oncology and
diabetes. The Company funded the Allied acquisition with cash on hand. The
Company accounted for the Allied acquisition using the purchase method of
accounting. The escrowed amount of the purchase price is payable in one-third
increments if Allied achieves specified earnings targets during each of the
three years following the closing. Additionally, the purchase price may be
increased during the three-year period by up to $40.0 million, if Allied's
performance exceeds specified earnings targets. The maximum purchase price
payable is $110.0 million.
GREEN SPRING MINORITY SHAREHOLDER CONVERSION. The minority shareholders of
Green Spring Health Services, Inc. ("Green Spring") converted their interests in
Green Spring into an aggregate of 2,831,516 shares of Company Common Stock
during January 1998 (the "Green Spring Minority Shareholder Conversion"). As a
result of the Green Spring Minority Shareholder Conversion, the Company owns
100% of Green Spring. The Company accounted for the Green Spring Minority
Shareholder Conversion as a purchase of minority interest at the fair value of
the consideration paid.
MERIT ACQUISITION OF CMG. On September 12, 1997, Merit acquired all of the
outstanding capital stock of CMG for approximately $48.7 million in cash and
approximately 739,000 shares of Merit common stock. In connection with Merit's
acquisition of CMG, the Company may be required to make contingent payments to
the former shareholders of CMG if the financial results of certain contracts
exceed specified base-line amounts. Such contingent payments are subject to an
aggregate maximum of $23.5 million.
30
UNAUDITED PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS
FOR THE YEAR ENDED SEPTEMBER 30, 1997
(IN THOUSANDS, EXCEPT PER SHARE DATA)
DIVESTED
OPERATIONS--
MAGELLAN CRESCENT PRO FORMA PRO FORMA
AS REPORTED TRANSACTIONS HAI ALLIED ADJUSTMENTS COMBINED MERIT CMG
----------- ------------ -------- -------- ----------- --------- -------- --------
Net revenue............... $1,210,696 $(555,324) $116,736 $143,889 $41,578(1) $957,575 $555,717 $101,356
----------- ------------ -------- -------- ----------- --------- -------- --------
Salaries, cost of care and
other operating
expenses................ 978,513 (426,862) 88,002 137,873 (7,797)(2) 769,729 504,510 99,434
Bad debt expense.......... 46,211 (42,720) 0 0 0 3,491 0 0
Depreciation and
amortization............ 44,861 (20,073) 312 362 6,164(3) 31,626 39,400 1,987
Interest, net............. 45,377 (3,233) (1,604) (725) (6,833)(4) 32,982 21,566 (516)
Stock option expense...... 4,292 0 0 0 0 4,292 0 0
Equity in loss of CBHS.... 8,122 0 0 0 12,028(5) 20,150 0 0
Loss on Crescent
Transactions............ 59,868 0 0 0 (59,868)(6) 0 0 0
Unusual items............. 357 (2,500) 0 0 0 (2,143) 8,239 1,200
----------- ------------ -------- -------- ----------- --------- -------- --------
1,187,601 (495,388) 86,710 137,510 (56,306) 860,127 573,715 102,105
----------- ------------ -------- -------- ----------- --------- -------- --------
Income (loss) before
income taxes and
minority interest....... 23,095 (59,936) 30,026 6,379 97,884 97,448 (17,998) (749)
Provision for (benefit
from) income taxes...... 9,238 (23,974) 11,480 0 41,705(7) 38,449 (4,126) (443)
----------- ------------ -------- -------- ----------- --------- -------- --------
Income (loss) before
minority interest....... 13,857 (35,962) 18,546 6,379 56,179 58,999 (13,872) (306)
Minority interest......... 9,102 0 0 0 0 9,102 0 0
----------- ------------ -------- -------- ----------- --------- -------- --------
Net income (loss)......... $ 4,755 $ (35,962) $ 18,546 $ 6,379 $56,179 $ 49,897 $(13,872) $ (306)
----------- ------------ -------- -------- ----------- --------- -------- --------
----------- ------------ -------- -------- ----------- --------- -------- --------
Average number of common
shares
outstanding--basic...... 28,781 28,781
----------- ---------
----------- ---------
Average number of common
shares
outstanding--diluted.... 29,474 29,474
----------- ---------
----------- ---------
Net income per common
share--basic............ $ 0.17 $ 1.73
----------- ---------
----------- ---------
Net income per common
share--diluted.......... $ 0.16 $ 1.69
----------- ---------
----------- ---------
THE
MERIT/CMG MERIT/CMG TRANSACTIONS
PRO FORMA PRO FORMA PRO FORMA PRO FORMA
ADJUSTMENTS COMBINED ADJUSTMENTS CONSOLIDATED
----------- ---------- ------------ ------------
Net revenue............... $(13,042)(8) $644,031 $ 0 $1,601,606
----------- ---------- ------------ ------------
Salaries, cost of care and
other operating
expenses................ (18,075)(9) 585,869 (500)(14) 1,355,098
Bad debt expense.......... 0 0 0 3,491
Depreciation and
amortization............ 2,365(10) 43,752 (6,416)(15) 68,962
Interest, net............. 4,390(11) 25,440 37,967(16) 96,389
Stock option expense...... 0 0 0 4,292
Equity in loss of CBHS.... 0 0 0 20,150
Loss on Crescent
Transactions............ 0 0 0 0
Unusual items............. (6,925)(12) 2,514 (1,314)(17) (943)
----------- ---------- ------------ ------------
(18,245) 657,575 29,737 1,547,439
----------- ---------- ------------ ------------
Income (loss) before
income taxes and
minority interest....... 5,203 (13,544) (29,737) $ 54,167
Provision for (benefit
from) income taxes...... 2,095(13) (2,474) (5,942)(18) 30,033
----------- ---------- ------------ ------------
Income (loss) before
minority interest....... 3,108 (11,070) (23,795) 24,134
Minority interest......... 0 0 (6,835)(19) 2,267
----------- ---------- ------------ ------------
Net income (loss)......... $ 3,108 $(11,070) $(16,960) $ 21,867
----------- ---------- ------------ ------------
----------- ---------- ------------ ------------
Average number of common
shares
outstanding--basic...... 2,832(19) 31,613
------------ ------------
------------ ------------
Average number of common
shares
outstanding--diluted.... 2,832(19) 32,306
------------ ------------
------------ ------------
Net income per common
share--basic............ $ 0.69
------------
------------
Net income per common
share--diluted.......... $ 0.68
------------
------------
See Notes to Unaudited Pro Forma Consolidated Statements of Operations
31
UNAUDITED PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS
FOR THE THREE MONTHS ENDED DECEMBER 31, 1997
(IN THOUSANDS, EXCEPT PER SHARE DATA)
MAGELLAN PRO FORMA
AS REPORTED HAI ALLIED ADJUSTMENTS
----------- ------- ------- -----------
Net revenue................................................. $216,097 $19,528 $30,945 $(2,143)(1)
----------- ------- ------- -----------
Salaries, cost of care and other operating expenses......... 175,621 15,031 31,068 (1,392)(2)
Bad debt expense............................................ 1,070 0 0 0
Depreciation and amortization............................... 6,969 34 100 1,075(3)
Interest, net............................................... 7,401 (256) (92) 1,816(4)
Stock option expense........................................ (3,959) 0 0 0
Equity in loss of CBHS...................................... 11,488 0 0 0
Unusual items............................................... 0 0 0 0
----------- ------- ------- -----------
198,590 14,809 31,076 1,499
----------- ------- ------- -----------
Income (loss) before income taxes and minority interest..... 17,507 4,719 (131) (3,642)
Provision for (benefit from) income taxes................... 7,003 1,879 0 (1,509)(7)
----------- ------- ------- -----------
Income (loss) before minority interest...................... 10,504 2,840 (131) (2,133)
Minority interest........................................... 2,876 0 0 0
----------- ------- ------- -----------
Net income (loss)........................................... $ 7,628 $ 2,840 $ (131) $(2,133)
----------- ------- ------- -----------
----------- ------- ------- -----------
Average number of common shares outstanding--basic.......... 28,969
-----------
-----------
Average number of common shares outstanding--diluted........ 29,784
-----------
-----------
Net income per common share--basic.......................... $ 0.26
-----------
-----------
Net income per common share--diluted........................ $ 0.26
-----------
-----------
THE TRANSACTIONS
PRO FORMA PRO FORMA PRO FORMA
COMBINED MERIT ADJUSTMENTS CONSOLIDATED
--------- -------- ---------------- ------------
Net revenue................................................. $264,427 $178,866 $ 0 $443,293
--------- -------- ------- ------------
Salaries, cost of care and other operating expenses......... 220,328 164,291 (1,915)(14) 382,704
Bad debt expense............................................ 1,070 0 0 1,070
Depreciation and amortization............................... 8,178 11,028 (1,736)(15) 17,470
Interest, net............................................... 8,869 6,142 9,674(16) 24,685
Stock option expense........................................ (3,959) 0 0 (3,959)
Equity in loss of CBHS...................................... 11,488 0 0 11,488
Unusual items............................................... 0 545 (545)(17) 0
--------- -------- ------- ------------
245,974 182,006 5,478 433,458
--------- -------- ------- ------------
Income (loss) before income taxes and minority interest..... 18,453 (3,140) (5,478) 9,835
Provision for (benefit from) income taxes................... 7,373 (468) (703)(18) 6,202
--------- -------- ------- ------------
Income (loss) before minority interest...................... 11,080 (2,672) (4,775) 3,633
Minority interest........................................... 2,876 0 (2,358)(19) 518
--------- -------- ------- ------------
Net income (loss)........................................... $ 8,204 $ (2,672) $(2,417) $ 3,115
--------- -------- ------- ------------
--------- -------- ------- ------------
Average number of common shares outstanding--basic.......... 28,969 2,832(19) 31,801
--------- ------- ------------
--------- ------- ------------
Average number of common shares outstanding--diluted........ 29,784 2,832(19) 32,616
--------- ------- ------------
--------- ------- ------------
Net income per common share--basic.......................... $ 0.28 $ 0.10
--------- ------------
--------- ------------
Net income per common share--diluted........................ $ 0.28 $ 0.10
--------- ------------
--------- ------------
See Notes to Unaudited Pro Forma Consolidated Statements of Operations
32
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS
(1) Adjustments to net revenue for the year ended September 30, 1997 represent
franchise fees payable by CBHS to the Company (the "Franchise Fees")
pursuant to the franchise agreement between them (the "Master Franchise
Agreement") of $55.5 million for the 259 days ended June 16, 1997 (prior to
consummation of the Crescent Transactions) less a $13.9 million decrease in
HAI revenue resulting from renegotiated contractual rates with Aetna as a
direct result of the acquisition of HAI by the Company. Adjustment to net
revenue for the three months ended December 31, 1997 represents the effect
of renegotiated contractual rates with Aetna for the two months prior to
consummation of the HAI acquisition.
The pro forma presentation assumes that all Franchise Fees due from CBHS
were paid when due. Based on projections of fiscal 1998 operations prepared
by management of CBHS, the Company believes that CBHS will be unable to pay
the full amount of the Franchise Fees it is contractually obligated to pay
during fiscal 1998. The Company currently estimates that CBHS will be able
to pay approximately $58.0 million to $68.0 million of the Franchise Fees in
fiscal 1998, a $10.0 million to $20.0 million shortfall relative to amounts
payable under the Master Franchise Agreement. The Company may be required to
record bad debt expense related to Franchise Fees receivable from CBHS, if
any, in fiscal 1998 or future periods if CBHS's operating performance does
not improve to levels achieved prior to the consummation of the Crescent
Transactions. If CBHS defaults in payment of the Franchise Fees, the Company
will pursue all remedies available to it under the Master Franchise
Agreement.
33
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
(2) Adjustments to salaries, cost of care and other operating expenses represent
the following (in thousands):
THREE MONTHS
YEAR ENDED ENDED
SEPTEMBER 30, DECEMBER 31,
TRANSACTION DESCRIPTION 1997 1997
- ----------- ----------------------------------- -------------------- ---------------------
Crescent Fees payable to CBHS by the Company
for the management of less than
wholly-owned hospital-based joint
ventures controlled by the Company
for the 259 days ended June 16,
1997............................... $ 7,564 $ --
Crescent Reduction of corporate overhead
that was transferred to CBHS for
the 259 days ended June 16, 1997... (2,845) --
HAI Elimination of Aetna overhead
allocations........................ (17,162) (2,044)
HAI Bonus expense previously reflected
in Aetna's financial statements.... 1,138 200
HAI Costs absorbed by HAI previously
incurred by Aetna including
information technology, human
resources and legal................ 5,110 852
Allied Reduction of shareholders'/
executives' compensation to revised
contractual level pursuant to the
Allied purchase agreement.......... (648) (197)
Allied Reduction of certain consulting
agreement costs to revised
contractual level pursuant to the
Allied purchase agreement.......... (954) (203)
-------- -------
$ (7,797) $ (1,392)
-------- -------
-------- -------
34
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
(3) Adjustments to depreciation and amortization represent the following (in
thousands):
THREE MONTHS
YEAR ENDED ENDED
SEPTEMBER 30, DECEMBER 31,
TRANSACTION DESCRIPTION 1997 1997
- ------------- ------------------------------------ -------------------- ---------------------
Crescent Elimination of amortization related
to impaired intangible assets....... $ (177) $ --
HAI Purchase price allocation (i)....... 3,948 676
Allied Purchase price allocation (ii)...... 2,393 399
------- -------
$ 6,164 $ 1,075
------- -------
------- -------
---------------------------------
(i) Represents $4.0 million estimated fair value of property and
equipment depreciated over an estimated useful life of 5 years, $83.3
million of goodwill amortized over an estimated useful life of 40
years and $20.7 million estimated fair value of other intangible
assets (primarily client lists) amortized over an estimated useful
life of 15 years less historical depreciation and amortization.
(ii) Represents $50.7 million of goodwill amortized over an estimated
useful life of 40 years and $16.9 million estimated fair value of
other intangible assets (primarily client lists and treatment
protocols) amortized over an estimated useful life of 15 years.
The allocation of the HAI and Allied purchase prices to equipment, goodwill
and identifiable intangible assets and estimated useful lives are based on
the Company's preliminary valuations, which are subject to change upon
receiving independent appraisals for such assets.
Subsequent to the consummation of the HAI acquisition, the Company may be
required to make additional contingent payments of up to $60 million
annually during the five years following the consummation of the HAI
acquisition to Aetna for aggregate potential contingent payments of $300
million. These contingent payments, if any, would be recorded as goodwill
and identifiable intangible assets, which would result in estimated
additional annual amortization of $11 million to $13 million in future
periods if all the contingent payments are made.
The Company may also be required to make contingent payments to the former
owners of Allied of up to $60 million during the three years subsequent to
consummation of the Allied acquisition, of which $20 million is in escrow.
These contingent payments, if any, would be recorded as goodwill, which
would result in estimated additional annual amortization of $1.5 million.
(4) Adjustments to interest, net, represent reductions in interest expense as a
result of the repayment of outstanding borrowings under the Magellan
Existing Credit Agreement with the proceeds from the Crescent Transactions
offset by forgone interest income as a result of using cash on hand to fund
the HAI and Allied acquisitions.
(5) Adjustment to equity in loss of CBHS represents the Company's 50% interest
in CBHS' pro forma loss for the 259 day period ended June 16, 1997. The
Company's investment in CBHS is accounted for under the equity method of
accounting. The Condensed Pro Forma Statement of Operations of CBHS for the
year ended September 30, 1997 is as follows (in thousands):
35
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
CBHS
OPERATIONS--
DIVESTED 106 DAYS ENDED PRO FORMA PRO FORMA
OPERATIONS SEPTEMBER 30, 1997 ADJUSTMENTS CONSOLIDATED
----------- -------------------- ------------ -------------
Net revenue............. $ 555,324 $ 213,730 $ 2,565(i) $ 771,619
----------- ---------- ------------ -------------
Salaries, supplies and
other operating
expenses.............. 426,862 210,277 103,723 (ii 740,862
Bad debt expense........ 42,720 17,437 0 60,157
Depreciation and
amortization.......... 20,073 668 (17,333) ii) 3,408
Interest, net........... 3,233 1,592 167 (iv 4,992
Unusual items........... 2,500 0 0 2,500
----------- ---------- ------------ -------------
495,388 229,974 86,557 811,919
----------- ---------- ------------ -------------
Income (loss) before
income taxes.......... 59,936 (16,244) (83,992) (40,300)
Provision for income
taxes................. 23,974 0 (23,974)(v) 0
----------- ---------- ------------ -------------
Net income (loss)..... $ 35,962 $ (16,244) $ (60,018) $ (40,300)
----------- ---------- ------------ -------------
----------- ---------- ------------ -------------
----------------------------------------
(i) Fees from the Company for the management of less than
wholly-owned hospital-based joint ventures controlled by the
Company (see note 2) less non-recurring accounts receivable
collection fees receivable from the Company (see note 6) of
approximately $5.0 million during the 106 days ended September
30, 1997.
(ii) Adjustments to salaries, supplies and other operating
expenses represent the following (in thousands):
259 DAYS
ENDED
JUNE 16, 1997
--------------
Franchise Fees (see note 1)............................................... $ 55,463
Rent expense under the Facilities Lease................................... 44,665
Additional corporate overhead............................................. 3,595
--------------
$ 103,723
--------------
--------------
(iii) Adjustment to depreciation and amortization represents the
decrease in depreciation expense as a result of the sale of
property and equipment to Crescent by the Company and the
elimination of amortization expense related to impaired
intangible assets.
(iv) Adjustment to interest, net, represents the following (in
thousands):
259 DAYS
ENDED
JUNE 16, 1997
--------------
Interest expense on debt repaid by the Company............................ $ (3,233)
Interest expense for the 259 days ended June 16, 1997 for estimated
average borrowings of $60 million at an assumed interest rate of 8% per
annum..................................................................... 3,400
--------------
$ 167
--------------
--------------
36
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
(v) CBHS is a limited liability company. Accordingly, provision
for income taxes is eliminated as the tax consequences of CBHS
ownership will pass through to the Company and COI, the other
50% owner of CBHS.
(6) Adjustment to loss on Crescent Transactions represents the elimination of
the non-recurring losses incurred by the Company as a result of the Crescent
Transactions as follows (in thousands):
Accounts receivable collection fees(i)............................ $ 21,400
Impairment losses on intangible assets(ii)........................ 14,408
Exit costs and construction obligation(iii)....................... 12,549
Loss on the sale of property and equipment........................ 11,511
---------
$ 59,868
---------
---------
----------------------------------------
(i) Accounts receivable collection fees represent the reduction
in the net realizable value of accounts receivable for
estimated collection fees on hospital-based receivables
retained by the Company. The Company paid CBHS 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 Transaction.
(ii) The impairment loss on intangible assets resulted from
reducing the book value of the Company's investment in CBHS to
its approximate fair value at the consummation date of the
Crescent Transactions. The impairment losses represent the
reductions in the carrying amount of goodwill and other
intangible assets related to the divested or contributed CBHS
operations.
(iii) Represents approximately $5.0 million of incremental costs
to perform finance and accounting functions transferred to CBHS
and approximately $7.5 million for the Company's obligation to
replace CBHS' Philadelphia hospital.
(7) Adjustments to provision for income taxes represent the tax expense related
to the pro forma adjustments at the Company's historic effective tax rate of
40% and the imputed income tax expense on the operating results of Allied,
which was an S-corporation for income tax purposes and historically did not
provide for income taxes.
(8) Adjustment to net revenue represents the elimination of the fiscal 1997
revenues of Choate Health Management, Inc. ("Choate"), which was sold by
Merit in fiscal 1997.
(9) Adjustment to salaries, cost of care and other operating expenses represents
the elimination of salaries, benefits and other costs of $5.5 million for
duplicate CMG personnel and facilities that were eliminated as a direct
result of Merit's acquisition of CMG and the elimination of fiscal 1997
expenses of $12.6 million for Choate, which was sold by Merit in fiscal
1997.
(10) Adjustment to depreciation and amortization represents the effect of
Merit's purchase price allocation related to the CMG acquisition.
(11) Adjustment to interest, net, represents the effect of increased borrowing
by Merit related to the CMG acquisition.
(12) Adjustments to unusual items, net, represents the elimination of
non-recurring losses on Merit's sale of Choate.
(13) Adjustment to provision for income taxes represents the tax effect of the
Merit/CMG pro forma adjustments.
37
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
(14) Adjustment to salaries, cost of care and other operating expenses
represents the elimination of fees paid by Merit to its former owner and the
elimination of salaries, benefits and other costs of $1.7 million for the
three months ended December 31, 1997 for duplicate CMG personnel and
facilities that have been announced as a direct result of Merit's
acquisition of CMG. The adjustment excludes approximately $60.0 million of
cost savings on an annual basis that the Company expects to achieve within
eighteen months following consummation of the Merit acquisition.
(15) Adjustments to depreciation and amortization represent the effect of the
Merit purchase price allocation and the Green Spring Minority Shareholder
Conversion as follows (in thousands):
THREE MONTHS
YEAR ENDED ENDED
SEPTEMBER 30, DECEMBER 31,
1997 1997
-------------- --------------
Estimated fair value of property and equipment of $52.4
million depreciated over an estimated useful life of 5
years...................................................... $ 10,485 $ 2,622
Estimated goodwill of $599.5 million amortized over an
estimated useful life of 40 years.......................... 14,989 3,746
Estimated fair value of other intangible assets (primarily
client lists and provider networks) of $121.3 million
amortized over an estimated useful life of 15 years........ 8,084 2,021
-------------- --------------
Total estimated depreciation and amortization................ 33,558 8,389
Elimination of Merit and CMG historical and pro forma
depreciation and amortization (i).......................... (40,655) (10,296)
Effect of Green Spring Minority Shareholder Conversion....... 681 171
-------------- --------------
$ (6,416) $ (1,736)
-------------- --------------
-------------- --------------
----------------------------------------
(i) Excludes amortization of deferred start-up costs of
approximately $3.1 million and $0.7 million for the year ended
September 31, 1997 and the three moths ended December 31, 1997,
respectively, which will be a continuing cost of the Company
after the Merit acquisition.
The allocation of the Merit purchase price to property and equipment,
goodwill and identifiable intangible assets and estimated useful lives are
based on the Company's preliminary valuations, which are subject to change
upon receiving independent appraisals for such assets.
38
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
(16) Adjustments to interest, net, represent the following (in thousands):
YEAR ENDED THREE MONTHS ENDED
SEPTEMBER 30, DECEMBER 31,
DESCRIPTION 1997 1997
- --------------------------------------------------- -------------------- -------------------
Elimination of Merit and CMG historical and pro
forma interest expense........................... $ (29,959) $ (7,216)
Elimination of historical interest expense for the
Magellan Outstanding Notes....................... (42,188) (10,547)
Elimination of the Company's historical deferred
financing cost amortization...................... (1,214) (610)
Tranche A Term Loan interest expense (i)........... 14,392 3,667
Tranche B Term Loan interest expense (i)........... 14,850 3,781
Tranche C Term Loan interest expense (i)........... 15,308 3,896
Revolving Facility interest expense (i)............ 1,570 400
Foregone interest income--cash proceeds utilized in
the Merit acquisition at 5.5% per annum.......... 4,712 1,178
The Notes at an interest rate of 9.0%.............. 56,250 14,063
Amortization of deferred financing costs of $34.2
million over a weighted average life of
approximately 8.1 years.......................... 4,245 1,062
-------- --------
$ 37,967 $ 9,674
-------- --------
-------- --------
----------------------------------------
(i) Assumes borrowings are one month LIBOR based, which is
consistent with the Company's past borrowing practices. Average
one month LIBOR was approximately 5.60% and 5.75% during the
year ended September 30, 1997 and the three months ended
December 31, 1997, respectively. Each Term Loan is
approximately $183.3 million and the Revolving Facility
borrowing is $20.0 million. Interest rates utilized to compute
pro forma adjustments are as follows:
YEAR ENDED THREE MONTHS ENDED
SEPTEMBER 30, DECEMBER 31,
1997 1997
----------------------- ---------------------
Tranche A Term Loan and Revolving
Facility (LIBOR plus 2.25%)............ 7.85% 8.00%
Tranche B Term Loan (LIBOR plus 2.50%)... 8.10% 8.25%
Tranche C Term Loan (LIBOR plus 2.75%)... 8.35% 8.50%
39
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
(17) Adjustments to unusual items represent the following (in thousands):
THREE MONTHS
YEAR ENDED ENDED
DESCRIPTION SEPTEMBER 30, 1997 DECEMBER 31, 1997
- --------------------------------------------------- -------------------- -------------------
Elimination of Merit's transaction costs related to
Merit's attempt to acquire HAI................... $ (733) $ --
Elimination of non-recurring employee benefit costs
related to stock options which were eliminated
upon consummation of the Acquisition............. (581) (57)
Elimination of Merit's transaction costs related
primarily to the Transactions.................... -- (488)
------- -------
$ (1,314) $ (545)
------- -------
------- -------
(18) Adjustment to provision for income taxes represents the tax benefit related
to the pro forma adjustments, excluding annual non-deductible goodwill
amortization of $14.9 million related to the Merit acquisition and the Green
Spring Minority Shareholder Conversion, at the Company's historic effective
tax rate of 40%.
(19) Adjustments to minority interest and average number of common shares
outstanding (primary and fully diluted) represents the effect of the Green
Spring Minority Shareholder Conversion.
40
UNAUDITED PRO FORMA CONSOLIDATED BALANCE SHEET
DECEMBER 31, 1997
(DOLLARS IN THOUSANDS)
THE
TRANSACTIONS
MAGELLAN PRO FORMA PRO FORMA
ASSETS AS REPORTED MERIT ADJUSTMENTS CONSOLIDATED
------------ ----------- ------------- -------------
Current assets:
Cash and cash equivalents........................... $ 170,459 $ 75,827 $ (85,677)(1) $ 160,609
Accounts receivable, net............................ 140,219 49,917 0 190,136
Deferred income taxes............................... 0 6,616 0 6,616
Other current assets................................ 34,438 11,409 0 45,847
------------ ----------- ------------- -------------
Total current assets.............................. 345,116 143,769 (85,677) 403,208
Assets restricted for settlement of unpaid claims and
other long-term liabilities......................... 73,020 0 0 73,020
Property and equipment:
Land................................................ 11,687 0 0 11,687
Buildings and improvements.......................... 72,102 3,596 0 75,698
Equipment........................................... 74,319 117,151 (68,320)(2) 123,150
------------ ----------- ------------- -------------
158,108 120,747 (68,320) 210,535
Accumulated depreciation............................ (41,169) (38,320) 38,320(2) (41,169)
------------ ----------- ------------- -------------
116,939 82,427 (30,000) 169,366
Construction in progress............................ 995 0 0 995
------------ ----------- ------------- -------------
Total property and equipment...................... 117,934 82,427 (30,000) 170,361
Other long-term assets................................ 42,932 27,432 (8,624)(3) 61,740
Deferred income taxes................................. 2,178 0 69,351(4) 71,529
Investments in CBHS................................... 5,390 0 0 5,390
Goodwill, net......................................... 242,968 141,787 462,227(5) 846,982
Other intangible assets, net.......................... 67,576 56,056 101,188(5) 224,820
------------ ----------- ------------- -------------
$ 897,114 $ 451,471 $ 508,465 $ 1,857,050
------------ ----------- ------------- -------------
------------ ----------- ------------- -------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable.................................... $ 37,663 $ 7,217 $ 0 $ 44,880
Accrued liabilities................................. 192,426 133,347 9,941(6) 335,714
Current maturities of long-term debt and capital
lease obligations................................. 3,604 1,263 (1,263)(7) 3,604
------------ ----------- ------------- -------------
Total current liabilities....................... 233,693 141,827 8,678 384,198
Long-term debt and capital lease obligations.......... 391,550 318,002 501,998(7) 1,211,550
Reserve for unpaid claims............................. 40,201 0 0 40,201
Deferred tax liabilities.............................. 0 13,525 (13,525)(4) 0
Deferred credits and other long-term liabilities...... 15,023 5,034 (3,262)(8) 16,795
Minority interest..................................... 64,785 0 (39,512)(8) 25,273
Commitments and contingencies
Stockholders' equity:
Common stock........................................ 8,387 294 414(9) 9,095
Additional paid-in capital.......................... 338,961 3,768 56,412(9) 399,141
Retained earnings (accumulated deficit)............. (122,327) (30,979) (2,738)(9) (156,044)
Warrants outstanding................................ 25,050 0 0 25,050
Common stock in treasury............................ (95,187) 0 0 (95,187)
Cumulative foreign currency adjustments............. (3,022) 0 0 (3,022)
------------ ----------- ------------- -------------
Total stockholders' equity........................ 151,862 (26,917) 54,088 179,033
------------ ----------- ------------- -------------
$ 897,114 $ 451,471 $ 508,465 1,857,050
------------ ----------- ------------- -------------
------------ ----------- ------------- -------------
See Notes to Unaudited Pro Forma Consolidated Balance Sheet
41
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED BALANCE SHEET
(1) Adjustments to cash and cash equivalents represent the following (in
thousands):
DESCRIPTION AMOUNT
- -------------------------------------------------------------------------------- ------------
Term Loan Facility borrowings................................................... $ 550,000
Revolving Facility borrowings................................................... 20,000
Proceeds from the Notes......................................................... 625,000
Repayment of Existing Merit Credit Agreement.................................... (219,265)
Repayment of Merit Outstanding Notes............................................ (100,000)
Repayment of Magellan Outstanding Notes......................................... (375,000)
Cash paid to Merit shareholders................................................. (448,867)
Transaction costs and accrued interest payments................................. (137,545)
------------
$ (85,677)
------------
------------
(2) Adjustments to equipment and accumulated depreciation accounts represent the
changes necessary to adjust Merit's property and equipment to fair value.
See note 15 to Unaudited Pro Forma Consolidated Statement of Operations.
(3) Adjustment to other long-term assets represents the reclassification of
deferred start-up costs to identifiable intangible assets.
(4) Adjustments to deferred income tax assets and liabilities represent the tax
consequences of the Transactions related primarily to basis differences and
recognition of net operating loss carry forwards.
(5) Adjustments to goodwill and other intangible assets represent the following
(in thousands):
DESCRIPTION AMOUNT
- --------------------------------------------------------------------------------- -----------
Merit purchase price allocation.................................................. $ 457,715
Green Spring Minority Shareholder Conversion..................................... 4,512
-----------
Goodwill pro forma adjustment................................................ $ 462,227
-----------
-----------
Merit purchase price allocation.................................................. $ 75,455
Write-off of Merit deferred financing costs...................................... (10,246)
Write-off of the Company's deferred financing costs.............................. (11,811)
Deferred financing costs related to the Transactions............................. 34,188
Green Spring Minority Shareholder Conversion..................................... 13,602
-----------
Other intangible asset pro forma adjustment.................................. $ 101,188
-----------
-----------
See note 15 to the Unaudited Pro Forma Consolidated Statements of
Operations.
(6) Adjustments to accrued liabilities represent the following (in thousands):
DESCRIPTION AMOUNT
- --------------------------------------------------------------------------------- -----------
Payment of Merit accrued interest................................................ $ (2,338)
Payment of the Company's accrued interest........................................ (8,721)
Accrued severance and related costs (i).......................................... 21,000
-----------
$ 9,941
-----------
-----------
- ------------------------
(i) Includes the initial estimates of costs of severance, lease
terminations, relocation and other related costs for the integration
of Merit into the Company's existing managed care operations. This
amount is subject to change based on finalization of the Company's
integration plan.
42
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED BALANCE SHEET (CONTINUED)
(7) Adjustments to long-term debt and capital lease obligations (including the
current portion) represent the following (in thousands):
DESCRIPTION AMOUNT
- --------------------------------------------------------------------------------- -----------
Term Loan Facility borrowings.................................................... $ 550,000
Revolving Facility borrowings.................................................... 20,000
The Notes........................................................................ 625,000
Repayment of Existing Merit Credit Agreement..................................... (219,265)
Repayment of Merit Outstanding Notes............................................. (100,000)
Repayment of Magellan Outstanding Notes.......................................... (375,000)
-----------
$ 500,735
-----------
-----------
(8) Adjustments to deferred credits and other long-term liabilities and minority
interest represent the effect of the Green Spring Minority Shareholder
Conversion.
(9) Adjustments to the stockholders' equity accounts represent the elimination
of Merit's historical stockholders' equity accounts, the increase in
accumulated deficit related to the $33.7 million extraordinary loss on the
early extinguishment of the Magellan Existing Credit Agreement and the
Magellan Outstanding Notes and the effect of issuing 2,831,516 shares of
Company Common Stock in the Green Spring Minority Shareholder Conversion,
which was valued using the closing price of Company Common Stock on December
31, 1997, of $21.50.
43
EXHIBITS
2(a) 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.
4(a) 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.
4(b) Purchase Agreement, dated February 5, 1998, between the Company and Chase Securities
Inc.
4(c) Exchange and Registration Rights Agreement, dated February 12, 1998 between the
Company and Chase Securities Inc.
4(d) 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.
23(a) Consent of Deloitte & Touche LLP to incorporation of the financial statements of
Merit Behavioral Care Corporation included herein in the Registrant's Registration
Statement on Form S-3 (File No. 333-20371).
23(b) Consent of Deloitte & Touche LLP to incorporation of the financial statements of
Merit Behavioral Care Corporation included herein in the Registrant's Registration
Statement on Form S-3 (File No. 333-01217).
99(a) Press release, dated October 27, 1997.*
99(b) Press release, dated February 12, 1998.*
- ------------------------
* Filed on February 27, 1998.
44
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
Dated: April 2, 1998 Magellan Health Services, Inc.
By: /s/ CRAIG L. MCKNIGHT
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Executive Vice President and
Chief Financial Officer
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