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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-Q
(MARK ONE)
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 1998
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ______________ TO ______________
COMMISSION FILE NO. 1-6639
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MAGELLAN HEALTH SERVICES, INC.
(Exact name of Registrant as specified in its charter)
DELAWARE 58-1076937
(State or other jurisdiction of (I.R.S. Employer Identification
Incorporation or organization) No.)
3414 PEACHTREE ROAD, N.E. 30326
SUITE 1400 (Zip Code)
ATLANTA, GEORGIA
(Address of principal executive offices)
(404) 841-9200
(Registrant's telephone number, including area code)
NOT APPLICABLE
(Former name, former address and former fiscal year, if changed since last
report)
------------------------
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No / /
The number of shares of the Registrant's common stock outstanding as of
January 29, 1999 was 31,777,788.
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FORM 10-Q
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
INDEX
PAGE NO.
-------------
PART I--FINANCIAL INFORMATION:
Condensed Consolidated Balance Sheets--
September 30, 1998 and December 31, 1998............................................................ 1
Condensed Consolidated Statements of Operations--
For the Three Months ended December 31, 1997 and 1998............................................... 2
Condensed Consolidated Statements of Cash Flows--
For the Three Months ended December 31, 1997 and 1998............................................... 3
Notes to Condensed Consolidated Financial Statements.................................................. 4
Management's Discussion and Analysis of Financial
Condition and Results of Operations................................................................. 17
PART II--OTHER INFORMATION:
Item 6.--Exhibits and Reports on Form 8-K............................................................. 29
Signatures............................................................................................ 30
MAGELLAN HEALTH SERVICES, INC.
QUARTERLY REPORT UNDER SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
PART I--FINANCIAL INFORMATION
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
SEPTEMBER 30, DECEMBER 31,
1998 1998
------------- ------------
ASSETS
Current Assets:
Cash and cash equivalents......................................................... $ 92,050 $ 49,358
Accounts receivable, net.......................................................... 174,846 172,990
Restricted cash and investments................................................... 89,212 132,099
Refundable income taxes........................................................... 4,939 --
Other current assets.............................................................. 38,677 33,916
------------- ------------
Total Current Assets.......................................................... 399,724 388,363
Assets restricted for settlement of unpaid claims and other liabilities............. 37,910 33,978
Property and equipment, net of accumulated depreciation of $60,100 at September 30,
1998 and $60,231 at December 31, 1998............................................. 177,169 156,436
Deferred income taxes............................................................... 97,386 94,069
Investments in unconsolidated subsidiaries.......................................... 11,066 31,814
Other long-term assets.............................................................. 35,415 18,751
Goodwill, net....................................................................... 992,431 1,067,085
Other intangible assets, net........................................................ 165,189 160,447
------------- ------------
$ 1,916,290 $1,950,943
------------- ------------
------------- ------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable.................................................................. $ 42,873 $ 33,593
Accrued liabilities............................................................... 193,530 242,199
Medical claims payable............................................................ 195,330 191,384
Income taxes payable.............................................................. -- 681
Current maturities of long-term debt and capital lease obligations................ 23,033 29,428
------------- ------------
Total Current Liabilities..................................................... 454,766 497,285
Long-term debt and capital lease obligations........................................ 1,202,613 1,156,020
Reserve for unpaid claims........................................................... 30,280 27,149
Deferred credits and other long-term liabilities.................................... 14,011 74,633
Minority interest................................................................... 26,985 4,683
Commitments and Contingencies
Stockholders' Equity:
Preferred stock, without par value
Authorized--10,000 shares
Issued and outstanding--none.................................................... -- --
Common Stock, par value $0.25 per share
Authorized--80,000 shares
Issued and outstanding--33,898 shares at September 30, 1998 and December 31,
1998.......................................................................... 8,476 8,476
Other Stockholders' Equity:
Additional paid-in capital...................................................... 349,651 349,663
Accumulated deficit............................................................. (149,238) (145,057)
Warrants outstanding............................................................ 25,050 25,050
Common stock in treasury, 2,289 shares at September 30, 1998 and December 31,
1998.......................................................................... (44,309) (44,309)
Cumulative foreign currency adjustments included in comprehensive income........ (1,995) (2,650)
------------- ------------
Total Stockholders' Equity.................................................... 187,635 191,173
------------- ------------
$ 1,916,290 $1,950,943
------------- ------------
------------- ------------
The accompanying Notes to Condensed Consolidated Financial Statements
are an integral part of these balance sheets.
1
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
FOR THE THREE MONTHS
ENDED
DECEMBER 31,
--------------------
1997 1998
--------- ---------
Net revenue............................................................. $ 212,371 $ 463,143
--------- ---------
Costs and expenses:
Salaries, cost of care and other operating expenses................... 172,331 413,216
Equity in (earnings) losses of unconsolidated subsidiaries............ 12,122 (4,982)
Depreciation and amortization......................................... 6,969 18,391
Interest, net......................................................... 7,401 24,109
Stock option expense (credit)......................................... (3,959) 12
Managed care integration costs........................................ -- 1,750
Unusual items......................................................... -- 22
--------- ---------
194,864 452,518
--------- ---------
Income before provision for income taxes and minority interest.......... 17,507 10,625
Provision for income taxes.............................................. 7,003 6,037
--------- ---------
Income before minority interest......................................... 10,504 4,588
Minority interest....................................................... 2,876 407
--------- ---------
Net income.............................................................. 7,628 4,181
Unrealized foreign currency adjustment, net of income tax (benefit)
provision of $39 in 1997 and $(436) in 1998........................... 59 (655)
--------- ---------
Comprehensive income.................................................... $ 7,687 $ 3,526
--------- ---------
--------- ---------
Average number of common shares outstanding--basic...................... 28,969 31,613
--------- ---------
--------- ---------
Average number of common shares outstanding--diluted.................... 29,784 31,660
--------- ---------
--------- ---------
Net income per common share--basic...................................... $ 0.26 $ 0.13
--------- ---------
--------- ---------
Net income per common share--diluted.................................... $ 0.26 $ 0.13
--------- ---------
--------- ---------
The accompanying Notes to Condensed Consolidated Financial Statements
are an integral part of these statements.
2
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
FOR THE THREE MONTHS
ENDED
DECEMBER 31,
--------------------
1997 1998
--------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income................................................................................. $ 7,628 $ 4,181
--------- ---------
Adjustments to reconcile net income to net cash provided by (used in) operating
activities:
Depreciation and amortization.......................................................... 6,969 18,391
Equity in (earnings) losses of unconsolidated subsidiaries............................. 12,122 (4,982)
Stock option expense (credit).......................................................... (3,959) 12
Non-cash interest expense.............................................................. 422 954
Gain on sale of assets................................................................. -- (1,062)
Cash flows from changes in assets and liabilities, net of effects from sales and
acquisitions of businesses:
Accounts receivable, net............................................................. (16,304) (6,267)
Restricted cash and investments...................................................... -- (42,887)
Other assets......................................................................... (10,633) 3,289
Accounts payable and other accrued liabilities....................................... (27,776) 34,142
Medical claims payable............................................................... 6,592 (3,946)
Reserve for unpaid claims............................................................ (9,256) (3,131)
Income taxes payable and deferred income taxes....................................... 2,056 9,363
Other liabilities.................................................................... (1,623) (223)
Minority interest, net of dividends paid............................................. 3,199 924
Other................................................................................ (1,162) (1,099)
--------- ---------
Total adjustments.................................................................. (39,353) 3,478
--------- ---------
Net cash provided by (used in) operating activities.............................. (31,725) 7,659
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures....................................................................... (4,578) (14,357)
Acquisitions and investments in businesses, net of cash acquired and return of escrowed
funds.................................................................................... (165,548) 6,444
Conversion of joint ventures from consolidation to equity method........................... -- (21,092)
Distributions received from unconsolidated subsidiaries.................................... -- 9,303
Decrease in assets restricted for settlement of unpaid claims and other liabilities........ 14,364 5,808
Proceeds from sale of assets............................................................... -- 3,619
Cresent Transaction costs.................................................................. (4,253) (7)
--------- ---------
Net cash used in investing activities................................................ (160,015) (10,282)
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of debt, net of issuance costs...................................... -- (69)
Payments on debt and capital lease obligations............................................. (140) (40,000)
Proceeds from exercise of stock options and warrants....................................... 1,917 --
Purchases of treasury stock................................................................ (12,456) --
--------- ---------
Net cash used in financing activities................................................ (10,679) (40,069)
--------- ---------
Net decrease in cash and cash equivalents.................................................... (202,419) (42,692)
Cash and cash equivalents at beginning of period............................................. 372,878 92,050
--------- ---------
Cash and cash equivalents at end of period................................................... $ 170,459 $ 49,358
--------- ---------
--------- ---------
The accompanying Notes to Condensed Consolidated Financial Statements
are an integral part of these statements.
3
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
(UNAUDITED)
NOTE A--BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q.
Accordingly, they do not include all of the information and footnotes required
by generally accepted accounting principles for complete financial statements.
In the opinion of management, all adjustments, consisting of normal recurring
adjustments considered necessary for a fair presentation, have been included.
These financial statements should be read in conjunction with the audited
consolidated financial statements of Magellan Health Services, Inc. and
Subsidiaries ("Magellan" or the "Company") for the fiscal year ended September
30, 1998, included in the Company's Annual Report on Form 10-K. Certain
reclassifications have been made to fiscal 1998 amounts to conform to fiscal
1999 presentation.
NOTE B--SUPPLEMENTAL CASH FLOW INFORMATION
Below is supplemental cash flow information related to the three months
ended December 31, 1997 and 1998 (in thousands):
FOR THE THREE
MONTHS ENDED
DECEMBER 31,
--------------------
1997 1998
--------- ---------
Income taxes paid, net of refunds received.............. $ 4,752 $ (3,570)
Interest paid, net of amounts capitalized............... 21,550 12,601
NOTE C--LONG-TERM DEBT AND LEASES
Information with regard to the Company's long-term debt and capital lease
obligations at September 30, 1998 and December 31, 1998 is as follows (in
thousands):
SEPTEMBER 30, DECEMBER 31,
1998 1998
------------- ------------
Credit Agreement:
Revolving Facility due through 2004........................... $ 40,000 $ --
Term Loan Facility (7.3725% to 7.8725% at December 31, 1998)
due through 2006............................................ 550,000 550,000
9.0% Senior Subordinated Notes due 2008....................... 625,000 625,000
6.07% to 11.5% Mortgage and other notes payable through
2005........................................................ 4,198 4,010
4.05% Capital lease obligations due through 2014.............. 6,448 6,438
------------- ------------
1,225,646 1,185,448
Less amounts due within one year.......................... 23,033 29,428
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$ 1,202,613 $1,156,020
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4
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(UNAUDITED)
NOTE D--ACCRUED LIABILITIES
Accrued liabilities consist of the following (in thousands):
SEPTEMBER 30, DECEMBER 31,
1998 1998
------------- ------------
Salaries, wages and other benefits.............................. $ 23,893 $ 12,504
Interest........................................................ 9,271 23,200
CHAMPUS adjustments............................................. 25,484 29,330
Other........................................................... 134,882 177,165
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$ 193,530 $ 242,199
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NOTE E--INCOME PER COMMON SHARE
The following table presents the components of average number of common
shares outstanding-diluted (in thousands):
THREE MONTHS
ENDED
DECEMBER 31,
--------------------
1997 1998
--------- ---------
Average number of common shares outstanding--basic... 28,969 31,613
Common stock equivalents--stock options.............. 762 39
Common stock equivalents--warrants................... 53 8
--------- ---------
Average number of common shares
outstanding--diluted............................... 29,784 31,660
--------- ---------
--------- ---------
Options to purchase approximately 1,649,000 shares of common stock at $14.56
to $31.00 per share were outstanding during the quarter ended December 31, 1998,
but were not included in the computation of diluted EPS because the options'
exercise prices were greater than the average market price of the common shares.
Approximately 1,315,000 of these options, which expire between fiscal 2001 and
2009, were outstanding at December 31, 1998.
Warrants to purchase approximately 4,713,000 shares of common stock at
$26.15 to $38.70 per share were outstanding during the quarter ended December
31, 1998, but were not included in the computation of diluted EPS because the
warrants' exercise prices were greater than the average market price of the
common shares. The warrants, which expire between fiscal 2000 and 2009, were
outstanding at December 31, 1998.
On November 17, 1998, the Company's Board of Directors approved the
repricing of stock options outstanding under the Company's existing stock option
plans which were held by current directors and full-time employees (the "Stock
Option Repricing"). Each holder of 10,000 or more stock options that was
5
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(UNAUDITED)
NOTE E--INCOME PER COMMON SHARE (CONTINUED)
eligible to participate in the Stock Option Repricing was required to forfeit a
percentage of outstanding stock options as follows:
- - Current Directors, including the Chief Executive Officer............. 40%
- - Named Executive Officers............................................. 30%
- - Holders of 50,000 or more stock options.............................. 25%
- - Holders of 10,000-49,999 stock options............................... 15%
The Stock Option Repricing was consummated on December 8, 1998, based on the
fair market value of the Company's common stock on such date. Approximately 1.7
million outstanding stock options were repriced to $8.41 and approximately 0.5
million outstanding stock options were forfeited as a result of the Stock Option
Repricing. Each participant in the Stock Option Repricing is precluded from
exercising repriced stock options until June 8, 1999.
NOTE F--INVESTMENTS IN UNCONSOLIDATED SUBSIDIARIES
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC. The Company owned a 50% interest in
Charter Behavioral Health Systems, LLC ("CBHS") as of September 30, 1998 and
December 31, 1998. The Company accounts for its investment in CBHS using the
equity method.
A summary of financial information for CBHS is as follows (in thousands):
SEPTEMBER 30, DECEMBER 31,
1998 1998
------------- ------------
Current assets.................................................. $ 147,119 $ 143,545
Property and equipment, net..................................... 21,148 21,460
Other nonconcurrent assets...................................... 8,871 9,211
------------- ------------
Total Assets.............................................. $ 177,138 $ 174,216
------------- ------------
------------- ------------
Current liabilities............................................. $ 141,379 $ 152,888
Long-term debt.................................................. 67,200 67,200
Other nonconcurrent liabilities................................. 35,437 47,661
Members' deficit................................................ (66,878) (93,533)
------------- ------------
Total Liabilities and Members' Deficit.................... $ 177,138 $ 174,216
------------- ------------
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6
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(UNAUDITED)
NOTE F--INVESTMENTS IN UNCONSOLIDATED SUBSIDIARIES (CONTINUED)
THREE MONTHS ENDED
DECEMBER 31,
--------------------
1997 1998
--------- ---------
Net Revenue.......................................... $ 178,058 $ 182,221
--------- ---------
Operating expenses................................... 199,664 206,290
Interest, net........................................ 1,370 1,588
--------- ---------
Net loss before preferred member
distribution................................. $ (22,976) $ (25,657)
--------- ---------
--------- ---------
Cash provided by (used in) operating activities...... $ (2,176) $ 4,904
--------- ---------
--------- ---------
Magellan equity loss (2)............................. $ (11,488) $ --
--------- ---------
--------- ---------
The Company's transactions with CBHS and related balances are as follows (in
thousands):
THREE MONTHS ENDED
DECEMBER 31,
-------------------------------
1997 1998
--------------- --------------
Franchise fee revenue (2)................... $ 19,575 $ --
------- --------------
Costs:
Accounts receivable collection fees....... $ 1,054 $ 93
Hospital-based joint venture management
fees.................................... 1,630 1,319
SEPTEMBER 30, DECEMBER 31,
1998 1998
--------------- --------------
Due to CBHS, net (1)....................... $ 1,127 $ 4,244
------- --------------
------- --------------
Prepaid CHARTER call center management
fees (3)................................ $ 2,953 $ 5,314
------- --------------
------- --------------
Net book value of leased property (4)..... $ 2,850 $ 7,250
------- --------------
------- --------------
- ------------------------
(1) The nature of hospital accounts receivable billing and collection processes
have resulted in the Company and CBHS receiving remittances which belong to
the other party. Additionally, the Company and CBHS have established a
settlement and allocation process for the accounts receivable related to
those patients who were not yet discharged from their treatment on June 16,
1997. These and other events result in the amount presented as due to CBHS.
(2) Franchise fees due from CBHS were approximately $38.0 million and $58.5
million as of September 30, 1998 and December 31, 1998, respectively. CBHS'
independent public accountants' report on CBHS' financial statements for the
year ended September 30, 1998, makes reference to uncertainty regarding
CBHS' ability to continue as a going concern. The Company recorded equity in
loss of its investment in CBHS until all franchise fees due from CBHS were
reduced to $0 at September 30, 1998. The Company received no franchise fee
payments from CBHS and recorded no franchise fee revenue related to CBHS
during the three months ended December 31, 1998, due to continuing
uncertainties surrounding their collectibility. Cumulative equity in losses
of CBHS in excess of the
7
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(UNAUDITED)
NOTE F--INVESTMENTS IN UNCONSOLIDATED SUBSIDIARIES (CONTINUED)
Company's investment in CBHS of $7.7 million ($5.1 million during the fiscal
year ended September 30, 1998; $2.6 million during the three months ended
Decemer 31, 1998) are not reflected in the Company's financial statements at
and for the three months ended December 31, 1998, since the Company has no
remaining obligation or commitment to fund CBHS and has no guarantees
outstanding for any CBHS obligations.
(3) CBHS is responsible for funding substantially all of the operations of the
1-800-CHARTER call center under a management agreement (the "Call Center
Management Agreement") which was entered into on December 22, 1997.
Under the Call Center Management Agreement, CBHS agreed to fund the
operations of the call center with the exceptions of capital expenditures
and lease payments for an initial term of eighteen months in exchange for
payment of approximately $5.9 million, which approximated the budgeted costs
for the call center over the term of the agreement. In December 1998, the
Call Center Management Agreement was extended for an additional twelve
months at a cost to the Company of approximately $3.3 million.
(4) CBHS leased two psychiatric hospital facilities (collectively, the "CBHS
Leaseholds") from the Company as of December 31, 1998, that were acquired by
the Company in connection with CBHS' acquisition of certain businesses from
Ramsay Health Care, Inc. on September 28, 1998. The Company paid
approximately $7.2 million for the CBHS Leaseholds ($2.8 million during
September 1998; $4.4 million during the quarter ended December 31, 1998).
The purchase of the CBHS Leaseholds was funded primarily through
distributions received from the Provider JV's (as defined). The CBHS
Leaseholds are leased to CBHS for a 10-year lease term at an annual rent of
$0.7 million. The Company accounted for the purchase of the CBHS Leaseholds
as an investment in income producing property. Both the Company and CBHS
account for these leases as operating leases.
Under the terms of a letter agreement dated November 10, 1998, between the
Company and Crescent Real Estate Funding VII, L.P. ("Crescent Funding"),
Crescent Funding has agreed to purchase the CBHS Leaseholds from the
Company, at the contract acquisition cost paid by the Company, upon the sale
of certain other property owned by Crescent Funding and leased by CBHS at
December 31, 1998. Crescent Funding is an affiliate of both Crescent
Operating, Inc. ("COI"), the other 50% owner of CBHS, and Crescent Real
Estate Equities, L.P. ("Crescent"), the lessor of the majority of the
properties in which CBHS conducts its business.
CHOICE BEHAVIORAL HEALTH PARTNERSHIP. The Company is a 50% partner with
Value Options, Inc. in Choice Behavioral Health Partnership ("Choice"), a
managed behavioral healthcare company. Choice derives all of its revenues from a
contract with the Civilian Health and Medical Program of the Uniformed Services
("CHAMPUS"), and with TriCare, the successor to CHAMPUS. The Company accounts
for its investment in Choice using the equity method.
8
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(UNAUDITED)
NOTE F--INVESTMENTS IN UNCONSOLIDATED SUBSIDIARIES (CONTINUED)
A summary of financial information for the Company's investment in Choice is
as follows (in thousands):
SEPTEMBER 30, 1998 DECEMBER 31, 1998
------------------ -----------------
Current assets......................................... $ 22,974 $ 20,957
Property and equipment, net............................ 345 310
------- -------
Total Assets..................................... $ 23,319 $ 21,267
------- -------
------- -------
Current liabilities.................................... $ 16,829 $ 16,514
Partners' capital...................................... 6,490 4,753
------- -------
Total Liabilities and Partners' Capital.......... $ 23,319 $ 21,267
------- -------
------- -------
Magellan Investment.................................... $ 3,245 $ 2,207
------- -------
------- -------
THREE MONTHS
ENDED
DECEMBER 31, 1998
-----------------
Net revenue................................................................ $ 14,580
Operating expenses......................................................... 8,348
-------
Net income........................................................... $ 6,232
-------
-------
Magellan equity income..................................................... $ 3,116
-------
-------
The Company acquired its investment in Choice on February 12, 1998, as part
of the Merit (as defined) acquisition. Accordingly, statement of operations data
for the three months ended December 31, 1997, is not presented.
PREMIER BEHAVIORAL SYSTEMS, LLC. The Company owns a 50% interest in Premier
Behavioral Systems, LLC ("Premier"). Premier was formed to manage behavioral
healthcare benefits for the State of Tennessee's TennCare program. The Company
accounts for its investment in Premier using the equity method. The Company's
investment in Premier at September 30, 1998 and December 31, 1998 was $5.8
million and $6.5 million, respectively. The Company's equity in earnings
(losses) of Premier for the three months ended December 31, 1997 and 1998 was
$(0.6) million and $0.7 million, respectively.
HOSPITAL-BASED JOINT VENTURES. The Company owns non-controlling interests
in five hospital-based joint ventures ("Provider JV's"). Generally, each member
of the joint venture leased and/or contributed certain assets in each respective
market to the joint venture with the Company becoming the managing member.
9
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(UNAUDITED)
NOTE F--INVESTMENTS IN UNCONSOLIDATED SUBSIDIARIES (CONTINUED)
A summary of the Provider JV's is as follows:
OWNERSHIP
MARKET DATE PERCENTAGE MINORITY OWNER/S
- --------------------------------- ----------------- --------------- -----------------------------------------------
Chicago, IL...................... June, 1994 75% Naperville Health Ventures
Albuquerque, NM.................. May, 1995 67% Columbia/HCA Healthcare Corporation
Raleigh, NC...................... June,1995 50% Columbia/HCA Healthcare Corporation
Lafayette, LA.................... October, 1995 50% Columbia/HCA Healthcare Corporation
Anchorage, AK.................... August, 1996 57% Columbia/HCA Healthcare Corporation
The Provider JV's results of operations were included in the Company's
consolidated financial statements from inception, less minority interest,
through September 30, 1998. On October 1, 1998, the Provider JV's were converted
from consolidation to the equity method of accounting. See "Management's
Discussion and Analysis--Recent Accounting Pronouncements--EITF 96-16".
The Company's ownership interests in the Provider JV's have been managed by
CBHS for a fee equivalent to Magellan's portion of the joint ventures' earnings
since June 17, 1997.
A summary of financial information for the Company's aggregate investment in
the Provider JV's is as follows (in thousands):
DECEMBER 31, 1998
-----------------
Current assets............................................................. $ 21,026
Property and equipment, net................................................ 23,761
Other noncurrent assets.................................................... 2,196
--------
Total Assets......................................................... $ 46,983
--------
--------
Current liabilities........................................................ $ 10,413
Partners' capital.......................................................... 36,570
--------
Total Liabilities and Partners' Capital.............................. $ 46,983
--------
--------
Magellan Investment........................................................ $ 20,455
--------
--------
THREE MONTHS
ENDED
DECEMBER 31, 1998
-----------------
Net revenue................................................................ $ 14,845
Operating expenses......................................................... 12,604
--------
Net income........................................................... $ 2,241
--------
--------
Magellan equity income..................................................... $ 1,199
--------
--------
10
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(UNAUDITED)
NOTE G--ACQUISITIONS
MANAGED CARE ACQUISITIONS. During fiscal 1998, the Company acquired the
following businesses in its Behavioral Managed Healthcare ("Behavioral") and
Specialty Managed Healthcare ("Specialty") business segments (collectively, the
"Managed Care Acquisitions"):
CONTRACT PURCHASE
ACQUISITION PRICE
ACQUIRED COMPANY SEGMENT DATE (IN MILLIONS)
- ------------------------------------------------------------ ------------ --------------- -----------------
Human Affairs International, Incorporated ("HAI") Behavioral 12/4/97 $ 122.1(1)
Allied Health Group, Inc. ("Allied") Specialty 12/5/97 $ 50.0(2)
Merit Behavioral Care Corporation ("Merit") Behavioral 2/12/98 $ 750.0
- ------------------------
(1) Excluding potential contingent consideration of up to $300.0 million.
(2) Excluding contingent consideration of $4.5 million paid during the quarter
ended December 31,1998.
The Company accounted for the Managed Care Acquisitions using the purchase
method of accounting. The purchase price allocation for the Merit acquisition is
tentative and subject to final valuation allowances on deferred tax assets,
integration plan matters (see Note I), CHAMPUS Adjustments (as defined) and
certain other matters. The Company expects the Merit purchase price allocation
to be finalized during the quarter ended March 31, 1999.
GREEN SPRING MINORITY STOCKHOLDER CONVERSION. In January 1998, the minority
stockholders of Green Spring converted their collective 39% interest in Green
Spring into an aggregate of 2,831,516 shares of the Company's common stock
through exercise of an exchange option (the "Green Spring Minority Stockholder
Conversion"). As a result of the Green Spring Minority Stockholder Conversion,
the Company owns 100% of Green Spring. The Company issued shares from treasury
to effect the Green Spring Minority Stockholder Conversion and accounted for it
as a purchase of minority interest at the fair value of consideration paid.
The following unaudited pro forma information for the quarter ended December
31, 1997, has been prepared assuming the Managed Care Acquisitions and the Green
Spring Minority Stockholder Conversion were consummated on October 1, 1997. The
unaudited pro forma information does not purport to be
11
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(UNAUDITED)
NOTE G--ACQUISITIONS (Continued)
indicative of the results that would have actually been obtained had such
transactions been consummated on October 1, 1997, or which may be attained in
future periods (in thousands, except per share amounts):
PRO FORMA
FOR THE THREE MONTHS
ENDED
DECEMBER 31,
1997
--------------------
Net revenue............................................................. $ 428,272
--------
--------
Net income (1).......................................................... $ 3,515
--------
--------
Net income per common share -- basic.................................... $ 0.11
--------
--------
Net income per common share -- diluted.................................. $ 0.11
--------
--------
- ------------------------
(1) Excludes expected unrealized cost savings related to the Integration Plan
(as defined).
NOTE H--CONTINGENCIES
The Company is self-insured for a substantial portion of its general and
professional liability risks. The reserves for self-insured general and
professional liability losses, including loss adjustment expenses, are included
in "Reserve for unpaid claims" in the Company's balance sheet and are based on
actuarial estimates that are discounted at an average rate of 6% to their
present value based on the Company's historical claims experience adjusted for
current industry trends. The undiscounted amount of the reserve for unpaid
claims at September 30, 1998 and December 31, 1998, was approximately $34.6
million and $30.3 million, respectively. The carrying amount of accrued medical
malpractice claims was $26.2 million and $23.8 million at September 30, 1998 and
December 31, 1998, respectively. The reserve for unpaid claims is adjusted
periodically as such claims mature, to reflect changes in actuarial estimates
based on actual experience. During the quarter ended December 31, 1997, the
Company recorded reductions in malpractice claim reserves of approximately $4.1
million, as a result of updated actuarial estimates. These reductions resulted
primarily from updates to actuarial assumptions regarding the Company's expected
losses for more recent policy years. These revisions are based on changes in
expected values of ultimate losses resulting from the Company's claim
experience, and increased reliance on such claim experience. While management
and its actuaries believe that the present reserve is reasonable, ultimate
settlement of losses may vary from the amount recorded.
The healthcare industry is subject to numerous laws and regulations. The
subjects of such laws and regulations include but are not limited to, matters
such as licensure, accreditation, government healthcare program participation
requirements, reimbursement for patient services, and Medicare and Medicaid
fraud and abuse. Recently, government activity has increased with respect to
investigations and/or allegations concerning possible violations of fraud and
abuse and false claims statutes and/or regulations by healthcare providers.
Entities that are found to have violated these laws and regulations may be
excluded from participating in government healthcare programs, subjected to
fines or penalties or required to repay amounts received from the government for
previously billed patient services. The Office of the Inspector General of the
Department of Health and Human Services and the United States Department of
Justice
12
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(UNAUDITED)
NOTE H--CONTINGENCIES (CONTINUED)
and certain other governmental agencies are currently conducting inquiries
and/or investigations regarding the compliance by the Company and certain of its
subsidiaries and the compliance by CBHS and certain of its subsidiaries with
such laws and regulations. Certain of the inquiries relate to the operations and
business practices of the Company's psychiatric provider operations prior to the
consummation of the Crescent Transactions (as defined). In addition, the Company
is also subject to or party to litigation, claims and civil suits relating to
its operations and business practices. In the opinion of management, the Company
has recorded reserves that are adequate to cover litigation, claims or
assessments that have been or may be asserted against the Company arising out of
such litigation, civil suits and governmental inquiries. Furthermore, management
believes that the resolution of such litigation, civil suits and governmental
inquiries will not have a material adverse effect on the Company's financial
position or results of operations; however, there can be no assurance in this
regard.
In October 1996, a group of eight plaintiffs purporting to represent an
uncertified class of psychiatrists, psychologists and social workers brought an
action under the federal antitrust laws in the United States District Court for
the Southern District of New York against nine behavioral health managed care
organizations, including Merit, CMG, Green Spring and HAI (collectively, the
"Defendants"). The complaint (the "Stephens Case") alleges that the Defendants
violated Section I of the Sherman Act by engaging in a conspiracy to fix the
prices at which the defendants purchase services from mental healthcare
providers such as the plaintiffs. The complaint further alleges that the
Defendants engaged in a group boycott to exclude mental healthcare providers
from the Defendants' networks in order to further the goals of the alleged
conspiracy. The complaint also challenges the propriety of the Defendants'
capitation arrangements with their respective customers, although it is unclear
from the complaint whether the plaintiffs allege that the Defendants unlawfully
conspired to enter into capitation arrangements with their respective customers.
The complaint seeks treble damages against the Defendants in an unspecified
amount and a permanent injunction prohibiting the Defendants from engaging in
the alleged conduct which forms the basis of the complaint, plus costs and
attorneys' fees. On May 12, 1998, the District Court granted the Defendants'
motion to dismiss the complaint with prejudice. On May 27, 1998, the plaintiffs
filed a notice of appeal of the District Court's dismissal of their complaint
with the United States Second Circuit Court of Appeals. On November 16, 1998,
the Second Circuit court issued a Summary Order affirming the District Court's
decision. The plaintiffs have not filed a petition for rehearing, and the time
allotted for doing so has expired. The plaintiffs have 90 days from the date of
judgment to file a petition for certiorari with the United States Supreme Court.
The plaintiffs have not indicated whether they will file such a petition. If no
petition is filed, or if a filed petition is denied, this matter will have been
concluded. The Company does not believe this matter will have a material adverse
effect on its financial position or results of operations.
On May 26, 1998, the counsel representing the plaintiffs in the Stephens
Case filed an action in the United States District Court for the District of New
Jersey on behalf of a group of thirteen plaintiffs who also purport to represent
an uncertified class of psychiatrists, psychologists and clinical social
workers. This complaint alleges substantially the same violations of federal
antitrust laws by the Defendants. The Defendants believe the factual and legal
issues involved in this case are substantially similar to those involved in the
Stephens Case and intend to vigorously defend themselves in this litigation. On
August 28, 1998, the Defendants filed a joint motion requesting that the case
be: i) transferred to the Southern District of New York; ii) alternatively, that
all proceedings be stayed pending the Second
13
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(UNAUDITED)
NOTE H--CONTINGENCIES (CONTINUED)
Circuit's determination of the Stephens Case appeal, given the RES JUDICATA
effect of the Stephens Case dismissal; and iii) if the Court proceeds with the
case, that the complaint be dismissed for failure to state a claim for
substantially the same reasons as in the Stephens Case. The plaintiffs have
opposed this motion, which was argued on November 23, 1998. At the conclusion of
the November 23 hearing, the Court ruled that the case should be transferred to
the Southern District of New York. The Defendants' motion to dismiss was deemed
withdrawn without prejudice to its resubmission in the Southern District. The
plaintiffs have stated that they intend to appeal the Court's transfer order to
the United States District Court for the District of New Jersey. The Company
does not believe this matter will have a material adverse effect on its
financial position or results of operations.
The Company provides mental health and substance abuse services, as a
subcontractor, to beneficiaries of CHAMPUS. The fixed monthly amounts that the
Company receives for medical costs under CHAMPUS contracts are subject to
retroactive adjustment ("CHAMPUS Adjustments") based upon actual healthcare
utilization during the period known as the "data collection period". The Company
has recorded reserves of approximately $29.3 million as of December 31, 1998,
for CHAMPUS Adjustments.
While management believes that the present reserve for CHAMPUS Adjustments
is reasonable, ultimate settlement resulting from the adjustment and available
appeal process may vary from the amount provided.
NOTE I--MANAGED CARE INTEGRATION PLAN AND COSTS
INTEGRATION PLAN. Management approved and committed the Company to a plan
to combine and integrate the operations of its Behavioral and Specialty segments
(the "Integration Plan") during fiscal 1998. The Integration Plan will result in
the elimination of duplicative functions and will standardize business practices
and information technology platforms.
The Integration Plan will result in the elimination of approximately 1,000
positions during fiscal 1998 and fiscal 1999. Approximately 425 employees had
been involuntarily terminated pursuant to the Integration Plan as of December
31, 1998. The Company estimates that approximately 100 additional employees will
be involuntarily terminated as a result of the Integration Plan. The remaining
positions have been or will be eliminated through normal attrition.
The employee groups of the Behavioral segment that are primarily affected
include executive management, finance, human resources, information systems and
legal personnel at the various corporate headquarters and regional offices and
credentialing, claims processing, contracting and marketing personnel at various
operating locations. The Company expects to complete the specific identification
of all personnel who will be involuntarily terminated during the quarter ended
March 31, 1999, and will complete its involuntary terminations by the end of
fiscal 1999.
The Integration Plan has resulted in the closure and identified closure of
approximately 20 leased facilities during fiscal 1998 and 1999. The Company
expects the remaining office closures, if any, to be insignificant.
The Company recorded approximately $21.3 million of liabilities related to
the Integration Plan, of which $12.4 million was recorded as part of the Merit
purchase price allocation and $8.9 million was
14
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(UNAUDITED)
NOTE I--MANAGED CARE INTEGRATION PLAN AND COSTS (CONTINUED)
recorded in the statement of operations under "Managed Care integration costs"
in fiscal 1998. The Company may record adjustments to such liabilities in fiscal
1999 depending on the Company's ability to sublease closed offices and upon
determination of the final amount of the Company's severance obligations.
The following table provides a rollforward of liabilities resulting from the
Integration Plan (in thousands).
BALANCE BALANCE
SEPTEMBER 30, DECEMBER 31,
TYPE OF COST 1998 ADDITIONS PAYMENTS 1998
- ------------------------------------------ ------------- ------------- ----------- ------------
Employee termination benefits............. $ 6,190 $ -- $ 2,824 $ 3,366
Facility closing costs.................... 7,475 -- 140 7,335
Other..................................... 169 -- -- 169
------------- --- ----------- ------------
$ 13,834 $ -- $ 2,964 $ 10,870
------------- --- ----------- ------------
------------- --- ----------- ------------
OTHER INTEGRATION COSTS. The Integration Plan will result in additional
incremental costs that must be expensed as incurred in accordance with Emerging
Issues Task Force Consensus 94-3, "Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity (Including Certain
Costs Incurred in a Restructuring)" that are not described above and certain
other charges. Other integration costs include, but are not limited to, outside
consultants, costs to relocate closed office contents and long-lived asset
impairments. Other integration costs are reflected in the statement of
operations under "Managed Care integration costs".
During the quarter ended December 31, 1998, the Company incurred
approximately $1.8 million in other integration costs, including outside
consulting costs of approximately $0.8 million and employee and office
relocation costs of approximately $0.4 million.
NOTE J--BUSINESS SEGMENT INFORMATION
The Company operates through five reportable segments which are engaged in
various aspects of the healthcare industry. Intersegment sales and transfers
among these segments are not significant.
15
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(UNAUDITED)
NOTE J--BUSINESS SEGMENT INFORMATION (CONTINUED)
The following tables summarize, for the periods indicated, net revenue,
Segment Profit (as defined) and total assets by business segment (in thousands):
BEHAVIORAL SPECIALTY
MANAGED HUMAN MANAGED HEALTHCARE HEALTHCARE CORPORATE
THREE MONTHS ENDED DECEMBER 31, 1997 HEALTHCARE SERVICES HEALTHCARE FRANCHISING PROVIDER OVERHEAD CONSOLIDATED
- -------------------------------------- ----------- ----------- ----------- ----------- ----------- ----------- ------------
Net revenue........................... $ 119,211 $ 26,314 $ 14,107 $ 19,575 $ 33,164 $ -- $ 212,371
Segment Profit (loss)................. 14,659 2,297 (676) 5,845 9,202 (3,409) 27,918
BEHAVIORAL SPECIALTY
MANAGED HUMAN MANAGED HEALTHCARE HEALTHCARE CORPORATE
THREE MONTHS ENDED DECEMBER 31, 1998 HEALTHCARE SERVICES HEALTHCARE FRANCHISING PROVIDER OVERHEAD CONSOLIDATED
- -------------------------------------- ----------- ----------- ----------- ----------- ----------- ----------- ------------
Net revenue........................... $ 356,551 $ 45,739 $ 41,041 $ 175 $ 19,637 $ -- $ 463,143
Segment Profit (loss)................. 52,620 5,287 416 (1,320) 1,199 (3,293) 54,909
BEHAVIORAL SPECIALTY
MANAGED HUMAN MANAGED HEALTHCARE HEALTHCARE CORPORATE
HEALTHCARE SERVICES HEALTHCARE FRANCHISING PROVIDER OVERHEAD CONSOLIDATED
----------- --------- ----------- ----------- ----------- ----------- ------------
Total assets, September 30, 1998...... $1,356,259 $ 119,356 $ 78,062 $ 1,941 $ 178,217 $ 182,455 $1,916,290
----------- --------- ----------- ----------- ----------- ----------- ------------
----------- --------- ----------- ----------- ----------- ----------- ------------
Total assets, December 31, 1998....... $1,463,516 $ 122,310 $ 75,129 $ 1,854 $ 136,757 $ 151,377 $1,950,943
----------- --------- ----------- ----------- ----------- ----------- ------------
----------- --------- ----------- ----------- ----------- ----------- ------------
The following tables reconcile Segment Profit (as defined) to consolidated
income before provision for income taxes and minority interest (in thousands):
THREE MONTHS ENDED DECEMBER 31, 1997
Segment Profit..................................................................... $ 27,918
Depreciation and amortization...................................................... (6,969)
Interest, net...................................................................... (7,401)
Stock option credit................................................................ 3,959
---------
Income before provision for income taxes and minority interest............... $ 17,507
---------
---------
THREE MONTHS ENDED DECEMBER 31, 1998
Segment Profit..................................................................... $ 54,909
Depreciation and amortization...................................................... (18,391)
Interest, net...................................................................... (24,109)
Stock option expense............................................................... (12)
Managed care integration costs..................................................... (1,750)
Unusual items...................................................................... (22)
---------
Income before provision for income taxes and minority interest............... $ 10,625
---------
---------
16
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
DECEMER 31, 1998
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
This Form 10-Q includes "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended (the "Securities Act") and
Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange
Act"). Although the Company believes that its plans, intentions and expectations
reflected in such forward-looking statements are reasonable, it can give no
assurance that such plans, intentions or expectations will be achieved.
Important factors that could cause actual results to differ materially from the
Company's forward-looking statements are set forth in the Company's Annual
Report on Form 10-K for the fiscal year ended September 30, 1998. All
forward-looking statements attributable to the Company or persons acting on
behalf of the Company are expressly qualified in their entirety by the
cautionary statements set forth in the Company's Annual Report on Form 10-K for
the fiscal year ended September 30, 1998.
OVERVIEW
The Company historically derived the majority of its revenue from providing
behavioral healthcare services in an inpatient setting prior to the consummation
of the Crescent Transactions on June 17, 1997. Payments from third-party payors
are the principal source of revenue for most behavioral healthcare providers. In
the early 1990's, many third party payors sought to control the cost of
providing care to their patients by instituting managed care programs or seeking
the assistance of managed care companies. Providers participating in managed
care programs agree to provide services to patients for a discount from
established rates, which generally results in pricing concessions by the
providers and lower margins. Additionally, managed care programs generally
encourage alternatives to inpatient treatment settings and reduce utilization of
inpatient services. As a result, third-party payors established managed care
programs or engaged managed care companies in many areas of healthcare,
including behavioral healthcare. The Company, which until the consummation of
the Crescent Transactions was the largest operator of psychiatric hospitals in
the United States, was adversely affected by the adoption of managed care
programs by the third-party payors.
Prior to the first quarter of fiscal 1996, the Company was not a provider of
behavioral managed healthcare services. During the first quarter of fiscal 1996,
the Company acquired a 61% ownership interest in Green Spring Health Services,
Inc. ("Green Spring"). At that time, the Company intended to become a fully
integrated behavioral healthcare provider by combining the behavioral managed
healthcare products offered by Green Spring with the direct treatment services
offered by the Company's psychiatric hospitals. The Company believed that an
entity that participated in both the managed care and the provider segments of
the behavioral healthcare industry could more efficiently provide and manage
behavioral healthcare for insured populations than an entity that was solely a
managed care company. The Company also believed that earnings from its
behavioral managed healthcare business would offset, in part, the negative
impact on the financial performance of its psychiatric hospitals caused by
managed care. Green Spring was the Company's first significant involvement in
behavioral managed healthcare. During the first quarter of fiscal 1998, pursuant
to the Green Spring Minority Stockholder Conversion, the minority stockholders
of Green Spring converted their interests in Green Spring into an aggregate of
2,831,516 shares of the Company's Common Stock.
Subsequent to the Company's acquisition of Green Spring, the growth of the
behavioral managed healthcare industry accelerated. Under the Company's majority
ownership, Green Spring increased its base of covered lives from 12.0 million as
of the end of calendar year 1995 to 21.1 million as of the end of calendar year
1997, a compound annual growth rate of over 32%. While growth in the industry
was
17
accelerating, the behavioral managed healthcare industry also began to
consolidate. The Company concluded that this consolidation presented an
opportunity for the Company to increase its participation in the behavioral
managed healthcare industry, which the Company believed offered growth and
earnings prospects superior to those of the psychiatric hospital industry.
Therefore, the Company decided to sell its domestic psychiatric facilities to
obtain capital for expansion in the behavioral managed healthcare business.
On June 17, 1997, the Company sold substantially all of its domestic acute
care psychiatric hospitals and residential treatment facilities (the
"Psychiatric Hospital Facilities"), to Crescent Real Estate Equities, L.P.
("Crescent") for $417.2 million in cash (before costs of approximately $16.0
million) and certain other consideration (the "Crescent Transactions"). The sale
of the Psychiatric Hospital Facilities provided the Company with approximately
$200 million of net cash proceeds, after debt repayment, for use in implementing
its business strategy to increase its participation in the managed healthcare
industry. The Company used the net cash proceeds of approximately $200 million
to finance the acquisitions of HAI and Allied in December 1997.
The Company further implemented its business strategy through the Merit
acquisition.
RESULTS OF OPERATIONS
The following tables summarize, for the periods indicated, operating results
by business segment (in thousands):
BEHAVIORAL SPECIALTY
MANAGED HUMAN MANAGED HEALTHCARE HEALTHCARE CORPORATE
THREE MONTHS ENDED DECEMBER 31, 1997 HEALTHCARE SERVICES HEALTHCARE FRANCHISING PROVIDER OVERHEAD CONSOLIDATED
- -------------------------------------- ----------- ----------- ----------- ----------- ----------- ----------- ------------
Net revenue........................... $ 119,211 $ 26,314 $ 14,107 $ 19,575 $ 33,164 $ -- $ 212,371
----------- ----------- ----------- ----------- ----------- ----------- ------------
Salaries, cost of care and other
operating expenses.................. 103,918 24,017 14,783 2,242 23,962 3,409 172,331
Equity in losses of unconsolidated
subsidiaries........................ 634 -- -- 11,488 -- -- 12,122
----------- ----------- ----------- ----------- ----------- ----------- ------------
104,552 24,017 14,783 13,730 23,962 3,409 184,453
----------- ----------- ----------- ----------- ----------- ----------- ------------
Segment Profit (loss)(1).......... $ 14,659 $ 2,297 $ (676) $ 5,845 $ 9,202 $ (3,409) $ 27,918
----------- ----------- ----------- ----------- ----------- ----------- ------------
----------- ----------- ----------- ----------- ----------- ----------- ------------
BEHAVIORAL SPECIALTY
MANAGED HUMAN MANAGED HEALTHCARE HEALTHCARE CORPORATE
THREE MONTHS ENDED DECEMBER 31, 1998 HEALTHCARE SERVICES HEALTHCARE FRANCHISING PROVIDER OVERHEAD CONSOLIDATED
- -------------------------------------- ----------- ----------- ----------- ----------- ----------- ----------- ------------
Net revenue........................... $ 356,551 $ 45,739 $ 41,041 $ 175 $ 19,637 $ -- $ 463,143
----------- ----------- ----------- ----------- ----------- ----------- ------------
Salaries, cost of care and other
operating expenses.................. 307,714 40,452 40,625 1,495 19,637 3,293 413,216
Equity in earnings of unconsolidated
subsidiaries........................ (3,783) -- -- -- (1,199) -- (4,982)
----------- ----------- ----------- ----------- ----------- ----------- ------------
303,931 40,452 40,625 1,495 18,438 3,293 408,234
----------- ----------- ----------- ----------- ----------- ----------- ------------
Segment Profit (loss)(1).......... $ 52,620 $ 5,287 $ 416 $ (1,320) $ 1,199 $ (3,293) $ 54,909
----------- ----------- ----------- ----------- ----------- ----------- ------------
----------- ----------- ----------- ----------- ----------- ----------- ------------
- ------------------------------
(1) The Company evaluates performance of its segments based on profit or loss
from operations before depreciation, amortization, interest, stock option
expense (credit), managed care integration costs, gain or loss on asset
sales, other unusual items, income taxes and minority interest ("Segment
Profit"). See the reconciliation of Segment Profit to consolidated income
before provision for income taxes and minority interest included in Note
J--"Business Segment Information" to the Company's condensed consolidated
financial statements set forth elsewhere herein.
BEHAVIORAL MANAGED CARE. Revenue increased 199.2% or $237.4 million, to
$356.6 million for the quarter ended December 31, 1998, from $119.2 million in
the same period in fiscal 1998. Salaries, cost of care and other operating
expenses increased 196.1%, or $203.8 million, to $307.7 million for the quarter
18
ended December 31, 1998, from $103.9 million in the same period in fiscal 1998.
Equity in earnings of unconsolidated subsidiaries increased $4.4 million to $3.8
million for the quarter ended December 31, 1998, from a loss of $0.6 million for
the same period in fiscal 1998. The increases resulted primarily from the
acquisitions of HAI and Merit in fiscal 1998 and internal growth at Green
Spring. Behavioral managed care revenues and equity in earnings of
unconsolidated subsidiaries also increased as a result of the award of several
new contracts in fiscal 1998 and significant improvements in negotiated rates
and terms of the TennCare contract in fiscal 1998. The increase in Segment
Profit was also attributable to reductions in administrative costs at Green
Spring and HAI as a result of the Integration Plan.
HUMAN SERVICES. Revenue increased 73.8%, or $19.4 million, to $45.7 million
for the quarter ended December 31, 1998, from $26.3 million in the same period
in fiscal 1998. Salaries, cost of care and other operating expenses increased
68.4%, or $16.5 million, to $40.5 million for the quarter ended December 31,
1998 from $24.0 million in the same period in fiscal 1998. The increases were
attributable to the eight acquisitions consummated in fiscal 1998 and fiscal
1999 and internal growth. Placements in Mentor homes increased 23.8% to 3,640 at
December 31, 1998, compared to 2,940 at December 31, 1997.
SPECIALTY MANAGED CARE. Revenue increased 190.9%, or $26.9 million, to
$41.0 million for the quarter ended December 31, 1998, compared to $14.1 million
in the same period in fiscal 1998. Salaries, cost of care and other operating
expenses increased 174.8%, or $25.8 million, to $40.6 million for the quarter
ended December 31, 1998, compared to $14.8 million in the same period in fiscal
1998. The increase in revenue and salaries, cost of care and other operating
expenses was primarily related to the Allied acquisition. Allied's revenues and
salaries, cost of care and other operating expenses were $40.8 million and $39.9
million, respectively, for the quarter ended December 31, 1998, compared to
$14.1 million and $13.3 million for the quarter ended December 31, 1997.
HEALTHCARE FRANCHISING. Revenue decreased to $0.2 million for the quarter
ended December 31, 1998, from $19.6 million in the same period in fiscal 1998.
Salaries, cost of care and other operating expenses decreased 33.3%, or $0.7
million, to $1.5 million for the quarter ended December 31, 1998, from $2.2
million in the same period in fiscal 1998. Equity in loss of CBHS decreased to
$0 for the quarter ended December 31, 1998, from $11.5 million in the same
period in fiscal 1998. The decrease in revenue resulted from uncertainties
surrounding the collectibility of franchise fees due from CBHS, for which no
franchise fee revenue was recognized during the quarter ended December 31, 1998,
while $19.6 million of CBHS franchise revenue was recognized and collected in
the same period in fiscal 1998. The decrease in equity in loss of CBHS is
attributable to the fact that the Company had reduced its investment in CBHS to
$0 at September 30, 1998, and was no longer required to record its pro rata
share of CBHS' loss for the quarter ended December 31, 1998. See Note
F--"Investments in Unconsolidated Subsidiaries--Charter Behavioral Health
Systems, LLC" to the Company's condensed consolidated financial statements set
forth elsewhere herein.
HEALTHCARE PROVIDER. Revenue decreased 41.0%, or $13.6 million, to $19.6
million for the quarter ended December 31, 1998, from $33.2 million in the same
period in fiscal 1998. Salaries, cost of care and other operating expenses
decreased 18.3%, or $4.4 million, to $19.6 million for the quarter ended
December 31, 1998 from $24.0 million in fiscal 1998. Equity in earnings of
unconsolidated subsidiaries increased to $1.2 million for the quarter ended
December 31, 1998, from $0 in the same period in fiscal 1998. These changes
resulted primarily from the conversion of five provider joint ventures from
consolidation to the equity method. See "--Recent Accounting
Pronouncements--EITF 96-16". During the quarter ended December 31, 1997, the
Company recorded reductions of expenses of $4.1 million as a result of updated
actuarial estimates related to malpractice claim reserves. These reductions
resulted primarily from updates to actuarial assumptions regarding the Company's
expected losses for more recent policy years. These revisions are based on
changes in expected values of ultimate losses resulting from the Company's claim
experience, and increased reliance on such claim experience. While management
and its actuaries
19
believe that the present reserve is reasonable, ultimate settlement of losses
may vary from the amount recorded and result in additional fluctuations in
income in future periods.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased
162.9%, or $11.4 million, to $18.4 million for the quarter ended December 31,
1998, from $7.0 million in the same period in fiscal 1998. The increase was
primarily attributable to depreciation and amortization resulting from the HAI,
Allied and Merit acquisitions of $10.9 million, in the aggregate, for the
quarter ended December 31, 1998 compared to $0.5 million for the same period in
fiscal 1998.
INTEREST, NET. Interest expense, net, increased 225.7%, or $16.7 million,
to $24.1 million for the quarter ended December 31, 1998, from $7.4 million in
the same period in fiscal 1998. The increase was primarily the result of
interest expense incurred on borrowings used to fund the Merit acquisition and
related transactions.
OTHER ITEMS. Stock option expense for the quarter ended December 31, 1998,
was not material compared to a credit of $4.0 million in fiscal 1998 primarily
due to the exercise of stock options by a certain optionee in fiscal 1998.
The Company recorded Managed Care integration costs of $1.8 million for the
quarter ended December 31, 1998. See Note I--"Managed Care Integration Plan and
Costs" to the Company's condensed consolidated financial statements set forth
elsewhere herein.
The Company's effective income tax rate increased to 56.8% for the quarter
ended December 31, 1998, compared to 40% in the same period in fiscal 1998. The
increase was primarily attributable to non-deductible goodwill amortization of
$4.5 million for the quarter ended December 31, 1998, resulting from the Merit
acquisition.
Minority interest decreased 86.2%, or $2.5 million, to $0.4 million,
compared to $2.9 million in the same period in fiscal 1998. This decrease
resulted primarily from the conversion of five provider joint ventures from
consolidation to the equity method (See "--Recent Accounting
Pronouncements--EITF 96-16") and from the Green Spring Minority Stockholder
Conversion in January 1998.
IMPACT OF THE MERIT ACQUISITION ON RESULTS OF OPERATIONS. As of December
31, 1998, the Company had approximately 62.8 million covered lives under
behavioral managed healthcare contracts. The Company believes it has the leading
market position in each of the major product markets in which it competes,
according to enrollment data reported in the industry trade publication entitled
"Managed Behavioral Health Market Share in the United States 1997-1998"
published by Open Minds, Gettysburg, Pennsylania ("Open Minds"). The Company
believes that the Merit acquisition created opportunities for the Company to
achieve significant cost savings in its behavioral managed healthcare business.
Management believes that cost saving opportunities will result from leveraging
fixed overhead over a larger revenue base and an increased number of covered
lives and from reducing duplicative corporate and regional selling, general and
administrative expenses. As a result, the Company expects to achieve
approximately $60.0 million of cost savings in its behavioral managed healthcare
business on an annual basis by September 30, 1999. Such cost savings are
measured relative to the combined operating expenses of Green Spring, HAI and
Merit prior to the Merit acquisition. The Company spent approximately $4.7
million during the quarter ended December 31, 1998 and, expects to spend an
additional $5.0 million to $10.0 million during fiscal 1999 in connection with
achieving such cost savings.
The Company expects to record additional managed care integration costs
during future periods to the extent the integration of Green Spring, HAI and
Merit results in additional facility closures at HAI and Green Spring and for
integration costs incurred that benefit future periods. The full implementation
of the integration plan is expected to be completed by fiscal 2000.
BEHAVIORAL MANAGED HEALTHCARE RESULTS OF OPERATIONS. The Company's
behavioral managed healthcare segment results of operations are subject to
significant fluctuations on a quarterly basis. These
20
potential earnings fluctuations may result from: (i) changes in utilization
levels by enrolled members of the Company's risk-based contracts; (ii)
performance-based contractual adjustments to revenue, reflecting utilization
results or other performance measures; (iii) retroactive contractual adjustments
under commercial contracts and CHAMPUS contracts; (iv) retrospective membership
adjustments and (v) timing of implementation of new contracts and enrollment
changes.
HISTORICAL LIQUIDITY AND CAPITAL RESOURCES
OPERATING ACTIVITIES. The Company's net cash provided by (used in)
operating activities was $(31.7) million and $7.7 million for the three months
ended December 31, 1997 and 1998, respectively. The increase in cash provided by
operating activities in fiscal 1999 compared to fiscal 1998 was primarily the
result of (i) reduction in interest paid of $8.9 million, (ii) reduction in
income taxes paid, net of refunds received, of $8.3 million, (iii) reduction in
payments of previously reserved claims of $6.1 million and (iv) increases in
cash flows from operations as a result of the HAI and Merit acquistions, offset
by reductions in franchise fees collected from CBHS of $19.6 million.
INVESTING ACTIVITIES. Capital expenditures increased 213.0%, or $9.8
million, to $14.4 million for the quarter ended December 31, 1998, compared to
$4.6 million in the same period in fiscal 1998. This increase was due primarily
to: i) capital expenditures at businesses acquired in fiscal 1998 and ii)
increased capital expenditures in the Company's Behavioral segment related to:
a) the Integration Plan (See Note I--"Managed Care Integration Plan and Costs"
to the Company's condensed consolidated financial statements set forth elsewhere
herein), and b) acceleration of capital expenditures related to year 2000
computer issues (See "--Potential Impact of Year 2000 Computer Issues").
The Company acquired businesses in its managed behavioral healthcare and
human services segments and acquired the assets of a psychiatric hospital (See
Note F--"Investment in Unconsolidated Subsidiaries--Charter Behavioral Health
Systems, LLC" to the Company's condensed consolidated financial statements set
forth elsewhere herein) for an aggregate cost of $7.7 million. Additionally, the
$20.0 million placed in escrow upon consummation of the Allied acquisition was
returned to the Company during the quarter, with $4.5 million then being paid by
the Company to the former owners of Allied as additional consideration for the
Allied acquisition.
The Company's condensed consolidated balance sheet at December 31, 1998,
reflects a reduction in cash and cash equivalents of $21.1 million from the
September 30, 1998 balance which is related to the conversion of several
subsidiaries from consolidation to the equity method. See "--Recent Accounting
Pronouncements--EITF 96-16". This reduction in cash and cash equivalents appears
as net cash used in investing activities in the Company's condensed consolidated
statement of cash flows for the quarter ended December 31, 1998, but does not
represent an actual reduction of cash and cash equivalents at the affected
subsidiaries. Additionally, the Company received $9.3 million in distributions
from unconsolidated subsidiaries, including those referred to above, during the
quarter ended December 31, 1998.
The Company utilized $165.5 million in funds, net of cash acquired, for
acquisitions and investments in businesses, including Allied and HAI, during the
quarter ended December 31, 1997. In addition, the Company paid approximately
$4.3 million for Crescent Transaction costs during the quarter ended December
31, 1997.
FINANCING ACTIVITIES. The Company repaid $40.0 million of debt obligations
outstanding under the Revolving Facility (as defined) during the quarter ended
December 31, 1998. As of December 31, 1998, the Company had $132.5 million of
availability under the Revolving Facility (as defined), excluding $17.5 million
of availability reserved for certain letters of credit. The Company was in
compliance with all debt covenants as of December 31, 1998.
The Company repurchased approximately 545,000 shares of its common stock for
approximately $12.5 million during the quarter ended December 31, 1997.
21
OUTLOOK-LIQUIDITY AND CAPITAL RESOURCES
DEBT SERVICE OBLIGATIONS. The interest payments on the Company's $625.0
million 9% Series A Senior Subordinated Notes due 2008 (the "Notes") and
interest and principal payments on indebtedness outstanding pursuant to the
Company's $700.0 million senior secured bank credit agreement (the "Credit
Agreement") represent significant liquidity requirements for the Company.
Borrowings under the Credit Agreement bear interest at floating rates and
require interest payments on varying dates depending on the interest rate option
selected by the Company. Borrowings pursuant to the New Credit Agreement include
$550.0 million under a term loan facility (the "Term Loan Facility") and up to
$150.0 million under a revolving facility (the "Revolving Facility"). Commencing
in the second quarter of fiscal 1999, the Company is required to make principal
payments with respect to the Term Loan Facility. The Company is required to
repay the principal amount of borrowings outstanding under the Term Loan
Facility and the principal amount of the Notes in the years and amounts set
forth in the following table (in thousands):
FISCAL YEAR PRINCIPAL AMOUNT
- ------------- ----------------
1999 $ 19.8
2000 32.4
2001 38.9
2002 49.4
2003 92.0
2004 156.5
2005 131.8
2006 29.2
2007 --
2008 625.0
--------
$ 1,175.0
--------
--------
In addition, any amounts outstanding under the Revolving Facility mature in
February 2004.
POTENTIAL PURCHASE PRICE ADJUSTMENTS. In December 1997, the Company
purchased HAI from Aetna US Healthcare, Inc. ("Aetna") for approximately $122.1
million, excluding transaction costs. In addition, the Company incurred the
obligation to make contingent payments to Aetna which may total up to $60.0
million annually over the five-year period subsequent to closing. The Company is
obligated to make contingent payments under two separate calculations as
follows: In respect of each Contract Year (as defined), the Company may be
required to pay to Aetna the "Tranche 1 Payments" (as defined) and the "Tranche
2 Payments" (as defined). "Contract Year" means each of the twelve-month periods
ending on the last day of December in 1998, 1999, 2000, 2001, and 2002.
Upon the expiration of each Contract Year, the Tranche 1 Payment shall vest
with respect to such Contract Year in an amount equal to the product of (i) the
Tranche 1 Cumulative Incremental Members (as defined) for such Contract Year and
(ii) the Tranche 1 Multiplier (as defined) for such Contract Year. The vested
amount of Tranche 1 Payment shall be zero with respect to any Contract Year in
which the Tranche 1 Cumulative Incremental Members is a negative number.
Furthermore, in the event that the number of Tranche 1 Cumulative Incremental
Members with respect to any Contract Year is a negative number due to a decrease
in the number of Tranche 1 Cumulative Incremental Members for such Contract Year
(as compared to the immediately preceding Contract Year), Aetna will forfeit the
right to receive a certain portion (which may be none or all) of the vested and
unpaid amounts of the Tranche 1 Payment relating to preceding Contract Years.
"Tranche 1 Cumulative Incremental Members" means, with respect to any
Contract Year, (i) the number of Equivalent Members (as defined) serviced by the
Company during such Contract Year for Tranche 1 Members, minus (ii) (A) for each
Contract Year other than the initial Contract Year, the
22
number of Equivalent Members serviced by the Company for Tranche 1 Members
during the immediately preceding Contract Year or (B) for the initial Contract
Year, the number of Tranche 1 Members as of September 30, 1997, subject to
certain upward adjustments. There were 3,761,253 Tranche 1 Members for the
initial Contract Year, prior to such upward adjustments. "Tranche 1 Members" are
members of managed behavioral healthcare plans for whom the Company provides
services in any of specified categories of products or services. "Equivalent
Members" for any Contract Year equals the aggregate Member Months for which the
Company provides services to a designated category or categories of members
during the applicable Contract Year divided by 12. "Member Months" means, for
each member, the number of months for which the Company provides services and is
compensated. The "Tranche 1 Multiplier" is $80, $50, $40, $25, and $20 for the
Contract Years 1998, 1999, 2000, 2001, and 2002, respectively.
For each Contract Year, the Company is obligated to pay to Aetna the lesser
of (i) the vested portion of the Tranche 1 Payment for such Contract Year and
the vested and unpaid amount relating to prior Contract Years as of the end of
the immediately preceding Contract Year and (ii) $25.0 million. To the extent
that the vested and unpaid portion of the Tranche 1 Payment exceeds $25.0
million, the Tranche 1 Payment remitted to Aetna shall be deemed to have been
paid first from any vested but unpaid amounts from previous Contract Years in
order from the earliest Contract Year for which vested amounts remain unpaid to
the most recent Contract Year at the time of such calculation. Except with
respect to the Contract Year ending in 2002, any vested but unpaid portion of
the Tranche 1 Payment shall be available for payment to Aetna in future Contract
Years, subject to certain exceptions. All vested but unpaid amounts of Tranche 1
Payments shall expire following the payment of the Tranche 1 Payment in respect
to the Contract Year ending in 2002, subject to certain exceptions. In no event
shall the aggregate Tranche 1 Payments to Aetna exceed $125.0 million.
Upon the expiration of each Contract Year, the Tranche 2 payment shall be an
amount equal to the lesser of: (a) (i) the product of (A) the Tranche 2
Cumulative Members (as defined) for such Contract Year and (B) the Tranche 2
Multiplier (as defined) applicable to such number of Tranche 2 Cumulative
Members, minus (ii) the aggregate of the Tranche 2 Payments paid to Aetna for
all previous Contract Years and (b) $35.0 million. The amount shall be zero with
respect to any Contract Year in which the Tranche 2 Cumulative Members is a
negative number.
"Tranche 2 Cumulative Members" means, with respect to any Contract Year, (i)
the Equivalent Members serviced by the Company during such Contract Year for
Tranche 2 Members, minus (ii) the Tranche 2 Members as of September 30, 1997,
subject to certain upward adjustments. There were 936,391 Tranche 2 Members
prior to such upward adjustments. "Tranche 2 Members" means Members for whom the
Company provides products or services in the HMO category. The "Tranche 2
Multiplier" with respect to each Contract Year is $65 in the event that the
Tranche 2 Cumulative Members are less than 2,100,000 and $70 if more than or
equal to 2,100,000.
For each Contract Year, the Company shall pay to Aetna the amount of Tranche
2 Payment payable for such Contract Year. All rights to receive Tranche 2
Payment shall expire following the payment of the Tranche 2 Payment in respect
to the Contract Year ending in 2002, subject to certain exceptions.
Notwithstanding anything herein to the contrary, in no event shall the aggregate
Tranche 2 Payment to Aetna exceed $175.0 million, subject to certain exceptions.
The Company believes it will be required to make both the full Tranche 1
Payment and the full Tranche 2 Payment for the Contract Year ended December 31,
1998, subject to further discussion with Aetna. Accordingly, the Company
recorded $60.0 million of goodwill and other intangible assets and a
corresponding liability (which is included in "Deferred credits and other long
term liabilities" in the Company's condensed consolidated balance sheet set
forth elsewhere herein) as of December 31, 1998. The Company intends to borrow
under the Revolving Facility to meet this obligation, which is expected to be
paid during the second quarter of fiscal 1999.
23
In December, 1997 the Company purchased Allied for $70.0 million, excluding
transaction costs. The purchase price the Company originally paid for Allied
consisted of a $50.0 million payment to the former owners of Allied and a $20.0
million deposit into an interest-bearing escrow account and was subject to
increase or decrease based on the operating performance of Allied during the
three years following the closing. The Company was required to pay up to $60.0
million, of which $20.0 million would have been distributed from the escrow
account, during the three years following the closing of the Allied acquisition
if Allied's performance exceeded certain earnings targets.
During the quarter ended December 31, 1998, the Company and the former
owners of Allied amended the Allied purchase agreement (the "Allied
Amendments"). The Allied Amendments resulted in the following changes to the
original terms of the Allied purchase agreement:
- The original $20.0 million placed in escrow by the Company at the
consummation of the Allied acquisition, plus accrued interest, was repaid
to the Company. This $20.0 million was included in the $70.0 million
originally paid for Allied.
- The Company paid the former owners of Allied $4.5 million additional
consideration which was recorded as goodwill.
- The Company capped future obligations with respect to additional
contingent payments for the purchase of Allied at $3 million. The earnings
targets which must be met by Allied for this amount to be paid were
revised upwards as well.
By virtue of acquiring Merit, the Company may be required to make certain
contingent payments in fiscal 1999 to the former shareholders of CMG Health,
Inc. ("CMG"), which was acquired by Merit in September, 1997, based upon the
performance of three CMG customer contracts. No contingent consideration will be
payable to the former shareholders of CMG based on the performance of two of the
three CMG customer contracts at December 31, 1998. The Company may still be
required to pay contingent consideration to the former shareholders of CMG
depending on the financial performance of Choice. The payment of contingent
consideration to the former shareholders of CMG depends on the financial
performance of Choice from October 1, 1996 to June 30, 1997, which is subject to
a CHAMPUS Adjustment the Company expects to receive in fiscal 1999. Such
contingent payments are subject to an aggregate maximum of $23.5 million.
CREDIT FACILITIES. The Revolving Facility will provide the Company with
revolving loans and letters of credit in an aggregate principal amount at any
time not to exceed $150.0 million. At December 31, 1998, the Company had
approximately $132.5 million of availability under the Revolving Facility. The
Company estimates that it will spend approximately $50.0 million for capital
expenditures in fiscal 1999. The majority of the Company's anticipated capital
expenditures relate to management information systems and related equipment. The
Company believes that the cash flows generated from its operations, together
with amounts available for borrowing under the Credit Agreement, should be
sufficient to fund its debt service requirements, anticipated capital
expenditures, contingent payments with respect to HAI and CMG, and other
investing and financing activities. The Company's future operating performance
and ability to service or refinance the Notes or to extend or refinance the
indebtedness outstanding pursuant to the Credit Agreement will be subject to
future economic conditions and to financial, business and other factors, many of
which are beyond the Company's control.
RESTRICTIVE FINANCING COVENANTS. The Credit Agreement imposes restrictions
on the Company's ability to make capital expenditures, and both the Credit
Agreement and the indenture governing the Notes (the "Indenture") limit the
Company's ability to incur additional indebtedness. Such restrictions, together
with the highly leveraged financial condition of the Company, may limit the
Company's ability to respond to market opportunities. The covenants contained in
the Credit Agreement also, among other things, restrict the ability of the
Company to dispose of assets; repay other indebtedness; amend other debt
instruments (including the Indenture); pay dividends; create liens on assets;
enter into sale and leaseback
24
transactions; make investments, loans or advances; redeem or repurchase common
stock and make acquisitions.
RECENT ACCOUNTING PRONOUNCEMENTS
In April 1998, the AICPA issued Statement of Position 98-5, "Reporting on
the Costs of Start-up Activities" ("SOP 98-5"). SOP 98-5 requires all
nongovernmental entities to expense costs of start-up activities as those costs
are incurred. Start-up costs, as defined by SOP 98-5, include pre-operating
costs, pre-opening costs and organization costs.
SOP 98-5 becomes effective for financial statements for fiscal years
beginning after December 15, 1998. At adoption, a company must record a
cumulative effect of a change in accounting principle to write off any
unamortized start-up costs remaining on the balance sheet when SOP 98-5 is
adopted. Prior year financial statements cannot be restated. The Company adopted
SOP 98-5 effective October 1, 1998. The Company's adoption of SOP 98-5 had no
impact on its financial position or results of operations.
Emerging Issues Task Force Issue 96-16, "Investor's Accounting for an
Investee When the Investor Has a Majority of the Voting Interest but a Minority
Shareholder or Shareholders Have Certain Approval or Veto Rights" ("EITF 96-16")
supplements the guidance contained in AICPA Accounting Research Bulletin 51,
"Consolidated Financial Statements", and in Statement of Financial Accounting
Standards No. 94, "Consolidation of All Majority-Owned Subsidiaries" ("ARB
51/FAS 94"), about the conditions under which the Company's consolidated
financial statements should include the financial position, results of
operations and cash flows of subsidiaries which are less than wholly-owned along
with those of the Company and its subsidiaries.
In general, ARB 51/FAS 94 requires consolidation of all majority-owned
subsidiaries except those for which control is temporary or does not rest with
the majority owner. Under the ARB 51/FAS 94 approach, instances of control not
resting with the majority owner were generally regarded to arise from such
events as the legal reorganization or bankruptcy of the majority-owned
subsidiary. EITF 96-16 expands the definition of instances in which control does
not rest with the majority owner to include those where significant approval or
veto rights, other than those which are merely protective of the minority
shareholder's interest, are held by the minority shareholder or shareholders
("Substantive Participating Rights"). Substantive Participating Rights include,
but are not limited to: i) selecting, terminating and setting the compensation
of management responsible for implementing the majority-owned subsidiary's
policies and procedures and ii) establishing operating and capital decisions of
the majority-owned subsidiary, including budgets, in the ordinary course of
business.
The provisions of EITF 96-16 apply to new investment agreements made after
July 24, 1997, and to existing agreements which are modified after such date.
The Company has made no new investments, and has modified no existing
investments, to which the provisions of EITF 96-16 would have applied.
In addition, the transition provisions of EITF 96-16 must be applied to
majority-owned subsidiaries previously consolidated under ARB 51/FAS 94 for
which the underlying agreements have not been modified in financial statements
issued for years ending after December 15, 1998 (fiscal 1999 for the
25
Company). The adoption of the transition provisions of EITF 96-16 on October 1,
1998 had the following effect on the Company's consolidated financial position
(in thousands):
OCTOBER 1,
1998
-----------
Increase (decrease) in:
Cash and cash equivalents....................................................... $ (21,092)
Other current assets............................................................ (9,538)
Long-term assets................................................................ (30,049)
Investment in unconsolidated subsidiaries....................................... 26,498
-----------
Total Assets................................................................ $ (34,181)
-----------
-----------
Current Liabilities............................................................. $ (10,381)
Minority interest............................................................... (23,800)
-----------
Total Liabilities........................................................... $ (34,181)
-----------
-----------
POTENTIAL IMPACT OF YEAR 2000 COMPUTER ISSUES
The year 2000 computer problem is the inability of computer systems which
store dates by using the last two digits of the year (i.e. "98" for "1998") to
reliably recognize that dates after December 31, 1999 are later than, and not
before, 1999. For instance, the date January 1, 2000, may be mistakenly
interpreted as January 1, 1900, in calculations involving dates on systems which
are non-year 2000 compliant.
The Company relies on information technology ("IT") systems and other
systems and facilities such as telephones, building access control systems and
heating and ventilation equipment ("Embedded Systems") to conduct its business.
These systems are potentially vulnerable to year 2000 problems due to their use
of date information.
The Company also has business relationships with customers and health care
providers and other critical vendors who are themselves reliant on IT and
Embedded Systems to conduct their businesses.
STATE OF READINESS
The Company's IT systems are largely decentralized, with each major
operating unit having its own standards for systems which include both purchased
and internally-developed software. The Company's IT hardware infrastructure is
built mainly around mid-range computers and IBM PC-compatible servers and
desktop systems.
The Company's principal means of ensuring year 2000 compliance for purchased
software has been the replacement of non-compliant systems. This replacement
process would have been undertaken for business reasons irrespective of the year
2000 problem; however, it would, more than likely, have been implemented over a
longer period of time. The Company's internally-developed software was either
designed to be year 2000 compliant from inception or is in the process of being
modified to be compliant. Approximately 70% of the Company's mid-range IT
hardware has been certified as year 2000 compliant, with the remainder scheduled
to be certified by the end of the third quarter of fiscal 1999. Most of the
Company's non-compliant IBM PC-compatible servers and desktops have been
replaced, with the remainder expected to be replaced by the end of fiscal 1999.
Additionally, the Company is in the process of integrating recently acquired
businesses and their associated IT systems. A primary focus of the integration
is on standardization of systems where possible, including ensuring the year
2000 compliance of the surviving systems.
26
Each of the Company's major operating units has a Chief Information Officer
who is responsible for ensuring that all year 2000 issues are addressed and
mitigated before any computational problems related to dates after December 31,
1999, occur.
The Company's plan for IT systems consists of several phases, primarily:
(i) Inventory--identifying all IT systems and the magnitude of year 2000
compliance risk of each according to its potential business impact;
(ii) Date assessment--identifying IT systems that use date functions and
assessing them for year 2000 functionality;
(iii) Remediation--reprogramming, or replacing where necessary, inventoried
items to ensure they are year 2000 ready; and
(iv) Testing and certification--testing the code modifications and new
inventory with other associated systems, including extensive date
testing and performing quality assurance testing to ensure successful
operation in the post-1999 environment. The Company has substantially
completed the inventory and assessment phases for substantially all of
its IT systems. The Company's IT systems are currently in the
remediation and testing and certification phases. The Company plans to
complete the remediation of substantially all of its critical IT
systems by the end of the second quarter of fiscal 1999, the
remediation of its other IT systems by the end of the third quarter of
fiscal 1999 and the testing and certification of all of its IT systems
by the end of fiscal 1999.
The Company leases most of the office space in which its reliance on
Embedded Systems presents a potential problem and is currently working with the
respective lessors to identify and correct any potential year 2000 problems
related to these Embedded Systems.
The Company believes that its year 2000 projects generally are on schedule.
EXTERNAL RELATIONSHIPS
The Company also faces the risk that one or more of its critical suppliers
or customers ("External Relationships") will not be able to interact with the
Company due to the third party's inability to resolve its own year 2000 issues,
including those associated with its own External Relationships. The Company has
completed its inventory of External Relationships and risk rated each External
Relationship based upon the potential business impact, available alternatives
and cost of substitution. The Company is attempting to determine the overall
year 2000 readiness of its External Relationships. In the case of significant
customers and mission critical suppliers such as banks, telecommunications
providers and other utilities and IT vendors, the Company is engaged in
discussions with the third parties and is attempting to obtain detailed
information as to those parties' year 2000 plans and state of readiness. The
Company, however, does not have sufficient information at the current time to
predict whether its External Relationships will be year 2000 ready.
YEAR 2000 COSTS
Total costs incurred solely for remediation of potential year 2000 problems
are currently estimated to be approximately $1.0 million in fiscal 1999. A large
majority of these costs are expected to be incremental expenses that will not
recur in the year 2000 or thereafter. The Company expenses these costs as
incurred and funds these costs through operating cash flows. In addition, the
Company estimates that it will accelerate approximately $5.0 million of capital
expenditures that would have been budgeted for future periods into fiscal 1999
to ensure year 2000 compliance for outdated systems.
Year 2000 compliance is critical to the Company. The Company has redeployed
some resources from non-critical system enhancements to address year 2000
issues. Due to the importance of IT systems to the Company's business,
management has deferred non-critical systems enhancements to become year 2000
27
ready. The Company does not expect these redeployments and deferrals to have a
material impact on the Company's financial condition or results of operations.
RISKS AND CONTINGENCY/RECOVERY PLANNING
If the Company's year 2000 issues were unresolved, the most reasonably
likely worst case scenario would include, among other possibilities, the
inability to accurately and timely authorize and process benefits and claims,
accurately bill customers, assess claims exposure, determine liquidity
requirements, report accurate data to management, stockholders, customers,
regulators and others, business interruptions or shutdowns, financial losses,
reputational harm, loss of significant customers, increased scrutiny by
regulators and litigation related to year 2000 issues. The Company is attempting
to limit the potential impact of the year 2000 by monitoring the progress of its
own year 2000 project and those of its critical External Relationships and by
developing contingency/recovery plans. The Company cannot guarantee that it will
be able to resolve all of its year 2000 issues. Any critical unresolved year
2000 issues at the Company or its External Relationships, however, could have a
material adverse effect on the Company's results of operations, liquidity or
financial condition.
The Company has developed contingency/recovery plans aimed at ensuring the
continuity of critical business functions before and after December 31, 1999. As
part of that process, the Company has substantially completed the development of
manual work alternatives to automated processes which will both ensure business
continuity and provide a ready source of input to affected systems when they are
returned to an operational status. These manual alternatives presume, however,
that basic infrastructure such as electrical power and telephone service, as
well as purchased systems which are advertised to be year 2000 compliant by
their manufacturers (primarily personal computers and productivity software)
will remain unaffected by the year 2000 problem.
28
PART II--OTHER INFORMATION
ITEM 6.--EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- ----------- ---------------------------------------------------------------------------------------------------------
2(a) Second Amendment to Asset Purchase Agreement, dated November 18, 1998, among the Company; Allied Health
Group, Inc.; Gut Management, Inc.; Sky Management Co.; Florida Specialty Network, LTD; Surgical
Associates of South Florida, Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David Russin, M.D.; and Lawrence
Schimmel, M.D., which was filed as Exhibit 2(m) to the Company's Annual Report on Form 10-K for the
fiscal year ended September 30, 1998, and is incorporated herein by reference.
2(b) Third Amendment to Asset Purchase agreement, dated December 31, 1998, among the Company; Allied Health
Group, Inc.; Gut Management, Inc.; Sky Management Co.; Florida Specialty Network, LTD; Surgical
Associates of South Florida, Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David Russin, M.D.; and Lawrence
Schimmel, M.D.
*10 Employment Agreement, dated December 9, 1998, between Magellan Behavioral Health, Inc. and John Wider,
President and Chief Operating Officer of Magellan Behavioral Health, Inc.
27 Financial Data Schedule
- ------------------------
* Constitutes a management contract or compensatory plan arrangement.
(b) Reports on Form 8-K
The following current reports on Form 8-K were filed by the Registrant with
the Securities and Exchange Commission during the quarter ended December 31,
1998.
FINANCIAL
STATEMENTS
DATE OF REPORT ITEM REPORTED AND DESCRIPTION FILED
- ------------------------------------------------------- -------------------------------------------- -----------
October 28, 1998(1) Acquisition--Merit acquisition Yes(2)
October 28, 1998 Other--Pro forma financial information Yes(3)
- ------------------------
(1) The date of the earliest event reported is February 12, 1998. This current
report on Form 8-K amends the Company's previous current reports on Form 8-K
related to the Merit acquisition which were filed on April 3, 1998 and
February 27, 1998.
(2) Audited Consolidated Balance Sheets for each of the two fiscal years in the
period ended September 30, 1997; Audited Consolidated Statements of
Operations, Audited Consolidated Statements of Stockholder's Equity, and
Audited Consolidated Statements of Cash Flows for each of the three fiscal
years in the period ended September 30, 1997; Unaudited Consolidated Balance
Sheet as of December 31, 1997; Unaudited Consolidated Statements of
Operations and Unaudited Consolidated Statements of Cash Flows for the
quarters ended December and 1996 for Merit Behavioral Care Corporation.
Unaudited Pro Forma Consolidated Balance Sheet as of December 31, 1997 and
Unaudited Pro Forma Consolidated Statements of Operations for the fiscal
year ended September 30, 1997, and for the quarter ended December 31, 1997,
for the Company.
(3) Unaudited Pro Forma Consolidated Statements of Operations for the fiscal
year ended September 30, 1997, and for the nine months ended June 30, 1998,
for the Company.
29
FORM 10-Q
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
MAGELLAN HEALTH SERVICES, INC.
-------------------------------------------
(Registrant)
/s/ CRAIG L. MCKNIGHT
-------------------------------------------
Date: February 12, Craig L. McKnight
1999 EXECUTIVE VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER
/s/ JEFFREY T. HUDKINS
-------------------------------------------
Date: February 12, Jeffrey T. Hudkins
1999 VICE PRESIDENT AND CONTROLLER
(PRINCIPAL ACCOUNTING OFFICER)
30