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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1997
or
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File No. 1-10968
PARAGON HEALTH NETWORK, INC.
(Exact name of registrant as specified in its Charter)
DELAWARE 74-2012902
(State or other Jurisdiction of (I.R.S. Employer
Incorporation or Organization Identification No.)
ONE RAVINIA DRIVE, SUITE 1500 30346
ATLANTA, GEORGIA (Zip Code)
(Address of principal executive
office)
(770) 393-0199
(Registrant's Telephone Number, Including Area Code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT
NAME OF EACH EXCHANGE ON
TITLE OF EACH CLASS WHICH REGISTERED
- ------------------- ------------------------
Common Stock, $.01 Par Value........................... New York Stock Exchange
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to the Form 10-K. [X]
The aggregate market value of the outstanding Common Stock of the registrant
held by non-affiliates of the registrant as of December 19, 1997 based on the
closing sale price of the Common Stock on the New York Stock Exchange on said
date, was $776,905,800.75. For purpose of the foregoing sentence only, all
directors are assumed to be affiliates.
There were 13,737,943 shares of Common Stock of the registrant outstanding
as of December 19, 1997.
DOCUMENTS INCORPORATED BY REFERENCE
PART OF
INCORPORATED DOCUMENT FORM 10-K
--------------------- --------
Proxy Statement for the 1998
Annual Meeting of Stockholders..................................... Part III
TABLE OF CONTENTS
PAGE
----
PART I
ITEM 1. BUSINESS................................................ 3
ITEM 2. PROPERTIES.............................................. 16
ITEM 3. LEGAL PROCEEDINGS....................................... 17
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS..... 19
ITEM 4A. EXECUTIVE MANAGEMENT OF THE REGISTRANT.................. 19
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED
STOCKHOLDER MATTERS.................................... 21
ITEM 6. SELECTED FINANCIAL INFORMATION.......................... 22
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.................... 23
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA............. 33
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE.................... 59
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT...... 59
ITEM 11. EXECUTIVE COMPENSATION.................................. 59
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT............................................. 59
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.......... 59
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON
FORM 8-K............................................... 60
2
PART I
ITEM 1. BUSINESS
GENERAL DEVELOPMENT OF THE BUSINESS
On November 4, 1997, the Company engaged in two merger transactions. First,
pursuant to an agreement and plan of merger among Apollo Management, L.P.
("Apollo Management," and together with certain of its affiliates, "Apollo"),
Apollo LCA Acquisition Corp. (a corporation owned by certain Apollo affiliates
and other investors, "Apollo Sub") and Living Centers of America, Inc.
("LCA"), Apollo Sub was capitalized with $240 million in cash and was merged
with and into LCA (the "Recapitalization Merger"). In the Recapitalization
Merger, LCA was the surviving corporation and was renamed Paragon Health
Network, Inc. ("Paragon"). Second, pursuant to an agreement and plan of merger
among LCA, GranCare, Inc. ("GranCare"), Apollo Management and LCA Acquisition
Sub, Inc. (a wholly owned subsidiary of Paragon, "LCA Sub"), GranCare merged
with LCA Sub with GranCare surviving as a wholly owned subsidiary of Paragon
(the "GranCare Merger," and collectively with the Recapitalization Merger, the
"Mergers"). The GranCare Merger was accounted for using purchase accounting.
The consummation of the Mergers required aggregate proceeds of approximately
$1.4 billion. The funds required for the Mergers and related transaction fees
and expenses were provided primarily by: (i) proceeds of approximately $449
million from the offering (the "Offering") of $275 million in Senior
Subordinated Notes and $294 million in Senior Subordinated Discount Notes
(collectively, the "Notes"); (ii) borrowings by the Company of approximately
$740 million under a new senior credit facility which provides for aggregate
commitments of up to $890 million (the "Senior Credit Facility"); and (iii)
the equity investment by Apollo and certain other investors (collectively with
Apollo, the "Apollo Investors") of approximately $240 million (the "Apollo
Investment"). The Offering, the Senior Credit Facility and the Apollo
Investment are referred to collectively herein as the "Financings," and the
Financings and the Mergers are referred to collectively herein as the
"Transactions." LCA and Paragon are the same legal entity. References to the
"Company" herein refer to LCA and its operating subsidiaries prior to the
consummation of the Transactions and to Paragon and its operating subsidiaries
following consummation of the Transactions.
GENERAL
The Company, through its various operating subsidiaries, is one of the
nation's leading providers of post-acute care. The Company's continuum of
post-acute care services encompasses skilled nursing, subacute and medically
complex care, as well as a variety of related ancillary services. These
ancillary services include pharmacy, rehabilitation and hospital program
management. The Company operates in 38 states with significant concentrations
of facilities and beds in its key markets. On a pro forma basis for the year
ended September 30, 1997 the Company generated revenues of approximately $1.9
billion.
Following the Mergers, the Company's operations are organized into four
divisions: (i) post-acute care; (ii) pharmaceutical services; (iii)
rehabilitation services; and (iv) hospital services. The Company operates 327
skilled nursing and assisted living facilities containing over 38,000 beds, as
well as 34 institutional pharmacies servicing more than 100,000 beds. The
Company also operates over 130 outpatient rehabilitation clinics and manages
specialty medical programs in acute care hospitals through more than 180
management contracts. In addition, the Company provides subacute care, home
health, hospice and private duty nursing services.
As a result of the Mergers, the Company has increased the density of the
services it provides in many of its markets, which management believes will
result in revenue enhancement and cost saving opportunities. Revenue
enhancements are expected to be realized by expanding the range of services
offered within each market, increasing patient acuity levels within the
Company's facilities and strengthening relationships with hospitals,
physicians and third-party payors. Cost saving opportunities include
leveraging fixed overhead costs over a larger revenue base, eliminating
redundant administrative functions and realizing purchasing synergies.
The Company's principal executive offices are located at One Ravinia Drive,
Suite 1500, Atlanta, Georgia 30346, and the Company's phone number at such
location is (770) 393-0199.
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INDUSTRY OVERVIEW
The healthcare industry has become one of the largest sectors of the U.S.
economy, representing 13.6% of the nation's gross domestic product ("GDP") in
1995. Care for the elderly encompasses a broad range of healthcare services,
including skilled nursing, rehabilitation services, home healthcare, assisted
living and pharmacy services. In response to increasing demands for quality
care in a cost effective setting, long-term care providers are increasingly
providing services for patients with specialized needs. These patients
typically do not require many of the services provided in an acute care
hospital setting but still have medically complex conditions that require
ongoing nursing and medical supervision as well as access to specialized
equipment and services. The Company believes that demand for its long-term
care services and specialized medical services will increase significantly due
to changing demographics, existing government restrictions, increasing focus
on cost containment and industry consolidation.
Demographic Trends--According to the U.S. Bureau of the Census,
approximately 1.4% of the population between the ages of 65 and 74 received
care in long-term care facilities in 1990; this percentage increased to 6.1%
for people 75 to 84 years of age and to 24.5% for those over the age of 85. In
addition, according to the U.S. Bureau of the Census, the number of
individuals over the age of 75 increased from approximately 10.0 million (4.4%
of the U.S. population) in 1980 to approximately 14.8 million (5.6% of the
U.S. population) in 1995. By 2005, this segment of the population is projected
to increase to approximately 17.8 million (6.2% of the U.S. population).
Although there is limited growth projected for the population of individuals
over the age of 65 between 1990 and 2000, a significant increase is expected
in the population of people over the age of 85, which comprises the largest
percentage of residents at long-term care facilities. This age group is the
fastest growing segment of the population, projected to increase by more than
55%, from approximately 3.6 million (1.4% of the U.S. population) in 1995 to
approximately 5.7 million (2.5% of the U.S. population) in the year 2010.
Government Restrictions on Long-Term Care Facilities--While the demand for
long-term care is growing, regulatory factors have served to limit the supply
of long-term care beds. The construction of new long-term care facilities and
the addition of beds to existing facilities are restricted by regulation in
many states, most of which require entities that desire to enter the local
long-term care market to apply for and obtain Certificates of Need ("CON") or
other approvals under similar laws. The application and approval process for a
CON or such other approval generally involves approval by a state regulatory
agency for the construction, acquisition or closure of a long-term care
facility, the addition or reduction of beds at a facility or the addition of
services provided by a facility. The significant construction costs and start-
up expenses in some markets may further limit the number of new beds.
Emphasis on Cost Containment--Escalating healthcare costs have caused
governmental and other third party payors, including managed care entities, to
implement cost containment initiatives. As a result, an increasing proportion
of subacute care is being delivered outside the acute care hospital setting.
Subacute care refers to complex medical care and intensive nursing care and
therapies provided to patients with higher acuity disorders, typically
following their discharge from an acute care hospital. Management believes
that this level of care is appropriately delivered in a skilled nursing
environment and that clinical outcomes in these settings are comparable to
those achieved in acute care settings where the cost structure is
significantly higher. Skilled nursing facilities are significantly less
capital intensive and do not require the specialized equipment used in acute
care hospitals. Labor costs are also lower than in hospitals, which typically
have a higher physician to nursing staff ratio and significantly more
administrative personnel, including nursing staff not fully dedicated to
providing care. Management believes that post-acute care providers can achieve
successful outcomes at a lower cost than acute care hospitals and that,
accordingly, hospital discharge planners, physicians and managed care and
insurance company case managers are referring an increasing number of patients
to post-acute care facilities, including those operated by affiliates of acute
care hospitals.
Industry Consolidation--Currently approximately 1.7 million people are cared
for in approximately 15,000 long-term care facilities in the United States.
Market share data suggests that the industry is fragmented, with the 30
largest operators accounting for less than 25% of the total beds available.
The post-acute care industry
4
has become subject to increasing competitive pressure, increased government
regulation and a changing reimbursement environment. As a result, management
believes that there is a trend towards consolidation of smaller, local
operators, which lack sophisticated management information systems and
services, into larger, more sophisticated national competitors.
BUSINESS STRATEGY
The Company's strategy is to become the provider of choice for both patients
and payors in each of its markets by offering an integrated comprehensive
network of high quality, cost efficient post-acute and long-term care
services. The Company's strategy includes the following five initiatives:
Develop Integrated Post-Acute Networks. The Company's goal is to maintain or
establish leadership positions in key markets by achieving a critical mass of
skilled nursing facilities and related specialty medical businesses to form an
integrated continuum of care. The Company places strategic emphasis on: (i)
expanding the services offered within its existing facilities; (ii)
strategically growing its base of facilities and related services; and (iii)
enhancing relationships with acute care hospitals and physicians. As an
integrated service provider in select markets, the Company can better respond
to the changing needs of its patients and offer payors a single source from
which to contract for post-acute healthcare services. Furthermore, the Company
believes that specific market expertise, coupled with a broad array of
ancillary services, will allow the Company to negotiate more effectively with
large contract payors such as managed care organizations.
Attract and Care for Higher Acuity Patients. The Company intends to
capitalize on the current trend towards reducing the length of patient stays
in acute care hospitals by offering specialty medical services such as
enteral, intravenous and respiratory therapies. The Company can provide these
services to patients with medically complex conditions who require ongoing
nursing and medical supervision, as well as access to specialized equipment,
and management believes that it can offer such medically complex care at costs
that are below those of acute care hospitals. Management believes that the
Company's ability to care for higher acuity patients will improve its payor
mix, expand its customer base and generate increased operating margins.
Provide Ancillary Services to Unaffiliated Facilities. In addition to
increasing the number of ancillary services provided in its own facilities,
the Company intends to be a leading third-party provider of ancillary
services. The Company provides pharmacy services to approximately 1,000
skilled nursing facilities, and is the nation's fifth largest provider of
institutional pharmacy services to the long-term care industry. The Company is
also one of the largest U.S. providers of contract therapy services and
provides rehabilitation services to over 450 skilled nursing facilities. In
addition, the Company's hospital services division manages specialty medical
programs for acute care hospitals through more than 180 contracts. By
continuing to offer its contract and ancillary services to unaffiliated
entities, the Company expects to increase revenues from these higher margin
ancillary businesses and to increase the quality of its payor mix.
Develop Industry Leading Infrastructure. Management is devoting substantial
time and resources to integrating the operations of LCA and GranCare in order
to realize significant benefits from the combination. Specifically, the
Company is: (i) establishing standardized information systems and operating
procedures; (ii) implementing a "shared services" model under which the
Company's operating divisions will utilize a common financial reporting and
accounting department; (iii) enhancing the internal audit process; and (iv)
combining and enhancing existing compliance and ethics programs. The Company
intends to be an industry leader in the implementation and maintenance of a
comprehensive compliance program, resulting in increased patient satisfaction,
improved staff performance and a "best practices" reputation among managed
care and other payors. The Company believes the enhanced infrastructure, once
completed, will enable it to market bundled services and integrate future
acquisitions more efficiently.
Actively Manage Portfolio of Facilities and Services. In order to increase
the breadth of its facility base and range of services provided in its target
markets, the Company will pursue a growth strategy which includes acquisitions
as well as, in certain limited circumstances, new construction. As such, the
Company intends to:
5
(i) increase the breadth and density of the Company's ancillary services
within its existing markets; (ii) expand into new markets with favorable
demographics, regulatory environments and competitive landscapes; and (iii)
exit markets or existing lines of business in markets where the Company
believes it would be inefficient to establish critical mass. The Company hopes
to take advantage of the ongoing consolidation within the post-acute care
industry through both small "fill-in" acquisitions and the purchase of larger
corporate entities.
OPERATIONS
Post-Acute Care Division
The Company's post-acute care division is the largest source of revenue for
the Company and operates the Company's 318 skilled nursing facilities (35 of
which include assisted living units) and nine freestanding assisted living
facilities encompassing over 38,000 beds in 21 states. The post-acute care
division is organized into three operating regions, with a total of 19
districts containing 15 to 20 facilities each. All of the Company's skilled
nursing facilities are certified by the appropriate state agencies for
participation in the Medicaid program and substantially all of the Company's
facilities are certified for Medicare participation.
The Company's skilled nursing facilities provide care to patients requiring
immediate access to 24-hour nursing care. Each of the Company's skilled
nursing facilities has a local medical director who assesses patient needs,
coordinates care plans and, as a member of the local medical community, is
familiar with the local healthcare market. Skilled nursing care is rendered in
the facilities 24 hours a day by registered and licensed practical and
vocational nurses and nurses' aides. All patients in the Company's facilities
receive assistance with various activities of daily living ("ADL services")
including, but not limited to, oversight, feeding, bathing, dressing, eating,
transportation, toiletry and related services. These basic services are
supplemented in the Company's Medicare certified facilities by rehabilitation
services and physical, occupational, speech, respiratory and psychological
therapies.
In addition, the Company operates specialized units in over 90 of its long-
term care facilities serving over 1,200 beds, which provide subacute care to
patients with medically complex conditions. Within these specialty units,
trained staff members offer care for patients in a technologically advanced
physical plant as an alternative to treatment in the more costly acute care
hospital setting. In addition to basic therapy services, these specialty units
offer enteral therapy, intravenous therapy, specialized wound management and
ventilator, tracheostomy, cancer and HIV care, although not all services are
offered in all specialty units. These specialized units have a higher staffing
level per patient than the Company's skilled nursing facilities and compete
with acute care and rehabilitation hospitals, which management believes
typically charge rates higher than those charged by the Company's specialty
units.
The Company's home health and hospice operations are also managed by the
post-acute care division. Through over 40 branches located within nine states,
the Company provides home health, private duty nursing and hospice services.
The Company intends to expand its home health business through the acquisition
and development of additional home health and hospice agencies in its key
markets. The expansion of home health and hospice agencies will complement the
Company's initiative to provide a continuum of post-acute healthcare in its
targeted markets. Additionally, these home care businesses are potential
customers for the Company's rehabilitation therapy and pharmacy operations.
The Company's assisted living facilities provide furnished rooms and suites
designed for individuals who are either able to live independently within a
sheltered community or who require minimal nursing attention. For assisted
living residents, the Company provides basic ADL services combined with the
availability of higher acuity settings should changes in the resident's health
condition require additional care.
The post-acute care division also provides services to residents with
Alzheimer's disease. Within specially designated and designed areas in certain
of its long-term care centers, the Company operates over 60 units with
approximately 1,700 beds dedicated to addressing the problems of
disorientation and perceptual confusion
6
typically experienced by residents with Alzheimer's disease. The Alzheimer's
care units also offer education and support to the residents' families. The
Company provides specially trained activity directors and nursing staffs to
these units and employs a Director of Alzheimer's Programming to supervise
program development and staff training.
Pharmaceutical Services Division
The Company's pharmaceutical services division, American Pharmaceutical
Services, Inc. ("APS") a former LCA subsidiary, is the fifth largest provider
of institutional pharmacy services in the United States. Through 34
institutional pharmacies in 11 states, APS provides services and products to
more than 1,000 long-term care centers with more than 100,000 beds in 35
states.
APS specializes in meeting the needs of healthcare providers in subacute
care, long-term care and assisted living settings. The division's primary
products are pharmacy dispensing, intravenous ("IV") and enteral therapy
supplies, respiratory therapy and orthotics. Through contractual agreements,
APS provides consultant pharmacists specializing in long-term care drug
regimen reviews and regulatory monitoring. Additionally, APS offers full
clinical support for its products and services through long-term care facility
staff education and quality assurance programs.
Substantially all of the Company's skilled nursing facilities previously
operated by GranCare are subject to pharmacy supply agreements with Vitalink
Pharmacy Services, Inc. which expire in March 2002. As a result, APS will not
provide pharmaceutical supplies or services to most GranCare facilities prior
to such expiration date.
Rehabilitation Services Division
The Company's rehabilitation services division, American Rehabilitation
Services, Inc., operates through three former subsidiaries of LCA: American
Therapy Services, Inc. ("ATS"); Rehability Health Services, Inc. ("Rehability
Health"); and Therapy Management Innovations, Inc. ("TMI"). ATS provides
physical, occupational, and speech therapy to nursing facility residents
through contracts with over 450 skilled nursing facilities throughout the
United States. Rehability Health operates over 130 outpatient rehabilitation
clinics in 18 states. The primary focus of these clinics is rehabilitation
services related to occupational and sports injuries. The primary payors for
services associated with occupational injuries and workers' compensation
claims are private employers and their insurance carriers. TMI provides a
variety of rehabilitation management consulting services to post-acute and
long-term care facilities. These consulting services focus on enhancing the
quality of rehabilitation therapy and include supervision of clinical
procedures, documentation and billing protocols, as well as monitoring of
patient outcomes.
The objective of these programs is to assist the patients in attaining their
optimal level of functional independence. Rehabilitation services are
instrumental in lowering the overall cost of care by reducing the length of a
patient's stay and in improving a patient's quality of life. Specialized
management staff oversee these rehabilitation programs to ensure high-quality
service delivery, program compliance and achievement of desired outcomes for
the patient.
Hospital Services Division
The Company's hospital services division operates over 180 medical programs
in 28 states. This division, operated through the Company's Cornerstone Health
Management Company subsidiary ("Cornerstone"), a former GranCare subsidiary,
develops and manages specialty geriatric programs on behalf of acute care
hospitals. In addition, the hospital services division operates two long-term
acute care ("LTAC") hospitals.
The hospital services division programs include subacute skilled nursing,
rehabilitation therapy, geriatric mental health, respiratory therapy and
geriatric primary care networks. This division is generally responsible for
managing the clinical and operational aspects of a prescribed program,
including quality control. Following the
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design and implementation of a program, Cornerstone provides a program
administrator who is supported by a centralized staff of experts. Cornerstone
receives a management fee, typically based on the number of beds it manages.
SOURCES OF REVENUE
The Company receives payments for services rendered to patients from the
federal government under Medicare, from the various states where the Company
operates under Medicaid and from private insurers and the patients themselves.
The sources and amounts of the Company's patient revenues are determined by a
number of factors, including licensed bed capacity of its facilities,
occupancy rate, the payor mix, the type of services rendered to the patient
and the rates of reimbursement among payor categories (private, Medicare and
Medicaid). Changes in the mix of the Company's patients among the private pay,
Medicare and Medicaid categories (quality mix) will significantly affect the
profitability of the Company's operations. Generally, private pay patients are
the most profitable and Medicaid patients are the least profitable. Also, the
Company derives higher revenues from providing specialized medical services
than routine skilled nursing care.
Although reimbursement for Medicare residents generates a higher level of
revenue per patient day, with margins that generally exceed those of Medicaid
patients, profitability is not proportionally tied to the revenue growth due
to the additional costs associated with providing the higher level of care and
other services required by such residents.
MARKETING
The Company's marketing strategy is to focus on relationship development at
the local market level. Information systems are being developed and
implemented to provide marketing managers with the ability to assess
competitors, identify and target referral sources and track several key
indicators of sales performance for each local market. Management believes
that these information systems will provide the Company with the ability to
manage and measure performance at both the local and national level, thereby
allowing the Company to identify shifts in market trends as they occur.
Local market sales efforts focus on establishing and maintaining cooperative
relationships and networks with physicians, acute care hospitals and other
healthcare providers, with an emphasis on specialists who treat ailments
involving long-term care and rehabilitation. Programs focusing on managed care
payors also exist at both the local and national level. Ongoing assessment of
customer satisfaction with the Company's services provides an opportunity for
continual improvements in product and sales performance.
Many of the Company's facilities are currently operated as part of a
marketing cluster. This environment creates a strong focus on identifying more
cost effective methods to provide healthcare. Opportunities to link services
and sell multiple services to a single payor within these targeted markets are
significant. Development of programs to coordinate sales efforts for all of
the Company's services within each targeted market are currently being
examined and management believes that this will improve the efficiency and
effectiveness of its sales efforts, while creating an ability to offer a
continuum of care of post-acute services.
The Company will take advantage of other opportunities for increased
profitability, including potential arrangements with healthcare providers such
as health maintenance organizations ("HMOs"). The Company will continue to
establish relationships with managed care providers which it believes will
increase its subacute care business. Being an industry leader in a particular
market is expected to enhance the Company's ability to serve large providers
of managed care within its targeted markets. Typically, patients referred by
managed care providers, including HMOs and preferred provider organizations,
generate higher revenues per patient day than Medicaid patients as a result of
the higher acuity of the enrollees. Management believes that the Company's
ability to provide subacute and specialty medical services at a lower cost
than acute care hospitals will be a competitive advantage in becoming the
provider of choice for managed care providers.
8
MANAGEMENT INFORMATION SYSTEMS
Management is devoting substantial time and resources integrating and
enhancing the existing information systems of LCA and GranCare. Management
expects to complete the installation of a new client-server based financial
and payroll/human resource software package during 1999. The new software is
expected to provide more timely retrieval of financial and operating data and
enhanced analytical review capabilities, thereby increasing the utility and
functionality of the Company's information systems. In preparation for this
implementation, LCA completed a business process review of its financial and
payroll/human resource processing procedures prior to the Mergers. This
business process review was designed so that maximum benefit from the
functionality offered by the new client-server software package could be
attained, best practices could be adopted for financial and payroll/human
resource processing based on procedures currently in use both within and
outside the industry and customization of software could be minimized.
Management expects the combination of the client-server implementation and
business process review to strategically position the Company to operate under
a shared services model. Benefits of a shared services model are expected to
include standardized financial reporting, streamlined human resource
management and increased access to critical and time-sensitive information
across the Company.
REGULATION
Various aspects of the Company's business are regulated by the federal
government and by the states where the Company has operations. Regulatory
requirements affect the Company's business activities by controlling growth,
requiring licensure and certification for the Company's facilities and
healthcare services, and controlling reimbursement for services provided. The
Company believes it materially complies with applicable regulatory
requirements, but there can be no assurance that the Company will be able to
maintain such compliance or will not be required to expend significant amounts
to do so. The Company is in the process of consolidating the compliance
programs and initiatives of LCA and GranCare and plans to roll-out a Company
wide program during 1998.
Medicare and Medicaid. The Medicare program was enacted in 1965 to provide a
nationwide, federally funded health insurance program for the elderly. The
Medicaid program is a joint federal-state cooperative arrangement established
for the purpose of enabling states to furnish medical assistance on behalf of
aged, blind, or disabled individuals, or members of families with dependent
children, whose income and resources are insufficient to meet the costs of
necessary medical services. All of the Company's nursing facilities, assisted
living facilities, home health and hospice agencies, pharmacies, and
rehabilitation clinics are licensed under applicable state law and will be
certified or approved (other than the assisted living facilities) as providers
or suppliers under one or more Medicare or Medicaid programs, as applicable.
Long-term care facilities must comply with certain requirements to
participate either as a skilled nursing facility under Medicare or a nursing
facility under Medicaid. Regulations effective October 1, 1990, pursuant to
the Omnibus Budget Reconciliation Act of 1987, obligate facilities to
demonstrate compliance with requirements relating to resident rights, resident
assessment, quality of care, quality of life, physician services, nursing
services, pharmacy services, dietary services, rehabilitation services,
infection control, physical environment and administration. Survey,
certification, and enforcement procedures to be used by state and federal
survey agencies to determine facilities' level of compliance with the
participation requirements for Medicare and Medicaid were adopted by Health
Care Finance Administration ("HCFA") regulations effective July 1, 1995. These
regulations require that surveys focus on residents' outcomes of care and
state that all deviations from participation requirements will be considered
deficiencies, but that all deficiencies will not constitute noncompliance. The
regulations identify alternative remedies against facilities and specify the
categories of deficiencies for which they will be applied.
The remedies include, but are not limited to: civil money penalties of
$5,000 to $10,000 per violation; facility closure and/or transfer of residents
in emergencies; directed plans of correction; and directed in-service
training.
9
HCFA requires compliance with certain standards as a condition to
participation in the Medicare and Medicaid home healthcare program. Failure to
comply may result in termination of the agency's Medicare and Medicaid
provider agreements. In 1989, Congress directed the Department of Health and
Human Services ("HHS") to develop and implement a range of intermediate, or
alternative, sanctions for home health agencies. HHS published proposed rules
to implement this authority in 1991; however, these rules have not been
finalized and thus far have not taken effect. The proposed sanctions would
include civil monetary penalties, temporary management, suspension of payment
for new admissions, and other sanctions to be imposed upon agencies found out
of compliance with standards.
The Company believes that its facilities and service providers materially
comply with applicable regulatory requirements. From time to time, however,
the Company receives notice of noncompliance with various requirements for
Medicare/Medicaid participation or state licensure. The Company reviews such
notices for factual correctness, and based on such review, either takes
appropriate corrective action or challenges the stated basis for the
allegation of noncompliance. In most cases, the Company and the reviewing
agency will agree upon the measure to be taken to bring the facility or
service provider into compliance. Under certain circumstances, however, such
as repeat violations or perceived severity of the violations, the federal
and/or state agencies have the authority to take adverse actions against a
facility or provider, including the imposition of monetary fines, the
decertification of a facility or provider from participation in the Medicare
and/or Medicaid programs, or licensure revocation. While in certain instances
facilities or providers have been fined, decertified, or had licensure
sanctions imposed, the Company has been able to reinstate the certifications
and satisfactorily resolve the fines and licensure sanctions. No such
enforcement action against a facility or provider has had a material adverse
impact on the Company (or, prior to the Mergers, LCA or GranCare), although
there can be no assurance that such an enforcement action will not have a
material impact on the Company in the future. The Company believes it
substantially complies with these regulatory requirements, but there can be no
assurance that the Company will be able to maintain such compliance, or will
not be required to expend significant amounts to do so.
Medicare utilizes a cost-based reimbursement system for nursing facilities,
long-term acute care hospitals and home health agencies for reasonable direct
and indirect allowable costs incurred in providing "routine service" (as
defined by the program and subject to certain limits) as well as capital costs
and ancillary costs. The Company is filing Routine Cost Limit Exception
requests for the facilities which exceed the limits and fit the criteria as
exception candidates. The Company may benefit from exceptions to the routine
cost limits. Allowable costs include nursing, administrative and general,
dietary, housekeeping, laundry, social services, activities, central supply,
maintenance and plant operations as well as ancillary and capital costs. There
can be no assurance that any such requests for the Routine Cost Limit
Exception will be granted.
Congress passed a fiscal year 1996 budget reconciliation bill that contained
a provision that would have required Medicare to pay skilled nursing
facilities on a prospective payment basis beginning in October 1997. Although
this bill was ultimately vetoed by the President, the Clinton Administration
had proposed adopting prospective payment for skilled nursing facilities in
1999. See the discussion of the Balanced Budget Act below for additional
discussion regarding the prospective payment system. Other legislative
proposals, including one adopted by the U.S. Senate, have called for
developing a prospective payment system for specialty medical care programs
within acute care hospitals. Proposals to reduce the growth in Medicare and
Medicaid expenditures are under active consideration in the current session of
Congress. The Company cannot predict at this time whether any of these
proposals will be adopted or, if adopted and implemented, what effect such
proposals would have on the Company. There can be no assurance that payments
under state or federal governmental programs will remain at levels comparable
to present levels or will be sufficient to cover the costs allocable to
patients eligible for reimbursement pursuant to such programs, particularly
with respect to the Medicaid programs, which generally provide lower
reimbursement rates than the Medicare program.
Medicare and Medicaid reimbursements have historically been determined from
annual cost reports filed by LCA and GranCare which are subject to audit by
the respective agency administering the programs. The audits generally focus
on the reasonableness and necessity of the costs incurred by providers,
including the costs of obtaining goods and/or services from related parties.
The Company has received notices for previous cost-reporting periods that the
reviewing agency intends to adjust certain costs with regard to services and
supplies
10
furnished by the Company's pharmacy and rehabilitation divisions to its
nursing facilities. The Company disagrees with the reviewing agency's position
and is pursuing all available appeal rights. The Company believes it has
substantial arguments in support of its position that the contested costs are
appropriate, but there can be no assurance that the Company will prevail on
all appeal issues, nor that it will not be required to expend significant
amounts to complete the appeal process. Adjustments to LCA's and GranCare's
cost reports historically have not had a material adverse effect on their
respective operating results. However, there can be no assurance that future
adjustments to such cost reports will not have a material adverse effect on
the Company's operating results.
The Balanced Budget Act, signed into law on August 5, 1997, makes numerous
changes to the Medicare and Medicaid programs which could potentially affect
the Company. With respect to the Medicare program, the new law required the
establishment of a prospective payment system for Medicare skilled nursing
facility services, under which facilities will be paid a federal per diem rate
for virtually all covered services. The prospective payment system will be
phased in over three cost reporting periods, starting with cost reporting
periods beginning on or after July 1, 1998. The Balanced Budget Act also
institutes consolidated billing for skilled nursing facility services, under
which payments for non-physician Part B services for beneficiaries no longer
eligible for Part A skilled nursing facility care will be made to the
facility, regardless of whether the item or service was furnished by the
facility, by others under arrangement or under any other contracting or
consulting arrangement, effective for items or services furnished on or after
July 1, 1998. Likewise, the Balanced Budget Act requires the Secretary of HHS
to establish a prospective payment system for home health services, to be
implemented beginning October 1, 1999. The legislation also requires home
health agencies to submit claims for all services, and all payments will be
made to the home health agencies regardless of whether the item or service was
furnished by the agency, by others under arrangement or under any other
contracting or consulting arrangement. The law also contains provisions
affecting outpatient rehabilitation agencies and providers, including a 10
percent reduction in operating and capital costs for 1998, a fee schedule for
therapy services beginning in 1999, and the application of per beneficiary
therapy caps currently applicable to independent therapists to all outpatient
rehabilitation services beginning in 1999. With regard to hospices, the
Balanced Budget Act limits reimbursement by setting the payment rate increase
at a market basket minus 1.0 percentage point for fiscal years 1998 through
2002. The law also institutes a number of reforms of the hospice benefit,
including a requirement that hospices can be reimbursed based on the location
where care is furnished (rather than the location of the hospice), effective
for cost reporting periods beginning on or after October 1, 1997. Other
provisions limit Medicare payments for certain drugs and biologicals, durable
medical equipment and parenteral and enteral nutrients and supplies.
The Balanced Budget Act also contains a number of changes affecting the
Medicaid program. Significantly, the law repeals the so-called Boren
Amendment, which required state Medicaid programs to reimburse nursing
facilities for the costs that are incurred by efficiently and economically
operated providers in order to meet quality and safety standards. Effective
for Medicaid services provided on or after October 1, 1997, states will have
considerable flexibility in establishing payment rates. The Company is not
able to predict whether any states will adopt changes in their Medicaid
reimbursement systems, or, if adopted and implemented, what effect such
initiatives would have on the Company. Nevertheless, there can be no assurance
that such changes in Medicaid reimbursement to nursing facilities will not
have an adverse effect on the Company. Further, the Balanced Budget Act allows
states to mandate enrollment in managed care systems without seeking approval
from the Secretary of HHS for waivers from certain Medicaid requirements as
long as certain standards are met. These managed care programs have
historically exempted institutional care. However, no assurance can be given
that these waiver provisions ultimately will not change the reimbursement
system for long-term care facilities from fee-for-service to managed care
negotiated or capitated rates or otherwise affect the level of payments to the
Company.
Healthcare reform remains an issue for healthcare providers. Many states are
currently evaluating various proposals to restructure the healthcare delivery
system within their jurisdiction. It is uncertain at this time what
legislation on healthcare reform will ultimately be implemented or whether
other changes in the administration or interpretation of governmental
healthcare programs will occur. Management anticipates that federal and state
legislatures will continue to review and assess various healthcare reform
proposals and alternative healthcare
11
systems and payment methodologies. Management is unable to predict the
ultimate impact of any federal or state restructuring of the healthcare
system, but such changes could have a material adverse impact on the
operations, financial condition and prospects of the Company.
Referral Restrictions and Fraud and Abuse. The Medicare and Medicaid anti-
kickback statute, 42 U.S.C. (S) 1320a-7(b), prohibits the knowing and willful
solicitation or receipt of any remuneration "in return for" referring an
individual, or for recommending or arranging for the purchase, lease, or
ordering, of any item or service for which payment may be made under Medicare
or a state healthcare program. In addition, the statute prohibits the offer or
payment of remuneration "to induce" a person to refer an individual, or to
recommend or arrange for the purchase, lease, or ordering of any item or
service for which payment may be made under the Medicare or state healthcare
programs. Violation of the anti-kickback statute, pursuant to the Balanced
Budget Act, now carries a civil monetary penalty of $50,000 per act, and
treble the remuneration involved without regard to whether any portion of that
remuneration relates to a lawful purpose. The statute contains "safe harbor"
exceptions for certain discounts, group purchasing organizations, employment
relationship, waivers of coinsurance by community health centers, health plans
and practices defined in regulatory safe harbors.
False claims are prohibited pursuant to criminal and civil statutes.
Criminal provisions at 42 U.S.C. (S) 1320a-7(b) prohibit filing false claims
or making false statements to receive payment or certification under Medicare
or Medicaid, or failing to refund overpayments or improper payments; offenses
for violation are felonies punishable by up to five years imprisonment, and/or
$25,000 fines. Civil provisions at 31 U.S.C. (S) 3729 prohibit the knowing
filing of a false claim or the knowing use of false statements to obtain
payment; penalties for violations are fines of not less than $5,000 nor more
than $10,000, plus treble damages, for each claim filed. Allegations have been
made under the civil provisions of the statute that the Company has filed
false claims. See "Legal Proceedings" for a discussion of these allegations.
The Ethics in Patient Referrals Act ("Stark I"), effective January 1, 1992,
generally prohibits physicians from referring Medicare patients to clinical
laboratories for testing if the referring physician (or a member of the
physician's immediate family) has a "financial relationship," through
ownership or compensation, with the laboratory. The Omnibus Budget
Reconciliation Act of 1993 contains provisions commonly known as "Stark II"
("Stark II") expanding Stark I by prohibiting physicians from referring
Medicare and Medicaid patients to an entity in which a physician has a
"financial relationship" for the furnishing of certain items set forth in a
list of "designated health services," including physical therapy, occupational
therapy, home health services, and other services. Subject to certain
exceptions, if such a financial relationship exists, the entity is generally
prohibited from claiming payment for such services under the Medicare or
Medicaid programs.
Other provisions in the Social Security Act authorize the imposition of
other penalties, including exclusion from participation in Medicare and
Medicaid, for various billing and other offenses.
Additionally, the Health Insurance Portability and Accountability Act of
1996 (the "Accountability Act") granted expanded enforcement authority to HHS
and the U.S. Department of Justice ("DOJ"), and provided enhanced resources to
support the activities and responsibilities of the Office of Inspector General
("OIG") and DOJ by authorizing large increases in funding for investigating
fraud and abuse violations relating to healthcare delivery and payment. The
Balanced Budget Act also includes numerous health fraud provisions, including
new civil money penalties for contracting with an excluded provider; new
surety bond and information disclosure requirements for certain providers and
suppliers; and an expansion of the mandatory and permissive exclusions added
by the Health Insurance Portability and Accountability Act of 1996 to any
federal healthcare program (other than the Federal Employees Health Benefits
Program).
Management expects that business practices of providers and financial
relationships between providers will be subject to increased scrutiny as
healthcare reform efforts continue at federal and state levels. Although the
Company has contractual arrangements with some healthcare providers, it
believes that its practices are not in violation of these federal and state
prohibitions. Management cannot reasonably predict whether enforcement
activities will increase at the federal or state level or the effect of any
such increase on the business of the Company.
In the summer of 1995, a major anti-fraud demonstration project, "Operation
Restore Trust," was announced by the OIG. A primary purpose for the project is
to scrutinize the activities of healthcare providers
12
who are reimbursed under the Medicare and Medicaid programs. Initial
investigative efforts have focused on skilled nursing facilities, home health
and hospice agencies, and durable medical equipment suppliers in Texas,
Florida, New York, Illinois, California, and Louisiana. On May 20, 1997, HHS
announced that Operation Restore Trust will be expanded during the next two
years to include 12 additional states (Arizona, Colorado, Georgia, Louisiana,
Massachusetts, Missouri, New Jersey, Ohio, Pennsylvania, Tennessee, Virginia
and Washington), as well as several other types of healthcare services. Over
the longer term, Operation Restore Trust investigative techniques will be used
in all 50 states, and will be applied throughout the Medicare and Medicaid
program. The OIG has issued, and will continue to issue, special Fraud Alert
bulletins identifying "suspect" characteristics of potentially illegal
practices by providers, and illegal arrangements between providers. The
bulletins contain "Hot Line" numbers and encourage Medicare beneficiaries,
healthcare company employees, competitors, and others to call to report
suspected violations. Enforcement actions could include criminal prosecutions,
suit for civil penalties, and/or Medicare program exclusion. While the Company
does not believe that it is in violation of any such laws or is the target of
any such investigation under Operation Restore Trust, there can be no
assurance that substantial amounts will not be expended by the Company to
cooperate with any such investigation or to defend allegations arising
therefrom. If it were found that any of the Company's practices (or the
practices of LCA or GranCare prior to the Mergers) failed to comply with the
anti-fraud provisions, the Company could be materially adversely affected.
Management is unable to predict the effect of future administrative or
judicial interpretations of these laws, or whether other legislation or
regulations on the federal or state level in any of these areas will be
adopted, what form such legislation or regulations may take, or their impact
on the Company. There can be no assurances that such laws will ultimately be
interpreted in a manner consistent with the Company's practices, nor that the
Company will not be required to expend significant sums in the event it
becomes subject to such investigative or enforcement actions under "Operation
Restore Trust." See "--Legal Proceedings."
Certificate of Need. CON statutes and regulations control the development
and expansion of healthcare services and facilities in certain states. The CON
process is intended to promote quality healthcare at the lowest possible cost
and to avoid the unnecessary duplication of services, equipment and
facilities. CON or similar laws generally require that approval be obtained
from the designated state health planning agency for certain acquisitions and
capital expenditures, and that such agency determine that a need exists prior
to the expansion of existing facilities, construction of new facilities,
addition of beds, acquisition of major items of equipment or introduction of
new services. CONs or other similar approvals may be required in connection
with the Company's future acquisitions and/or expansions. There can be no
assurance that the Company will be able to obtain the CONs or other approvals
necessary for any or all such projects.
Contract Management Regulation. Contract managers of geriatric mental health
centers, subacute care units, specialty acute hospitals and senior health
centers are not typically subject to direct regulation, although the Company
may be held responsible for violations of certain federal and state laws, such
as the referral restrictions described above. Further, the facilities managed
by the Company on a contract basis will be subject to regulation. Management
contracts with these facilities may hold the Company accountable in certain
instances to a facility which is cited for non-compliance with regulatory
requirements. Further, there can be no assurance that the facilities managed
by the Company will not be subject to statutory or regulatory changes which
might adversely impact these facilities and, indirectly, the Company's
contract management business.
Therapy Regulation. The Company furnishes therapy services on a contract
basis to certain providers as well as to patients in most of its facilities,
and the providers bill Medicare for reimbursement of the amounts paid to the
Company for these services. HCFA has the authority to establish limits on the
amount Medicare reimburses for therapy services. For services other than
inpatient hospital services, these limits are equivalent to the reasonable
amount that would have been paid if provider employees had furnished the
services. HCFA has exercised this authority by publishing "salary equivalency
guidelines" for physical therapy and respiratory therapy services. HCFA does
not currently have salary equivalency guidelines for other therapy services,
but Medicare auditors may nonetheless impose disallowances with respect to
purchasers that have failed to act as "prudent buyers." On March 28, 1997,
HCFA issued a proposed regulation that would revise the salary equivalency
guidelines for physical therapy and respiratory therapy and establish salary
equivalency guidelines
13
for speech-language pathology and occupational therapy service. HCFA estimates
that the proposed regulation would increase the reimbursement rates for
physical therapy by 30.5% and for respiratory therapy by 8.1%. The proposed
salary equivalency rates for occupational therapy and speech-language
pathology, however, would reduce current reimbursement rates by 42.7% and
28.1%, respectively. Management cannot predict whether this proposed
regulation will be adopted or, if adopted, the effect it would have on the
Company.
Pharmacy Regulation. Pharmacy operations are subject to regulation by the
various states in which the Company conducts its business as well as by the
federal government. The Company's pharmacies are regulated under the Food,
Drug and Cosmetic Act and the Prescription Drug Marketing Act, which are
administered by the United States Food and Drug Administration. Under the
Comprehensive Drug Abuse Prevention and Control Act of 1970, which is
administered by the United States Drug Enforcement Administration ("DEA"), the
pharmacies, as dispensers of controlled substances, must register with the
DEA, file reports of inventories and transactions and provide adequate
security measures. Failure to comply with such requirements could result in
civil or criminal penalties. The Company believes that its pharmacy operations
are in substantial compliance with such regulations.
Home Health/Hospice. On September 15, 1997, President Clinton imposed a
first-ever six month moratorium on the entry of new home health agencies into
the Medicare program in order to allow new regulations to be written that will
attempt to curb fraud and abuse within the home healthcare industry. HHS will
have authority to grant exceptions from the moratorium for areas of the
country with no access to home healthcare services. In addition to the
moratorium, the Clinton administration will also require, among other things,
that home health agencies re-enroll in the Medicare program every three years
and, at the time of re-enrollment, submit to an independent audit of their
records and practices. Finally, the President pledged to double the number of
audits conducted of home health agencies, while at the same time, HCFA will
increase the number of claims reviewed by 25%. Until the new regulations are
released, the Company is unable to predict what impact, if any, the new
regulations will have on its home health operations. On September 19, 1997,
the OIG issued its report on "Hospice Patients in Nursing Homes" which made
findings of lower frequency of services, the overlap of services and the
questionable enrollment in hospice by nursing home patients, and concluded
that current payment levels for hospice care in nursing homes may be
excessive. The OIG recommended that HCFA seek legislation to modify Medicare
or Medicaid payments for hospice patients living in nursing homes. Until such
legislation is adopted, the Company is unable to predict what impact, if any,
modification of payment will have.
COMPETITION
The long-term healthcare industry is segmented into a variety of competitive
areas which market similar services. These competitors include nursing homes,
assisted living facilities, hospitals, extended care centers, retirement
centers and communities, and home health and hospice agencies. Many operators
of acute care hospitals offer or may offer post-acute care services. These
operators would have the competitive advantage of being able to offer services
to patients through their affiliated post-acute care operators. The Company's
facilities historically have competed on a local basis with other long-term
care providers and the Company's competitive position will vary from center to
center within the various communities it serves. Significant competitive
factors include the quality of care provided, reputation, location and
physical appearance of the long-term care facilities and, in the case of
private pay residents, charges for services. Since there is little price
competition with respect to Medicaid and Medicare residents, the range of
services provided by the Company's facilities covered by Medicaid and Medicare
as well as the location and physical condition of its facilities will
significantly affect its competitive position in its markets. Competition in
the institutional pharmaceutical and the rehabilitation services markets
ranges from small local operators to companies that are national in scope and
distribution capability. In order to enhance its ability to compete at both
the national and regional market level, the Company is implementing certain
marketing and information systems initiatives. See "--Marketing" and "--
Management Information Systems."
14
INSURANCE
The Company maintains, on behalf of itself and its subsidiaries, insurance
coverages that it deems adequate. The Company also requires that physicians
practicing at its long-term care facilities carry medical malpractice
insurance to cover their individual practice. Moreover, insurance coverage in
certain states is not available to cover punitive damages, and proceedings
involving claims of punitive damages are pending in certain of these states.
EMPLOYEES
At December 19, 1997, the Company employed approximately 45,000 individuals,
of which approximately 1,000 worked at the corporate and field offices. The
Company has collective bargaining agreements with unions representing
employees at 26 facilities and with employee councils at two of its
facilities, most of which are with the Service Employees International Union
and expire in April or May 1998. The Company is preparing to negotiate with
the Service Employees Internation Union. The Company cannot predict the
outcome of these negotiations at this time. The Company cannot predict the
effect continued union representation or organizational activities will have
on its future activities. However, the aforementioned organizations have not
caused any material work stoppages in the past.
CAUTIONARY STATEMENTS
Information provided herein by the Company contains, and from time to time
the Company may disseminate materials and make statements which may contain
"forward-looking" information, as that term is defined by the Private
Securities Litigation Reform Act of 1995 (the "Act"). In particular, the
information contained in "Management's Discussion and Analysis of Financial
Condition and Results of Operation--Liquidity and Capital Resources" contains
information concerning the ability of the Company to service its debt
obligations and other financial commitments as they come due and "--Business
Strategy" contains information regarding management's belief concerning the
growth opportunities available to the Company. The aforementioned forward
looking statements, as well as other forward looking statements made herein,
are qualified in their entirety by these cautionary statements, which are
being made pursuant to the provisions of the Act and with the intention of
obtaining the benefits of the "safe harbor" provisions of the Act.
The Company cautions investors that any forward-looking statements made by
the Company are not guarantees of future performance and that actual results
may differ materially from those in the forward-looking statements as a result
of various factors, including, but not limited to, the following:
(i) In recent years, an increasing number of legislative proposals have
been introduced or proposed by Congress and in some state legislatures
which would effect major changes in the healthcare system. However, the
Company cannot predict the form of healthcare reform legislation which may
be proposed or adopted by Congress or by state legislatures. Accordingly,
the Company is unable to assess the effect of any such legislation on its
business. There can be no assurance that any such legislation will not have
a material adverse impact on the future growth, revenues and net income of
the Company.
(ii) The Company derives substantial portions of its revenues from third-
party payors, including government reimbursement programs such as Medicare
and Medicaid, and some portions of its revenues from non-governmental
sources, such as commercial insurance companies, health maintenance
organizations and other charge-based contracted payment sources. Both
government and non government payors have undertaken cost-containment
measures designed to limit payments to healthcare providers. There can be
no assurance that payments under governmental and non-governmental payor
programs will be sufficient to cover the costs allocable to patients
eligible for reimbursement. The Company cannot predict whether or what
proposals or cost-containment measures will be adopted or, if adopted and
implemented, what effect, if any, such proposals might have on the
operations of the Company.
15
(iii) The Company is subject to extensive federal, state and local
regulations governing licensure, conduct of operations at existing
facilities, construction of new facilities, purchase or lease of existing
facilities, addition of new services, certain capital expenditures, cost-
containment and reimbursement for services rendered. The failure to obtain
or renew required regulatory approvals or licenses, the delicensing of
facilities owned, leased or operated by the Company or the disqualification
of the Company from participation in certain federal and state
reimbursement programs could have a material adverse effect upon the
operations of the Company.
(iv) There can be no assurance that the Company will be able to continue
its substantial growth or be able to fully implement its business
strategies for its post-acute care, pharmaceutical services, rehabilitation
services, or hospital services divisions or that management will be able to
successfully integrate the operations of GranCare and LCA.
ITEM 2. PROPERTIES
As of November 30, 1997 the Company operated 327 long-term care facilities
(318 skilled nursing facilities and nine free standing assisted living
facilities) with 38,272 licensed beds located in 21 states. Licensed beds
represent the number of beds for which a license has been issued and may vary
from the actual beds available for use. As of November 30, 1997, the Company
operated the following facilities:
OWNED LEASED MANAGED TOTAL
----------------- ----------------- --------------- -----------------
FACILITIES BEDS FACILITIES BEDS FACILITIES BEDS FACILITIES BEDS
---------- ------ ---------- ------ ---------- ---- ---------- ------
Alabama................. 7 848 -- -- -- -- 7 848
Arizona................. 4 506 10 1,236 -- -- 14 1,742
California.............. 1 99 30 3,381 -- -- 31 3,480
Colorado................ 19 2,032 11 1,374 -- -- 30 3,406
Florida................. 2 295 -- -- -- -- 2 295
Georgia................. 4 429 6 706 -- -- 10 1,135
Illinois................ 13 1,114 6 766 1 209 20 2,089
Indiana................. -- -- 3 471 -- -- 3 471
Iowa.................... 1 99 6 448 -- -- 7 547
Louisiana............... -- -- 9 1,500 -- -- 9 1,500
Michigan................ 13 1,863 -- -- -- -- 13 1,863
Mississippi............. 1 124 10 1,104 -- -- 11 1,228
Nebraska................ 7 612 -- -- -- -- 7 612
North Carolina.......... 29 3,429 4 600 1 60 34 4,089
Ohio.................... -- -- 1 100 -- -- 1 100
South Carolina.......... 2 265 9 964 -- -- 11 1,229
Tennessee............... -- -- 2 226 -- -- 2 226
Texas................... 48 5,558 42 4,640 1 120 91 10,318
Virginia................ -- -- 5 343 -- -- 5 343
Wisconsin............... 7 1,302 7 924 -- -- 14 2,226
Wyoming................. 3 385 2 140 -- -- 5 525
--- ------ --- ------ --- --- --- ------
Total................... 161 18,960 163 18,923 3 389 327 38,272
=== ====== === ====== === === === ======
16
In addition to long-term care facilities, at November 30, 1997 the Company
operated 133 outpatient rehabilitation clinics in 18 states and 34
institutional pharmacies in 11 states, as follows:
OUTPATIENT INSTITUTIONAL
STATE CLINICS PHARMACIES
----- ---------- -------------
Alabama........................................... -- 1
Arizona........................................... 1 2
California........................................ 5 --
Colorado.......................................... -- 3
Connecticut....................................... 3 --
Florida........................................... 17 9
Georgia........................................... 1 2
Illinois.......................................... -- 1
Indiana........................................... -- 1
Kansas............................................ 7 --
Kentucky.......................................... 1 --
Louisiana......................................... 6 2
Maryland.......................................... 2 --
Mississippi....................................... 7 --
Missouri.......................................... 4 --
Nevada............................................ 1 --
New Jersey........................................ -- 1
North Carolina.................................... 22 2
South Carolina.................................... 9 --
Tennessee......................................... 10 --
Texas............................................. 29 10
Virginia.......................................... 7 --
Washington........................................ 1 --
--- ---
Total......................................... 133 34
=== ===
Substantially all of the Company's outpatient rehabilitation clinics and
institutional pharmacy facilities are leased under "triple net" leases.
Subject to the exceptions set forth below, the Company's hospital services
division enters into contracts with acute care hospitals for the management of
geriatric specialty programs, generally located inside such hospitals. Such
management contracts do not generally involve the lease or purchase of any
property. This division does, however, own two properties. The two owned
facilities are The Specialty Hospital of Austin (Texas) and The Specialty
Hospital of Houston (Texas), which have 104 beds and 134 beds, respectively.
The Company considers its properties to be in good operating condition and
suitable for the purposes for which they are being used.
Certain of the above properties serve as collateral for various mortgage
debt instruments or capitalized lease obligations. See Notes 5 and 11 to the
Consolidated Financial Statements. The Company regularly reviews its portfolio
of properties and intends to divest those properties which it believes do not
meet quality or financial performance standards.
ITEM 3. LEGAL PROCEEDINGS
As is typical in the healthcare industry, the Company is and will be subject
to claims that its services have resulted in resident injury or other adverse
effects, the risks of which will be greater for higher acuity residents
receiving services from the Company than for other long-term care residents.
The Company is, from time to time, subject to such negligence claims and other
litigation. In addition, resident, visitor, and employee injuries will also
subject the Company to the risk of litigation. From time to time, the Company
and its subsidiaries have
17
been parties to various legal proceedings in the ordinary course of their
respective business. In the opinion of management, except as described below,
there are currently no proceedings which, individually or in the aggregate, if
determined adversely to the Company and after taking into account the
insurance coverage maintained by the Company, would have a material adverse
effect on the Company's financial position or results of operations.
The Company received a letter dated September 5, 1997 from an Assistant
United States Attorney ("AUSA") in the United States Attorney's Office for the
Eastern District of Texas (Beaumont) advising that the office is involved in
an investigation of allegations that services provided at some of the
Company's facilities may violate the Civil False Claims Act. The AUSA informed
the Company that the investigation is the result of a qui tam complaint (which
involves a private citizen requesting the federal government to intervene in
an action because of an alleged violation of a federal statute) filed under
seal against the Company, and the AUSA is investigating the allegations in
order to determine if the United States will intervene in the proceedings. The
AUSA has requested that the Company voluntarily produce a substantial amount
of documents, including medical records of former residents. Counsel for the
Company has met with the AUSA, and the parties are currently engaged in
discussions on whether the voluntary production of former residents' medical
records can be accomplished without violating the residents' rights to privacy
and confidentiality. Based upon the information currently known about the
complaint, the Company believes that given an opportunity to address the
allegations, the AUSA will find intervention by the United States is without
merit. The Company will vigorously contest the alleged claims if the complaint
is pursued.
The Department of Justice ("DOJ") has advised the Company that the United
States has declined to intervene in the qui tam complaint filed against The
Brian Center Corporation ("BCC") and one of its subsidiaries, Med-Therapy
Rehabilitation Services, Inc. ("Med-Therapy"), both wholly-owned subsidiaries
of the Company (and of LCA before the Mergers) in the federal district court
for the Western District of North Carolina. The Company does not know whether
the individual plaintiff will continue to pursue the alleged claims that BCC
and Med-Therapy caused certain therapists to make improper therapy record
entries with respect to screening services, and that any claims filed with
Medicare for payments based upon such improper record entries should be viewed
as false claims under the Civil False Claims Act. The Company will vigorously
contest any claims which the individual plaintiff pursues. No assurance can be
given that, if the plaintiff were to prevail in his claim, the resulting
judgement would not have a material adverse effect on the Company. Moreover,
in connection with the Company's acquisition of BCC, the primary stockholder
(Donald C. Beaver) agreed to indemnify and hold harmless the Company from and
against any and all loss, expense, damage, penalty and liability which could
result from this claim, subject to further adjustment. Mr. Beaver's indemnity
requires any payment to the Company to be in the form of shares of the Company
common stock held by him.
The Company was served with a Petition, Cause No. 97-1500-G, Community
Healthcare Services of America, Inc., v. Rehability Health Services, Inc. and
Living Centers of America, Inc., in the 319th Judicial District Court of
Nueces County, Texas, seeking $5.0 million in damages, filed by Community
Health Services, Inc. ("Community"), in connection with a home health agency
management agreement entered into between Community and a subsidiary of the
Company. Such subsidiary operated a Texas home health agency which Community
managed. The Company is vigorously defending the allegations of Community that
the Company breached the agreement by terminating Community's management
services and has filed a lawsuit against Community for breach of the
agreement, Cause No. 97-03569; Rehability Health Services, Inc. v. Community
Healthcare Services, Inc., in the 353rd Judicial District Court of Travis
County, Texas. The Nueces County action was transferred to Travis County and
the two cases have been consolidated into Cause No. 97-03569.
18
On June 10, 1997, a GranCare stockholder filed a civil action in state
district court in Harris County, Texas: Howard Gunty, Inc. Profit Sharing Plan
v. Gene E. Burleson, Charles M. Blalack, Antoinette Hubenette, Joel S. Kanter,
Ronald G. Kenny, Robert L. Parker, William G. Petty, Jr., Edward V. Regan,
Gary U. Rolle and GranCare, Inc. This complaint alleged, generally, that the
defendants breached their fiduciary duties owed to GranCare's stockholders by
failing to take all reasonable steps necessary to ensure that GranCare's
stockholders receive maximum value for their shares of GranCare common stock
in connection with the GranCare Merger. The plaintiffs sought (i) an
injunction prohibiting the consummation of the GranCare Merger or (ii)
alternatively, if the GranCare Merger were consummated, to have such
transaction rescinded and set aside. In addition, the plaintiffs sought
unspecified compensatory damages, costs and to have the action certified as a
class action.
On October 28, 1997, the parties to the aforementioned litigation entered
into an Agreement and Stipulation of Settlement (the "Settlement Agreement")
pursuant to which the plaintiffs agreed to dismiss, with prejudice, all claims
against GranCare in consideration of, among other things, (i) certain
additional disclosure included in the disclosure documents sent to GranCare
stockholders in connection with their approval of the GranCare Merger and (ii)
the payment by GranCare of the fees and expenses of plaintiffs' counsel in an
aggregate amount of no more than $350,000. The effectiveness of the Settlement
Agreement is subject to a number of conditions, including, among others, the
entry by the court of a final judgement approving the terms of the settlement.
GranCare entered into the Settlement Agreement based upon its belief that a
speedy resolution of this dispute was in the best interest of the GranCare
stockholders and in so doing did not in any way admit any wrongdoing or
liability in connection with this matter. The Company believes that the court
will accept the Settlement Agreement once filed following appropriate
shareholder notification.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
ITEM 4A. EXECUTIVE MANAGEMENT OF THE REGISTRANT
NAME AGE POSITION
---- --- --------
Keith B. Pitts.......... 40 Chairman of the Board, President, Chief Executive Officer
and Director
Leroy D. Williams....... 55 President--Post-Acute Division
Dennis G. Johnston...... 50 President--Hospital Services Division
William R. Korslin...... 47 President--Pharmaceutical Services Division
David L. Ward........... 42 President--Rehabilitation Services Division
Charles B. Carden....... 53 Executive Vice President and Chief Financial Officer
R. Jeffrey Taylor....... 49 Senior Vice President, Development
Susan Thomas Whittle.... 50 Senior Vice President, General Counsel and Secretary
Keith B. Pitts was appointed Chairman of the Board, President, Chief
Executive Officer and a Director of the Company on November 4, 1997. Prior to
this, Mr. Pitts served as a consultant to Apollo in connection with the
Transactions since August 1997. From February 1997 to August 1997 Mr. Pitts
was a consultant to Tenet Healthcare Corp. ("Tenet"). Mr. Pitts served as the
Executive Vice President and Chief Financial Officer of OrNda HealthCorp, a
healthcare service provider in the United States, from August 1992 until its
merger with Tenet in January 1997. Prior to joining OrNda HealthCorp, from
July 1991 to August 1992, Mr. Pitts was a partner in Ernst & Young LLP's
Southeast Region Health Care Consulting Group, and from January 1988 to July
1991 he was a partner and Regional Director in Ernst & Young LLP's Western
Region Health Care Consulting Group. Mr. Pitts is a director of Sunburst
Hospitality Corporation, a corporation engaged in the hotel business.
19
Leroy D. Williams was appointed President--Post-Acute Care Division of the
Company on November 4, 1997. Prior to this, Mr. Williams served as President,
Chief Operating Officer and as a director of LCA. Mr. Williams became a
director of LCA in January 1992, Chief Operating Officer of LCA in August 1995
and President in February 1996. Mr. Williams served as Executive Vice
President of LCA from December 1991 to February 1996. In 1978 Mr. Williams
joined LCA as Regional Controller of LCA--Eastern Region. From May 1983 to
February 1985, Mr. Williams was Financial Vice President for LCA--Texas. In
March 1985, he was appointed Vice President--Finance and became Senior Vice
President--Finance in January 1991.
Dennis G. Johnston was appointed President--Hospital Services Division of
the Company on November 4, 1997. Prior to this, Mr. Johnston served as a
Senior Vice President of GranCare and as President of Cornerstone, a wholly-
owned subsidiary of GranCare. Mr. Johnston joined GranCare as President of
Cornerstone in April 1995 and became Senior Vice President of GranCare in July
1995. Mr. Johnston was the co-founder of Cornerstone in 1990 and served as its
President and Chief Executive Officer from 1990 to 1995. From 1984 to 1989,
Mr. Johnston held various positions with the management subsidiary of Republic
Health Corporation, including that of Senior Development Officer.
William R. Korslin was appointed President--Pharmaceutical Services Division
of the Company on November 4, 1997. Prior to this, Mr. Korslin served as a
Vice President of LCA since September 1995 and as President of APS, LCA's
pharmaceutical services subsidiary, since May 1994. Mr. Korslin joined APS in
July 1987 as General Manager Enteral Services. From 1989 through 1992, he
served as Eastern Area Vice President of APS and, from 1992 to 1994, Mr.
Korslin was Senior Vice President in charge of all field operations of APS.
David L. Ward was appointed President--Rehabilitation Services Division of
the Company on November 4, 1997. Prior to this, Mr. Ward served as an officer
of LCA's American Rehability Services division since joining LCA in May 1996.
Prior to joining LCA, Mr. Ward served in a variety of management positions
with NovaCare, Inc., a national provider of rehabilitation services to long-
term care and other healthcare facilities since January 1988, including the
Southern States Regional President of NovaCare's Outpatient Division, the
Arizona Regional President for NovaCare's Hospital Division, NovaCare's Vice
President of Organizational Planning and Development, the Southwestern Vice
President of NovaCare's Contract Services Division, the Western Vice President
of NovaCare's Contract Services Division and NovaCare's National Sales
Manager.
Charles B. Carden was appointed Executive Vice President and Chief Financial
Officer of the Company on November 4, 1997. Prior to this, Mr. Carden served
as Executive Vice President and Chief Financial Officer of LCA since October
1996. Before joining LCA, Mr. Carden was Chief Financial Officer of Leaseway
Transportation Corp., where he was employed for 14 years. He also has held
various supervisory and analytical positions in corporate finance with Ford
Motor Company.
R. Jeffrey Taylor was appointed Senior Vice President, Development on
November 19, 1997. Prior to this, Mr. Taylor served as Senior Vice President
of GranCare since January 1997, as President of GranCare's ancillary services
division from November 1996 through January 1997, and as President of GCI
Renal Care, Inc., a subsidiary of GranCare, from February 1996 through
November 1996. Before joining GranCare, Mr. Taylor was Chief Executive Officer
of American Outpatient Services Corporation, a dialysis company, from July
1995 to February 1996. From January 1992 to June 1994 he was President of
Weisman, Taylor, Simpson & Sabatino, a health care merchant banking firm based
in California. From 1982 through 1992 Mr. Taylor served in several executive
capacities with American Medical International, Inc. including General Counsel
and Executive Vice President, Chief Administrative Officer.
Susan Thomas Whittle was appointed Senior Vice President, General Counsel
and Secretary of the Company on November 4, 1997. Prior to this, Ms. Whittle
served as Vice President, General Counsel and Secretary of LCA since September
1993. Before joining LCA, Ms. Whittle was a partner with the law firms of
Clark, Thomas & Winters of Austin, Texas since February 1992 and Wood,
Lucksinger & Epstein, a national healthcare law firm, from May 1981 through
February 1992.
20
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
PRINCIPAL MARKETS AND SALES PRICES OF COMMON EQUITY SECURITIES
The Company's common stock was traded on the New York Stock Exchange under
the symbol "LCA" through November 4, 1997. Since the time of the Mergers, the
Company's common stock has been traded on the NYSE under the symbol "PGN." The
high and low sales prices for each quarter for the last two fiscal years is
presented in the table below:
On November 24, 1997, the Board of Directors of the Company declared a
three-for-one stock split to stockholders of record as of December 15, 1997 to
be paid on December 30, 1997. The information below has been adjusted to give
effect to this stock split.
FISCAL YEAR 1997 FISCAL YEAR 1996
----------------------- -----------------------
QUARTER ENDED HIGH LOW HIGH LOW
------------- -------- -------- -------- --------
December 31...... 9 7/16 9 3/16 11 11/16 8 1/2
March 31......... 11 3/4 11 1/4 13 11/16 10 1/2
June 30.......... 13 1/4 12 15/16 13 1/16 10 7/8
September 30..... 13 11/16 12 1/2 9 3/8 6 15/16
NUMBER OF STOCKHOLDERS
As of December 19, 1997, there were approximately 1,248 owners of record of
the Company's common stock.
DIVIDENDS
The Company has not paid any cash dividends on its common stock since
inception and it does not currently anticipate paying any such dividends on
its common stock. The Company's Senior Credit Facility, indenture with respect
to the Notes, and various other note agreements contain covenants which
effectively limit the ability of the Company to pay cash dividends. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Liquidity and Capital Resources" and Note 5 to the Consolidated
Financial Statements.
21
ITEM 6. SELECTED FINANCIAL INFORMATION
The following selected financial data are derived from LCA's Consolidated
Financial Statements, which have been audited by Ernst & Young LLP,
independent auditors. The Consolidated Financial Statements give retroactive
effect to the acquisition of BCC as though the transaction occurred on
September 30, 1992; such transaction has been accounted for using the pooling
of interests method of accounting. THE CONSOLIDATED FINANCIAL STATEMENTS DO
NOT GIVE EFFECT TO THE MERGERS. The information set forth below is qualified
by reference to, and should be read in conjunction with, the Consolidated
Financial Statements and the Notes thereto, and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" included elsewhere
in this filing. All dollar amounts are presented in thousands, except per
share amounts.
YEARS ENDED SEPTEMBER 30,
--------------------------------------------------------------------
1997 1996 1995 1994 1993
------------- ------------- ------------ ------------ ------------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AND STATISTICAL DATA)
INCOME STATEMENT DATA:
Net revenues.......... $ 1,140,288 $ 1,114,491 $ 893,869 $ 708,873 $ 576,140
Income from
operations........... 95,108 89,556 57,005 49,468 38,464
Interest expense,
net................ 16,852 12,461 10,817 10,894 8,998
Equity
earnings/minority
interests.......... (735) (156) (204) 1,603 1,582
Net Income.......... 43,917 43,180 24,234 26,616 20,899
Pro forma taxes(1).... -- -- 599 899 899
Pro forma net
income(1)............ 43,917 43,180 23,635 25,717 20,000
Earnings per share(2). $ 0.74 $ 0.71 $ 0.42 $ 0.52 $ 0.44
Pro forma earnings per
share(1)(2).......... $ 0.74 $ 0.71 $ 0.41 $ 0.50 $ 0.42
Weighted average
number of shares
outstanding (in
thousands)(2)........ 59,325 60,945 57,102 51,240 47,472
OPERATING STATISTICS:
Number of centers (end
of period)........... 202 206 294 288 267
Average occupancy
rate................. 82.9% 83.9% 85.1% 85.2% 84.3%
Percentage of patient
revenues from:
Private............. 33.4% 31.9% 25.5% 23.7% 24.0%
Medicare............ 25.7 25.5 23.9 17.5 13.6
Medicaid............ 40.9 42.6 50.6 58.8 62.4
Percentage operating
margin............... 8.3% 8.0% 6.4% 7.0% 6.7%
SEPTEMBER 30,
--------------------------------------------------------------------
1997 1996 1995 1994 1993
------------- ------------- ------------ ------------ ------------
BALANCE SHEET DATA:
Working capital....... $102,104 $101,091 $34,631 $ 14,955 $ 15,960
Total assets.......... 874,367 809,612 730,708 525,639 376,248
Long term debt,
including current
portion.............. 295,959 276,448 216,910 206,097 135,409
Stockholders' equity.. 375,283 329,315 303,596 172,018 119,432
Total capitalization.. 671,242 605,763 520,506 378,115 254,841
- --------
(1) A pro forma income tax provision has been provided to reflect the
estimated federal and state income taxes as if all BCC S corporations were
taxable entities. See Note 1 to Consolidated Financial Statements.
(2) Earnings per share and number of shares outstanding have been adjusted to
reflect the three-for-one stock split. See Note 19 to Consolidated
Financial Statements.
22
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
On November 4, 1997, in connection with the Mergers, LCA changed its name to
"Paragon Health Network, Inc." While "Paragon" is the same legal entity as
"LCA," following the Mergers the financial position of the Company was
significantly different from the financial position of the Company prior to
the Mergers. The historical financial information contained herein does not
reflect the financial position of the Company on a combined basis because the
Mergers were consummated subsequent to the Company's fiscal year end of
September 30, 1997. Accordingly, all financial information as of September 30,
1997 contained herein should not be construed as being indicative of the
financial position of the Company following the Mergers unless otherwise
noted. For an additional discussion of the Mergers, see Notes 1 and 19 to the
Consolidated Financial Statements.
On November 24, 1997, the Board of Directors of the Company declared a
three-for-one stock split to stockholders of record as of December 15, 1997 to
be paid on December 30, 1997. The per share information contained in this
section, and in the Company's Consolidated Financial Statements, is presented
on a pro forma basis in order to give effect to the stock split.
The Company derives its revenues by providing: (i) post-acute care; (ii)
pharmacy, therapy, subacute and other specialty medical services; and (iii)
contract management of specialty medical programs for acute care hospitals. In
general, the Company generates higher revenues and operating income from the
provision of specialty medical services than from routine skilled nursing
care. The Company seeks to enhance its operating margins by increasing the
proportion of its revenues derived from specialty medical services.
Subacute care refers to complex medical care and intensive nursing care
provided to patients with high acuity disorders. Post-acute care refers to any
care that a patient receives after discharge from an acute care hospital
setting, including subacute, long-term and specialty medical care. Long-term
care refers to care, typically conducted over an extended period of time, at a
skilled nursing or assisted living facility, as well as care rendered in a
patient's home, regardless of whether such care is rendered following
discharge from an acute care hospital. Specialty medical services refer to any
service provided by the Company other than routine skilled nursing care.
The Company's revenues and profitability are affected by ongoing efforts of
third-party payors to contain healthcare costs by limiting reimbursement
rates, increasing case management review and negotiating reduced contract
pricing. Government payors, such as state-administered Medicaid programs and,
to a lesser extent, the federal Medicare program, generally provide more
restricted coverage and lower reimbursement rates than private pay sources.
23
RESULTS OF OPERATIONS
The following table sets forth data from the statement of income expressed
as a percentage of net revenues:
YEARS ENDED SEPTEMBER 30,
----------------------------
1997 1996 1995
-------- -------- --------
Net Revenues:
Nursing home.............................. 65.6% 69.7% 82.6%
Non-nursing home:
Pharmacy................................ 17.3 11.4 10.4
Therapy................................. 15.7 18.5 6.6
Other................................... 1.4 0.4 0.4
-------- -------- --------
100.0 100.0 100.0
-------- -------- --------
Costs and Expenses:
Salaries and wages........................ 38.5 40.9 40.3
Employee benefits......................... 8.6 8.7 9.1
Nursing, dietary, and other supplies...... 4.7 5.4 6.3
Ancillary services........................ 19.7 16.9 16.6
General and administrative................ 14.2 15.1 15.1
Depreciation and amortization............. 3.5 3.5 3.5
Provision for bad debts................... 2.3 1.5 1.3
Life insurance proceeds................... -- (0.2) --
Gain on sale.............................. -- (2.0) --
Impairment of long-lived assets........... -- 1.9 --
Other..................................... -- 0.3 --
Mergers and acquisition cost.............. 0.2 -- 1.4
-------- -------- --------
Income from operations...................... 8.3 8.0 6.4
Interest expense, net....................... 1.5 1.1 1.2
-------- -------- --------
Income before income taxes and equity
earnings/minority interest................. 6.8 6.9 5.2
Provision for income taxes.................. 2.9 3.0 2.4
-------- -------- --------
Income before equity earnings/minority
interest................................... 3.9 3.9 2.8
Equity earnings/minority interest........... -- -- --
-------- -------- --------
Net income.................................. 3.9 3.9 2.8
Pro forma taxes............................. -- -- 0.1
-------- -------- --------
Pro forma net income........................ 3.9% 3.9% 2.7%
======== ======== ========
Nursing home revenues are derived from the provision of two basic services:
routine services ($590.7 million or 79.0% in fiscal year 1997) and ancillary
services ($157.4 million or 21.0% in fiscal year 1997) and are a function of
occupancy rates in the long-term care facilities and the payor mix. Occupancy
rates, as identified in the following table, decreased in fiscal year 1997 due
to the divestiture of DevCon (see Note 2 to the Consolidated Financial
Statements) in the fourth quarter of fiscal year 1996 and a higher level of
competitive activity resulting from an increase in hospital-operated skilled
units, assisted living facilities, and other alternative care providers in key
markets. The DevCon divestiture reduced weighted average licensed bed count by
1,604 and total average residents by 1,428 for fiscal year 1997. The Company
has invested in the marketing and managed care areas and has implemented an
aggressive marketing program to increase census and improve quality mix.
24
YEARS ENDED SEPTEMBER 30,
----------------------------
1997 1996 1995
-------- -------- --------
Weighted average licensed bed count......... 23,028 25,498 26,355
Total average residents..................... 19,095 21,405 22,428
Average occupancy........................... 82.9% 83.9% 85.1%
Payor mix is the source of payment for the services provided and consists of
private pay, Medicare and Medicaid. Private pay includes revenue from
individuals who pay directly for services without governmental assistance
through the Medicare and Medicaid programs. These sources include managed care
companies, commercial insurers, health maintenance organizations and Veteran's
administration contractual payments. Managed care as a payor source to health
care providers is expected to increase over the next several years. The
Company has increased its managed care contracting capabilities and has
created a system which allows the centralized case management of these
patients within targeted markets. However, the impact to the Company of this
increasing payor source cannot be determined at this time.
Reimbursement rates from government sponsored programs, such as Medicare and
Medicaid, are strictly regulated and subject to funding appropriations from
federal and state governments. To the extent unfavorable changes in economic
conditions impact payments under governmental or third-party payor programs,
the Company would be adversely affected. See "Business--Regulation." Revenues
derived from the Company's pharmacy and therapy groups are also influenced by
payor mix. The table below presents the approximate percentage of the
Company's net patient revenues derived from the various sources of payment for
the periods indicated:
YEARS ENDED SEPTEMBER 30,
----------------------------
1997 1996 1995
-------- -------- --------
Private pay................................. 33.4% 31.9% 25.5%
Medicare.................................... 25.7% 25.5% 23.9%
Medicaid.................................... 40.9% 42.6% 50.6%
The higher percentage of revenues derived from private pay sources for
fiscal year 1997 is primarily attributable to the growth in the Company's
pharmacy operations, which had a higher percentage of revenue derived from
private pay sources than any other pay source, and the divestiture of DevCon
in the fourth quarter of fiscal year 1996 which resulted in a reduction in the
percentage of net revenue derived from the Medicaid program for fiscal year
1997. In addition to pharmacy operations, the higher percentages of revenue
derived from private pay and Medicare sources in fiscal year 1996 is primarily
attributable to the acquisitions of American Rehabilitation Services, Inc. and
TMI late in fiscal year 1995. Average reimbursement rates for Medicare
patients have also increased more rapidly than for Medicaid residents due
primarily to the higher reimbursement rates associated with the increase in
acuity levels. Although cost reimbursement for Medicare residents generates a
higher level of revenue per patient day, profitability is not proportionally
increased due to the additional costs associated with the required higher
level of care and other services for such residents.
The administrative procedures associated with the Medicare cost
reimbursement program generally preclude final determination of amounts due
the Company until cost reports are audited or otherwise reviewed and settled
with the applicable administrative agencies. The Company does not expect any
differences between revenue recorded and as finally determined to have a
significant effect on the Company's results of operations or financial
position. See Note 1 to the Consolidated Financial Statements.
Costs and expenses, excluding depreciation and amortization, primarily
consist of salaries, wages, and employee benefits. Various federal, state, and
local regulations impose, depending on the services provided, a variety of
regulatory standards for the type, quality and level of personnel required to
provide care or services. These regulatory requirements have an impact on
staffing levels, as well as the mix of staff, and therefore impact total costs
and expenses. See "Business--Regulation." The cost of ancillary services,
which includes pharmaceuticals, is also affected by the level of service
provided and patient acuity. General and administrative
25
expenses include the cost of the Company's various insurance programs, except
worker's compensation. See Note 12 to the Consolidated Financial Statements.
Fiscal 1997 Compared to Fiscal 1996. Net revenues comprising nursing home
and non-nursing home operations totaled $1.1 billion for the year ended
September 30, 1997, an increase of $25.8 million or 2.3%, as compared to
fiscal 1996. Revenues from nursing home operations decreased by $28.5 million,
which included $63.5 million due to divestitures, primarily the disposition of
the DevCon operations in the fourth quarter of fiscal 1996, and an $8.0
million reduction due to lower average occupancy rates. Rate increases of
$30.2 million and higher ancillary service billings of $13.8 million resulting
from the improvement in mix, primarily Medicare, partially offset the nursing
home revenue decreases. Non-nursing home revenue increased by $54.3 million
which consisted of an increase of $69.3 million for pharmacy services, a
decrease of $26.3 million for therapy services, and an increase of $11.3
million from home health, hospice and other services. The acquisition of
pharmacies in fiscal year 1996 that occurred late in the year primarily caused
the increase in pharmacy services revenue. The closure of approximately 30
clinics during fiscal 1996 that no longer met the Company's financial or
operating objectives resulted in a decrease in therapy services revenue. The
increase in home health, hospice and other services is primarily due to the
purchase of Colorado Home Care, Inc. in January 1997 and the purchase of the
remaining 50% interest in Heart of America Hospice, LLC during fiscal year
1997.
Costs and expenses totaled $1.0 billion for the year ended September 30,
1997, an increase of $20.2 million or 2.0%, as compared to fiscal 1996.
Excluding divestitures, costs for payroll and employee benefits, ancillary,
and general and administrative increased by $19.2, $38.1, and $7.0 million,
respectively. The increase in ancillary services was primarily the result of
higher pharmaceutical costs related to the increase in pharmacy services
revenue. Divestitures, primarily DevCon, reduced total expenses by $53.0
million.
The provision for bad debt expense increased by $9.6 million for the year
ended September 30, 1997, which included a reduction of $1.9 million due to
collection of a note receivable and other receivable that were substantially
reserved. The remaining increase of $11.5 million was primarily due to an
increase in average days outstanding for accounts receivable related to the
increase in pharmacy revenues, which have a higher provision for bad debts,
and focused Medicare reviews in several states for therapy operations, which
delays the payment cycle for Medicare receivables while each claim receives a
medical review. In addition, the centralization of billing and collection for
therapy operations resulted in delayed billing and a longer billing cycle
which resulted in an increase in average days outstanding for receivables. In
order to improve the collection process, therapy operations have improved the
timeliness of billing, implemented new collection procedures, and opened three
new regional collections sites for the clinics. Therapy operations were
partially removed from focused billing review in Texas during the third fiscal
quarter and fully removed in October 1997, although certain other states
remain on billing review. Although significant reductions in average days
outstanding were achieved during the fourth quarter of fiscal 1997, average
days outstanding for the therapy operations remain high compared to historical
levels. As a result, the Company recorded an additional provision for bad
debts of $5.0 million during the fourth quarter to reserve for potential
uncollectibility on the older accounts.
Merger and acquisition costs increased total expenses in fiscal year 1997 by
$2.6 million compared to a reduction of costs and expenses in fiscal 1996 of
$1.1 million from non-recurring items. The merger and acquisition costs of
$2.6 million for fiscal 1997 were related to the Mergers. The $1.1 million
reduction of expense from non-recurring items for 1996 consisted of a $2.0
million gain from the receipt of life insurance proceeds on the former
President of the rehabilitation services group, a $22.5 million gain in
September 1996 on the sale of the DevCon operations, a $2.9 million charge
primarily related to the closure of the Company's medical supplies business
and write-off of unamortized loan acquisition costs related to the Second
Amended and Restated Credit Agreement, and a $20.5 million impairment loss
related to the adoption of SFAS 121 (see Note 8 to the Consolidated Financial
Statements).
Net interest expense totaled $16.9 million for the year ended September 30,
1997, an increase of $4.4 million as compared to the same period for fiscal
1996. The increase reflected interest expense to finance the
26
higher average level of working capital during fiscal year 1997, additional
debt to purchase $20.0 million of the Company's common stock late in fiscal
1996, and acquisitions, investments, and other capital expenditures during
fiscal 1997.
The provision for income taxes totaled $33.6 million in fiscal year 1997, a
decrease of $0.2 million from fiscal year 1996. The 1997 effective tax rate of
43.3% was 0.5% lower than the 1996 effective rate as a result of lower
amortization of non-deductible goodwill amortization and higher tax credits
which were partially offset by non-deductible merger and acquisition costs.
Fiscal 1996 Compared to Fiscal 1995. Net revenues comprising nursing home
and non-nursing home operations totaled $1.1 billion for the year ended
September 30, 1996, an increase of $220.6 million or 24.7%, as compared to
fiscal 1995. Nursing home operations contributed $38.1 million of the increase
which included rate increases of $37.2 million and higher ancillary service
billings resulting from the improvement in patient mix, primarily Medicare, of
$22.6 million. Divestiture of nursing home operations decreased revenue $19.6
million and lower census reduced revenue by $7.6 million. Non-nursing home
operations contributed $182.5 million of the increase, consisting of $34.6
million from pharmacy operations, $146.5 million from therapy services and
$1.4 million from medical supplies. Acquisitions, primarily Rehability,
provided $177.0 million of the $182.5 million increase in non-nursing home
revenue.
Costs and expenses, including non-recurring items, totaled $1.0 billion for
the year ended September 30, 1996, an increase of $188.1 million or 22.5%, as
compared to fiscal 1995. Acquisitions, primarily Rehability and TMI, were
$171.0 million of the increase, and divestitures reduced total expenses by
$24.3 million. Other increases include payroll and related items ($15.8
million) and ancillary services ($28.4 million). The increase in ancillary
services corresponds to the increase in ancillary revenue and the higher level
of patient acuity as well as an increase in the cost of pharmaceuticals
related to higher pharmacy services revenue.
Non-recurring items reduced total costs and expenses in fiscal year 1996 by
$1.1 million compared to the $12.4 million of merger and acquisition costs
from the BCC purchase in fiscal 1995. Non-recurring items included a $2.0
million gain from the receipt of life insurance proceeds on the former
President of the Rehabilitation Services Group. In addition, the Company
recognized a $22.5 million gain in September 1996 on the sale of its DevCon
operations, which provided training and habilitation services to individuals
with mental retardation and developmental disabilities, through the
recapitalization and subsequent sale of the majority of DevCon's stock for
$47.5 million. The Company also recorded charges of $2.9 million primarily
related to the closure of its medical supplies business and the write-off of
unamortized loan acquisition costs related to the Second Amended and Restated
Credit Agreement.
The adoption of SFAS 121, which occurred in the fourth quarter, resulted in
the identification and measurement of an impairment loss of $20.5 million
related to nursing facilities with a history of cash flow losses ($1.8
million), certain other nursing facilities where management believed an
impairment existed as a result of the competitive environment ($0.6 million),
goodwill, primarily TMI ($9.7 million), and other assets to be disposed ($8.4
million). Management estimated the undiscounted cash flows to be generated by
each of these assets and compared them to their carrying value. If the
undiscounted future cash flow estimates were less than the carrying value of
the asset then the carrying value was written down to estimated fair value.
Goodwill associated with an impaired asset was included with the carrying
value of that asset in performing both the impairment test and in measuring
the amount of impairment loss related to the asset. Fair value was estimated
based on either management's estimate of fair value, present value of future
cash flows, or market value less estimated cost to sell for certain facilities
to be disposed. The facilities with a history of cash flow losses operated at
a loss for periods ranging from one to four years. The undiscounted cash flows
for TMI were estimated based on the operating results of TMI subsequent to the
death of the President of the rehabilitation services group (founder of TMI)
and adjusted for the loss of contracts and impending business changes as a
result of his death (See Note 7 to the Consolidated Financial Statements). The
decision regarding the disposition of certain nursing facilities, which had
operating losses of $0.4 million during fiscal 1996, was completed at the time
of adoption of SFAS 121. See Note 8 to the Consolidated Financial Statements.
27
Net interest expense totaled $12.5 million for the year ended September 30,
1996, an increase of $1.6 million or 15.2%, as compared to the same period for
fiscal 1995. The increase reflects a full year of interest expense for fiscal
1996 versus three months of interest expense for fiscal 1995 on the additional
debt incurred to acquire Rehability.
The provision for income taxes increased $12.0 million in fiscal year 1996
but resulted in a lower effective tax rate of 43.8% compared to 47.1% in
fiscal year 1995. The decrease in non-deductible merger and acquisition costs
reduced the effective tax rate by 7.2% while the elimination of the Targeted
Jobs Tax Credit, increased non-deductible goodwill amortization, and other
items resulted in an increase of 3.9%.
SEASONALITY
The Company's revenues and operating income generally fluctuate from quarter
to quarter. This seasonality is related to a combination of factors which
include the timing of Medicaid rate increases, the number of work days in the
period, and seasonal census cycles.
LIQUIDITY AND CAPITAL RESOURCES--HISTORICAL
Cash and cash equivalents were $14.4 million at September 30, 1997, a $7.0
million decrease from September 30, 1996, and working capital was $102.1
million, an increase of $1.0 million during fiscal year 1997. Cash provided by
operations was $54.8 million or $23.0 million more than fiscal year 1996. Net
income of $43.9 million and non-cash items totaling $65.6 million contributed
to the cash provided by operations. These items were offset by the decrease in
accrued expenses and other current liabilities of $5.7 million, primarily
related to income taxes due on the gain on sale of DevCon stock that were paid
in the second quarter of fiscal year 1997, and an increase in receivables of
$44.4 million. The increase in receivables was primarily attributable to
acquisitions ($4.1 million), revenue increases ($18.8 million), and an
increase in average days outstanding ($14.8 million).
The increase in receivables resulting from an increase in average days
outstanding is primarily related to the Company's therapy operations. The
increase in receivables for the therapy operations is related to the
centralization of billing and collection which resulted in delayed billing and
a longer billing cycle, and focused billing review, primarily in Texas.
Focused billing review substantially increases the processing time for payment
of therapy services by fiscal intermediaries. Therapy operations were
partially removed from focused billing review in Texas during the third fiscal
quarter and fully removed in October 1997, although certain other states
remain on billing review. In addition, therapy operations have implemented new
collection procedures and opened three new regional collection sites for the
clinics to improve the collection process. Although significant reductions in
average days outstanding were achieved during the fourth quarter of fiscal
1997, average days outstanding for the therapy operations remain high compared
to historical levels. As a result, the Company recorded an additional
provision for bad debts of $5.0 million during the fourth quarter to reserve
for potential uncollectibility on the older accounts.
Cash used in investing activities was $77.3 million in fiscal 1997 compared
to $66.7 million in fiscal year 1996. Investing activities in fiscal year 1997
included five pharmacy related acquisitions ($6.9 million), construction of
three assisted living facilities and expansion of existing facilities ($8.2
million), the acquisition of the remaining 50% interest in a hospice operation
($3.3 million), the acquisition of two home health agencies ($4.1 million),
and routine capital expenditures. Capital commitments on one assisted living
facility remaining under construction and expansion of existing long-term care
facilities totaled $2.2 million at September 30, 1997. These commitments are
expected to be funded by cash from operations or the Senior Credit Facility.
Cash flow from the disposition of assets was primarily related to the
divestiture of two long-term care facilities in Texas. Restricted investments
increased $20.5 million due to the collection of outstanding receivables from
the Company's third party insurance carrier and current year funding.
Financing activities provided $15.4 million during fiscal 1997 and were
primarily used to fund acquisitions, investments, and other capital
expenditures. In addition to the Senior Credit Facility, the Company has a
lease arrangement providing for up to $100.0 million to be used as a funding
mechanism for future assisted living and skilled nursing facility
construction, lease conversions, and other facility acquisitions (the
"Synthetic Lease"). This leasing program allows the Company to complete these
projects without committing significant financing
28
resources. The lease is an unconditional "triple net" lease for a period of
seven years with the annual lease obligation a function of the amount spent by
the lessor to acquire or construct the project, a variable interest rate, and
commitment and other fees. The Company guarantees a minimum of approximately
83% of the residual value of the leased property and also has an option to
purchase the properties at any time prior to the maturity date at a price
sufficient to pay the entire amount financed, accrued interest, and certain
expenses. At September 30, 1997 approximately $28.9 million of this leasing
arrangement was utilized. The leasing program is accounted for as an operating
lease.
LIQUIDITY AND CAPITAL RESOURCES--FOLLOWING THE TRANSACTIONS
Senior Credit Facility. Prior to the Mergers, both LCA and GranCare
maintained senior credit facilities that were replaced with a new Senior
Credit Facility in connection with the Mergers. The Senior Credit Facility
consists of four components: a 6 1/2 year term loan facility in an aggregate
principal amount of $240 million (the "Tranche A Term Loan Facility"); a 7 1/2
year term loan facility in an aggregate principal amount of $250 million (the
"Tranche B Term Loan Facility"); an 8 1/2 year term loan facility in an
aggregate principal amount of $250 million (the "Tranche C Term Loan
Facility"); and a 6 1/2 year revolving credit facility in the maximum amount
of $150 million (the "Revolving Credit Facility"). Loans made under the
Tranche A Term Loan Facility ("Tranche A Term Loans"), the Tranche B Term Loan
Facility ("Tranche B Term Loans") and the Tranche C Term Loan Facility
("Tranche C Term Loans") are collectively referred to herein as "Term Loans."
Advances under the Revolving Credit Facility are sometimes referred to as
"Revolving Loans." The proceeds from borrowings under the Term Loans were
used, along with the proceeds of the Senior Subordinated Notes offering, to
fund a portion of the Recapitalization Merger, refinance a significant portion
of LCA's and GranCare's pre-merger indebtedness and to pay costs and expenses
associated with the Mergers.
The Term Loans will be amortized in quarterly installments totaling $0,
$26.5 million, $49.0 million, $51.5 million, $51.5 million, $56.5 million,
$186.0 million, $239.0 million and $80 million in the fiscal years 1998, 1999,
2000, 2001, 2002, 2003, 2004, 2005 and 2006, respectively. Principal amounts
outstanding under the Revolving Credit Facility will be due and payable in
April 2005. With the exception of approximately $14.0 million of letter of
credit issuances, as of December 19, 1997, there were no amounts borrowed
under the Revolving Credit Facility.
Interest on outstanding borrowings will accrue, at the option of the
Company, at the customary Alternate Base Rate (the "ABR") of The Chase
Manhattan Bank ("Chase") or at a reserve adjusted Eurodollar Rate (the
"Eurodollar Rate") plus, in each case, an Applicable Margin. The term
"Applicable Margin" means a percentage that will vary in accordance with a
pricing matrix based upon the respective term loan tenor and the Company's
leverage ratio. Through April 1998, the Applicable Margin for Revolving Loans
and Tranche A Term Loans will equal 1.25% for loans based on ABR ("ABR Loans")
and 2.25% for loans based on the Eurodollar Rate ("Eurodollar Loans"); for
Tranche B Term Loans, 1.50% in the case of ABR Loans and 2.50% in the case of
Eurodollar Loans; and for Tranche C Term Loans, 1.75% in the case of ABR Loans
and 2.75% in the case of Eurodollar Loans.
Subject in each case to certain exceptions, the following amounts are
required to be applied, as mandatory prepayments, to prepay the Term Loans:
(i) 75% of the net cash proceeds of the sale or issuance of equity by the
Company; (ii) 100% of the net cash proceeds of the incurrence of certain
indebtedness; (iii) 75% of the net cash proceeds of any sale or other
disposition by the Company or any of its subsidiaries of any assets (excluding
the sale of inventory and obsolete or worn-out property, and subject to a
limited exception for reinvestment of such proceeds within 12 months); and
(iv) 75% of excess cash flow for each fiscal year, which percentage will be
reduced to 50% in the event the Company's leverage ratio as of the last day of
such fiscal year is not greater than 4.50 to 1.00. Mandatory prepayments will
be applied pro rata to the unmatured installments of the Tranche A Term Loans,
the Tranche B Term Loans and the Tranche C Term Loans; provided, however, that
as long as any Tranche A Term Loans remain outstanding, each holder of a
Tranche B Term Loan or a Tranche C Term Loan will have the right to refuse any
such mandatory prepayment otherwise allocable to it, in which case the amount
so refused will be applied as an additional prepayment of the Tranche A Term
Loans. The Company will also have the right to prepay the Senior Credit
Facility, in whole or in part, at its option. Partial prepayments must be in
minimum amounts of $1 million and in increments of $100,000 in excess thereof.
29
Amounts applied as prepayments of the Revolving Credit Facility may be
reborrowed; amounts prepaid under the Term Loans may not be reborrowed.
Senior Subordinated Notes. Also in connection with the Mergers, on November
4, 1997 the Company completed a private offering to institutional investors of
$275 million of its 9.5% Senior Subordinated Notes due 2007, at a price of
99.5% of face value and $294 million of its 10.5% Senior Subordinated Discount
Notes due 2007, at a price of 59.6% of face value (collectively, the "Notes").
Interest on the Senior Subordinated Notes is payable semi-annually commencing
May 1, 1998. Interest on the Senior Subordinated Discount Notes will accrete
until November 1, 2002 at a rate of 10.57% per annum, compounded semi-
annually, and will be cash pay thereafter. The Notes will mature on November
1, 2007. The net proceeds from this offering, along with proceeds from the
Senior Credit Facility, were used to fund a portion of the Recapitalization
Merger, refinance a significant portion of LCA's and GranCare's pre-merger
indebtedness and to pay costs and expenses associated with the Mergers.
Other Significant Indebtedness. In connection with the Mergers, the Company
became a party to various agreements between GranCare and Health and
Retirement Properties Trust ("HRPT") and Omega Healthcare Investors, Inc.
("Omega"). HRPT is the holder of a mortgage loan to AMS Properties, Inc. ("AMS
Properties"), a wholly owned subsidiary of the Company, dated October 1, 1994,
in the aggregate principal amount of $11.5 million (the "HRPT Loan"). The HRPT
Loan is secured, in part, by mortgage and security agreements dated as of
March 31, 1995 (collectively, the "HRPT Mortgage") in favor of HRPT and
encumbering two nursing facilities in Wisconsin owned by AMS Properties. HRPT
has also leased seven nursing facilities located in Arizona, California and
South Dakota to GCI Health Care Centers, Inc. ("GCIHCC") under a master lease
agreement dated as of June 30, 1992 (the "GCIHCC Lease").
In connection with certain transactions effected in February 1997 by
GranCare's predecessor with Vitalink Pharmacy Services, Inc. ("Vitalink"),
Vitalink (a) paid a consent fee to HRPT in the amount of $10 million, which
was promptly reimbursed by GranCare immediately following the consummation of
the transactions with Vitalink and (b) entered into a limited guaranty (not to
exceed $15 million in the aggregate) of the obligations by GranCare, AMS
Properties and GCIHCC under the HRPT Mortgages, the GCIHCC Lease and the HRPT
Loan (collectively, the "HRPT Obligations") for so long as such obligations
remained outstanding. To support Vitalink's limited guaranty of the foregoing
obligations, GranCare caused an irrevocable letter of credit to be issued to
Vitalink in the event Vitalink made any payments under the limited guaranty
(the "HRPT Letter of Credit").
In connection with obtaining HRPT's consent to the Mergers, GranCare and
HRPT executed a Restructure and Asset Exchange Agreement dated October 31,
1997 pursuant to which HRPT and GranCare are in the process of restructuring
their relationship (the "HRPT/GranCare Restructuring"). As a part of the
HRPT/GranCare Restructuring, HRPT consented to the consummation of the Mergers
and the transactions related thereto. In addition, Vitalink's guaranty of the
HRPT Obligations was released and the HRPT Letter of Credit was terminated and
replaced with an unlimited guaranty by the Company and all subsidiaries of the
Company having an ownership interest in AMS and/or GCIHCC (individually, a
"Tenant Entity" and collectively, the "Tenant Entities") which guaranty is
secured by a cash collateral deposit of $15 million, the earned interest on
which is retained by HRPT. The performance by the Tenant Entities of their
respective obligations to HRPT continues to be secured by a pledge of one
million shares of HRPT common stock beneficially owned by GranCare and, as
part of the HRPT/GranCare Restructuring, GranCare agreed to waive the ability
to request a release of such collateral upon the attainment of certain
financial conditions. Accordingly, the Company does not have the ability to
sell these shares to meet any capital requirements. The terms of the leases
between HRPT and the Tenant Entities were extended to January 31, 2013,
constituting lease extensions ranging from 3 to 7 years and the aggregate base
rental for all facilities leased from HRPT (excluding the Exchange Facilities
(as defined below)) increased by $500,000 per year. AMS Properties will also
prepay the $11.5 million HRPT Loan and HRPT will release the HRPT Mortgage. In
addition, by April 29, 1998 the Tenant Entities will exchange, in a
transaction structured as a like-kind exchange transaction (the "Exchange
Transaction"), five nursing facilities (the two nursing facilities previously
subject to the HRPT Mortgage and three nursing facilities currently owned by
the Company (collectively the "Exchange Facilities")) for four nursing
facilities owned by HRPT. Following completion of the Exchange Transaction,
the Tenant Entities will
30
lease back the Exchange Facilities for an aggregate annual rent amount equal
to the aggregate rent on the four HRPT facilities.
In consideration of the HRPT/GranCare Restructuring, the Company paid HRPT a
one time restructuring payment of $10 million. The overall impact of the
HRPT/GranCare Restructuring is not expected to have any material effect on the
Company's operations or cash flows. The Company also paid an aggregate amount
of $19.0 million to Vitalink Pharmacy Services, Inc. ("Vitalink") and
ManorCare, Inc. ("ManorCare") in connection with the settlement of certain
litigation initiated by Vitalink and ManorCare seeking to enjoin the
consummation of the GranCare Merger.
A wholly owned subsidiary of the Company, Professional Health Care
Management, Inc. ("PHCMI"), is the borrower under a $58.8 million mortgage
note executed on August 14, 1997 (the "Omega Note") in favor of Omega, and
under the related Michigan loan agreement dated as of June 7, 1992 as amended
(the "Omega Loan Agreement"). All $58.8 million was outstanding as of December
28, 1997.
The Omega Loan bears interest at a rate which is adjusted annually based on
either (i) changes in the Consumer Price Index or (ii) a percentage of the
change in gross revenues of PHCMI and its subsidiaries from year to year,
divided by 58.8 million, whichever is higher, but in any event subject to a
maximum rate not to exceed 105% of the interest rate in effect for the Omega
Loan for the prior calendar year. The current interest rate is 14.5% per
annum. The Omega Loan currently requires monthly, interest-only payments.
Additional interest accrues on the outstanding principal of the Omega Loan at
the rate of 1% per annum. Such interest is compounded annually and is due and
payable on a pro rata basis at the time of each principal payment or
prepayment. Beginning October 1, 2002, quarterly amortizing installments of
principal in the amount of $1.5 million will also become due and payable on
the first day of each calendar quarter. The entire outstanding principal
amount of the Omega Loan is due and payable on August 13, 2007. The Omega Loan
may be prepaid without penalty during the first 100 days following August 14,
2002. Payment of the Omega Loan after acceleration upon the occurrence of an
event of default will result in a prepayment penalty in the nature of a "make
whole" premium.
In addition to the interest on the Omega Loan described in the preceding
paragraph, and as a condition to obtaining Omega's consent to the transaction
between Vitalink and GranCare, PHCMI agreed to pay additional interest to
Omega in the amount of $20,500 per month, through and including July 1, 2002.
If the principal balance of the Omega Loan for any reason becomes due and
payable prior to that date, there will be added to the indebtedness owed by
PHCMI: (i) the sum of $1.0 million, plus; (ii) interest thereon at 11% per
annum to the prepayment date; less (iii) the amount of such additional
interest paid to Omega prior to the prepayment date.
As substitute collateral for certain divested PHCMI facilities, and as
consideration for granting its consent to such divestiture, Omega required
GranCare to cause a letter of credit in favor of Omega to be issued in the
amount of $9.0 million (the "Omega Letter of Credit"). The Omega Letter of
Credit can be drawn upon following the occurrence of: (i) any event of default
under the Omega Loan documents; (ii) if the Omega Letter of Credit is not
renewed or extended at least 30 days prior to its scheduled expiration date
(currently March 31, 1998); or (iii) if certain representations, warranties or
covenants of PHCMI under the Omega Loan documents are breached and such
breaches are not cured within the prescribed time after notice. Following the
Mergers, the Company caused the Omega Letter of Credit to be replaced with a
new standby letter of credit issued under the Senior Credit Facility.
The Omega Loan Agreement obligates PHCMI, among other things, to maintain a
minimum tangible net worth of at least $10 million, increased or decreased by
25% of PHCMI's net income (but in no event less than $10 million). The Company
must contribute additional equity to PHCMI if and when necessary to assure
that such minimum tangible net worth test is met. PHCMI has satisfied this
test in the past without the contribution of additional equity and management
believes that it will continue to do so in the future.
Other Factors Affecting Liquidity and Capital Resources. While federal
regulations do not provide states with grounds to curtail payments under their
Medicaid reimbursement programs due to state budget deficiencies or delays in
enactment of new budgets, states have nevertheless curtailed payments in such
circumstances in the past. In particular, some states have delayed the payment
of significant amounts owed to health care providers
31
such as the Company for health care services provided under their respective
Medicaid programs. The failure by a state to reimburse the Company for its
Medicaid receivables could have a material adverse effect on the financial
position of the Company.
In addition to principal and interest payments on its long-term
indebtedness, the Company has significant rent obligations relating to its
leased facilities. The Company's estimated principal payments, cash interest
payments, and rent obligations for 1998 are approximately $187 million.
The Company's operations require capital expenditures for renovations of
existing facilities in order to continue to meet regulatory requirements, to
upgrade facilities for the treatment of subacute patients and to accommodate
the addition of specialty medical services, and to improve the physical
appearance of its facilities for marketing purposes. The Company estimates
that total capital expenditures for the year ending September 30, 1998 will be
approximately $60 million of which $30 million represents maintenance capital
expenditures.
Management is in the process of integrating the operations of LCA and
GranCare and conforming their respective accounting policies. As discussed
above, LCA's provision for bad debt expense increased by $9.6 million for the
year ended September 30, 1997 as compared to the prior fiscal year, primarily
as the result of an increase in average days outstanding for accounts
receivable related to the increase in pharmacy revenues, focused Medicare
reviews in several states for therapy operations, and the centralization of
billing and collection for therapy operations. In addition, GranCare increased
its provision for bad debt expense by $8.0 million in the quarter ended June
30, 1997 as a result of a change in methodology in calculating bad debt
expense. In connection with conforming the accounting policies of LCA and
GranCare, management is continuing to monitor trends in the Company's accounts
receivable and is reviewing the Company's collection procedures (including the
timing of filing claims for reimbursement) and allowance policy, which could
result in a historical adjustment to GranCare's allowance for bad debts and in
future changes to the Company's bad debt expense.
The Company believes that the cash flow generated from its operations, the
Company's cash and cash equivalents, together with amounts available under the
Senior Credit Facility, should be sufficient to fund its debt service
requirements, working capital needs, anticipated capital expenditures and
other operating expenses. The Revolving Credit Facility will provide the
Company with revolving loans in an aggregate principal amount at any time not
to exceed $150 million, of which $136 million is expected to be available
after considering approximately $14 million in outstanding letters of credit.
The Company's future operating performance and ability to service or refinance
the Notes and to extend or refinance the Senior Credit Facility will be
subject to future economic conditions and to financial, business and other
factors, many of which are beyond the Company's control.
As discussed above, the Company's revenues are a function of occupancy rates
in the Company's facilities and payor mix. Management believes that the
Mergers will have a slightly positive effect on the Company's occupancy rates
and payor mix.
Because the Mergers were completed on November 4, 1997, the Company plans to
recognize the costs associated therewith during the quarter ending December
31, 1997. While management has not yet determined the amount of the costs,
management expects that such costs will be significant.
IMPACT OF INFLATION
The health care industry is labor intensive. Wages and other labor-related
costs are especially sensitive to inflation. Increases in wages and other
labor-related costs as a result of inflation, or the increase in minimum wage
requirements effective September 1997, without a corresponding increase in
Medicaid and Medicare reimbursement rates would adversely impact the Company.
32
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT AUDITORS
To the Stockholders and Board of Directors of Paragon Health Network, Inc.
We have audited the accompanying consolidated balance sheets of Paragon
Health Network, Inc. (formerly Living Centers of America, Inc.) and
subsidiaries as of September 30, 1997 and 1996 and the related consolidated
statements of income, stockholders' equity and cash flows for each of the
three years in the period ended September 30, 1997. Our audits also included
the financial statement schedule listed in the index at Item 14. These
consolidated financial statements and schedule are the responsibility of the
management of Paragon Health Network, Inc. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of Paragon Health Network, Inc., and subsidiaries at September 30, 1997 and
1996, and the consolidated results of their operations and their cash flows
for each of the three years in the period ended September 30, 1997, in
conformity with generally accepted accounting principles. Also, in our
opinion, the related financial statement schedule, when considered in relation
to the basic financial statements taken as a whole, presents fairly, in all
material respects, the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, in the
fourth quarter of 1996, the Company changed its method of accounting for
impairment of long-lived assets in accordance with the adoption of SFAS 121.
ERNST & YOUNG LLP
Houston, Texas
December 10, 1997
33
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)
SEPTEMBER 30,
------------------
ASSETS 1997 1996
------ -------- --------
CURRENT ASSETS:
Cash and cash equivalents................................ $ 14,355 $ 21,394
Receivables (less allowances of $33,138 and $17,405)..... 211,989 192,340
Notes receivable, net.................................... 2,223 3,756
Supplies................................................. 21,237 16,582
Prepaid expenses......................................... 5,276 6,450
Deferred income taxes.................................... 24,294 19,644
Other (including patient trust funds of $3,799 and
$3,768)................................................. 7,855 9,273
-------- --------
TOTAL CURRENT ASSETS................................... 287,229 269,439
PROPERTY AND EQUIPMENT:
Land, buildings and improvements......................... 378,251 359,137
Furniture, fixtures and equipment........................ 121,698 104,363
Leased property under capital leases..................... 12,551 12,551
-------- --------
512,500 476,051
Less accumulated depreciation............................ 210,117 186,333
-------- --------
302,383 289,718
GOODWILL, NET.............................................. 196,120 188,508
RESTRICTED INVESTMENTS..................................... 51,976 31,040
INVESTMENT IN UNCONSOLIDATED AFFILIATE..................... 5 3,016
NOTES RECEIVABLE, NET...................................... 11,200 10,780
OTHER ASSETS............................................... 25,454 17,111
-------- --------
$874,367 $809,612
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
CURRENT LIABILITIES:
Notes payable and current maturities of long-term debt... $ 43,196 $ 13,746
Accounts payable......................................... 46,872 48,088
Accrued payroll and related expenses..................... 66,866 60,089
Accrued property taxes................................... 5,342 4,995
Patient trust funds...................................... 3,799 3,768
Accrued income taxes payable............................. 6,231 16,921
Other accrued expenses................................... 12,819 20,741
-------- --------
TOTAL CURRENT LIABILITIES.............................. 185,125 168,348
LONG-TERM DEBT, NET OF CURRENT MATURITIES.................. 252,763 262,702
LONG-TERM INSURANCE RESERVES............................... 27,555 26,093
MINORITY INTERESTS......................................... 733 289
DEFERRED INCOME TAXES AND OTHER NONCURRENT LIABILITIES..... 32,908 22,865
COMMITMENTS AND CONTINGENCIES..............................
STOCKHOLDERS' EQUITY:
Preferred stock, par value $ .01; 4,650,000 shares
authorized; none issued................................. -- --
Series A--Junior participating preferred stock, par value
$.01; 350,000 authorized and reserved; none issued...... -- --
Common stock, par value $ .01; 75,000,000 shares
authorized; 60,803,760 shares issued.................... 608 608
Capital surplus.......................................... 226,972 227,766
Retained earnings........................................ 164,650 120,733
Unrealized gain (loss) on securities available-for-sale.. 244 (18)
Treasury stock at cost--2,004,444 and 2,301,159 shares... (17,191) (19,774)
-------- --------
TOTAL STOCKHOLDERS' EQUITY............................. 375,283 329,315
-------- --------
$874,367 $809,612
======== ========
The accompanying notes are an integral part of these financial statements.
34
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
YEARS ENDED SEPTEMBER 30,
--------------------------------
1997 1996 1995
---------- ---------- --------
NET REVENUES
Nursing home revenue:
Net patient services..................... $ 742,046 $ 767,747 $724,924
Other.................................... 6,004 8,799 13,556
Non-nursing home revenue:
Pharmacy services........................ 196,748 127,439 92,843
Therapy services......................... 179,506 205,785 59,278
Home health, hospice, and other.......... 15,984 4,721 3,268
---------- ---------- --------
1,140,288 1,114,491 893,869
COSTS AND EXPENSES:
Salaries and wages......................... 438,693 455,702 360,571
Employee benefits.......................... 98,070 96,716 82,007
Nursing, dietary and other supplies........ 53,531 60,427 55,991
Ancillary services......................... 224,912 188,937 148,746
General and administrative................. 161,795 168,333 134,697
Depreciation and amortization.............. 39,309 39,214 31,158
Provision for bad debts.................... 26,282 16,666 11,220
Life insurance proceeds.................... -- (2,015) --
Gain on sale............................... -- (22,451) --
Impairment of long-lived assets............ -- 20,489 --
Other expenses............................. -- 2,917 --
Merger and acquisition costs............... 2,588 -- 12,474
---------- ---------- --------
1,045,180 1,024,935 836,864
---------- ---------- --------
INCOME FROM OPERATIONS................. 95,108 89,556 57,005
INTEREST EXPENSE, NET:
Interest expense........................... 21,492 16,750 15,073
Interest income............................ (4,640) (4,289) (4,256)
---------- ---------- --------
16,852 12,461 10,817
---------- ---------- --------
INCOME BEFORE INCOME TAXES AND EQUITY
EARNINGS/MINORITY INTEREST............ 78,256 77,095 46,188
PROVISION FOR INCOME TAXES................... 33,604 33,759 21,750
---------- ---------- --------
INCOME BEFORE EQUITY EARNINGS/ MINORITY
INTEREST.............................. 44,652 43,336 24,438
EQUITY EARNINGS/MINORITY INTEREST............ (735) (156) (204)
---------- ---------- --------
NET INCOME................................... $ 43,917 $ 43,180 $ 24,234
========== ========== ========
PRO FORMA DATA (UNAUDITED):
INCOME BEFORE PRO FORMA TAXES.............. $ 43,917 $ 43,180 $ 24,234
PRO FORMA TAXES............................ -- -- 599
---------- ---------- --------
PRO FORMA NET INCOME................... $ 43,917 $ 43,180 $ 23,635
========== ========== ========
WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT
SHARES OUTSTANDING.......................... 59,325 60,945 57,102
========== ========== ========
EARNINGS PER SHARE........................... $ 0.74 $ 0.71 $ 0.42
========== ========== ========
PRO FORMA EARNINGS PER SHARE................. $ 0.74 $ 0.71 $ 0.41
========== ========== ========
The accompanying notes are an integral part of these financial statements.
35
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(DOLLARS AND SHARES IN THOUSANDS)
UNREALIZED
COMMON STOCK GAIN TREASURY STOCK
------------- CAPITAL RETAINED (LOSS) ON ----------------
SHARES AMOUNT SURPLUS EARNINGS SECURITIES SHARES AMOUNT TOTAL
------ ------ -------- -------- ---------- ------ -------- --------
BALANCE, SEPTEMBER 30,
1994................... 51,405 $514 $119,500 $54,802 -- 525 $(2,798) $172,018
Net income.............. 24,234 24,234
Transfer S corporation
earnings, net of
distributions.......... (898) 898 0
Stockholder
distributions.......... (2,381) (2,381)
Proceeds from additional
public offering........ 8,625 86 98,975 99,061
Issuance of stock as
consideration for TMI
merger transaction..... 774 8 8,315 8,323
Funding of employee
benefit plans.......... 656 (132) 678 1,334
Funding of options
exercised under 1992
Employee Stock Option
Plan, net of tax....... 146 (162) 861 1,007
------ ---- -------- -------- ---- ----- -------- --------
BALANCE, SEPTEMBER 30,
1995................... 60,804 608 226,694 77,553 -- 231 (1,259) 303,596
Net income.............. 43,180 43,180
Funding of employee
benefit plans.......... 736 (138) 846 1,582
Funding of options
exercised under 1992
Employee Stock Option
Plan, net of tax....... 336 (120) 639 975
Purchase of treasury
stock.................. 2,328 (20,000) (20,000)
Unrealized loss on
securities available-
for-sale............... (18) (18)
------ ---- -------- -------- ---- ----- -------- --------
BALANCE, SEPTEMBER 30,
1996................... 60,804 608 227,766 120,733 (18) 2,301 (19,774) 329,315
Net income.............. 43,917 43,917
Funding of employee
benefit plans.......... 92 (177) 1,521 1,613
Funding of options
exercised under 1992
Employee Stock Option
Plan, net of tax....... (15) (21) 191 176
Issuance of treasury
stock in exchange for
warrants............... (871) (99) 871 0
Unrealized gain on
securities available-
for-sale............... 262 262
------ ---- -------- -------- ---- ----- -------- --------
BALANCE, SEPTEMBER 30,
1997................... 60,804 $608 $226,972 $164,650 $244 2,004 $(17,191) $375,283
====== ==== ======== ======== ==== ===== ======== ========
The accompanying notes are an integral part of these financial statements.
36
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
YEARS ENDED SEPTEMBER 30,
------------------------------
1997 1996 1995
-------- --------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income................................... $ 43,917 $ 43,180 $ 24,234
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization.............. 39,309 39,214 31,158
Income taxes deferred...................... (753) (9,141) (3,429)
Equity earnings/minority interest.......... 735 156 204
Provision for bad debts.................... 26,282 16,666 11,220
Gain on sale............................... -- (22,451) --
Impairment of long-lived assets............ -- 20,489 --
Changes in noncash working capital:
Receivables................................ (44,362) (69,634) (35,387)
Receivable from affiliates................. -- 2,698 (844)
Supplies................................... (3,984) (519) 258
Prepayments, including insurance........... 1,227 4,053 (4,106)
Other current assets....................... (1,032) (221) (2,073)
Accounts payable........................... (2,073) (13,774) 34,194
Accrued expenses and other current
liabilities............................... (5,673) 17,465 8,860
Changes in long-term insurance reserves...... 1,462 3,107 1,321
Other........................................ (215) 520 824
-------- --------- ---------
NET CASH PROVIDED BY OPERATING ACTIVITIES...... 54,840 31,808 66,434
CASH FLOWS USED IN INVESTING ACTIVITIES:
Acquisitions and investments................. (30,548) (68,710) (87,602)
Purchases of property and equipment.......... (36,961) (53,366) (38,946)
Proceeds from sale of DevCon................. -- 47,500 --
Disposals of property, equipment and other
assets...................................... 8,365 2,690 7,022
Restricted investments....................... (20,543) 5,564 (19,822)
Additions to notes receivable................ (2,069) (1,519) (3,488)
Collections on notes receivable.............. 4,649 981 3,173
Other........................................ (211) 209 (198)
-------- --------- ---------
NET CASH USED IN INVESTING ACTIVITIES.......... (77,318) (66,651) (139,861)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from long-term debt................. 1,875 1,469 219,342
Net draws under credit line.................. 22,685 194,615 1,955
Repayment of long-term debt.................. (9,297) (138,708) (247,461)
Proceeds from additional public offering..... -- -- 99,061
Purchase of treasury stock................... -- (20,000) --
Shareholder distributions.................... -- -- (2,381)
Funding of options under 1992 employee stock
option plan and employee benefit plans...... 176 975 1,007
-------- --------- ---------
NET CASH PROVIDED BY FINANCING ACTIVITIES...... 15,439 38,351 71,523
INCREASE (DECREASE) IN CASH AND CASH EQUIVA-
LENTS......................................... (7,039) 3,508 (1,904)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD. 21,394 17,886 19,790
-------- --------- ---------
CASH AND CASH EQUIVALENTS, END OF PERIOD....... $ 14,355 $ 21,394 $ 17,886
======== ========= =========
The accompanying notes are an integral part of these financial statements.
37
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
Paragon Health Network, Inc. ("Paragon"), formerly known as Living Centers
of America, Inc. ("LCA"), was formed in November 1997 through the
recapitalization by merger of LCA with a newly-formed entity owned by certain
affiliates of Apollo Management, L.P. and certain other investors (the
"Recapitalization Merger"), and the subsequent merger of GranCare, Inc.
("GranCare") with a wholly-owned subsidiary of LCA (the "GranCare Merger" and
collectively with the Recapitalization Merger, the "Mergers"). See Note 19.
The accompanying consolidated financial statements include the accounts of LCA
and its subsidiaries and all significant intercompany accounts and
transactions have been eliminated. The accompanying consolidated financial
statements do not give effect to the Mergers as they occurred subsequent to
September 30, 1997 and are not indicative of the consolidated financial
statements following the Mergers.
References to the "Company" herein refer to LCA and its operations prior to
the consummation of the Mergers and to Paragon and its operations following
the consummation of the Mergers. The Company's continuum of post-acute care
services encompasses skilled nursing, subacute and medically complex care as
well as a variety of related ancillary services. These ancillary services
include pharmacy, rehabilitation, and hospital program management. The Company
operates in 38 states with significant concentration of facilities and beds in
its key markets.
Effective July 31, 1995, the Company issued approximately 19,437,000 shares
(6,479,000 shares prior to the three-for-one stock split, see Note 19) of its
common stock in a merger transaction with The Brian Center Corporation ("BCC")
and 16 related S corporations (collectively the "BCC Entities"). The merger
was accounted for using the pooling of interests methodology and the
accompanying financial statements have been restated to include the accounts
of the BCC Entities as though the transaction occurred on September 30, 1992.
See Note 3.
Cash Management
The Company maintains a centralized cash management system in which cash
receipts are transferred daily from facility and ancillary company depository
accounts to a cash concentration account. Cash is then used to provide for
normal working capital requirements, including reduction of the outstanding
credit lines or placement of excess funds in commercial grade investments. To
the extent that cash transferred from the facility and ancillary company
depository accounts is not sufficient to provide for cash disbursement
requirements, a cash advance is obtained from the Company's bank credit
facility. See Note 5. Cash equivalents consist of temporary investments with
original maturities of three months or less.
Notes Receivable, net
Notes receivable, net, aggregating $13.4 million and $14.5 million at
September 30, 1997 and 1996, respectively, consist primarily of notes which
arose from divestitures of certain operating facilities. These notes, which
are generally collateralized by long-term care facilities, have interest rates
ranging generally from 5% to 12% and maturities through 2012, including
approximately $9.8 million due after 2000. Notes receivable, net, at September
30, 1997 and 1996, include reserves for potential uncollectible amounts of
$1.2 million and $3.5 million, respectively. Management believes the
collateral values are sufficient to recover the net carrying amount of these
notes in the event of default.
Supplies
Supplies, consisting principally of pharmaceutical and medical supplies, are
valued at the lower of cost (first-in, first-out) or market.
38
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Property and Equipment
Property and equipment are stated at cost and include interest on funds
borrowed to finance construction. Capitalized interest was $0.3 million, $0.2
million and none for the three years ended September 30, 1997, 1996 and 1995,
respectively. Maintenance and repairs are charged to operations as incurred
and replacements and significant improvements are capitalized. Depreciation
and amortization are provided over the estimated useful lives of the assets on
a straight-line basis as follows:
Buildings..................................................... 25-40 years
Building improvements......................................... 10-15 years
Furniture, fixtures and equipment............................. 3-15 years
Goodwill, net
Goodwill represents an allocation from the Company's previous parent as a
result of a management buyout transaction which is amortized on a straight-
line basis over 40 years and the excess of purchase price over fair market
value of assets acquired in various purchase transactions which is amortized
on a straight-line basis over 30 years. Accumulated amortization at September
30, 1997 and 1996 was $20.3 million and $11.7 million, respectively.
Amortization of goodwill charged to expense was $7.3 million, $5.6 million and
$2.8 million for the three years ended September 30, 1997, 1996 and 1995,
respectively.
Impairment of Long-Lived Assets
In September 1996 the Company adopted Statement of Financial Accounting
Standards No. 121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed of ("SFAS 121"). SFAS 121 requires impairment
losses to be recognized for long-lived assets when indicators of impairment
are present and the undiscounted cash flows are not sufficient to recover the
assets' carrying amount. Goodwill is also evaluated for recoverability by
estimating the projected undiscounted cash flows, excluding interest, of the
related business activities. The impairment loss of these assets, including
goodwill, is measured by comparing the carrying amount of the asset to its
fair value with any excess of carrying value over fair value written off. Fair
value is based on market prices where available, an estimate of market value,
or determined by various valuation techniques including discounted cash flow.
See Note 8.
Prior to adoption of SFAS 121 the Company performed its analyses of
impairment of long-lived assets by consideration of the projected undiscounted
cash flows on an entity-wide basis.
Restricted Investments
Restricted investments represent cash and other investments that have been
designated to pay insurance claims of the Company's wholly-owned insurance
subsidiary. The invested funds restricted to pay insurance claims have been
classified as available-for-sale securities in accordance with Statement of
Financial Accounting Standards No. 115, "Accounting for Certain Investments in
Debt and Equity Securities" and are recorded at their estimated fair value.
See Note 4.
Investment in Unconsolidated Affiliate
Investment in unconsolidated affiliate at September 30, 1996 primarily
consisted of a 50% owned interest in Heart of America Hospice, LLC, ("HOA") a
Kansas-based hospice which was recorded under the equity method. The remaining
50% interest of HOA was purchased during fiscal 1997. See Note 3.
39
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Income Taxes
Noncurrent deferred income taxes arise primarily from timing differences
resulting from using accelerated depreciation for tax purposes and reserves
for uninsured losses not deductible in the current period. Current deferred
income taxes result from timing differences in the recognition of revenues and
expenses for tax and financial reporting purposes which are expected to
reverse within one year. See Note 10.
The Company filed a consolidated federal income tax return for the year
ended September 30, 1995 which included pre-merger (non-BCC entities)
operations and has continued to file on a consolidated basis for subsequent
years. Federal and state income tax payments made (including the BCC Entities)
for the three years ended September 30, 1997, 1996 and 1995 were $40.0
million, $31.5 million and $21.2 million, respectively.
The various corporations (exclusive of the S corporations) included in the
BCC Entities filed consolidated tax returns through the date of the BCC
merger. For state income tax purposes, each corporation within the federal
consolidated group filed a separate income tax return. The S corporations
included in the BCC merger were not subject to income taxes as their
attributes flow through to their individual stockholders; accordingly, the
accompanying consolidated financial statements do not include a provision for
income taxes with respect to the earnings of these entities through July 31,
1995. A pro forma income tax provision has been provided to reflect the
estimated federal and state income taxes as if all of the S corporations were
taxable entities. This estimate is based on the maximum effective federal and
state income tax rates in effect during the years presented. Effective August
1, 1995, all of these corporations became taxable entities and the operations
of these companies are included in the consolidated tax return of LCA.
Treasury Stock
During fiscal year 1996, the Company acquired 2,327,220 shares of treasury
stock (775,740 shares prior to the three-for-one stock split) on the open
market for a total cost of $20.0 million. The shares repurchased were
primarily intended to be used as part of a plan to fund the employer's
contributions to the Company's 401(k) Plan and Deferred Retirement Incentive
Plan and to fund employee purchases made under the Company's Employee Stock
Purchase Plan. See Note 16.
Net Revenues
Revenues are recorded in the period in which services are provided at
established rates whether or not collection in full is anticipated.
Contractual adjustments and the results of other arrangements for providing
services at less than established rates are reported as deductions to arrive
at net revenues. Contractual adjustments include differences between
established billing rates and amounts estimated by management as reimbursable
under various cost reimbursement formulas or contracts in effect. An
appropriate provision for bad debt expense is included as an operating expense
and a corresponding reserve for doubtful accounts is reflected in net
receivables to reduce gross receivables to an amount actually expected to be
collected.
The administrative procedures associated with the Medicare cost
reimbursement program generally preclude final determination of amounts due
the Company until cost reports are audited or otherwise reviewed and settled
with the applicable administrative agencies. Normal estimation differences
between final settlements and amounts recorded in previous years are generally
reported as current year contractual adjustments. The Company does not expect
any differences between revenue recorded and as finally determined to have a
significant effect on the Company's results of operations or financial
position. Medicare revenues represented 26%, 26% and 24% and Medicaid revenues
represented 41%, 43% and 51% of net revenue for the three years ended
September 30, 1997, 1996 and 1995, respectively.
40
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Laws and regulations governing the Medicare and Medicaid programs are
complex and subject to interpretation. The Company is aware of one current
investigation and an additional possible investigation involving allegations
of potential wrongdoing. See Note 11. While the Company believes that it is in
compliance with all applicable laws and regulations, compliance with such laws
and regulations can be subject to future government review and interpretation
as well as significant regulatory action including fines, penalties, and
exclusion from the Medicare and Medicaid programs.
Stock-Based Compensation
The Company grants stock options for a fixed number of shares to employees
with an exercise price equal to the fair value of the shares at the date of
grant. The Company accounts for stock option grants in accordance with APB
Opinion 25 "Accounting for Stock Issued to Employees" and, accordingly,
recognizes no compensation expense for the stock option grants.
In October 1995 the Financial Accounting Standards Board adopted Statement
of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123"). SFAS 123 allows companies the option to retain the
current accounting approach for recognizing stock-based expense in the
financial statements or to adopt a new accounting method based on the
estimated fair value of the employee stock options. Companies that do not
follow the new fair-value based method are required to provide pro forma
disclosures of net income and earnings per share as if the fair-value method
of accounting had been applied. See Note 16 for the pro forma effects on the
Company's reported net income and earnings per share assuming the election had
been made to recognize compensation expense on stock-based awards in
accordance with SFAS 123.
Earnings per Share
In February 1997 the Financial Accounting Standards Board adopted Statement
of Financial Accounting Standards No. 128, "Earnings per Share" ("SFAS 128").
SFAS 128 is designed to simplify the standards for computing earnings per
share and increase the comparability of earnings per share data on an
international basis. The Company will implement SFAS 128 in the first quarter
of fiscal year 1998. The earnings per share impact of this implementation has
not yet been determined.
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Although these estimates are based on management's
knowledge of current events, they may ultimately differ from actual results.
Other
Certain prior year amounts have been reclassified to conform with the 1997
presentation.
NOTE 2. DIVESTITURES
In September 1996, the Company completed the divestiture of its DevCon
operations, which provided training and habilitation services to individuals
with mental retardation and developmental disabilities, through the
recapitalization and subsequent sale of the majority of DevCon's stock for
$47.5 million in cash. The Company retained a small ownership interest in the
recapitalized company. Proceeds from the divestiture were utilized to reduce
debt related to various acquisitions.
41
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
NOTE 3. ACQUISITIONS
Fiscal Year 1997 Acquisitions
During fiscal year 1997 the Company acquired the remaining 50% interest in
Heart of America Hospice, L.L.C., a Kansas based hospice company, for $3.3
million in cash. This transaction was recorded using the purchase method of
accounting.
The Company also acquired institutional pharmacies, home health agencies,
and therapy operations as part of several smaller transactions, primarily for
cash. All such acquisitions were recorded using the purchase method of
accounting.
Fiscal Year 1996 Acquisitions
In May 1996, the Company acquired a 50% interest in Heart of America
Hospice, L.L.C., for $2.8 million in cash.
In June 1996, the Company acquired certain assets of Lahr Pharmacy, Inc. and
related companies for $13.4 million in cash. An additional $2.0 million was
paid during 1997 in connection with this acquisition based on the achievement
of predetermined earnings targets and an additional $1.5 million may be paid
if predetermined earnings targets are achieved during the subsequent two
years. Additional consideration is included in goodwill when paid.
Effective September 1, 1996, the Company acquired the stock of Allied
Pharmacy Management, Inc., which operated five institutional pharmacies and a
home health care business in Florida, for $29.6 million in cash.
The Company also acquired other previously leased long-term care facilities,
institutional pharmacies, and therapy operations as part of several smaller
transactions, primarily for cash. All such acquisitions were recorded using
the purchase method of accounting.
Fiscal Year 1995 Acquisitions
On June 30, 1995, LCA completed a merger with Rehability Corporation in
which it acquired all of the outstanding stock of the company through a cash
tender offer of $11.50 per share. In the transaction, the Company paid
approximately $88.1 million in cash for the stock and various transaction
costs and assumed approximately $36.0 million in debt. The name of the
acquired company was subsequently changed to American Rehabilitation Services,
Inc. ("ARS" or "Rehability"). The transaction was recorded using the purchase
method of accounting. The allocation of purchase price included approximately
$81.9 million of goodwill which will be amortized over a 30-year period.
Effective August 1, 1995 the Company issued approximately 774,000 shares
(258,000 shares prior to the three-for-one stock split) of its common stock
valued at $8.3 million in exchange for all of the capital stock of Therapy
Management Innovations, Inc. and related entities ("TMI"). The transaction was
recorded using the purchase method of accounting. The allocation of purchase
price included approximately $7.9 million of goodwill. The goodwill was
subsequently written off in September, 1996. See Notes 7 and 8.
42
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The following information presents the results of operations on a pro forma
basis as though the Rehability and TMI transactions all occurred on October 1,
1994. Information is presented for informational purposes only and may not be
indicative of actual operating results that would have been achieved. All
amounts are in thousands, except per share amounts.
YEAR ENDED
SEPTEMBER 30, 1995
------------------
Net revenues .......................................... $1,041,228
Net income............................................. 26,893(a)
Earnings per share..................................... $ 0.46(a)
- --------
(a) Excluding non-recurring merger and acquisition and other related costs of
$14.3 million, net income and earnings per share would have been $38.8
million and $0.67, respectively.
On July 31, 1995, the Company acquired all of the outstanding stock of the
BCC Entities in exchange for approximately 19,437,000 shares (6,479,000 shares
prior to the three-for-one stock split) of its common stock in a merger
transaction which was accounted for as a pooling of interests. In addition,
the Company paid $3.7 million in cash to acquire various minority interests
associated with several of the BCC affiliates. The Company used a portion of
its bank credit facility to retire approximately $70.0 million of existing
debt of BCC. The retained earnings of the S corporations ($1.8 million at July
31, 1995 and $2.6 million at September 30, 1994) have been reclassified to
Capital Surplus.
Separate results of operations of the companies prior to the acquisition are
summarized below (in thousands):
TEN MONTHS ENDED
JULY 31, 1995
--------------------------
LIVING BCC
CENTERS ENTITIES COMBINED
-------- -------- --------
Net Revenues........................................ $529,405 183,127 $712,532
Income from Operations (a).......................... $ 37,310 10,004 $ 47,314
Net Income.......................................... $ 20,110 2,109 $ 22,219
Pro Forma Net Income................................ $ 20,110 1,510 $ 21,620
- --------
(a) Includes merger and acquisition expenses of $4.5 million for LCA and $1.3
million for BCC Entities.
In addition to the above, the Company acquired other long-term care
facilities and five separate pharmaceutical operations as part of several
smaller transactions, primarily for cash. All such acquisitions were recorded
using the purchase method of accounting.
43
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
NOTE 4. RESTRICTED INVESTMENTS
Restricted investments at September 30, 1997 and 1996 included the
following:
GROSS GROSS ESTIMATED
AMORTIZED UNREALIZED UNREALIZED FAIR
SEPTEMBER 30, 1997 COST GAINS LOSSES VALUE
- ------------------ --------- ---------- ---------- ---------
U.S. Treasury Notes................... $36,234 $234 $ (9) $36,459
Asset-backed securities............... 2,604 32 (2) 2,634
Corporate debt securities............. 5,073 68 -- 5,141
Mortgage-backed securities............ 4,273 54 (2) 4,325
Repurchase Pooling Arrangement........ 539 -- -- 539
Cash.................................. 2,878 -- -- 2,878
------- ---- ---- -------
Total............................... $51,601 $388 $(13) $51,976
======= ==== ==== =======
GROSS GROSS ESTIMATED
AMORTIZED UNREALIZED UNREALIZED FAIR
SEPTEMBER 30, 1996 COST GAINS LOSSES VALUE
- ------------------ --------- ---------- ---------- ---------
U.S. Treasury Notes................... $14,187 $122 $(186) $14,123
Asset-backed securities............... 5,859 21 (32) 5,848
Corporate debt securities............. 2,691 25 (27) 2,689
Mortgage-backed securities............ 1,401 59 -- 1,460
Repurchase Pooling Arrangement........ 5,892 -- -- 5,892
Cash.................................. 1,028 -- -- 1,028
------- ---- ----- -------
Total............................... $31,058 $227 $(245) $31,040
======= ==== ===== =======
Proceeds from the sale and maturities of investments were $19.1 million,
$14.5 million and $3.7 million for the three years ended September 30, 1997,
1996 and 1995, respectively. Gross gains (losses) of ($0.2) million, $0.1
million and $0.1 million were realized for the three years ended September 30,
1997, 1996 and 1995, respectively.
The amortized cost and estimated fair value of debt securities and other
investments at September 30, 1997 by contractual maturity are shown below.
Expected maturities may differ from contractual maturities because borrowers
may have the right to call or repay obligations with or without call or
prepayment penalties.
ESTIMATED
AMORTIZED FAIR
COST VALUE
--------- ---------
Due in one year or less..................................... $ 7,044 $ 7,047
Due after one year through five years....................... 26,579 26,752
Due after five years through ten years...................... 7,684 7,801
------- -------
41,307 41,600
Asset-backed securities..................................... 2,604 2,634
Mortgage-backed securities.................................. 4,273 4,325
Repurchase Pooling Arrangement.............................. 539 539
Cash........................................................ 2,878 2,878
------- -------
Total..................................................... $51,601 $51,976
======= =======
The Repurchase Pooling Arrangement is subject to market risk associated with
changes in the value of the underlying financial instruments as well as the
risk of loss of appreciation if a counter party fails to perform.
44
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
NOTE 5. DEBT
Long-term debt at September 30, 1997 and 1996 is summarized in the following
table (in thousands):
SEPTEMBER 30,
------------------
1997 1996
-------- --------
Bank Credit Facility........................................ $255,000 $225,315
SouthTrust Bank of Alabama, NA.............................. 20,000 20,000
Variable Annuity Life Insurance Company..................... 10,000 10,000
NationsBank of Texas, NA.................................... 3,000 10,000
Mortgage notes (6% to 10.75% due through 2014).............. 609 1,444
Other notes payable (8% to 10% due through 2008)............ 3,547 5,688
-------- --------
292,156 272,447
Obligations under capital leases ........................... 3,803 4,001
-------- --------
295,959 276,448
Less short-term notes payable and current portion........... (43,196) (13,746)
-------- --------
Total long-term debt........................................ $252,763 $262,702
======== ========
Interest expense paid was $21.8 million, $19.3 million and $17.7 million
during the three years ended September 30, 1997, 1996 and 1995, respectively.
Substantially all of the above indebtedness was refinanced in connection with
the Mergers. See Note 19.
In February 1992, the Company entered into an agreement (the "Bank Credit
Facility") with several banks in which the banks provided financing to the
Company. During the last several years, the Bank Credit Facility has been
amended and/or restated to provide working capital financing and expansion
capital for various purchase transactions. In August 1996, the Company entered
into a Third Amended and Restated Credit Agreement (the "1996 Bank Credit
Facility"), pursuant to which the banks agreed to provide $500 million to LCA,
including a $350 million five-year revolving credit and competitive advance
facility ("Tranche A") and a $150 million 364-day revolving credit facility
with a four-year term out ("Tranche B"). The Company recorded a non-recurring
charge of $0.9 million for the write-off of unamortized deferred financing
costs related to the Second Amended and Restated Credit Agreement. See Note 8.
The 1996 Bank Credit Facility allows LCA to borrow at the base rate in effect
at NationsBank of Texas, N.A. or at LIBOR plus an applicable margin ranging
from 0.25% to 0.65% and also provides for a facility fee of 0.15% to 0.225%.
The applicable margin and facility fee are subject to adjustment depending on
LCA's leverage ratio at the quarter-end immediately preceding the borrowing.
LCA may prepay borrowings made under Tranche A at any time, but all amounts
drawn must be repaid by August 19, 2001 with a provision for earlier extension
if the Company and banks agree. The Tranche B balance at August 18, 1997 of
$140.0 million was converted to a term loan and scheduled to be repaid in
equal quarterly installments beginning October 1, 1997. The 1996 Bank Credit
Facility is an unsecured credit facility and contains various financial
covenants similar to those in the original Bank Credit Facility. Balances
available under the 1996 Bank Credit Facility and predecessor agreements at
September 30, 1997 and 1996 (after giving consideration to outstanding letters
of credit of $4.7 million) were $230.3 million and $270.0 million,
respectively. As of September 30, 1997 and 1996, the announced base rate of
NationsBank was 8.5% and 8.25%, respectively.
The Company has entered into interest rate swap agreements to reduce the
impact of changes in interest rates on its floating rate long-term debt. At
September 30, 1997, the Company had outstanding three interest rate swap
agreements with commercial banks having a total notional principal amount of
$60 million. These
45
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
agreements effectively changed the Company's interest rate exposure on $60
million under the 1996 Bank Credit Facility to approximately 6.8% through
2005. The Company receives floating rates on these swaps which are based on
LIBOR.
The Company's use of swap agreements and reverse swap agreements did not
have a material effect on the weighted-average borrowing rate of reported
interest expense during the years ended September 30, 1997, 1996, and 1995 and
the Company is not exposed to credit loss on these swaps. See Note 13 for fair
value disclosures. The difference between amounts paid and received on swap
agreements is recorded on an accrual basis as an adjustment to interest
expense over the periods covered by the agreements. The related amount
receivable from or payable to counter parties is included in other receivables
or payables, respectively. The fair values of the swap agreements and changes
thereto are not recognized in the consolidated financial statements.
In October 1993 the Company borrowed $20 million from SouthTrust Bank of
Alabama, NA which is unsecured and bears interest at the rate of 6.95%,
payable semi-annually. The principal is repayable in five annual payments of
$4 million beginning October 1, 1998.
In January 1994, the Company issued, in a private placement, a $10 million
note to American General Insurance Company that was later sold to The Variable
Annuity Life Insurance Company ("Variable Annuity Life") at a fixed rate of
interest of 7.79%. The note is unsecured and will mature in a single payment
due in ten years. The note agreement contains restrictions similar to other
unsecured debt of the Company.
In May 1994, the Company executed a $10 million promissory note with
NationsBank of Texas, N.A. Subject to NationsBank's prior approval of any
request for an advance, the Company may borrow, repay and reborrow principal
amounts in increments such that the unpaid principal balance at anytime shall
not exceed $10 million. The original maturity date of the earlier of demand or
May 1995 was extended by several subsequent extension agreements to November
1997. The interest rate on each advance is quoted separately based on market
conditions that exist at that time. At September 30, 1997, there was $3.0
million outstanding under the note agreement.
Long-term debt maturing in the next five fiscal years, prior to the Mergers
(see Note 19), is presented below (in thousands):
SEPTEMBER 30, 1997
------------------
1998................................................. $43,196
1999................................................. 5,468
2000................................................. 4,990
2001................................................. 222,541
2002................................................. 4,913
The covenants governing the 1996 Bank Credit Facility and the notes with
SouthTrust Bank and Variable Annuity Life provide for the maintenance of
various financial ratios and limitations on dividends. See Note 19 which
details long-term debt subsequent to the Mergers.
NOTE 6. EMPLOYEE RETIREMENT PLANS
The Company's employees are eligible to participate in defined contribution
retirement plans sponsored by the Company. Company contributions to these
plans represent a matching percentage of certain employee contributions which
is subject to management's discretion based upon consolidated financial
performance. The employees of ARS are also covered by a defined contribution
plan which provides for Company contributions in cash of up to 50% of certain
employee contributions. Total combined expense recognized by the Company under
both of these plans was $3.5 million, $2.2 million and $1.8 million for the
three years ended September 30, 1997, 1996 and 1995, respectively.
46
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The Company does not provide post-retirement health care or life insurance
benefits to employees. Accordingly, the Company is not subject to the
requirements of Statement of Financial Accounting Standards No. 106,
"Employers Accounting for Post Retirement Benefits Other Than Pensions."
NOTE 7. LIFE INSURANCE PROCEEDS
In the third quarter of fiscal year 1996 the Company recorded a non-taxable
gain of $2.0 million from the receipt of insurance proceeds on Don W. Wortley,
former President of TMI.
NOTE 8. IMPAIRMENT OF LONG-LIVED ASSETS AND OTHER EXPENSES
In the fourth quarter of fiscal year 1996 the Company adopted SFAS 121 which
resulted in the identification and measurement of an impairment loss of $20.5
million related to nursing facilities with a history of cash flow losses,
certain other nursing facilities where management believed an impairment
existed as a result of the competitive environment, goodwill (primarily
attributable to TMI), and other assets to be disposed. Management estimated
the undiscounted cash flows to be generated by each of these assets and
compared them to their carrying value. If the undiscounted future cash flow
estimates were less than the carrying value of the asset then the carrying
value was written down to estimated fair value. Goodwill associated with an
impaired asset was included with the carrying value of that asset in
performing both the impairment test and in measuring the amount of impairment
loss related to the asset. Fair value was estimated based on either
management's estimate of fair value, present value of future cash flows, or
market value less estimated cost to sell for certain facilities to be
disposed. The facilities with a history of cash flow losses operated at a loss
for periods ranging from one to four years. The undiscounted cash flows for
TMI were estimated based on the operating results of TMI subsequent to the
death of the President of the rehabilitation services group (founder of TMI)
and adjusted for the loss of contracts and impending business changes as a
result of his death. See Note 7. The decision regarding the disposition of
certain nursing facilities, which had operating losses of $0.4 million during
fiscal 1996, was completed at the time of adoption of SFAS 121. Facilities to
be disposed of had a carrying value of $1.5 million and $4.8 million at
September 30, 1997 and 1996, respectively.
The Company also recorded other charges of $2.9 million in the fourth
quarter of fiscal year 1996 primarily related to the closure of its medical
supplies business and the write-off of unamortized loan acquisition costs
related to the Second Amended and Restated Credit Agreement.
47
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
NOTE 9. RESTRUCTURING PLAN
On June 14, 1996, the Company finalized and approved a plan originating in
June 1995 to restructure the operations and exit certain activities of ARS.
This plan included centralization of billing and collection, closing or
downsizing unprofitable clinics and offsite contracts, and staff reductions of
approximately 300 employees in both corporate overhead and field management.
This plan resulted in an increase to the original purchase price of the
acquisition by $10.1 million, which was recorded in June 1996 and included an
accrual for estimated exit costs of $4.4 million related to
termination/severance for displaced employees and $4.2 million related to
future lease costs for abandoned real property. During the fourth quarter of
fiscal year 1997 the Company lowered its original estimate of the accrual for
exit costs which resulted in a reduction to the original purchase price of
$1.9 million. The revised increase in purchase price as a result of the
restructuring plan includes the following:
Termination/severance for displaced employees..................... $3,760
Future lease costs for abandoned real property.................... 2,561
Write off of abandoned tangible and intangible assets at closed
locations........................................................ 1,920
------
Total........................................................... $8,241
======
Through September 30, 1997 the Company has charged $3.3 million against the
accrual for termination/severance for approximately 350 displaced employees
and $1.5 million against the accrual for future lease costs. The restructuring
was substantially completed by March 31, 1997. At September 30, 1997, the
Company believes the remaining accruals for the restructuring are adequate.
NOTE 10. INCOME TAXES
The provision for income taxes is presented in the table below (in
thousands):
YEARS ENDED SEPTEMBER
30,
-------------------------
1997 1996 1995
------- ------- -------
Current:
Federal............................................ $34,214 $38,326 $21,982
State & Local...................................... 5,370 5,141 4,237
------- ------- -------
39,584 43,467 26,219
Deferred:
Federal............................................ (4,922) (8,276) (3,698)
State & Local...................................... (1,058) (1,432) (771)
------- ------- -------
(5,980) (9,708) (4,469)
------- ------- -------
Total............................................ $33,604 $33,759 $21,750
======= ======= =======
48
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The provision for income taxes varies from the amount determined by applying
the Federal statutory rate to pre-tax income as a result of the following:
YEARS ENDED SEPTEMBER 30,
----------------------------
1997 1996 1995
-------- -------- --------
Federal statutory income tax rate................ 35.0% 35.0% 35.0%
Increased (decrease) in taxes resulting from:
State & local taxes, net of federal tax
benefits...................................... 3.6 3.4 4.9
Permanent book/tax differences, primarily
resulting from goodwill....................... 2.7 7.0 2.0
Work opportunity/targeted job tax credits...... (0.3) -- (2.7)
Non-deductible merger and acquisition cost..... 1.0 -- 7.2
Other, net....................................... 1.3 (1.6) 0.7
-------- -------- --------
Effective tax rate............................... 43.3% 43.8% 47.1%
======== ======== ========
The components of deferred income taxes are as follows (in thousands):
YEARS ENDED SEPTEMBER
30,
-------------------------
1997 1996 1995
------- ------- -------
Reserves for potential claims....................... $ 907 $(2,134) $(1,984)
Purchase accounting................................. (1,835) (1,749) (1,828)
FAS 121 asset valuation............................. 1,669 (4,030) --
Tax depreciation under book......................... (1,066) (1,822) (1,023)
Bad debts........................................... (6,841) (1,295) (761)
Texas Occupational Injury accrual................... -- 1,847 835
Net operating losses................................ (59) (262) --
Other, net.......................................... 1,186 (525) 292
Changes in valuation allowance...................... 59 262 --
------- ------- -------
Total............................................. $(5,980) $(9,708) $(4,469)
======= ======= =======
49
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The components of the net deferred tax liability are as follows (in
thousands):
SEPTEMBER 30,
------------------
1997 1996
-------- --------
Deferred tax liabilities:
Amounts relating to property and equipment................ $(32,967) $(34,773)
Other..................................................... (5,107) (1,596)
-------- --------
Total deferred tax liabilities ....................... (38,074) (36,369)
-------- --------
Deferred tax assets:
Financial reserves not yet deductible for tax purposes:
Asset valuation......................................... 3,552 4,243
Insurance............................................... 7,261 8,524
Notes receivable allowance.............................. -- 821
Payroll and benefits.................................... 4,362 4,884
Bad debts............................................... 13,429 6,572
Restructuring reserve................................... 863 3,159
NOL carryforwards....................................... 1,844 1,785
Other miscellaneous..................................... 6,183 5,243
Timing differences in Medicare.......................... 1,716 1,592
-------- --------
Total deferred tax assets............................. 39,210 36,823
Less valuation allowances................................... (1,844) (1,785)
-------- --------
Net deferred tax liability.................................. $ (708) $ (1,331)
======== ========
The net change in the valuation allowance for deferred tax assets was an
increase of $59 and $977 at September 30, 1997 and 1996, respectively.
NOTE 11. COMMITMENTS AND CONTINGENCIES
Certain of the Company's facilities are held under operating or capital
leases. All capital leases will expire by 2009. Certain of these leases also
contain provisions allowing the Company to purchase the leased assets during
the term or at the expiration of the lease, at fair market value. Facilities
operating under capital leases are summarized as follows (in thousands):
SEPTEMBER 30,
----------------
1997 1996
------- -------
Facilities operating under capital leases............... $12,551 $12,551
Less accumulated amortization........................... (5,799) (5,084)
------- -------
$ 6,752 $ 7,467
======= =======
In October 1996 the Company entered into a leasing program, initially
totaling $70.0 million and subsequently increased to $100.0 million, to be
used as a funding mechanism for future assisted living and skilled nursing
facility construction, lease conversions, and other facility acquisitions. The
lease is an unconditional "triple net" lease for a period of seven years with
the annual lease obligation a function of the amount spent by the lessor to
acquire or construct the project, a variable interest rate, and commitment and
other fees. The Company guarantees a minimum of approximately 83% of the
residual value of the leased property and also has an option to purchase the
properties at any time prior to the maturity date at a price sufficient to pay
the entire amount financed, accrued interest, and certain expenses. At
September 30, 1997, approximately $28.9 million of this leasing arrangement
was utilized. The leasing program is accounted for as an operating lease.
50
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Rental expense, net of sublease rent income, for all operating leases was
$42.5 million, $44.2 million and $36.9 million for the three years ended
September 30, 1997, 1996 and 1995, respectively. Certain leases also contain
increases based on the Consumer Price Index, Medicaid reimbursement rates, or
at amounts specified in the lease agreement. Sublease rent income was $6.5
million, $6.9 million and $6.1 million for the three years ended September 30,
1997, 1996 and 1995, respectively. Contingent rent based primarily on revenues
was $1.8 million, $1.6 million and $1.4 million for the three years ended
September 30, 1997, 1996 and 1995, respectively.
The table below presents a schedule of the future minimum rental commitments
and sublease income under all noncancellable leases as of September 30, 1997
(in thousands):
SUBLEASE
OPERATING INCOME CAPITAL
--------- -------- -------
1998.......................................... $ 36,383 $ 6,869 $1,281
1999.......................................... 30,371 4,881 953
2000.......................................... 24,181 1,656 853
2001.......................................... 21,697 1,675 658
2002.......................................... 18,507 1,467 664
Subsequent years.............................. 77,629 6,503 --
-------- ------- ------
Total minimum rental obligations.............. $208,768 $23,051 4,409
======== =======
Less amount representing interest............. (606)
------
Present value of capital leases............... 3,803
Less current portion.......................... (1,097)
------
Long-term obligations under capital leases.... $2,706
======
As is typical in the healthcare industry, the Company is and will be subject
to claims that its services have resulted in resident injury or other adverse
effects, the risks of which will be greater for higher acuity residents
receiving services from the Company than for other long-term care residents.
The Company is, from time to time, subject to such negligence claims and other
litigation. In addition, resident, visitor, and employee injuries will also
subject the Company to the risk of litigation. From time to time, the Company
and its subsidiaries have been parties to various legal proceedings in the
ordinary course of their respective business. In the opinion of management,
except as described below, there are currently no proceedings which,
individually or in the aggregate, if determined adversely to the Company and
after taking into account the insurance coverage maintained by the Company,
would have a material adverse effect on the Company's financial position or
results of operations.
The Company received a letter dated September 5, 1997 from an Assistant
United States Attorney ("AUSA") in the United States Attorney's Office for the
Eastern District of Texas (Beaumont) advising that the office is involved in
an investigation of allegations that services provided at some of the
Company's facilities may violate the Civil False Claims Act. The AUSA informed
the Company that the investigation is the result of a qui tam complaint (which
involves a private citizen requesting the federal government to intervene in
an action because of an alleged violation of a federal statute) filed under
seal against the Company, and the AUSA is investigating the allegations in
order to determine if the United States will intervene in the proceedings. The
AUSA has requested that the Company voluntarily produce a substantial amount
of documents, including medical records of former residents. Counsel for the
Company has met with the AUSA, and the parties are currently engaged in
discussions on whether the voluntarily production of former residents' medical
records can be accomplished without violating the residents' rights to privacy
and confidentiality. Based upon the information currently known about the
complaint, the Company believes that given an opportunity to address the
51
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
allegations, the AUSA will find intervention by the United States is without
merit. The Company will vigorously contest the alleged claims if the complaint
is pursued.
The Department of Justice ("DOJ") has advised the Company that the United
States has declined to intervene in the qui tam complaint filed against The
Brian Center Corporation ("BCC") and one of its subsidiaries, Med-Therapy
Rehabilitation Services, Inc. ("Med-Therapy"), both wholly-owned subsidiaries
of the Company (and of LCA before the Mergers) in the federal district court
for the Western District of North Carolina. The Company does not know whether
the individual plaintiff will continue to pursue the alleged claims that BCC
and Med-Therapy caused certain therapists to make improper therapy record
entries with respect to screening services, and that any claims filed with
Medicare for payments based upon such improper record entries should be viewed
as false claims under the Civil False Claims Act. The Company will vigorously
contest any claims which the individual plaintiff pursues. No assurance can be
given that, if the plaintiff were to prevail in his claim, the resulting
judgement would not have a material adverse effect on the Company. Moreover,
in connection with the Company's acquisition of BCC, the primary stockholder
(Donald C. Beaver) agreed to indemnify and hold harmless the Company from and
against any and all loss, expense, damage, penalty and liability which could
result from this claim, subject to further adjustment. Mr. Beaver's indemnity
requires any payment to the Company to be in the form of shares of the Company
common stock held by him.
The Company was served with a Petition, Cause No. 97-1500-G, Community
Healthcare Services of America, Inc., v. Rehability Health Services, Inc. and
Living Centers of America, Inc., in the 319th Judicial District Court of
Nueces County, Texas, seeking $5.0 million in damages, filed by Community
Health Services, Inc. ("Community"), in connection with a home health agency
management agreement entered into between Community and a subsidiary of the
Company. Such subsidiary operated a Texas home health agency which Community
managed. The Company is vigorously defending the allegations of Community that
the Company breached the agreement by terminating Community's management
services and has filed a lawsuit against Community for breach of the
agreement, Cause No. 97-03569; Rehability Health Services, Inc. v. Community
Healthcare Services, Inc., in the 353rd Judicial District Court of Travis
County, Texas. The Nueces County action was transferred to Travis County and
the two cases have been consolidated into Cause No. 97-03569.
NOTE 12. INSURANCE COVERAGES
The Company insures automobile, general, and professional liability and
workers' compensation risks through insurance policies with third parties.
Some of these third-party policies subsequent to February 21, 1994 are subject
to reinsurance agreements between the insurer and LCA Insurance Company, Ltd.,
a wholly-owned subsidiary of the Company that was formed during 1994. The
business written by LCA Insurance Company, Ltd. is the reinsurance of policies
providing coverage for nursing home professional liability, automobile
liability, and workers' compensation. All of these are occurrence policies
which cover only the Company and its subsidiaries and their employees.
Pursuant to the reinsurance agreements, LCA Insurance Company, Ltd. is
responsible to pay all losses which are incurred by the company issuing the
policies. The maximum loss exposure with respect to these policies is $0.5
million per occurrence (policy periods prior to July 1, 1996) and $1.0 million
per occurrence (policy periods subsequent to July 1, 1996) for nursing home
professional liability; $0.25 million per occurrence for automobile liability;
and $0.5 million per occurrence for workers' compensation liability.
The liabilities for incurred losses are estimated by independent actuaries
on an undiscounted basis. The obligations of LCA Insurance Company, Ltd. under
the reinsurance agreements are collateralized through a security trust account
which has been designated as restricted investments to pay for future claims
experience applicable to policy periods subsequent to February 21, 1994.
Restricted investments at September 30, 1997 and 1996 designated to pay such
claims were $52.0 million and $31.0 million, respectively.
52
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
In 1992, the Company elected under Texas law to decline to participate in
the Texas workers' compensation insurance program. As part of the election,
the Company implemented an employee benefit plan providing for employer-paid
benefits comparable to those provided under the Texas workers' compensation
program and obtained insurance that limits the Company's exposure for any
individual injury. During 1994, the Company established a trust in which to
fund the amount applicable to actuarially determined claims to be incurred for
fiscal year 1994 and subsequent years.
The BCC Entities are insured for current and past workers' compensation
claims under various types of insurance and financial plans, certain of which
are loss-sensitive in nature and design, which subject the BCC Entities to
additional future premiums for losses incurred in a prior year but paid in a
subsequent fiscal period, as losses develop. The BCC Entities have recorded
expenses under these plans based upon actual and estimated losses based on the
available incurred loss structure.
Additionally, certain of these loss-sensitive workers' compensation plans in
which the BCC Entities have participated were organized as pools or funds,
with joint and several or pro rata liability ascribed to its members. Such
plans may lead to the potential of future loss assessments for the BCC
Entities; however, the amount of such additional potential assessments, if
any, is not determinable at this time. It is the opinion of management that
any additional assessments will not have a material adverse effect on the
financial position or results of operations of the Companies.
NOTE 13. DISCLOSURES REGARDING FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair value
of each class of financial instruments for which it is practicable to estimate
that value:
Cash and Cash Equivalents
The carrying amount approximates fair value because of the short maturity of
those instruments.
Notes Receivable
Fair value for each significant note receivable was estimated based on the
net present value of cash flows that would be received on each note over the
remaining note term using current market interest rates rather than stated
interest rates. The discount factor was the estimated rate for long-term debt
in effect at September 30, 1997 and 1996. Further adjustments were made to the
value of the notes based on management's opinion of the credit risk of the
note obligee.
Long-Term Debt
The Company believes that the fair value of the long-term debt is properly
reflected at current carrying amounts except for certain fixed rate debt
instruments. Fair values for each significant fixed rate debt instrument was
estimated based on the net present value of cash flows that would be paid on
each note over the remaining note term using the Company's current incremental
borrowing rate rather than the stated interest rates on the notes. See Note 5.
Interest Rate Swap Agreements
Fair values for the Company's various interest rate swap agreements were
based on market quotes which would be required to terminate the agreement. See
Note 5.
53
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The estimated values of the Company's financial instruments as of September
30, 1997 and 1996 are as follows (in thousands):
SEPTEMBER 30,
----------------------------------
1997 1996
---------------- ----------------
CARRYING FAIR CARRYING FAIR
AMOUNT VALUE AMOUNT VALUE
-------- ------- -------- -------
Cash and cash equivalents............. $14,355 $14,355 $21,394 $21,394
Notes receivable...................... 13,423 14,172 14,536 15,517
Restricted investments................ 51,976 51,976 31,040 31,040
Long-term debt........................ 295,959 298,843 276,448 277,413
Interest rate swap agreements......... -- (1,622) -- 341
NOTE 14. RELATED PARTY TRANSACTIONS
The Company purchases services and medical supplies from APS at current
market prices under certain service and supply agreements and all significant
intercompany purchases have been eliminated for the three years ended
September 30, 1997, 1996 and 1995. The Company also purchases therapy services
from ARS and TMI at current market prices under certain service agreements.
The total purchases from these companies prior to their acquisition by the
Company on June 30, 1995 and August 1, 1995, respectively amounted to $1.5
million for ARS and $1.9 million for TMI. All significant intercompany
purchases from these two subsidiaries since their acquisition have been
eliminated.
NOTE 15. EARNINGS PER COMMON SHARE
On November 24, 1997, the Board of Directors declared a three-for-one stock
split to be distributed on December 30, 1997 to shareholders of record on
December 15, 1997. See Note 19. The table below represents a reconciliation of
the number of weighted average common shares used in computing primary
earnings per share (in thousands) and reflects the stock split identified
above.
YEARS ENDED
SEPTEMBER 30,
------------------------
1997 1996 1995
------ ------ ------
Common shares outstanding, end of period...... 58,794 58,503 60,570
Effect of using weighted average shares
outstanding.................................. (180) 1,869 (4,020)
Effect of using treasury stock method on stock
options...................................... 711 573 552
------ ------ ------
Shares used in computing earnings per share... 59,325 60,945 57,102
====== ====== ======
In February 1995, the Company issued an additional 8,625,000 shares
(2,875,000 shares prior to the three-for-one stock split) of its common stock
in an additional public offering. The net proceeds of the transaction,
approximately $99.1 million, were used primarily to retire existing debt.
Assuming the transaction had occurred on October 1, 1994, net income and
earnings per share for the year ended September 30, 1995 would have been $25.5
million and $0.42, respectively.
NOTE 16. EMPLOYEE STOCK OPTION AND STOCK PURCHASE PLANS
The Company established an Employee Stock Option Plan in 1992 which
authorizes the granting of incentive stock options, nonqualified options, or
any combination of the foregoing to purchase up to 4,200,000 shares (1,400,000
shares prior to the three-for-one stock split) of the Company's common stock.
The exercise
54
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
price per share of common stock with respect to each incentive stock option is
the fair market value of a share of common stock (defined as the closing price
per share of the common stock on the New York Stock Exchange) on the date such
option is granted while the exercise price per share of common stock with
respect to a nonqualified option is the fair market value of a share of common
stock on the date such option is granted or on a subsequent date or as
otherwise provided in any agreement with the recipient, but in no event will
the exercise price with respect to a nonqualified option be less than 50% of
the fair market value of a share of common stock on the date of the grant. The
options have a term as fixed by the Stock Option Committee, but, in no event,
longer than ten years after the date of grant. Options are exercisable only by
the optionee and only while the optionee is an employee or nonemployee
director of the Company or, unless such optionee's employment is terminated
for cause, within three months after the optionee ceases to be an employee or
director of the Company. Options are exercisable for 12 months after the death
or permanent disability of an optionee. The option exercise price must be paid
in cash or, at the discretion of the Stock Option Committee, may be paid in
whole or in part in shares of common stock valued at fair market value on the
date of exercise. As of September 30, 1997 and 1996, there were 3,901,404 and
3,778,644, respectively (1,300,468 and 1,259,548 prior to the three-for-one
stock split, respectively), options granted and outstanding. All of these
options were converted into cash or shares of Company common stock in
connection with the Mergers. See Note 19.
The following is a summary of the stock option activity and related
information which has been adjusted to reflect the three-for-one stock split:
YEARS ENDED SEPTEMBER 30,
--------------------------------------------------------------------
1997 1996 1995
---------------------- ---------------------- ----------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE
------------ -------- ------------ -------- ------------ --------
Outstanding at beginning
of period.............. 3,778,644 $9.18 2,338,875 $ 8.27 1,793,325 $ 6.62
Granted................. 645,972 8.30 2,074,620 10.23 1,002,750 11.08
Exercised............... (21,831) 6.86 (118,302) 6.28 (162,030) 6.14
Forfeited............... (501,381) 9.95 (516,549) 9.87 (295,170) 8.99
------------ ----- ------------ ------ ------------ ------
Outstanding at end of
period................. 3,901,404 8.95 3,778,644 9.18 2,338,875 8.27
============ ============ ============ ======
Exercisable at end of
period................. 1,567,092 7.71 951,033 6.99 621,840 5.46
============ ============ ============ ======
Price range............. $4.42-$12.92 $4.42-$12.92 $4.42-$12.92
============ ============ ============
Weighted average fair
value of options
granted during the
year................... $5.00 $ 5.59 $ 6.28
===== ====== ======
The Company has elected to follow Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees" ("APB 25") and related
interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under SFAS
123 requires use of option valuation models that were not developed for use in
valuing employee stock options. Under APB 25, because the exercise price of
the Company's employee stock options equals the market price of the underlying
stock on the date of grant, no compensation expense is recognized.
Pro forma information regarding net income and earnings per share is
required by SFAS 123. The fair value for these options was estimated at the
date of grant using a Black-Scholes option pricing model with the
55
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
following weighted-average assumptions for 1997, 1996 and 1995: risk-free
interest rates ranging from 5.99% to 6.11%; a dividend yield of 0%; volatility
factors of the expected market price of the Company's common stock of 0.42;
and a weighted-average expected life of the option of eight years.
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options which have no vesting restrictions and are
fully transferable. In addition, option valuation models require the input of
highly subjective assumptions including the expected stock price volatility.
Because the Company's employee stock options have characteristics
significantly different from those of traded options, and because changes in
the subjective input assumptions can materially affect the fair value
estimate, in management's opinion, the existing models do not necessarily
provide a reliable single measure of the fair value of its employee stock
options.
WEIGHTED
AVERAGE
WEIGHTED REMAINING
AVERAGE CONTRACTUAL
EXERCISE LIFE
RANGE OPTIONS PRICE (YEARS)
----- --------- -------- -----------
$4.42--$5.83............................... 631,260 $ 4.82 4.83
$6.75--$8.25............................... 1,107,042 $ 7.89 9.08
$8.58--$9.88............................... 501,255 $ 9.48 7.58
$10.54--$10.96............................. 1,061,100 $10.62 7.83
$11.79--$12.92............................. 600,747 $11.86 8.42
---------
3,901,404
=========
For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. The
Company's pro forma information follows (in thousands except for earnings per
share information):
1997 1996 1995
------- ------- -------
Pro forma net income............................. $42,489 $42,405 $23,920
Pro forma earnings per share..................... $ 0.72 $ 0.70 $ 0.42
The Company established an Employee Stock Purchase Plan in 1993. The plan
authorizes the purchase of up to 360,000 shares (120,000 shares prior to the
three-for-one stock split) of the Company's common stock by eligible
employees. The provisions of the plan include eligibility for all full time
employees who have completed one year of service, employee contributions equal
to the lesser of 10% of base salary or $10,000, the purchase price being equal
to the lesser of the fair market value of the stock on the first or the last
day of the plan year, and an option to purchase shares of stock or withdraw
all payroll deductions plus interest at the end of the plan year. As of
September 30, 1997 and 1996, a total of 177,789 and 129,480 shares,
respectively, (59,263 and 43,160 prior to the three-for-one stock split) had
been issued under the plan. The Employee Stock Purchase Plan was terminated
effective September 17, 1997.
56
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
NOTE 17. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
The table below sets forth summarized quarterly financial data for the years
ended September 30, 1997 and 1996 (in thousands, except per share amounts) and
has been adjusted to reflect the three-for-one stock split. See Note 19.
FOURTH THIRD SECOND FIRST
1997 QUARTER QUARTER QUARTER QUARTER
- ---- -------- -------- -------- --------
Net revenues...................... $286,335 $288,433 $285,318 $280,202
Income from operations............ 19,126 (a) 28,456 25,844 21,682
Income before income taxes and
equity earnings/minority
interests........................ 15,198 23,968 21,462 17,628
Equity earnings/minority interest. (330) (223) (119) (63)
Net income........................ $ 7,709 $ 13,669 $ 12,214 $ 10,325
======== ======== ======== ========
Earnings per share................ $ 0.13 $ 0.23 $ 0.21 $ 0.18
======== ======== ======== ========
Weighted average common and common
equivalent shares outstanding.... 59,796 59,658 59,241 58,797
======== ======== ======== ========
- --------
(a) Includes $2.6 million merger and acquisition costs (or $0.04 per share
expense after tax.)
FOURTH THIRD SECOND FIRST
1996 QUARTER QUARTER QUARTER QUARTER
- ---- -------- -------- -------- --------
Net revenues...................... $284,838 $281,217 $278,056 $270,380
Income from operations............ 21,172 (b) 22,951(b) 24,110 21,323
Income before income taxes and
equity earnings/minority
interests........................ 17,700 20,038 21,154 18,203
Equity earnings/minority
interests........................ (87) 122 (189) (2)
Net income........................ $ 7,053 $ 12,816 $ 12,412 $ 10,899
======== ======== ======== ========
Earnings per share................ $ 0.12 $ 0.21 $ 0.20 $ 0.18
======== ======== ======== ========
Weighted average common and common
equivalent shares outstanding.... 59,739 61,503 61,509 61,080
======== ======== ======== ========
- --------
(b) Includes $2.0 million income and $0.9 million expense of non-recurring
items in the third and fourth quarters, respectively (or $0.03 per share
income and $0.06 per share expense after tax, respectively)
NOTE 18. STOCKHOLDER RIGHTS PLAN
Since November 17, 1994, when the Company's Board of Directors declared a
dividend of one right for each outstanding share of the Company's common
stock, each share of the Company's outstanding common stock carries with it
such right. Each right entitles the holder to purchase from the Company one
one-hundredth of a share of Series A Junior Participating Preferred Stock, par
value $0.01 per share, for an exercise price of $160, subject to adjustment.
Such rights will not be exercisable nor transferable apart from the Common
Stock until such time as a person or group acquires 15% of the Company's
Common Stock or initiates a tender offer or exchange offer that will result in
ownership of 15% of the Company's Common Stock.
In the event that the Company is merged, and its Common Stock is exchanged
or converted, the rights will entitle the holders to buy shares of the
acquiror's common stock at a 50% discount. Under certain other circumstances,
the rights can become rights to purchase the Company's Common Stock at a 50%
discount. The
57
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
rights may be redeemed by the Company for $0.01 per right at any time until 10
days following the first public announcement of a 15% acquisition of
beneficial ownership of the Company's Common Stock. On May 7, 1997, LCA's
Board of Directors amended the Rights Agreement under which the rights were
granted such that the Rights Agreement terminated immediately prior to the
Mergers. See Note 19.
NOTE 19. SUBSEQUENT EVENTS
Recapitalization Merger Agreement
During 1997 the Company entered into a Recapitalization Merger Agreement
(the "Recapitalization Merger") with Apollo Management, L.P. ("Apollo") and
one of its affiliates which was completed effective November 1, 1997. In
connection with the Recapitalization Merger, certain affiliates of Apollo and
certain other investors (the "Apollo Investors") invested $240 million to
purchase approximately 5.9 million shares of newly issued common stock of LCA
(see below). Concurrent with the Recapitalization Merger, LCA changed its name
to Paragon Health Network, Inc. ("Paragon").
Also effective November 1, 1997, Paragon sold $275 million of its 9.5%
Senior Subordinated Notes due 2007, at a price of 99.5% of face value and $294
million of its 10.5% Senior Subordinated Discount Notes due 2007, at a price
of 59.6% of face value (collectively the "Notes"), in a private offering to
institutional investors. Concurrent with the private Notes offering, Paragon
entered into a new Senior Credit Facility which is composed of $740 million in
Term Loans and a Revolving Credit Facility which provides for borrowings up to
an additional $150 million. The Term Loans consist of (i) a $240 million Term
Loan for 6 1/2-years, (ii) a $250 million Term Loan for 7 1/2-years, and (iii)
a $250 million Term Loan for 8 1/2-years. Borrowings under the Senior Credit
Facility are at the Chase Manhattan, N.A. base rate or LIBOR plus an
applicable margin ranging from 0.75% to 2.75% depending upon the respective
term loan tenor and the Company's leverage ratio. The Senior Credit Facility
imposes restrictions on the Company's ability to make capital expenditures and
both the Senior Credit Facility and the indenture governing the Notes limit
the Company's ability to incur additional indebtedness. The covenants
contained in the Senior Credit Facility also, among other things, restrict the
ability of the Company to dispose of assets, repay other indebtedness or amend
other debt instruments, pay dividends, and make acquisitions. Annual
maturities of Paragon's long-term debt in the next five fiscal years are
expected to be as follows: $3.3 million in 1998, $29.4 million in 1999, $50.9
million in 2000, $53.3 million in 2001, $52.8 million in 2002, and $1.1
billion thereafter.
Paragon used the $240 million invested by Apollo Investors, the $1.189
billion of net proceeds provided by the Notes offering and the Term Loans to
(i) purchase approximately 90.5% of the issued and outstanding common stock of
the Company for a per share price of $40.50 (prior to the three-for-one stock
split), (ii) to repay substantially all amounts outstanding under the
Company's and under GranCare Inc.'s (see below for description of the
GranCare, Inc. merger acquisition) previous credit facilities and (iii) pay
for certain costs associated with the Mergers.
GranCare Purchase Business Combination
Effective November 1, 1997, and subsequent to the Company's
recapitalization, Paragon completed the merger acquisition of GranCare, Inc.
("GranCare") pursuant to the terms of the previously announced GranCare Merger
Agreement. In the merger acquisition, GranCare common stock was exchanged for
0.2346 of a share of Paragon common stock. The acquisition was accounted for
under the purchase method. Following the recapitalization and acquisition, the
Apollo Investors and certain other investors owned approximately 44.0%, prior
GranCare shareholders owned approximately 41.9% and prior LCA shareholders
retained approximately 14.1% of the outstanding shares of Paragon common
stock.
The Recapitalization Merger and the GranCare Merger effectively reduced the
Company's total stockholders' equity from $375 million at September 30, 1997
to approximately $77 million following the Mergers.
58
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Paragon Stock Split
On November 24, 1997, the Board of Directors of Paragon declared a three-
for-one stock split on Paragon's (formerly LCA's) common stock. In all
instances throughout the financial statements and footnotes, common stock and
additional paid-in capital as of September 30, 1997 and 1996 have been
restated to reflect this split. The number of shares issued at September 30,
1997 and 1996 after giving effect to the split was 60,803,760 shares
(20,267,920 shares before the split).
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information on directors of the registrant will appear in the Company's
Proxy Statement for the 1998 annual meeting of stockholders, which will be
filed with the Securities and Exchange Commission, and is incorporated herein
by reference. Information required by this item for the Company's executive
officers is contained in Item 4 of this report.
ITEM 11. EXECUTIVE COMPENSATION
Information on executive compensation will appear in the Company's Proxy
Statement for the 1998 annual meeting of stockholders, which will be filed
with the Securities and Exchange Commission, and is incorporated herein by
reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information on security ownership of certain beneficial owners will appear
in the Company's Proxy Statement for the 1998 annual meeting of stockholders,
which will be filed with the Securities and Exchange Commission, and is
incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information on certain relationships and related transactions will appear in
the Company's Proxy Statement for the 1998 annual meeting of stockholders,
which will be filed with the Securities and Exchange Commission, and is
incorporated herein by reference.
59
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K
FINANCIAL STATEMENTS
The following reports, financial statements and schedule are filed herewith
on the pages indicated:
PAGE
----
Report of Independent Auditors............................................ 33
Consolidated Balance Sheets at September 30, 1996 and 1997................ 34
Consolidated Statements of Income for Fiscal Years 1995, 1996 and 1997.... 35
Consolidated Statements of Stockholders' Equity for Fiscal Years 1995,
1996 and 1997............................................................ 36
Consolidated Statements of Cash Flows for Fiscal Years 1995, 1996 and
1997..................................................................... 37
Notes to Consolidated Financial Statements................................ 38
FINANCIAL STATEMENT SCHEDULE
Schedule II--Valuation and Qualifying Accounts and Reserves............... 69
All other schedules for which provision is made in the applicable accounting
regulations of the Securities and Exchange Commission are not required under
the related instructions or are inapplicable, and, therefore, have been
omitted.
EXHIBITS
--------
*2.1 Stock Purchase Agreement by and between Abbey Healthcare Group,
Incorporated and Living Centers of America, Inc. with respect to the
sale of Abbey Pharmaceutical Services, Inc. (filed as Exhibit 99.2
to Registrant's Form 8-K dated October 14, 1994 and incorporated
herein by reference).
*2.2 Schedule 14D-1 Tender Offer Statement for Rehability Corporation
filed on May 23, 1995.
*2.3 Amended and Restated Agreement and Plan of Merger dated March 27,
1995 among Living Centers of America, Inc. and Living Centers/Brian
Care Company and the Brian Care Center Corporation, The Beaver
Property Entities and Donald C. Beaver, as amended (filed as Exhibit
2.1 of the Fourth Amendment to the Registrant's Registration
Statement on Form S-4, Registration No. 33-90676, and incorporated
herein by reference).
*2.4 Agreement of Purchase and Exchange among Living Centers of America,
Inc. and Living Centers Specialty Care Services, Inc. and Cason,
Inc., Don W. Wortley, Don W. Wortley Trust, Mary Ann Wortley Trust,
and 726 Cottonwood, Ltd. dated as of August 1, 1995 (filed as
Exhibit 10.1 to Registrant's Registration Statement on Form S-3,
Registration No. 33-97616, and incorporated herein by reference).
*2.5 Recapitalization Agreement, as amended, by and among Living Centers
of America, Inc., DevCon Holding Company, Living Centers-DevCon,
Inc., and Golber, Thoma, Cressey, Raimer Fund IV, L.P. (filed as
Exhibit 2.7 to Registrant's Annual Report on Form 10-K for the
fiscal year ended September 30, 1996, File No. 001-10968, and
incorporated herein by reference).
*2.6 Amended and Restated Agreement and Plan of Merger dated September
17, 1997 among Apollo Management, L.P. ("Apollo"), Apollo LCA
Acquisition Corp. and Living Centers of America, Inc. (filed as
Annex I to Registrant's Registration Statement on Form S-4,
Registration No. 333-36525, and incorporated herein by reference).
*2.7 Amended and Restated Agreement and Plan of Merger dated September
17, 1997 among Living Centers of America, Inc., GranCare, Inc.
("GranCare"), Apollo and LCA Acquisition Sub, Inc. (filed as Annex
II to Registrant's Registration Statement on Form S-4, Registration
No. 333-36525, and incorporated herein by reference).
60
EXHIBITS
--------
*3.1 Amended and Restated Certificate of Incorporation of Paragon Health
Network, Inc. (filed as Annex III to Registrant's Registration
Statement on Form S-4, Registration No. 333-36525, and incorporated
herein by reference).
*3.2 Amended and Restated Bylaws of Paragon Health Network, Inc. (filed
as Annex IV to Registrant's Registration Statement on Form S-4,
Registration No. 333-36525, and incorporated herein by reference).
4.1 Amended and Restated Certificate of Incorporation of Paragon Health
Network, Inc. (filed as Exhibit 3.1 hereto).
4.2 Amended and Restated Bylaws of Paragon Health Network, Inc. (filed
as Exhibit 3.2 hereto).
*4.3 Stockholders' Agreement by and among Paragon Health Network, Inc.,
Apollo and certain other investors (filed as Annex V to Registrant's
Registration Statement on Form S-4, Registration No. 333-36525, and
incorporated herein by reference).
*4.4 Registration Rights Agreement among Paragon Health Network, Inc. and
certain investors (filed as Exhibit 4.7 to Registrant's Registration
Statement on Form S-4, Registration No. 333-36525, and incorporated
herein by reference).
4.5 Indenture dated as of November 4, 1997, between Paragon Health
Network, Inc. and IBJ Schroder Bank & Trust Company.
4.6 Exchange and Registration Rights Agreement dated as of November 4,
1997, among Paragon Health Network, Inc., Chase Securities, Inc.,
Smith Barney Inc. and Credit Suisse First Boston Corporation.
4.7 Form of Common Stock Certificate of Paragon Health Network, Inc.
4.8 10 1/2% Senior Subordinated Discount Note Due 2007 pertaining to
CUSIP No. 698940 AB 9.
4.9 10 1/2% Senior Subordinated Discount Note Due 2007 pertaining to
CUSIP No. U69879 AB 7.
4.10 10 1/2% Senior Subordinated Discount Note Due 2007 pertaining to
CUSIP No. 698940 AD 5.
4.11 9 1/2% Senior Subordinated Note Due 2007 pertaining to CUSIP No.
698940 AA 1.
4.12 9 1/2% Senior Subordinated Note Due 2007 pertaining to CUSIP No.
U69879 AA 9.
4.13 9 1/2% Senior Subordinated Note Due 2007 pertaining to CUSIP No.
698940 AC 7.
10.1 +Employment Agreement between Paragon Health Network, Inc. and Keith
B. Pitts.
10.2 +Employment Agreement between Paragon Health Network, Inc. and John
D. Lee.
10.3 +Employment Agreement between Paragon Health Network, Inc. and Susan
Thomas Whittle.
10.4 +Employment Agreement between Paragon Health Network, Inc. and
William R. Korslin.
10.5 +Employment Agreement between Paragon Health Network, Inc. and
Dennis G. Johnston.
10.6 +Employment Agreement between Paragon Health Network, Inc. and David
W. Budke.
10.7 +Employment Agreement between Paragon Health Network, Inc. and David
L. Ward.
10.8 +Employment Agreement between Paragon Health Network, Inc. and
Charles B. Carden.
10.9 +Employment Agreement between Paragon Health Network, Inc. and Aruna
Poddatoori.
10.10 +Employment Agreement between Paragon Health Network, Inc. and Leroy
D. Williams.
10.11 +Employment Agreement between Paragon Health Network, Inc. and R.
Jeffrey Taylor.
61
EXHIBITS
--------
10.12 +Form of Employment Agreement entered into between Paragon Health
Network, Inc. and its Vice Presidents.
*10.13 +1992 Stock Option Plan of Living Centers of America, Inc., as
amended (filed as Exhibit 10.1 to Registrant's Registration
Statement Form S-8, Registration Statement No. 333-09707, and
incorporated herein by reference).
*10.14 +Deferred Retirement Incentive Plan of Living Centers of America,
Inc. (filed as Exhibit 10.4 to Registrant's Annual Report on Form
10-K for the fiscal year ended September 30, 1992, File No. 001-
10968, and incorporated herein by reference).
*10.15 +Management Incentive Bonus Plan of Living Centers of America, Inc.
(filed as Exhibit 10.8 to Registrant's Annual Report on Form 10-K
for the fiscal year ended September 30, 1992, File No. 001-10968,
and incorporated herein by reference).
*10.16 +Employee Stock Purchase Plan of Living Centers of America, Inc.
(filed as Exhibit 10.2 to Registrant's Quarterly Report on Form 10-Q
for the quarter ended March 31, 1993, File No.
001-10968, and incorporated herein by reference).
10.17 +Paragon Health Network, Inc. 1997 Long-Term Incentive Plan.
10.18 +Paragon Health Network, Inc. Incentive Compensation Plan.
*10.19 +GranCare, Inc. 1996 Stock Incentive Plan (filed with Amendment No.
1 to GranCare's Registration Statement on Form S-1, Registration No.
333-19097, and incorporated herein by reference).
*10.20 +GranCare, Inc. 1996 Replacement Stock Option Plan (filed with
Amendment No. 1 to GranCare's Registration Statement on Form S-1,
Registration No. 333-19097, and incorporated herein by reference).
*10.21 +GranCare, Inc. Outside Directors' Stock Incentive Plan (filed with
Amendment No. 1 to GranCare's Registration Statement on Form S-1,
Registration No. 333-19097, and incorporated herein by reference).
*10.22 +Executive Deferred Compensation Plan (filed with Amendment No. 1 to
GranCare's Registration Statement on Form S-1, Registration No. 333-
19097, and incorporated herein by reference).
*10.23 +GranCare, Inc. 401(k) Savings Plan and Trust (filed with GranCare's
Annual Report on Form 10-K for the year ended December 31, 1995, and
incorporated herein by reference).
*10.24 +Assignment, Assumption and Amendment of the GranCare, Inc. 401(k)
Savings Plan (filed with Amendment No. 1 to GranCare's Registration
Statement on Form S-1, Registration No. 333-19097, and incorporated
herein by reference).
*10.25 Indemnification Agreement dated as of February 21, 1992 between
Living Centers of America, Inc. and the ARA Group, Inc. (filed as
Exhibit 10.4 to Registrant's Registration Statement on Form
S-1, Registration No. 33-44726, and incorporated herein by
reference).
*10.26 Assignment Agreement dated as of February 21, 1992 between Living
Centers of America, Inc. and The ARA Group, Inc. (filed as Exhibit
10.6 to Registrant's Registration Statement on Form
S-1, Registration No. 33-44726, and incorporated herein by
reference).
10.27 Purchase Agreement dated October 30, 1997, by and among Living
Centers of America, Inc. and Chase Securities, Inc., Smith Barney
Inc. and Credit Suisse First Boston Corporation.
10.28 Termination Release Agreement dated as of September 3, 1997, by and
among GranCare, Manor Care, Inc. and Vitalink Pharmacy Services,
Inc., Apollo Management, L.P. and Living Centers of America, Inc.
62
EXHIBITS
--------
10.29 Letter Agreement regarding Liquidated Damages Calculation in
Pharmaceutical Supply Agreements dated September 3, 1997, by and
among GranCare, Inc., TeamCare, Inc. and Vitalink Pharmacy
Services, Inc.
10.30 Letter Agreement regarding Preferred Provider Arrangement dated
August 29, 1997, by and among Vitalink Pharmacy Services, Inc. and
GranCare.
10.31 Amendment to AMS Properties, Inc. Facility Leases dated as of
October 31, 1997 between Health and Retirement Properties Trust
("HRPT") and AMS Properties, Inc. ("AMS").
10.32 Collateral Pledge Agreement dated as of October 31, 1997 by and
between Paragon Health Network, Inc. and HRPT.
10.33 Guaranty by GranCare dated as of October 31, 1997 by GranCare in
favor of HRPT.
10.34 Guaranty by Paragon Health Network, Inc. dated as of October 31,
1997 by Paragon Health Network, Inc. in favor of HRPT.
10.35 Restructure and Asset Exchange Agreement dated as of October 31,
1997 among HRPT, GranCare, AMS and GCI Health Care Centers, Inc.
10.36 Subordination Agreement dated as of October 31, 1997 by and among
HRPT and the corporations listed on the signature page thereto.
10.37 Amendment to GCI Health Care Centers, Inc. Facility Leases dated as
of October 31, 1997.
*10.38 Amendment to Acquisition Agreement, Agreement to Lease and Mortgage
Loan Agreement dated as of December 29, 1993 among HRPT, GranCare,
AMS and GCI Health Care Centers, Inc. (filed with GranCare's
Current Report on Form 8-K filed January 13, 1994, and incorporated
herein by reference).
*10.39 Master Lease Document dated December 28, 1990, between HRPT and AMS
Properties, Inc. ("AMS") (filed with GranCare's Registration
Statement on Form S-1, Registration No. 33-42595, and incorporated
herein by reference).
*10.40 Form of Guaranty dated December 28, 1990, by American Medical
Services, Inc. and each of its subsidiaries in favor of HRPT (filed
with GranCare's Registration Statement on Form S-1, Registration
No. 33-42595, and incorporated herein by reference).
*10.41 Amendment to Master Lease between HRPT and AMS dated as of December
29, 1993 (filed with GranCare's Current Report on Form 8-K filed
January 13, 1994, and incorporated herein by reference).
*10.42 Amendment to Master Lease Document and Facility Lease between GCI
Health Care Center, Inc. and HRPT dated as of October 31, 1994
(filed with GranCare's Annual Report on Form 10-K for the year
ended December 31, 1995, and incorporated herein by reference).
*10.43 Amendment to Master Lease Document and Facility Lease between AMS
and HRPT dated as of October 31, 1994 (filed with GranCare's Annual
Report on Form 10-K for the year ended December 31, 1995, and
incorporated herein by reference).
*10.44 Promissory Note from AMS to HRPT in the principal amount of $11.5
million, dated October 1, 1994 (filed with GranCare's Annual Report
on Form 10-K for the year ended December 31, 1995, and incorporated
herein by reference).
*10.45 Mortgage and Security Agreement from AMS to HRPT for the Northwest
and River Hills West Health Care Centers dated as of March 31, 1995
(filed with GranCare's Annual Report on Form 10-K for the year
ended December 31, 1995, and incorporated herein by reference).
*10.46 Assumption Agreement by GranCare in favor of HRPT (filed with
GranCare's Amendment No. 1 to Registration Statement on Form S-1,
Registration No. 333-19097, and incorporated herein by reference).
63
EXHIBITS
--------
*10.47 Consent and Amendment to Transaction Documents dated as of December
31, 1996 (the "Consent and Amendment") among GCI Health Care
Centers, Inc., GranCare, Vitalink Pharmacy Services, Inc., HRPT and
AMS (filed with GranCare's Amendment No. 1 to Registration
Statement on Form S-1, Registration No. 333-19097, and incorporated
herein by reference).
10.48 Credit Agreement for $890,000,000 dated as of November 4, 1997, by
and among Paragon Health Network, Inc., as Borrower, The Chase
Manhattan Bank, as Administrative Agent, NationsBank, N.A., as
Documentation Agent, and the several lenders from time to time
parties thereto
10.49 Guarantee and Collateral Agreement dated as of November 4, 1997, by
and among Paragon Health Network, Inc. and certain of its
subsidiaries in favor of The Chase Manhattan Bank, as Collateral
Agent.
10.50 Amended and Restated Participation Agreement dated November 4,
1997, by and among Living Centers Holding Company, as Lessee, FBTC
Leasing Corp., as Lessor, The Chase Manhattan Bank, as Agent for
the Lenders, the Fuji Bank Limited (Houston Agency), as Co-Agent,
and the Lenders parties thereto.
10.51 Amended and Restated Guaranty dated November 4, 1997, by and among
Paragon Health Network, Inc. and certain other guarantors signatory
thereto in favor of The Chase Manhattan Bank, as Administrative
Agent.
10.52 Lease dated October 10, 1996, between FBTC Leasing Corp., as
Lessor, and Living Centers Holding Company, as Lessee.
10.53 Amendment to Lease dated as of November 4, 1997 between FBTC
Leasing Corp. and Living Centers Holding Company.
*10.54 Form of Mortgage and Security Agreement with respect to five of
GranCare's facilities located in the State of Illinois to secure a
loan in the aggregate principal amount of $16.5 million from Health
Care Capital Finance, Inc. (the "Health Care Capital Loan"), each
agreement dated as of March 23, 1995 (filed with GranCare's Annual
Report on Form 10-K for the year ended December 31, 1995, and
incorporated herein by reference).
*10.55 Master Settlement Agreement between GranCare and the Service
Employees International Union ("SEIU"), dated as of November 6,
1995 (filed with GranCare's Annual Report on Form 10-K for the year
ended December 31, 1995).
*10.56 Settlement Agreement between GranCare and the SEIU with respect to
four of GranCare's facilities located in the State of Michigan,
dated as of January 29, 1996 (filed with GranCare's Annual Report
on Form 10-K for the year ended December 31, 1995).
*10.57 Settlement Agreement between GranCare and the SEIU with respect to
seven of GranCare's facilities located in the State of Wisconsin
(filed with GranCare's Annual Report on Form 10-K for the year
ended December 31, 1995).
*10.58 Settlement Agreement between GranCare and the SEIU with respect to
seven of GranCare's facilities located in the State of California
(filed with GranCare's Annual Report on Form 10-K for the year
ended December 31, 1995).
10.59 +Agreement Respecting Termination of Employee--Employer
Relationship between Paragon Health Network, Inc. and Keith Krein
dated November 4, 1997.
10.60 +Agreement Respecting Termination of Employee--Employer
Relationship between Paragon Health Network, Inc. and Edward L.
Kuntz dated November 4, 1997.
11 Statement regarding computation of earnings per share.
21 Subsidiaries of Paragon Health Network, Inc.
64
EXHIBITS
--------
23 Consent of Ernst & Young LLP.
24 Power of Attorney.
27 Financial Data Schedule.
- --------
* Incorporated by reference as indicated.
+ Represents management contracts or compensatory plans or arrangements
required to be filed as exhibits to this Annual Report by Item
601(d)(10)(iii) of Regulation S-K.
Paragon Health Network, Inc. will furnish a copy of any exhibit described
above to any beneficial holder of its securities upon receipt of a written
request therefor, provided that such request sets forth a good faith
representation that as of December 18, 1997, the date of record for its 1998
annual stockholders' meeting to be held on February 19, 1998, such beneficial
owner is entitled to vote at such meeting, and provided further that such
holder pays to Paragon Health Network, Inc. a fee compensating it for its
reasonable expenses in furnishing such exhibits.
(B) REPORTS ON FORM 8-K.
There were no reports filed on Form 8-K during the quarter ended September
30, 1997.
(C) EXHIBITS
The response to this portion of Item 14 is contained in Item 14(a)(3) of
this report.
(D) FINANCIAL STATEMENT SCHEDULE
The response to this portion of Item 14 is contained in Item 8 of this
report.
65
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
PARAGON HEALTH NETWORK, INC.
(Registrant)
By: /s/ Susan Thomas Whittle
-----------------------------------
Susan Thomas Whittle
Senior Vice President, General
Counsel and Secretary
Date: December 29, 1997
66
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the date indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ Keith B. Pitts Chairman of the Board, December 29, 1997
- ------------------------------------ President and Chief
Keith B. Pitts Executive Officer
(Principal Executive
Officer)
/s/ Charles B. Carden Executive Vice President and December 29, 1997
- ------------------------------------ Chief Financial Officer
Charles B. Carden (Principal Financial
Officer)
* Director December 29, 1997
- ------------------------------------
Donald C. Beaver
* Director December 29, 1997
- ------------------------------------
Laurence M. Berg
* Director December 29, 1997
- ------------------------------------
Gene E. Burleson
* Director December 29, 1997
- ------------------------------------
Peter P. Copses
* Director December 29, 1997
- ------------------------------------
Jay M. Gillert
* Director December 29, 1997
- ------------------------------------
Joel S. Kanter
* Director December 29, 1997
- ------------------------------------
John H. Kissick
* Director December 29, 1997
- ------------------------------------
Baltej S. Maini, M.D.
* Director December 29, 1997
- ------------------------------------
William G. Petty, Jr.
* Director December 29, 1997
- ------------------------------------
Robert L. Rosen
/s/ Ronald W. Fleming Vice President, Controller December 29, 1997
- ------------------------------------ and Chief Accounting
Ronald W. Fleming Officer (Principal
Accounting Officer)
*Executed on behalf of the aforementioned directors by Susan Thomas Whittle
pursuant to the powers of attorney included in Exhibit 24.
/s/ Susan Thomas Whittle December 29, 1997
- -------------------------------
Susan Thomas Whittle
67
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
PARAGON HEALTH NETWORK, INC.
(DOLLARS IN THOUSANDS)
BALANCE DEDUCTION ADDITIONS BALANCE
BEGINNING CHARGED FROM FROM END OF
OF PERIOD TO INCOME RESERVE ACQUISITIONS PERIOD
--------- --------- --------- ------------ --------
Fiscal Year 1997:
Allowance for doubtful
accounts............... $17,405 $27,760 $(12,027) $ -- $ 33,138
======= ======= ======== ====== ========
Notes receivable
reserves............... $ 3,516 $(1,478)(a) $ (850) $ -- $ 1,188
======= ======= ======== ====== ========
Fiscal Year 1996:
Allowance for doubtful
accounts............... $13,332 $16,666 $(14,702) $2,109 $ 17,405
======= ======= ======== ====== ========
Notes receivable
reserves............... $ 3,550 $ -- $ (34) $ -- $ 3,516
======= ======= ======== ====== ========
Fiscal Year 1995:
Allowance for doubtful
accounts............... $ 6,632 $10,520 $(11,659) $7,839 $ 13,332
======= ======= ======== ====== ========
Notes receivable
reserves............... $ 2,850 $ 700 $ -- $ -- $ 3,550
======= ======= ======== ====== ========
- --------
(a) Includes reversal of reserves based on collections of notes previously
considered doubtful.
68