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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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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, 2000
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______________ to ______________
COMMISSION FILE NO. 1-6639
MAGELLAN HEALTH SERVICES, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 58-1076937
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
6950 COLUMBIA GATEWAY DRIVE
SUITE 400
COLUMBIA, MARYLAND 21046
(Address of principal executive (Zip Code)
offices)
Registrant's telephone number, including area code: (410) 953-1000
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Securities registered pursuant to Section 12(b) of the Act:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
Common Stock ($0.25 par value) New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No / /
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. / /
The aggregate market value of the common stock held by non-affiliates of the
registrant at November 30, 2000 was approximately $93,939,264.
The number of shares of the registrant's common stock outstanding as of
November 30, 2000 was 34,921,746.
DOCUMENTS INCORPORATED BY REFERENCE: The registrant's definitive proxy
materials on Schedule 14A relating to its annual meeting of stockholders to be
held on February 21, 2001 are incorporated by reference into Part III as set
forth herein.
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MAGELLAN HEALTH SERVICES, INC.
ANNUAL REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2000
TABLE OF CONTENTS
PAGE
--------
PART I
ITEM 1. Business.................................................... 3
ITEM 2. Properties.................................................. 26
ITEM 3. Legal Proceedings........................................... 27
ITEM 4. Submission of Matters to a Vote of Security Holders......... 29
PART II
ITEM 5. Market Price for Registrant's Common Equity and Related
Stockholder Matters....................................... 29
ITEM 6. Selected Financial Data..................................... 29
ITEM 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 31
ITEM 7A. Quantitative and Qualitative Disclosures About Market
Risk...................................................... 42
ITEM 8. Financial Statements and Supplementary Data................. 42
ITEM 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................. 42
PART III
ITEM 10. Directors and Executive Officers of the Registrant.......... 43
ITEM 11. Executive Compensation...................................... 43
ITEM 12. Security Ownership of Certain Beneficial Owners and
Management................................................ 43
ITEM 13. Certain Relationships and Related Transactions.............. 43
PART IV
ITEM 14. Exhibits, Financial Statement Schedule and Reports on
Form 8-K.................................................. 43
2
PART I
ITEM 1. BUSINESS
Magellan Health Services, Inc. (the "Company"), which was incorporated in
1969 under the laws of the State of Delaware, is a national healthcare company.
The Company primarily operates through two principal segments and engages in the
behavioral managed healthcare business and the human services business The
Company's executive offices are located at Suite 400, 6950 Columbia Gateway
Drive, Columbia, Maryland 21046, and its telephone number at that location is
(410) 953-1000.
RECENT DEVELOPMENTS
DIVESTITURE OF SPECIALTY MANAGED HEALTHCARE BUSINESS. On October 4, 2000
the Board of Directors of the Company, adopted a formal plan of disposal of the
specialty managed healthcare business segment. This action represents a disposal
of a business segment under Accounting Principles Board Opinion No. 30,
"Reporting the Results of Operations--Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions" ("APB 30"). APB 30 requires that the results of
continuing operations be reported separately from those of discontinued
operations for all periods presented and that any gain or loss from disposal of
a segment of a business be reported in conjunction with the related results of
discontinued operations. Accordingly, the Company has restated its results of
operations for all prior periods. The Company recorded an after-tax loss on
disposal of its specialty managed healthcare segment of approximately
$17.7 million (primarily non-cash), in the fourth quarter of fiscal 2000. See
Note 3--"Discontinued Operations" to the Company's audited consolidated
financial statements set forth elsewhere herein.
The specialty managed healthcare segment includes the businesses acquired in
conjunction with the purchase of Vivra, Inc. ("Vivra") on February 29, 2000 and
Allied Health Group, Inc. ("Allied") on December 5, 1997. The initial purchase
price of Vivra was $10.25 million and additional consideration of $10.0 million
may be payable based upon future results. Approximately 30% of the voting
interest in Vivra was owned by the investment firm Texas Pacific Group ("TPG")
at the time of the Company's acquisition. Three of the Company's twelve board
members are affiliated with TPG; however, these three Board members did not
participate in the Board's approval of the Vivra acquisition. TPG is the holder
of 59,063 shares of the Company's redeemable preferred stock, representing
approximately 16% of the outstanding voting securities of the Company at
September 30, 2000. See Note 7--"Redeemable Preferred Stock" to the Company's
audited consolidated financial statements set forth elsewhere herein. The
Company paid approximately $54.5 million for Allied.
BANK AMENDMENT. On August 11, 2000, the Company was successful in amending
certain financial covenants and terms of the Credit Agreement (as defined). The
Company believes the amended Credit Agreement will enable the Company to comply
with all future financial covenants based on the Company's projected operating
performance. The Company incurred approximately $3.1 million in fees to obtain
this amendment and the Company's borrowing rate on its term debt was increased
by 1.25%, resulting in increased interest cost in future periods.
TPG INVESTMENT. On December 15, 1999, the Company entered into an amended
and restated definitive agreement with TPG Magellan, LLC, an affiliate of the
investment firm Texas Pacific Group ("TPG"), pursuant to which TPG purchased
approximately $59.1 million of the Company's Series A Cumulative Convertible
Preferred Stock (the "Series A Preferred Stock") and an Option (the "Option") to
purchase an additional approximately $21.0 million of Series A Preferred Stock.
Net proceeds from issuance of the Series A Preferred Stock were $54.0 million.
Approximately 50% of the net proceeds received from the issuance of the
Series A Preferred Stock was used to reduce debt outstanding under the Term Loan
Facility (as defined) with the remaining 50% of the proceeds being used for
general corporate purposes. The Series A Preferred Stock carries a dividend of
6.5% per annum, payable in quarterly installments in cash or common stock,
subject to certain conditions. Dividends not paid in cash or common
3
stock will accumulate. The Series A Preferred Stock is convertible at any time
into the Company's common stock at a conversion price of $9.375 per share (which
would result in approximately 6.3 million shares of common stock if all of the
currently issued Series A Preferred Stock were to convert) and carries "as
converted" voting rights. The Company may, under certain circumstances, require
the holders of the Series A Preferred Stock to convert such stock into common
stock. The Series A Preferred Stock, plus accrued and unpaid dividends thereon,
must be redeemed by the Company on December 15, 2009. The Option may be
exercised in whole or in part at any time on or prior to June 15, 2002. The
terms of the shares of Series A Preferred Stock issuable pursuant to the Option
are identical to the terms of the shares of Series A Preferred Stock issued to
TPG at the closing of the TPG Investment. See Note 7--"Redeemable Preferred
Stock" to the Company's audited consolidated financial statements set forth
elsehwere herein.
TPG has three representatives on the Company's twelve-member Board of
Directors.
HISTORY
Prior to June 1997, the Company's primary business was the operation of
psychiatric hospitals. During the first quarter of fiscal 1996, the Company
acquired a 61% ownership interest in Green Spring Health Services, Inc. ("Green
Spring"), a managed care company specializing in mental health and substance
abuse/dependence services. At that time, the Company intended to become a fully
integrated behavioral healthcare provider by combining the behavioral managed
healthcare products offered by Green Spring with the direct treatment services
offered by the Company's psychiatric hospitals. Subsequent to the Company's
acquisition of Green Spring, the growth of the behavioral managed healthcare
industry accelerated. The Company concluded that the behavioral managed
healthcare industry offered growth and earnings prospects superior to those of
the psychiatric hospital industry. Therefore, the Company decided to sell its
domestic psychiatric facilities to obtain capital for expansion of its managed
healthcare business.
In June 1997, the Company sold substantially all of its domestic acute-care
psychiatric hospitals and residential treatment facilities (collectively, the
"Psychiatric Hospital Facilities") to Crescent Real Estate ("Crescent") for
approximately $400.0 million (the "Crescent Transactions"). Simultaneously with
the sale of the Psychiatric Hospital Facilities, the Company and Crescent
Operating, Inc. ("COI"), an affiliate of Crescent, formed Charter Behavioral
Health Systems, LLC ("CBHS") to conduct the operations of the Psychiatric
Hospital Facilities and certain other facilities transferred to CBHS by the
Company. The Company retained a 50% ownership of CBHS; the other 50% of the
ownership interest of CBHS was owned by COI.
During fiscal 1999, the Company completed its exit from the healthcare
provider and franchising businesses. In April 1999, the Company sold its
European psychiatric provider operations to Investment AB Bure of Sweden for
approximately $57.0 million. On September 10, 1999, the Company consummated the
transfer of certain assets and other interests pursuant to a Letter Agreement
dated August 10, 1999 with Crescent, COI and CBHS. Under the Letter Agreement,
the Company redeemed 80% of its common interest and all of its preferred
interest in CBHS, agreed to transfer to CBHS its interests in five of its six
hospital-based joint ventures ("Provider JVs") and related real estate as soon
as practicable, transferred certain assets to CBHS, agreed to pay $2.0 million
to CBHS in 12 equal monthly installments beginning on the first anniversary of
the closing date, transferred its healthcare franchising interest to CBHS and
forgave unpaid franchise fees of approximately $115 million (the "CBHS
Transaction").
The CBHS Transaction, together with the formal plan of disposal authorized
by the Company's Board of Directors on September 2, 1999, represents the
disposal of the Company's healthcare provider and healthcare franchising
business segments under APB 30. Pursuant to APB 30, the Company has restated its
results of operations for all prior periods. The Company recorded an after-tax
loss on disposal of its healthcare provider and healthcare franchising business
segments of approximately $47.4 million (primarily non-cash), in the fourth
quarter of fiscal 1999.
4
The Crescent Transactions provided the Company with approximately
$200 million of net cash proceeds, after debt repayment, for use in implementing
its business strategy of expanding its managed care operations. The Company used
the proceeds to finance the acquisition of Allied as well as two important
acquisitions in managed behavioral healthcare (collectively, the "Managed Care
Acquisitions"). A summary of the Managed Care Acquisitions and related
transactions are as follows:
HUMAN AFFAIRS INTERNATIONAL, INCORPORATED ACQUISITION. On December 4, 1997,
the Company consummated the purchase of Human Affairs International,
Incorporated ("HAI"), formerly a unit of Aetna/U.S. Healthcare ("Aetna"), for
approximately $122.1 million, which the Company funded from cash on hand. HAI
managed behavioral healthcare programs primarily through employee assistance
programs ("EAPs") and other behavioral managed healthcare plans. The Company may
be required to make additional contingent payments of up to $60.0 million
annually to Aetna through 2003. The Company has made additional purchase price
payments totaling $120 million through September 30, 2000. The amount and timing
of the payments will be contingent upon the number of HAI's covered lives in
specified products. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Outlook--Liquidity and Capital Resources."
MERIT ACQUISITION. On February 12, 1998, the Company consummated the
acquisition of Merit Behavioral Care Corporation ("Merit") for cash
consideration of approximately $450 million plus the repayment of Merit's debt.
Merit managed behavioral healthcare programs across all segments of the
healthcare industry, including health maintenance organizations ("HMO's"), Blue
Cross/Blue Shield organizations and other insurance companies, corporations and
labor unions, federal, state and local governmental agencies and various state
Medicaid programs. In connection with the consummation of the Merit acquisition,
the Company entered into a new senior secured bank credit agreement (the "Credit
Agreement"), providing for a revolving credit facility (the "Revolving
Facility") and a term loan facility (the "Term Loan Facility") which provides
for borrowings of up to $700 million and the Company issued the 9% Series A
Senior Subordinated Notes due 2008 (the "Notes") pursuant to an indenture which
governs the Notes ("Indenture").
INDUSTRY
According to industry sources, 22.1 percent of American adults suffer from a
diagnosable mental disorder in any given year. Applied to recent population
census, this would translate to approximately 44 million individuals. In the
United States during 1996, approximately $69 billion was spent or more than
seven percent of total health spending, was on mental health services. Further,
direct costs associated with substance abuse were nearly $13 billion. These
direct costs have grown, in part, as society has begun to recognize and address
behavioral health concerns and employers have realized that rehabilitation of
employees suffering from substance abuse and relatively mild mental health
problems can reduce losses due to absenteeism and decreased productivity. In
addition, estimation of indirect costs associated with these issues approach
$79 billion annually, reflecting the fact that four of the ten leading causes of
disability in the United States are mental disorders.
In response to these escalating costs, behavioral managed healthcare
companies such as Green Spring, HAI and Merit were formed. Behavorial managed
healthcare companies focus on matching an appropriate level of specialist and
treatment setting with the patient to provide care in a cost-efficient manner
while improving early access to care and utilizing the most modern and effective
treatments. As the growth of behavioral managed healthcare has increased, there
has been a significant decrease in occupancy rates and average lengths of stay
for inpatient psychiatric facilities and an increase in outpatient treatment and
alternative care services.
According to an industry trade publication entitled "Open Minds Year Book of
Managed Behavioral Health Market Share in the United States 2000-2001" published
by Open Minds, Gettysburg, Pennsylvania (hereinafter referred to as "OPEN
MINDS"), as of July 2000, approximately 209.2 million beneficiaries were
5
covered by some form of behavioral managed healthcare plan. The number of
covered beneficiaries has grown from approximately 86.3 million beneficiaries in
1993 to approximately 209.2 million as of July 2000, representing a 13% compound
annual growth rate since 1993 and 15% growth just in the last year. In addition,
according to OPEN MINDS, beneficiaries covered under risk-based programs, see
below, are growing even more rapidly, from approximately 13.6 million as of
January 1993 to approximately 62.9 million as of July, 2000, representing a
compound annual growth rate of 24% and growth of over 27% since last year.
OPEN MINDS divides the managed behavioral healthcare industry as of
July 2000 into the following categories of care, based on services provided,
extent of care management and level of risk assumption:
BENEFICIARIES PERCENT OF
CATEGORY OF CARE (IN MILLIONS) TOTAL
- ---------------- ------------- ----------
Risk-Based Network Products................................. 62.9 30.1%
EAPs........................................................ 51.0 24.3
Integrated Products......................................... 15.5 7.4
Utilization Review/Care Management Products................. 37.4 17.9
Non-Risk-Based Network Products............................. 42.4 20.3
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Total................................................. 209.2 100.0%
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Management believes the current trends in the behavioral healthcare industry
include increased risk-based network managed care products and significant
expansion of EAP services offered to employees. Management believes that these
trends have developed in response to the attempt by payors to reduce rapidly
escalating behavioral healthcare costs and to limit their risk associated with
such costs while continuing to provide access to high quality care. Expansion of
EAP services is a reflection of the tight labor market and represents a
relatively inexpensive way to help retain workers and reduce turnover. According
to OPEN MINDS, risk-based network products and EAPs are the most rapidly growing
segments of the behavioral managed healthcare industry.
The following is a summary of each of these categories of care.
RISK-BASED NETWORK PRODUCTS. Under risk-based network products, the
behavioral managed healthcare company assumes all or a portion of the
responsibility for the cost of providing a full or specified range of behavioral
healthcare treatment services. Most of these programs have payment arrangements
in which the managed care company agrees to arrange for services in exchange for
a fixed fee per member per month that varies depending on the profile of the
beneficiary population or otherwise shares the responsibility for arranging for
all or some portion of the treatment services at a specific cost per member.
Under these products, the behavioral managed healthcare company not only reviews
and monitors a course of treatment, but also arranges and pays for the provision
of patient care. Therefore, the behavioral managed healthcare company must
contract with, credential and manage a network of specialized providers and
facilities that covers the complete continuum of care. The behavioral managed
healthcare company must also see that the appropriate level of care is delivered
in the appropriate setting. Given the ability of payors of behavioral healthcare
benefits to reduce their risk with respect to the cost of treatment services
through risk-based network products while continuing to provide access to high
quality care, this market segment has grown rapidly in recent years. In addition
to the expected growth in total beneficiaries covered under behavioral managed
healthcare products, this shift of beneficiaries into risk-based network
products should further contribute to revenue growth for the behavioral managed
healthcare industry because such contracts generate significantly higher revenue
than non-risk based contracts. The higher revenue is intended to compensate the
behavioral managed healthcare company for bearing the financial responsibility
for the cost of delivering care. The Company's risk-based products are
risk-based network products as defined by OPEN MINDS.
6
According to OPEN MINDS, industry enrollment in risk-based products has
grown from approximately 13.6 million covered lives in 1993 to approximately
62.9 million covered lives in 2000, a compound annual growth rate of over 24%.
Despite this growth, only approximately 30% of total managed behavioral
healthcare covered lives were enrolled in risk-based products as of July, 2000.
The Company believes that the market for risk-based products has grown and will
continue to grow as payors attempt to reduce their responsibility for the cost
of providing behavioral healthcare while ensuring an appropriate level of access
to care. Risk-based products can generate significantly greater revenue per
covered life than other non-risk product types. See "Cautionary
Statements--Risk--Based Products."
EMPLOYEE ASSISTANCE PROGRAMS. An EAP is a worksite-based program designed
to assist in the early identification and resolution of productivity problems
associated with behavioral conditions or other personal concerns of employees
and their dependants. Under an EAP, staff or network providers or other
affiliated clinicians provide assessment and referral services to employee
beneficiaries and their dependants. These services consist of evaluating a
patient's needs and, if indicated, providing limited counseling and/or
identifying an appropriate provider, treatment facility or other resource for
more intensive treatment services. The EAP industry developed largely out of
employers' efforts to combat alcoholism and substance abuse problems afflicting
workers. A recent industry survey estimated the total cost of this dependency at
approximately $98.6 billion per year. Many businesses have implemented
alcoholism and drug abuse treatment programs in the workplace, and in some cases
have expanded those services to cover a wider spectrum of personal problems
experienced by workers and their families. As a result, EAP products now
typically include consultation services, evaluation and referral services,
employee education and outreach services. The Company believes that federal and
state "drug-free workplace" measures and Federal Occupational Safety and Health
Act requirements, taken together with the growing public perception of increased
violence in the workplace, have prompted many companies to implement EAPs.
Although EAPs originated as a support tool to assist managers in dealing with
troubled employees, payors increasingly regard EAPs as an important component in
the continuum of behavioral healthcare services.
INTEGRATED EAP/MANAGED BEHAVIORAL HEALTHCARE PRODUCTS. EAPs are utilized in
a preventive role and in facilitating early intervention and brief treatment of
behavioral healthcare problems before more extensive treatment is required.
Consequently, EAPs often are marketed and sold in tandem with managed behavioral
healthcare programs through "integrated" product offerings. Integrated products
offer employers comprehensive management and treatment of all aspects of
behavioral healthcare. In an effort to reduce costs, increase accessibility and
ease of treatment, employers are increasingly attempting to consolidate EAP and
managed behavioral healthcare services into a single product. Although
integrated EAP/managed behavioral healthcare products are currently only a small
component of the overall industry, the Company expects this market segment to
grow.
UTILIZATION REVIEW/CARE MANAGEMENT PRODUCTS. Under utilization review/care
management products, a managed behavioral healthcare company manages and often
arranges for treatment, but does not maintain a network of providers or assume
any of the responsibility for the cost of providing treatment services. The
Company categorizes its products within this segment of the managed behavioral
healthcare industry (as it is defined by OPEN MINDS) as administrative services
only ("ASO") products. The Company does not expect this segment of the industry
to experience significant growth.
NON-RISK-BASED NETWORK PRODUCTS. Under non-risk-based network products, the
behavioral managed healthcare company provides a full array of managed care
services, including selecting, credentialing and managing a network of providers
(such as psychiatrists, psychologists, social workers and hospitals), and
performs utilization review, claims administration and care management
functions. The third-party payor remains responsible for the cost of providing
the treatment services rendered. The Company categorizes its products within
this segment of the behavioral managed healthcare industry (as it is defined by
OPEN MINDS) as ASO products.
7
Management believes that the growth of the behavioral managed healthcare
industry will continue, as payors of behavioral healthcare benefits attempt to
reduce the costs of behavioral healthcare while maintaining high quality care.
Management also believes that a number of opportunities exist in the behavioral
managed healthcare industry for continued growth, primarily for risk-based
products, including state and federal parity legislation.
State and federal legislation that eliminates the difference in coverage
limits for medical health coverage as compared to mental health coverage is
referred to as parity legislation or anti-discrimination legislation.
Historically, copayments and deductibles have been higher for mental health
treatment than for traditional medical coverage. This has served as an
artificial barrier to utilization in some cases. Currently, 29 states have
passed legislation that requires insurance companies to provide the same levels
of coverage between medical and mental health coverage. The Company believes
that this trend will continue, and perhaps accelerate. All federal employees
will be covered by mental health parity effective January 1, 2001 due to an
executive order signed by President Clinton. Additional federal legislation is
under consideration that could apply to all companies regardless of the
exemptions provided under the Employee Retirement Income Security Act of 1974
("ERISA"). The Company believes parity and other legislation may result in
additional demands for its products due to: (1) increased need for managed
behavioral healthcare services to mitigate increased cost and (2) current
customers of ASO products switching to risk arrangements due to the higher
coverage requirements associated with parity.
HUMAN SERVICES. The Company's human services business (see below) is
conducted in three markets, the mental retardation/developmental disability
community-based ("MR/DD") market, the at-risk youth market and the acquired
brain injury market. It is estimated that in 1998, approximately $25 billion was
spent for MR/DD services for approximately 400,000 persons, which is believed to
represent only 10% of the estimated potential market of persons with some level
of developmental disability. Over the past twenty years, the preferred care for
these persons has been shifting from institutional to community-based care and
the demand continues to outpace capacity. State Medicaid programs are the
primary source of funding for MR/DD services. The at-risk youth market, which
includes children with severe emotional, developmental and behavioral disorders
and youth under the auspices of the juvenile justice system, is expected to grow
from $22 billion in 1998 to approximately $29.3 billion in 2003. Program models
utilized to treat at-risk youth include residential treatment facilities,
alternative schools and community-based programs. The acquired brain injury
market ("ABI") serves the more than 2 million individuals who suffer traumatic
brain injuries each year. Improvements in medicine result in more persons
surviving ABI but often with a resulting substantial disability, often for
extended periods of time. The Company believes the improvements in medicine,
pressures of managed care, and other factors will result in increasing need for
community-based, post-acute long-term care options.
COMPANY OVERVIEW
The Company conducts operations in two business segments: behavioral managed
healthcare and human services.
BEHAVIORAL MANAGED HEALTHCARE. According to enrollment data reported in
OPEN MINDS, the Company is the nation's largest provider of behavioral managed
healthcare services. As of September 30, 2000, the Company had approximately
71.0 million covered lives under behavioral managed healthcare contracts and
managed behavioral healthcare programs for approximately 3,300 customers.
Through its current network of over 40,000 providers and 5,000 treatment
facilities, the Company manages behavioral healthcare programs for HMOs, Blue
Cross/Blue Shield organizations and other insurance companies, corporations,
federal, state and local governmental agencies, labor unions and various state
Medicaid programs. The Company believes it has the largest and most
comprehensive behavioral healthcare provider network in the United States.
8
The Company's professional care managers coordinate and manage the delivery
of behavioral healthcare treatment services through the Company's network of
providers, which includes psychiatrists, psychologists, licensed clinical social
workers, marriage and family therapists and licensed clinical professional
counselors. The treatment services provided by the Company's behavioral provider
network include outpatient programs (such as counseling and therapy),
intermediate care programs (such as sub-acute emergency care, intensive
outpatient programs and partial hospitalization services), inpatient treatment
services and alternative care services (such as residential treatment, home and
community-based programs and rehabilitative and support services). The Company
provides these services through: (i) risk-based products; (ii) EAPs; (iii) ASO
products and (iv) products that combine features of some or all of these
products. Under risk-based products, the Company arranges for the provision of a
full range of behavioral healthcare services for beneficiaries of its customers'
healthcare benefit plans through fee arrangements under which the Company
assumes all or a portion of the responsibility for the cost of providing such
services in exchange for a fixed per member per month fee. Under EAPs, the
Company provides assessment services to employees and dependents of its
customers, and if required, referral services to the appropriate behavioral
healthcare service provider. Under ASO products, the Company provides services
such as utilization review, claims administration and provider network
management. The Company does not assume the responsibility for the cost of
providing behavioral healthcare services pursuant to its ASO products.
HUMAN SERVICES. The Company's human services business provided specialty
home-based behavioral healthcare services through its wholly-owned subsidiary
National Mentor, Inc. ("Mentor"), to approximately 7,800 individuals in 21
states as of September 30, 2000. Mentor was founded in 1983 and was acquired by
the Company in January 1995. Mentor's services include specialty home-based
behavioral healthcare services, which feature individualized home and
community-based health and human services delivered in highly structured and
professionally monitored family environments or "mentor" homes. The mentor homes
serve clients with chronic behavioral disorders and disabilities requiring
long-term care, including children and adolescents with behavioral problems,
individuals with mental retardation or developmental disabilities, and
individuals with neurological impairment or other medical and behavioral
frailties. Mentor also provides various residential and day services for
individuals with acquired brain injuries and for individuals with mental
retardation and developmental disabilities.
For financial information regarding the business segments see
Note 14--"Business Segment Information" to the Company's audited consolidated
financial statements set forth elsewhere herein.
BUSINESS STRATEGY
The Company's business strategy is comprised of two primary objectives:
(i) evaluate the potential to sell or exit non-core and/or under performing
assets and (ii) take advantage of our market leadership position and economies
of scale to improve cost structure and overall efficiency in providing service
in the behavioral managed healthcare arena.
The Company has taken aggressive action recently to dispose of those assets
that are not generating cash for debt reduction or are not part of its ongoing
strategy. These activities include: (i) the exit from its specialty managed
healthcare segment; (ii) the exit from its psychiatric practice management
business; and (iii) the sale of its Canadian operations. The Company is
currently evaluating the potential to divest on acceptable terms certain other
assets and businesses, including Mentor, and is currently involved in
discussions with various parties. There can be no assurance that the Company
will be able to divest any asset or businesses or that such divestiture would
result in significant reductions of long-term debt or improvements in liquidity.
9
The second part of the Company's strategy centers on improving the
efficiencies of its business. In the past two years, Magellan consolidated its
behavioral managed healthcare businesses, elminating duplicate staffing and
facilities. The Company is now focusing on the next level of integration that
includes reduction in computer system platforms, best practices analysis,
standardization of provider contracting and utilization of the internet to
reduce administrative burden to both providers, customers and beneficiaries. The
Company believes that it will reduce administrative costs and improve customer
service through these measures; however, there can be no assurance that the
Company will be able to implement these initiatives or realize the anticipated
savings.
The Company believes this strategy will position the Company to take
advantage of favorable macro-economic trends that support continued growth in
the behavioral managed healthcare industry.
BEHAVIORAL MANAGED HEALTHCARE PRODUCTS AND SERVICES
GENERAL. The following table sets forth the approximate number of covered
lives as of September 30, 1999 and 2000 and revenue for fiscal 1999 and 2000 for
the types of behavioral managed healthcare programs offered by the Company:
PROGRAMS COVERED LIVES PERCENT REVENUE PERCENT
- -------- ------------- -------- -------- --------
(IN MILLIONS, EXCEPT PERCENTAGES)
1999
Risk-Based Products(1)................................ 35.8 53.9% $1,282.8 86.5%
ASO products.......................................... 30.6 46.1 200.4 13.5
---- ----- -------- -----
Total............................................. 66.4 100.0% $1,483.2 100.0%
==== ===== ======== =====
2000
Risk-Based Products(1)................................ 39.1 55.1% $1,453.4 87.8%
ASO products.......................................... 31.9 44.9 201.7 12.2
---- ----- -------- -----
Total............................................. 71.0 100.0% $1,655.1 100.0%
==== ===== ======== =====
- ------------------------
(1) Includes Risk-Based Products, Employee Assistance Programs and Integrated
Products.
The number of covered lives fluctuates based on several factors, including the
number of contracts entered into by the Company and changes in the number of
employees, subscribers or enrollees of the Company's customers covered by such
contracts.
RISK-BASED PRODUCTS. Under the Company's risk-based products, the Company
typically arranges for the provision of a full range of outpatient, intermediate
and inpatient treatment services to beneficiaries of its customers' healthcare
benefit plans, primarily through arrangements in which the Company assumes all
of the responsibility for the cost of providing such services in exchange for a
per member per month fee. The Company's experience with risk-based contracts
covering a large number of lives has given it a broad base of data from which to
analyze utilization rates. The Company believes that this broad database permits
it to estimate utilization trends and costs more accurately than many of its
competitors, which allows it to bid effectively. The Company believes that its
experience has also allowed it to develop effective measures for managing the
cost of providing a unit of care to its covered lives. The Company has developed
or acquired clinical protocols, which permit it to assist its network providers
to administer effective treatment in a cost efficient manner, and claims
management technology, which permits the Company to reduce the cost of
processing claims. The Company's care managers are an essential element in its
provision of cost-effective care. Care managers, in consultation with treating
professionals, and using the Company's clinical protocols, authorize an
appropriate level and intensity of services that can be delivered in a
cost-efficient manner.
10
EMPLOYEE ASSISTANCE PROGRAMS. The Company's EAP products typically provide
assessment and referral services to employees and dependents of the Company's
customers in an effort to assist in the early identification and resolution of
productivity problems associated with the employees who are impaired by
behavioral conditions or other personal concerns. For many EAP customers, the
Company also provides limited outpatient therapy (typically limited to eight or
fewer sessions) to patients requiring such services. For these services, the
Company typically is paid a fixed fee per member per month; however, the Company
is usually not responsible for the cost of providing care beyond these services.
If further services are necessary beyond limited outpatient therapy, the Company
will refer the beneficiary to an appropriate provider or treatment facility.
INTEGRATED PRODUCTS. Under its integrated products, the Company typically
establishes an EAP to function as the "front end" of a managed care program that
provides a full range of services, including more intensive treatment services
not covered by the EAP. The Company typically manages the EAP and accepts all or
some of the responsibility for the cost of any additional treatment required
upon referral out of the EAP, thus integrating the two products and using both
the Company's care management and clinical care techniques to manage the
provision of care.
ASO PRODUCTS. Under its ASO products, the Company provides services ranging
from utilization review and claims administration to the arrangement for and
management of a full range of patient treatment services, but does not assume
any of the responsibility for the cost of providing treatment services. Services
include member assistance, management reporting and claims processing in
addition to utilization review and care management. The Company is paid a fee
for such services.
BEHAVIORAL MANAGED HEALTHCARE CUSTOMERS
GENERAL. The following table sets forth the approximate number of covered
lives as of September 30, 1999 and 2000 and revenue for fiscal 1999 and 2000 in
each of the Company's behavioral customer groups described below:
MARKET COVERED LIVES PERCENT REVENUE PERCENT
- ------ ------------- -------- -------- --------
(IN MILLIONS, EXCEPT PERCENTAGES)
1999
Workplace (Corporations and Labor Unions)............ 27.0 40.7% $ 230.6 15.5%
Health Plans......................................... 36.5 54.9 846.9 57.1
Public Sector (Primarily Medicaid)................... 2.9 4.4 405.9 27.4
---- ------ -------- ------
Total............................................ 66.4 100.0% $1,483.2 100.0%
==== ====== ======== ======
2000
Workplace (Corporations and Labor Unions)............ 27.9 39.3% $ 234.4 14.1%
Health Plans......................................... 40.1 56.5 951.1 57.5
Public Sector (Primarily Medicaid)................... 3.0 4.2 469.6 28.4
---- ------ -------- ------
Total............................................ 71.0 100.0% $1,655.1 100.0%
==== ====== ======== ======
CORPORATIONS AND LABOR UNIONS. Corporations and, to a lesser extent, labor
unions, account for a large number of the Company's contracts to provide
behavioral managed healthcare services and, in particular, EAP and integrated
EAP/managed care services. The Company has structured a variety of fee
arrangements with corporate customers to cover all or a portion of the
responsibility of the cost of providing treatment services. In addition, the
Company operates a number of programs for corporate customers on an ASO basis.
Management believes the corporate market is an area of potential growth for the
Company, as corporations are anticipated to increase their utilization of
behavioral managed healthcare services. In an effort to increase penetration of
the corporate market, the Company intends to build upon its experience in
managing programs for large corporate customers (such as IBM, Federal Express
11
and AT&T) and to market integrated programs to existing EAP customers and other
prospective corporate clients.
HEALTH PLANS. The Company is a leader in providing behavioral managed
healthcare services to HMO beneficiaries. HMO contracts are Risk-Based or ASO
contracts. Although certain large HMOs provide their own behavioral managed
healthcare services, many HMOs "carve out" behavioral healthcare from their
general healthcare services and subcontract such services to behavioral managed
healthcare companies such as the Company. The Company anticipates that its
business with HMOs will continue to grow. The Company believes that it is one of
the nation's leading providers of behavioral managed healthcare services to Blue
Cross/Blue Shield organizations, serving 33 such organizations as of
September 30, 2000.
PUBLIC SECTOR. The Company provides behavioral managed healthcare services
to Medicaid recipients through both direct contracts with state and local
governmental agencies and through subcontracts with HMOs focused on Medicaid
beneficiary populations. In addition to the Medicaid population, other public
entitlement programs, such as Medicare and state insurance programs for the
uninsured, offer the Company areas of potential future growth. The Company
expects that governmental agencies will continue to implement a significant
number of managed care Medicaid programs through contracts with HMOs and that
many HMOs will subcontract with behavioral managed healthcare organizations,
such as the Company, for behavioral healthcare services. The Company also
expects that other states will continue the trend of "carving-out" behavioral
healthcare services from their general healthcare benefit plans and contracting
directly with behavioral managed healthcare companies such as the Company. See
"Cautionary Statements--Dependence on Government Spending for Managed
Healthcare; Possible Impact of Healthcare Reform" and "Cautionary
Statements--Regulation".
BEHAVIORAL MANAGED HEALTHCARE CONTRACTS
The Company's contracts with customers typically have terms of one to three
years, and in certain cases contain renewal provisions (at the customer's
option) for successive terms of between one and two years (unless terminated
earlier). Substantially all of these contracts may be immediately terminated
with cause and many are terminable without cause by the customer or the Company
either upon the giving of requisite notice and the passage of a specified period
of time (typically between 60 and 180 days) or upon the occurrence of other
specified events. In addition, the Company's contracts with federal, state and
local governmental agencies, under both direct contract and subcontract
arrangements with HMOs, generally are conditioned on legislative appropriations.
These contracts, notwithstanding terms to the contrary, generally can be
terminated or modified by the customer if such appropriations are not made. See
"Cautionary Statements--Risk-Based Products" and "Cautionary
Statements--Reliance on Customer Contracts."
The specific terms of the Company's contracts are determined by whether the
contracts are for risk-based, EAP, integrated or ASO products. Risk-based, EAP
and ASO contracts generally provide for payment of a per member per month fee to
the Company. The Company's billing arrangements for integrated products vary on
a case by case basis.
BEHAVIORAL MANAGED HEALTHCARE NETWORK
The Company's behavioral managed healthcare and EAP treatment services are
provided by a network of third-party providers. The number and type of providers
in a particular area depend upon customer preference, site, geographic
concentration and demographic make-up of the beneficiary population in that
area. Network providers include a variety of specialized behavioral healthcare
personnel, such as psychiatrists, psychologists, licensed clinical social
workers, substance abuse counselors and other professionals.
12
As of September 30, 2000, the Company had contractual arrangements covering
over 40,000 individual third-party network providers. The Company's network
providers are independent contractors located throughout the local areas in
which the Company's customers' beneficiary populations reside. Network providers
work out of their own offices, although the Company's personnel are available to
assist them with consultation and other needs. Network providers include both
individual practitioners, as well as individuals who are members of group
practices or other licensed centers or programs. Network providers typically
execute standard contracts with the Company for which they are typically paid by
the Company on a fee-for-service basis. In some cases, network providers are
paid on a "case rate" basis, whereby, the provider is paid a set rate for an
entire course of treatment, or through other risk sharing arrangements.
As of September 30, 2000, the Company's behavorial managed healthcare
network also included contractual arrangements with approximately 5,000
third-party treatment facilities, including inpatient psychiatric and substance
abuse hospitals, intensive outpatient facilities, partial hospitalization
facilities, community health centers and other community-based facilities,
rehabilitative and support facilities, and other intermediate care and
alternative care facilities or programs. This variety of facilities enables the
Company to offer patients a full continuum of care and to refer patients to the
most appropriate facility or program within that continuum. Typically, the
Company contracts with facilities on a per diem or fee-for-service basis and, in
some cases, on a "case rate" or capitated basis. The contracts between the
Company and inpatient and other facilities typically are for one year terms and,
in some cases, are automatically renewable at the Company's option. Facility
contracts are usually terminable by the Company or the facility owner upon 30 to
120 days' notice.
COMPETITION
Each segment of the Company's business is highly competitive. With respect
to its behavioral managed healthcare business, the Company competes with large
insurance companies, HMOs, PPOs, third-party administrators ("TPAs"),
independent practitioner associations ("IPAs"), multi-disciplinary medical
groups and other managed care companies. Many of the Company's competitors are
significantly larger and have greater financial, marketing and other resources
than the Company, and some of the Company's competitors provide a broader range
of services. The Company may also encounter substantial competition in the
future from new market entrants. Many of the Company's customers that are
managed care companies may, in the future, seek to provide behavioral managed
healthcare services directly to their employees or subscribers directly, rather
than by contracting with the Company for such services. Because of competition,
the Company does not expect to be able to rely on price increases to achieve
revenue growth and expects to continue experiencing pressure on direct operating
margins. See "Cautionary Statements--Highly Competitive Industry."
The Company's human services operations compete with various for profit and
not-for-profit entities, including, but not limited to: (i) behavioral managed
healthcare companies that have started managing human services for governmental
agencies; (ii) home health care organizations; (iii) proprietary nursing home
companies; and (iv) proprietary human services companies. The Company believes
that the most significant factors in a customer's selection of services include
price, quality of services and outcomes. The pricing aspect of such services is
especially important to attract public sector agencies looking to outsource
public services to the private sector as demand for quality services escalates
while budgeted dollars for healthcare services are reduced. The Company's
management believes that it competes effectively with respect to these factors.
The Company believes it benefits from the competitive strengths described
below:
INDUSTRY LEADERSHIP. The Company is the largest provider of behavioral
managed healthcare services in the United States, according to enrollment data
reported in OPEN MINDS. The Company believes, based on data reported in OPEN
MINDS, that it also now has the number one market position in each of the major
behavioral managed healthcare product markets in which it competes. The Company
believes its position
13
will enhance its ability to: (i) provide a consistent level of high quality
service on a nationwide basis; (ii) enter into agreements with behavioral
healthcare providers that allow it to control healthcare costs for its
customers; and (iii) market its behavioral managed care products to large
corporate, HMO and health insurance customers, which, the Company believes,
increasingly prefer to be serviced by a single-source provider on a national
basis. See "Cautionary Statements--Highly Competitive Industry" and "--Reliance
on Customer Contracts" for a discussion of the risks associated with the highly
competitive nature of the behavioral managed healthcare industry and the
Company's reliance on contracts with payors of behavioral healthcare benefits,
respectively.
BROAD PRODUCT OFFERING AND NATIONWIDE PROVIDER NETWORK. The Company offers
behavioral managed care products that can be designed to meet specific customer
needs, including risk-based and partial risk-based products, integrated EAPs,
stand-alone EAPs and ASO products. The Company's provider network encompasses
approximately 40,000 providers and 5,000 treatment facilities in all 50 states.
The Company believes that the combination of its product offerings and its
provider network allows the Company to meet its customers needs for behavioral
managed healthcare on a nationwide basis, and positions the Company to capture
incremental revenue opportunities resulting from the continued growth of the
behavioral managed healthcare industry and the continued migration of its
customers from ASO and EAP products to higher revenue risk-based products. See
"Cautionary Statements--Risk-Based Products" for a discussion of the risks
associated with risk-based products, which are the Company's primary source of
revenue.
BROAD BASE OF CUSTOMER RELATIONSHIPS. The Company believes that the breadth
of its customer relationships are attributable to the Company's broad product
offerings, nationwide provider network, commitment to quality care and ability
to manage behavioral healthcare costs effectively. The Company's customers
include: (i) Blue Cross/Blue Shield organizations; (ii) national HMOs and other
large insurers, such as Aetna and Humana; (iii) large corporations, such as IBM,
Federal Express and AT&T; (iv) state and local governmental agencies through
commercial, Medicaid and other programs; and (v) the federal government through
contracts with CHAMPUS, as defined, and the U.S. Postal Service. This broad base
of customer relationships provides the Company with stable and diverse sources
of revenue, earnings and cash flows and an established base from which to
continue to increase covered lives and revenue. See "Cautionary
Statements--Reliance on Customer Contracts" for a discussion of the risks
associated with the Company's reliance on certain contracts with payors of
behavioral healthcare benefits.
PROVEN RISK MANAGEMENT EXPERIENCE. The Company had approximately
39.1 million covered lives under risk-based contracts at September 30, 2000,
making it the nation's industry leader in at-risk behavioral managed healthcare
products, based on data reported in OPEN MINDS. The Company's experience with
risk-based products covering a large number of lives has given it a broad base
of data from which to analyze utilization rates. The Company believes that this
broad database permits it to estimate utilization trends and costs more
accurately than many of its competitors, which allows it to bid effectively. The
Company believes that its experience has also allowed it to develop effective
measures for controlling the cost of providing a unit of care to its covered
lives. Among other cost control measures, the Company has developed or acquired
clinical protocols, which permit the Company to assist its network providers to
administer effective treatment in a cost efficient manner, and claims management
technology, which permits the Company to reduce the cost of processing claims.
INSURANCE
The Company maintains a general, professional and managed care liability
insurance policy with an unaffiliated insurer. The policy is written on a
"claims-made" basis, subject to a $250,000 per claim and $1.0 million annual
aggregate self-insured retention for general and professional liability, and
also subject to a $500,000 per claim and $2.5 million annual aggregate
self-insured retention for managed care liability, for a two-year policy period
ending June 17, 2002.
14
REGULATION
GENERAL. The behavioral managed healthcare industry and the provision of
behavioral healthcare services are subject to extensive and evolving state and
federal regulation. The Company is subject to certain state laws and
regulations, including those governing: (i) the licensing of insurance
companies, HMOs, PPOs, TPAs and companies engaged in utilization review and
(ii) the licensing of healthcare professionals, including restrictions on
business corporations from practicing, controlling or exercising excessive
influence over behavioral healthcare services through the direct employment of
psychiatrists or, in a few states, psychologists and other behavioral healthcare
professionals. These laws and regulations vary considerably among states and the
Company may be subject to different types of laws and regulations depending on
the specific regulatory approach adopted by each state to regulate the managed
care business and the provision of behavioral healthcare treatment services. In
addition, the Company is subject to certain federal laws as a result of the role
the Company assumes in connection with managing its customers' employee benefit
plans. The regulatory scheme generally applicable to the Company's behavioral
managed healthcare operations is described in this section.
The Company believes its operations are structured to comply with applicable
laws and regulations in all material respects and that it has received all
licenses and approvals that are material to the operation of its business.
However, regulation of the managed healthcare industry is evolving, with new
legislative enactments and regulatory initiatives at the state and federal
levels being implemented on a regular basis. Consequently, it is possible that a
court or regulatory agency may take a position under existing or future laws or
regulations, or as a result of a change in the interpretation thereof, that such
laws or regulations apply to the Company in a different manner than the Company
believes such laws or regulations apply. Moreover, any such position may require
significant alterations to the Company's business operations in order to comply
with such laws or regulations, or interpretations thereof. Expansion of the
Company's business to cover additional geographic areas, to serve different
types of customers, to provide new services or to commence new operations could
also subject the Company to additional licensure requirements and/or regulation.
LICENSURE. Certain regulatory agencies having jurisdiction over the Company
possess discretionary powers when issuing or renewing licenses or granting
approval of proposed actions such as mergers, a change in ownership, transfer or
assignment of licenses and certain intracorporate transactions. One or multiple
agencies may require as a condition of such licensure or approval that the
Company cease or modify certain of its operations in order to comply with
applicable regulatory requirements or policies. In addition, the time necessary
to obtain licensure or approval varies from state to state, and difficulties in
obtaining a necessary license or approval may result in delays in the Company's
plans to expand operations in a particular state and, in some cases, lost
business opportunities. Compliance activities, mandated changes in the Company's
operations, delays in the expansion of the Company's business or lost business
opportunities as a result of regulatory requirements or policies could have a
material adverse effect on the Company.
INSURANCE, HMO AND PPO ACTIVITIES. To the extent that the Company operates
or is deemed to operate in one or more states as an insurance company, HMO, PPO
or similar entity, it may be required to comply with certain laws and
regulations that, among other things, may require the Company to maintain
certain types of assets and minimum levels of deposits, capital, surplus,
reserves or net worth. In many states, entities that assume risk under contracts
with licensed insurance companies or HMOs have not been considered by state
regulators to be conducting an insurance or HMO business. As a result, the
Company has not sought licensure as either an insurer or HMO in certain states.
The National Association of Insurance Commissioners (the "NAIC") has undertaken
a comprehensive review of the regulatory status of entities arranging for the
provision of healthcare services through a network of providers that, like the
Company, may assume risk for the cost and quality of healthcare services, but
that are not currently licensed as an HMO or similar entity. As a result of this
review, the NAIC developed a "health organizations risk-based capital" formula,
designed specifically for managed care organizations, that
15
establishes a minimum amount of capital necessary for a managed care
organization to support its overall operations, allowing consideration for the
organization's size and risk profile. The NAIC initiative also may result in the
adoption of a model NAIC regulation in the area of health plan standards, which
could be adopted by individual states in whole or in part, and could result in
the Company being required to meet additional or new standards in connection
with its existing operations. Individual states have also recently adopted their
own regulatory initiatives that subject entities such as the Company to
regulation under state insurance laws. This includes, but is not limited to,
requiring licensure as an insurance company or HMO and requiring adherence to
specific financial solvency standards. State insurance laws and regulations may
limit the ability of the Company to pay dividends, make certain investments and
repay certain indebtedness. Licensure as an insurance company, HMO or similar
entity could also subject the Company to regulations governing reporting and
disclosure, mandated benefits, rate setting, and other traditional insurance
regulatory requirements. PPO regulations to which the Company may be subject may
require the Company to register with a state authority and provide information
concerning its operations, particularly relating to provider and payor
contracting. The imposition of such requirements could increase the Company's
cost of doing business and could delay the Company's conduct or expansion of its
business in some areas. The licensure process under state insurance laws can be
lengthy and, unless the applicable state regulatory agency allows the Company to
continue to operate while the licensure process is ongoing, the Company could
experience a material adverse effect on its operating results and financial
condition while its licensure application is pending. In addition, failure by
the Company to obtain and maintain required licenses typically also constitutes
an event of default under the Company's contracts with its customers. The loss
of business from one or more of the Company's major customers as a result of
such an event of default or otherwise could have a material adverse effect on
the Company.
UTILIZATION REVIEW AND THIRD-PARTY ADMINISTRATOR ACTIVITIES. Numerous
states in which the Company does business have adopted, or are expected to
adopt, regulations governing entities engaging in utilization review and TPA
activities. Utilization review regulations typically impose requirements with
respect to the qualifications of personnel reviewing proposed treatment,
timeliness and notice of the review of proposed treatment, and other matters.
TPA regulations typically impose requirements regarding claims processing and
payments and the handling of customer funds. Utilization review and TPA
regulations may increase the Company's cost of doing business in the event that
compliance requires the Company to retain additional personnel to meet the
regulatory requirements and to take other required actions and make necessary
filings. Although compliance with utilization review regulations has not had a
material adverse effect on the Company, there can be no assurance that specific
regulations adopted in the future would not have such a result, particularly
since the nature, scope and specific requirements of such provisions vary
considerably among states that have adopted regulations of this type.
There is a trend among states to require licensure or certification of
entities performing utilization review or TPA activities; however, certain
federal courts have held that such licensure requirements are preempted by the
Employee Retirement Income Security Act of 1974, as amended, ("ERISA"). ERISA
preempts state laws that mandate employee benefit structures or their
administration, as well as those that provide alternative enforcement
mechanisms. The Company believes that its TPA activities performed for its
self-insured employee benefit plan customers are exempt from otherwise
applicable state licensing or registration requirements based upon federal
preemption under ERISA and has relied on this general principle in determining
not to seek licensure for certain of its activities in many states. Existing
case law is not uniform on the applicability of ERISA preemption with respect to
state regulation of utilization review or TPA activities. There can be no
assurance that additional licensure will not be required with respect to
utilization review or TPA activities in certain states.
"ANY WILLING PROVIDER" LAWS. Several states in which the Company does
business have adopted, or are expected to adopt, "any willing provider" laws.
Such laws typically impose upon insurance companies, PPOs, HMOs or other types
of third-party payors an obligation to contract with, or pay for the services
of, any healthcare provider willing to meet the terms of the payor's contracts
with similar providers.
16
Compliance with any willing provider laws could increase the Company's costs of
assembling and administering provider networks and could, therefore, have a
material adverse effect on its operations.
LICENSING OF HEALTHCARE PROFESSIONALS. The provision of behavioral
healthcare treatment services by psychiatrists, psychologists and other
providers is subject to state regulation with respect to the licensing of
healthcare professionals. In addition, the oversight supervision and case
management of the human services business is subject to similar regulation
requiring licensure or accreditation of personnel performing such functions. The
Company believes that the healthcare professionals who provide behavioral
healthcare treatment on behalf of or under contracts with the Company and the
case managers and other personnel of the health services business are in
compliance with the applicable state licensing requirements and current
interpretations thereof; however, there can be no assurance that changes in such
state licensing requirements or interpretations thereof will not adversely
affect the Company's existing operations or limit expansion. With respect to the
Company's crisis intervention program, additional licensure of clinicians who
provide telephonic assessment or stabilization services to individuals who are
calling from out-of-state may be required if such assessment or stabilization
services are deemed by regulatory agencies to be treatment provided in the state
of such individual's residence. The Company believes that any such additional
licensure could be obtained; however, there can be no assurance that such
licensing requirements will not adversely affect the Company's existing
operations or limit expansion.
PROHIBITION ON FEE SPLITTING AND CORPORATE PRACTICE OF PROFESSIONS. The
laws of some states limit the ability of a business corporation to directly
provide, control or exercise excessive influence over behavioral healthcare
services through the direct employment of psychiatrists, psychologists, or other
behavioral healthcare professionals, who are providing direct clinical services.
In addition, the laws of some states prohibit psychiatrists, psychologists, or
other healthcare professionals from splitting fees with other persons or
entities. These laws and their interpretations vary from state to state and
enforcement by the courts and regulatory authorities may vary from state to
state and may change over time. The Company believes that its operations as
currently conducted are in material compliance with the applicable laws,
however, there can be no assurance that the Company's existing operations and
its contractual arrangements with psychiatrists, psychologists and other
healthcare professionals will not be successfully challenged under state laws
prohibiting fee splitting or the practice of a profession by an unlicensed
entity, or that the enforceability of such contractual arrangements will not be
limited. The Company believes that it could, if necessary, restructure its
operations to comply with changes in the interpretation or enforcement of such
laws and regulations, and that such restructuring would not have a material
adverse effect on its operations.
DIRECT CONTRACTING WITH LICENSED INSURERS. Regulators in several states in
which the Company does business have adopted policies that require HMOs or, in
some instances, insurance companies, to contract directly with licensed
healthcare providers, entities or provider groups, such as IPAs, for the
provision of treatment services, rather than with unlicensed intermediary
companies. In such states, the Company's customary model of contracting directly
with its customers may need to be modified so that, for example, the IPAs
(rather than the Company) contract directly with the HMO or insurance company,
as appropriate, for the provision of treatment services. The Company intends to
work with a number of these HMO customers to restructure existing contractual
arrangements, upon contract renewal or in renegotiations, so that the entity
which contracts with the HMO directly is an IPA. The Company does not expect
this method of contracting to have a material adverse effect on its operations.
CONFIDENTIALITY AND PATIENT PRIVACY. Confidentiality and patient privacy
requirements are particularly strict in the field of behavioral healthcare
services, and additional legislative initiatives relating to confidentiality and
privacy are expected. The Health Insurance Portability and Accountability Act of
1996 ("HIPAA") requires the Secretary of the Department of Health and Human
Services ("HHS") to adopt standards relating to the transmission of health
information by healthcare providers and healthcare plans. HIPAA calls for HHS to
create regulations in several different areas to address security, privacy and
17
administrative simplification. The regulations specifically relate to electronic
transactions and code sets, security and electronic signatures, privacy,
provider and employer IDs as well as health plan and individual IDs. While only
the regulations relating to electronic transactions and code sets section are
final, other areas of the regulations are expected to be finalized in the next
few months. The regulations go into effect 26 months after they are released,
with a deadline to implement the regulations governing electronic transaction
and code sets by October 16, 2002. On November 3, 1999, the Secretary
promulgated proposed regulations to protect the privacy of such health
information that is electronically transmitted or maintained. In addition, on
August 17, 2000, HHS published a final rule establishing standard data content
and formats for the submission of electronic claims and other administrative and
health transactions. The wide reaching implications of these regulations are
beginning to be addressed now to ensure the Company's compliance with the
regulations by the implementation dates. These regulations, while creating a
need for some software changes, present more business and policy issues rather
than technology issues. The regulations will require changes to the Company's
provider contracts, as well as the creation of new policies for transmitting
patient information to ensure that the new privacy and electronic security
measures are satisfied. In some cases, these changes will mean executing chain
of trust agreements with business partners and ensuring that encryption
technology is used when transmitting electronic files. In addition, the
Company's systems must be equipped to handle both the electronic transactions
governed by the regulations, as well as paper transactions, which are not
affected by the regulations and to manage different sets of data depending on
whether the transaction is electronic or paper in nature. While the Company
believes it has existing systems and policies in place in many instances that
will assist in the Company's compliance, the Company expects that significant
resources will be required over the next two years to ensure compliance.
REGULATION OF CUSTOMERS. Regulations imposed upon the Company's customers
include, among other things, benefits mandated by statute, exclusions from
coverages prohibited by statute, procedures governing the payment and processing
of claims, record keeping and reporting requirements, requirements for and
payment rates applicable to coverage of Medicaid and Medicare beneficiaries,
provider contracting and enrollee rights, and confidentiality requirements.
Although the Company believes that such regulations do not at present materially
impair the Company's operations, there can be no assurance that such indirect
regulation will not have a material adverse effect on the Company in the future.
ERISA. Certain of the Company's services are subject to the provisions of
ERISA. ERISA governs certain aspects of the relationship between
employer-sponsored healthcare benefit plans and certain providers of services to
such plans through a series of complex laws and regulations that are subject to
periodic interpretation by the Internal Revenue Service and the Department of
Labor. In some circumstances, and under certain customer contracts, the Company
may be expressly named as a "fiduciary" under ERISA, or be deemed to have
assumed duties that make it an ERISA fiduciary, and thus be required to carry
out its operations in a manner that complies with ERISA requirements in all
material respects. Although the Company believes that it is in material
compliance with the applicable ERISA requirements and that such compliance does
not currently have a material adverse effect on the Company's operations, there
can be no assurance that continuing ERISA compliance efforts or any future
changes to the applicable ERISA requirements will not have a material adverse
effect on the Company.
OTHER PROPOSED LEGISLATION. In the last five years, legislation has
periodically been introduced at the state and federal level providing for new
healthcare regulatory programs and materially revising existing healthcare
regulatory programs. Any such legislation, if enacted, could materially
adversely affect the Company's business, financial condition or results of
operations. Such legislation could include both federal and state bills
affecting the Medicaid programs which may be pending in or recently passed by
state legislatures and which are not yet available for review and analysis. Such
legislation could also include proposals for national health insurance and other
forms of federal regulation of health insurance and healthcare delivery. It is
not possible at this time to predict whether any such legislation will be
adopted at the federal or state level, or the nature, scope or applicability to
the Company's business of any such
18
legislation, or when any particular legislation might be implemented. No
assurance can be given that any such federal or state legislation will not have
a material adverse effect on the Company.
REGULATION OF HUMAN SERVICES. The human services business is subject to
certain state laws, regulations, and/or requirements with respect to its
services, including those governing: (i) the licensing of child placement
agencies; (ii) the registration or certification of Medicaid participating
providers; and (iii) a state's authorization or recognition of a provider's
capacity to deliver services to adults with developmental disabilities and/or
mental retardation. These laws and regulations vary considerably among states
and the Company may be subject to different types of laws and regulations
depending on the specific regulatory approach adopted by each state to regulate
the provision of these services.
OTHER REGULATION OF HEALTHCARE PROVIDERS. The Company's business is
affected indirectly by regulations imposed upon healthcare providers.
Regulations imposed upon healthcare providers include provisions relating to the
conduct of, and ethical considerations involved in, the practice of psychiatry,
psychology, social work and related behavioral healthcare professions and, in
certain cases, the common law duty to warn others of danger or to prevent
patient self-injury.
CAUTIONARY STATEMENTS
This Form 10-K includes "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended (the "Securities Act") and
Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange
Act"). Although the Company believes that its plans, intentions and expectations
reflected in such forward-looking statements are reasonable, it can give no
assurance that such plans, intentions or expectations will be achieved.
Important factors that could cause actual results to differ materially from the
Company's forward-looking statements are set forth below and elsewhere in this
Form 10-K. All forward-looking statements attributable to the Company or persons
acting on behalf of the Company are expressly qualified in their entirety by the
cautionary statements set forth below.
LEVERAGE AND DEBT SERVICE OBLIGATIONS. The Company is currently highly
leveraged, with indebtedness that is substantial in relation to its
stockholders' equity. As of September 30, 2000, the Company's aggregate
outstanding indebtedness was approximately $1.1 billion and the Company's
stockholders' equity was approximately $128.5 million. The Credit Agreement and
the Indenture permit the Company to incur or guarantee certain additional
indebtedness, subject to certain limitations.
The Company's high degree of leverage could have important consequences to
the Company, including, but not limited to, the following: (i) the Company's
ability to obtain additional financing for working capital, capital
expenditures, acquisitions, general corporate purposes or other purposes may be
impaired in the future; (ii) a substantial portion of the Company's cash flows
from operations must be dedicated to the payment of principal and interest on
its indebtedness; (iii) the Company is substantially more leveraged than certain
of its competitors, which might place the Company at a competitive disadvantage;
(iv) the Company may be hindered in its ability to adjust rapidly to changing
market conditions and (v) the Company's high degree of leverage could make it
more vulnerable in the event of a downturn in general economic conditions or its
business or in the event of adverse changes in the regulatory environment or
other adverse circumstances applicable to the Company.
The Company's ability to repay or to refinance its indebtedness and to pay
interest on its indebtedness will depend on its financial and operating
performance, which, in turn, is subject to prevailing economic and competitive
conditions and to certain financial, business and other factors, many of which
are beyond the Company's control. These factors could include operating
difficulties, increased operating costs, the actions of competitors, regulatory
developments and delays in implementing strategic projects. The Company's
ability to meet its debt service and other obligations may depend in significant
part on the extent to which the Company can successfully implement its business
strategy. There can be no assurance
19
that the Company will be able to implement its strategy fully or that the
anticipated results of its strategy will be realized. See "Business--Business
Strategy."
If the Company's cash flows and capital resources are insufficient to fund
its debt service obligations, the Company may be forced to reduce or delay
capital expenditures, sell assets or seek to obtain additional equity capital or
to restructure its debt. There can be no assurance that the Company's cash flows
and capital resources will be sufficient for payment of principal of and
interest on its indebtedness in the future, or that any such alternative
measures would be successful or would permit the Company to meet its scheduled
debt service obligations.
In addition, because the Company's obligations under the Credit Agreement
bear interest at floating rates, an increase in interest rates could adversely
affect, among other things, the Company's ability to meet its debt service
obligations. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations--Outlook--Results of Operations."
RESTRICTIVE FINANCING COVENANTS. The Credit Agreement and the Indenture
contain a number of covenants that restrict the operations of the Company and
its subsidiaries. In addition, the Credit Agreement, as amended, requires the
Company to comply with specified financial ratios and tests, including a minimum
interest coverage ratio, a maximum leverage ratio, a minimum net worth test, a
maximum senior debt ratio and a minimum "EBITDA" test (as defined in the Credit
Agreement, as amended). There can be no assurance that the Company will be able
to comply with such covenants, ratios and tests in the future. The Company's
ability to comply with such covenants, ratios and tests may be affected by
events beyond its control, including prevailing economic, financial and industry
conditions. The breach of any such covenants, ratios or tests could result in a
default under the Credit Agreement that would permit the lenders to declare all
amounts outstanding thereunder to be immediately due and payable, together with
accrued and unpaid interest, and to prevent the Company from paying principal,
premium, interest or other amounts due on any or all of the Notes until the
default is cured or all senior indebtedness is paid or satisfied in full.
Furthermore, the commitments of the lenders under the Credit Agreement to make
further extensions of credit thereunder could be terminated. If the Company were
unable to repay all amounts accelerated, the lenders could proceed against the
subsidiary guarantors and the collateral securing the Company's and the
subsidiary guarantors' obligations pursuant to the Credit Agreement. If the
indebtedness outstanding pursuant to the Credit Agreement were to be
accelerated, there can be no assurance that the assets of the Company would be
sufficient to repay such indebtedness and the other indebtedness of the Company.
The value of the Company's common stock would be adversely affected if the
Company were unable to repay such indebtedness.
RISK-BASED PRODUCTS. Revenues under risk-based contracts are the primary
source of the Company's revenue from its behavioral managed healthcare business.
Such revenues accounted for approximately 77.6% of the Company's total revenue
and approximately 87.8% of its behavioral managed healthcare revenue in fiscal
2000. Under a risk-based contract, the Company assumes all or a portion of the
responsibility for the cost of providing a full or specified range of behavioral
healthcare treatment services to a specified beneficiary population in exchange,
generally, for a fixed fee per member per month. In order for such contracts to
be profitable, the Company must accurately estimate the rate of service
utilization by beneficiaries enrolled in programs managed by the Company and
control the unit cost of such services. If the aggregate cost of behavioral
healthcare treatment services provided to a given beneficiary population in a
given period exceeds the aggregate of the per member per month fees received by
the Company with respect to the beneficiary population in such period, the
Company will incur a loss with respect to such beneficiary population during
such period. Furthermore, the Company may be required to pay during any period
amounts with respect to behavioral healthcare treatment services provided to a
given beneficiary population that exceed per member per month fees received with
respect to such beneficiary population during the same period. There can be no
assurance that the Company's assumptions as to service utilization rates and
costs will accurately and adequately reflect actual utilization rates and costs,
nor can there be any assurance that increases in behavioral healthcare costs or
20
higher-than-anticipated utilization rates, significant aspects of which are
outside the Company's control, will not cause expenses associated with such
contracts to exceed the Company's revenue for such contracts. In addition, there
can be no assurance that adjustments will not be required to the estimates,
particularly those regarding cost of care, made in reporting historical
financial results. See Note 1 to the audited consolidated financial statements
of the Company included elsewhere herein. The Company expects to attempt to
increase membership in its risk-based products. If the Company is successful in
this regard, the Company's exposure to potential losses from its risk-based
products will also be increased. Furthermore, certain of such contracts and
certain state regulations limit the profits that may be earned by the Company on
risk-based business and may require refunds if the loss experience is more
favorable than that originally anticipated. Such contracts and regulations may
also require the Company or certain of its subsidiaries to reserve a specified
amount of cash as financial assurance that it can meet its obligations under
such contracts. As of September 30, 2000, the Company had restricted cash and
investments of $117.7 million pursuant to such contracts and regulations. Such
amounts will not be available to the Company for general corporate purposes.
Furthermore, certain state regulations restrict the ability of subsidiaries that
offer risk-based products to pay dividends to the Company. Certain state
regulations relating to the licensing of insurance companies may also adversely
affect the Company's risk-based business. See "Business Regulation." Although
experience varies on a contract-by-contract basis, historically, the Company's
risk-based contracts have been profitable. However, the degree of profitability
varies significantly from contract to contract. For example, the Company's
Medicaid contracts with governmental entities generally tend to have direct
profit margins that are lower than the Company's other contracts. The most
significant factor affecting the profitability of risk-based contracts is the
ability to control direct service costs in relation to contract pricing.
RELIANCE ON CUSTOMER CONTRACTS. Approximately 88.3% of the Company's
revenue in fiscal 2000 was derived from contracts with payors of behavioral
healthcare benefits. The Company's behavioral managed healthcare contracts
typically have terms of one to three years, and in certain cases contain renewal
provisions providing for successive terms of between one and two years (unless
terminated earlier). Substantially all of these contracts are immediately
terminable with cause and many, including some of the Company's most significant
contracts, are terminable without cause by the customer upon the provision of
requisite notice and the passage of a specified period of time (typically
between 60 and 180 days), or upon the occurrence of certain other specified
events. The Company's ten largest behavioral managed healthcare customers
accounted for approximately 56.6% of the Company's behavioral managed healthcare
revenue for fiscal 2000. Both the Company and Premier Behavioral Systems of
Tennessee, LLC ("Premier"), in which the Company has a fifty percent interest,
separately contract with the State of Tennessee to manage the behavioral
healthcare benefits for the State's TennCare program. The Company's direct
Contract (exclusive of Premier) represented approximately 13.7% of the Company's
behavioral managed healthcare revenue and approximately 12.1% of the Company's
consolidated revenue in fiscal 2000. The Company's managed behavioral contracts
with Aetna, including Nylcare and Prudential, which were acquired by Aetna in
July 1998 and August 1999, respectively, represented approximately 17.2% of the
Company's behavioral managed healthcare revenue and approximately 15.2% of the
Company's consolidated revenue in fiscal 2000. The current TennCare and Aetna
contracts extend through December 31, 2000 and December 31, 2003, respectively.
The Company is in the process of renegotiating its TennCare contract. There can
be no assurance that such contracts will be extended or successfully
renegotiated or that the terms of any new contracts will be comparable to those
of existing contracts. Loss of all of these contracts or customers would, and
loss of any one of these customers could, have a material adverse effect on the
Company. In addition, price competition in bidding for contracts can
significantly affect the financial terms of any new or renegotiated contract.
DEPENDENCE ON GOVERNMENT SPENDING FOR HEALTHCARE; POSSIBLE IMPACT OF
HEALTHCARE REFORM. A significant portion of the Company's revenue is derived,
directly or indirectly, from federal, state and local governmental agencies,
including state Medicaid programs. Reimbursement rates vary from state to state,
are subject to periodic negotiation and may limit the Company's ability to
maintain or increase rates. The
21
Company is unable to predict the impact on the Company's operations of future
regulations or legislation affecting Medicaid or Medicare programs, or the
healthcare industry in general, and there can be no assurance that future
regulations or legislation will not have a material adverse effect on the
Company. Moreover, any reduction in government spending for such programs could
also have a material adverse effect on the Company. In addition, the Company's
contracts with federal, state and local governmental agencies, under both direct
contract and subcontract arrangements, generally are conditioned upon financial
appropriations by one or more governmental agencies, especially with respect to
state Medicaid programs. These contracts generally can be terminated or modified
by the customer if such appropriations are not made. Finally, some of the
Company's contracts with federal, state and local governmental agencies, under
both direct contract and subcontract arrangements, require the Company to
perform additional services if federal, state or local laws or regulations
imposed after the contract is signed so require, in exchange for additional
compensation to be negotiated by the parties in good faith. Government and other
third-party payors are generally seeking to impose lower reimbursement rates and
to renegotiate reduced contract rates with service providers in a trend toward
cost control. See "Business--Industry--Areas of Growth" and "Business--Business
Strategy."
The House of Representatives of the U.S. Congress recently passed the
Norwood-Dingell bill which would (if it or similar legislation became law),
among other things, place limits on healthcare plans, methods of operations,
limit employers' and health care plans' ability to define medical necessity and
permit employers and health care plans to be sued in state courts for coverage
determinations. It is uncertain whether the Company could recoup, through higher
premiums or other measures, the increased costs of federally mandated benefits
or other increased costs caused by such legislation or similar legislation. The
Company cannot predict the effect of this legislation, nor other legislation
that may be adopted by Congress, and no assurance can be given that such
legislation will not have an adverse effect on the Company.
REGULATION. The healthcare industry and the provision of behavioral
healthcare and human services are subject to extensive and evolving state and
federal regulation. The Company is subject to certain state laws and
regulations, including those governing: (i) the licensing of insurance
companies, HMOs, PPOs, TPAs and companies engaged in utilization review and
(ii) the licensing of healthcare professionals, including restrictions on
business corporations from practicing, controlling or exercising excessive
influence over behavioral healthcare services through the direct employment of
psychiatrists or, in a few states, psychologists and other behavioral healthcare
professionals. In addition, the Company is subject to certain federal laws as a
result of the role the Company assumes in connection with managing its
customers' employee benefit plans. The Company's managed care operations are
also indirectly affected by regulations applicable to the establishment and
operation of behavioral healthcare clinics and facilities.
In many states, entities that assume risk under contracts with licensed
insurance companies or HMOs have not been considered by state regulators to be
conducting an insurance or HMO business. As a result, the Company has not sought
licensure as either an insurer or HMO in certain states. Regulators in some
states, however, have determined that risk assuming activity by entities that
are not themselves providers of care is an activity that requires some form of
licensure. There can be no assurance that other states in which the Company
operates will not adopt a similar view, thus requiring the Company to obtain
additional licenses. Such additional licensure might require the Company to
maintain minimum levels of deposits, net worth, capital, surplus or reserves, or
limit the Company's ability to pay dividends, make investments or repay
indebtedness. The imposition of these additional licensure requirements could
increase the Company's cost of doing business or delay the Company's conduct or
expansion of its business.
Regulators may impose operational restrictions on entities granted licenses
to operate as insurance companies or HMOs. For example, the California
Department of Corporations ("DOC") imposed certain restrictions on the Company
in connection with its issuance of an approval of the Company's acquisitions of
HAI and Merit, including restrictions on the ability of the California
subsidiaries of HAI and Merit to
22
fund the Company's operations in other states and on the ability of the Company
to make certain operational changes with respect to HAI and Merit California
subsidiaries.
In addition, utilization review and TPA activities conducted by the Company
are regulated by many states, which states impose requirements upon the Company
that increase its business costs. The Company believes that its TPA activities
performed for its self-insured employee benefit plan customers are exempt from
otherwise applicable state licensing or registration requirements based upon
federal preemption under ERISA, and has relied on this general principle in
determining not to seek licensure for certain of its activities in many states.
Existing case law is not uniform on the applicability of ERISA preemption with
respect to state regulation of utilization review or TPA activities. There can
be no assurance that additional licensure will not be required with respect to
utilization review or TPA activities in certain states. See
"Business--Regulation--Insurance, HMO, and PPO Activities" and "--Utilization
Review and Third-Party Administrator Activities."
State regulatory agencies responsible for the administration and enforcement
of the laws and regulations to which the Company's operations are subject have
broad discretionary powers. A regulatory agency or a court in a state in which
the Company operates could take a position under existing or future laws or
regulations, or change its interpretation or enforcement practices with respect
thereto, that such laws or regulations apply to the Company differently than the
Company believes such laws and regulations apply or should be enforced. The
resultant compliance with, or revocation of, or failure to obtain, required
licenses and governmental approvals could result in significant alteration to
the Company's business operations, delays in the expansion of the Company's
business and lost business opportunities, any of which, under certain
circumstances, could have a material adverse effect on the Company.
The laws of some states limit the ability of a business corporation to
directly provide, control or exercise excessive influence over behavioral
healthcare services through the direct employment of psychiatrists,
psychologists, or other behavioral healthcare professionals. In addition, the
laws of some states prohibit psychiatrists, psychologists, or other healthcare
professionals from splitting fees with other persons or entities. These laws and
their interpretations vary from state to state and enforcement by the courts and
regulatory authorities may vary from state to state and may change over time.
The Company believes that its operations as currently conducted are in material
compliance with the applicable laws, however there can be no assurance that the
Company's existing operations and its contractual arrangements with
psychiatrists, psychologists and other healthcare professionals will not be
successfully challenged under state laws prohibiting fee splitting or the
practice of a profession by an unlicensed entity, or that the enforceability of
such contractual arrangements will not be limited. The Company believes that it
could, if necessary, restructure its operations to comply with changes in the
interpretation or enforcement of such laws and regulations, and that such
restructuring would not have a material adverse effect on its operations.
Confidentiality and patient privacy requirements are particularly strict in
the field of behavioral healthcare services, and additional legislative
initiatives relating to confidentiality and privacy are expected. HIPAA requires
the HHS to adopt standards relating to the transmission of health information by
healthcare providers and healthcare plans. HIPAA calls for HHS to create
regulations in several different areas to address security, privacy and
administrative simplification. The regulations specifically relate to electronic
transactions and code sets, security and electronic signatures, privacy,
provider and employer IDs as well as health plan and individual IDs. While only
the regulations relating to electronic transactions and code sets section are
final, other areas of the regulations are expected to be finalized in the next
few months. The regulations go into effect 26 months after they are released,
with a deadline to implement the regulations governing electronic transaction
and code sets by October 16, 2002. On November 3, 1999, the Secretary
promulgated proposed regulations to protect the privacy of such health
information that is electronically transmitted or maintained. In addition, on
August 17, 2000, HHS published a final rule establishing standard data content
and formats for the submission of electronic claims and other administrative and
health transactions. The wide reaching implications of these regulations are
beginning to be
23
addressed now to ensure the Company's compliance with the regulations by the
implementation dates. These regulations, while creating a need for some software
changes, present more business and policy issues rather than technology issues.
The regulations will require changes to the Company's provider contracts, as
well as the creation of new policies for transmitting patient information to
ensure that the new privacy and electronic security measures are satisfied. In
some cases, these changes will mean executing chain of trust agreements with
business partners and ensuring that encryption technology is used when
transmitting electronic files. In addition, the Company's systems must be
equipped to handle both the electronic transactions governed by the regulations,
as well as paper transactions, which are not affected by the regulations and to
manage different sets of data depending on whether the transaction is electronic
or paper in nature. While the Company believes it has existing systems and
policies in place in many instances that will assist in the Company's
compliance, the Company expects that significant resources will be required over
the next two years to ensure compliance.
Several states in which the Company does business have adopted, or are
expected to adopt, "any willing provider" laws. Such laws typically impose upon
insurance companies, PPOs, HMOs or other types of third-party payors an
obligation to contract with, or pay for the services of, any healthcare provider
willing to meet the terms of the payor's contracts with similar providers.
Compliance with any willing provider laws could increase the Company's costs of
assembling and administering provider networks and could, therefore, have a
material adverse effect on its operations.
HIGHLY COMPETITIVE INDUSTRY. The industry in which the Company conducts its
managed care businesses is highly competitive. The Company competes with large
insurance companies, HMOs, PPOs, TPAs, provider groups and other managed care
companies. Many of the Company's competitors are significantly larger and have
greater financial, marketing and other resources than the Company, and some of
the Company's competitors provide a broader range of services. The Company may
also encounter substantial competition in the future from new market entrants.
Many of the Company's customers that are managed care companies may, in the
future, seek to provide behavioral managed healthcare services to their
employees or subscribers directly, rather than contracting with the Company for
such services. See "Business--Competition."
RISKS RELATED TO AMORTIZATION OF INTANGIBLE ASSETS. The Company's total
assets at September 30, 2000 reflect goodwill of approximately $1.1 billion,
which is amortized over 25 to 40 years, and other identifiable intangible assets
(primarily customer lists, provider networks and treatment protocols) of
approximately $152.0 million that are amortized over 4 to 30 years. At
September 30, 2000, net intangible assets were 68.0% of total assets of
$1.8 billion. The amortization periods used by the Company may differ from those
used by other entities. In addition, the Company may be required to shorten the
amortization period for intangible assets in future periods based on the
prospects of acquired companies. There can be no assurance that the value of
such assets will ever be realized by the Company. The Company evaluates, on a
regular basis, whether events and circumstances have occurred that indicate that
all or a portion of the carrying value of intangible assets may no longer be
recoverable, in which case a charge to earnings for impairment losses could
become necessary. During fiscal 2000 the Company recorded a $91.0 million
impairment charge. This charge related to the write-down of certain long-lived
assets of the Company's specialty managed healthcare segment and the Company's
Group Practice Affiliates subsidiary (GPA). See Note 3--"Discontinued
Operations" and Note 10--"Managed Care Integration Plan and Costs and Special
Charges", to the Company's audited consolidated financial statements included
elsewhere herein. Any determination requiring additional write-offs of a
significant portion of unamortized intangible assets would adversely affect the
Company's results of operations. A write-off of intangible assets could become
necessary if the anticipated undiscounted cash flows of an acquired company do
not support the carrying value of long-lived assets, including intangible
assets.
PROFESSIONAL LIABILITY; INSURANCE. The management and administration of the
delivery of behavioral and specialty managed healthcare services and human
services, like other healthcare services, entail
24
significant risks of liability. The Company is regularly subject to lawsuits
alleging malpractice and related legal theories, some of which involve
situations in which participants in the Company's behavioral programs have
committed suicide. The Company is also subject to claims of professional
liability for alleged negligence in performing utilization review activities, as
well as for acts and omissions of independent contractors participating in the
Company's third-party provider networks. The Company is subject to claims for
the costs of services for which payment was denied. There can be no assurance
that the Company's procedures for limiting liability have been or will be
effective, or that one or more lawsuits will not have a material adverse effect
on the Company in the future.
Recently, certain managed healthcare companies, including the Company, have
been targeted as defendants in several national class action lawsuits regarding
their business practices. These class action complaints include (i) inadequate
disclosure of provider compensation arrangements to members,
(ii) misrepresentation and omissions in advertising and health plan materials
and (iii) concealment of information from health plan members used to determine
what claims will be paid, procedures to determine medical necessity and
procedures to determine the extent and type of coverage. The Company believes
that these national class action lawsuits are part of a trend targeting the
healthcare industry, particularly managed care companies. There can be no
assurance that such lawsuits, which are generally uninsured, won't have a
material adverse effect on the Company.
The Company carries professional liability insurance, subject to certain
deductibles. There can be no assurance that such insurance will be sufficient to
cover any judgments, settlements or costs relating to present or future claims,
suits or complaints or that, upon expiration thereof, sufficient insurance will
be available on favorable terms, if at all. If the Company is unable to secure
adequate insurance in the future, or if the insurance carried by the Company is
not sufficient to cover any judgments, settlements or costs relating to any
present or future actions or claims, there can be no assurance that the Company
will not be subject to a liability that could have a material adverse effect on
the Company. See "Business--Insurance" and "Legal Proceedings."
The Company has certain potential liabilities relating to the self-insurance
program it maintained with respect to its provider business prior to the
Crescent Transactions. In addition, the Company continues to be subject to
governmental investigations and inquiries, civil suits and other claims and
assessments with respect to the provider business. See "Legal Proceedings" and
Note 12--"Commitments and Contingencies", to the Company's audited consolidated
financial statements included elsewhere herein.
25
EXECUTIVE OFFICERS OF THE REGISTRANT
NAME AGE POSITION
- ---- -------- --------
Henry T. Harbin, M.D................... 53 President, Chief Executive Officer and Director
Daniel S. Messina...................... 45 Executive Vice President, Chief Operating Officer and
Director
Mark S. Demilio........................ 45 Executive Vice President, Finance and Legal
Clarissa C. Marques, Ph.D.............. 48 Executive Vice President and Chief Administrative
Officer
Dennis P. Moody........................ 43 Executive Vice President, Business Operations
HENRY T. HARBIN, M.D. became President, Chief Executive Officer and a
Director of the Company on March 18, 1998. Dr. Harbin served as President and
Chief Executive Officer of Green Spring from 1994 to 1998. Dr. Harbin served as
Executive Vice President of the Company from 1995 until becoming President and
Chief Executive Officer of the Company.
DANIEL S. MESSINA became Executive Vice President and Chief Operating
Officer in September 2000. Prior to joining the Company, Mr. Messina was chief
financial officer and head of business strategy for Aetna U.S. Healthcare in
Hartford, Connecticut from February 1990 to September 2000. Mr. Messina has also
served on the Board of Directors of the Company since 1998.
MARK S. DEMILIO became Executive Vice President, Finance and Legal of the
Company in November 2000. Mr. Demilio served as Executive Vice President and
General Counsel from July 1999. Prior thereto, Mr. Demilio was with Youth
Services International, Inc., a publicly traded company that managed facilities
for adjudicated youth, serving as Executive Vice President Business Development
and General Counsel from March 1997 and Acting Chief Financial Officer from
June 1998. Mr. Demilio was a partner with Miles & Stockbridge, a Baltimore,
Maryland-based law firm, from 1994 to March 1997 and served as an associate with
that firm from 1989.
CLARISSA C. MARQUES, PH.D. became Executive Vice President and Chief
Adminsitrative Officer in June 2000. Prior thereto, Dr. Marques served as the
Executive Vice President and Clinical and Quality Management since March 1998.
Dr. Marques serviced as the Executive Vice President and Chief Clinical Officer
of Green Spring during 1997 and 1998 and Senior Vice President of Green Spring
from 1992 to 1997.
DENNIS P. MOODY became Executive Vice President of Business Operations in
October 2000. Prior thereto, Mr. Moody served as President and Chief Operating
Officer of the Health Plan Solutions Group since February 1998. Mr. Moody
previously held the following positions with Merit from 1991 through 1997:
Executive Vice President, National Business (1997), Executive Vice President,
National Services (1995 - 1996), Executive Vice President, Regional Operations
(1994 - 1995), and Regional Vice President (1991 - 1994).
EMPLOYEES OF THE REGISTRANT
At September 30, 2000, the Company had approximately 12,800 full-time and
part-time employees. The Company believes it has satisfactory relations with its
employees.
ITEM 2. PROPERTIES
The Company's principal executive offices are located in Columbia, Maryland;
the lease for the Company's headquarters expires in 2003. Additionally, the
Company leases 158 offices with terms expiring between 2000 and 2008.
26
ITEM 3. LEGAL PROCEEDINGS
The management and administration of the delivery of behavioral managed
healthcare services, and the direct provision of behavioral healthcare treatment
services, entail significant risks of liability. From time to time, the Company
is subject to various actions and claims arising from the acts or omissions of
its employees, network providers or other parties. In the normal course of
business, the Company receives reports relating to suicides and other serious
incidents involving patients enrolled in its programs. Such incidents
occasionally give rise to malpractice, professional negligence and other related
actions and claims against the Company or its network providers. As the number
of lives covered by the Company grows and the number of providers under contract
increases, actions and claims against the Company (and, in turn, possible legal
liability) predicated on malpractice, professional negligence or other related
legal theories can be expected to increase. See "Business Cautionary
Statements--Professional Liability; Insurance." Many of these actions and claims
received by the Company seek substantial damages and therefore require the
defendant to incur significant fees and costs related to their defense. To date,
claims and actions against the Company alleging professional negligence have not
resulted in material liabilities and the Company does not believe that any
pending action against it will have a material adverse effect on the Company.
However, there can be no assurance that pending or future actions or claims for
professional liability (including any judgments, settlements or costs associated
therewith) will not have a material adverse effect on the Company. See
"--Insurance" and "Cautionary Statements--Professional Liability; Insurance."
From time to time, the Company receives notifications from and engages in
discussions with various governmental agencies concerning its respective managed
care businesses and operations. As a result of these contacts with regulators,
the Company in many instances implements changes to its operations, revises its
filings with such agencies and/or seeks additional licenses to conduct its
business. In recent years, in response to governmental agency inquiries or
discussions with regulators, the Company has determined to seek licensure as a
single service HMO, TPA or utilization review agent in one or more
jurisdictions.
The healthcare industry is subject to numerous laws and regulations. The
subjects of such laws and regulations include, but are not limited to, matters
such as licensure, accreditation, government healthcare program participation
requirements, reimbursement for patient services, and Medicare and Medicaid
fraud and abuse. Recently, government activity has increased with respect to
investigations and/or allegations concerning possible violations of fraud and
abuse and false claims statutes and/or regulations by healthcare providers.
Entities that are found to have violated these laws and regulations may be
excluded from participating in government healthcare programs, subjected to
fines or penalties or required to repay amounts received from the government for
previously billed patient services. The Office of the Inspector General of the
Department of Health and Human Services and the United States Department of
Justice ("Department of Justice") and certain other governmental agencies are
currently conducting inquiries and/or investigations regarding the compliance by
the Company and certain of its subsidiaries with such laws and regulations.
Certain of the inquiries relate to the operations and business practices of the
Psychiatric Hospital Facilities prior to the consummation of the Crescent
Transactions in June 1997. The Department of Justice has indicated that its
inquiries are based on its belief that the federal government has certain civil
and administrative causes of action under the Civil False Claims Act, the Civil
Monetary Penalties Law, other federal statutes and the common law arising from
the participation in federal health benefit programs of The Psychiatric Hospital
Facilities nationwide. The Department of Justice inquiries relate to the
following matters: (i) Medicare cost reports; (ii) Medicaid cost statements;
(iii) supplemental applications to CHAMPUS (as defined) based on Medicare cost
reports; (iv) medical necessity of services to patients and admissions;
(v) failure to provide medically necessary treatment or admissions; and
(vi) submission of claims to government payors for inpatient and outpatient
psychiatric services. No amounts related to such proposed causes of action have
yet been specified. The Company cannot reasonably estimate the settlement
amount, if any, associated with the Department of Justice inquiries.
Accordingly, no reserve has been recorded related to this matter.
27
Five affiliated outpatient clinic providers that are participating providers
in the TennCare program asserted claims against Green Spring Health
Services, Inc., a wholly-owned subsidiary of the Company ("Green Spring") and
Premier, the joint venture that contracts with the State of Tennessee to manage
services under the TennCare program and in which the Company holds a 50%
interest, alleging that Premier and Green Spring failed to pay the providers in
accordance with their contracts. The claims allege losses of in excess of
$16.0 million in the aggregate and are proceeding in five separate arbitrations.
On December 8, 2000 the Chancery Court of Davidson County, Tennessee entered a
judgment confirming an arbitration award against Premier and Green Spring in the
amount of $3.7 million in favor of one of the providers. The Court denied a
motion by Premier and Green Spring to vacate the arbitration award on grounds
that the provider procured the award by fraud and that the arbitrators exceeded
their authority. Premier and Green Spring believe that the Court's order was
erroneous and intend to pursue vigorously an appeal of this judgment. The other
arbitrations are at various stages of proceedings. The Company believes that
adequate reserves have been recorded with respect to any potential loss in these
matters.
On or about August 4, 2000, the Company was served with a lawsuit filed by
Wachovia Bank, N.A. ("Wachovia") in the Court of Common Pleas of Richland
County, South Carolina seeking recovery under the indemnification provisions of
the Engagement Letter between South Carolina National Bank (now Wachovia) and
the Company and the ESOP Trust Agreement between South Carolina National Bank
(now Wachovia) and the Company for losses sustained in a settlement entered into
by Wachovia with the United States Department of Labor in connection with the
ESOP's purchase of stock of the Company while Wachovia served as ESOP Trustee.
Wachovia also alleges fraud, negligent misrepresentation and other claims and
asserts its losses exceed $30 million. While the claim is in the initial stage,
and an outcome cannot be determined, the Company believes the claims of Wachovia
are without merit and is defending them vigorously.
On October 26, 2000, two class action complaints (the "Class Actions") were
filed against Magellan Health Services, Inc. and Magellan Behavioral
Health, Inc. (the "Defendants") in the United States District Court for the
Eastern District of Missouri under the Racketeer Influenced and Corrupt
Organizations Act ("RICO") and the Employment Retirement Income Security Act of
1974 ("ERISA"). The class representatives purport to bring the actions on behalf
of a nationwide class of individuals whose behavioral health benefits have been
provided, underwritten and/or arranged by the Defendants since 1996. The
complaints allege violations of RICO and ERISA arising out of the Defendants'
alleged misrepresentations with respect to and failure to disclose, its claims
practices, the extent of the benefits coverage and other matters that cause the
value of benefits to be less than the amount of premium paid. The complaints
seek unspecified compensatory damages, treble damages under RICO, and an
injunction barring the alleged improper claims practices, plus interest, costs
and attorneys' fees. These actions are similar to suits filed against a number
of other health care organizations, elements of which have already been
dismissed by various courts around the country. While the Class Actions are in
the initial stages, and an outcome cannot be determined, the Company believes
that the claims are without merit and intend to defend them vigorously.
The Company also is subject to or party to other litigation, claims, and
civil suits relating to its operations and business practices. Certain of the
Company's managed care litigation matters involve class action lawsuits, which
allege (i) the Company inappropriately denied and/or failed to authorize
benefits for mental health treatment under insurance policies with a customer of
the Company and (ii) a provider at a Company facility violated privacy rights of
certain patients. In addition, the Company is subject to certain contingencies
in connection with the CBHS bankruptcy as discussed in Note 3--"Discontinued
Operations" to the Company's audited consolidated financial statements set forth
elsewhere herein. In the opinion of management, the Company has recorded
reserves that are adequate to cover litigation and claims that have been or may
be asserted against the Company, and for which the outcome is probable and
reasonably estimable, arising out of such other litigation and claims.
Furthermore, management believes that the resolution of such litigation and
claims will not have a material adverse effect on the Company's financial
position or results of operations; however, there can be no assurance in this
regard.
28
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET PRICE FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company has one class of common stock, $0.25 par value per share, which
is listed for trading on the New York Stock Exchange (ticker symbol "MGL"). As
of December 22, 2000, there were 9,289 holders of record of the Company's common
stock. The following table sets forth the high and low sales prices of the
Company's common stock from October 1, 1998 through the fiscal year ended
September 30, 2000 as reported by the New York Stock Exchange:
COMMON
STOCK SALES
PRICES
-------------------------
CALENDAR YEAR HIGH LOW
- ------------- ----------- -----------
1998
Fourth Quarter.......................................... 10 3/4 6 3/8
1999
First Quarter........................................... 11 1/8 4 3/16
Second Quarter.......................................... 10 3 9/16
Third Quarter........................................... 10 1/2 6 7/8
Fourth Quarter.......................................... 7 1/4 5 5/16
2000
First Quarter........................................... 7 9/16 4 5/8
Second Quarter.......................................... 4 13/16 1 15/16
Third Quarter........................................... 4 1 1/4
The Company did not declare any cash dividends during fiscal 1999 or 2000.
As of December 22, 2000, the Company was prohibited from paying dividends on its
common stock under the terms of the Credit Agreement, except in very limited
circumstances.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected historical consolidated financial
information of the Company for each of the five years in the period ended
September 30, 2000. On September 2, 1999, the Company's Board of Directors
approved a formal plan to dispose of the businesses included in the Company's
healthcare provider and healthcare franchising segments and on September 10,
1999, the Company consummated such disposal. On October 4, 2000, the Company
adopted a formal plan to dispose of the business included in the Company's
specialty managed healthcare segment. Accordingly, the statement of operations
data has been restated to reflect the healthcare provider, healthcare
franchising and specialty managed healthcare segments as discontinued
operations. Selected consolidated financial information for the three years
ended September 30, 2000 and as of September 30, 1999 and 2000 presented below,
have been derived from, and should be read in conjunction with, the Company's
audited consolidated financial statements and the notes thereto included
elsewhere herein. Selected consolidated financial information for the two years
ended September 30, 1997 and as of September 30, 1996 and 1997 has been derived
from the Company's unaudited consolidated financial statements. The selected
financial data set forth below also should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" appearing elsewhere herein.
29
FISCAL YEAR ENDED SEPTEMBER 30,
-----------------------------------------------------------
1996 1997 1998 1999 2000
--------- -------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
STATEMENT OF OPERATIONS DATA:
Net revenue................................ $ 302,573 $463,872 $1,167,274 $1,674,479 $1,873,554
Salaries, cost of care and other operating
expenses................................. 299,855 436,169 1,043,251 1,468,879 1,652,582
Equity in (earnings) loss of unconsolidated
subsidiaries............................. 2,005 5,567 (12,795) (20,442) (9,792)
Depreciation and amortization.............. 14,290 19,683 46,898 68,921 75,413
Interest, net.............................. 48,584 46,438 76,505 93,752 97,286
Stock option expense (credit).............. 914 4,292 (5,623) 18 --
Managed care integration costs............. -- -- 16,962 6,238 --
Special charges, net....................... 1,221 -- -- 4,441 25,398
Income (loss) from continuing operations
before income taxes, minority interest
and extraordinary items.................. (64,296) (48,277) 2,076 52,672 32,667
Provision for (benefit from) income
taxes.................................... (25,719) (19,311) 5,238 28,256 15,478
Income (loss) from continuing operations
before minority interest and
extraordinary items...................... (38,577) (28,966) (3,162) 24,416 17,189
Minority interest.......................... 4,531 6,856 4,094 630 114
Income (loss) from continuing operations
before extraordinary items............... (43,108) (35,822) (7,256) 23,786 17,075
Discontinued operations:
Income (loss) from discontinued
operations............................. 75,491 40,577 20,988 28,325 (65,221)
Loss on disposal of discontinued
operations............................. -- -- -- (47,423) (17,662)
Income (loss) before extraordinary items... 32,383 4,755 13,732 4,688 (65,808)
Extraordinary items -- losses on early
extinguishments of debt.................. -- (5,253) (33,015) -- --
Net income (loss).......................... 32,383 (498) (19,283) 4,688 (65,808)
Preferred dividend requirement and
amortization of redeemable preferred
stock issuance costs..................... -- -- -- -- 3,802
Income (loss) available to common
stockholders............................. $ 32,383 $ (498) $ (19,283) $ 4,688 $ (69,610)
INCOME (LOSS) PER COMMON SHARE AVAILABLE TO
COMMON STOCKHOLDERS -- BASIC:
Income (loss) from continuing operations
before extraordinary items............... (1.39) (1.24) (0.24) 0.75 0.41
Income (loss) from discontinued
operations............................... 2.43 1.41 0.68 (0.60) (2.58)
Loss from extraordinary items.............. -- (0.18) (1.07) -- --
Net income (loss).......................... $ 1.04 $ (0.02) $ (0.63) $ (0.15) $ (2.17)
INCOME (LOSS) PER COMMON SHARE AVAILABLE TO
COMMON STOCKHOLDERS -- DILUTED:
Income (loss) from continuing operations
before extraordinary items............... $ (1.39) $ (1.24) $ (0.24) $ 0.75 $ 0.41
Income (loss) from discontinued
operations............................... 2.43 1.41 0.68 (0.60) (2.56)
Loss from extraordinary items.............. -- (0.18) (1.07) -- --
Net income (loss).......................... $ 1.04 $ (0.02) $ (0.63) $ (0.15) $ (2.15)
BALANCE SHEET DATA (END OF PERIOD):
Current assets............................. $ 338,150 $507,038 $ 399,724 $ 374,927 $ 319,653
Current liabilities........................ 274,316 219,376 454,766 474,268 469,879
Property and equipment, net................ 495,390 109,214 177,169 120,667 112,612
Total assets............................... 1,140,137 896,868 1,917,088 1,881,615 1,803,787
Total debt and capital lease obligations... 572,058 395,294 1,225,646 1,144,308 1,098,047
Stockholders' equity....................... 121,817 159,498 188,433 196,696 128,464
30
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
SEPTEMBER 30, 2000
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Prior to June 1997, the Company derived the majority of its revenue from
providing behavioral healthcare services in an inpatient setting. During the
first quarter of fiscal 1996, the Company acquired a 61% ownership interest in
Green Spring Health Services, Inc. At that time, the Company intended to become
a fully integrated behavioral healthcare provider by combining the behavorial
managed healthcare products offered by Green Spring with the direct treatment
services offered by the Company's psychiatric hospitals. During the second
quarter of fiscal 1998, the minority stockholders of Green Spring converted
their 39% ownership interest in Green Spring into an aggregate of 2,831,516
shares of Magellan common stock.
Subsequent to the Company's acquisition of Green Spring, the growth of the
behavioral managed healthcare industry accelerated. The Company concluded that
the behavioral managed healthcare industry offered growth and earnings prospects
superior to those of the psychiatric hospital industry. Therefore, the Company
decided to sell its domestic psychiatric facilities to obtain capital for
expansion of its behavioral managed healthcare business.
On June 17, 1997, the Company consummated the Crescent Transactions which
provided the Company with approximately $200 million of net cash proceeds, after
debt repayment, for use in implementing its business strategy to increase its
participation in the managed healthcare industry. The Company used the net cash
proceeds of approximately $200 million, after debt repayment, to finance the
acquisitions of HAI and Allied in December 1997. The Company further implemented
its business strategy through the acquisition of Merit in February 1998.
On September 10, 1999, the Company consummated the CBHS Transactions. The
CBHS Transactions, together with the formal plan of disposal authorized by the
Company's Board of Directors on September 2, 1999, represented the disposal of
the Company's healthcare provider and healthcare franchising business segments.
On October 4, 2000, the Company adopted a formal plan to dispose of the
business included in the Company's specialty managed healthcare segment. The
specialty managed healthcare segment includes the businesses acquired in
conjunction with the purchase of Vivra which was consummated February 29, 2000
and Allied on December 5, 1997. The initial purchase price of Vivra was
$10.25 million and additional consideration of $10.0 million may be payable
based upon future results. The Company paid approximately $54.5 million for
Allied.
APB 30 requires that the results of continuing operations be reported
separately from those of discontinued operations for all periods presented and
that any gain or loss from disposal of a segment of a business be reported in
conjunction with the related results of discontinued operations. Accordingly,
the Company has restated its results of operations for all prior periods related
to the healthcare provider, healthcare franchising and specialty managed
healthcare business segments. The Company recorded an after-tax loss on disposal
of its healthcare provider and healthcare franchising business segments of
approximately $47.4 million (primarily non-cash), in fiscal 1999 and an after
tax loss of $17.7 million on the disposal of its specialty managed healthcare
segment in fiscal 2000.
The Company currently operates through two principal business segments which
are engaged in:
- THE BEHAVIORAL MANAGED HEALTHCARE BUSINESS. The Company's behavioral
managed healthcare segment coordinates and manages the delivery of
behavioral healthcare treatment services through its network of providers,
which includes psychiatrists, psychologists and other medical
professionals.
31
The treatment services provided through these provider networks include
outpatient programs (such as counseling or therapy), intermediate care
programs (such as intensive outpatient programs and partial
hospitalization services), inpatient treatment and alternative care
services (such as residential treatment and home or community-based
programs). The Company provides these services primarily through:
(i) risk-based products, where the Company assumes all or a portion of the
responsibility for the cost of providing treatment services in exchange
for a fixed per member per month fee, (ii) ASO products, where the Company
provides services such as utilization review, claims administration or
provider network management, (iii) EAPs and (iv) products which combine
features of some or all of the Company's risk-based, ASO, or EAP products.
- THE HUMAN SERVICES BUSINESS. The Company provides various human services
through Mentor. These human services include specialty home-based
healthcare services provided through "mentor" homes as well as residential
and day treatment services for individuals with acquired brain injuries
and for individuals with mental retardation and developmental
disabilities.
At September 30, 2000, the Company's behavioral managed healthcare segment,
managed the behavioral healthcare benefits of approximately 71.0 million
individuals and Mentor, the human services segment, provided over 7,800
individuals with community-based services.
RESULTS OF OPERATIONS
The following tables summarize, for the periods indicated, operating results
by continuing business segments (in thousands).
BEHAVIORAL CORPORATE
MANAGED HUMAN OVERHEAD
FISCAL 1998 HEALTHCARE SERVICES AND OTHER CONSOLIDATED
- ----------- ---------- ------------ ---------- ------------
Net revenue..................................... $1,026,243 $141,031 $ -- $1,167,274
---------- -------- -------- ----------
Salaries, cost of care and other operating
expenses...................................... 901,846 125,539 15,866 1,043,251
Equity in earnings of unconsolidated
subsidiaries.................................. (12,795) -- -- (12,795)
---------- -------- -------- ----------
889,051 125,539 15,866 1,030,456
---------- -------- -------- ----------
Segment Profit(1)............................... $ 137,192 $ 15,492 $(15,866) $ 136,818
========== ======== ======== ==========
BEHAVIORAL CORPORATE
MANAGED HUMAN OVERHEAD
FISCAL 1999 HEALTHCARE SERVICES AND OTHER CONSOLIDATED
- ----------- ---------- ------------ ---------- ------------
Net revenue..................................... $1,483,202 $191,277 $ -- $1,674,479
---------- -------- -------- ----------
Salaries, cost of care and other operating
expenses...................................... 1,285,391 169,549 13,939 1,468,879
Equity in earnings of unconsolidated
subsidiaries.................................. (20,442) -- -- (20,442)
---------- -------- -------- ----------
1,264,949 169,549 13,939 1,448,437
---------- -------- -------- ----------
Segment Profit(1)............................... $ 218,253 $ 21,728 $(13,939) $ 226,042
========== ======== ======== ==========
BEHAVIORAL CORPORATE
MANAGED HUMAN OVERHEAD
FISCAL 2000 HEALTHCARE SERVICES AND OTHER CONSOLIDATED
- ----------- ---------- ------------ ---------- ------------
Net revenue..................................... $1,655,101 $218,453 -- $1,873,554
---------- -------- -------- ----------
Salaries, cost of care and other operating
expenses...................................... 1,442,964 196,332 13,286 1,652,582
Equity in earnings of unconsolidated
subsidiaries.................................. (9,792) -- -- (9,792)
---------- -------- -------- ----------
1,433,172 196,332 13,286 1,642,790
---------- -------- -------- ----------
Segment Profit(1)............................... $ 221,929 $ 22,121 $(13,286) $ 230,764
========== ======== ======== ==========
32
- ------------------------
(1) The Company evaluates performance of its segments based upon profit or loss
from continuing operations before depreciation, amortization, interest, net,
stock option expense (credit), managed care integration costs, special
charges, net, income taxes and minority interest ("Segment Profit"). See
Note 14, "Business Segment Information", to the Company's audited
consolidated financial statements appearing elsewhere herein.
FISCAL 1999 COMPARED TO FISCAL 2000
BEHAVIORAL MANAGED HEALTHCARE. Revenue increased 11.6% or $171.9 million,
to $1.66 billion for fiscal 2000, from $1.48 billion in fiscal 1999. Salaries,
cost of care and other operating expenses increased 12.3%, or $157.6 million, to
$1.44 billion for fiscal 2000, from $1.29 billion for fiscal 1999. The increases
resulted primarily from increased membership growth and new contracts. Operating
expenses increased at a greater rate than revenue primarily as a result of
losses and reduced profitability in certain public sector contracts. Total
covered lives increased 6.9% or 4.6 million to 71.0 million at September 30,
2000 from 66.4 million at September 30, 1999. Equity in earnings of
unconsolidated subsidiaries decreased 52.1% or $10.7 million to $9.8 million in
fiscal 2000 from $20.4 million in fiscal 1999. This decrease was a result of the
decreased earnings of Premier Behavioral Systems of Tennessee, LLC ("Premier"),
in which the Company maintains a 50% interest. The decrease in Premier's
profitability was primarily a result of the 1999 period benefiting from positive
contractual rate adjustments and an increase in accruals for potential losses
from certain legal actions in the 2000 period. The Company frequently records
retroactive customer settlements, which may be favorable or unfavorable, under
its commercial behavioral managed healthcare contracts. Revenue and Segment
Profit for fiscal 2000 reflect approximately $1.4 million of such favorable
settlements compared to favorable settlements of $9.8 million during fiscal
1999. The Company recorded $3.7 million and $(0.8) million of favorable
(unfavorable) retroactive customer settlements in the fourth quarter of fiscal
1999 and 2000, respectively.
HUMAN SERVICES. Revenue from the human services segment increased 14.2%, or
$27.2 million, to $218.5 million for fiscal 2000, from $191.3 million in fiscal
1999. Salaries, cost of care and other operating expenses increased 15.8%, or
$26.8 million, to $196.3 million for fiscal 2000 from $169.5 million in fiscal
1999. The increase in revenue is a result of increased placements and
acquisitions completed in fiscal 1999 and 2000. Increased operating expenses
resulted from: (i) increase in placements; (ii) decreased profitability and exit
costs incurred related to certain contracts and operations; and (iii) increased
spending on conversion of computer systems. Total placements increased 21.9% to
approximately 7,800 at September 30, 2000, compared to approximately 6,400 at
September 30, 1999.
CORPORATE OVERHEAD AND OTHER. Salaries and other operating expenses
decreased 4.9%, or $0.7 million, primarily as a result of ongoing integration of
corporate administrative functions with business unit administrative functions.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased
9.4%, or $6.5 million, to $75.4 million for fiscal 2000, from $68.9 million in
fiscal 1999. The increase was primarily attributed to depreciation related to
recent capital expenditures and amortization related to the additional purchase
price payment of $60 million with respect to the HAI acquisition made in fiscal
2000. See Note 3--"Acquisitions and Joint Ventures" to the Company's audited
consolidated financial statements set forth elsewhere herein.
INTEREST, NET. Interest expense, net, increased 3.7%, or $3.5 million, to
$97.3 million for fiscal 2000, from $93.8 million in fiscal 1999. The increase
was primarily the result of higher borrowing rates during fiscal 2000.
OTHER ITEMS. The Company recorded special charges of $25.4 million during
fiscal 2000 comprised of: (i) $4.5 million of severance and lease termination
costs and $15.8 million of impairment of certain long lived assets related to
the closure of offices in connection with the psychiatric practice management
33
business; (ii) $7.0 million of severance and lease termination costs related to
the restructuring of the corporate function and certain behavioral managed
healthcare sites and (iii) a $1.9 million non-recurring gain on the sale of the
corporate aircraft.
The Company's effective tax rate was 47.4% for fiscal 2000. The effective
tax rate exceeds statutory rates due primarily to non-deductible goodwill
amortization resulting primarily from acquisitions, offset by reductions in
reserve estimates of approximately $9.1 million related to settlements with the
Internal Revenue Service during the fourth quarter of fiscal 2000.
DISCONTINUED OPERATIONS. The following tables summarize, for the periods
indicated, income (loss) from discontinued operations, net of tax:
1999 2000
-------- --------
Healthcare provider segment.............................. $32,883 $ --
Healthcare franchising segment........................... (3,238) --
Specialty managed healthcare segment..................... (1,320) (65,221)
------- --------
$28,325 $(65,221)
======= ========
Income from the healthcare provider segment decreased 100%, or
$32.8 million to $0 million for fiscal 2000 compared to $32.8 million for fiscal
1999. The decrease is primarily attributable to (i) the net effect of the
Company's sale of its European hospital operations in April 1999, which included
a gain on sale of $14.4 million, net of tax, (ii) income of $8.8 million, net of
tax, from cost report settlements related primarily to the resolution of
Medicare cost report matters in the fourth quarter of fiscal 1999 associated
with the Company's sale of the Psychiatric Hospital Facilities, and
(iii) discontinuance of all significant activities related to this segment in
fiscal 2000. The Company ceased all activities related to its healthcare
franchising segments during fiscal 1999.
The loss from the specialty managed healthcare segment increased
$63.9 million, to a loss of $65.2 million, net of tax, for fiscal 2000 compared
to a loss of $1.3 million, net of tax, for fiscal 1999. During fiscal 2000 the
Company recorded: (i) a pre-tax charge of $58.2 million in the second quarter
related to the impairment of long-lived assets; (ii) pre-tax operating losses of
approximately $41.1 million prior to the discontinued operations measurement
date; and (iii) a federal tax benefit of $34.1 million. The operating losses
were attributable to: (i) performance of certain risk-based contracts;
(ii) cost to exit risk-based contracts including provision for uncollectible
receivables and additional contractual liabilities; and (iii) severance and shut
down cost incurred in conjunction with the wind down of operations.
The Company recorded a loss on disposal of discontinued operations of
approximately $17.7 million, net of tax benefit of $9.2 million, at the end of
fiscal 2000. This loss represents the additional cost incurred as a result of
the plan adopted on October 4, 2000 to fully exit the specialty managed
healthcare segment. See Note 3-"Discontinued Operations" to the Company's
audited consolidated financial statements set forth elsewhere herein. The
pre-tax loss is comprised of a $17.1 million impairment of the remaining
long-lived assets and $9.8 million in lease terminations and other exit costs as
defined by APB 30.
FISCAL 1998 COMPARED TO FISCAL 1999
BEHAVIORAL MANAGED HEALTHCARE. Revenue increased 44.5% or $457.0 million,
to $1.48 billion for fiscal 1999, from $1.03 billion in fiscal 1998. Salaries,
cost of care and other operating expenses increased 42.5%, or $383.5 million, to
$1.29 billion for fiscal 1999, from $901.8 million in fiscal 1998. Equity in
earnings of unconsolidated subsidiaries increased $7.6 million, to
$20.4 million for fiscal 1999, from $12.8 million for fiscal 1998. The increases
resulted primarily from (i) the HAI and Merit acquisitions in fiscal 1998,
(ii) increased enrollment related to existing customers, (iii) expanded services
and lives under management with certain public sector customers, (iv) new
business development and (v) increases in retroactive customer settlements,
offset by reductions in general and administrative costs as a result of the
34
integration of Green Spring, HAI and Merit and the termination of one public
sector contract (Montana Medicaid) in fiscal 1999. Total covered lives increased
7.8% or 4.8 million to 66.4 million at September 30, 1999 from 61.6 million at
September 30, 1998. The Company frequently records retroactive customer
settlements, which may be favorable or unfavorable, under its commercial
behavioral managed healthcare contracts. Revenue and Segment Profit for fiscal
1999 reflect approximately $9.8 million of such favorable settlements compared
to favorable settlements of $1.8 million during fiscal 1998. The Company
recorded $3.7 million of favorable retroactive customer settlements in the
fourth quarter of fiscal 1999.
HUMAN SERVICES. Revenue from the human services segment increased 35.7%, or
$50.3 million, to $191.3 million for fiscal 1999, from $141.0 million in fiscal
1998. Salaries, cost of care and other operating expenses increased 35.1%, or
$44.0 million, to $169.5 million for fiscal 1999 from $125.5 million in fiscal
1998. The increases were attributable to acquisitions consummated in fiscal 1998
and fiscal 1999 and internal growth, offset by reductions in revenue and Segment
Profit at one acquired business in fiscal 1999 as a result of rate and placement
reductions from a state agency. Total placements increased 9.5% to approximately
6,400 at September 30, 1999, compared to approximately 5,900 at September 30,
1998.
CORPORATE OVERHEAD AND OTHER. Salaries and other operating expenses
decreased 12.1%, or $1.9 million, primarily as a result of ongoing integration
of corporate administrative functions with business unit administrative
functions.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased
46.9%, or $22.0 million, to $68.9 million for fiscal 1999, from $46.9 million in
fiscal 1998. The increase was primarily attributed to (i) the acquisition of HAI
and Merit in fiscal 1998, (ii) depreciation related to fiscal year 2000 capital
expenditures and (iii) amortization related to the additional purchase price
payment of $60 million to Aetna with respect to the HAI acquisition made in
fiscal 1999.
INTEREST, NET. Interest expense, net, increased 22.6%, or $17.3 million, to
$93.8 million for fiscal 1999, from $76.5 million in fiscal 1998. The increase
was primarily the result of interest expense incurred on borrowings used to fund
the Merit acquisition and related transactions in fiscal 1998.
OTHER ITEMS. Stock option expense for fiscal 1999 was not material compared
to a credit of $5.6 million in fiscal 1998 primarily due to fluctuations in the
market price of the Company's stock in fiscal 1998.
The Company recorded managed care integration costs of $6.2 million for
fiscal 1999, compared to $17.0 million in fiscal 1998. For a more complete
discussion of managed care integration costs, see Note 10, "Managed Care
Integration Plan and Costs and Special Charges" to the Company's audited
consolidated financial statements set forth elsewhere herein.
The Company recorded special charges of $4.4 million during fiscal 1999
related primarily to the loss on disposal of an office building, executive
severance and costs associated with moving the Company's corporate headquarters
from Atlanta, Georgia to Columbia, Maryland.
The Company's effective income tax rate was 53.6% for fiscal 1999. The
effective income tax rate exceeds statutory rates due primarily to
non-deductible goodwill amortization resulting from acquisitions.
Minority interest decreased $3.5 million, to $0.6 million during fiscal 1999
primarily as a result of the Green Spring minority stockholder conversion in
fiscal 1998.
35
DISCONTINUED OPERATIONS. The following tables summarize, for the periods
indicated, income (loss) from discontinued operations, net of tax:
SEGMENT 1998 1999
- ------- -------- --------
Health Care Provider Segment.............................. $12,132 $32,883
Health Care Franchising Segment........................... 8,399 (3,238)
Specialty Managed Healthcare Segment...................... 457 (1,320)
------- -------
$20,988 $28,325
======= =======
Income from the healthcare provider segment increased 171.1%, or
$20.8 million to $32.9 million for fiscal 1999 compared to $12.1 million for
fiscal 1998. The increase is primarily attributable to (i) the net effect of the
Company's sale of its three European Hospitals in April 1999, which included a
gain on sale of $14.4 million, net of tax, (ii) increases in income of
$8.8 million, net of tax, from cost report settlements related primarily to the
resolution of Medicare cost report matters in the fourth quarter of fiscal 1999
associated with the Company's sale of the Psychiatric Hospital Facilities, and
(iii) increases in income of $4.8 million, net of tax, related to adjustments to
accounts receivable collection fee reserves recorded in connection with the
Crescent Transactions, offset by reductions in adjustments to income of
$2.5 million, net of tax, related to updated actuarial estimates of malpractice
claims.
Income from the healthcare franchising segment decreased $11.6 million, net
of tax, to a loss of $3.2 million, net of tax, for fiscal 1999 compared to
income of $8.4 million, net of tax, for the same period in 1998. The decrease
was primarily attributable to the declining operating performance of CBHS, which
resulted in the Company recording and collecting no franchise fees from CBHS in
fiscal 1999.
Income from the specialty managed healthcare segment decreased
$1.8 million, to a loss of $1.3 million, net of tax, for fiscal 1999 compared to
an income of $0.5 million, net of tax, for the same period in 1998. The decrease
is primarily a result of a loss of a significant customer at the end of 1998 and
increased administrative spending during 1999.
The Company recorded a loss on disposal of discontinued operations of
approximately $47.4 million during fiscal 1999 as a result of the CBHS
Transactions. See Note 3, "Discontinued Operations" to the Company's audited
consolidated financial statements set forth elsewhere herein.
EXTRAORDINARY ITEM. The Company recorded an extraordinary loss on early
extinguishment of debt of approximately $33.0 million, net of tax, during fiscal
1998, related primarily to refinancing the Company's long-term debt in
connection with the Merit acquisition.
OUTLOOK--RESULTS OF OPERATIONS
BEHAVIORAL MANAGED HEALTHCARE RESULTS OF OPERATIONS. The Company's
behavioral managed healthcare Segment Profit is subject to significant
fluctuations on a quarterly basis. These fluctuations may result from:
(i) changes in utilization levels by enrolled members of the Company's
risk-based contracts, including seasonal utilization patterns;
(ii) performance-based contractual adjustments to revenue, reflecting
utilization results or other performance measures; (iii) retroactive contractual
adjustments under commercial contracts and CHAMPUS contracts;
(iv) retrospective membership adjustments; (v) timing of implementation of new
contracts and enrollment changes; (vi) pricing adjustments upon long-term
contract renewals; and (vii) changes in estimates regarding medical costs and
incurred but not yet reported medical claims.
Both the Company and Premier, in which the Company has a fifty percent
interest, separately contract with the State of Tennessee to manage the
behavioral healthcare benefits for the State's TennCare program ("TennCare
Contracts"). The Company's direct contract (exclusive of Premier) represented
approximately 13.7% of the Company's behavioral managed healthcare revenue and
approximately 12.1% of the
36
Company's consolidated revenue in fiscal 2000. The TennCare Contracts contained
provisions that limited the Company's profits, subject to the recoupment of
losses incurred in prior periods. An amendment to the contracts in July 2000
eliminated the ability to recoup prior period losses. The Company's profit under
the TennCare Contracts benefited during fiscal 1999 and, to a lesser extent,
during fiscal 2000 from the ability to recoup prior period losses. The Company's
Segment Profit under the TennCare Contracts was lower in fiscal 2000 than fiscal
1999 as result of these contract provisions and accruals for potential losses
related to litigation involving Premier in which the Company has a 50% interest.
See Item 3--"Legal Proceedings". The Company anticipates segment profit in
fiscal 2001 to be comparable to fiscal 2000.
INTEREST RATE RISK. The Company had $466.6 million of total debt
outstanding under the Credit Agreement at September 30, 2000. Debt under the
Credit Agreement bears interest at variable rates. Historically, the Company has
elected the interest rate option under the Credit Agreement that is an adjusted
London inter-bank offer rate ("LIBOR") plus a borrowing margin. See Note 5,
"Long-Term Debt, Capital Lease Obligations and Operating Leases", to the
Company's audited consolidated financial statements appearing elsewhere herein.
Based on September 30, 2000 borrowing levels, a 25 basis point increase in
interest rates would cost the Company approximately $1.2 million per year in
additional interest expense. LIBOR-based Eurodollar borrowing rates have
increased during fiscal 2000. One month and six month LIBOR-based Eurodollar
rates increased by approximately 120 basis points and 80 basis points,
respectively, between September 1999 and September 2000 and may continue to
increase during fiscal 2001. The Company's earnings could be adversely affected
by further increases in interest rates.
HISTORICAL LIQUIDITY AND CAPITAL RESOURCES--FISCAL 1998-2000
OPERATING ACTIVITIES. The Company's net cash provided by (used in)
operating activities was $(4.2) million, $41.9 million and $86.7 million for
fiscal 1998, 1999 and 2000, respectively. The increase in cash provided by
operating activities in fiscal 2000 compared to fiscal 1999 was primarily
effected by: (i) $22.6 million reduction of liability related to the unpaid
claims portfolio transfer consummated during fiscal 1999; (ii) improved
collection of accounts receivable in fiscal 2000 including amounts in connection
with Medicare cost reports related to the psychiatric hospital business;
(iii) increases in medical claims payables and (iv) offset by non-recurring cash
payments totaling $38.1 million related to CHAMPUS adjustments incurred in
fiscal 2000. The increase in cash provided by operating activities in fiscal
1999 compared to fiscal 1998 was primarily the result of reduction in income
taxes paid, net of refunds received, of $10.8 million, and increases in cash
flows from operations as a result of the HAI and Merit acquisitions, offset by
reductions in franchise fees collected from CBHS of $40.6 million, changes in
reserve for unpaid claims of $11.0 million and increases in interest paid of
$6.9 million.
INVESTING ACTIVITIES. The Company utilized $44.2 million, $48.1 million and
$36.9 million in funds during fiscal 1998, 1999 and 2000, respectively, for
capital expenditures. The increase in fiscal 1999 was the result of the
Company's transition to the managed care business from the provider business.
The Company used $1.05 billion, $69.5 million and $68.6 million in funds
during fiscal 1998, 1999 and 2000, respectively, net of cash acquired, for
acquisitions and investments in businesses. This included primarily managed care
acquisitions and human services acquisitions in fiscal 1998 and additional
purchase price consideration of $60.0 million paid to Aetna in connection with
the HAI acquisition in fiscal 1999 and 2000.
The Company received distributions from unconsolidated subsidiaries of
$11.4 million, $22.0 million and $14.3 million in fiscal 1998, 1999 and 2000,
respectively. Distributions received from Choice (as defined) were
$11.4 million, $13.0 million and $14.1 million in fiscal 1998, 1999 and 2000
respectively, with the remaining distributions being received from the Provider
JVs in fiscal 1999 and 2000.
The Company received proceeds from the sale of assets of $11.9 million,
$54.2 million and $3.3 million in fiscal 1998, 1999 and 2000, respectively. The
sales proceeds were generated primarily from (i) the sale of hospital real
estate related to closed hospitals retained by the Company in fiscal 1998,
(ii) the sale
37
of the European psychiatric provider operations in fiscal 1999, and (iii) sale
of the corporate aircraft in fiscal 2000.
FINANCING ACTIVITIES. The Company borrowed approximately $1.2 billion,
$76.8 million and $59.6 million during fiscal 1998, 1999 and 2000, respectively.
The fiscal 1998 borrowings primarily funded the Merit acquisition and related
long-term debt refinancing with the remaining amounts representing borrowings
under the Revolving Facility for short-term capital needs. The fiscal 1999 and
2000 borrowings were primarily draws under the Revolving Facility for short-term
capital needs.
The Company repaid approximately $438.6 million, $156.0 million and
$110.3 million of debt and capital lease obligations during fiscal 1998, 1999
and 2000, respectively. The fiscal 1998 repayments related primarily to the
extinguishment of the Magellan Outstanding Notes as part of the Merit
acquisition. The fiscal 1999 and 2000 payments were for Term Loan Facility
principal amortization and required Term Loan Facility principal payments
primarily related to the sale of the European Hospitals and the TPG investment.
The Company completed the sale of 59,063 shares of Series A Redeemable
Preferred Stock to TPG during the quarter ended December 31, 1999, for a total
price of approximately $54.0 million, net of issuance costs. Approximately 50%
of the net proceeds were used to reduce debt outstanding under the Term Loan
Facility with the remaining 50% being used for general corporate purposes. See
Note 7--"Redeemable Preferred Stock" to the Company's audited historical
consolidated financial statements set forth elsewhere herein.
On November 1, 1996, the Company announced that its board of directors had
approved the repurchase of an additional 3.0 million shares of common stock from
time to time subject to the terms of the Company's then current credit
agreements. During fiscal 1998, the Company repurchased approximately
0.7 million shares of its common stock for approximately $14.4 million.
As of September 30, 2000, the Company had approximately $90.4 million of
availability under the Revolving Facility, excluding approximately
$29.6 million of availability reserved for certain letters of credit. The
Company believes it was in compliance with all debt covenants as of
September 30, 2000.
OUTLOOK--LIQUIDITY AND CAPITAL RESOURCES
DEBT SERVICE OBLIGATIONS. The interest payments on the Company's
$625.0 million 9% Series A Senior Subordinated Notes due 2008 and interest and
principal payments on indebtedness outstanding pursuant to the Company's
$700.0 million Credit Agreement represent significant liquidity requirements for
the Company. Borrowings under the Credit Agreement bear interest at floating
rates and require interest payments on varying dates depending on the interest
rate option selected by the Company. As of September 30, 2000, borrowings
pursuant to the Credit Agreement included $436.6 million under the Term Loan
Facility and up to $150.0 million under the Revolving Facility. The Company had
$30.0 million of borrowings and $29.6 million of letters of credit outstanding
under the Revolving Facility at September 30, 2000. As of September 30, 2000,
the Company is required to repay the principal amount of borrowings
38
outstanding under the Term Loan Facility and the principal amount of the Notes
in the years and amounts set forth in the following table (in millions):
REMAINING
FISCAL YEAR PRINCIPAL AMOUNT
- ----------- ----------------
2001........................................................ $ 34.1
2002........................................................ 43.3
2003........................................................ 80.7
2004........................................................ 167.3
2005........................................................ 115.6
2006........................................................ 25.6
2007........................................................ --
2008........................................................ $625.0
In addition, any amounts outstanding under the Revolving Facility mature in
February 2004.
POTENTIAL PURCHASE PRICE ADJUSTMENTS. In December 1997, the Company
purchased HAI from Aetna for approximately $122.1 million, excluding transaction
costs. In addition, the Company incurred the obligation to make contingent
payments to Aetna which may total up to $60.0 million annually over the
five-year period subsequent to closing. The Company may be obligated to make
contingent payments under two separate calculations, which are primarily based
upon membership levels during the contract year (as defined) and are calculated
at the end of the contractual year. "Contract Year" means each of the
twelve-month periods ending on the last day of December in 1998, 1999, 2000,
2001, and 2002.
The Company paid $60.0 million to Aetna for both the Contract Years ended
December 31, 1998 and 1999. Also, based upon the most recent membership
enrollment data related to the Contract Year to end December 31, 2000 ("Contract
Year 3"), the Company believes beyond a reasonable doubt that it will be
required to make the full $60.0 million payment related to Contract Year 3 and,
therefore, the amount is included in goodwill and other intangible assets at
September 30, 2000. The Company recorded $120.0 million of goodwill and other
intangible assets related to the purchase of HAI during fiscal 1999 related to
Contract Years 1 and 2. The Contract Year 3 liability of $60.0 million is
included in "Deferred credits and other long-term liabilities" in the Company's
consolidated balance sheet as of September 30, 2000. The Company intends to
borrow under the Revolving Facility, if necessary, to meet this obligation,
which is expected to be paid during the second quarter of fiscal 2001.
By virtue of acquiring Merit, the Company may be required to make certain
payments to the former shareholders of CMG Health, Inc. ("CMG"), a managed
behavioral healthcare company that was acquired by Merit, in September, 1997.
Such contingent payments are subject to an aggregate maximum of $23.5 million.
The Company has initiated legal proceedings against certain former owners of CMG
with respect to representations made by such former owners in conjunction with
Merit's acquisition of CMG. Whether any contingent payments will be made to the
former shareholders of CMG and the amount and timing of contingent payments, if
any, may be subject to the outcome of these proceedings.
REVOLVING FACILITY AND LIQUIDITY. The Revolving Facility provides the
Company with revolving loans and letters of credit in an aggregate principal
amount at any time not to exceed $150.0 million. At September 30, 2000, the
Company had approximately $90.4 million of availability under the Revolving
Facility. The Company estimates that it will spend approximately $34.0 million
for capital expenditures in fiscal 2001. The majority of the Company's
anticipated capital expenditures relate to management information systems and
related equipment. The Company believes that the cash flows generated from its
operations, together with amounts available for borrowing under the Revolving
Facility, will be sufficient to fund its debt service requirements, anticipated
capital expenditures, contingent payments, if any, with respect to HAI and CMG,
and other investing and financing activities over the next year. The Company
expects to have significant liquidity needs during the second fiscal quarter of
fiscal 2001 including, but not
39
limited to, (i) semi-annual interest payments on the Notes of $28.1 million and
(ii) contingent consideration payable to Aetna of $60.0 million. The Company
expects its borrowing capacity under the Revolving Facility to decline to
approximately $25.0 million to $35.0 million by March 31, 2001 subject to, among
other things: (i) the timing and amount of contingent consideration paid related
to HAI and CMG (if any), (ii) operating and cash flow performance of the Company
in fiscal 2001 and (iii) capital resources needed to pursue certain new
risk-based managed care business. If the Company's estimate of its borrowing
capacity under the Revolving Facility is projected to fall below the levels
described above, management intends to delay or forego certain investing
activities, including capital expenditures and acquisitions, and possibly forego
certain new business opportunities. The Company's future operating performance
and ability to service or refinance the Notes or to extend or refinance the
indebtedness outstanding pursuant to the Credit Agreement will be subject to
future economic conditions and to financial, business, legal, regulatory and
other factors, many of which are beyond the Company's control.
RESTRICTIVE FINANCING COVENANTS. The Credit Agreement imposes restrictions
on the Company's ability to make capital expenditures, and both the Credit
Agreement and the Indenture limit the Company's ability to incur additional
indebtedness. Such restrictions, together with the highly leveraged financial
condition of the Company, may limit the Company's ability to respond to market
opportunities. The covenants contained in the Credit Agreement also, among other
things, restrict the ability of the Company to: dispose of assets; repay other
indebtedness; amend other debt instruments (including the Indenture); pay
dividends; create liens on assets; enter into sale and leaseback transactions;
make investments, loans or advances; redeem or repurchase common stock; and make
acquisitions.
STRATEGIC ALTERNATIVES TO REDUCE LONG-TERM DEBT AND IMPROVE LIQUIDITY. The
Company's sale of the European Hospitals in April 1999 was one of the steps in
the Company's exit from the healthcare provider and healthcare franchising
businesses in order to reduce long-term debt and improve liquidity. The Company
is currently involved in discussions with various parties to divest certain
other non-core businesses. This may include the sale of Mentor, if the Company
can negotiate terms that it deems to be acceptable. There can be no assurance
that the Company will be able to divest any businesses or that the divestiture
of such businesses would result in significant reductions of long-term debt or
improvements in liquidity.
On December 15, 1999, the Company received approximately $54.0 million of
net proceeds (after transaction costs) upon issuance of Series A Preferred Stock
to TPG. Approximately 50% of the net proceeds received from the issuance of the
Series A Preferred Stock was used to reduce debt outstanding under the Term Loan
Facility with the remaining 50% of the proceeds being used for general corporate
purposes. The Company is also reviewing additional strategic alternatives to
improve its capital structure and liquidity. There can be no assurance that the
Company will be able to consummate any transaction that will improve its capital
structure and/or liquidity.
NET OPERATING LOSS CARRYFORWARDS. During fiscal 2000, the Company reached
an agreement (the "Agreement") with the Internal Revenue Service ("IRS") related
to its federal income tax returns for the fiscal years ended September 30, 1992
and 1993. The IRS had originally proposed to disallow approximately
$162 million of deductions related primarily to interest expense in fiscal 1992.
Under the Agreement, the Company will pay approximately $1 million in taxes and
interest to the IRS to resolve the assessment relating to taxes due for these
open years, although no concession was made by either party as to the Company's
ability to utilize these deductions through net operating loss carryforwards. As
a result of the Agreement the Company recorded a reduction in deferred tax
reserves of approximately $9.1 million as a change in estimate in the current
year. While any IRS assessment related to these deductions is not expected to
result in a material cash payment for income taxes related to prior years the
Company's federal income tax net operating loss carryforwards could be reduced
if the IRS later successfully challenges these deductions.
40
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, FAS No. 133 "Accounting for Derivative Instruments and Hedging
Activities," (FAS No. 133) was issued. FAS No. 133 establishes accounting and
reporting standards for derivative instruments and derivative instruments
embedded in other contracts, (collectively referred to as derivatives) and for
hedging activities. It requires that an entity recognize all derivatives as
either assets or liabilities in the statement of financial position and measure
those instruments at fair value. If certain conditions are met, a derivative may
be specifically designated as (a) a hedge of the exposure to changes in the fair
value of a recognized asset or liability or an unrecognized firm commitment,
(b) a hedge of the exposure to variability in cash flows attributable to a
particular risk, or (c) a hedge of the foreign currency exposure of a net
investment on a foreign operation, an unrecognized firm commitment, an available
for sale security and a forecasted transaction. FAS No. 137, "Accounting for
Derivative Instruments and Hedging Activities--Deferral of the Effective Date of
FASB Statement No. 133" was issued in June 1999 and deferred the effective date
of FAS No. 133 to fiscal years beginning after June 15, 2000. FAS No. 138,
"Accounting for Certain Derivative Instruments and Certain Hedging Activities",
was issued on June 2000 and also amends FAS No. 133. FAS No. 138 addresses a
limited number of issues causing implementation difficulties. Consequently, the
Company will be required to implement FAS No. 133 for all fiscal quarters for
the fiscal year beginning October 1, 2000. The Company expects the adoption of
this pronouncement will not have a material effect on the Company's financial
statements.
Emerging Issues Task Force Issue 96-16, "Investor's Accounting for an
Investee When the Investor Has a Majority of the Voting Interest but a Minority
Shareholder or Shareholders Have Certain Approval or Veto Rights" ("EITF 96-16")
supplements the guidance contained in AICPA Accounting Research Bulletin 51,
"Consolidated Financial Statements", and in Statement of Financial Accounting
Standards No. 94, "Consolidation of All Majority-Owned Subsidiaries" ("ARB
51/FAS 94"), about the conditions under which the Company's consolidated
financial statements should include the financial position, results of
operations and cash flows of subsidiaries which are less than wholly-owned along
with those of the Company and its subsidiaries.
In general, ARB 51/FAS 94 requires consolidation of all majority-owned
subsidiaries except those for which control is temporary or does not rest with
the majority owner. Under the ARB 51/FAS 94 approach, instances of control not
resting with the majority owner were generally regarded to arise from such
events as the legal reorganization or bankruptcy of the majority-owned
subsidiary. EITF 96-16 expands the definition of instances in which control does
not rest with the majority owner to include those where significant approval or
veto rights, other than those which are merely protective of the minority
shareholder's interest, are held by the minority shareholder or shareholders
("Substantive Participating Rights"). Substantive Participating Rights include,
but are not limited to: (i) selecting, terminating and setting the compensation
of management responsible for implementing the majority-owned subsidiary's
policies and procedures; and (ii) establishing operating and capital decisions
of the majority-owned subsidiary, including budgets, in the ordinary course of
business.
The provisions of EITF 96-16 apply to new investment agreements made after
July 24, 1997, and to existing agreements which are modified after such date.
The Company has made no new investments, and has modified no existing
investments, to which the provisions of EITF 96-16 would have applied.
In addition, the transition provisions of EITF 96-16 must be applied to
majority-owned subsidiaries previously consolidated under ARB 51/FAS 94 for
which the underlying agreements have not been modified in financial statements
issued for years ending after December 15, 1998 (fiscal 1999 for the
41
Company). The adoption of the transition provisions of EITF 96-16 on October 1,
1998 had the following effect on the Company's consolidated financial position:
OCTOBER 1,
1998
----------
Increase (decrease) in:
Cash and cash equivalents............................... $(21,092)
Other current assets.................................... (9,538)
Long-term assets........................................ (30,049)
Investment in unconsolidated subsidiaries............... 26,498
--------
Total Assets........................................ $(34,181)
========
Current liabilities..................................... $(10,381)
Minority interest....................................... (23,800)
--------
Total Liablities.................................... $(34,181)
========
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company has significant interest rate risk related to its variable rate
debt outstanding under the Credit Agreement. See "Cautionary
Statements--Leverage and Debt Service Obligations," "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Outlook--Results of
Operations" and "Outlook--Liquidity and Capital Resources" and
Note 5-"Long-Term Debt, Capital Lease Obligations and Operating Leases" to the
Company's audited consolidated financial statements set forth elsewhere herein.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Information with respect to this item is contained in the Company's audited
consolidated financial statements and financial statement schedule indicated in
the Index on Page F-1 of this Annual Report on Form 10-K and is incorporated
herein by reference.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
42
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information with respect to the Company's executive officers is contained
under "Item 1. Business--Executive Officers of the Registrant." Pursuant to
General Instruction G(3) to Form 10-K, the information required by this item
with respect to directors and compliance with Section 16(a) of the Exchange Act
has been omitted inasmuch as the Company files with the Securities and Exchange
Commission a definitive proxy statement not later than 120 days subsequent to
the end of its fiscal year. Such information is incorporated herein by
reference.
ITEM 11. EXECUTIVE COMPENSATION
Pursuant to General Instruction G(3) to Form 10-K, the information required
with respect to this item has been omitted inasmuch as the Company files with
the Securities and Exchange Commission a definitive proxy statement not later
than 120 days subsequent to the end of its fiscal year. Such information is
incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Pursuant to General Instruction G(3) to Form 10-K, the information required
with respect to this item has been omitted inasmuch as the Company files with
the Securities and Exchange Commission a definitive proxy statement not later
than 120 days subsequent to the end of its fiscal year. Such information is
incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Pursuant to General Instruction G(3) to Form 10-K, the information required
with respect to this item has been omitted inasmuch as the Company files with
the Securities and Exchange Commission a definitive proxy statement not later
than 120 days subsequent to the end of its fiscal year. Such information is
incorporated herein by reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(A) DOCUMENTS FILED AS PART OF THE REPORT:
1. FINANCIAL STATEMENTS
Information with respect to this item is contained on Pages F-1 to F-44 of
this Annual Report on Form 10-K.
2. FINANCIAL STATEMENT SCHEDULE
Information with respect to this item is contained on page S-1 of this
Annual Report on Form 10-K.
43
3. EXHIBITS
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- --------------------- ----------------------
2(a) Master Service Agreement, dated August 5, 1997, between the
Company, Aetna U.S. Healthcare, Inc. and Human Affairs
International, Incorporated, which was filed as Exhibit 2(b)
to the Company's current report on Form 8-K, which was filed
on December 17, 1997, and is incorporated herein by
reference.
2(b) First Amendment to Master Services Agreement, dated December
4, 1997, between the Company, Aetna U.S. Healthcare, Inc.
and Human Affairs International, Incorporated, which was
filed as Exhibit 2(d) to the Company's current report on
Form 8-K, which was filed on December 17, 1997, and is
incorporated herein by reference.
2(c) Asset Purchase Agreement, dated October 16, 1997, among the
Company; Allied Health Group, Inc.; Gut Management, Inc.;
Sky Management Co,; Florida Specialty Network, LTD; Surgical
Associates of South Florida, Inc.; Surginet, Inc.; Jacob
Nudel, M.D.; David Russin, M.D. and Lawrence Schimmel, M.D.,
which was filed as Exhibit 2(e) to the Company's Quarterly
Report on Form 10-Q for the quarterly period ended December
31, 1997, and is incorporated herein by reference.
2(d) First Amendment to Asset Purchase Agreement, dated December
5, 1997, among the Company; Allied Health Group, Inc.; Gut
Management, Inc.; Sky Management Co.; Florida Specialty
Network, LTD; Surgical Associates of South Florida, Inc.;
Surginet, Inc.; Jacob Nudel, M.D.; David Russin M.D.; and
Lawrence Schimmel, M.D., which was filed as Exhibit 2(f) to
the Company's Quarterly Report on Form 10-Q for the
quarterly period ended December 31, 1997, and is
incorporated herein by reference.
2(e) Second Amendment to Asset Purchase Agreement, dated November
18, 1998, among the Company; Allied Health Group, Inc.; Gut
Management, Inc.; Sky Management Co.; Florida Specialty
Network, LTD; Surgical Associates of South Florida, Inc.;
Surginet, Inc.; Jacob Nudel, M.D.; David Russin M.D.; and
Lawrence Schimmel, M.D., which was filed as Exhibit 2(m) to
the Company's Annual Report on Form 10-K for the fiscal year
ended September 30, 1998 and is incorporated herein by
reference.
2(f) Third Amendment to Asset Purchase agreement, dated December
31, 1998, among the Company; Allied Health Group, Inc.; Gut
Management, Inc.; Sky Management Co.; Florida Specialty
Network, LTD; Surgical Associates of South Florida, Inc.;
Surginet, Inc.; Jacob Nudel, M.D.; David Russin, M.D.; and
Lawrence Schimmel, M.D., which was filed as Exhibit 2(b) to
the Company's Quarterly on Form 10-Q for the quarterly
period ended December 31, 1998 and is incorporated herein by
reference.
2(g) Agreement and Plan of Merger, dated October 24, 1997, among
the Company, Merit Behavioral Care Corporation and MBC
Merger Corporation which was filed as Exhibit 2(g) to the
Company's Quarterly Report on Form 10-Q for the quarterly
period ended December 31, 1997, and is incorporated herein
by reference.
2(h) Share Purchase Agreement, dated April 2, 1999, by and among
the Company, Charter Medical International, S.A., Inc. (a
wholly owned subsidiary of the Company), Investment AB Bure,
and CMEL Holding Limited (a wholly owned subsidiary of
Investment AB Bure), filed as Exhibit 2(a) to the Company's
current report on Form 8-K, which was filed on April 12,
1999, and is incorporated herein by reference.
44
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- --------------------- ----------------------
2(i) Stock Purchase Agreement, dated April 2, 1999, by and among
the Company, Charter Medical International S.A., Inc. (a
wholly owned subsidiary of the Company), Investment AB Bure
and Grodrunden 515 AB (a wholly owned subsidiary of
Investment AB Bure), filed as Exhibit 2(b) to the Company's
current report on Form 8-K, which was filed on April 12,
1999, and is incorporated herein by reference.
2(j) First Amendment to Share Purchase Agreement, dated April 8,
1999, by and among the Company, Charter Medical
International S.A., Inc. (a wholly owned subsidiary of the
Company), Investment AB Bure, and CMEL Holding Limited (a
wholly owned subsidiary of Investment AB Bure), filed as
Exhibit 2(c) to the Company's current report on Form 8-K,
which was filed on April 12, 1999, and is incorporated
herein by reference.
2(k) First Amendment to Stock Purchase Agreement, dated April 8,
1999, among the Company, Charter Medical International S.A.,
Inc. (a wholly owned subsidiary of the Company), Investment
AB Bure, and CMEL Holding Limited (a wholly owned subsidiary
of Investment AB Bure), filed as Exhibit 2(d) to the
Company's current report on Form 8-K, which was filed on
April 12, 1999, and is incorporated herein by reference.
2(l) Letter Agreement dated August 10, 1999 by and among the
Company, Charter Behavioral Health Systems, LLC, Crescent
Real Estate Equities Limited Partnership and Crescent
Operating, Inc., which was filed as Exhibit 2(a) to the
Company's current report on Form 8-K, which was filed on
September 24, 1999 and is incorporated herein by reference.
3(a) Restated Certificate of Incorporation of the Company, as
filed in Delaware on October 16, 1992, which was filed as
Exhibit 3(a) to the Company's Annual Report on Form 10-K for
the year ended September 30, 1992, and is incorporated
herein by reference.
3(b) Bylaws of the Company, which were filed as Exhibit 3(b) to
the Corporation's Annual Report on Form 10-K for the year
ended September 30, 1999 and are incorporated herein by
reference.
3(c) Certificate of Ownership and Merger merging Magellan Health
Services, Inc. (a Delaware corporation) into Charter Medical
Corporation (a Delaware corporation), as filed in Delaware
on December 21, 1995, which was filed as Exhibit 3(c) to the
Company's Annual Report on Form 10-K for the year ended
September 30, 1995, and is incorporated herein by reference.
4(a) Stock and Warrant Purchase Agreement, dated December 22,
1995, between the Company and Richard E. Rainwater, which
was filed as Exhibit 4(f) to the Company's Quarterly Report
on Form 10-Q for the quarterly period ended December 31,
1995, and is incorporated herein by reference.
4(b) Amendment No. 1 to Stock and Warrant Purchase Agreement,
dated January 25, 1996, between the Company and
Rainwater-Magellan Holdings, L.P., which was filed as
Exhibit 4.7 to the Company's Registration Statement on Form
S-3 dated February 26, 1996, and is incorporated herein by
reference.
4(c) Warrant Purchase Agreement, dated January 29, 1997, between
the Company and Crescent Real Estate Equities Limited
Partnership which was filed as Exhibit 4(a) to the Company's
current report on Form 8-K, which was filed on April 23,
1997, and is incorporated herein by reference.
45
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- --------------------- ----------------------
4(d) Amendment No. 1, dated June 17, 1997, to the Warrant
Purchase Agreement, dated January 29, 1997, between the
Company and Crescent Real Estate Equities Limited
Partnership, which was filed as Exhibit 4(b) to the
Company's current report on Form 8-K, which was filed on
June 30, 1997, and is incorporated herein by reference.
4(e) Indenture, dated as of February 12, 1998, between the
Company and Marine Midland Bank, as trustee, relating to the
9% Senior Subordinated Notes due February 15, 2008 of the
Company, which was filed as Exhibit 4(a) to the Company's
Current Report on Form 8-K, which was filed April 3, 1998,
and is incorporated herein by reference.
4(f) Purchase Agreement, dated February 5, 1998, between the
Company and Chase Securities Inc., which was filed as
Exhibit 4(b) to the Company's Current Report on Form 8-K,
which was filed April 3, 1998, and is incorporated herein by
reference.
4(g) Exchange and Registration Rights Agreement, dated February
12, 1998, between the Company and Chase Securities Inc.,
which was filed as Exhibit 4(c) to the Company's Current
Report on Form 8-K, which was filed on April 3, 1998, and is
incorporated herein by reference.
4(h) Credit Agreement, dated February 12, 1998, among the
Company, certain of the Company's subsidiaries listed
therein and The Chase Manhattan Bank, as administrative
agent, which was filed as Exhibit 4(d) to the Company's
Current Report on Form 8-K, which was filed April 3, 1998,
and is incorporated herein by reference.
4(i) Amendment No. 1, dated as of September 30, 1998, to the
Credit Agreement, dated as of February 12, 1998, among the
Company, certain of the Company's subsidiaries listed
therein and The Chase Manhattan Bank, as administrative
agent, which was filed as Exhibit 4(e) to the Company's
Registration Statement Form S-4 (no. 333-49335), which was
filed on October 5, 1998, and is incorporated herein by
reference.
4(j) Amendment No. 2, dated as of April 30, 1999, to the Credit
Agreement dated as of February 12, 1998, among the Company
certain of the Company's subsidiaries listed therein and the
Chase Manhattan Bank, as administrative agent which was
filed as Exhibit 4(a) to the Company's Quarterly Report on
Form 10-Q for the quarterly period ended June 30, 1999 and
is incorporated herein by reference.
4(k) Amendment No. 3, dated as of July 29, 1999, to the Credit
Agreement dated as of February 12, 1998, among the Company's
subsidiaries listed therein and the Chase Manhattan Bank, as
administrative agent, which was filed as Exhibit 4(n) to the
Company's Annual Report on Form 10-K for the year ended
September 30, 1999 and is incorporated herein by reference.
4(l) Amendment No. 4, dated as of September 8, 1999, to the
Credit Agreement dated as of February 12, 1998, among the
Company's subsidiaries listed therein and the Chase
Manhattan Bank, as administrative agent, which was filed as
Exhibit 4(o) to the Company's Annual Report on Form 10-K for
the year ended September 30, 1999 and is incorporated herein
by reference..
4(m) Amendment No. 5, dated as of January 12, 2000, to the Credit
Agreement dated as of February 12, 1998, among the Company,
certain of the Company's subsidiaries listed therein and the
Chase Manhattan Bank, as adminitrative agent, which was
filed as Exhibit 4(a) to the Company's Quarterly Report on
Form 10-Q for the quarterly period ended December 31, 1999
and is incorporated herein by reference.
46
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- --------------------- ----------------------
4(n) Registration Rights Agreement, dated as of July 19, 1999,
between the Company and TPG Magellan LLC, filed as Exhibit
4.2 to the Company's current report on Form 8-K, which was
filed on July 21, 1999, and is incorporated herein by
reference.
4(o) Amended and Restated Investment Agreement, dated December
14, 1999, between the Company and TPG Magellan LLC together
with the following exhibits: (i) form of Certificate of
Designations of Series A Cumulative Convertible Preferred
Stock; (ii) form of Certificate of Designation of Series B
Cumulative Convertible Preferred Stock; (iii) form of
Certificate of Designations of Series C Junior Participating
Preferred Stock, which was filed as Exhibit 4(r) to the
Company's Annual Report on Form 10-K for the year ended
September 30, 1999 and is incorporated herein by reference.
4(p) Amendment Number One to Registration Rights Agreement, dated
as of October 15, 1999, between the Company and TPG Magellan
LLC, which was filed as Exhibit 4(d) to the Company's
Quarterly Report on Form 10-Q for the quarterly period ended
December 31, 1999 and is incorporated herein by reference.
4(q) Amendment No. 6, dated as of August 10, 2000, to the Credit
Agreement dated as of February 12, 1998, among the Company,
certain of the Company's subsidiaries listed therein and the
Chase Manhattan Bank, as administrative agent, which was
filed as Exhibit 4(a) to the Company's Quarterly Report on
Form 10-Q for the quarterly period ended June 30, 2000 and
is incorporated herein by reference.
+4(r) Amendment No. 7, dated as of September 19, 2000, to the
Credit Agreement dated as of February 12, 1998, among the
Company, certain of the Company's subsidiaries listed
therein and the Chase Manhattan Bank, as administrative
agent.
+4(s) Amendment No. 8, dated as of November 21, 2000, to the
Credit Agreement dated as of February 12, 1998, among the
Company, certain of the Company's subsidiaries listed
therein and the Chase Manhattan Bank, as administrative
agent.
*10(a) 1992 Stock Option Plan of the Company, as amended, which was
filed as Exhibit 10(c) to the Company's Annual Report on
Form 10-K for the year ended September 30, 1994, and is
incorporated herein by reference.
*10(b) 1992 Directors' Stock Option Plan of the Company, as
amended, which was filed as Exhibit 10(d) to the Company's
Annual Report on Form 10-K for the year ended September 30,
1994, and is incorporated herein by reference.
*10(c) 1994 Stock Option Plan of the Company, as amended, which was
filed as Exhibit 10(e) to the Company's Annual Report on
Form 10-K for the year ended September 30, 1994, and is
incorporated herein by reference.
*10(d) Directors' Unit Award Plan of the Company, which was filed
as Exhibit 10(i) to the Company's Registration Statement on
Form S-4 (No. 33-53701) filed May 18, 1994, and is
incorporated herein by reference.
*10(e) 1996 Stock Option Plan of the Company, which was filed as
Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q
for the quarterly period ended March 31, 1996 and is
incorporated herein by reference.
*10(f) 1996 Directors' Stock Option Plan of the Company, which was
filed as Exhibit 10(b) to the Company's Quarterly Report on
Form 10-Q for the quarterly period ended March 31, 1996 and
is incorporated herein by reference.
47
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- --------------------- ----------------------
*10(g) 1997 Stock Option Plan of the Company, which was filed as
Exhibit 10(i) to the Company's Quarterly Report on Form 10-Q
for the quarterly period ended June 30, 1997, and is
incorporated herein by reference.
*10(h) Amendment to the Company's 1992 Directors' Stock Option
Plan, which was filed as Exhibit 10(d) to the Company's
Quarterly Report on Form 10-Q for the quarterly period ended
March 31, 1999 and is incorporated herein by reference.
*10(i) Amendment to the Company's Directors' 1996 Directors Stock
Option Plan, which was filed as Exhibit 10(e) to the
Company's Quarterly Report on Form 10-Q for the quarterly
period ended March 31, 1999 and is incorporated herein by
reference.
*10(j) Amendment to the Company's 1994 Stock Option Plan, which was
filed as Exhibit 10(f) to the Company's Quarterly Report on
Form 10-Q for the quarterly period ended March 31, 1999 and
is incorporated herein by reference.
*10(k) Amendment to the Company's 1996 Stock Option Plan, which was
filed as Exhibit 10(g) to the Company's Quarterly Report on
Form 10-Q for the quarterly period ended March 31, 1999 and
is incorporated herein by reference.
*10(l) Amendment to the Company's 1997 Stock Option Plan, which was
filed as Exhibit 10(h) to the Company's Quarterly Report on
Form 10-Q for the quarterly period ended March 31, 1999 and
is incorporated herein by reference.
*10(m) Amended 1998 Stock Option Plan of the Company, which was
filed as Exhibit 10(i) to the Company's Quarterly Report on
Form 10-Q for the quarterly period ended March 31, 1999 and
is incorporated herein by reference.
*10(n) Third Amendment to the Company's 1998 Stock Option Plan,
which was filed as Exhibit 10(j) to the Company's Quarterly
Report on Form 10-Q for the quarterly period ended March 31,
1999 and is incorporated herein by reference.
*10(o) Written description of the Green Spring Health Services,
Inc. Annual Incentive Plan for the period ended September
30, 1998, which was filed as Exhibit 10(s) to the Company's
Annual Report on Form 10-K for the year ended September 30,
1998 and is incorporated herein by reference.
*10(p) Magellan Corporate Short-Term Incentive Plan for the fiscal
year ended September 30, 1999, which was filed as Exhibit
10(a) to the Company's Quarterly Report on Form 10-Q for the
quarterly period ended March 31, 1999 and is incorporated
herein by reference.
*10(q) Magellan Behavioral Health Short-Term Incentive Plan for the
fiscal year ended September 30, 1999, which was filed as
Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q
for the quarterly period ended March 31, 1999 and is
incorporated herein by reference.
*10(r) Letter Agreement, dated March 2, 1999, between the Company
and Clifford W. Donnelly, Executive Vice President of the
Company, which was filed as Exhibit 4(a) to the Company's
Quarterly Report on Form 10-Q for the quarterly period ended
December 31, 1999 and is incorporated herein by reference.
*10(s) Letter Agreement, dated June 4, 1999, between the Company
and Mark S. Demilio, Executive Vice President of the
Company, which was filed as Exhibit 4(a) to the Company's
Quarterly Report on Form 10-Q for the quarterly period ended
December 31, 1999 and is incorporated herein by reference.
48
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- --------------------- ----------------------
10(t) Warrant Purchase Agreement, dated June 16, 1997, between the
Company and Crescent Operating, Inc., which was filed as
Exhibit 99(g) to the Company's current report on Form 8-K,
which was filed on June 30, 1997, and is incorporated herein
by reference.
*10(u) 1998 Stock Option Plan of the Company which was filed as
Exhibit (ay) to the Company's Registration Statement on Form
S-4, which was filed on April 3, 1998, and is incorporated
herein by reference.
*10(v) Employment Agreement, dated December 9, 1998, between
Magellan Behavioral Health, Inc. and John Wider, President
and Chief Operating Officer of Magellan Behavioral Health,
Inc., which was filed as Exhibit 10 to the Company's Form
10-Q for the quarterly period ended December 31, 1998 and is
incorporated herein by reference.
*10(w) Employment Agreement, dated February 11, 1999, between the
Company and Clarissa C. Marques, Ph.D., Executive Vice
President of the Company, which was filed as Exhibit 10(c)
to the Company's Quarterly Report on Form 10-Q for the
quarterly period ended March 31, 1999 and is incorporated
herein by reference.
*10(x) Employment Agreement, dated June 25, 1998, between the
Company and Henry T. Harbin, M.D., President, Chief
Executive Officer of the Company, which was filed as exhibit
10(a) to the Company's quarterly report on Form 10-Q for the
quarterly period ended June 30, 1998 and is incorporated
herein by reference.
10(y) Offer to Purchase and Consent Solicitation Statement, dated
January 12, 1998, by the Company for all of its 11 1/4%
Series A Senior Subordinated Notes due 2008, which was filed
as Exhibit 10(ad) to the Company's Registration Statement on
Form S-4, which was filed on April 3, 1998, and is
incorporated herein by reference.
10(z) Offer to Purchase and Consent Solicitation Statement, dated
January 12, 1998, by Merit Behavioral Care Corporation for
all of its 11 1/2% Senior Subordinated Notes due 2005, which
was filed as Exhibit 10(ad) to the Company's Registration
Statement on Form S-4, which was filed on April 3, 1998, and
is incorporated herein by reference.
10(aa) Agreement and Plan of Merger by and among Merit Behavioral
Care Corporation, Merit Merger Corp., and CMG Health, Inc.
dated as of July 14, 1997, which was filed as Exhibit 10(ah)
to the Company's Annual Report on Form 10-K for the year
ended September 30, 1998 and is incorporated herein by
reference.
10(ab) Stock purchase Agreement, dated as of Januiary 28, 2000, by
and among Magellan Health Services, Inc.; Allied Specialty
Care Services, Inc. and Vivra Holdings, Inc., which was
filed as Exhibit 2 to the Company's Quarterly Report on Form
10-Q for the quarterly period ended March 31, 2000 and is
incorporated herein by reference.
10(ac) Magellan Corporate Short-Term Incentive Plan for the fiscal
year ended September 30, 2000, which was filed as Exhibit
10(a) to the Company's Quarterly Report on Form 10-Q for the
quarterly period ended March 31, 2000 and is incorporated
herein by reference.
10(ad) Magellan Behavioral Health Short-Term Incentive Plan for the
fiscal year ended September 30, 2000, which was filed as
Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q
for the quarterly period ended March 31, 2000 and is
incorporated herein by reference.
+10(ae) Magellan Health Services, Inc.--2000 Employee Stock Purchase
Plan.
+10(af) Magellan Health Services, Inc.--2000 Long-Term Incentive
Compensation Plan.
+21 List of subsidiaries of the Company.
49
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- --------------------- ----------------------
+23 Consent of Arthur Andersen LLP.
+27 Financial Data Schedule
- ------------------------
* Constitutes a management contract or compensatory plan arrangement.
+ Filed herewith.
(B) REPORTS ON FORM 8-K:
None
(C) EXHIBITS REQUIRED BY ITEM 601 OF REGULATION S-K:
Exhibits required to be filed by the Company pursuant to Item 601 of
Regulation S-K are contained in a separate volume.
(D) FINANCIAL STATEMENTS AND SCHEDULES REQUIRED BY REGULATION S-X ITEM 14(D):
(1) The audited consolidated financial statements of Choice Behavioral
Health Partnership ("Choice"), which has a fiscal year end of
December 31, 2000, will be filed in an amendment to this Form 10-K no
later than March 31, 2001.
(2) Not applicable.
(3) Information with respect to this item is contained on page S-1 of this
Annual Report on Form 10-K.
50
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned thereunto duly authorized.
MAGELLAN HEALTH SERVICES, INC.
(Registrant)
Date: December 26, 2000
----------------------------------------------------
Mark S. Demilio
Executive Vice President, Finance and Legal
Date: December 26, 2000
----------------------------------------------------
Thomas C. Hofmeister
Senior Vice President and Chief Accounting Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
------------------------------------------- President, Chief Executive December 26, 2000
Henry T. Harbin Officer And Director
------------------------------------------- Director December 26, 2000
David Bonderman
------------------------------------------- Director December 26, 2000
Jonathan J. Coslet
------------------------------------------- Director December 26, 2000
G. Fred DiBona, Jr.
------------------------------------------- Director December 26, 2000
Andre C. Dimitriadis
------------------------------------------- Director December 26, 2000
A.D. Frazier, Jr.
------------------------------------------- Director December 26, 2000
Gerald L. McManis
51
SIGNATURE TITLE DATE
--------- ----- ----
------------------------------------------- Chief Operating Officer and December 26, 2000
Daniel S. Messina Director
------------------------------------------- Chairman of the Board of December 26, 2000
Robert W. Miller Directors
------------------------------------------- Director December 26, 2000
Darla D. Moore
------------------------------------------- Director December 26, 2000
Jeffrey A. Sonnenfeld
------------------------------------------- Director December 26, 2000
James B. Williams
52
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS
The following consolidated financial statements of the registrant and its
subsidiaries are submitted herewith in response to Item 8 and Item 14(a)1:
PAGE
--------
MAGELLAN HEALTH SERVICES, INC.
Audited Consolidated Financial Statements
Report of independent public accountants................ F-2
Consolidated balance sheets as of September 30, 1999 and
2000................................................... F-3
Consolidated statements of operations for the fiscal
years ended September 30, 1998, 1999 and 2000.......... F-4
Consolidated statements of changes in stockholders'
equity for the fiscal years ended September 30, 1998,
1999 and 2000.......................................... F-5
Consolidated statements of cash flows for the fiscal
years ended September 30, 1998, 1999 and 2000.......... F-6
Notes to consolidated financial statements.............. F-7
The following financial statement schedule of the registrant and its
subsidiaries is submitted herewith in response to Item 14(a)2:
PAGE
--------
Schedule II -- Valuation and qualifying accounts........ S-1
Financial statements in response to Item 14(d)(1):
CHOICE BEHAVIORAL HEALTH PARTNERSHIP
The audited consolidated financial statements of Choice Behavioral Health
Partnership ("Choice"), which has a fiscal year end of December 31, 2000, will
be filed in an amendment to this Form 10-K no later than March 31, 2001.
F-1
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors of Magellan Health Services, Inc:
We have audited the accompanying consolidated balance sheets of Magellan
Health Services, Inc. (a Delaware corporation) and subsidiaries as of
September 30, 1999 and 2000, and the related consolidated statements of
operations, changes in stockholders' equity and cash flows for each of the three
years in the period ended September 30, 2000. These consolidated financial
statements and the schedule referred to below are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Magellan Health
Services, Inc. and subsidiaries as of September 30, 1999 and 2000 and the
results of their operations and their cash flows for each of the three years in
the period ended September 30, 2000 in conformity with accounting principles
generally accepted in the United States.
Our audits were made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedule listed in the index to
financial statements is presented for purposes of complying with the Securities
and Exchange Commission's rules and is not part of the basic financial
statements. This schedule has been subjected to the auditing procedures applied
in the audits of the basic financial statements and, in our opinion, fairly
states, in all material respects, the financial data required to be set forth
therein in relation to the basic financial statements taken as a whole.
Arthur Andersen LLP
Baltimore, Maryland
December 11, 2000
F-2
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
SEPTEMBER 30,
-------------------------
1999 2000
------------ ----------
ASSETS
Current Assets:
Cash and cash equivalents................................. $ 37,440 $ 41,628
Accounts receivable, less allowance for doubtful accounts
of $28,437 at September 30, 1999 and $11,592 at
September 30, 2000...................................... 198,646 137,224
Restricted cash and investments........................... 116,824 117,723
Refundable income taxes................................... 3,452 4,416
Other current assets...................................... 18,565 18,662
---------- ----------
Total Current Assets.................................. 374,927 319,653
Property and equipment, net................................. 120,667 112,612
Deferred income taxes....................................... 91,657 121,782
Investments in unconsolidated subsidiaries.................. 18,396 12,746
Other long-term assets...................................... 9,599 10,235
Goodwill, net of accumulated amortization of $60,869 at
September 30, 1999 and $81,286 at September 30, 2000...... 1,108,086 1,074,753
Other intangible assets, net of accumulated amortization of
$26,457 at September 30, 1999 and $40,789 at September 30,
2000...................................................... 158,283 152,006
---------- ----------
$1,881,615 $1,803,787
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable.......................................... $ 44,425 $ 40,687
Accrued liabilities....................................... 209,796 175,698
Medical claims payable.................................... 189,928 219,375
Current maturities of long-term debt and capital lease
obligations............................................. 30,119 34,119
---------- ----------
Total Current Liabilities............................. 474,268 469,879
---------- ----------
Long-term debt and capital lease obligations................ 1,114,189 1,063,928
---------- ----------
Deferred credits and other long-term liabilities............ 92,948 83,226
---------- ----------
Minority interest........................................... 3,514 456
---------- ----------
Commitments and Contingencies
Redeemable Preferred Stock.................................. -- 57,834
---------- ----------
Stockholders' Equity:
Preferred stock, without par value
Authorized -- 10,000 shares at September 30, 1999 and
9,793 shares at September 30, 2000
Issued and outstanding -- none.......................... -- --
Common stock, par value $.25 per share
Authorized -- 80,000 shares
Issued and outstanding -- 34,268 shares at September 30,
1999 and 34,936 shares at September 30, 2000........... 8,566 8,733
Other Stockholders' Equity:
Additional paid-in capital.............................. 352,030 349,541
Accumulated deficit..................................... (144,550) (210,358)
Warrants outstanding.................................... 25,050 25,050
Common stock in treasury, 2,289 shares at September 30,
1999 and September 30, 2000............................ (44,309) (44,309)
Cumulative foreign currency adjustments included in
other comprehensive income............................. (91) (193)
---------- ----------
Total Stockholders' Equity............................ 196,696 128,464
---------- ----------
$1,881,615 $1,803,787
========== ==========
The accompanying Notes to Consolidated Financial Statements
are an integral part of these consolidated balance sheets.
F-3
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
FISCAL YEAR ENDED SEPTEMBER 30,
------------------------------------
1998 1999 2000
---------- ---------- ----------
Net revenue................................................. $1,167,274 $1,674,479 $1,873,554
---------- ---------- ----------
Costs and expenses:
Salaries, cost of care and other operating expenses....... 1,043,251 1,468,879 1,652,582
Equity in earnings of unconsolidated subsidiaries......... (12,795) (20,442) (9,792)
Depreciation and amortization............................. 46,898 68,921 75,413
Interest, net............................................. 76,505 93,752 97,286
Stock option expense (credit)............................. (5,623) 18 --
Managed care integration costs............................ 16,962 6,238 --
Special charges........................................... -- 4,441 25,398
---------- ---------- ----------
1,165,198 1,621,807 1,840,887
---------- ---------- ----------
Income from continuing operations before income taxes,
minority interest and extraordinary items................. 2,076 52,672 32,667
Provision for income taxes.................................. 5,238 28,256 15,478
---------- ---------- ----------
Income (loss) from continuing operations before minority
interest and extraordinary items.......................... (3,162) 24,416 17,189
Minority interest........................................... 4,094 630 114
---------- ---------- ----------
Income (loss) from continuing operations before
extraordinary items....................................... (7,256) 23,786 17,075
---------- ---------- ----------
Discontinued operations:
Income (loss) from discontinued operations (1)............ 20,988 28,325 (65,221)
Loss on disposal of discontinued operations, net of income
tax benefit of $31,616 in 1999 and $9,224 in 2000....... -- (47,423) (17,662)
---------- ---------- ----------
20,988 (19,098) (82,883)
---------- ---------- ----------
Income (loss) before extraordinary items.................... 13,732 4,688 (65,808)
Extraordinary items -- net losses on early extinguishments
of debt (net of income tax benefit of $22,010 in 1998).... (33,015) -- --
---------- ---------- ----------
Net income (loss)........................................... (19,283) 4,688 (65,808)
Preferred dividend requirement and amortization of
redeemable preferred stock issuance costs................. -- -- 3,802
---------- ---------- ----------
Income (loss) available to common stockholders.............. (19,283) 4,688 (69,610)
Other comprehensive income (loss)........................... 675 1,106 (102)
---------- ---------- ----------
Comprehensive income (loss)................................. $ (18,608) $ 5,794 $ (69,712)
========== ========== ==========
Weighted average number of common shares outstanding --
basic..................................................... 30,784 31,758 32,144
========== ========== ==========
Weighted average number of common shares outstanding --
diluted................................................... 30,784 31,916 32,386
========== ========== ==========
Income (loss) per common share available to common
stockholders -- basic:
Income (loss) from continuing operations before
extraordinary items..................................... $ (0.24) $ 0.75 $ 0.41
========== ========== ==========
Income (loss) from discontinued operations................ $ 0.68 $ (0.60) $ (2.58)
========== ========== ==========
Extraordinary losses on early extinguishments of debt..... $ (1.07) $ -- $ --
========== ========== ==========
Net income (loss)........................................... $ (0.63) $ 0.15 $ (2.17)
========== ========== ==========
Income (loss) per common share available to common
stockholders -- diluted:
Income (loss) from continuing operations before
extraordinary items..................................... $ (0.24) $ 0.75 $ 0.41
========== ========== ==========
Income (loss) from discontinued operations................ $ 0.68 $ (0.60) $ (2.56)
========== ========== ==========
Extraordinary losses on early extinguishments of debt..... $ (1.07) $ -- $ --
========== ========== ==========
Net income (loss)........................................... $ (0.63) $ 0.15 $ (2.15)
========== ========== ==========
- ------------------------------
(1) Net of income tax provision (benefit) of $13,687, $19,763 and (34,059) for
fiscal 1998, 1999 and 2000, respectively.
The accompanying Notes to Consolidated Financial Statements
are an integral part of these consolidated statements.
F-4
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(IN THOUSANDS)
FISCAL YEAR ENDED SEPTEMBER 30,
---------------------------------
1998 1999 2000
--------- --------- ---------
Common Stock:
Balance, beginning of period.............................. $ 8,361 $ 8,476 $ 8,566
Exercise of options....................................... 115 90 167
--------- --------- ---------
Balance, end of period.................................... 8,476 8,566 8,733
--------- --------- ---------
Additional paid-in capital:
Balance, beginning of period.............................. 340,645 349,651 352,030
Stock option expense (credit)............................. (5,623) 18 --
Exercise of options and warrants.......................... 3,867 2,542 1,313
Preferred dividend requirement and amortization of
redeemable preferred stock issuance cost................ -- -- (3,802)
Green Spring Minority Stockholder Conversion.............. 10,722 -- --
Other..................................................... 40 (181) --
--------- --------- ---------
Balance, end of period.................................... 349,651 352,030 349,541
--------- --------- ---------
Accumulated deficit:
Balance, beginning of period.............................. (129,955) (149,238) (144,550)
Net income (loss)......................................... (19,283) 4,688 (65,808)
--------- --------- ---------
Balance, end of period.................................... (149,238) (144,550) (210,358)
--------- --------- ---------
Warrants outstanding:
Balance, beginning and end of period...................... 25,050 25,050 25,050
--------- --------- ---------
Common stock in treasury:
Balance, beginning of period.............................. (82,731) (44,309) (44,309)
Purchases of treasury stock............................... (14,352) -- --
Green Spring Minority Stockholder Conversion.............. 52,774 -- --
--------- --------- ---------
Balance, end of period.................................... (44,309) (44,309) (44,309)
--------- --------- ---------
Cumulative foreign currency adjustments included in other
comprehensive income:
Balance, beginning of period.............................. (1,872) (1,197) (91)
Components of other comprehensive income (loss):
Unrealized foreign currency translation gain (loss) (net
of reclassification adjustment related to sale of
European Hospitals of $1,678 in 1999)................... 1,125 (230) (171)
Sale of European Hospitals................................ -- 2,074 --
--------- --------- ---------
1,125 1,844 (171)
Provision for (benefit from) income taxes................. 450 738 (69)
--------- --------- ---------
Other comprehensive income (loss)......................... 675 1,106 (102)
--------- --------- ---------
Balance, end of period.................................... (1,197) (91) (193)
--------- --------- ---------
Total Stockholders' Equity.................................. $ 188,433 $ 196,696 $ 128,464
========= ========= =========
The accompanying Notes to Consolidated Financial Statements
are an integral part of these consolidated statements.
F-5
MAGELLAN HEALTH SERVICES, INC. SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
FISCAL YEAR ENDED SEPTEMBER 30,
--------------------------------
1998 1999 2000
---------- -------- --------
Cash Flows From Operating Activities
Net income (loss)........................................... $ (19,283) $ 4,688 $(65,808)
---------- -------- --------
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Gain on sale of assets.................................. (3,001) (23,623) (2,442)
Loss on CBHS Transactions............................... -- 79,039 --
Depreciation and amortization........................... 49,264 73,531 79,244
Impairment of long-lived assets......................... 2,507 -- 91,015
Other non-cash portion of special charges and
discontinued operations................................ 37,499 (422)
Equity in earnings of unconsolidated subsidiaries....... (12,795) (20,442) (9,792)
Stock option expense (credit)........................... (5,623) 18 --
Non-cash interest expense............................... 2,935 3,843 4,376
Extraordinary losses on early extinguishments of debt... 55,025 -- --
Cash flows from changes in assets and liabilities, net of
effects from sales and acquisitions of businesses:
Accounts receivable, net................................ (1,585) (21,321) 63,057
Restricted cash and investments......................... (21,782) (22,130) (899)
Other assets............................................ 1,945 8,759 (8,246)
Accounts payable and accrued liabilities................ (50,082) (20,842) (42,960)
Medical claims payable.................................. 6,358 (22,202) 19,767
Income taxes payable and deferred income taxes.......... (14,489) 14,143 (31,089)
Reserve for unpaid claims............................... (19,177) (30,196) (78)
Other liabilities....................................... (9,290) 17,224 (8,361)
Minority interest, net of dividends paid................ (929) 3,142 (1,010)
Other................................................... (1,701) (1,333) (102)
---------- -------- --------
Total adjustments....................................... 15,079 37,188 152,480
---------- -------- --------
Net cash provided by (used in) operating activities... (4,204) 41,876 86,672
---------- -------- --------
Cash Flows From Investing Activities:
Capital expenditures.................................... (44,213) (48,119) (36,924)
Acquisitions and investments in businesses, net of cash
acquired............................................... (1,046,436) (69,457) (68,597)
Conversion of joint ventures from consolidation to
equity method.......................................... -- (21,092) --
Distributions received from unconsolidated
subsidiaries........................................... 11,441 21,970 14,324
Decrease in assets restricted for settlement of unpaid
claims and other long-term liabilities................. 51,006 42,570 (214)
Proceeds from sale of assets............................ 11,875 54,196 3,300
---------- -------- --------
Net cash used in investing activities................. (1,016,327) (19,932) (88,111)
---------- -------- --------
Cash Flows From Financing Activities:
Payments on debt and capital lease obligations.......... (438,633) (156,004) (110,260)
Proceeds from issuance of debt, net of issuance costs... 1,188,706 76,818 59,642
Proceeds from issuance of redeemable preferred stock,
net of issuance costs.................................. -- -- 54,765
Proceeds from exercise of stock options and warrants.... 3,982 2,632 1,480
Purchases of treasury stock............................. (14,352) -- --
---------- -------- --------
Net cash provided by (used in) financing activities... 739,703 (76,554) 5,627
---------- -------- --------
Net increase (decrease) in cash and cash equivalents........ (280,828) (54,610) 4,188
Cash and cash equivalents at beginning of period............ 372,878 92,050 37,440
---------- -------- --------
Cash and cash equivalents at end of period.................. $ 92,050 $ 37,440 $ 41,628
========== ======== ========
The accompanying Notes to Consolidated Financial Statements
are an integral part of these consolidated statements
F-6
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2000
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements of Magellan Health Services, Inc., a
Delaware corporation, ("Magellan" or the "Company") include the accounts of the
Company and its subsidiaries. All significant intercompany accounts and
transactions have been eliminated in consolidation.
The Company conducts business in two business segments, the behavioral
managed healthcare business segment and the human services business segment.
These segments are described in further detail in Note 14, "Business Segment
Information."
On September 2, 1999, the Company's Board of Directors approved a formal
plan to dispose of the businesses and interests that comprise the Company's
healthcare provider and healthcare franchising business segments (the "Disposal
Plan"). On October 4, 2000, the Company adopted a formal plan to dispose of the
business and interest that comprised the Company's specialty managed healthcare
business segment. The results of operations of the healthcare provider,
healthcare franchising and specialty managed healthcare business segments have
been reported in the accompanying financial statements as discontinued
operations for all periods presented. In reporting the specialty managed
healthcare segment as discontinued operations, the Company has followed the
provisions of Emerging Issues Task Force No. 95-18 ("EITF 95-18"), "Accounting
and Reporting for a Discontinued Business Segment When the Measurement Date
Occurs after the Balance Sheet Date but before the Issuance of Financial
Statements."
USE OF ESTIMATES
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the date
of the financial statements and the reported amounts of revenue and expenses
during the reporting period. Actual results could differ from those estimates.
MANAGED CARE REVENUE
Managed care revenue is recognized over the applicable coverage period on a
per member basis for covered members and as earned and estimable for
performance-based revenues. Deferred revenue is recorded when premium payments
are received in advance of the applicable coverage period.
ADVERTISING COSTS
The production costs of advertising are expensed as incurred. The Company
does not consider any of its advertising costs to be direct-response and,
accordingly, does not capitalize such costs. Advertising costs consist primarily
of radio and television air time, which are expensed as incurred, and printed
media services. Advertising expense for continuing operations was approximately
$2.4 million, $2.1 million and $2.9 million for the fiscal years ended
September 30, 1998, 1999 and 2000, respectively. Advertising expense for
discontinued operations was approximately $2.5 million, $0.5 million and
$0.1 million for the years ended September 30, 1998, 1999, and 2000,
respectively.
F-7
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INTEREST, NET
The Company records interest expense net of interest income. Interest income
for the fiscal years ended September 30, 1998, 1999, and 2000 was approximately
$10.8 million, $10.4 million and $9.4 million, respectively.
CASH AND CASH EQUIVALENTS
Cash equivalents are short-term, highly liquid interest-bearing investments
with a maturity of three months or less when purchased, consisting primarily of
money market instruments.
RESTRICTED CASH AND INVESTMENTS
Restricted cash and investments at September 30, 1999 and 2000 include
approximately $116.8 million and $117.7 million, respectively that is held for
the payment of claims under the terms of certain behavioral managed care
contracts and for regulatory purposes related to the payment of claims in
certain jurisdictions.
CONCENTRATION OF CREDIT RISK
Accounts receivable subject the Company to a concentration of credit risk
with third party payors that include health insurance companies, managed
healthcare organizations, healthcare providers and governmental entities. The
Company establishes an allowance for doubtful accounts based upon factors
surrounding the credit risk of specific payors, historical trends and other
information. Management believes the allowance for doubtful accounts is adequate
to provide for normal credit losses.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost, except for assets that have been
impaired, for which the carrying amount is reduced to estimated fair value.
Expenditures for renewals and improvements are charged to the property accounts.
Replacements and maintenance and repairs that do not improve or extend the life
of the respective assets are expensed as incurred. Internal-use software is
capitalized in accordance with AICPA Statement of Position 98-1, "Accounting for
Cost of Computer Software Developed or Obtained for Internal Use." Amortization
of capital lease assets is included in depreciation expense. Depreciation is
provided on a straight-line basis over the estimated useful lives of the assets,
which is generally two to ten years for buildings and improvements, three to ten
years for equipment and three to five years for capitalized internal-use
software. Depreciation expense for continuing operations was $18.6 million,
$28.0 million and $34.2 million for the fiscal years ended September 30, 1998,
1999 and 2000, respectively. Depreciation expense for discontinued operations
was $5.4 million, $4.3 million and $2.5 million for the fiscal years ended
September 30, 1998, 1999 and 2000, respectively.
F-8
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Property and equipment, net, consisted of the following at September 30,
1999 and 2000 (in thousands):
SEPTEMBER 30,
-------------------
1999 2000
-------- --------
Land.................................................... $ 114 $ 114
Buildings and improvements.............................. 12,079 13,146
Equipment............................................... 119,518 130,953
Capitalized internal-use software....................... 55,648 63,500
-------- --------
187,359 207,713
Accumulated depreciation................................ (66,692) (95,101)
-------- --------
Property and equipment, net............................. $120,667 $112,612
======== ========
INTANGIBLE ASSETS
Intangible assets are composed principally of (i) goodwill, (ii) customer
lists and relationships and (iii) deferred financing costs. Goodwill represents
the excess of the cost of businesses acquired over the fair value of the net
identifiable assets at the date of acquisition and is amortized using the
straight-line method over 25 to 40 years. Customer lists and relationships and
other intangible assets are amortized using the straight-line method over their
estimated useful lives of 4 to 30 years. Deferred financing costs are amortized
over the terms of the underlying agreements.
The Company continually monitors events and changes in circumstances which
could indicate that carrying amounts of intangible assets may not be
recoverable. When events or changes in circumstances are present that indicate
the carrying amount of intangible assets may not be recoverable, the Company
assesses the recoverability of intangible assets by determining whether the
carrying value of such intangible assets will be recovered through the future
cash flows expected from the use of the asset and its eventual disposition. In
fiscal 2000, the Company recorded impairment losses on intangible assets and
other long-lived assets of $15.8 million for continuing operations and
$75.3 million for discontinued operations. See Note 3--"Discontinued Operations"
and Note 10--"Managed Care Integration Costs and Special Charges".
MEDICAL CLAIMS PAYABLE
Medical claims payable represent the liability for healthcare claims
reported but not yet paid and claims incurred but not yet reported ("IBNR")
related to the Company's managed healthcare businesses. The IBNR portion of
medical claims payable is estimated based upon authorized healthcare services,
past claim payment experience for member groups, adjudication decisions,
enrollment data, utilization statistics and other factors. Although considerable
variability is inherent in such estimates, management believes the liability for
medical claims payable is adequate. Medical claims payable balances are
continually monitored and reviewed. Changes in assumptions for care costs caused
by changes in actual experience could cause these estimates to change in the
near term.
F-9
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
FOREIGN CURRENCY
Changes in the cumulative translation of foreign currency assets and
liabilities are presented as a separate component of stockholders' equity. Gains
and losses resulting from foreign currency transactions, which were not
material, are included in operations as incurred.
NET INCOME (LOSS) PER COMMON SHARE
Net income (loss) per common share is computed based on the weighted average
number of shares of common stock and common stock equivalents outstanding during
the period. See Note 6.
STOCK-BASED COMPENSATION
In October 1995, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation," ("FAS 123") which became effective for fiscal years beginning
after December 15, 1995 (fiscal 1997 for the Company). FAS 123 established new
financial accounting and reporting standards for stock-based compensation plans.
Entities are allowed to measure compensation cost for stock-based compensation
under FAS 123 or APB Opinion No. 25, "Accounting for Stock Issued to Employees"
("APB 25"). Entities electing to remain with the accounting in APB 25 are
required to make pro forma disclosures of net income and income per common share
as if the provisions of FAS 123 had been applied. The Company has adopted
FAS 123 on a pro forma disclosure basis. The Company continues to account for
stock-based compensation under APB 25. See Note 6, "Stockholders' Equity".
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, FAS No. 133 "Accounting for Derivative Instruments and Hedging
Activities," (FAS No. 133) was issued. FAS No. 133 establishes accounting and
reporting standards for derivative instruments and derivative instruments
embedded in other contracts, (collectively referred to as derivatives) and for
hedging activities. It requires that an entity recognize all derivatives as
either assets or liabilities in the statement of financial position and measure
those instruments at fair value. If certain conditions are met, a derivative may
be specifically designated as (a) a hedge of the exposure to changes in the fair
value of a recognized asset or liability or an unrecognized firm commitment,
(b) a hedge of the exposure to variability in cash flows attributable to a
particular risk, or (c) a hedge of the foreign currency exposure of a net
investment on a foreign operation, an unrecognized firm commitment, an available
for sale security and a forecasted transaction. FAS No. 137, "Accounting for
Derivative Instruments and Hedging Activities--Deferral of the Effective Date of
FASB Statement No. 133" was issued in June 1999 and deferred the effective date
of FAS No. 133 to fiscal years beginning after June 15, 2000. FAS No. 138,
"Accounting for Certain Derivative Instruments and Certain Hedging Activities",
was issued on June 2000 and also amends FAS No. 133. FAS No. 138 addresses a
limited number of issues causing implementation difficulties. Consequently, the
Company will be required to implement FAS No. 133 for all fiscal quarters for
the fiscal year beginning October 1, 2000. The Company expects the adoption of
this pronouncement will not have a material effect on the Company's financial
statements.
Emerging Issues Task Force Issue 96-16, "Investor's Accounting for an
Investee When the Investor Has a Majority of the Voting Interest but the
Minority Shareholder or Shareholders Have Certain
F-10
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Approval or Veto Rights" ("EITF 96-16") supplements the guidance contained in
AICPA Accounting Research Bulletin 51, "Consolidated Financial Statements", and
in Statement of Financial Accounting Standards No. 94, "Consolidation of All
Majority-Owned Subsidiaries" ("ARB 51/FAS 94"), about the conditions under which
the Company's consolidated financial statements should include the financial
position, results of operations and cash flows of subsidiaries which are less
than wholly-owned along with those of the Company's wholly-owned subsidiaries.
In general, ARB 51/FAS 94 requires consolidation of all majority-owned
subsidiaries except those for which control is temporary or does not rest with
the majority owner. Under the ARB 51/FAS 94 approach, instances of control not
resting with the majority owner were generally regarded to arise from such
events as the legal reorganization or bankruptcy of the majority-owned
subsidiary. EITF 96-16 expands the definition of instances in which control does
not rest with the majority owner to include those where significant approval or
veto rights, other than those which are merely protective of the minority
shareholder's interest, are held by the minority shareholder or shareholders
("Substantive Participating Rights"). Substantive Participating Rights include,
but are not limited to: i) selecting, terminating and setting the compensation
of management responsible for implementing the majority-owned subsidiary's
policies and procedures, and ii) establishing operating and capital decisions of
the majority-owned subsidiary, including budgets, in the ordinary course of
business.
The provisions of EITF 96-16 apply to new investment agreements made after
July 24, 1997, and to existing investment agreements which are modified after
this date. The Company has made no new investments, and has modified no existing
investments, to which the provisions of EITF 96-16 would have applied.
In addition, the provisions of EITF 96-16 must be applied to majority-owned
subsidiaries previously consolidated under ARB 51/FAS 94 for which the
underlying agreements have not been modified in financial statements issued for
years ending after December 15, 1998 (fiscal 1999 for the Company). The adoption
of the provisions of EITF 96-16 on October 1, 1998, had the following effects on
the Company's consolidated financial position (in thousands):
OCTOBER 1,
1998
----------
Increase (decrease) in:
Cash and cash equivalents................................. $(21,092)
Other current assets...................................... (9,538)
Long-term assets.......................................... (30,049)
Investment in unconsolidated subsidiaries................. 26,498
--------
Total Assets............................................ $(34,181)
========
Current liabilities....................................... $(10,381)
Minority interest......................................... (23,800)
--------
Total Liabilities....................................... $(34,181)
========
F-11
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
RECLASSIFICATIONS
Certain reclassifications have been made to fiscal 1998 and 1999 amounts to
conform to fiscal 2000 presentation.
2. ACQUISITIONS AND JOINT VENTURES
ACQUISITIONS
MERIT ACQUISITION. On February 12, 1998, the Company consummated the
acquisition of Merit Behavioral Care Corporation ("Merit") for cash
consideration of approximately $448.9 million plus the repayment of Merit's
debt. Merit managed behavioral healthcare programs across all segments of the
healthcare industry, including HMOs, Blue Cross/Blue Shield organizations and
other insurance companies, corporations and labor unions, federal, state and
local governmental agencies and various state Medicaid programs. The Company
accounted for the Merit acquisition using the purchase method of accounting. By
virtue of acquiring Merit, the Company may be required to make certain payments
to the former shareholders of CMG Health, Inc. ("CMG") a managed behavioral
healthcare company that was acquired by Merit in September 1997. Such contingent
payments are subject to an aggregate maximum of $23.5 million. The Company has
initiated legal proceedings against certain former owners of CMG with respect to
representations made by such former owners in conjunction with Merit's
acquisition of CMG. Whether any contingent payments will be made to the former
shareholders of CMG and the amount and timing of contingent payments, if any,
may be subject to the outcome of these proceedings.
In connection with the acquisition of Merit, the Company (i) terminated its
existing credit agreement; (ii) repaid all loans outstanding pursuant to Merit's
existing credit agreement; (iii) completed a tender offer for its 11.25%
Series A Senior Subordinated Notes due 2004 (the "Old Notes"); (iv) completed a
tender offer for Merit's 11.50% Senior Subordinated notes due 2005 (the "Merit
Outstanding Notes"); (v) entered into a new senior secured bank credit agreement
(the "Credit Agreement") providing for a revolving credit facility (the
"Revolving Facility") and a term loan facility (the "Term Loan Facility") of up
to $700 million; and (vi) issued $625 million in 9.0% Senior Subordinated Notes
due 2008 (the "Notes").
F-12
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
The following table sets forth the sources and uses of funds for the Merit
acquisition and related transactions (the "Transactions") at closing (in
thousands):
SOURCES:
Cash and cash equivalents................................... $ 59,290
Credit Agreement:
Revolving Facility (1).................................... 20,000
Term Loan Facility........................................ 550,000
The Notes................................................... 625,000
----------
Total sources........................................... $1,254,290
==========
USES:
Cash paid to Merit Shareholders............................. $ 448,867
Repayment of Merit existing credit agreement (2)............ 196,357
Purchase of the Old Notes (3)............................... 432,102
Purchase of Merit Outstanding Notes (4)..................... 121,651
Transaction costs (5)....................................... 55,313
----------
Total uses.............................................. $1,254,290
==========
- ------------------------
(1) The Revolving Facility provides for borrowings of up to $150.0 million.
(2) Includes principal amount of $193.7 million and accrued interest of
$2.8 million.
(3) Includes principal amount of $375.0 million, tender premium of
$43.4 million and accrued interest of $13.7 million.
(4) Includes principal amount of $100.0 million, tender premium of
$18.8 million and accrued interest of $2.9 million.
(5) Transaction costs include, among other things, expenses associated with the
debt tender offers, the Notes offering, the Merit acquisition and the Credit
Agreement.
HAI ACQUISITION. On December 4, 1997, the Company consummated the purchase
of Human Affairs International, Incorporated ("HAI"), formerly a unit of
Aetna, Inc. ("Aetna"), for approximately $122.1 million, which the Company
funded from cash on hand. HAI managed behavioral healthcare programs, primarily
through Employee Assistance Programs ("EAPs") and other behavioral managed
healthcare plans. The Company may be obligated to make contingent payments
totaling $60 million annually, under two separate calculations, which are
primarily based upon membership levels during the contract year (as defined) and
are calculated at the end of the contract year. "Contract Year" means each of
the twelve-month periods ending on the last day of December in 1998, 1999, 2000,
2001 and 2002. The Company accounted for the HAI acquisition using the purchase
method of accounting.
The Company paid $60.0 million to Aetna for both the Contract Years ended
December 31, 1998 and 1999. Also, based upon the most recent membership
enrollment data related to the Contract Year to end December 31, 2000 ("Contract
Year 3"), the Company believes beyond a reasonable doubt that it will be
required to make the full $60 million payment related to Contract Year 3 and has
included this amount in
F-13
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
goodwill. The Company recorded $120.0 million of goodwill and other intangible
assets related to the purchase of HAI during fiscal 1999, related to Contract
Years 1 and 2. The Contract Year 3 liability of $60.0 million is included in
"Deferred credits and other long-term liabilities" in the Company's consolidated
balance sheet as of September 30, 2000. The Company intends to borrow under the
Revolving Facility to meet this obligation, which is expected to be paid during
the second quarter of fiscal 2001.
The Company would record additional contingent consideration payable, if
any, as goodwill and identifiable intangible assets.
GREEN SPRING ACQUISITION. On December 13, 1995, the Company acquired a 51%
ownership interest in Green Spring Health Services, Inc. ("Green Spring") for
approximately $68.9 million in cash, the issuance of 215,458 shares of common
stock valued at approximately $4.3 million and the contribution of Group
Practice Affiliates, Inc. ("GPA"), a wholly-owned subsidiary of the Company,
which became a wholly-owned subsidiary of Green Spring. In addition, the
minority stockholders of Green Spring were issued an option agreement whereby
they could exchange their interests in Green Spring for an equivalent of the
Company's common stock or subordinated notes (the "Exchange Option"). On
December 20, 1995, the Company acquired an additional 10% ownership interest in
Green Spring for approximately $16.7 million in cash as a result of an exercise
by a minority stockholder of its Exchange Option. In January 1998, the minority
stockholders of Green Spring converted their collective 39% interest in Green
Spring into an aggregate of 2,831,516 shares of the Company's common stock
through exercise of the Exchange Option (the "Green Spring Minority Stockholder
Conversion"). As a result of the Green Spring Minority Stockholder Conversion,
the Company owns 100% of Green Spring. The Company issued shares from treasury
to effect the Green Spring Minority Stockholder Conversion and accounted for it
as a purchase of minority interest at a fair value of consideration paid of
approximately $63.5 million.
The Company accounted for the Green Spring acquisition using the purchase
method of accounting. Green Spring's results of operations have been included in
the Company's consolidated financial statements since the acquisition date, less
minority interest through January, 1998, at which time the Company became the
sole owner of Green Spring.
The following unaudited pro forma information for the fiscal year ended
September 30, 1998 has been prepared assuming the HAI acquisition, Merit
acquisition and the Green Spring Minority Stockholder Conversion (as defined)
were consummated on October 1, 1997. The unaudited pro forma information does
not purport to be indicative of the results that would have actually been
obtained had such
F-14
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
transactions been consummated on October 1, 1997 or which may be attained in
future periods (in thousands, except per share data):
SEPTEMBER 30,
1998
-------------
Net revenue................................................. $1,437,572
Loss from continuing operations before extraordinary
item(1)(2)................................................ (1,700)
Loss per common share -- basic:
Loss from continuing operations before extraordinary
item.................................................... (0.06)
Loss per common share -- diluted:
Loss from continuing operations before extraordinary
item.................................................... (0.06)
- ------------------------
(1) Excludes expected unrealized cost savings related to the Integration Plan
(as defined) and managed care integration costs (See Note 10).
(2) Excludes the extraordinary losses on early extinguishment of debt for the
year ended September 30, 1998.
JOINT VENTURES
Through its acquisition of Merit, the Company became a 50% partner with
Value Options, Inc. in Choice Behavioral Health Partnership ("Choice"), a
managed behavioral healthcare company. Choice derives all of its revenues from a
contract with the Civilian Health and Medical Program of the Uniformed Services
("CHAMPUS"), and with TriCare, the successor to CHAMPUS. The Company accounts
for its investment in Choice using the equity method.
F-15
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
A summary of unaudited financial information for the Company's investment in
Choice is as follows (in thousands):
SEPTEMBER 30, SEPTEMBER 30,
1999 2000
------------- -------------
Current assets.............................................. $19,572 $19,144
Property and equipment, net................................. 228 132
------- -------
Total assets............................................ $19,800 $19,276
======= =======
Current liabilities......................................... $12,673 $16,212
Partners' capital........................................... 7,127 3,064
------- -------
Total liabilities and partners' capital................. $19,800 $19,276
======= =======
Magellan investment in Choice............................... $ 3,563 $ 1,532
======= =======
FOR THE 231 DAYS
ENDED FISCAL YEAR ENDED FISCAL YEAR ENDED
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1998 1999 2000
---------------- ----------------- -----------------
Net revenue................................... $38,676 $54,880 $56,349
Operating expenses............................ 22,914 28,124 32,141
------- ------- -------
Net income.................................. $15,762 $26,756 $24,208
======= ======= =======
Magellan equity income........................ $ 7,881 $13,378 $12,104
======= ======= =======
Cash distributions from Choice................ $13,039 $13,047 $14,137
======= ======= =======
The Company owns a 50% interest in Premier Behavioral Systems of Tennessee,
LLC ("Premier"). Premier was formed to manage behavioral healthcare benefits for
the State of Tennessee's TennCare program. The Company accounts for its
investment in Premier using the equity method. The Company's investment in
Premier at September 30, 1998, 1999 and 2000 was $5.8 million, $12.1 million and
$8.1 million, respectively. The Company's equity in income (loss) of Premier for
fiscal 1998, 1999 and 2000 was $(4.7) million, $6.3 million and $(4.0) million,
respectively. The Company has not received a partnership distribution from
Premier during fiscal year 1998, 1999 and 2000.
3. DISCONTINUED OPERATIONS
HEALTHCARE PROVIDER AND FRANCHISING SEGMENTS
During fiscal 1997, the Company sold substantially all of its domestic
acute-care psychiatric hospitals and residential treatment facilities
(collectively, the "Psychiatric Hospital Facilities") to Crescent Real Estate
Equities ("Crescent") for $417.2 million in cash (before costs of approximately
$16.0 million) and certain other consideration (the "Crescent Transactions").
Simultaneously with the sale of the Psychiatric Hospital Facilities, the Company
and Crescent Operating, Inc. ("COI"), an affiliate of Crescent, formed Charter
Behavioral Health Systems, LLC ("CBHS") to conduct the operations of the
Psychiatric Hospital Facilities and certain other facilities transferred to CBHS
by the Company. The Company retained a 50% ownership of CBHS; the other 50% of
the ownership interest of CBHS was owned by COI.
F-16
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
3. DISCONTINUED OPERATIONS (CONTINUED)
The Company initially used approximately $200 million of the proceeds from
the Crescent Transactions to reduce its long-term debt, including borrowings
under its then existing credit agreement. In December 1997, the Company used the
remaining proceeds from the Crescent Transactions to acquire additional managed
healthcare businesses. See Note 2, "Acquisitions and Joint Ventures."
On September 10, 1999, the Company consummated the transfer of assets and
other interests pursuant to a Letter Agreement dated August 10, 1999 with
Crescent, COI and CBHS that effects the Company's exit from its healthcare
provider and healthcare franchising businesses (the "CBHS Transactions"). The
terms of the CBHS Transactions are summarized as follows:
HEALTHCARE PROVIDER INTERESTS
- The Company redeemed 80% of its CBHS common interest and all of its CBHS
preferred interest, leaving it with a 10% non-voting common interest in
CBHS.
- The Company agreed to transfer to CBHS its interests in five of its six
hospital-based joint ventures ("Provider JVs") and related real estate as
soon as practicable.
- The Company transferred to CBHS the right to receive approximately
$7.1 million from Crescent for the sale of two psychiatric hospitals that
were acquired by the Company (and leased to CBHS) in connection with CBHS'
acquisition of certain businesses from Ramsay Healthcare, Inc. in fiscal
1998.
- The Company forgave receivables due from CBHS of approximately
$3.3 million for payments received by CBHS for patient services prior to
the formation of CBHS on June 17, 1997. The receivables related primarily
to patient stays that "straddled" the formation date of CBHS.
- The Company became obligated to pay $2.0 million to CBHS in 12 equal
monthly installments beginning on the first anniversary of the closing
date.
- CBHS became obligated to indemnify the Company for 20% of up to the first
$50 million (i.e., $10 million) for expenses, liabilities and settlements,
if any, related to government investigations for events that occurred
prior to June 17, 1997 (the "CBHS Indemnification"). CBHS would be
required to pay the Company a maximum of $500,000 per year under the CBHS
Indemnification.
- Crescent, COI, CBHS and Magellan have provided each other with mutual
releases of claims among all of the parties with respect to the original
transactions that effected the formation of CBHS and the operation of CBHS
since June 17, 1997 with certain specified exceptions.
- The Company transfered certain other real estate and interests related to
the healthcare provider business to CBHS.
HEALTHCARE FRANCHISING INTERESTS
- The Company transferred its healthcare franchising interests to CBHS,
which included Charter Advantage, LLC, the Charter call center operation,
the Charter name and related intellectual property. The Company was
released from performing any further franchise services or incurring
future franchising expenses.
F-17
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
3. DISCONTINUED OPERATIONS (CONTINUED)
- The Company forgave prepaid call center management fees of approximately
$2.7 million.
- The Company forgave unpaid franchise fees of approximately $115 million.
The CBHS Transactions, together with the formal plan of disposal authorized
by the Company's Board of Directors on September 2, 1999, represented the
disposal of the Company's healthcare provider and healthcare franchising
business segments.
The Company's original plan of disposal contemplated that the disposition of
all provider joint venture interests would take place within twelve months of
the measurement date. The Company, with the cooperation of its joint venture
partners and CBHS, has closed two of the five hospital-based joint ventures and
is currently negotiating to sell its interest in the remaining three joint
ventures. The proceeds from these sales will be transferred to CBHS subject to
all rights of offset the Company has for certain amounts due from CBHS and
certain other matters related to CBHS's bankruptcy proceedings (see discussion
below). The Company is attempting to resolve with CBHS the amounts due to and
from CBHS, which resolution, if any, will be subject to approvals required by
CBHS's bankruptcy proceedings. Accordingly, these sales and transfers are not
entirely within the control of the Company. The Company anticipates resolving
these matters in fiscal 2001.
On February 16, 2000, CBHS filed a voluntary petition for relief of
indebtedness under Chapter 11 of the United States Bankruptcy Code. The Company
has no material receivables from CBHS apart from any amount which may be owed in
the future for indemnification claims under the previously described provisions
of the CBHS Transactions. In connection with the bankruptcy proceedings, CBHS
has indicated it believes it has claims against the Company regarding certain
previous transactions. The Company believes such claims are without merit; and
in the event any such claims are made, the Company will vigorously defend such
claims. The Company does not believe that CBHS' bankruptcy will have a material
impact on its financial position.
SPECIALTY MANAGED HEALTHCARE SEGMENT
On December 5, 1997, the Company purchased the assets of Allied Health
Group, Inc. and certain affiliates ("Allied"). Allied provided specialty managed
care services, including risk-based products and administrative services to a
variety of insurance companies and other customers. Allied's products included,
among other things, claims authorization, analysis, adjudication and payment,
comprising multiple clinical specialities. The Company paid approximately
$50.0 million for Allied, with cash on hand. During the quarter ended
December 31, 1998, the Company and the former owners of Allied amended the
Allied purchase agreement (the "Allied Amendments"). The Allied Amendments
resulted in the Company paying the former owners of Allied $4.5 million
additional consideration, which was recorded as goodwill. On February 29, 2000,
the Company consummated the purchase of the outstanding stock of Vivra, Inc.
("Vivra"), which also provided specialty managed care services. The initial
purchase price of Vivra was $10.25 million, excluding transaction costs. Allied
and Vivra, as well as certain other related assets comprised the Company's
specialty managed healthcare segment. The Company accounted for the Allied and
Vivra acquisitions using the purchase method of accounting.
On October 4, 2000, the Company adopted a formal plan to dispose of the
business and interest that comprise the company's specialty managed healthcare
segment. The Company intends to exit the Specialty business via sale and/or
abandonment of businesses and related assets, certain of which activities had
F-18
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
3. DISCONTINUED OPERATIONS (CONTINUED)
already occurred in the normal course prior to October 4, 2000. The Company does
not expect to receive significant proceeds from the sale of assets. Further, the
Company is actively exiting all significant contracts entered into by Allied and
Vivra. This effort is expected to be completed by September 30, 2001.
ACCOUNTING FOR DISCONTINUED OPERATIONS
The Company has accounted for the disposal of the segments under Accounting
Principles Board Opinion No. 30, "Reporting the Results of Operations--Reporting
the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual
and Infrequently Occurring Events and Transactions" ("APB 30"). APB 30 requires
that the results of continuing operations be reported separately from those of
discontinued operations for all periods presented and that any gain or loss from
disposal of a segment of a business be reported in conjunction with the related
results of discontinued operations. Further, although the company adopted its
formal plan on October 4, 2000, EITF 95-18 provides that the estimated loss from
disposal and segment operating results should be presented as discontinued
operations in the yet to be issued financial statements, if those statement are
filed subsequent to the measurement date. Accordingly, the Company has restated
its results of operations for all prior periods. The Company recorded an
after-tax loss on disposal of its healthcare provider and healthcare franchising
business segments of approximately $47.4 million, (primarily non-cash) in the
fourth quarter of fiscal 1999 and an after-tax loss of $17.7 million related to
the disposal of the specialty managed healthcare segment in the fourth quarter
of fiscal 2000.
The summarized results of the discontinued operations segments are as
follows (in thousands):
FISCAL YEARS ENDED SEPTEMBER 30
---------------------------------
1998 1999 2000
--------- --------- ---------
HEALTHCARE PROVIDER
Net revenue (1)............................................. $133,256 $ 74,860 $ --
-------- -------- --------
Salaries, cost of care and other operating expenses......... 106,760 53,952 --
Equity in earnings of unconsolidated subsidiaries........... -- (2,901) --
Depreciation and amortization............................... 5,266 2,141 --
Interest income (2)......................................... (1,130) (76) --
Special charges (income), net............................... 135 (33,046) --
Other expenses (3).......................................... 10,093 21,907 --
-------- -------- --------
Income (loss) from discontinued operations.................. $ 12,132 $ 32,883 $ --
======== ======== ========
HEALTHCARE FRANCHISING
Net revenue................................................. $ 55,625 $ 563 $ --
-------- -------- --------
Salaries, cost of care and other operating expenses......... 9,072 5,623 --
Equity in earnings of unconsolidated subsidiaries........... 31,878 -- --
Depreciation and amortization............................... 355 337 --
Special charges............................................. 323 -- --
Other expenses (3).......................................... 5,598 (2,159) --
-------- -------- --------
Income (loss) from discontinued operations.................. $ 8,399 $ (3,238) $ --
======== ======== ========
F-19
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
3. DISCONTINUED OPERATIONS (CONTINUED)
FISCAL YEARS ENDED SEPTEMBER 30
---------------------------------
1998 1999 2000
--------- --------- ---------
SPECIALTY MANAGED HEALTHCARE
Net revenue................................................. $143,504 $197,157 $128,229
-------- -------- --------
Salaries, cost of care and other operating expenses......... 140,375 194,747 165,505
Depreciation and amortization............................... 2,366 4,610 3,831
Special charges............................................. -- -- 58,173
Other expenses (3).......................................... 306 (880) (34,059)
-------- -------- --------
Income (loss) from discontinued operations.................. $ 457 $ (1,320) $(65,221)
======== ======== ========
DISCONTINUED OPERATIONS -- COMBINED
Net revenue (1)............................................. $332,385 $272,580 $128,229
-------- -------- --------
Salaries, cost of care and other operating expenses......... 256,207 254,322 165,505
Equity in (earnings) losses of unconsolidated
subsidiaries.............................................. 31,878 (2,901) --
Depreciation and amortization............................... 7,987 7,088 3,831
Interest income (2)......................................... (1,130) (76) --
Special charges (income), net............................... 458 (33,046) 58,173
Other expenses (3).......................................... 15,997 18,868 (34,059)
-------- -------- --------
Income (loss) from discontinued operations.................. $ 20,988 $ 28,325 $(65,221)
======== ======== ========
- ------------------------
(1) Includes $7.0 million and $21.6 million in fiscal 1998 and 1999,
respectively, related to the settlement and adjustment of reimbursement
issues related to prior periods ("Cost Report Settlements").
(2) Interest expense has not been allocated to discontinued operations.
(3) Includes income taxes and minority interest.
LOSS ON DISPOSAL OF HEALTHCARE PROVIDER AND FRANCHISING SEGMENTS
The summary of the loss on disposal recorded in fiscal 1999 related to the
healthcare provider and healthcare franchising segments is as follows (in
thousands):
Basis in Provider JV's...................................... $44,598
Basis in Real Estate transferred to CBHS.................... 13,969
Basis in Franchise and other operations..................... 7,285
Working capital forgiveness................................. 5,565
Transaction costs and legal fees............................ 7,622
-------
Loss before income taxes.................................... 79,039
Income tax benefit.......................................... (31,616)
-------
$47,423
=======
Remaining assets and liabilities of the provider business at September 30,
2000 include, among other things, (i) hospital-based real estate of
$6.0 million, (ii) long-term debt of $6.4 million related to the hospital-based
real estate; (iii) reserve for discontinued operations of $5.8 million and
(iv) accrued
F-20
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
3. DISCONTINUED OPERATIONS (CONTINUED)
liabilities of $12 million. The Company is also subject to inquiries and
investigations from governmental agencies related to its operating and business
practices prior to June 17, 1997. See Note 12 -- "Commitments and
Contingencies".
The following table provides a rollforward of liabilities resulting from the
CBHS Transactions (in thousands):
BALANCE BALANCE
SEPTEMBER 30, RECEIPTS SEPTEMBER 30,
TYPE OF COST 1998 ADDITIONS (PAYMENTS) OTHER 1999
- ------------ ------------- --------- ---------- -------- -------------
Transaction costs and legal fees......... $ -- $ 7,622 $ (69) $ -- $ 7,553
Provider JV working capital.............. -- 2,931 -- 185 3,116
Other.................................... -- 755 -- -- 755
------- ------- ------- ---- -------
$ -- $11,308 $ (69) $185 $11,424
======= ======= ======= ==== =======
BALANCE BALANCE
SEPTEMBER 30, RECEIPTS SEPTEMBER 30,
TYPE OF COST 1999 ADDITIONS (PAYMENTS) OTHER 1999
- ------------ ------------- --------- ---------- -------- -------------
Transaction costs and legal fees......... $ 7,553 $ -- $(5,804) $ -- $ 1,749
Provider JV working capital.............. 3,116 -- -- -- 3,116
Other.................................... 755 -- 150 -- 905
------- ------- ------- ---- -------
$11,424 $ -- $(5,654) $ -- $ 5,770
======= ======= ======= ==== =======
LOSS ON DISPOSAL OF SPECIALTY MANAGED HEALTHCARE SEGMENTS
The summary of the loss on disposal recorded during fiscal 2000 related to
the disposal of the Company's specialty managed healthcare segment is as follows
(in thousands):
Estimated leasehold obligations............................. $ 5,051
Impairment of long-lived assets............................. 17,058
Other Cost of Disposal...................................... 4,777
-------
Loss Before Income Taxes................................ 26,886
Income Tax Benefit.......................................... (9,224)
-------
$17,662
=======
The remaining assets and liabilities of the specialty managed healthcare
segment at September 30, 2000 include, among other things, (i) cash and accounts
receivable of $9.5 million, (ii) property and equipment of $2.0 million,
(iii) medical claims payable of $9.3 million, (iv) reserve for discontinued
operations of $8.6 million and (v) accounts payable and accrued liabilities of
$27.1 million. The reserve for discontinued operations is comprised of
$5.1 million of estimated leasehold termination costs and $3.5 million of
estimated operating losses from the measurement date to the date of disposal.
F-21
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
3. DISCONTINUED OPERATIONS (CONTINUED)
SPECIAL CHARGES (INCOME) RECORDED IN DISCONTINUED OPERATIONS
GENERAL
The following table summarizes special charges (income) recorded during the
three years in the period ended September 30, 2000 in the Company's healthcare
provider, healthcare franchising and specialty managed healthcare segments (in
thousands):
FISCAL YEAR ENDED SEPTEMBER 30,
---------------------------------
1998 1999 2000
--------- --------- ---------
Gains on the sale of psychiatric hospitals,
net........................................... $(3,000) $(24,974) $ --
Collection fee reserves......................... -- (8,072) --
Termination of CBHS sale transaction............ 3,458 -- --
Impairment of long-lived assets--Allied......... -- -- 58,173
------- -------- -------
$ 458 $(33,046) $58,173
======= ======== =======
GAINS ON SALE OF PSYCHIATRIC FACILITIES, NET
During fiscal 1998 and 1999, the Company recorded gains of approximately
$3.0 million and $1.1 million, respectively, related to the sales of psychiatric
hospitals and other real estate.
On April 9, 1999, the Company sold its European psychiatric provider
operations to Investment AB Bure of Sweden for approximately $57.0 million
(before transaction costs of approximately $2.5 million) (the "Europe Sale").
The Europe Sale resulted in a non-recurring gain of approximately $23.9 million
before provision for income taxes which is included in gain of sale of
psychiatric hospitals.
The Company used approximately $38.2 million of the net proceeds from the
Europe Sale to make mandatory unscheduled principal payments on indebtedness
outstanding under the Term Loan Facility (as defined). The remaining proceeds
were used to reduce borrowings outstanding under the Revolving Facility (as
defined).
COLLECTION FEE RESERVES
The Company reduced certain accounts receivable collection fee reserves by
$8.1 million during the fourth quarter of fiscal 1999 as substantially all
hospital-based receivables subject to the collection fees had been collected at
September 30, 1999.
TERMINATION OF CBHS SALE TRANSACTION
On March 3, 1998, the Company and certain of its wholly owned subsidiaries
entered into definitive agreements with COI and CBHS pursuant to which the
Company would have, among other things, sold the Company's franchise operations,
certain domestic provider operations and certain other assets and operations. On
August 19, 1998, the Company announced that it had terminated discussions with
COI for the sale of its interest in CBHS.
F-22
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
3. DISCONTINUED OPERATIONS (CONTINUED)
In connection with the termination of the CBHS sale transaction, the Company
recorded a charge of approximately $3.5 million as follows (in thousands):
Severance(1)................................................ $ 488
Lease termination(1)........................................ 1,067
Impairment of long-lived assets............................. 153
Transaction costs and other................................. 1,750
------
$3,458
======
- ------------------------
(1) Relates to staffing reductions and lease terminations incurred in the
Company's franchising and outcomes monitoring subsidiaries.
IMPAIRMENT OF LONG-LIVED ASSETS--ALLIED
The Company recorded a charge of approximately $58.2 million in the quarter
ended March 31, 2000, related to the impairment of certain of Allied's
long-lived assets in accordance with Statement of Financial Accounting Standards
No. 121 "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of" ("FAS 121"). This amount included certain goodwill,
certain property and equipment and identifiable intangible assets of Allied
which, prior to the Vivra acquisition, was the principal component of the
Company's specialty managed healthcare business segment. During the six months
ended March 31, 2000, Allied recorded significant losses associated primarily
with the termination or restructuring of various customer contracts. These
events and the resulting expectation of lower future earnings and cash flows
from Allied represented a change in circumstances with respect to the business
of Allied. At that time the Company estimated that the future undiscounted cash
flows expected to be generated by Allied were insufficient to fully recover the
recorded cost of the long-lived assets. The Company recorded the impairment
charge to write these assets down to their estimated fair value.
4. BENEFIT PLANS
The Company currently has a defined contribution retirement plan (the
"401(k) Plan"), which is in the form of an amendment and restatement of the
Green Spring 401(k) Plan. Certain other 401(k) plans and assets, including the
Magellan 401(k) Plan, were merged into the Green Spring Plan effective
January 1, 1999. Employee participants can elect to voluntarily contribute up to
15% of their compensation to the 401(k) Plan. The Company makes contributions to
the 401(k) Plan based on employee compensation and contributions. Additionally,
the Company can make a discretionary contribution of up to 2% of each eligible
employee's compensation. The Company matches 50% of each employee's contribution
up to 3% of their compensation. The Company recognized $3.0 million and
$7.4 million of expense for the years ended September 30, 1999 and 2000,
respectively, for the matching contribution to the 401(k) Plan.
Prior to January 1, 1999, the Company maintained a separate defined
contribution plan (the "Magellan 401-K Plan"). Participants could contribute up
to 15% of their compensation to the Magellan 401-K Plan. The Company made
discretionary contributions of 2% of each employee's compensation and matched
50% of each employee's contribution up to 3% of their compensation. During the
fiscal years
F-23
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
4. BENEFIT PLANS (CONTINUED)
ended September 30, 1998 and 1999 the Company expensed approximately
$3.2 million and $1.2 million, respectively, to the Magellan 401-K Plan.
Prior to January 1, 1999, Green Spring maintained a separate defined
contribution plan (the "Green Spring 401-K Plan"). Employee participants could
elect to voluntarily contribute up to 6% or 12% of their compensation, depending
upon each employee's compensation level, to the Green Spring 401-K Plan. Green
Spring matched up to 3% of each employee's compensation. Employees vested in
employer contributions over five years. During the fiscal years ended
September 30, 1998 and 1999 the Company expensed approximately $1.2 million and
$2.9 million, respectively, to the Green Spring 401-K Plan.
5. LONG-TERM DEBT, CAPITAL LEASE OBLIGATIONS AND OPERATING LEASES
Information with regard to the Company's long-term debt and capital lease
obligations at September 30, 1999 and 2000 is as follows (in thousands):
SEPTEMBER 30, SEPTEMBER 30,
1999 2000
------------- -------------
Credit Agreement:
Revolving Facility (10.125% at September 30, 2000) due
through 2004............................................ $ 20,000 $ 30,000
Term Loan Facility (10.31% to 10.81% at September 30,
2000) due through 2006.................................. 492,873 436,612
9.0% Senior Subordinated Notes due 2008................... 625,000 625,000
11.5% other notes payable through 2005.................... 35 35
5.65% capital lease obligations due through 2014.......... 6,400 6,400
---------- ----------
1,144,308 1,098,047
Less amounts due within one year........................ 30,119 34,119
---------- ----------
$1,114,189 $1,063,928
========== ==========
The aggregate scheduled maturities of long-term debt and capital lease
obligations during the five fiscal years and beyond subsequent to September 30,
2000 are as follows (in thousands): 2001--$34,119; 2002--$43,328; 2003--$80,692,
2004--$167,336, 2005--$115,585 and 2006 and beyond--$656,987.
The Notes, which are carried at cost, had a fair value of approximately
$534 million and $421 million at September 30, 1999 and 2000, respectively,
based on market quotes. The Company's remaining debt is also carried at cost,
which approximates fair market value.
The Company recognized a net extraordinary loss from the early
extinguishment of debt of approximately $33.0 million, net of income tax
benefit, during fiscal 1998, to write off unamortized deferred financing costs
related to terminating the previous credit agreement and extinguishing the Old
Notes, to record the tender premium and related costs of extinguishing the Old
Notes and to record the gain on extinguishment of the Company's 7.5% Swiss
bonds. The Credit Agreement provides for a Term Loan Facility in an original
aggregate principal amount of $550 million, consisting of an approximately
$183.3 million Tranche A Term Loan (the "Tranche A Term Loan"), an approximately
$183.3 million Tranche B Term Loan (the "Tranche B Term Loan") and an
approximately $183.4 million Tranche C Term Loan (the "Tranche C Term Loan"),
and a Revolving Facility providing for revolving loans to the Company
F-24
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
5. LONG-TERM DEBT, CAPITAL LEASE OBLIGATIONS AND OPERATING LEASES (CONTINUED)
and the "Subsidiary Borrowers" (as defined therein) and the issuance of letters
of credit for the account of the Company and the Subsidiary Borrowers in an
aggregate principal amount (including the aggregate stated amount of letters of
credit) of $150.0 million. Letters of credit outstanding were $29.6 million at
September 30, 2000.
The Tranche A Term Loan and the Revolving Facility mature on February 12,
2004. The Tranche B Term Loan matures on February 12, 2005 and the Tranche C
Term Loan matures on February 12, 2006. The Tranche A Term Loan amortizes in
installments in each fiscal year in amounts equal to $30.3 million in 2001,
$39.5 million in 2002, $42.1 million in 2003 and $9.9 million in 2004. The
Tranche B Term Loan amortizes in installments in amounts equal to $1.9 million
in each of 2001 and 2002, $36.7 million in 2003, $90.7 million in 2004 and
$26.2 million in 2005. The Tranche C Term Loan amortizes in installments in each
fiscal year in amounts equal to $1.9 million in each of 2001 through 2003,
$36.7 million in 2004, $89.4 million in 2005 and $25.6 million in 2006. In
addition, the Revolving Facility and Term Loan Facility are subject to mandatory
prepayment and reductions (to be applied first to the Term Loan Facility) in an
amount equal to (a) 75% of the net proceeds of certain offerings of equity
securities by the Company or any of its subsidiaries, (b) 50% for the sale of
National Mentor, Inc. ("Mentor") and certain identified non-core assets and 100%
of the net proceeds of certain debt issues of the Company or any of its
subsidiaries, (c) 75% of the Company's excess cash flow beginning September 30,
2001, upon the sale of Mentor, otherwise September 30, 2002, as defined, and
(d) 100% of the net proceeds of certain other asset sales or other dispositions
of property of the Company and its subsidiaries, in each case subject to certain
limited exceptions.
The Credit Agreement contains a number of covenants that, among other things
restrict the ability of the Company and its subsidiaries to dispose of assets,
incur additional indebtedness, incur or guarantee obligations, prepay other
indebtedness or amend other debt instruments (including the indenture for the
Notes (the "Indenture")), pay dividends, create liens on assets, make
investments, make loans or advances, redeem or repurchase common stock, make
acquisitions, engage in mergers or consolidations, change the business conducted
by the Company and its subsidiaries and make capital expenditures. In addition,
the Credit Agreement requires the Company to comply with specified financial
ratios and tests, including minimum coverage ratios, maximum leverage ratios,
maximum senior debt ratios and minimum "EBITDA" (as defined in the Credit
Agreement) and minimum net worth tests. As of September 30, 2000, the Company
was in compliance with its debt covenants.
At the Company's election, the interest rates per annum applicable to the
loans under the Credit Agreement are a fluctuating rate of interest measured by
reference to either (a) an adjusted London inter-bank offer rate ("LIBOR") plus
a borrowing margin or (b) an alternate base rate ("ABR") (equal to the higher of
the Chase Manhattan Bank's published prime rate or the Federal Funds effective
rate plus 1/2 of 1%) plus a borrowing margin. The borrowing margins applicable
to the Tranche A Term Loan and loans under the Revolving Facility are currently
2.50% for ABR loans and 3.50% for LIBOR loans, and are subject to reduction
after December 2001 if the Company's financial results satisfy certain leverage
tests. The borrowing margins applicable to the Tranche B Term Loan and the
Tranche C Term Loan are currently 2.75% and 3.0%, respectively, for ABR loans
and 3.75% and 4.0%, respectively, for LIBOR loans, and are not subject to
reduction. Amounts outstanding under the credit facilities not paid when due
bear interest at a default rate equal to 2.00% above the rates otherwise
applicable to each of the loans under the Term Loan Facility and the Revolving
Facility.
F-25
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
5. LONG-TERM DEBT, CAPITAL LEASE OBLIGATIONS AND OPERATING LEASES (CONTINUED)
The obligations of the Company and the Subsidiary Borrowers under the Credit
Agreement are unconditionally and irrevocably guaranteed by, subject to certain
exceptions, each wholly owned subsidiary of the Company. In addition, the
Revolving Facility, the Term Loan Facility and the guarantees are secured by
security interests in and pledges of or liens on substantially all the material
tangible and intangible assets of the guarantors, subject to certain exceptions.
The Notes are general unsecured senior subordinated obligations of the
Company. The Notes are limited in aggregate principal amount to $625.0 million
and will mature on February 15, 2008. Interest on the Notes accrues at the rate
of 9.0% per annum and is payable semi-annually on each February 15 and
August 15. The Notes were originally issued as unregistered securities and later
exchanged for securities which were registered with the Securities and Exchange
Commission. Due to a delay in the registration of the Notes to be exchanged, the
Company was required to increase the interest rate on the Notes by 100 basis
points per annum for the period from July 13, 1998 through November 9, 1998, the
date of issuance of the Notes to be exchanged.
The Notes are redeemable at the option of the Company. The Notes may be
redeemed at the option of the Company, in whole or in part, at the redemption
prices (expressed as a percentage of the principal amount) set forth below, plus
accrued and unpaid interest, during the twelve-month period beginning on
February 15 of the years indicated below:
REDEMPTION
YEAR PRICES
- ---- ----------
2003........................................................ 104.5%
2004........................................................ 103.0%
2005........................................................ 101.5%
2006 and thereafter......................................... 100.0%
In addition, at any time and from time to time prior to February 15, 2001,
the Company may, at its option, redeem up to 35% of the original aggregate
principal amount of the Notes at a redemption price (expressed as a percentage
of the principal amount) of 109%, plus accrued and unpaid interest with the net
cash proceeds of one or more equity offerings; provided that at least 65% of the
original aggregate principal amount of Notes remains outstanding immediately
after the occurrence of such redemption and that such redemption occurs within
60 days of the date of the closing of any such equity offering.
The Indenture limits, among other things: (i) the incurrence of additional
indebtedness by the Company and its restricted subsidiaries; (ii) the payment of
dividends on, and redemption or repurchase of, capital stock of the Company and
its restricted subsidiaries and the redemption of certain subordinated
obligations of the Company; (iii) certain other restricted payments, including
investments; (iv) sales of assets; (v) certain transactions with affiliates;
(vi) the creation of liens; and (vii) consolidations, mergers and transfers of
all or substantially all the Company's assets. The Indenture also prohibits
certain restrictions on distributions from restricted subsidiaries. However, all
such limitations and prohibitions are subject to certain qualifications and
exceptions.
The Company leases certain of its operating facilities. The leases, which
expire at various dates through 2008, generally require the Company to pay all
maintenance, property and tax insurance costs.
F-26
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
5. LONG-TERM DEBT, CAPITAL LEASE OBLIGATIONS AND OPERATING LEASES (CONTINUED)
At September 30, 2000, aggregate amounts of future minimum payments under
operating leases for continuing operations were as follows:
2001--$36.5 million; 2002--$31.5 million; 2003--$20.0 million;
2004--$11.3 million; 2005--$7.3 million; 2006 and beyond--$7.9 million.
Rent expense for continuing operations was $26.8 million, $39.5 million and
$42.2 million, respectively, for the fiscal years ended September 30, 1998, 1999
and 2000. Rent expense for discontinued operations was $3.8 million,
$2.1 million and $1.0 million, respectively, for the fiscal years ended
September 30, 1998, 1999 and 2000.
6. STOCKHOLDERS' EQUITY
COMMON STOCK
The Company is prohibited from paying dividends on its common stock under
the terms of the Indenture and the Credit Agreement except under very limited
circumstances.
STOCK OPTION PLANS
The Company has stock option plans under which employees and non-employee
directors may be granted options to purchase shares of Company common stock at
the fair market value at the time of grant. Options generally vest over a period
of three to four years and expire 10 years from the date of grant. The Company's
stock option plan for employees also provides for the granting of performance
based stock awards.
Summarized information relative to the Company's stock option plans is as
follows:
FISCAL YEAR ENDED SEPTEMBER 30,
---------------------------------------------------------------------
1998 1999 2000
--------------------- --------------------- ---------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE
---------- -------- ---------- -------- ---------- --------
Balance, beginning of period.................. 4,122,109 $20.13 3,835,912 $22.23 4,406,882 $10.15
Granted....................................... 1,386,500 24.22 1,669,303 5.73 2,309,742 3.77
Canceled...................................... (1,082,331) 23.66 (1,050,067) 19.97 (1,336,719) 16.32
Exercised..................................... (590,366) 9.90 (48,266) 7.99 (800) 4.19
---------- ------ ---------- ------ ---------- ------
Balance, end of period........................ 3,835,912 $22.23 4,406,882 $10.15 5,379,105 $ 5.57
---------- ------ ---------- ------ ---------- ------
Exercisable, end of period.................... 2,375,919 $20.89 2,190,538 $13.74 2,020,049 $ 7.37
========== ====== ========== ====== ========== ======
At September 30, 2000, 1,159,150 shares were available for future grants
under the terms of these plans.
STOCK OPTION REPRICING
On November 17, 1998, the Company's Board of Directors approved the
repricing of stock options outstanding under the Company's existing stock option
plans (the "Stock Option Repricing"). Each holder
F-27
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
6. STOCKHOLDERS' EQUITY (CONTINUED)
of 10,000 or more stock options that was eligible to participate in the Stock
Option Repricing was required to forfeit a percentage of outstanding stock
options as follows:
- - Directors, including the Chief Executive Officer.......... 40%
- - Named Executive Officers.................................. 30%
- - Other holders of 50,000 or more stock options............. 25%
- - Other holders of 10,000-49,999 stock options.............. 15%
The Stock Option Repricing was consummated on December 8, 1998 based on the
fair value of the Company's common stock on such date. Approximately
2.0 million outstanding stock options were repriced to $8.406 and approximately
0.7 million outstanding stock options were cancelled as a result of the Stock
Option Repricing. Each participant in the Stock Option Repricing was precluded
from exercising vested repriced stock options until June 8, 1999.
STOCK OPTIONS OUTSTANDING
Summarized information relative to the Company's stock options outstanding
on September 30, 2000 is as follows:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
- ------------------------------------------------------------- --------------------
WEIGHTED
AVERAGE WEIGHTED WEIGHTED
RANGE OF REMAINING AVERAGE AVERAGE
EXERCISE CONTRACTUAL EXERCISE EXERCISE
PRICE OPTIONS LIFE (YEARS) PRICE OPTIONS PRICE
- ----------------------- --------- ------------ -------- --------- --------
$1.310 - $8.188 3,816,376 7.17 $4.40 741,524 $5.57
$8.406 1,517,729 6.29 8.41 1,263,524 8.41
$9.210 - $9.719 45,000 6.47 9.66 15,001 9.66
--------- ---- ----- --------- -----
5,379,105 6.92 $5.57 2,020,049 $7.37
========= ==== ===== ========= =====
EMPLOYEE STOCK PURCHASE PLANS
The 1997 Employee Stock Purchase Plan (the "1997 ESPP") covered shares of
common stock that could be purchased by eligible employees of the Company. The
1997 ESPP offering periods had a term not less than three months and not more
than 12 months. The first offering period under the 1997 ESPP began January 1,
1997 and the last offering period ended on or before December 31, 1999. The
option price of each offering period was the lesser of (i) 85% of the fair value
of a share of common stock on the first day of the offering period or (ii) 85%
of the fair value of a share of common stock on the last day of the offering
period.
F-28
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
6. STOCKHOLDERS' EQUITY (CONTINUED)
A summary of the 1997 ESPP is as follows:
OFFERING SHARES PURCHASE
PERIOD BEGAN ENDED PURCHASED PRICE
- --------------------- --------------- ----------------- --------- --------
1 January 2, 1997 June 30, 1997 73,410 $ 19.125
2 August 1, 1997 December 31, 1997 26,774 $ 19.125
3 January 1, 1998 June 30, 1998 43,800 $18.4875
4 July 1, 1998 December 31, 1998 163,234 $ 7.0125
5 January 1, 1999 June 30, 1999 152,570 $ 7.0125
6 July 1, 1999 December 31, 1999 185,079 $ 5.1531
The 2000 Employee Stock Purchase Plan (the "2000 ESPP") covers 1.2 million
shares of common stock that can be purchased by eligible employees of the
Company. The 2000 ESPP offering periods will have a term not less than three
months and not more than 12 months. The first offering period under the 2000
ESPP began January 1, 2000 and the last offering period will end on or before
December 31, 2003. The option price of each offering period will be the lesser
of (i) 85% of the fair value of a share of common stock on the first day of the
offering period or (ii) 85% of the fair value of a share of common stock on the
last day of the offering period.
A summary of the 2000 ESPP is as follows:
OFFERING SHARES PURCHASE
PERIOD BEGAN ENDED PURCHASED PRICE
- --------------------- --------------- ----------------- --------- --------
1 January 1, 2000 June 30, 2000 481,922 $1.0625
2 July 1, 2000 December 31, 2000 -- --
The number of options granted and the option price for the most recent
offering period will be determined on December 31, 2000 when the option price is
known.
RIGHTS PLAN
The Company adopted a share purchase rights plan in fiscal 1992 (the "Rights
Plan"). Pursuant to the Rights Plan, each share of common stock also represents
one share purchase right (collectively, the "Rights"). The Rights trade
automatically with the underlying shares of common stock. Upon becoming
exercisable, but prior to the occurrence of certain events, each Right initially
entitles its holder to buy one share of common stock from the Company at an
exercise price of $60.00. The Rights will be distributed and become exercisable
only if a person or group acquires, or announces its intention to acquire,
common stock exceeding certain levels, as specified in the Rights Plan. Upon the
occurrence of such events, the exercise price of each Right reduces to one-half
of the then current market price. The Rights also give the holder certain rights
in an acquiring company's common stock. The Company is entitled to redeem the
Rights at a price of $.01 per Right at any time prior to the distribution of the
Rights. The Rights have no voting power until exercised.
COMMON STOCK WARRANTS
The Company issued 114,690 warrants in fiscal 1992 which expire on June 30,
2002 (the "2002 Warrants") to purchase one share each of the Company's common
stock. The 2002 Warrants have an exercise price of $5.24 per share. During
fiscal 1998, 1,553 shares were issued upon the exercise of 2002 Warrants. At
September 30, 2000, 18,920 of the 2002 Warrants were outstanding.
The Company also has 146,791 warrants outstanding with an exercise price of
$38.70 per share which expire on September 1, 2006.
F-29
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
6. STOCKHOLDERS' EQUITY (CONTINUED)
Crescent and COI each have the right to purchase 1,283,311 shares of common
stock 2,566,622 shares in aggregate; collectively the "Crescent Warrants") at a
warrant exercise price of $30.00 per share (subject to adjustment pursuant to
antidilution provisions). The Crescent Warrants are exercisable at the following
times and in the following amounts:
DATE FIRST NUMBER OF SHARES OF END OF
EXERCISABLE COMMON STOCK ISSUABLE EXERCISE PERIOD
JUNE 17, UPON EXERCISE OF WARRANTS JUNE 17,
- --------------------- ------------------------- ---------------
1998 30,000 2001
1999 62,325 2002
2000 97,114 2003
2001 134,513 2004
2002 174,678 2005
2003 217,770 2006
2004 263,961 2007
2005 313,433 2008
2006 366,376 2009
2007 422,961 2009
2008 483,491 2009
Crescent's and COI's rights with respect to the Crescent Warrants are not
contingent on or subject to the satisfaction or completion of any obligation
that Crescent or COI may have to CBHS, or that CBHS may have to the Company, or
by any subordination of fees otherwise payable to the Company by CBHS.
The Crescent Warrants contain provisions relating to adjustments in the
number of shares covered by the Crescent Warrants and the warrant exercise price
in the event of stock splits, stock dividends, mergers, reorganizations and
similar transactions.
The Crescent Warrants were recorded at $25.0 million upon issuance, which
was their approximate fair value upon execution of the Warrant Purchase
Agreement in January 1997.
TREASURY STOCK TRANSACTIONS
During fiscal 1998, the Company repurchased an aggregate of 696,600 shares
of its common stock in the open market for approximately $14.4 million. Those
transactions were funded with cash on hand.
In January 1998, the Company issued an aggregate of 2,831,516 shares of
treasury stock to the then existing minority stockholders of Green Spring to
effect the Green Spring Minority Stockholder Conversion. See Note 2,
"Acquisitions and Joint Ventures."
F-30
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
6. STOCKHOLDERS' EQUITY (CONTINUED)
INCOME (LOSS) PER COMMON SHARE
The following table presents the components of weighted average common
shares outstanding and income (loss) per share from continuing operations (in
thousands, except per share data):
YEAR ENDED SEPTEMBER 30,
------------------------------
1998 1999 2000
-------- -------- --------
Numerator:
Income (loss) from continuing operations before
extraordinary items....................................... $(7,256) $23,786 $17,075
Less: preferred dividend requirement and amortization of
redeemable preferred stock issuance costs............... -- -- 3,802
------- ------- -------
Income (loss) from continuing operations available to common
stockholders--basic....................................... (7,256) 23,786 13,273
Add: presumed conversion of redeemable preferred stock.... -- -- --
------- ------- -------
Income (loss) from continuing operations available to common
stockholders--diluted..................................... $(7,256) $23,786 $13,273
======= ======= =======
Denominator:
Weighted average common shares outstanding -- basic......... 30,784 31,758 32,144
Common stock equivalents -- stock options................... -- 151 242
Common stock equivalents -- warrants........................ -- 7 --
Common stock equivalents -- redeemable Preferred Stock...... -- -- --
------- ------- -------
Weighted average common shares outstanding -- diluted....... 30,784 31,916 32,386
======= ======= =======
Income (loss) from continuing operations available to common
stockholders per common share:
Basic (basic numerator/basic denominator)................... $ (0.24) $ 0.75 $ 0.41
======= ======= =======
Diluted (diluted numerator/diluted denominator)............. $ (0.24) $ 0.75 $ 0.41
======= ======= =======
Conversion of redeemable preferred stock, and the redemption of the TPG series
"A" option (see Note 7--"Redeemable Preferred Stock") were not presumed
outstanding for fiscal 2000 due to their anti-dilutive effect.
Certain options and warrants to purchase shares of common stock which were
outstanding during fiscal 2000 were not included in the computation of diluted
EPS because of their anti-dilutive effect.
STOCK-BASED COMPENSATION
The Company discloses stock-based compensation under the requirements of
FAS 123. FAS 123 requires disclosure of pro forma net income and pro forma net
income per share as if the fair value-based method of accounting for stock
options had been applied in measuring compensation cost for stock-based awards.
F-31
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
6. STOCKHOLDERS' EQUITY (CONTINUED)
Reported and pro forma net income and net income per share amounts are set
forth below (in thousands, except per share data):
FISCAL YEAR ENDED
SEPTEMBER 30,
------------------------------
1998 1999 2000
-------- -------- --------
Reported:
Income (loss) from continuing operations before
extraordinary items..................................... $ (7,256) $23,786 $17,075
Net income (loss)......................................... (19,283) 4,688 (65,808)
Income (loss) per common share -- basic:
Income (loss) from continuing operations before
extraordinary items..................................... (0.24) 0.75 0.41
Net income (loss)......................................... (0.63) 0.15 (2.17)
Income (loss) per common share -- diluted:
Income (loss) from continuing operations before
extraordinary items..................................... (0.24) 0.75 0.41
Net income (loss)......................................... (0.63) 0.15 (2.15)
Pro Forma:
Income (loss) from continuing operations before
extraordinary items..................................... $(11,201) $16,763 $13,664
Net loss.................................................. (23,228) (2,335) (69,219)
Income (loss) per common share -- basic:
Income (loss) from continuing operations before
extraordinary items..................................... (0.36) 0.53 0.31
Net loss.................................................. (0.75) (0.07) (2.15)
Income (loss) per common share -- diluted:
Income (loss) from continuing operations before
extraordinary items..................................... (0.36) 0.53 0.31
Net loss.................................................. (0.75) (0.07) (2.14)
The fair values of the stock options and ESPP options granted were estimated
on the date of their grant using the Black-Scholes option pricing model based on
the following weighted average assumptions:
1998 1999 2000
-------- --------- --------
Risk-free interest rate.......................... 4.5% 5.8% 6.3%
Expected life.................................... 4 years 3.8 years 3 years
Expected volatility.............................. 50% 50% 85%
Expected dividend yield.......................... 0% 0% 0%
The weighted average fair value of options granted during fiscal 1998, 1999
and 2000 was $9.53, $2.21 and $1.83, respectively.
7. REDEEMABLE PREFERRED STOCK
TPG INVESTMENT. On December 5, 1999, the Company entered into a definitive
agreement to issue approximately $59.1 million of cumulative convertible
preferred stock to TPG Magellan, LLC, an affiliate of the investment firm Texas
Pacific Group ("TPG") (the "TPG Investment").
Pursuant to the agreement, TPG purchased approximately $59.1 million of the
Company's Series A Cumulative Convertible Preferred Stock (the "Series A
Preferred Stock") and an Option (the "Option") to purchase an additional
approximately $21.0 million of Series A Preferred Stock. Net proceeds from
F-32
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
7. REDEEMABLE PREFERRED STOCK (CONTINUED)
issuance of the Series A Preferred Stock were $54.0 million. Approximately 50%
of the net proceeds received from the issuance of the Series A Preferred Stock
was used to reduce debt outstanding under the Term Loan Facility (as defined)
with the remaining 50% of the proceeds being used for general corporate
purposes. The Series A Preferred Stock carries a dividend of 6.5% per annum,
payable in quarterly installments in cash or common stock, subject to certain
conditions. Dividends not paid in cash or common stock will accumulate. The
Series A Preferred Stock is convertible at any time into the Company's common
stock at a conversion price of $9.375 per share (which would result in
approximately 6.3 million shares of common stock if all of the currently issued
Series A Preferred Stock were to convert) and carries "as converted" voting
rights. The Company may, under certain circumstances, require the holders of the
Series A Preferred Stock to convert such stock into common stock. The Series A
Preferred Stock, plus accrued and unpaid dividends thereon, must be redeemed by
the Company on December 15, 2009. The Option may be exercised in whole or in
part at any time on or prior to June 15, 2002. The Company may, under certain
circumstances, require TPG to exercise the Option. The terms of the shares of
Series A Preferred Stock issuable pursuant to the Options are identical to the
terms of the shares of Series A Preferred Stock issued to TPG at the closing of
the TPG Investment.
TPG has three representatives on the Company's twelve-member Board of
Directors.
The TPG Investment is reflected under the caption "Redeemable preferred
stock" in the Company's condensed consolidated balance sheet as follows (in
thousands):
SEPTEMBER 30,
2000
-------------
Redeemable convertible preferred stock:
Series A -- stated value $1, 87 shares authorized, 59
shares issued and outstanding........................... $59,063
Series B -- stated value $1, 60 shares authorized, none
issued and outstanding.................................. --
Series C -- stated value $1, 60 shares authorized, none
issued and outstanding.................................. --
-------
59,063
Less: Fair value of Series A Option......................... (3,366)
-------
Total redeemable convertible preferred stock................ 55,697
Accretion and accumulated unpaid dividends on Series A
Preferred Stock........................................... 3,401
Fair value of Series A Option............................... 3,366
Issuance costs, net of amortization of $401................. (4,630)
-------
$57,834
=======
F-33
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
8. INCOME TAXES
The provision for income taxes related to continuing operations consisted of
the following (in thousands):
FISCAL YEAR ENDED SEPTEMBER 30,
---------------------------------
1998 1999 2000
--------- --------- ---------
Income taxes currently payable:
Federal......................................... $3,462 $ 555 $ 1,000
State........................................... 589 2,800 1,300
Foreign......................................... -- 500 500
Deferred income taxes:
Federal......................................... 1,611 23,294 9,068
State........................................... (424) 1,107 3,610
Foreign......................................... -- -- --
------ ------- -------
$5,238 $28,256 $15,478
====== ======= =======
A reconciliation of the Company's income tax provision (benefit) to that
computed by applying the statutory federal income tax rate is as follows (in
thousands):
FISCAL YEAR ENDED SEPTEMBER 30,
---------------------------------
1998 1999 2000
--------- --------- ---------
Income tax provision at federal statutory income tax rate... $ 727 $18,435 $11,433
State income taxes, net of federal income tax benefit....... 107 2,540 1,828
Non-deductable goodwill amortization........................ 5,680 9,383 8,883
IRS settlement-change in estimate........................... -- -- (9,091)
Other--net.................................................. (1,276) (2,102) 2,425
------- ------- -------
Income tax provision........................................ $ 5,238 $28,256 $15,478
======= ======= =======
As of September 30, 2000, the Company has estimated tax net operating loss
("NOL") carryforwards of approximately $537 million available to reduce future
federal taxable income. These NOL carryforwards expire in 2006 through 2020 and
are subject to examination by the Internal Revenue Service. In addition, the
Company also has estimated tax NOL carryforwards of approximately $125 million
available to reduce the federal taxable income of Merit and its subsidiaries.
These NOL carryforwards expire in 2009 through 2018 and are subject to
examination by the Internal Revenue Service. Further, these NOL carryforwards
are subject to limitations on the taxable income of Merit and its subsidiaries.
The Company has recorded a valuation allowance against the portion of the total
NOL deferred tax asset and certain other deferred tax assets, that in
management's opinion, are not likely to be recovered.
F-34
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
8. INCOME TAXES (CONTINUED)
Components of the net deferred income tax (assets) liabilities at
September 30, 1999 and 2000 are as follows (in thousands):
SEPTEMBER 30,
---------------------
1999 2000
--------- ---------
Deferred tax liabilities:
Property and depreciation........................... $ (2,060) $ (18,081)
Long-term debt and interest......................... (19,735) (8,476)
ESOP................................................ (12,968) (15,005)
Intangible assets................................... (11,332) --
Other............................................... (15,209) (17,069)
--------- ---------
Total deferred tax liabilities.................... (61,304) (58,631)
--------- ---------
Deferred tax assets:
Intangible assets................................... -- 19,764
Operating loss carryforwards........................ 254,696 264,627
Self-insurance reserves............................. 2,220 --
Discontinued operations liabilities................. 9,552 21,985
Other............................................... 51,953 18,995
--------- ---------
Total deferred tax assets........................... 318,421 325,371
--------- ---------
Valuation allowance................................. (165,460) (144,958)
--------- ---------
Deferred tax assets after valuation allowance....... 152,961 180,413
--------- ---------
Net deferred tax assets............................. $ 91,657 $ 121,782
========= =========
During fiscal 2000, the Company reached an agreement (the "Agreement") with
the Internal Revenue Service ("IRS") related to its federal income tax returns
for the fiscal years ended September 30, 1992 and 1993. The IRS had originally
proposed to disallow approximately $162 million of deductions related primarily
to interest expense in fiscal 1992. Under the Agreement, the Company will pay
approximately $1 million in taxes and interest to the IRS to resolve the
assessment relating to taxes due for these open years, although no concession
was made by either party as to the Company's ability to utilize these deductions
through NOL carryforwards. As a result of the Agreement, the Company recorded a
reduction in related reserves of approximately reversed $9.1 million, as a
change in estimate in the current year.
The Internal Revenue Service is currently examining Merit's income tax
returns for pre-acquisition periods. In management's opinion, adequate
provisions have been made for any adjustments which may result from these
examinations, including a potential reduction in the amount of NOL
carryforwards. The Company believes the examinations could result in a reduction
in NOL carryforwards available to offset future taxable income.
F-35
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
9. ACCRUED LIABILITIES
Accrued liabilities consist of the following (in thousands):
SEPTEMBER 30,
-------------------
1999 2000
-------- --------
Salaries, wages and other benefits...................... $ 22,318 $ 21,411
CHAMPUS Adjustments..................................... 51,784 22,603
Due to Providers........................................ 35,918 7,711
Other................................................... 99,776 123,973
-------- --------
$209,796 $175,698
======== ========
10. MANAGED CARE INTEGRATION COSTS AND SPECIAL CHARGES
INTEGRATION PLAN
During fiscal 1998, management committed the Company to a plan to combine
and integrate the operations of its behavioral managed care organizations
(BMCOs) and specialty managed care organizations (the "Integration Plan") that
resulted in the elimination of duplicative functions and standardized business
practices and information technology platforms. The Integration Plan resulted in
the elimination of approximately 1,000 positions during fiscal 1998 and fiscal
1999. Approximately 510 employees were involuntarily terminated pursuant to the
Integration Plan.
The employee groups of the BMCOs that were primarily affected include
executive management, finance, human resources, information systems and legal
personnel at the various BMCOs corporate headquarters and regional offices and
credentialing, claims processing, contracting and marketing personnel at various
operating locations.
The Integration Plan resulted in the closure of approximately 20 leased
facilities during fiscal 1998 and 1999.
The Company initially recorded approximately $21.3 million of liabilities
related to the Integration Plan, of which $12.4 million was recorded as part of
the Merit purchase price allocation and $8.9 million was recorded in the
statement of operations under "Managed care integration costs" in fiscal 1998.
During fiscal 1999, the Company recorded adjustments of approximately $(0.3)
million, net, to such liabilities, of which $(0.8) million was recorded as part
of the Merit purchase price allocation and $0.5 million was recorded in the
statement of operations under "Managed care integration costs." The Company may
record additional adjustments to such liabilities during the future periods
depending on changes in its ability to sublease closed offices.
F-36
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
10. MANAGED CARE INTEGRATION COSTS AND SPECIAL CHARGES (CONTINUED)
The following table provides a rollforward of liabilities resulting from the
Integration Plan (in thousands):
BALANCE BALANCE
SEPTEMBER 30, SEPTEMBER 30,
TYPE OF COST 1998 ADJUSTMENTS PAYMENTS 1999
- ------------ ------------- ----------- -------- -------------
Employee termination benefits.................. $ 6,190 $1,959 $(7,380) $ 769
Facility closing costs......................... 7,475 (2,071) (2,310) 3,094
Other.......................................... 169 (169) -- --
------- ------ ------- ------
$13,834 $ (281) $(9,690) $3,863
======= ====== ======= ======
BALANCE BALANCE
SEPTEMBER 30, SEPTEMBER 30,
TYPE OF COST 1999 ADJUSTMENTS PAYMENTS 2000
- ------------ ------------- ----------- -------- -------------
Employee termination benefits.................. $ 769 $151 $ (735) $ 185
Facility closing costs......................... 3,094 (151) (1,312) 1,631
------ ---- ------- ------
$3,863 $ -- $(2,047) $1,816
====== ==== ======= ======
OTHER INTEGRATION COSTS
The Integration Plan resulted in additional incremental costs that were
expensed as incurred in accordance with Emerging Issues Task Force Consensus
94-3, "Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)"
that are not described above and certain other charges. Other integration costs
include, but are not limited to, outside consultants, costs to relocate closed
office contents and long-lived asset impairments. Other integration costs are
reflected in the statement of operations under "Managed care integration costs".
During fiscal 1998, the Company incurred approximately $8.1 million, in
other integration costs, including long-lived asset impairments of approximately
$2.4 million, and outside consulting costs of approximately $4.1 million. The
asset impairments relate primarily to identifiable intangible assets and
leasehold improvements that no longer have value and have been written off as a
result of the Integration Plan.
During fiscal 1999, the Company incurred approximately $5.7 million in other
integration costs, primarily for outside consulting costs and employee and
office relocation costs.
SPECIAL CHARGES.
During fiscal 1999, the Company recorded special charges of approximately
$4.4 million related primarily to the loss on disposal of an office building,
executive severance and relocation of its corporate headquarters from Atlanta,
Georgia to Columbia, Maryland. In addition, during fiscal 2000 the Company
incurred special charges of $9.6 million related to: (i) the closure of certain
GPA offices, (ii) restructuring of the corporate function and certain behavioral
managed healthcare office sites, and (iii) net of the $1.9 million non-recurring
gain on the sale of the corporate aircraft. These charges resulted in
$5.9 million
F-37
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
10. MANAGED CARE INTEGRATION COSTS AND SPECIAL CHARGES (CONTINUED)
of accrued severance; $4.7 million of accrued lease termination costs and
$0.9 million of other exit costs at September 30, 2000.
The Company recorded a charge of approximately $15.8 million during fiscal
2000 related to the impairment of certain long-lived assets in accordance with
FAS 121. This amount is included in "Special charges" in the Company's
consolidated statements of operations for such periods and is related to the
goodwill, property and equipment and identifiable intangible assets of Group
Practice Affiliate ("GPA"), which is a component of the Company's behavioral
health business segment.
During the quarter ended September 30, 2000, GPA recorded operating losses
of $2.0 associated primarily with the termination or restructuring of various
customer contracts. These events and the resulting expectation of lower future
earnings and cash flows from GPA represent a change in circumstances with
respect to the business of GPA. The Company estimates that the future
undiscounted cash flows expected to be generated by GPA are insufficient to
fully recover the recorded cost of the GPA assets.
Accordingly, the Company adjusted the GPA assets to their estimated fair
value as of September 30, 2000. Based upon the circumstances described above,
the Company estimated that the fair value of the GPA assets was approximately
$2.1 million at September 30, 2000. This value reflects the Company's estimate
of the recoverable fair value of GPA's property and equipment through sale or
continued use.
11. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental cash flow information is as follows (in thousands):
YEAR ENDED SEPTEMBER 30,
-------------------------------
1998 1999 2000
--------- -------- --------
Income taxes paid, net of refunds received.................. $11,116 $ 347 $ 3,208
Interest paid, net of amounts capitalized................... 95,153 102,094 102,236
Non-cash Transactions:
Common Stock in Treasury issued in connection with the
purchase of the remaining 39% interest in Green Spring
Health Services, Inc.................................... 63,496 -- --
12. COMMITMENTS AND CONTINGENCIES
The Company is self-insured for a portion of its general and professional
liability risks. The reserves for self-insured general and professional
liability losses, including loss adjustment expenses, were included in reserve
for unpaid claims in the Company's balance sheet and were based on actuarial
estimates that were discounted at an average rate of 6% to their present value
based on the Company's historical claims experience adjusted for current
industry trends. These reserves related primarily to the professional liability
risks of the Company's healthcare provider segment prior to the Crescent
Transactions. The undiscounted amount of the reserve for unpaid claims at
September 30, 1998 was approximately $34.6 million. The carrying amount of
accrued medical malpractice claims was $26.2 million at September 30, 1998. The
reserve for unpaid claims was adjusted periodically as such claims matured, to
reflect changes in actuarial estimates based on actual experience. During fiscal
1998, the Company recorded reductions in malpractice claim reserves of
approximately $4.1 million, respectively, as a result of updated actuarial
F-38
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
12. COMMITMENTS AND CONTINGENCIES (CONTINUED)
estimates which is included in discontinued operations. This reduction resulted
primarily from updates to actuarial assumptions regarding the Company's expected
losses for more recent policy years. This revision was based on changes in
expected values of ultimate losses resulting from the Company's claim
experience, and increased reliance on such claim experience. On July 2, 1999,
the Company transferred its remaining medical malpractice claims portfolio (the
"Loss Portfolio Transfer") to a third-party insurer for approximately
$22.3 million. The Loss Portfolio Transfer was funded from assets restricted for
settlement of unpaid claims. The insurance limit obtained through the Loss
Portfolio Transfer for future medical malpractice claims is $26.3 million.
The healthcare industry is subject to numerous laws and regulations. The
subjects of such laws and regulations include, but are not limited to, matters
such as licensure, accreditation, government healthcare program participation
requirements, reimbursement for patient services, and Medicare and Medicaid
fraud and abuse. Recently, government activity has increased with respect to
investigations and/or allegations concerning possible violations of fraud and
abuse and false claims statutes and/or regulations by healthcare providers.
Entities that are found to have violated these laws and regulations may be
excluded from participating in government healthcare programs, subjected to
fines or penalties or required to repay amounts received from the government for
previously billed patient services. The Office of the Inspector General of the
Department of Health and Human Services and the United States Department of
Justice ("Department of Justice") and certain other governmental agencies are
currently conducting inquiries and/or investigations regarding the compliance by
the Company and certain of its subsidiaries with such laws and regulations.
Certain of the inquiries relate to the operations and business practices of the
Psychiatric Hospital Facilities prior to the consummation of the Crescent
Transactions in June 1997. The Department of Justice has indicated that its
inquiries are based on its belief that the federal government has certain civil
and administrative causes of action under the Civil False Claims Act, the Civil
Monetary Penalties Law, other federal statutes and the common law arising from
the participation in federal health benefit programs of CBHS psychiatric
facilities nationwide. The Department of Justice inquiries relate to the
following matters: (i) Medicare cost reports; (ii) Medicaid cost statements;
(iii) supplemental applications to CHAMPUS/TRICARE based on Medicare cost
reports; (iv) medical necessity of services to patients and admissions;
(v) failure to provide medically necessary treatment or admissions; and
(vi) submission of claims to government payors for inpatient and outpatient
psychiatric services. No amounts related to such proposed causes of action have
yet been specified. The Company cannot reasonably estimate the settlement
amount, if any, associated with the Department of Justice inquiries.
Accordingly, no reserve has been recorded related to this matter.
Five affiliated outpatient clinic providers that are participating providers
in the TennCare program asserted claims against Green Spring Health
Services, Inc., a wholly-owned subsidiary of the Company ("Green Spring") and
Premier Behavioral Systems of Tennessee, LLC, ("Premier") the joint venture that
contracts with the State of Tennessee to manage services under the TennCare
program and in which the Company holds a 50% interests alleging, that Premier
and Green Spring failed to pay the providers in accordance with their contracts.
The claims, allege losses in excess of $16 million in the aggregate and are
proceeding in five separate arbitrations. On December 8, the Chancery Court of
Davidson County, Tennessee entered a judgment confirming an arbitration award
against Premier and Green Spring in the amount of $3.7 million in favor of one
of the providers. The Court denied a motion by Premier and Green Spring to
vacate the arbitration award on grounds that the provider procured the award by
fraud and that the arbitrators exceeded their authority. Premier and Greenspring
believe that the Court's order was
F-39
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
12. COMMITMENTS AND CONTINGENCIES (CONTINUED)
erroneous and intend to pursue vigorously an appeal of this judgment. The other
arbitrations are at various stages of proceedings. Management intends to
rigorously defend these claims. The Company believes that adequate reserves have
been recorded with respect to any potential loss in these matters.
On or about August 4, 2000, the Company was served with a lawsuit filed by
Wachovia Bank, N.A. ("Wachovia") in the Court of Common Pleas of Richland
County, South Carolina seeking recovery under the indemnification provisions of
an Engagement Letter between South Carolina National Bank (now Wachovia) and the
Company and the ESOP Trust Agreement between South Carolina National Bank (now
Wachovia) and the Company for losses sustained in a settlement entered into by
Wachovia with the United States Department of Labor in connection with the
ESOP's purchase of stock of the Company while Wachovia served as ESOP Trustee.
Wachovia also alleges fraud, negligent misrepresentation and other claims and
asserts its losses exceed $30 million. While the claim is in its initial stage
and an outcome cannot be determined, the Company believes the claims of Wachovia
are without merit and is defending them vigorously.
On October 26, 2000, two class action complaints (the "Class Actions") were
filed against Magellan Health Services, Inc. and Magellan Behavioral
Health, Inc. (the "Defendants") in the United States District Court for the
Eastern District of Missouri under the Racketeer Influenced and Corrupt
Organizations Act ("RICO") and the Employment Retirement Income Security Act of
1974 ("ERISA"). The class representatives purport to bring the actions on behalf
of a nationwide class of individuals whose behavioral health benefits have been
provided, underwritten and/or arranged by the Defendants since 1996. The
complaints allege violations of RICO and ERISA arising out of the Defendants'
alleged misrepresentations with respect to and failure to disclose, its claims
practices, the extent of the benefits coverage and other matters that cause the
value of benefits to be less than the amount of premium paid claims practices.
The complaints seek unspecified compensatory damages, treble damages under RICO,
and an injunction barring the alleged improper claims practices, plus interest,
costs and attorneys' fees. While the claim is in the initial stages and an
outcome cannot be determined, the Company believes that the claims are without
merit and intends to defend them vigorously.
The Company is also subject to or party to other litigation, claims, and
civil suits, relating to its operations and business practices. Certain of the
Company's managed care litigation matters involve class action lawsuits, which
allege (i) the Company inappropriately denied and/or failed to authorize
benefits for mental health treatment under insurance policies with a customer of
the Company and (ii) a provider at a Company facility violated privacy rights of
certain patients. The Company is also subject to certain contingencies in
connection with the CBHS bankruptcy as discussed in Note 3. In the opinion of
management, the Company has recorded reserves that are adequate to cover
litigation, claims or assessments that have been or may be asserted against the
Company, and for which the outcome is probable and reasonably estimable, arising
out of such other litigation, claims and civil suits. Furthermore, management
believes that the resolution of such litigation, claims and civil suits will not
have a material adverse effect on the Company's financial position or results of
operations; however, there can be no assurance in this regard.
The Company provides mental health and substance abuse services, as a
subcontractor, to beneficiaries of CHAMPUS. The fixed monthly amounts that the
Company receives for medical costs under CHAMPUS contracts are subject to
retroactive adjustment ("CHAMPUS Adjustments") based upon actual healthcare
utilization during the period known as the "data collection period". The Company
has
F-40
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
12. COMMITMENTS AND CONTINGENCIES (CONTINUED)
recorded reserves of approximately $51.8 million and $22.6 million as of
September 30, 1999 and 2000, respectively, for CHAMPUS Adjustments. During the
first quarter of fiscal 2000, the Company reached a settlement agreement with a
contractor under one of its CHAMPUS contracts whereby the Company agreed to pay
approximately $38.1 million to the contractor during the quarter ended
December 31, 1999. The Company and the contractor under this CHAMPUS contract
are in the process of appealing the department of defense's retroactive
adjustment. While management believes that the present reserve for CHAMPUS
Adjustments is reasonable, ultimate settlement resulting from the adjustment and
available appeal process may vary from the amount provided.
13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Gerald L. McManis, a director of the Company, is the President of McManis
Associates, Inc. ("MAI"), a healthcare development and management consulting
firm. During fiscal 1998, MAI provided consulting services to the Company with
respect to the development of strategic plans and a review of the Company's
business processes. The Company incurred approximately $85,000 in fees for such
services and related expenses during fiscal 1998.
G. Fred DiBona, Jr., a director of the Company, is a Director and the
President and Chief Executive Officer of Independence Blue Cross ("IBC"), a
health insurance company.
IBC owned 16.67% of Green Spring prior to December 13, 1995. On
December 13, 1995, IBC sold 4.42% of its ownership interest in Green Spring to
the Company for $5,376,000 in cash. IBC had a cost basis of $3,288,000 in the
4.42% ownership interest sold to the Company. The Exchange Option described
previously gave IBC the right to exchange its ownership interest in Green Spring
for a maximum of 889,456 shares of Common Stock or $20,460,000 in subordinated
notes through December 13, 1998. IBC exercised its Exchange Option in
January 29, 1998 for Magellan Common Stock valued at approximately
$17.9 million.
IBC and its affiliated entities contract with the Company for provider
network, care management and medical review services pursuant to contractual
relationships. The Company recorded revenue of approximately $54.6 million,
$59.1 million and $58.8 million from IBC during fiscal 1998, 1999 and 2000,
respectively.
Darla D. Moore, a director of the Company since February 1996, is the spouse
of Richard E. Rainwater, Chairman of the Board of Crescent and one of the
largest stockholders of the Company. Because of her relationship to
Mr. Rainwater, Ms. Moore did not participate in any Board action taken with
respect to the Crescent Transactions.
Approximately 30% of the voting interest in Vivra was owned by TPG at the
time of the Company's acquisition of Vivra.
14. BUSINESS SEGMENT INFORMATION
The Company operates through two reportable business segments engaging in
the behavioral managed healthcare business and the human services business. The
behavioral managed healthcare segment provides behavioral managed care services
to health plans, insurance companies, corporations, labor unions and various
governmental agencies. The human services segment provides therapeutic foster
care
F-41
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
14. BUSINESS SEGMENT INFORMATION (CONTINUED)
services and residential and day services to individuals with acquired brain
injuries and for individuals with mental retardation and developmental
disabilities.
The accounting policies of the segments are the same as those described in
the summary of significant accounting policies. The Company evaluates
performance of its segments based on profit or loss from continuing operations
before depreciation, amortization, interest, net, stock option expense (credit),
managed care integration costs, special charges, net, income taxes and minority
interest ("Segment Profit"). Intersegment sales and transfers are not
significant.
The following tables summarize, for the periods indicated, operating results
and other financial information, by business segment (in thousands):
BEHAVIORAL CORPORATE
MANAGED OVERHEAD AND
HEALTHCARE HUMAN SERVICES OTHER CONSOLIDATED
---------- -------------- ------------ ------------
1998
Net revenue................................ $1,026,243 $141,031 $ -- $1,167,274
Segment profit (loss)...................... 137,192 15,492 (15,866) 136,818
Equity in earnings of unconsolidated
subsidiaries............................. 12,795 -- -- 12,795
Investment in unconsolidated
subsidiaries............................. 10,125 -- 941 11,066
Capital expenditures....................... 27,535 8,391 8,287 44,213
Total assets............................... $1,356,259 $119,356 $441,473 $1,917,088
1999
Net revenue................................ $1,483,202 $191,277 $ -- $1,674,479
Segment Profit (loss)...................... 218,253 21,728 (13,939) 226,042
Equity in earnings of unconsolidated
subsidiaries............................. 20,442 -- -- 20,442
Investment in unconsolidated
subsidiaries............................. 18,396 -- -- 18,396
Capital expenditures....................... 37,487 5,779 4,853 48,119
Total assets............................... $1,472,539 $127,348 $281,728 $1,881,615
2000
Net revenue................................ $1,655,101 $218,453 $ -- $1,873,554
Segment Profit (loss)...................... 221,931 22,119 (13,286) 230,764
Equity in earnings of unconsolidated
subsidiaries............................. 9,792 -- -- 9,792
Investment in unconsolidated
subsidiaries............................. 12,746 -- -- 12,746
Capital expenditures....................... 26,550 7,153 3,221 36,924
Total assets............................... $1,471,937 $135,685 $196,165 $1,803,787
The following tables reconcile segment profit to consolidated income from
continuing operations before income taxes, minority interest and extraordinary
items:
F-42
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
14. BUSINESS SEGMENT INFORMATION (CONTINUED)
1998
Segment profit.............................................. $136,818
Depreciation and amortization............................... (46,898)
Interest, net............................................... (76,505)
Stock option credit......................................... 5,623
Managed care integration costs.............................. (16,962)
--------
Income from continuing operations before income taxes,
minority interest and extraordinary items................. $ 2,076
========
1999
Segment Profit.............................................. $226,042
Depreciation and amortization............................... (68,921)
Interest, net............................................... (93,752)
Stock option expense........................................ (18)
Managed care integration costs.............................. (6,238)
Special charges............................................. (4,441)
--------
Income from continuing operations before income taxes,
minority interest and extraordinary items................. $ 52,672
========
2000
Segment Profit.............................................. $230,764
Depreciation and amortization............................... (75,413)
Interest, net............................................... (97,286)
Special charges............................................. (25,398)
--------
Income from continuing operations before income taxes,
minority interest and extraordinary items................. $ 32,667
========
Revenue generated and long-lived assets located in foreign countries are not
material. Revenues from two customers of the Company's behavioral managed
healthcare segment each represented approximately $284 million and $227 million
of the Company's consolidated revenues for fiscal 2000 and $235 million and
$214 million of the Company's consolidated revenues for fiscal 1999. In fiscal
1998, approximately $154 million in revenues were derived from one contract.
F-43
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of the unaudited quarterly results of operations
for the years ended September 30, 1999 and 2000.
FOR THE QUARTER ENDED
---------------------------------------------------
DECEMBER 31, MARCH 31, JUNE 30, SEPTEMBER 30,
1999 2000 2000 2000
------------ --------- -------- -------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
FISCAL 2000
Net Revenue...................................... $436,969 $466,200 $479,174 $491,211
-------- -------- -------- --------
Cost and expenses:
Salaries, cost of care and other operating
expenses..................................... 383,724 413,611 422,409 432,838
Equity in earnings of unconsolidated
subsidiaries................................. (3,474) (2,908) (2,465) (945)
Depreciation and amortization.................. 18,268 18,509 19,171 19,465
Interest, net.................................. 23,991 24,254 23,956 25,085
Special charges, net........................... -- -- -- 25,398
-------- -------- -------- --------
422,509 453,466 463,071 501,841
-------- -------- -------- --------
Income (loss) from continuing operations before
income taxes and minority interest............. 14,460 12,734 16,103 (10,630)
Provision for income taxes....................... 7,240 3,244 8,653 (3,659)
-------- -------- -------- --------
Income (loss) from continuing operations before
minority interest.............................. 7,220 9,490 7,450 (6,971)
Minority interest................................ 142 (111) 74 9
-------- -------- -------- --------
Income (loss) from continuing operations......... 7,078 9,601 7,376 (6,980)
Discontinued operations:
Income (loss) from discontinued operations..... (4,412) (55,137) (2,418) (3,254)
Loss on disposal of discontinued operations.... -- -- -- (17,662)
-------- -------- -------- --------
(4,412) (55,137) (2,418) (20,916)
-------- -------- -------- --------
Net income (loss)................................ 2,666 (45,536) 4,958 (27,896)
Preferred dividend requirement and amortization
of redeemable preferred stock issuance costs... 216 1,088 1,195 1,303
-------- -------- -------- --------
Income (loss) available to common stockholders... $ 2,450 $(46,624) $ 3,763 $(29,199)
======== ======== ======== ========
Weighted average number of shares outstanding
-- basic..................................... 31,980 32,058 32,166 32,368
======== ======== ======== ========
Weighted average number of shares outstanding
-- diluted................................... 33,324 38,589 38,878 32,368
======== ======== ======== ========
Income (loss) per share available to common
stockholders -- basic
Income from continuing operations.............. $ 0.22 $ 0.27 $ 0.19 $ (0.26)
======== ======== ======== ========
Income (loss) from discontinued operations..... $ (0.14) $ (1.72) $ (0.07) $ (0.64)
======== ======== ======== ========
Net income (loss)................................ $ 0.08 $ (1.45) $ 0.12 $ (0.90)
======== ======== ======== ========
Income (loss) per common share available to
common stockholders -- diluted:
Income from continuing operations.............. $ 0.21 $ 0.25 $ 0.19 $ (0.26)
======== ======== ======== ========
Income (loss) from discontinued operations..... $ (0.13) $ (1.43) $ (0.06) $ (0.64)
======== ======== ======== ========
Net income (loss)................................ $ 0.08 $ (1.18) $ 0.13 $ (0.90)
======== ======== ======== ========
F-44
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000
15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (CONTINUED)
FOR THE QUARTER ENDED
---------------------------------------------------
DECEMBER 31, MARCH 31, JUNE 30, SEPTEMBER 30,
1998 1999 1999 1999
------------ --------- -------- -------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
FISCAL 1999
Net Revenue..................................... $402,290 $429,342 $418,680 $424,167
-------- -------- -------- --------
Cost and expenses:
Salaries, cost of care and other operating
expenses.................................... 351,688 380,208 368,371 368,612
Equity in earnings of unconsolidated
subsidiaries................................ (3,783) (6,262) (8,196) (2,201)
Depreciation and amortization................. 16,567 16,690 18,701 16,963
Interest, net................................. 24,122 24,229 22,662 22,739
Stock option expense.......................... 12 6 -- --
Managed care integration costs................ 1,750 2,119 522 1,847
Special charges, net.......................... 1,084 2,252 -- 1,105
-------- -------- -------- --------
391,440 419,242 402,060 409,065
-------- -------- -------- --------
Income from continuing operations before income
taxes and minority interest................... 10,850 10,100 16,620 15,102
Provision for income taxes...................... 6,127 5,847 8,444 7,838
-------- -------- -------- --------
Income from continuing operations before
minority interest............................. 4,723 4,253 8,176 7,264
Minority interest............................... 410 (34) 189 65
-------- -------- -------- --------
Income from continuing operations............... 4,313 4,287 7,987 7,199
Discontinued operations:
Income (loss) from discontinued operations.... (132) (330) 13,512 15,275
Loss on Disposal of discontinued operations... -- -- -- (47,423)
-------- -------- -------- --------
(132) (330) 13,512 (32,148)
-------- -------- -------- --------
Net income (loss)............................... 4,181 3,957 21,499 (24,949)
Preferred dividend requirement and amortization
of redeemable preferred stock issuance
costs......................................... -- -- -- --
-------- -------- -------- --------
Income (loss) available to common
stockholders.................................. $ 4,181 $ 3,957 $ 21,499 $(24,949)
======== ======== ======== ========
Weighted average number of shares
outstanding-basic............................. 31,613 31,741 31,778 31,850
======== ======== ======== ========
Weighted average number of shares outstanding-
diluted....................................... 31,660 31,751 32,041 32,200
======== ======== ======== ========
Income (loss) per common share available to
common stockholders -- basic:
Income from continuing operations............. $ 0.14 $ 0.13 $ 0.25 $ 0.23
======== ======== ======== ========
Income (loss) from discontinued operations.... $ (0.01) $ (0.01) $ 0.43 $ (1.01)
======== ======== ======== ========
Net income (loss)............................... $ 0.13 $ 0.12 $ 0.68 $ (0.78)
======== ======== ======== ========
Income (loss) per common share available to
common stockholders -- diluted:
Income from continuing operations............. $ 0.14 $ 0.13 $ 0.25 $ 0.22
======== ======== ======== ========
Income (loss) from discontinued operations.... $ (0.01) $ (0.01) $ 0.42 $ (1.00)
======== ======== ======== ========
Net income (loss)............................... $ 0.13 $ 0.12 $ 0.67 $ (0.78)
======== ======== ======== ========
F-45
MAGELLAN HEALTH SERVICES, INC.
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)
CHARGED TO
BALANCE AT CHARGED TO OTHER
BEGINNING OF COSTS AND ACCOUNTS-- DEDUCTIONS-- BALANCE AT
CLASSIFICATION PERIOD EXPENSES DESCRIBE DESCRIBE END OF PERIOD
- -------------- ------------ ---------- ---------- ------------ -------------
Fiscal year ended
September 30, 1998:
Allowance for doubtful $15,031(A) $24,440(B)
accounts.............. $40,311 $ 4,977(D) 4,376(C) 5,388(F) $34,867
------- ------- ------- ------- -------
$40,311 $ 4,977 $19,407 $29,828 $34,867
======= ======= ======= ======= =======
Fiscal year ended
September 30, 1999:
$ 1,280(B)
Allowance for doubtful $ 3,277(D) $ 2,362(A) 672(F)
accounts.............. $34,867 (8,072)(E) 604(C) 2,649(H) $28,437
------- ------- ------- ------- -------
$34,867 $(4,795) $ 2,966 $ 4,601 $28,437
======= ======= ======= ======= =======
Fiscal year ended
September 30, 2000:
Allowance for doubtful $ 3,355(B)
accounts.............. $28,437 $ 8,651(D) $ 494(A) 22,635(C) $11,592
------- ------- ------- ------- -------
$28,437 $ 8,651 $ 494 $25,990 $11,592
======= ======= ======= ======= =======
- ------------------------
(A) Recoveries of accounts receivable previously written off.
(B) Accounts written off.
(C) Allowance for doubtful accounts (net) assumed or disposed of in acquisitions
or dispositions.
(D) Bad debt expense.
(E) Accounts receivable collection fees included in loss on Crescent
Transactions.
(F) Accounts receivable collection fees payable to CBHS and outside vendors.
(G) Amounts reclassified to contractual allowances.
(H) Conversion of Provider JVs from consolidation to equity method.
S-1