Back to GetFilings.com

Use these links to rapidly review the document
TABLE OF CONTENTS

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the Quarterly Period Ended June 30, 2002

or

For the transition period from                              to                             

Commission File No. 1-6639

MAGELLAN HEALTH SERVICES, INC.
(Exact name of registrant as specified in its charter)

(410) 953-1000
(Registrant's telephone number, including area code)

        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 ý No o

        The number of shares of the registrant's common stock outstanding as of July 31, 2002 was 35,138,686.

FORM 10-Q
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
INDEX

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)

The accompanying notes to Unaudited Condensed Consolidated Financial Statements
are an integral part of these statements.

3

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share amounts)

(1)

Net of income tax provision of $218 and $920 for the three months ended June 30, 2001 and 2002, respectively, and $3,464 and $1,556 for the nine months ended June 30, 2001 and 2002, respectively.

(2)

Net of income tax provision (benefit) of $1,457 and $(422) for the three months ended June 30, 2001 and 2002, respectively, and $10,761 and $129 for the nine months ended June 30, 2001 and 2002, respectively.

The accompanying notes to Unaudited Condensed Consolidated Financial Statements
are an integral part of these statements.

4

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)

The accompanying notes to Unaudited Condensed Consolidated Financial Statements
are an integral part of these statements.

5

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2002
(Unaudited)

NOTE A—Summary of Significant Accounting Policies

Basis of Presentation

        The accompanying unaudited condensed consolidated financial statements of Magellan Health Services, Inc. and subsidiaries ("Magellan" or the "Company") have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments considered necessary for a fair presentation, have been included.

        All references to fiscal years contained herein refer to periods of twelve consecutive months ending on September 30. Certain reclassifications have been made to fiscal 2001 amounts to conform to fiscal 2002 presentation.

        These financial statements should be read in conjunction with the Company's audited consolidated financial statements for the fiscal year ended September 30, 2001 and the notes thereto, which are included in the Company's Annual Report on Form 10-K/A.

Segments

        The Company operates in the managed behavioral healthcare business, which it has divided into four reporting segments based on the types of services it provides and customers that it serves. The four segments of the Company are as follows: (i) Health Plan Solutions Group ("Health Plans"); (ii) Workplace Group ("Workplace"); (iii) Public Solutions Group ("Public"); and (iv) Corporate and Other. These segments are described in further detail in Note K—"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 comprised 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. On January 18, 2001, the Company's Board of Directors approved and the Company entered into a definitive agreement for the sale of National Mentor, Inc. ("Mentor"), which represented the business and interest that comprised the Company's human services business segment. On March 9, 2001, the Company consummated the sale of the stock of Mentor. As discussed in Note H—"Discontinued Operations", the results of operations of the healthcare provider, healthcare franchising, specialty managed healthcare and human services business segments have been reported in the accompanying unaudited condensed consolidated statements of operations as discontinued operations for all periods presented.

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. Significant estimates of the Company include, among other things, accounts receivable realizability, valuation allowances for deferred tax assets, valuation of goodwill and other intangible assets, medical claims payable and legal liabilities. Actual results could differ from those estimates.

6

Managed Care Revenue

        Managed care revenue is recognized over the applicable coverage period on a per member basis for covered members. Managed care risk revenues, including revenues from the Company's TRICARE contracts, earned for the three months ended June 30, 2001 and 2002 approximated $376.5 million and $383.6 million, respectively, and approximated $1,159.4 million and $1,153.0 million for the nine months ended June 30, 2001 and 2002, respectively.

        The Company has the ability to earn performance-based revenue, primarily under certain non-risk contracts. Performance-based revenue generally is based on the ability of the Company to manage care for its administrative services only ("ASO") clients below specified targets. For each such contract, the Company estimates and records performance-based revenue after considering the relevant contractual terms and the data available for the performance-based revenue calculation. Pro-rata performance-based revenue is recognized on a quarterly reporting basis during the term of the contract pursuant to the rights and obligations of each party upon termination of the contracts. The Company recognized performance revenue of approximately $5.3 million and $4.3 million during the three months ended June 30, 2001 and 2002, respectively, and approximately $19.0 million and $11.7 million during the nine months ended June 30, 2001 and 2002, respectively.

        The Company provides mental health and substance abuse services to the beneficiaries of TRICARE, formerly the Civilian Health and Medical Program of the Uniformed Services ("CHAMPUS"), under two separate subcontracts with health plans that contract with TRICARE. The Company receives fixed fees for the management of the services, which are subject to certain bid-price adjustments ("BPAs"). The BPAs are calculated in accordance with contractual provisions and are based on actual healthcare utilization from historical periods as well as changes in certain factors during the contract period. The Company has information to record, on a quarterly basis, reasonable estimates of the BPAs as part of its managed care risk revenues. These estimates are based upon information available on a quarterly basis from both the TRICARE program and the Company's information systems. Under the contract, the Company settles the BPAs at set intervals over the term of the contracts.

        The Company recorded estimated liabilities of approximately $3.8 million and $0.9 million as of September 30, 2001 and June 30, 2002, respectively, based upon the Company's interim calculations of the estimated BPAs. Such liabilities were recorded as deductions from revenues. While management believes that the estimated liabilities for TRICARE adjustments are adequate, ultimate settlement resulting from adjustments and available appeal processes may vary from the amounts provided.

        Prior to fiscal 2001, the Company and its contractors under its TRICARE contracts filed joint appeals regarding incorrect data provided and contractual issues related to the initial bidding process. These contingent claims were settled in fiscal 2001, resulting in the Company recording approximately $30.3 million in additional revenues in the nine month period ended June 30, 2001.

Significant Customers

        Net revenues from two of the Company's customers each exceeded 10% of consolidated net revenues in each of the three and nine month periods ended June 30, 2001 and 2002, respectively. Net revenue from the State of Tennessee's TennCare program approximated $63.2 million and $59.6 million of consolidated net revenues for the three months ended June 30, 2001 and 2002, respectively, and $184.6 million and $174.5 million of consolidated net revenues for the nine months ended June 30, 2001 and 2002, respectively. Net revenue from Aetna, Inc. ("Aetna") approximated $79.8 million and $55.8 million of consolidated net revenues for the three months ended June 30, 2001 and 2002, respectively, and $238.4 million and $195.9 million of consolidated net revenues for the nine months ended June 30, 2001 and 2002, respectively. The declines in Aetna revenues were mainly due to decreased membership as a result of Aetna intentionally reducing its membership levels during the year

7

in an effort to exit less profitable businesses. Aetna has announced its expectation that its membership may be further reduced during the remainder of calendar year 2002. The Company is not fully aware of which members Aetna anticipates will terminate in the future, if any, or which products such members currently receive. Therefore, the Company cannot reasonably estimate the amount by which revenue will be further reduced as a result of the membership reduction.

Property and Equipment

        In the first quarter of fiscal 2002, the Company approved and implemented a plan to consolidate the Company's information systems. As a result of this plan, the Company reduced the remaining estimated useful life of certain capitalized internal use claims processing software to eighteen months. In addition, management also reevaluated the estimated useful lives of certain other computer software and hardware, and reduced the estimated useful lives from five to three years. At the end of the second quarter of fiscal 2002, the Company appoved a plan to further accelerate the consolidation of certain information systems. As a result of this plan, the Company reduced, as of April 1, 2002, the remaining useful lives of certain other information systems to periods ranging from 12-24 months. The net book value of assets affected by these changes in useful lives at June 30, 2002 was $14.7 million.

        These changes resulted in increased depreciation of these assets on a prospective basis. The effect of these changes in useful lives was to increase depreciation expense for the three and nine month periods ended June 30, 2002 by $1.8 million and $4.2 million, respectively, and to reduce net income for the three and nine month periods ended June 30, 2002 by $1.1 million and $2.5 million, respectively, or $0.03 and $0.07 per diluted share. The Company expects to incur incremental depreciation expense of $1.8 million related to these changes in useful lives in the fourth quarter of fiscal 2002.

Goodwill and Other Intangible Assets

        In the first quarter of fiscal 2002, the Company early adopted Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards No. 142 "Goodwill and Other Intangible Assets" ("SFAS 142"). Under SFAS 142, the Company will no longer amortize goodwill over its estimated useful life. SFAS 142 also requires the Company to allocate goodwill to its identifiable reporting units (as defined) and test for impairment based upon fair values on an annual basis.

        In accordance with the early adoption of SFAS 142, the Company must perform an initial impairment test as of October 1, 2001. Accordingly, the Company has completed the first phase of the goodwill impairment test and has determined that the allocated book value of its Workplace segment exceeds its fair value. Therefore, the Company plans to proceed with the second phase of the impairment test, which is the measurement of the potential loss. The Company will record any impairment charge as a change in accounting principle, separate from operating results. The Company expects to complete its analyses and record the impact of the change in accounting principle no later than September 30, 2002. The Company will perform its annual impairment test as of July 1, 2002, during the Company's fiscal quarter ending September 30, 2002.

        Adoption of SFAS 142 resulted in the Company not recording approximately $7.8 million and $23.4 million of amortization expense during the three months and nine months ended June 30, 2002, respectively. Had the Company adopted SFAS 142 effective October 1, 2000, the Company would not have recorded approximately $7.5 million and $22.2 million of amortization expense during the three months and nine months ended June 30, 2001, respectively. The following table summarizes the

8

proforma effects on the three months and nine months ended June 30, 2001 had SFAS 142 been adopted October 1, 2000.

Income Taxes

        The Company's effective income tax rate approximated 54.9% and 43.5% for the three months ended June 30, 2001 and 2002, respectively, and 50.5% and 41.7% for the nine months ended June 30, 2001 and 2002, respectively. The effective rates for the current year periods exceed federal statutory rates primarily due to state income tax provision. The prior year periods are also impacted by non-deductible goodwill amortization resulting primarily from acquisitions.

NOTE B—Supplemental Cash Flow Information

        Below is supplemental cash flow information related to the nine months ended June 30, 2001 and 2002 (in thousands):

NOTE C—Goodwill and Other Intangible Assets, Net

Goodwill

        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 not amortized in accordance with SFAS 142. See Note A—"Summary of Significant Accounting Policies—Goodwill and Other Intangible Assets." The Company's goodwill was approximately $1,033.3 million and $1,126.0 million at September 30, 2001 and June 30, 2002, respectively. During the first quarter of fiscal 2002, the Company reclassified certain workforce intangible assets to goodwill as part of adopting SFAS 142. The Company also identified $35.1 million associated with a portion of the contingent purchase price payments related to the acquisition of Human Affairs International ("HAI") which was previously capitalized as intangible assets and should have been capitalized as goodwill. These amounts were reclassified to goodwill during the first quarter of fiscal 2002. The classification of these amounts did not have a material impact on any reporting period.

        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 purchase price payments to Aetna which may total up to $60.0 million annually over the five-year period subsequent to closing. The Company paid $60.0 million to Aetna for each of the first four years

9

subsequent to closing, including $60 million paid in each of fiscal years 2001 and 2002, and has accrued the final payment in June 2002.

Other Intangible Assets, Net

        Intangible assets acquired were identified at the time of acquisition and were valued based upon independent appraisals at that time. The following is a summary of acquired intangibles, the estimated useful life and the net book value at June 30, 2002 (in thousands):

        Amortization expense for the three months and nine months ended June 30, 2002 was $2.4 million and $7.2 million, respectively.

        Deferred financing costs, which were previously classified as intangible assets, have been reclassified by the Company into other long term assets at September 30, 2001 and June 30, 2002.

NOTE D—Long-Term Debt and Capital Lease Obligations

        Information with regard to the Company's long-term debt and capital lease obligations at September 30, 2001 and June 30, 2002 is as follows (in thousands):

        The Credit Agreement, as amended, provides for a Term Loan Facility in an original aggregate principal amount of $550.0 million, and a Revolving Facility providing for revolving loans to the Company and the issuance of letters of credit for the account of the Company and its subsidiaries in an aggregate principal amount (including the aggregate stated amount of letters of credit) of $150.0 million. Letters of credit outstanding were $51.2 million at June 30, 2002. The Revolving Facility matures on February 12, 2004. Subsequent to June 30, 2002, the Company borrowed $30.0 million under the Revolving Facility, leaving a total outstanding balance for the Revolving Facility of $45.0 million as of August 13, 2002.

10

        The Credit Agreement imposes restrictions on the Company's ability to make capital expenditures, and the Credit Agreement, the Subordinated Notes Indenture and the Senior Notes Indenture limit the Company's ability to incur additional indebtedness. These restrictions, together with the highly leveraged financial condition of the Company, may adversely affect the Company's ability to finance its future operations or capital needs or engage in other business activities that may be in its interest. 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 for the 9.0% Senior Subordinated Notes due fiscal 2008 (the "Subordinated Notes") and the indenture for the Senior Notes), 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.

        The Credit Agreement also requires the Company to comply with specified financial ratios and tests, including a minimum interest coverage ratio, a maximum leverage ratio, and a maximum senior debt ratio. The breach of any such covenants, ratios or tests could result in a default under the Credit Agreement which then could result in a default under the Senior Notes Indenture or the Subordinated Notes Indenture, which defaults would permit the lenders under the Credit Agreement, and in certain circumstances the holders of the Senior Notes or Subordinated Notes, to declare all amounts outstanding under those agreements to be immediately due and payable, together with accrued and unpaid interest. Management estimates that the Company will not be in compliance with one or more of its financial covenants, as amended, as of September 30, 2002 and beyond. Management is evaluating certain alternatives to alleviate this issue, including further amendments to the Credit Agreement or refinancing amounts outstanding under the Credit Agreement. There can be no assurance that management will be able to successfully implement such alternatives. If the Company is unable to implement such alternatives at sufficient financing levels, the Company would not have the liquidity necessary to repay any debt that was so accelerated, and the Company's ability to obtain liquidity required for its operations would be uncertain. The Company's auditors have informed management that if the Company is unable to sufficiently remediate its anticipated non-compliance with debt covenants, the auditors expect to issue a going concern modification within the auditor's report on the September 30, 2002 financial statements.

        In fiscal 2001, the Company issued $250.0 million of 9.375% Senior Notes which mature on November 15, 2007 and are general senior unsecured obligations of the Company. Interest on the Senior Notes is payable semi-annually on each May 15 and November 15, commencing on November 15, 2001. The Senior Notes were issued as unregistered securities and were required to be exchanged for securities registered with the Securities and Exchange Commission by January 25, 2002. The Company has not registered and/or exchanged the Senior Notes by the required dates and therefore is subject to penalty interest. Penalty interest is calculated at the rate of $0.192 per week per $1,000 principal amount of the Senior Notes, which approximates $48,000 per week, until such time as the Senior Notes are exchanged. During the nine months ended June 30, 2002, the Company incurred approximately $1.3 million in penalty interest, of which $0.9 million has been paid as of June 30, 2002.

NOTE E—Accrued Liabilities

        Accrued liabilities consist of the following (in thousands):

11

NOTE F—Income per Common Share

        The following tables reconcile income (numerator) and shares (denominator) used in the Company's computations of income from continuing operations per common share (in thousands):

        Conversion of the redeemable preferred stock (see Note L—"Redeemable Preferred Stock") was presumed for the nine months ended June 30, 2001. Conversion of the redeemable preferred stock was not presumed for the three months ended June 30, 2001 and 2002, and for the nine months ended June 30, 2002, due to the anti-dilutive effect. In addition, accrued dividends on redeemable preferred stock, which were payable in cash or common stock as of June 30, 2001, were payable only in cash at June 30, 2002. Certain stock options and warrants which were outstanding during the three months and nine months ended June 30, 2001 and 2002, were not included in the computation of diluted earnings per share because of their anti-dilutive effect.

NOTE G—Investments in Unconsolidated Subsidiaries

        Choice Behavioral Health Partnership.    The Company is a 50% partner in Choice Behavioral Health Partnership ("Choice"), a general partnership, with Value Options, Inc. Choice is a managed behavioral healthcare company which derives all of its revenues from a subcontract with a health plan that contracts with TRICARE. The original term of the contract was for the 12 month option period ended June 30, 1997, with an additional option period available for contract extensions at the discretion of TRICARE. The fifth option period extended through June 30, 2001; however, during 2000 Choice received notification that two additional option periods were added to the contract, extending it to

12

June 30, 2003. Choice's future results may be unfavorably affected if it is unable to extend the contract beyond June 30, 2003 and/or maintain adequate reimbursement rates. The Company accounts for its investment in Choice using the equity method.

        A summary of unaudited financial information for the Company's investment in Choice is as follows (in thousands):

        Choice's subcontract with respect to TRICARE has similar provisions as the Company's TRICARE arrangements (See Note A—"Summary of Significant Accounting Policies"). During the second quarter of fiscal 2001, Choice and its contractor agreed to a settlement of a joint appeal regarding incorrect data provided and contractual issues related to the initial bidding process, resulting in Choice receiving approximately $50.0 million. As a result, net revenue for Choice for the nine months ended June 30, 2001 includes $45.9 million related to the settlement of this contingent claim and the Company's equity in earnings of Choice benefited by 50% of such settlement revenue. Approximately $2.8 million of the $50.0 million settlement is recorded as deferred revenue at June 30, 2002 and will be fully recognized by June 2003, based on the terms of the settlement.

        Premier Behavioral Systems, LLC.    The Company owns a 50% interest in Premier Behavioral Systems, LLC ("Premier"). Premier was formed to manage behavioral healthcare benefits for the State of Tennessee's TennCare program. The Company accounts for its investment in Premier using the equity method. The Company's investment in Premier at September 30, 2001 and June 30, 2002 was $5.6 million and $1.8 million, respectively. The Company's equity in earnings (loss) of Premier for the three months ended June 30, 2001 and 2002 was $0.1 million and $(4.2) million, respectively, and for the nine months ended June 30, 2001 and 2002 was $(1.7) million and $(3.8) million, respectively. The Company has not received a partnership distribution from Premier in any period presented. In May 2002, the Company signed a new contract with the State of Tennessee under which the Company will provide all services under the TennCare program through a direct contract. The new TennCare contract covers the period from July 1, 2002 through December 31, 2003. Premier was to cease providing services upon the expiration of its contract on June 30, 2002, however the State of Tennessee

13

has delayed the transfer of Premier's TennCare membership to the Company pending the State's clarification of certain matters regarding the membership transfer. The Company believes that the Premier membership will shift to the Company during either the first or second quarter of fiscal 2003, at which time the Premier contract will terminate. The State of Tennessee requires Premier to exist for 24 months after contract termination during which time the final run-out of claims and other liabilities will occur.

        Royal Health Care, LLC.    The Company owns a 37.1% interest in Royal Health Care, LLC ("Royal"). Royal is a managed services organization that receives management fees for the provision of administrative, marketing, management and support services to five managed care organizations. Royal does not provide any services to the Company. The Company accounts for its investment in Royal using the equity method. The Company's investment in Royal at September 30, 2001 and June 30, 2002 was $5.3 million and $7.2 million, respectively. The Company's equity in earnings of Royal for the three months ended June 30, 2001 and 2002 was $0.7 million and $1.6 million, respectively, and for the nine months ended June 30, 2001 and 2002 was $2.0 million and $3.0 million, respectively. The Company received $0.0 million and $0.4 million in partnership distributions from Royal for the three months ended June 30, 2001 and 2002, respectively. The Company received $0.4 million and $1.1 million in partnership distributions from Royal for the nine months ended June 30, 2001 and 2002, respectively. The Company's equity in income from Royal for the three months and nine months ended June 30, 2002 includes a favorable $0.7 million retroactive adjustment associated with a change in the operating agreement for Royal.

NOTE H—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 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% ownership interest of CBHS was owned by COI.

        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 effected the Company's exit from its healthcare provider and healthcare franchising businesses (the "CBHS Transactions"). As part of this transaction, the Company agreed to provide CBHS with the net economic value of five hospital-based joint ventures ("Provider JVs") and agreed to transfer to CBHS its interests in the Provider JVs and related real estate as soon as practicable. In addition, 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 (the "CBHS Note").

        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 February 16, 2000, CBHS filed a voluntary petition for relief of indebtedness under Chapter 11 of the United States Bankruptcy Code. In connection with the bankruptcy proceedings, CBHS indicated that it believed that it had certain claims against the Company regarding certain previous transactions. During fiscal 2001, the Company entered into an agreement with CBHS that provided the Company with a full release of all claims. The agreement was approved by the bankruptcy court in April 2001. Under the agreement, (i) the Company was released of all obligations to CBHS; (ii) the Company

14

obtained the economic value of the five Provider JVs that was previously conveyed to CBHS; and (iii) the Company agreed to pay CBHS approximately $26 million over a 9 month period. The Company paid the final installment of $5.0 million to CBHS in January 2002. The Company has sold the assets and operations of three Provider JVs and ceased the operations of the other two Provider JVs.

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 specialties. 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 comprised the Company's specialty managed healthcare segment. The Company exited the specialty managed healthcare business through the sale and/or abandonment of businesses and related assets, certain of which activities had already occurred in the normal course prior to October 4, 2000. The Company has exited all operating contracts entered into by Allied and Vivra; however, the Company is obligated to satisfy lease agreements through 2008, for which the Company believes it has adequate reserves at June 30, 2002.

Human Services Segment

        On January 18, 2001, the Company's Board of Directors approved and the Company entered into a definitive agreement for the sale of Mentor, which represented the business and interest that comprised the Company's human services segment. On March 9, 2001, the Company consummated the sale of the stock of Mentor for approximately $113.5 million, net of approximately $2.0 million in transaction costs. The Company's consideration consisted of $103.5 million in cash and $10.0 million in the form of an interest-bearing note. Additionally, the Company assumed liabilities of approximately $3.0 million. Approximately $50.2 million of the proceeds were used to retire loans under the Term Loan Facility as required by the Credit Agreement with the remainder of the cash proceeds used to reduce amounts outstanding under the Revolving Facility.

Accounting for Discontinued Operations

        The Company has accounted for the disposal of the discontinued segments under Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB 30"). APB 30 requires that the results of continuing operations be reported separately from those of discontinued operations for all periods presented and that any gain or loss from disposal of a segment of a business be reported in conjunction with the related results of discontinued operations. Accordingly, the Company has restated its results of operations for: (a) fiscal 1999 and prior for the discontinuance of the healthcare provider and healthcare franchising businesses; (b) fiscal 2000 and prior for the discontinuance of the specialty managed healthcare segment; and

15

(c) the first quarter of fiscal 2001 and prior for the discontinuance of the human services segment. The restatements involved segregating the operating results of the discontinued segments from continuing operations and disclosing the results, net of income tax, in a separate income statement caption "Discontinued operations—Income (loss) from discontinued operations". The losses the Company incurred to exit the discontinued operations are reflected, net of income tax, in the caption "Discontinued operations—Income (loss) on disposal of discontinued operations". The assets, liabilities and cash flows related to discontinued operations have not been segregated from those related to continuing operations.

        The summarized results of discontinued operations segments are as follows (in thousands):

(1)

Amounts represent positive settlements of certain outstanding Medicare and Medicaid cost reports, net of cost of collection, legal fees and settlement of other liabilities. Net revenue for the three and nine months ending June 30, 2002 related to the healthcare provider and franchising segments includes a reduction of estimates of regulatory reserves pertaining to the former psychiatric hospital facilities of approximately $3.1 million, before taxes.

(2)

Interest expense has not been allocated to discontinued operations.

(3)

Includes provision (benefit) for income taxes, minority interest and (income) loss from disposal of discontinued operations.

16

Remaining Assets and Liabilities

        Healthcare Provider and Healthcare Franchising—Segments.    The remaining assets and liabilities of the provider business at June 30, 2002 include, among other things, (i) restricted cash of $1.2 million, (ii) hospital-based real estate of $3.4 million, (iii) long-term debt of $6.4 million related to the hospital-based real estate and (iv) accrued liabilities of $7.6 million. The Company is also subject to inquiries and investigations from governmental agencies and other legal contingencies related to its operating and business practices prior to June 17, 1997. See Note I—"Commitments and Contingencies".

        Specialty Managed Healthcare Segment.    The remaining assets and liabilities of the specialty managed healthcare segment at June 30, 2002 include, among other things, (i) cash and security deposits of $0.2 million, (ii) reserve for discontinued operations of $4.1 million and (iii) accounts payable and accrued liabilities of $0.6 million.

        The following table provides a roll-forward of reserves related to the discontinuance of the specialty managed healthcare segment:

(1)

The Company reevaluated its lease reserve balance related to the specialty managed healthcare segment as of June 30, 2002. The reserve was increased by an estimated $1.3 million to reflect changes in estimates.

        Human Services Segment. As of June 30, 2002 the human services segment has remaining liabilities of $0.7 million consisting of accrued liabilities.

NOTE I—Commitments and Contingencies

Insurance

        The Company is self-insured for a portion of its general and current professional liability risks. The reserves for self-insured general and professional liability losses for the period prior to June 17, 1997, including loss adjustment expenses, were included in reserve for unpaid claims in the Company's consolidated 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. 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 Company continually evaluates the adequacy of these insured limits and management believes these amounts are sufficient; however, there can be no assurance in that regard.

        The Company previously maintained general, professional and managed care liability insurance policies with unaffiliated insurers covering the two-year period from June 17, 2000 to June 16, 2002. The policies were 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. The Company renewed its general, professional and managed care liability insurance policies with unaffiliated insurers for a one-year period beginning June 17, 2002. The new policies are also written

17

on a "claims-made" basis, and are subject to a $1.0 million per claim ($5.0 million per class action claim) unaggregated self-insured retention for managed care liability, and a $250,000 per claim unaggregated self-insured retention for general and professional liability. The Company also purchases excess liability coverage in an amount deemed reasonable by management for the size and profile of the organization. The Company is responsible for claims within its self-insured retentions, excluding portions of claims reported after the expiration date of the policies if they are not renewed, or if policy limits are exceeded.

Regulatory Issues

        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, information privacy and security, reimbursement for patient services, and Medicare and Medicaid fraud and abuse. Over the past several years, 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.

HIPAA

        Confidentiality and patient privacy requirements are particularly strict in the field of behavioral healthcare service. 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, privacy and security of health information by healthcare providers and healthcare plans. HIPAA calls for HHS to create regulations in several different areas to address the following areas: electronic transactions and code sets, privacy, security, provider IDs, employer IDs, health plan IDs and individual IDs. At present, regulation relating to electronic transactions and code sets, privacy and employer IDs have been released in final form.

        The Transactions and Code Sets regulation is final and was originally scheduled to become effective on October 16, 2002; however, companies may now elect a one-year deferral. This regulation establishes standard data content and formats for the submission of electronic claims and other administrative and health transactions. This regulation only applies to electronic transactions, and healthcare providers will still be able to submit paper documents without being subject to this

18

regulation. In addition, health plans must be prepared to receive these various transactions. The Company intends to file for the extension as permitted by law.

        The final regulation on privacy was published on December 28, 2000 and accepted by Congress on February 16, 2001. This regulation, which became effective on April 14, 2001 with a compliance date of April 14, 2003, requires patient consent and authorization to release healthcare information, creates rules about how much and when information may be released and creates rights for patients to review and amend their health records. This regulation applies to both electronic and paper transactions. A new proposed modification to this rule was published on March 27, 2002 in the federal register with a 30 day comment period. This proposal seeks to change some of the areas of the privacy regulation that had an unintended adverse effect on the provision of care. The final modification to the privacy regulation will be published in the August 14, 2002 Federal Register.

        The draft version of the regulation on security was published on August 12, 1998. The final version of this rule was originally expected to be released shortly after the privacy regulation. It is now expected to be released sometime after September 30, 2002. This regulation creates safeguards for physical and electronic storage of, maintenance and transmission of, and access to, individual health information.

        The provider ID and employer ID regulations are similar in concept. The provider ID regulation was published in draft form on May 7, 1998 and would create a unique number for healthcare providers that will be used by all health plans. The employer ID regulation was published in draft form on June 16, 1998 and calls for using the Employer Identification Number (the taxpayer identifying number for employers that is assigned by the Internal Revenue Service) as the identifying number for employers that will be used by all health plans. The final regulation on employer IDs was published on May 31, 2002 with a compliance date of July 30, 2004. The health plan ID and individual ID regulations have not been released in draft form.

        Management is currently assessing and acting on the wide reaching implications of these regulations to ensure the Company's compliance by the implementation dates. Management has identified HIPAA as a major initiative impacting the Company's systems, business processes and business relationships. This issue extends beyond the Company's internal operations and requires active participation and coordination with the Company's customers, providers and business partners. Management has commissioned a dedicated HIPAA project team to develop, coordinate and implement our compliance plan. With respect to the proposed regulation on security and the final regulation on privacy, Management has hired a chief security officer, appointed an officer who will be responsible for privacy issues, commissioned separate security and privacy workgroups to identify and assess the potential impact of the regulations and reviewed current policies and drafted new policies to comply with the new requirements. Management believes that significant resources will be required over the next 18 to 21 months to ensure compliance with the new requirements. The Company incurred approximately $2.7 million in operating costs and $1.9 million in capital expenditures related to HIPAA in the nine months ended June 30, 2002. Management estimates that the Company will incur approximately $1.0 million to $2.0 million in operating expenditures and approximately $2.0 million to $3.0 million in capital expenditures related to these efforts during the fourth quarter of fiscal 2002.

Legal

        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 Employee Stock Ownership Plan ("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

19

("DOL") in connection with the ESOP's purchase of stock of the Company in 1990 while Wachovia served as ESOP Trustee. The participants of the ESOP were primarily employees who worked in the Company's healthcare provider and franchising segments. Wachovia also alleges fraud, negligent misrepresentation and other claims, and asserts losses of $30 million from the settlement with the DOL (plus costs and interest which amount to approximately $8 million as of the date of filing of this Form 10-Q). During the second quarter of fiscal 2001, the court entered an order dismissing all of the claims asserted by Wachovia, with the exception of the contractual indemnification portion of the claim. The Company disputes Wachovia's claims and has been vigorously contesting such claims. This matter is scheduled to go to trial in October 2002. As a result of court-ordered mediation, management is considering settlement of this claim at substantially less than the amount of claimed losses, contingent upon the approval of our board of directors and the exclusion of the potential settlement from the financial covenants under the Company's current or refinanced debt instruments. This latter condition is not largely within the Company's control and neither of these conditions has been satisfied. As a result, the Company has not recorded any reserves relating to this matter.

        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 (RICO class) and 1994 (ERISA class). 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 premiums paid. The complaints seek unspecified compensatory damages, treble damages under RICO, and an injunction barring the alleged improper practices, plus interest, costs and attorneys' fees. During the third quarter of fiscal 2001, the court transferred the Class Actions to the United States District Court for the District of Maryland. 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, including the Maryland court where the Class Actions are now pending. 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 intends to defend them vigorously. The Company has not recorded any reserves related to this matter.

        The Company is also subject to or party to other litigation and claims relating to its operations and business practices. The Company's managed care litigation matters include a class action lawsuit, which alleges that a provider at a Company facility violated privacy rights of certain patients.

        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. 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. One or more significant adverse outcomes with regard to such litigation and claims could impair the Company's ability to comply with certain financial covenants under its Credit Agreement.

NOTE J—Special Charges

        In June 2002, the Company implemented a new business improvement initiative, named Accelerated Business Improvement ("ABI"). ABI was instituted to expand the initiatives of the 2002 Restructuring Plan (as defined below) to the Company as a whole, and is focused on reducing operational and administrative costs, while maintaining or improving service to customers. ABI resulted in the recognition of special charges of approximately $0.5 million during the three-month period

20

ended June 30, 2002 to terminate 30 employees, the majority of which were field operational personnel. The employee termination costs of $0.5 million include severance and related termination benefits, including payroll taxes. All terminations and termination benefits were communicated to the affected employees in the third quarter of fiscal 2002, and six terminations were completed by June 30, 2002. The majority of the employee termination costs currently accrued will be paid in full by June 30, 2003. At June 30, 2002, outstanding liabilities of $0.5 million related to ABI are included in "Accrued liabilities" in the accompanying Balance Sheets. The following provides a roll-forward of liabilities resulting from the special charges incurred in the implementation of this plan:

        As of December 31, 2001, management committed the company to a restructuring plan to eliminate certain duplicative functions and facilities (the "2002 Restructuring Plan") primarily related to the Health Plans segment. The Company's 2002 Restructuring Plan resulted in the recognition of special charges of approximately $8.2 million during the nine-month period ended June 30, 2002. The special charges consisted of (a) $6.3 million to terminate 277 employees, the majority of which were field operational personnel in the Health Plans segment, and (b) $1.9 million to downsize and close excess facilities, and other associated activities. The employee termination costs of $6.3 million include severance and related termination benefits, including payroll taxes. All terminations and termination benefits were communicated to the affected employees in the first three quarters of fiscal 2002, and all terminations were completed by June 30, 2002. The majority of the employee termination costs will be paid in full by March 31, 2003. The special charges of $1.9 million to downsize and close excess facilities were incurred in connection with the closure of approximately 12 leased facilities. These closure and exit costs include payments required under lease contracts (less any applicable existing and/or estimated sublease income) after the properties were abandoned, write-offs of leasehold improvements related to the facilities and other related expenses. The leased facilities have lease termination dates ranging from fiscal 2002 through fiscal 2006. At June 30, 2002, outstanding liabilities of $3.4 million related to the 2002 Restructuring Plan are included in "Accrued liabilities" in the accompanying Balance Sheets. The following table provides a roll-forward of liabilities resulting from these special charges:

        During the first quarter of fiscal 2001, the Company sold its Canadian behavioral managed care operations, CHC, to Family Guidance Group, Inc. for approximately $9.7 million net of transaction costs of $0.3 million. The sale of the Canadian operations resulted in a non-recurring loss of approximately $3.3 million before provision for income taxes. The Company received net proceeds of approximately $8.4 million at the date of the sale and received an additional $0.7 million in January 2002. The Company expects to receive an additional $0.6 million in December 2002. Proceeds received from the sale were used to reduce debt outstanding under the Term Loan Facility.

        During the fourth quarter of fiscal 2000 the Company incurred special charges related to the closure of certain provider offices and restructuring of the corporate function and certain behavioral managed healthcare office sites. Upon reevaluation of lease reserves related to this restructuring plan

21

in the third quarter of fiscal 2002, the Company recorded estimated additional lease reserves in the amount of $0.5 million. The following table provides a roll-forward of liabilities resulting from these special charges:

NOTE K—Business Segment Information

        The Company operates solely in the managed behavioral healthcare business. The Company provides managed behavioral healthcare services to health plans, insurance companies, corporations, labor unions and various governmental agencies. Within the managed behavorial healthcare business, the Company is further divided into the following four segments, based on the services it provides and the customers that it serves, as described below.

        Health Plans.    The Company provides managed behavioral healthcare services to beneficiaries of managed care companies, health insurers and other health plans. Health Plans' contracts are risk-based or ASO contracts. Although certain large health plans provide their own managed behavioral healthcare services, many health plans "carve out" behavioral healthcare from their general healthcare services and subcontract such services to managed behavioral healthcare companies such as the Company. Certain of the Company's health plan customers include Blue Cross/Blue Shield plans, Aetna and TRICARE.

        Workplace.    The Company provides Employee Assistance Plans ("EAP") services and integrated products that combine EAP and managed behavioral healthcare services primarily to corporations and, to a lesser extent, labor unions. The Company's contracts with corporate customers generally provide for a fee (per member per month) to be paid to the Company for which the Company provides all required consultation, assessment and referral services and, in certain cases, arranges and pays for all or a portion of the costs of providing treatment services. In addition, the Company operates a number of programs for corporate customers on an ASO basis.

        Public.    The Company provides managed behavioral healthcare services to Medicaid recipients through both direct contracts with state and local governmental agencies and through subcontracts with health maintenance organizations ("HMOs") focused on Medicaid beneficiary populations. The Company provides managed behavioral healthcare services to the State of Tennessee's TennCare program, both through a direct contract and through its Premier joint venture. In May 2002, the Company signed a new contract with the State of Tennessee under which the Company will provide all services under the TennCare program through a direct contract. The new TennCare contract covers the period from July 1, 2002 through December 31, 2003. Premier was to cease providing services upon the expiration of its contract on June 30, 2002, however the State of Tennessee has delayed the transfer of Premier's TennCare membership to the Company pending the State's clarification of certain matters regarding the membership transfer. The Company believes that the Premier membership will shift to the Company during either the first or second quarter of fiscal 2003, at which time the Premier contract will terminate. The State of Tennessee requires Premier to exist for 24 months after contract termination during which time the final run-out of claims and other liabilities will occur. Public risk contracts generally have higher average per member premiums, costs and (to some degree) more volatility than both Health Plans and Workplace, due to the nature of populations, benefits provided and other matters.

22

        Corporate and Other.    This segment of the Company is comprised primarily of operational support functions such as claims administration, network services, sales and marketing, and information technology as well as corporate support functions such as executive, finance and legal. Discontinued operations activity is not included in the Corporate and Other segment operating results.

        The Company evaluates performance of its segments based on profit or loss from continuing operations before depreciation, amortization, interest (net), special charges, income taxes and minority interest ("Segment Profit"). Intersegment sales and transfers are not significant.