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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON D.C 20549
-----------------
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended SEPTEMBER 30, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
COMMISSION FILE NUMBERS 333-43549 AND 333-97293
EXTENDICARE HEALTH SERVICES, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 111 WEST MICHIGAN STREET 98-0066268
(State or other jurisdiction of MILWAUKEE, WI 53203 (I.R.S. Employer
incorporation or organization) (Address of principal executive office Identification Number)
Including zip code)
(414) 908-8000
(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 [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act)
Yes [ ] No [X]
Common Stock - authorized 1,000 shares, $1.00 par value; issued and
outstanding 947 shares as of November 11, 2003. All issued and outstanding
shares of Common Stock are held indirectly by Extendicare Inc., a publicly
traded Canadian company.
EXTENDICARE HEALTH SERVICES, INC.
INDEX
PAGE
----
PART I FINANCIAL INFORMATION:
Item 1 Financial Statements:
Condensed Consolidated Statements of Earnings for the Three Months and
Nine Months Ended September 30, 2003 and 2002................................................ 3
Condensed Consolidated Balance Sheets, September 30, 2003 and December 31, 2002................. 4
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended
September 30, 2003 and 2002.................................................................. 5
Notes to Condensed Consolidated Financial Statements............................................ 6
Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations........... 14
Item 3 Quantitative and Qualitative Disclosures About Market Risk...................................... 26
Item 4 Controls and Procedures......................................................................... 27
PART II OTHER INFORMATION:
Item 1 Legal Proceedings............................................................................... 28
Item 2 Changes in Securities and Use of Proceeds....................................................... 28
Item 3 Defaults Upon Senior Securities................................................................. 28
Item 4 Submission of Matters to a Vote of Security Holders............................................. 28
Item 5 Other Information............................................................................... 28
Item 6 Exhibits and Reports on Form 8-K................................................................ 28
SIGNATURES ............................................................................................... 29
EXHIBIT INDEX.............................................................................................. 30
CERTIFICATIONS............................................................................................. 31
2
PART I
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
EXTENDICARE HEALTH SERVICES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS
FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
(DOLLARS IN THOUSANDS)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPT. 30, SEPT. 30,
2003 2002 2003 2002
---------- ---------- ---------- ----------
REVENUES:
Nursing and assisted living centers...................... $ 212,827 $ 200,368 $ 623,836 $ 586,272
Outpatient therapy....................................... 3,017 2,491 8,745 7,585
Other.................................................... 4,186 3,906 12,133 12,927
---------- ---------- ---------- ----------
220,030 206,765 644,714 606,784
COSTS AND EXPENSES (INCOME):
Operating................................................ 183,402 174,941 542,943 510,117
General and administrative............................... 8,310 7,786 23,869 24,329
Lease costs.............................................. 2,298 2,697 6,834 8,411
Depreciation and amortization............................ 9,409 9,383 27,719 28,228
Interest expense......................................... 8,511 8,784 25,572 24,754
Interest income.......................................... (899) (23) (2,024) (833)
Loss (gain) on disposal of assets........................ - - - (3,961)
Provision for closure and exit costs and other items..... - - - 5,293
Loss on early retirement of debt......................... - - - 2,849
---------- ---------- ---------- ----------
211,031 203,568 624,913 599,187
---------- ---------- ---------- ----------
EARNINGS BEFORE INCOME TAXES............................... 8,999 3,197 19,801 7,597
Income tax expense......................................... 3,598 1,192 7,931 3,428
---------- ---------- ---------- ----------
NET EARNINGS............................................... $ 5,401 $ 2,005 $ 11,870 $ 4,169
========== ========== ========== ==========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
EXTENDICARE HEALTH SERVICES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, 2003 AND DECEMBER 31, 2002
(DOLLARS IN THOUSANDS EXCEPT SHARE DATA)
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- -------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents................................. $ 51,821 $ 27,016
Accounts receivable, less allowances of $12,491
and $9,309, respectively................................. 98,037 104,064
Supplies, inventories and other current assets............ 7,346 7,226
Income taxes receivable................................... 404 518
Deferred state income taxes............................... 5,593 5,810
Due from shareholder and affiliates:
Federal income taxes receivable.......................... 11,793 12,292
Deferred federal income taxes............................ 29,410 29,647
Other.................................................... 6,658 4,493
------------- -------------
Total current assets..................................... 211,062 191,066
Property and equipment..................................... 443,746 453,119
Goodwill and other intangible assets....................... 75,761 76,339
Other assets............................................... 109,664 112,410
------------- -------------
Total Assets............................................. $ 840,233 $ 832,934
============= =============
LIABILITIES AND SHAREHOLDER'S EQUITY
CURRENT LIABILITIES:
Bank indebtedness......................................... $ 8,947 $ 2,656
Current maturities of long-term debt...................... 959 716
Accounts payable.......................................... 15,293 20,850
Accrued liabilities....................................... 100,460 100,879
Current portion of accrual for self-insured liabilities 20,000 28,000
------------- -------------
Total current liabilities 145,659 153,101
Accrual for self-insured liabilities....................... 26,111 27,089
Long-term debt............................................. 394,826 397,434
Deferred state income taxes................................ 9,173 8,495
Other long-term liabilities................................ 41,318 40,749
Due to shareholder and affiliates:
Deferred federal income taxes............................. 46,504 43,381
Other..................................................... 3,484 3,484
------------- -------------
Total liabilities........................................ 667,075 673,733
------------- -------------
SHAREHOLDER'S EQUITY:
Common stock, $1 par value, 1,000 shares authorized,
947 shares issued and outstanding........................ 1 1
Additional paid-in capital................................ 208,787 208,787
Accumulated other comprehensive loss...................... (301) (2,388)
Accumulated deficit....................................... (35,329) (47,199)
------------- -------------
Total Shareholder's Equity............................... 173,158 159,201
------------- -------------
Total Liabilities and Shareholder's Equity............... $ 840,233 $ 832,934
============= =============
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
EXTENDICARE HEALTH SERVICES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
(DOLLARS IN THOUSANDS)
NINE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 2003 SEPTEMBER 30, 2002
------------------ ------------------
OPERATING ACTIVITIES:
Net earnings................................................ $ 11,870 $ 4,169
Adjustments to reconcile net earnings to net cash
provided from operating activities:
Depreciation and amortization............................ 27,719 28,228
Amortization of deferred financing costs................. 1,118 1,368
Provision for uncollectible accounts receivable.......... 8,152 7,874
Reserve for settlements with third-party payors.......... 2,200
Provision for self-insured liabilities................... 4,500 3,937
Payment of self-insured liability claims................. (13,478) (18,565)
Deferred income taxes.................................... 2,881 3,026
Gain on disposal of assets............................... - (3,961)
Provision for closure and exit costs and other items..... - 5,293
Loss on early retirement of debt......................... - 2,849
Changes in assets and liabilities:
Accounts receivable...................................... (2,148) (5,086)
Supplies, inventories and other current assets........... (121) (817)
Accounts payable......................................... (5,557) (592)
Accrued liabilities...................................... (429) 13,350
Income taxes payable/receivable.......................... 114 (60)
Current due to shareholder and affiliates................ (1,665) (11,710)
--------- ----------
Cash provided from operating activities............... 35,156 29,303
--------- ----------
INVESTING ACTIVITIES:
Payments for purchase of property and equipment.......... (15,636) (12,638)
Proceeds from sale of property and equipment............. 34 14,291
Changes in other non-current assets...................... 770 1,012
--------- ----------
Cash (used for) provided from investing activities.... (14,832) 2,665
--------- ----------
FINANCING ACTIVITIES:
Proceeds from issuance of long-term debt................. - 160,625
Payments of deferred financing costs..................... - (7,090)
Other long-term liabilities.............................. 580 1,726
Payments of long-term debt............................... (2,391) (157,931)
Change in bank indebtedness.............................. 6,292 (585)
--------- ----------
Cash provided from (used for) financing activities .. 4,481 (3,255)
--------- ----------
INCREASE IN CASH AND CASH EQUIVALENTS....................... 24,805 28,713
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD.............. 27,016 997
--------- ----------
CASH AND CASH EQUIVALENTS, END OF PERIOD.................... $ 51,821 $ 29,710
========= ==========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
EXTENDICARE HEALTH SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BUSINESS
Extendicare Health Services, Inc. and its subsidiaries (hereafter
referred to as the "Company", unless the context requires otherwise) operates in
one reporting segment, nursing and assisted living facilities, throughout the
United States. The Company is an indirect wholly owned subsidiary of Extendicare
Inc. ("Extendicare"), a Canadian publicly traded company.
BASIS OF PRESENTATION
The accompanying condensed consolidated financial statements as of, and
for the three and nine month periods ended September 30, 2003 and 2002 are
unaudited and have been prepared in accordance with the instructions to Form
10-Q and do not include all of the information and the footnotes required by
generally accepted accounting principles in the United States of America for
complete statements. In the opinion of management, all adjustments necessary for
a fair presentation of such financial statements have been included. The
condensed consolidated balance sheet information as of December 31, 2002 has
been derived from audited financial statements.
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amount of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Management's most significant estimates
include the recoverability of long-lived assets, and provisions for bad debts,
Medicaid and Medicare revenue rate settlements, self-insured general and
professional liability claims, facility closure accruals, workers compensation
accruals, self-insured health and dental claims and income taxes. Actual results
could differ from those estimates.
The accompanying financial statements include the accounts of the
Company and its majority owned subsidiaries. All transactions between
Extendicare and its majority owned subsidiaries have been eliminated.
These condensed consolidated financial statements should be read in
conjunction with the consolidated financial statements and notes thereto for the
year ended December 31, 2002 contained in the Company's Annual Report on Form
10-K. Certain reclassifications have been made to the 2002 condensed
consolidated financial statements to conform to the presentation for 2003.
2. NEW ACCOUNTING PRONOUNCEMENTS
In May 2002, the FASB issued SFAS No. 145, "Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13 and Technical
Corrections." The most significant provision of SFAS No. 145 addresses the
termination of extraordinary item treatment for gains and losses on early
retirement of debt. The Company adopted the provisions of this standard in the
first quarter of 2003 and has modified the presentation of its financial
statements for the comparative 2002 period by recording the loss on early
retirement of debt in earnings before income taxes.
In July 2002, the FASB issued SFAS No. 146, "Accounting for Exit and
Disposal Activities." The provisions of SFAS No. 146 modify the accounting for
the costs of exit and disposal activities by requiring that liabilities for
these activities be recognized when the liability is incurred. Previous
accounting literature permitted recognition of certain exit and disposal
liabilities at the date of commitment to an exit plan. The provisions of this
statement apply to exit or disposal activities initiated after December 31,
2002. The Company has not initiated any exit or disposal activities after
December 31, 2002 and thus SFAS No. 146 has had no impact on the Company's
financial statements.
6
In November 2002, the FASB issued FASB Interpretation No. 45 ("FIN
45"), "Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Direct Guarantees of Indebtedness of Others." FIN 45 clarifies that a
guarantor is required to recognize, at the inception of a guarantee, a liability
for the fair value of the obligation undertaken in issuing the guarantee. FIN 45
also elaborates on the disclosures to be made by a guarantor about its
obligations under certain guarantees that it has issued. The recognition and
measurement provisions of FIN 45 are applicable on a prospective basis to
guarantees issued or modified after December 31, 2002. The disclosure
requirements are effective for financial statements for interim or annual
periods ending after December 15, 2002. The Company has no guarantees as defined
in FIN 45.
In January 2003, the FASB issued FASB Interpretation No. 46 ("FIN 46"),
"Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51."
FIN 46 addresses consolidation by business enterprises of "variable interest
entities," which have one or both of the following characteristics: (1) the
equity investment at risk is not sufficient to permit the entity to finance its
activities without additional subordinated financial support from other parties,
which is provided through other interests that will absorb some or all of the
expected losses of the entity, and/or (2) the equity investors lack one or more
of the following essential characteristics of a controlling financial interest:
(a) the direct or indirect ability to make decisions about the entity's
activities through voting rights or similar rights, (b) the obligation to absorb
the expected losses of the entity if they occur, which makes it possible for the
entity to finance its activities, and/or (c) the right to receive the expected
residual returns of the entity if they occur, which is the compensation for the
risk of absorbing the expected losses. Not-for-profit organizations are not
subject to FIN 46 unless they are used by business enterprises in an attempt to
circumvent the provisions of this Interpretation. If a business enterprise has a
controlling financial interest in a variable interest entity, the assets,
liabilities and results of the activities of the variable interest entity must
be included in the consolidated financial statements of the business enterprise.
FIN 46 applies immediately to variable interest entities created after January
31, 2003, and to variable interest entities in which an enterprise obtains an
interest after that date. It applies in the first fiscal year or interim period
beginning after June 15, 2003, to variable interest entities in which an
enterprise holds a variable interest that it acquired before February 1, 2003.
The FASB has proposed to defer the effective date for entities that have not yet
adopted FIN 46 until the end of the first interim or annual period ending after
December 15, 2003. The Company is currently evaluating the impact that FIN 46
will have on its financial statements, if any.
3. GAIN ON DISPOSAL OF ASSETS, PROVISION FOR CLOSURE AND EXIT COSTS, AND
IMPAIRMENT OF LONG-LIVED ASSETS
In May 2002, Tandem Health Care, Inc. ("Tandem") exercised its option
to purchase seven leased properties in Florida from the Company for gross
proceeds of $28.6 million, consisting of cash of $15.6 million and $13.0 million
in 8.5% five-year notes (net proceeds of $25.5 million). The Company applied
$12.4 million of the proceeds to reduce bank debt. Until this date, Tandem
operated these facilities under a lease agreement with a purchase option. The
carrying value of the seven facilities was $21.5 million. As a result, the
Company recorded a gain on the sale of the assets of $4.0 million, inclusive of
the deferred gain of $2.2 million from the sale of two leased nursing properties
in April 2001. The Company deferred the gain from the April 2001 transaction in
accordance with Statement of Financial Accounting Standard No. 66. The May 2002
transaction also involved the conversion of $1.9 million in preferred shares
received in the April 2001 transaction into $1.9 million 8.5% notes, due in
April 2006.
In May 2002, the Company recorded a provision for closure and exit
costs relating to the divested Florida operations of $5.3 million relating to
cost report settlement issues, and the settlement of claims with suppliers and
employees.
7
Below is a summary of activity of the accrued liabilities balance
relating to divested operations and facility closures:
RESIDENT
EMPLOYEE LIABILITY AND RENT OTHER
TERMINATION OTHER CLAIMS EXPENSE EXPENSES(1) TOTAL
----------- ------------ ------- ----------- -----
(IN THOUSANDS)
Balance December 31, 2000.... 32 -- 698 2,784 3,514
Cash Payments.............. (1,377) (1,113) (234) (5,016) (7,740)
Provisions................. 1,399 3,163 (464) 8,130 12,228
----------- ----------- ----------- ----------- -----------
Balance December 31, 2001.... 54 2,050 -- 5,898 8,002
----------- ----------- ----------- ----------- -----------
Cash Payments.............. -- (1,231) -- (3,460) (4,691)
Provisions(2).............. -- 295 -- 6,112 6,407
----------- ----------- ----------- ----------- -----------
Balance December 31, 2002.... 54 1,114 -- 8,550 9,718
Cash Payments.............. -- -- -- (1,251) (1,251)
----------- ----------- ----------- ----------- -----------
Balance September 30, 2003 .. $ 54 $ 1,114 $ -- $ 7,299 $ 8,467
=========== =========== =========== =========== ===========
(1) The liability for other expenses consists of amounts reserved for cost
report and other settlements with the states of Florida and Texas and other
Medicare fiscal intermediaries, collection of receivables, and settlement of
claims with suppliers and employees.
(2) The provision of $6.4 million for 2002 includes the provision for closure
and exit costs of $5.3 million and selling expenses relating to the sale of
assets to Tandem and other items of $1.1 million.
4. ACQUISITION OF PREVIOUSLY-LEASED FACILITIES
On October 1, 2002 the Company completed a transaction in which it
exercised its right to acquire seven previously-leased nursing facilities in the
states of Ohio and Indiana for $17.9 million. The purchase included cash of $7.4
million and a $10.5 million interest bearing 10-year note. In September 2003, as
part of an agreement to fix the interest rate with the holder of the note, the
Company paid $2.0 million and agreed to refinance the 10-year note. Should the
Company not proceed, the interest rate would be settled through the re-opening
of arbitration.
5. OTHER ASSETS
The Company is pursuing collection of a number of outstanding Medicaid
and Medicare settlement receivables. As of September 30, 2003 the balance of
outstanding Medicaid and Medicare settlement receivables was $38.9 million, net
of an allowance of $17.6 million. For one specific Medicare receivable issue
which concerns fiscal years prior to the implementation of the Prospective
Payment System and involves the allocation of overhead costs, the first of three
specific claim years was presented to the Provider Reimbursement Review Board
("PRRB") at a hearing in January 2003. The hearing procedures were discontinued
after the parties negotiated a methodology for resolution of the claim for one
of the years in dispute. The negotiated settlement for this and other issues
relating to the 1996 cost report year, resulted in no adjustment to the recorded
receivable balance, and the Company subsequently collected $3.0 million from the
Fiscal Intermediary ("FI"). For another specific issue involving a staffing cost
matter, a settlement of the first year of seven specific claim years was reached
prior to the January 2003 PRRB hearing, and the Company continues to negotiate
the remaining years in dispute with the FI. For both the overhead allocation and
staffing issues, which the Company is appealing for the recovery of $11.6
million and $6.4 million respectively, further negotiations on the remaining
years under appeal are expected to occur prior to the hearing dates which are
scheduled for the first and second quarters, respectively, of 2004. The Company
also has a hearing scheduled in the third quarter of 2004 on a Director of
Nursing staff cost issue. In the third quarter of 2003, the Company made a
provision for $2.2 million as a reduction of revenue pertaining to individual
claims in dispute with the FI for the cost report years 1996 through 1998. The
Company is continuing to pursue collection of these claims with the FI.
8
6. LINE OF CREDIT AND LONG-TERM DEBT
On June 28, 2002, the Company completed a private placement of $150
million of its 9.5% Senior Notes due July 1, 2010 (the "Senior Notes") which
were issued at a discount of 0.25% of par to yield 9.54%. In January 2003, the
Company completed its offer to exchange new 9.5% Senior Notes due 2010 that have
been registered under the Securities Act of 1933 for the Notes issued in June
2002. The terms of the new Senior Notes are identical to the terms of the Senior
Notes issued in June 2002 and are guaranteed by all existing and future active
subsidiaries of the Company.
The Company used the proceeds of $149.6 million from the Senior Notes
to pay related fees and expenses of $8.3 million, to retire $124.5 million of
indebtedness outstanding under its previous credit facility and term loans, to
refinance $6.3 million of other debt, and for general corporate purposes. The
retirement of the previous credit facility resulted in a loss on early
retirement of debt of $2.8 million ($1.7 million after income taxes). Also on
June 28, 2002, the Company entered into an interest rate swap agreement and an
interest rate cap agreement. See Note 7 for terms of these agreements.
Concurrent with the sale of the Senior Notes, the Company established a
new five-year $105 million senior secured revolving credit facility (the "Credit
Facility") that is used to back letters of credit and for general corporate
purposes. Borrowings under the Credit Facility bear interest, at the Company's
option, at the Eurodollar rate or the prime rate, plus applicable margins,
depending upon the Company's leverage ratio. As of September 30, 2003 the
Company had no borrowings under the Revolving Credit Facility. The unused
portion of the Revolving Credit Facility, that is available for working capital
and corporate purposes, after reduction for outstanding letters of credit of
$41.1 million, was $63.9 million as of September 30, 2003.
The Senior Notes and the Credit Facility contain a number of covenants,
including: restrictions on the payment of dividends by the Company; limitations
on capital expenditures, investments, redemptions of the Company's common stock
and changes of control of the Company; as well as financial covenants, including
fixed charge coverage, debt leverage, and tangible net worth ratios. The Company
is required to make mandatory prepayments of principal upon the occurrence of
certain events, such as certain asset sales and certain issuances of securities.
The Company is permitted to make voluntary prepayments at any time under the
Credit Facility. The Senior Notes are redeemable at the option of the Company
starting on July 1, 2006. The redemption prices, if redeemed during the 12-month
period beginning on July 1 of the year indicated, are as follows:
YEAR PERCENTAGE
- --------------------- ----------
2006................. 104.750%
2007................. 102.375%
2008 and thereafter.. 100.000%
The Company is in compliance with the financial covenants as of
September 30, 2003.
The Company has no independent assets or operations, the guarantees of
the Senior Notes are full and unconditional, and joint and several, and any of
the Company's subsidiaries that do not guarantee the Senior Notes are
insignificant.
7. ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
Objectives and Strategies Prior to Issuance of Senior Notes
Prior to the issuance of the Senior Notes in June 2002, the Company had
variable-rate long-term debt of approximately $124.5 million, which exposed the
Company to variability in interest payments due to changes in interest rates.
The Company hedged a portion of its variable-rate debt through interest rate
swaps designated as cash-flow hedges with a notional amount of $25 million
maturing in February 2003 under which the Company received variable interest
rate payments and made fixed-rate interest payments. When the Company issued the
fixed-rate Senior Notes these interest rate swaps were terminated by the Company
in June 2002 with a cash payment of $0.6 million and charged to loss on early
retirement of debt.
9
Objectives and Strategies After Issuance of Senior Notes
After the issuance of the Senior Notes, all but $32 million of the
Company's outstanding debt obligations have fixed interest rates. In June 2002,
the Company entered into an interest rate swap (used to hedge the fair value of
fixed-rate debt obligations) with a notional amount of $150 million maturing in
December 2007. Under this swap, the Company pays a variable rate of interest
equal to the one-month London Interbank Borrowing Rate ("LIBOR") (1.12% as of
September 30, 2003), adjustable monthly, plus a spread of 4.805% and receives a
fixed rate of 9.35%. Under the terms of the interest rate swap, the counterparty
can call the swap upon 30 days notice. This swap is designated as a fair value
hedge and, as a result, changes in the market value of the swap had no impact on
the income statement during 2002 or 2003.
Also in June 2002, the Company entered into an interest rate cap with a
notional amount of $150 million maturing in December 2007. Under this cap, the
Company pays a fixed rate of interest equal to 0.24% and receives a variable
rate of interest equal to the excess, if any, of the one-month LIBOR rate,
adjusted monthly, over the cap rate of 7%. Under the terms of the interest rate
cap, the counterparty can call the cap upon 30 days notice. A portion of the
interest rate cap with a notional amount of $32 million is designated as a
hedging instrument (cash-flow hedge) to effectively limit possible increases in
interest payments under variable-rate debt obligations. The remainder of the
interest rate cap with a notional amount of $118 million is used to offset
increases in variable-rate interest payments under the interest rate swap to the
extent one-month LIBOR exceeds 7%. This portion of the interest rate cap is not
designated as a hedging instrument under SFAS 133.
Quantitative Disclosures
Changes in the fair value of a derivative that is highly effective and
that is designated and qualifies as a fair-value hedge, along with the loss or
gain on the hedged asset or liability of the hedged item that is attributable to
the hedged risk, are recorded in earnings. Changes in the fair value of cash
flow hedges are reported as Accumulated Other Comprehensive Income ("AOCI") as a
component of Shareholder's Equity. Changes in the fair value of the portion of
the interest rate cap not designated as a hedging instrument is reported in
earnings. As of September 30, 2003, the fair value of the interest rate swap
designated as a fair value hedge is an asset of $8.7 million and is offset by a
liability of $8.7 million relating to the change in market value of the hedged
item (long-term debt obligations). The fair value of the cash-flow hedges is a
liability recorded in other long-term liabilities of $0.2 million as of
September 30, 2003 and the gain credited to AOCI (net of income tax effect) for
the nine months ended September 30, 2003 was $12,000. The fair value of the
portion of the interest rate cap not designated as a hedging instrument is a
liability recorded in other long-term liabilities as of September 30, 2003 of
$0.7 million. During the remainder of 2003, none of the gains or losses in AOCI
(net of income tax effect) related to the interest rate cap are expected to be
reclassified into interest expense as a yield adjustment of the hedged debt
obligation.
8. COMMITMENTS AND CONTINGENCIES
Capital Expenditures
At September 30, 2003, the Company had capital expenditure purchase
commitments outstanding of approximately $6.1 million relating to on-going
capital improvements and purchases. In addition, the Company has entered into
construction agreements for the expansion of four assisted living facilities (86
units) and two skilled nursing facilities (38 beds) and the addition of one new
assisted living facility (40 units). Four of these seven projects are expected
to be completed in 2004, with the remainder to be completed in early 2005. The
total approximate cost of the projects is $15.2 million and capital expenditure
commitments totaling $9.7 million have been made.
Insurance and Self-insured Liabilities
The Company insures certain risks with affiliated insurance
subsidiaries of Extendicare and third party insurers. The insurance policies
cover comprehensive general and professional liability (including malpractice
insurance) for the Company's health providers, assistants and other staff as it
relates to their respective duties performed on the Company's behalf, property
coverage, workers' compensation and employers' liability in amounts and with
such coverage and deductibles as determined by the Company, based on the nature
and risk of its businesses, historical experiences, availability and industry
standards. The Company also self-insures for health and dental claims, in
certain states for workers'
10
compensation and employers' liability and for general and professional liability
claims. Self-insured liabilities with respect to general and professional
liability claims are included within the accrual for self-insured liabilities.
Litigation
The Company and its subsidiaries are defendants in actions brought
against them from time to time in connection with their operations. While it is
not possible to estimate the final outcome of the various proceedings at this
time, such actions generally are resolved within amounts provided.
The U.S. Department of Justice and other federal agencies are
increasing resources dedicated to regulatory investigations and compliance
audits of healthcare providers. The Company is diligently addressing these
regulatory efforts.
Omnicare Preferred Provider Agreement
In 1998, the Company disposed of its pharmacy operations to Omnicare,
Inc. ("Omnicare"). Subsequently, the Company entered into a Preferred Provider
Agreement with Omnicare, the terms of which enabled Omnicare to execute Pharmacy
Service Agreements and Consulting Service Agreements with all of the Company's
skilled nursing facilities. Under the terms of the agreement, the Company
secured "per diem" pricing arrangements for pharmacy supplies for the first four
years of the Agreement, which period expired December 2002. The Preferred
Provider Agreement contains a number of provisions which involve sophisticated
calculations to determine the "per diem" pricing during this first four-year
period. Under the "per diem" pricing arrangement, pharmacy costs fluctuate based
upon occupancy levels in the facilities. The "per diem" rates were established
assuming a declining "per diem" value over the initial four years of the
contract to coincide with the phase-in of the Medicare Prospective Payment
System ("PPS") rates. Omnicare subsequently asserted that "per diem" rates for
managed care and Medicare beneficiaries are subject to an upward adjustment
based upon a comparison of per diem rates to pricing models based on Medicaid
rates.
In 2001, the Company and Omnicare brought a matter to arbitration,
involving a "per diem" pricing rate billed for managed care residents. This
matter was subsequently settled and amounts reflected in the financial results.
The parties are currently negotiating the pricing of drugs for Medicare
residents and should this matter not be settled, the matter will be taken to
arbitration. Provision for settlement of this claim is included within the
financial statements.
In 2002, in connection with its agreements to provide pharmacy services
to the Company, Omnicare requested arbitration for an alleged lost profits claim
related to the Company's disposition of assets, primarily in Florida. Damage
amounts, if any, cannot be reasonably estimated based on information available
at this time. An arbitration hearing has not yet been scheduled. The Company
believes it has interpreted correctly and has complied with the terms of the
Preferred Provider Agreement. However, there can be no assurance that other
claims will not be made with respect to the agreement.
11
9. COMPREHENSIVE INCOME
Comprehensive Income is as follows for the periods shown (dollars in
thousands):
THREE MONTHS THREE MONTHS NINE MONTHS NINE MONTHS
ENDED ENDED ENDED ENDED
SEPT. 30, 2003 SEPT. 30, 2002 SEPT. 30, 2003 SEPT. 30, 2002
-------------- -------------- -------------- --------------
NET EARNINGS......................................... $ 5,401 $ 2,005 $ 11,870 $ 4,169
OTHER COMPREHENSIVE INCOME (LOSS):
Unrealized gain (loss) on investments, before tax... 908 (1,338) 3,458 (2,538)
Gain (loss) on cash flow hedges, before tax........ 61 (17) 3 1,559
------------ ------------ ------------ ------------
Other comprehensive income, before tax.............. 969 (1,355) 3,461 (979)
Income tax provision related to items of other
comprehensive income (loss)....................... 387 (541) 1,374 (469)
------------ ------------ ------------ ------------
Other comprehensive income (loss), net of tax....... 582 (814) 2,087 (510)
------------ ------------ ------------ ------------
COMPREHENSIVE EARNINGS............................... $ 5,983 $ 1,191 $ 13,957 $ 3,659
============ ============ ============ ============
10. UNCERTAINTIES AND CERTAIN SIGNIFICANT RISKS
Medicare and Medicaid funding
The Company's earnings are highly contingent on Medicare and Medicaid
funding rates, and the effective management of staffing and other costs of
operations which are strictly monitored through state and federal regulatory
authorities. The Company is unable to predict whether the federal or any state
government will adopt changes in their reimbursement systems, or if adopted and
implemented, what effect such initiatives would have on the Company. Limitations
on Medicare and Medicaid reimbursement for healthcare services are continually
proposed. Changes in applicable laws and regulations could have an adverse
effect on the levels of reimbursement from governmental, private and other
sources.
The incremental Medicare relief packages received from the Balanced
Budget Refinement Act of 1999 ("BBRA") and Benefits Improvement and Protection
Act of 2000 ("BIPA") provided a total of $2.7 billion in temporary Medicare
funding enhancements to provide some interim relief to the long-term care
industry. The funding enhancements implemented by the BBRA and BIPA fall into
two categories. The first category is "Legislative Add-ons", which included a
16.66% add-on to the nursing component of the Resource Utilization Groupings
("RUGs") rate and a 4% base adjustment. The second category is "RUGs
Refinements" which involves an initial 20% add-on for 15 RUGs categories
identified as having high intensity, non-therapy ancillary services. The 20%
add-ons from three RUGs categories were later redistributed to 14 rehabilitation
categories at an add-on rate of 6.7% each.
On September 30, 2002 the Legislative Add-ons expired resulting in a
reduction in Medicare funding for all long-term care providers. The Company
estimates that based upon the Medicare case mix and census for the nine months
ended September 30, 2002, it received an average rate of $31.22 per resident day
related to the Legislative Add-ons. This decline in Medicare rates was partially
offset by a 2.6% market basket increase received on October 1, 2002. For the
nine months ended September 30, 2003 the average daily Medicare Part A rate was
$292.93, as compared to $311.55 for the nine months ended September 30, 2002.
Based upon the Medicare case mix and census for the nine months ended September
30, 2003, the lower average Medicare Part A rate, primarily resulting from the
loss of the Legislative Add-ons, reduced revenues by approximately $10.1 million
for the nine months ended September 30, 2003 as compared to the nine months
ended September 30, 2002.
With respect to the RUGs Refinements, on April 23, 2002 the Centers for
Medicare and Medicaid Services ("CMS") announced that it would delay the
refinement of the RUGs categories thereby extending the related funding
enhancements for at least one additional year to September 30, 2003. In May
2003, CMS released a proposed rule to maintain the current
12
RUGs classification until October 1, 2004. Further to this, Congress enacted
legislation directing CMS to conduct a study of the RUGs classification system
and report its recommendations to Congress by January 2005. The proposed federal
2003/2004 budget extends the additional funding for the RUGs Refinements to
September 30, 2004. Based upon the Medicare case mix and census for the nine
months ended September 30, 2003, the Company estimates that it received an
average $23.61 per resident day, which on an annualized basis amounts to $17.0
million related to the RUGs Refinements. A decision to discontinue all or part
of the enhancement could have a significant impact on the Company.
Effective September 1, 2003, CMS implemented a $1,590 annual payment
cap per Medicare beneficiary for outpatient Part B rehabilitation therapy
services. For 2003, the cap will apply to services provided after August 31,
2003. For 2004 and thereafter, the cap will apply on a calendar year basis. The
impact of this payment cap cannot be reasonably estimated based on the
information available at this time; however, the cap is expected to reduce
therapy revenues.
In February 2003, CMS announced its plan to reduce its level of
reimbursement for uncollectible Part A co-insurance. Under current law, skilled
nursing facilities are reimbursed 100% for any bad debts incurred. Over the next
three years, CMS plans to phase down the reimbursement level to 70% as follows:
90% effective for the government fiscal year commencing October 1, 2003; 80% for
the government fiscal year commencing October 1, 2004; and 70% for the
government fiscal year commencing October 1, 2005 and thereafter. This plan is
consistent with the bad debt reimbursement plan for hospitals. The Company
estimates that should this plan be implemented, the impact on earnings before
income taxes would be approximately $1.3 million in 2004, increasing to
approximately $3.3 million in 2006. These estimates are based upon historical
experience and known state reimbursement changes that are subject to change.
Effective October 1, 2003 CMS increased Medicare rates by 6.26%
reflecting (1) a cumulative forecast correction ("Administrative Fix") which
increased the Federal base payment rates by 3.26%, and (2) the annual market
basket increase of 3.0%. The Company estimates that based on the Medicare case
mix for the first nine months of 2003, this Medicare rate increase would add
approximately $18.45 per Medicare day. Based on the Medicare patient days for
the nine months ended September 30, 2003, this Medicare rate increase amounts to
additional annualized revenue of approximately $13.3 million going forward,
which will be tempered by higher labor and other operating costs.
Assets from Divested Operations
Through the divestiture program in Texas and Florida, the Company has
assumed notes from the purchasers of properties and operations sold, and in
other transactions retained ownership of certain nursing home properties, which
the Company leases to other unrelated long-term care providers. As a result, the
earnings and cash flow of the Company could be influenced by the financial
stability of these unrelated long-term care providers.
As at September 30, 2003 the Company has $21.4 million in notes
receivable from Tandem, which are due in full at various dates between April
2006 and December 2007.
In addition, pursuant to disposition agreement with Greystone Tribeca
Acquisition L.L.C. ("Greystone") in September 2000, the Company received initial
cash proceeds of $30.0 million and contingent consideration in the form of a
series of interest bearing notes, which have a minimum value of $10.0 million
and maximum aggregate value of $30.0 million, plus interest. As a significant
portion of the sale proceeds were contingent, the disposal was accounted for as
a deferred sale in accordance with SFAS No. 66. There was no gain or loss
recorded on the initial transaction, and the Company continues to depreciate the
fixed assets on its balance sheet, which as at September 30, 2003 have a net
book value of $34.3 million. The notes receivable mature in March 2004 at which
time the notes and interest are payable to the Company.
The Company owns $16.3 million in nursing home properties in Texas and
Florida relating to divested operations and has $8.3 million in accounts
receivable with unrelated long-term care providers who lease the properties. For
the nine months ended September 30, 2003 and 2002, the Company earned management
and consulting fees of $0.7 million and $1.1 million, respectively, and rental
revenue of $1.5 million and $3.0 million, respectively, from properties owned
and leased to unrelated long-term care operators.
13
Accrual for Self-Insured Liabilities
The Company has $46.1 million in accruals for self-insured liabilities
as of September 30, 2003. An actuarial valuation was completed as of September
30, 2003 and it was determined that no adjustment was required to the accrual
for self-insured liabilities amounts on the balance sheet. Though the Company
has been successful in exiting from the states of Texas and Florida and limiting
future exposure to general liability claims in these states, the timing and
eventual settlement costs for these claims cannot be precisely defined.
11. SUBSEQUENT EVENTS
Subsequent to September 30, 2003 the Company entered into several
agreements which are anticipated to be completed in the fourth quarter of 2003.
The Company entered into agreements to purchase one skilled nursing facility (99
beds) and an adjacent piece of land in Wisconsin for approximately $4.4 million
and has signed a letter of intent to purchase one currently leased skilled
nursing facility in Washington for approximately $1.5 million. In addition, the
Company has an agreement to sell, for approximately $1.8 million, a previously
closed nursing facility with a net book value of approximately $1.4 million.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Based on number of beds, we are one of the largest providers of
long-term care and related services in the United States. As of September 30,
2003, we operated 139 nursing facilities (14,126 beds) and 35 assisted living
and retirement facilities (1,728 units) located in 13 states. In addition, we
managed 14 nursing facilities (1,689 beds) and five assisted living and
retirement facilities (156 units) and provided selected consulting services to
61 nursing facilities (7,483 beds) and two assisted living facilities (186 beds)
owned by third parties. In total, we operated, managed or provided selected
consulting services to 256 long-term care facilities (25,368 beds) in 16 states,
of which 214 are nursing facilities (23,298 beds) and 42 are assisted living and
retirement facilities (2,070 units).
FORWARD-LOOKING STATEMENTS
This quarterly report on Form 10-Q contains forward-looking statements
that are intended to qualify for the safe harbors from liability established by
the Private Securities Litigation Reform Act of 1995. All statements other than
statements of historical fact, including statements regarding anticipated
financial performance, business strategy and management's plans and objectives
for future operations, are forward-looking statements. These forward-looking
statements can be identified as such because the statements generally include
words such as "expect," "intend," "believe," "anticipate," "estimate," "plan" or
"objective" or other similar expressions. These forward-looking statements are
subject to risks and uncertainties that could cause actual results to differ
materially from those expressed in, or implied by, these statements. Some, but
not all, of the risks and uncertainties include those described in the "Risk
Factors of the Industry" section of our Annual Report on Form 10-K for the year
ended December 31, 2002 and include the following:
- Medicare and Medicaid reimbursement policies;
- resident care litigation, including exposure for punitive damage
claims and increased insurance costs, which among other things
caused us to exit Florida and Texas markets;
- the shortage of, and related costs of hiring and retraining
qualified staff and employees;
- federal and state regulation of our business;
- actions by our competitors; and
14
- fee pressures and slow payment practices by health maintenance
organizations and preferred provider organizations.
All forward-looking statements contained in this report are based upon
information available at the time the statement is made and we assume no
obligation to update any forward-looking statement.
REVENUES
We derive revenues by providing healthcare services in our network of
facilities, including long-term care services such as nursing care, assisted
living and other related medical services such as subacute care and
rehabilitative therapy. We derive nursing and assisted living facility revenues
by providing routine and ancillary services for our facilities' residents. We
derive outpatient therapy revenue by providing such services to outside third
parties at our clinics.
We generate our revenue from Medicare, Medicaid and private pay
sources. The following table sets forth our Medicare, Medicaid and private pay
sources of revenue by percentage of total revenue:
THREE MONTHS ENDED SEPT. 30 NINE MONTHS ENDED SEPT. 30,
--------------------------- ---------------------------
2003 2002 2003 2002
---- ---- ---- ----
Medicare.............................. 26.2% 26.1% 27.1% 25.7%
Medicaid.............................. 50.0% 49.4% 48.9% 49.7%
Private Pay........................... 23.8% 24.5% 24.0% 24.6%
LEGISLATIVE ACTIONS AFFECTING REVENUES
Our earnings are highly contingent on Medicare and Medicaid funding
rates, and the effective management of staffing and other costs of operations
which are strictly monitored through state and federal regulatory authorities.
We are unable to predict whether the federal or any state government will adopt
changes in their reimbursement systems, or if adopted and implemented, what
effect such initiatives would have on us. Limitations on Medicare and Medicaid
reimbursement for healthcare services are continually proposed. Changes in
applicable laws and regulations could have an adverse effect on the levels of
reimbursement from governmental, private and other sources.
The incremental Medicare relief packages received from the Balanced
Budget Refinement Act of 1999 ("BBRA") and Benefits Improvement and Protection
Act of 2000 ("BIPA") provided a total of $2.7 billion in temporary Medicare
funding enhancements to provide some interim relief to the long-term care
industry. The funding enhancements implemented by the BBRA and BIPA fall into
two categories. The first category is "Legislative Add-ons", which included a
16.66% add-on to the nursing component of the Resource Utilization Groupings
("RUGs") rate and a 4% base adjustment. The second category is "RUGs
Refinements" which involves an initial 20% add-on for 15 RUGs categories
identified as having high intensity, non-therapy ancillary services. The 20%
add-ons from three RUGs categories were later redistributed to 14 rehabilitation
categories at an add-on rate of 6.7% each.
On September 30, 2002 the Legislative Add-ons expired resulting in a
reduction in Medicare funding for all long-term care providers. We have
estimated that based upon the Medicare case mix and census for the nine months
ended September 30, 2002, we received an average rate of $31.22 per resident day
related to the Legislative Add-ons. This decline in Medicare rates was partially
offset by a 2.6% market basket increase received on October 1, 2002. For the
nine months ended September 30, 2003 the average daily Medicare Part A rate was
$292.93, as compared to $311.55 for the nine months ended September 30, 2002.
Based upon the Medicare case mix and census for the nine months ended September
30, 2003, the lower average Medicare Part A rate, primarily resulting from the
loss of the Legislative Add-ons, reduced revenues by approximately $10.1 million
for the nine months ended September 30, 2003 as compared to the nine months
ended September 30, 2002.
With respect to the RUGs Refinements, on April 23, 2002 the Centers for
Medicare and Medicaid Services ("CMS")
15
announced that it would delay the refinement of the RUGs categories thereby
extending the related funding enhancements for at least one additional year to
September 30, 2003. In May 2003, CMS released a proposed rule to maintain the
current RUGs classification until October 1, 2004. Further to this, Congress
enacted legislation directing CMS to conduct a study of the RUGs classification
system and report its recommendations to Congress by January 2005. The proposed
federal 2003/2004 budget extends the additional funding for the RUGs Refinements
to September 30, 2004. Based upon the Medicare case mix and census for the nine
months ended September 30, 2003, we estimated that we received an average $23.61
per resident day, which on an annualized basis amounts to approximately $17.0
million related to the RUGs Refinements. A decision to discontinue all or part
of the enhancement could have a significant impact on us.
Effective September 1, 2003, CMS implemented a $1,590 annual payment
cap per Medicare beneficiary for outpatient Part B rehabilitation therapy
services. For 2003, the cap will apply to services provided after August 31,
2003. For 2004 and thereafter, the cap will apply on a calendar year basis. The
impact of this payment cap cannot be reasonably estimated based on the
information available at this time; however, the cap is expected to reduce
therapy revenues.
In February 2003, CMS announced its plan to reduce its level of
reimbursement for uncollectible Part A co-insurance. Under current law, skilled
nursing facilities are reimbursed 100% for any bad debts incurred. Over the next
three years, CMS plans to phase down the reimbursement level to 70% as follows:
90% effective for the government fiscal year commencing October 1, 2003; 80% for
the government fiscal year commencing October 1, 2004; and 70% for the
government fiscal year commencing October 1, 2005 and thereafter. This plan is
consistent with the bad debt reimbursement plan for hospitals. We have estimated
that should this plan be implemented, the impact on earnings before income taxes
would be approximately $1.3 million in 2004, increasing to approximately $3.3
million in 2006. These estimates are based upon historical experience and known
state reimbursement changes that are subject to change.
Effective October 1, 2003 CMS increased Medicare rates by 6.26%
reflecting (1) a cumulative forecast correction ("Administrative Fix") which
increased the Federal base payment rates by 3.26%, and (2) the annual market
basket increase of 3.0%. We have estimated that based on the Medicare case mix
for the first nine months of 2003, this Medicare rate increase would add
approximately $18.45 per Medicare day. Based on the Medicare patient days for
the nine months ended September 30, 2003, this Medicare rate increase amounts to
additional annualized revenue of approximately $13.3 million going forward,
which will be tempered by higher labor and other operating costs.
CRITICAL ACCOUNTING POLICIES
For a full discussion of our critical accounting policies, refer to the
Management Discussion and Analysis section in our Annual Report on Form 10-K for
the year ended December 31, 2002. Our disclosures in such report on Form 10-K
have not materially changed since that report was filed. We consider our
accounting policies to be critical to an understanding of our financial
statements because their application requires significant judgement and reliance
on estimations of matters that are inherently uncertain. Specific risks relate
to the accounting policies applied in revenue recognition and the valuation of
accounts receivable, the valuation of assets and determination of asset
impairment, the accrual for self-insured liabilities and accounting for deferred
income taxes.
SIGNIFICANT EVENTS IN 2003 AND 2002
ISSUANCE OF SENIOR NOTES
On June 28, 2002 we completed a private placement of $150 million of
our 9.5% Senior Notes due July 1, 2010, which were issued at a discount of 0.25%
of par to yield 9.54%. In January 2003, we completed the offer to exchange our
9.5% Senior Notes due 2010 that have been registered under the Securities Act of
1933 for the Notes issued in June 2002. The terms of the new Senior Notes are
identical to the terms of the Senior Notes issued in June 2002 and are
guaranteed by all of our existing and future active subsidiaries.
We used the proceeds of $149.6 million to pay $8.3 million of related
fees and expenses, retire $130.8 million of debt (consisting of $124.5 million
outstanding under the previous credit facility and term loans and $6.3 million
of other debt), and
16
the remainder for general corporate purposes. We had hedged a portion of our
previous variable-rate long-term debt through an interest rate swap with a
notional amount of $25 million maturing in February 2003. Upon refinancing of
the debt, we terminated this swap with a cash payment of $0.6 million. This
amount and other deferred financing costs related to the previous credit
facility resulted in a loss on early retirement of debt of $2.8 million ($1.7
million after income taxes) in June 2002.
In June 2002, we entered into an interest rate swap (used to hedge the
fair value of fixed-rate debt obligations) with a notional amount of $150
million maturing in December 2007. Under this swap, we pay a variable rate of
interest equal to the one-month London Interbank Borrowing Rate ("LIBOR") (1.12%
as of September 30, 2003), adjustable monthly, plus a spread of 4.805% and
receive a fixed rate of 9.35%. Under the terms of the interest rate swap, the
counterparty can call the swap upon 30 days notice. This swap is designated as a
fair value hedge and, as a result, changes in the market value of the swap had
no impact on the income statement during 2002 or 2003.
In June 2002, we entered into an interest rate cap with a notional
amount of $150 million maturing in December 2007. Under this cap, we pay a fixed
rate of interest equal to 0.24% and receive a variable rate of interest equal to
the excess, if any, of the one-month LIBOR rate, adjusted monthly, over the cap
rate of 7%. Under the terms of the interest rate cap, the counterparty can call
the cap upon 30 days notice. A portion of the interest rate cap with a notional
amount of $32 million is designated as a hedging instrument (cash-flow hedge) to
effectively limit possible increases in interest payments under variable-rate
debt obligations. The remainder of the interest rate cap with a notional amount
of $118 million is used to offset increases in variable-rate interest payments
under the interest rate swap to the extent one-month LIBOR exceeds 7%. This
portion of the interest rate cap is not designated as a hedging instrument under
SFAS 133.
PURCHASE OF PREVIOUSLY-LEASED FACILITIES
In October 2002, we purchased three skilled nursing facilities in Ohio
and four skilled nursing facilities in Indiana that we previously leased for an
aggregate purchase price of $17.9 million. The purchase price consisted of $7.4
million in cash and a $10.5 million ten-year note. In September 2003, as part of
an agreement to fix the interest rate with the holder of the note, the Company
paid $2.0 million and agreed to refinance the 10-year note. Should the Company
not proceed, the interest rate would be settled through the re-opening of
arbitration.
17
ASSET DIVESTITURES AND PROVISION FOR CLOSURE AND EXIT COSTS
In May 2002, Tandem Health Care, Inc. exercised its option to purchase
seven properties that it leased from us in Florida for gross proceeds of $28.6
million, consisting of cash of $15.6 million and $13.0 million in 8.5% five-year
notes (net proceeds of $25.5 million). We applied $12.4 million of the proceeds
to reduce our bank debt. Until this date, Tandem operated these facilities under
a lease agreement with a purchase option. The carrying value of the seven
facilities was $21.5 million. As a result, we recorded a gain on the sale of
assets of $4.0 million, inclusive of the deferred gain of $2.2 million from the
sale of two leased nursing properties in April 2001 to Tandem. We deferred the
gain from this April 2001 transaction in accordance with Statement of Financial
Accounting Standard No. 66.
We review on an ongoing basis the level of our overall reserves for
losses related to our Florida and Texas operations, which reserves were
initially established when we decided to exit these states. See footnote 4 to
our consolidated financial statements in our Annual Report on Form 10K for the
year ended December 31, 2002. As a result of events which became known to us in
2002, we concluded in the second quarter of 2002 that we should increase our
overall reserves by $5.3 million for cost report and other settlements with the
state of Florida and other Medicare fiscal intermediaries, collection of
receivables, and settlement of claims with suppliers and employees.
DEVELOPMENT OF NEW FACILITIES
In the second quarter of 2003, we entered into construction agreements
for the expansion of four assisted living facilities (86 units) and two skilled
nursing facilities (38 beds) and the addition of one new assisted living
facility (40 units). Four of the seven projects are expected to be completed in
2004, with the remainder completed in early 2005. The total approximate cost of
the projects is $15.2 million. Capital expenditure commitments of $9.7 million
have been made. Costs incurred through September 30, 2003 were $1.3 million.
OTHER ITEMS
We continue to negotiate collection on a number of outstanding Medicare
and Medicaid settlement receivables. Normally such issues are resolved during an
annual audit process; however we record provisions for disagreements that
require settlement through a formal appeal process. For one specific Medicare
receivable issue which concerns fiscal years prior to the implementation of the
Prospective Payment System and involves the allocation of overhead costs, the
first of three specific claim years was presented to the Provider Reimbursement
Review Board ("PRRB") at a hearing in January, 2003. The hearing procedures were
discontinued after the parties negotiated a methodology for resolution of the
claim for one of the years in dispute. The negotiated settlement for this and
other issues relating to the 1996 cost report year, resulted in no adjustment to
the recorded receivable balance, and we subsequently collected $3.0 million from
the Fiscal Intermediary ("FI"). For another specific issue involving a staffing
cost issue, a settlement of the first year of seven specific claim years was
reached prior to the January 2003 PRRB hearing, and we continue to negotiate
years in dispute with the FI. For both the overhead allocation and staffing
issues, which we are appealing for the recovery of $11.6 million and $6.4
million respectively, further negotiations on the remaining years under appeal
are expected to occur prior to the hearing dates which are scheduled for the
first and second quarters, respectively, of 2004. We also have a hearing
scheduled in the third quarter on a Director of Nursing staff cost issue. In the
third quarter of 2003, we made a provision for $2.2 million as a reduction of
revenue pertaining to individual claims in dispute with the FI relating to the
cost report years 1996 through 1998. We continue to pursue collection of these
claims with the FI. As of September 30, 2003 we had $56.5 million in gross
Medicare and Medicaid settlement receivables with a related allowance for
doubtful accounts of $17.6 million. The net amounts receivable represents our
estimate of the amount collectible on Medicare and Medicaid prior period cost
reports.
We have $46.1 million in accruals for self-insured liabilities as of
September 30, 2003. An actuarial valuation was completed as of September 30,
2003 and it was determined that no adjustment was required to the accrual for
self-insured liabilities amounts on the balance sheet. Though we have been
successful in exiting from the states of Texas and Florida and limiting future
exposure to general liability claims in these states, the timing and eventual
settlement costs for these claims cannot be precisely defined.
We entered into a Preferred Provider Agreement with Omnicare, Inc.
("Omnicare") pursuant to the divestiture of its
18
pharmacy operation in 1998. We and Omnicare are currently negotiating the 2001
and 2002 pricing of drugs for Medicare residents and, should this matter not be
settled, the matter will be taken to arbitration. In connection with its
agreement to provide pharmacy services, Omnicare has requested arbitration for
an alleged lost profits claim relating to our disposition of assets, primarily
in Florida. Damage amounts, if any cannot be reasonably estimated based on
information available at this time. An arbitration hearing for this matter has
not been scheduled. We believe that we have interpreted correctly and complied
with the terms of the Preferred Provider Agreement. However, there can be no
assurances that other claims will not be made with respect to this agreement.
SUBSEQUENT EVENTS
Subsequent to September 30, 2003 we entered into agreements to purchase
one skilled nursing facility (99 beds) and an adjacent piece of land in
Wisconsin for approximately $4.4 million and signed a letter of intent to
purchase one currently leased skilled nursing facility in Washington for
approximately $1.5 million. In addition, we have an agreement to sell, for
approximately $1.8 million, a previously closed nursing facility with a net book
value of approximately $1.4 million.
RESULTS FROM OPERATIONS:
The following table sets forth details of revenues and earnings as a percentage
of total revenues:
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPT. 30, SEPT. 30,
------------------- -------------------
2003 2002 2003 2002
------- ------- ------- -------
Revenues:
Nursing and assisted living centers.............. 96.7% 96.9% 96.8% 96.6%
Outpatient therapy............................... 1.4 1.2 1.3 1.3
Other............................................ 1.9 1.9 1.9 2.1
------- ------- ------- -------
100.0 100.0 100.0 100.0
Expenses:
Operating and general and administrative costs .. 87.1 88.4 87.9 88.1
Lease costs, depreciation and amortization....... 5.3 5.8 5.4 6.0
Interest, net.................................... 3.5 4.2 3.7 3.9
Gain on disposal of assets....................... - - - (0.7)
Provision for closure and exit costs............. - - - 0.9
Loss on early retirement of debt................. - - - 0.5
------- ------- ------- -------
Earnings before taxes............................ 4.1 1.6 3.0 1.3
Income tax expense............................... 1.6 0.6 1.2 0.6
------- ------- ------- -------
Net Earnings..................................... 2.5% 1.0% 1.8% 0.7%
======= ======= ======= =======
Average occupancy in our long-term care facilities was as follows:
THREE MONTHS ENDED SEPT. 30, NINE MONTHS ENDED SEPT. 30,
---------------------------- ---------------------------
2003 2002 2003 2002
---- ---- ---- ----
Skilled nursing facilities............ 91.6% 90.8% 91.4% 90.0%
Assisted living facilities............ 86.9% 84.5% 86.0% 83.1%
19
THREE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED WITH THREE MONTHS ENDED SEPTEMBER
30, 2002
Our key Medicare and Medicaid results and statistics for our nursing
operations, including ancillary revenues, for the three months ended September
30, 2003 ("2003 quarter") and the three months ended September 30, 2002 ("2002
quarter") are summarized as follows:
MEDICARE MEDICAID
----------------------------- ------------------------------
2003 2002 CHANGE 2003 2002 CHANGE
------ ------ ------ ------ ------ ------
Average daily rate ............... $ 312 $ 338 (7.7%) $ 136 $ 126 7.9%
Residents as a percent of total
census ........................... 15.2 13.3 14.3% 67.7 68.5 (1.2%)
Average daily census ............. 1,970 1,702 15.7% 8,745 8,746 (0.0%)
The Medicare Part A average daily rate decreased from $311.11 for the
2002 quarter to $294.12 for the 2003 quarter. The decrease in the total Medicare
and Part A Medicare rate is primarily relating to the loss of Legislative
Add-ons and the $2.2 million provision for prior year long-term Medicare
settlement receivables (refer to note 5 of financial statements).
REVENUES
Revenues in the 2003 quarter were $220.0 million, representing an
increase of $13.2 million, or 6.4%, from $206.8 million in the 2002 quarter.
Outpatient therapy and other revenues increased by $0.8 million.
Revenues from nursing and assisted living facilities increased $12.4
million due to:
- a 4.7% increase in the average daily nursing Medicaid rate (which
included cost-offset funding as a result of increased state
assessments and bed taxes of $1.8 million), which increased revenues
by $4.8 million;
- an increase in Medicare residents from 13.3% of total residents in
the 2002 quarter to 15.2% in the 2003 quarter, which increased
revenues by $3.3 million;
- a 1.1% increase in nursing resident census from an average daily
census of 12,775 in the 2002 quarter to 12,915 in the 2003 quarter,
which increased revenues by $2.4 million;
- a recovery of $1.9 million in Medicaid revenues as the outcome of a
favorable court decision in the State of Ohio relating to the
recovery of alleged government overpayments for adjudicated Medicaid
cost report periods. We continue to review prior year cost report
settlements as they relate to the court's decision;
- increases in other average daily nursing rates, which resulted in
additional revenues of $1.8 million;
- an increase in nursing ancillary revenues of $2.0 million, primarily
due to increased therapy services; and
- an increase of $1.0 million when comparing the 2003 quarter with the
2002 quarter due to more favorable Medicaid cost settlements in 2003;
and
- an increase in assisted living revenues of $0.5 million due to
increased occupancy and higher rates;
These increases were offset by a decrease of $3.1 million in Medicare
revenue primarily relating to the expiration of the Legislative Add-ons as of
October 1, 2002 and a decrease of $2.2 million for prior year long-term Medicare
settlement receivables (refer to note 5 of financial statements).
20
OPERATING AND GENERAL AND ADMINISTRATIVE COSTS
Operating and general and administrative costs increased $9.0 million,
or 4.9%, between periods, and included increases of:
- wages and benefits of $2.1 million, or a 1.7% increase, which
includes an average wage increase of 2.5% in nursing operations,
offset by lesser increases in other areas;
- state assessments and bed taxes of $1.8 million;
- drug expense of $1.2 million due to higher resident census, Medicare
mix and drug prices;
- professional fees expense of $1.0 million primarily due to legal fees
and nursing consulting; and
- other operating and general and administrative expenses of $2.9
million.
LEASE COSTS, DEPRECIATION AND AMORTIZATION
Lease costs decreased $0.4 million when comparing periods, including
$0.5 million as a result of the purchase of previously leased facilities in
2002, offset by an increase of $0.1 million relating to other facilities that we
continue to operate. Depreciation and amortization was unchanged at $9.4 million
for both the 2003 quarter and the 2002 quarter.
INTEREST
Interest expense, net of interest income, decreased $1.2 million to
$7.6 million for the 2003 quarter compared to $8.8 million for the 2002 quarter.
The weighted average interest rate of all long-term debt decreased to 7.61%
during the 2003 quarter compared to approximately 8.11% during the 2002 quarter.
Net interest expense was net of interest income of $1.3 million from interest
rate swaps and $0.1 from the rate cap in the 2003 quarter compared to net
interest income of $1.0 million from interest rate swaps and interest expense of
$0.5 million from the rate cap in the 2002 quarter. The average debt level
increased to $397.2 million during the 2003 quarter compared to $388.9 million
during the 2002 quarter.
INCOME TAXES
Income tax expense for the 2003 quarter was $3.6 million compared to
$1.2 million for the 2002 quarter. Our effective tax rate was 40.0% for the 2003
quarter as compared to 37.3% for the 2002 quarter. The increase was due to
incremental state income taxes in 2003.
NET EARNINGS
Net earnings for the 2003 quarter were $5.4 million compared to $2.0
million for the 2002 quarter. The improvement in net earnings is due to the
reasons described herein.
RELATED PARTY TRANSACTIONS
We insure certain risks, including comprehensive general liability,
property coverage, excess workers' compensation and employer's liability
insurance, with Laurier Indemnity Company and Laurier Indemnity Ltd., affiliated
insurance subsidiaries of Extendicare Inc. We recorded approximately $2.7
million of expenses for this purpose for each of the three months ended
September 30, 2003 and 2002.
We purchase computer hardware and software support services from
Virtual Care Provider, Inc., an affiliated subsidiary of Extendicare Inc.
Expenses related to these services were $1.7 million and $2.1 million for the
three months ended September 30, 2003 and 2002, respectively.
21
NINE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED WITH NINE MONTHS ENDED SEPTEMBER
30, 2002
Our key Medicare and Medicaid results and statistics for our nursing
operations, including ancillary revenues, for the nine months ended September
30, 2003 ("2003 period") and the nine months ended September 30, 2002 ("2002
period") are summarized as follows:
MEDICARE MEDICAID
------------------------------------ ------------------------------------
2003 2002 CHANGE 2003 2002 CHANGE
-------- -------- ------ -------- -------- ------
Average daily rate................ $ 317 $ 337 (5.9%) $ 132 $ 126 4.8%
Residents as a percent of total
census.......................... 15.4 13.1 17.6% 67.4 68.6 (1.7%)
Average daily census.............. 1,978 1,663 18.9% 8,681 8,703 (0.3%)
The Medicare Part A average daily rate decreased from $311.55 for the
2002 period to $292.93 for the 2003 period. The decrease in the total Medicare
and Part A Medicare rate is primarily relating to the loss of Legislative
Add-ons and the $2.2 million provision for prior year long-term Medicare
settlement receivables (refer to note 5 of financial statements).
REVENUES
Revenues in the 2003 period were $644.7 million, representing an
increase of $37.9 million, or 6.2%, from $606.8 million in the 2002 period.
Outpatient therapy and other revenues increased by $0.3 million in the 2003
period primarily due to growth of the outpatient therapy operations.
Revenues from nursing and assisted living facilities increased $37.6
million in the 2003 period due to:
- an increase in Medicare residents from 13.1% of total residents in
the 2002 period to 15.4% in the 2003 period, which increased revenues
by $11.8 million;
- a 3.6% increase in the average daily nursing Medicaid rate (which
included cost-offset funding as a result of increased state
assessments and bed taxes of $2.6 million), which increased revenues
by $10.7 million;
- a 1.5% increase in nursing resident census from an average daily
census of 12,682 for the 2002 period to 12,872 in the 2003 period,
which increased revenues by $9.8 million;
- increases in other average daily nursing rates, which resulted in
additional revenues of $6.5 million;
- an increase in nursing ancillary revenues of $5.8 million, primarily
due to increased therapy services;
- a recovery of $3.4 million in Medicaid revenues as the outcome of a
favorable court decision in the State of Ohio relating to the
recovery of alleged government overpayments for adjudicated Medicaid
cost report periods. We continue to review prior year cost report
settlements as they relate to the court's decision; and
- an increase in assisted living revenues of $1.9 million due to
increased occupancy and higher rates.
These increases were offset by a decrease of $10.1 million in Medicare
revenue primarily relating to the expiration of the Legislative Add-ons as of
October 1, 2002 and a decrease of $2.2 million for prior year long-term Medicare
settlement receivables, which are under review with the fiscal intermediary
(refer to note 5 of financial statements).
22
OPERATING AND GENERAL AND ADMINISTRATIVE COSTS
Operating and general and administrative costs increased $32.4 million,
or 6.1%, between the 2003 period and the 2002 period, and included increases of:
- wages and benefits of $14.8 million and contracted staffing for food
and laundry services of $3.6 million totaling $18.4 million, or a
4.8% increase, which includes an average wage rate increase of 3.8%
in nursing operations;
- drug expense of $3.0 million due to higher resident census, Medicare
mix and drug prices;
- state assessments and bed taxes of $2.6 million;
- supplies expense of $1.9 million primarily due to higher occupancy;
- professional fees expense of $1.6 million primarily due to legal fees
and nursing consulting; and
- other operating and general and administrative expenses of $4.9
million.
LEASE COSTS, DEPRECIATION AND AMORTIZATION
Lease costs decreased $1.6 million when comparing periods, including
$1.5 million as a result of the purchase of previously leased facilities in 2002
and $0.1 million relating to other facilities that we continue to operate.
Depreciation and amortization decreased $0.5 million to $27.7 million for the
2003 period compared to $28.2 million for the 2002 period.
INTEREST
Interest expense, net of interest income, decreased $0.4 million to
$23.5 million for the 2003 period compared to $23.9 million for the 2002 period.
The weighted average interest rate of all long-term debt increased to 7.77%
during the 2003 period compared to approximately 7.70% during the 2002 period.
Net interest expense was net of net interest income of $3.3 million from
interest rate swaps and caps in the 2003 period compared to $0.3 million of net
interest expense from interest rate swaps and caps in the 2002 period. The
average debt level increased to $397.7 million during the 2003 period compared
to $383.5 million during the 2002 period.
LOSS (GAIN) ON DISPOSAL OF ASSETS AND PROVISION FOR CLOSURE AND EXIT COSTS AND
OTHER ITEMS
For 2002, we recorded a gain on disposal of assets of $4.0 million
relating to the sale of seven properties in Florida to Tandem and a provision
for closure and exit costs of $5.3 million. The gain of $4.0 million includes
the recognition of a deferred gain of $2.2 million from the April 2001 sale of
two other properties to Tandem. We deferred the gain from the April 2001
transaction in accordance with Statement of Financial Accounting Standard No.
66. The provision for closure and exit costs relates to an increase in the
overall disposition reserve for cost report and other settlements with the
states of Florida and Texas and other Medicare fiscal intermediaries, collection
of receivables, and settlement of claims with suppliers and employees.
LOSS ON EARLY RETIREMENT OF DEBT
Loss on early retirement of debt was $2.8 million for the 2002 period
due to the retirement in June 2002 of our credit facility using proceeds from
the issuance of the Senior Notes.
INCOME TAXES
Income tax expense for the 2003 period was $7.9 million compared to
$3.4 million for the 2002 period. Our effective tax rate was 40.1% for the 2003
period as compared to 45.1% for the 2002 period. The tax rate for the 2002
period was higher because of the reversal of current and prior year state
deferred income tax benefits in the 2002 period. When we assess the
realizability of deferred tax assets, we consider whether it is more likely than
not that some portion or all of the deferred tax
23
assets will not be realized and record a valuation allowance, if required. The
ultimate realization of deferred tax assets depends upon us generating future
taxable income during the periods in which those temporary differences become
deductible. We consider the scheduled reversal of deferred tax liabilities,
projected future taxable income and tax planning strategies when we make this
assessment.
NET EARNINGS
Net earnings for the 2003 period were $11.9 million compared to $4.2
million for the 2002 period. The improvement in net earnings is due to the
reasons described herein.
RELATED PARTY TRANSACTIONS
We insure certain risks, including comprehensive general liability,
property coverage, excess workers' compensation and employer's liability
insurance, with Laurier Indemnity Company and Laurier Indemnity Ltd., affiliated
insurance subsidiaries of Extendicare Inc. We recorded approximately $8.0
million and $8.5 million of expenses for this purpose for the 2003 period and
2002 period, respectively.
We purchase computer hardware and software support services from
Virtual Care Provider, Inc., an affiliated subsidiary of Extendicare Inc.
Expenses related to these services were $5.2 million and $5.9 million for the
2003 period and 2002 period, respectively.
LIQUIDITY AND CAPITAL RESOURCES
We had cash and cash equivalents of $51.8 million at September 30, 2003
and $27.0 million at December 31, 2002. We generated cash flow of $35.2 million
from operating activities for the nine months ended September 30, 2003 compared
with $29.3 million in the comparable 2002 period. The increase was primarily due
to an improvement in earnings and a reduction of $5.1 million in payments for
self-insured liabilities.
Our working capital increased $27.4 million from $38.0 million at
December 31, 2002 to $65.4 million at September 30, 2003. The increase included
a $17.0 million net decrease in accounts payable, accrued liabilities and
current portion of accrual for self-insured liability. This increase in working
capital was partially offset by a $6.1 million decrease in accounts receivable.
Accounts receivable at September 30, 2003 were $98.0 million compared
with $104.1 million at December 31, 2002, representing a decrease of $6.1
million. The reduction in accounts receivable included a $6.7 million decrease
within the nursing operations, offset by an increase of $0.6 million in
outpatient therapy receivables Within the nursing operations, billed patient
care and other receivables decreased $1.5 million and third-party payor
settlement receivables, based on Medicare and Medicaid cost reports, decreased
$5.2 million.
The decrease in settlement receivables of $5.2 million from December
31, 2002 to September 30, 2003 included decreases of $3.9 million from
collections of Medicare settlements, $5.6 million for collections of Medicare
co-insurance amounts recorded as revenue in 2002 and $3.2 million for collection
of Medicaid cost report settlements. These decreases were partially offset by an
increase of $7.5 million relating to revenue in the 2003 period for anticipated
Medicare reimbursement for uncollectible co-insurance amounts.
Property and equipment decreased $9.4 million from December 31, 2002 to
a total of $443.7 million at September 30, 2003. The decrease was the result of
depreciation expense of $25.0 million and asset disposals of $0.1 million. These
decreases were partially offset by capital expenditures of $15.7 million.
Total long-term debt, including both current and long-term maturities
of debt, totaled $395.8 million at September 30, 2003. This represents a
decrease of $2.4 million from December 31, 2002, due to repayments of long-term
debt.
24
The weighted average interest rate of all of our long-term debt was
7.54% at September 30, 2003 and 7.77% for the 2003 period (including the effects
of the interest rate swap and cap) and such debt had maturities ranging from
2003 to 2014.
As of September 30, 2003, our parent, Extendicare Inc., held $27.9
million, or 14.0%, of our outstanding Senior Subordinated Notes.
Cash used in investing activities was $14.8 million for the nine months
ended September 30, 2003 compared to $2.7 million provided from investing
activities for the comparable 2002 period. The change of $17.5 million was due
to proceeds in 2002 from the sale of property and equipment of $14.3 million, an
increase in 2003 of $3.0 million in purchases of property and equipment and a
decrease in 2003 in the collection of notes receivable of $0.2 million.
Cash provided from financing activities was $4.5 million for the 2003
period compared to $3.3 million used in financing activities for the comparable
2002 period. The change of $7.7 million primarily relates to increased bank
indebtedness partially offset by the payoff of debt in June 2002 using proceeds
from the issuance of new debt as described below.
On June 28, 2002, we refinanced all outstanding indebtedness under our
then existing credit facility with the proceeds from the issuance of our 9.5%
Senior Notes due 2010 and we entered into a new credit facility that provides
senior secured financing of up to $105.0 million on a revolving basis. As of
September 30, 2003, we did not have any borrowings outstanding under this new
credit facility, but we had $41.1 million of letters of credit outstanding
thereunder. The new credit facility will terminate on June 28, 2007. Borrowings
drawn during the first four fiscal quarters following closing of the new credit
facility will initially bear interest, at our option, at an annual rate equal
to:
- LIBOR, plus 3.50%; or
- the Base Rate, as defined in our new credit facility, plus 2.50%;
thereafter, in each case, subject to adjustments based on financial performance.
Our obligations under the new credit facility are guaranteed by:
- Extendicare Holdings, Inc., our direct parent;
- each of our current and future domestic subsidiaries excluding
certain inactive subsidiaries; and
- any other current or future foreign subsidiaries that guarantee or
otherwise provide direct credit support for any U.S. debt obligations
of ours or any of our domestic subsidiaries.
Our obligations are secured by a perfected first priority security
interest in certain of our tangible and intangible assets and all of our and our
subsidiary guarantors' capital stock. The new credit facility is also secured by
a pledge of 65% of the voting stock of our and our subsidiary guarantors'
foreign subsidiaries, if any. Our new credit facility contains customary
covenants and events of default and is subject to various mandatory prepayments
and commitment reductions. The new credit facility requires that we comply with
various financial covenants, on a consolidated basis including:
- a minimum fixed charge coverage ratio starting at 1.10 to 1 and
increasing to 1.20 to 1 in 2005;
- a minimum tangible net worth starting at 85% of our tangible net
worth at March 31, 2002 and increasing by 50% of our net income for
each fiscal quarter plus 100% of any additional equity we raise;
- a maximum senior leverage ratio starting at 4.25 to 1 and reducing to
4.00 to 1 in 2005; and
- a maximum senior secured leverage ratio starting at 1.75 to 1 and
reducing to 1.50 to 1 in 2005.
We are in compliance with these financial covenants as of September 30,
2003.
25
To hedge our exposure to fluctuations in the market value of the Senior
Notes, we entered into a five-year interest rate swap contract with a notional
amount of $150 million. The contract effectively converted up to $150 million of
our fixed interest rate indebtedness into variable interest rate indebtedness.
Also in June 2002, we entered into a five-year interest rate cap with a
notional amount of $150 million. Under this cap, we pay a fixed rate of interest
equal to 0.24% and receive a variable rate of interest equal to the excess, if
any, of the one-month LIBOR rate, adjusted monthly, over the cap rate of 7%. We
use the interest rate cap to offset possible increases in interest payments
under the interest rate swap caused by increases in market interest rates over a
certain level and also as a cash flow hedge to effectively limit increases in
interest payments under our variable-rate debt obligations. Under the terms of
the interest rate cap, the counterparty can call the cap upon 30 days notice.
We believe that our cash from operations and anticipated growth,
together with other available sources of liquidity, including borrowings
available under our new credit facility, will be sufficient for the foreseeable
future to fund anticipated capital expenditures and make required payments of
principal and interest on our debt, including payments due on the notes and
obligations under our new credit facility.
OFF BALANCE SHEET ARRANGEMENTS
We have no significant off balance sheet arrangements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Qualitative Disclosures
We use interest rate swaps to hedge the fair value of our debt
obligations and interest rate caps as a cash flow hedge of our variable-rate
debt and also to offset possible increases in variable-rate payments under our
interest rate swap related to increases in market interest rates.
We also have market risk relating to investments in stock and stock
warrants that we obtained in connection with the 1998 sale of our pharmacy
operations. In effect, these holdings can be considered contingent purchase
price proceeds whose value, if any, may not be realized for several years. These
stock and warrant holdings are subject to various trading and exercise
limitations. We intend to hold them until we believe the market opportunity is
appropriate to trade or exercise the holdings.
We monitor the markets to adequately determine the appropriate market
timing to sell or otherwise act with respect to our stock and warrant holdings
in order to maximize their value. With the exception of the above holdings, we
do not enter into derivative instruments for any purpose other than cash flow
hedging purposes. That is, we do not speculate using derivative instruments and
do not engage in trading activity of any kind.
26
Quantitative Disclosures
The table below presents principal, or notional, amounts and related
weighted average interest rates by year of maturity for our debt obligations and
interest rate swaps as of September 30, 2003 (dollars in thousands):
FAIR
VALUE OF
AFTER LIABILITY
2003 2004 2005 2006 2007 2007 TOTAL (ASSET)
------- ------- ------- ------- -------- -------- -------- --------
LONG-TERM DEBT:
Fixed Rate......................... $ 372 $ 982 $ 984 $ 977 $203,801 $156,669 $363,785 $383,495
Average Interest Rate.............. 7.48% 8.33% 8.46% 8.46% 9.32% 9.58% 9.42%
Variable Rate...................... -- -- -- -- -- $ 32,000 $ 32,000 $ 32,000
Average Interest Rate.............. -- -- -- -- -- 1.16% 1.16%
INTEREST RATE SWAPS: (fixed to
variable)
Notional Amount.................... -- -- -- -- -- $150,000 $150,000 $ (8,747)
Average Pay Rate (variable rate)... -- -- -- -- -- -- 5.93%
Average Receive Rate (fixed rate).. -- -- -- -- -- -- 9.35%
INTEREST RATE CAPS:
Notional Amount.................. -- -- -- -- -- $150,000 $150,000 $ 936
The above table incorporates only those exposures that existed as of
September 30, 2003 and does not consider those exposures or positions which
could arise after that date or future interest rate movements. As a result, the
information presented above has limited predictive value. Our ultimate results
with respect to interest rate fluctuations will depend upon the exposures that
occur, our hedging strategies at the time and interest rate movements.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures
The Company's management evaluated, with the participation of the
Company's Chairman of the Board and Chief Executive Officer and Vice President,
Chief Financial Officer and Treasurer, the effectiveness of the design and
operation of the Company's disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities and Exchange Act of 1934) as
of the end of the quarter ended September 30, 2003. Based upon their evaluation
of these disclosure controls and procedures, the Chairman of the Board and Chief
Executive Officer and Vice President, Chief Financial Officer and Treasurer
concluded that the disclosure controls and procedures were effective, as of the
end of the quarter ended September 30, 2003, to ensure that material information
relating to the Company (including its consolidated subsidiaries) was made known
to them by others within those entities, particularly during the period in which
this Quarterly Report on Form 10-Q was being prepared.
Changes in internal control
There was no change in the Company's internal control over financial
reporting that occurred during the quarter ended September 30, 2003 that has
materially affected, or is reasonably likely to materially affect, the Company's
internal control over financial reporting.
27
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
There were no material developments related to the Company's legal
proceedings during the quarter ended September 30, 2003. For further information
regarding the Company's legal proceedings, refer to Item 3 - Legal Proceedings
in the Company's Annual Report on Form 10-K for the year ended December 31, 2002
as well as the paragraphs which discuss litigation and the Omnicare Preferred
Provider Agreement in note 8 of the condensed consolidated financial statements
included in this Form 10-Q.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) List of Exhibits:
31.1 Certification Pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002 - Chairman of the Board and Chief Executive
Officer
31.2 Certification Pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002 - Vice President, Chief Financial Officer and
Treasurer
32 Certification Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002 - Chairman of the Board and Chief Executive
Officer and Vice President, Chief Financial Officer and
Treasurer
(b) Reports on Form 8-K
Form 8-K furnished on August 11, 2003, relating to a press release
dated August 11, 2003, which announced earnings for the quarter ended
June 30, 2003, pursuant to item 12.
28
EXTENDICARE HEALTH SERVICES, INC.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
EXTENDICARE HEALTH SERVICES, INC.
Date: November 12, 2003 By: /s/ Mark W. Durishan
--------------------------
Mark W. Durishan
Vice President, Chief Financial
Officer and Treasurer
(principal financial officer and
principal accounting officer)
29
EXTENDICARE HEALTH SERVICES, INC.
EXHIBIT INDEX
31.1 Certification Pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002 - Chairman of the Board and Chief Executive
Officer
31.2 Certification Pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002 - Vice President, Chief Financial Officer and
Treasurer
32 Certification Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002 - Chairman of the Board and Chief Executive
Officer and Vice President, Chief Financial Officer and
Treasurer
30