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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
(Mark One)
/X/ Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
/ / Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
FOR THE TRANSITION PERIOD FROM TO .
COMMISSION FILE NUMBER 1-12040
SUN HEALTHCARE GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 85-0410612
(State of Incorporation) (I.R.S. Employer Identification No.)
101 SUN AVENUE NE
ALBUQUERQUE, NEW MEXICO 87109
(505) 821-3355
(Address and telephone number of Registrant)
Securities registered pursuant to Section 12(b) of the Act:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
Common Stock, par value $.01 per share, and New York Stock Exchange
Preferred Stock Purchase Rights
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports
required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes /X/ No / /
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in the definitive proxy statement
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. / /
On March 27, 1998, Sun Healthcare Group, Inc. had 49,594,627 outstanding
shares of Common Stock, net of treasury stock. Of those, 42,254,045 shares of
Common Stock were held by nonaffiliates. The aggregate market value of such
Common Stock held by nonaffiliates, based on the average of the high and low
sales prices of such shares on the New York Stock Exchange on March 27, 1998,
was approximately $788,302,027.
Documents Incorporated By Reference
Portions of the Sun Healthcare Group, Inc. definitive Proxy Statement for
the 1998 Annual Meeting of Stockholders, to be filed on or before April 30,
1998, are incorporated by reference into Part III of this Form 10-K.
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SUN HEALTHCARE GROUP, INC.
FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
INDEX
PAGE
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PART I
Item 1. Business..................................................................................... 2
Item 2. Properties................................................................................... 32
Item 3. Legal Proceedings............................................................................ 35
Item 4. Submission of Matters to a Vote of Security Holders.......................................... 36
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters........................ 37
Item 6. Selected Financial Data...................................................................... 38
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations........ 39
Item 7A. Quantitative and Qualitative Disclosure About Market Risk.................................... 61
Item 8. Financial Statements and Supplementary Data.................................................. 61
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures........ 61
PART III
Item 10. Directors and Executive Officers of the Registrant........................................... 62
Item 11. Executive Compensation....................................................................... 64
Item 12. Security Ownership of Certain Beneficial Owners and Management............................... 64
Item 13. Certain Relationships and Related Transactions............................................... 64
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.............................. 65
Signatures................................................................................... 73
SUNSOLUTION-Registered Trademark-, SUNDANCE-Registered Trademark-,
SUNSCRIPT-Registered Trademark- and CAREERSTAFF UNLIMITED-Registered Trademark-
and related names herein are registered trademarks of Sun and its subsidiaries.
1
PART I
ITEM 1. BUSINESS
GENERAL
Sun Healthcare Group, Inc., through its direct and indirect subsidiaries
(collectively referred to herein as "Sun" or the "Company"), is a leading
provider of high quality and cost efficient long-term, subacute and related
specialty healthcare services in the United States and the United Kingdom and
also has operations in Spain, Germany and Australia. At December 31, 1997, Sun
operated 321 long-term and subacute care facilities (which includes assisted
living facilities and managed facilities) with 36,655 licensed beds in the
United States and 162 long-term care and acute care facilities with 10,448
licensed beds internationally. Sun is one of the largest providers of ancillary
services to long-term care providers in the United States, including the
provision of rehabilitation therapy (the provision of physical, occupational and
speech therapy), respiratory therapy (the provision of respiratory therapy and
the distribution of related equipment and supplies), temporary therapy staffing
services and pharmaceutical products and services. Sun provides these services
to over 1,500 affiliated and nonaffiliated long-term and subacute care
facilities in the United States.
Sun's inpatient care facilities provide a broad range of healthcare
services, including nursing care, subacute care, therapy and other specialized
services such as care to patients with Alzheimer's disease. Sun's long-term and
subacute care operations have experienced significant growth since Sun's
inception in 1989, primarily from acquisitions of additional facilities. See
"Acquisitions." Sun believes its inpatient care operations provide it with a
platform to expand its therapy and pharmaceutical businesses (which include
dispensing pharmaceuticals for such purposes as infusion therapy, pain
management, antibiotic therapy and parenteral nutrition) to affiliated and
nonaffiliated long-term and subacute care facilities. Sun believes that its
expertise in operating long-term and subacute care facilities enables it to
provide its therapy and pharmaceutical services more effectively and efficiently
than providers without such operating expertise.
Sun believes it is one of the three largest providers of contract therapy in
the United States, offering rehabilitation therapy through SunDance
Rehabilitation Corporation ("SunDance") and respiratory therapy through SunCare
Respiratory Services, Inc. ("SunCare"). At December 31, 1997, Sun provided
therapy services to 1,565 facilities in 45 states, 1,278 of which were operated
by nonaffiliated parties and 287 of which were affiliated facilities.
Through CareerStaff Unlimited, Inc. ("CareerStaff"), the Company is a
nationwide provider of temporary therapy staffing. CareerStaff provides licensed
therapists skilled in the areas of physical, occupational and speech therapy
primarily to hospitals and nursing home contract service providers. At December
31, 1997, Sun had 27 division offices providing temporary therapy staffing
services in major metropolitan areas and six division offices specializing in
placements of temporary traveling therapists in smaller cities and rural areas.
Through SunScript Pharmacy Corporation ("SunScript"), as of December 31,
1997, Sun operated 38 pharmacies and one pharmaceutical billing and consulting
center which together provided pharmaceutical products and services to a total
of 801 long-term and subacute care facilities in 29 states, 546 of which were
nonaffiliated. In addition, the Company operated 19 pharmacies and one supply
distribution center in the United Kingdom at December 31, 1997.
INTERNATIONAL OPERATIONS
In 1997, Sun expanded its international operations by acquiring 83
facilities in the United Kingdom, Spain, Australia and Germany. Sun is the
second largest operator of long-term care facilities in the United Kingdom,
operating 137 facilities with 7,837 licensed beds as of December 31, 1997. Sun's
growth in the
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United Kingdom is due in large part to its acquisitions of APTA Healthcare PLC
("APTA") in December 1996 and Ashbourne PLC ("Ashbourne") in January 1997, which
together added 81 long-term care facilities with 4,877 licensed beds to Sun's
operations.
In July 1997, the Company acquired a majority interest in Eurosar, S.A.
("Eurosar"), a privately-owned company that operated eight long-term care
facilities in Spain with 1,328 licensed beds. In August 1997, Sun acquired 38%
of the equity of Alpha Healthcare Limited ("Alpha"), a publicly held acute care
provider in Australia that operated ten facilities with 686 licensed beds. In
November 1997, Sun acquired from Moran Health Care Group Pty Ltd. ("Moran") a
majority interest in six hospitals in Australia. In December 1997, Sun acquired
a majority interest in Heim Plan--Uternehmensgruppe, an operator of 11 long-term
care facilities with 930 licensed beds in Germany. See "Acquisitions."
INDUSTRY OVERVIEW
The long-term care industry encompasses a broad range of related specialty
healthcare services provided to the elderly and to other patients with medically
complex needs who can be cared for outside of the acute care hospital
environment and generally cannot be efficiently and effectively cared for at
home. Long-term and subacute care facilities offer skilled nursing care, routine
rehabilitation therapy and other support services, primarily to elderly
patients. Long-term and subacute care facilities may also provide a broad range
of specialized healthcare services such as care for patients with Alzheimer's
disease and subacute care. Subacute care includes those services provided to
patients with medically complex conditions who require ongoing medical and
nursing supervision and access to specialized equipment and services, but do not
require many of the other services provided by an acute care hospital. The
Company believes that the demand for the services provided by long-term and
subacute care facilities will increase substantially during the next decade due
primarily to demographic trends, advances in medical technology and the impact
of cost containment measures by government and private pay sources. At the same
time, government restrictions and high construction and start-up costs are
expected to limit the supply of long-term and subacute care facilities.
In the United Kingdom, the Company believes that the recent increased demand
for long-term care has led to an overbuilding of long-term care facilities in
the market place, which has resulted in an excess number of available beds. The
Company believes that this imbalance, although it is expected to improve, will
not be fully corrected in 1998.
LONG-TERM AND SUBACUTE CARE SERVICES--UNITED STATES
As of December 31, 1997, the Company owned, leased or managed, through its
subsidiaries in the United States, 321 licensed long-term and subacute care
facilities with 36,655 licensed beds located in 26 states. Each long-term and
subacute care facility is located near at least one general acute care hospital,
and the Company has entered into transfer agreements with local hospitals to
accept patients discharged from such hospitals.
BASIC PATIENT AND ANCILLARY SERVICES. The Company's long-term and subacute
care facilities provide inpatient skilled nursing and custodial services as well
as rehabilitative, restorative and transitional medical services. The Company
provides 24-hour nursing care in these facilities by registered nurses, licensed
practical nurses and certified nursing aides. The Company also provides a broad
range of support services including rehabilitation therapy, dietary services,
therapeutic recreational activities, social services, housekeeping and laundry
services and pharmaceutical and medical supplies.
SPECIALIZED SERVICES. Specialized healthcare services are those provided to
patients with medically complex needs. Under the current reimbursement system,
these services typically generate higher profit margins than those associated
with the provision of routine patient services because of the higher
reimbursement rates associated with caring for patients with complex medical
conditions. Under the Propsective Payment System ("PPS"), it is unclear what the
profit margins will be since the payment schedules have not been finalized. See
"United States Revenue Sources--Medicare," "Certain Additional
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Business Risks--Risks Related to Prospective Payment System," "--Risks
Associated with the Development and Expansion of Ancillary Services" and "Item
7--Management's Discussion and Analysis of Financial Condition and Results of
Operations." At December 31, 1997, the Company provided therapy services,
through SunDance and SunCare, for patients at 287 of its 321 long-term and
subacute care facilities. Therapy services are provided to Medicare patients
within distinct units at these facilities. At December 31, 1997, the Company
provided specialized care for patients with Alzheimer's disease at 45 of its 321
long-term and subacute care facilities under the supervision of specially
trained skilled nursing staff. These facilities also provide therapeutic
recreation and social services personnel. The Company's Alzheimer's program
includes an individually planned activities program, counseling, sensory
stimulation and a family support group.
SUBACUTE CARE. The Company defines subacute care as the provision of a
minimum of four and one-half nursing hours and one hour of therapy per patient
day. Subacute care includes those services provided to patients with medically
complex conditions who require ongoing medical and nursing supervision and
access to specialized equipment and services, but do not require many of the
other services provided by an acute care hospital. Services in this category
include ventilator and oxygen care, HIV care, intravenous therapy, complex wound
care, traumatic brain injury care, post-stroke care and hospice care. The
Company has the ability to provide subacute services at most of its long-term
care facilities. In addition, the Company operated 87 Phoenix Units at December
31, 1997, which are free-standing dedicated subacute care units within long-term
care facilities. The subacute care units represent, in some cases, a substantial
portion of the total beds in the facility; in other cases, these units represent
a smaller portion of overall facility capacity. The Company plans to expand its
provision of subacute care to other long-term care facilities. The Company
believes that there is significant demand for subacute care and that this sector
of the healthcare market offers opportunities for growth. By offering a
continuum of subacute healthcare services, the Company is able to respond to a
broad spectrum of patient clinical needs and payor cost containment objectives.
LONG-TERM CARE AND ACUTE CARE SERVICES--INTERNATIONAL
UNITED KINGDOM. As of December 31, 1997, the Company operated 137 long-term
care facilities with 7,837 licensed beds in the United Kingdom. Of these
facilities, 10, 12 and 9 were opened in each of the years ended December 31,
1995, 1996 and 1997, respectively. The Company has no immediate plans to develop
any more facilities in the United Kingdom other than the two facilities under
construction as of December 31, 1997.
Basic resident services include those typically provided to residents in
nursing homes with respect to activities of daily living and general medical
needs. The Company provides 24-hour nursing and personal care by registered
nurses and care assistants in all of its facilities. The Company also provides a
broad range of support services, including dietary services, therapeutic
recreational activities, social services, housekeeping and laundry services,
pharmaceutical and medical supplies and routine therapy.
The Company currently offers various specialized services at certain of its
nursing homes, including day care, care for the young physically disabled, care
for elderly mentally infirm residents and post-operative care. These services
typically generate higher profit margins than those associated with the
provision of routine patient services. Day care services provide elderly members
of the community with facilities focused on their personal care, recreation and
stimulation. The care of the young physically disabled involves occupational
therapy in addition to basic services. Certain of the Company's homes provide
care for elderly mentally infirm residents, including those with Alzheimer's
disease.
OTHER INTERNATIONAL OPERATIONS. As of December 31, 1997, the Company
operated 11 long-term care facilities with 930 beds in Germany, eight long-term
care facilities with 1,328 beds in Spain and six acute care facilities with 353
beds in Australia. All of those facilities were acquired by the Company in 1997.
In addition, in 1997 the Company acquired 38% of the equity in Alpha, a publicly
held acute care provider in Australia that operated ten facilities with 686
licensed beds. See "Acquisitions."
4
Additional financial information regarding the Company's international
operations is included in Note 17 to Sun's Consolidated Financial Statements
included elsewhere herein.
THERAPY SERVICES
The Company provided therapy services in 45 states as of December 31, 1997.
These services primarily consist of rehabilitation services provided by SunDance
and respiratory therapy services provided by SunCare. These services were
provided by approximately 10,200 therapists to 287 affiliated and 1,278
nonaffiliated long-term and subacute care facilities as of December 31, 1997.
TEMPORARY THERAPY STAFFING
CareerStaff is the one of the largest providers of temporary therapy
staffing in the United States and has a nationwide network of offices.
CareerStaff provides therapists skilled in the areas of physical, occupational
and speech therapy primarily to hospitals and nursing home contract service
providers, with a growing emphasis towards home healthcare providers. As of
December 31, 1997, CareerStaff had on assignment approximately 2,100 therapists
working out of 27 offices providing temporary rehabilitation therapist staffing
in major metropolitan areas and six division offices specializing in placements
of temporary traveling therapists in smaller cities and rural areas. The Company
believes that CareerStaff complements the Company's rehabilitation therapy
services operations by enabling the Company to provide temporary therapy
staffing services for Sun's rehabilitation contracts with both affiliated and
nonaffiliated facilities.
For the years ended December 31, 1995, 1996 and 1997, hospitals represented
approximately 49%, 47% and 32%, respectively, of CareerStaff's revenues and
nursing home contract service providers represented approximately 23%, 22% and
27%, respectively, of CareerStaff's revenues. Although CareerStaff continues to
derive the majority of its revenues from hospitals and nursing home contract
service providers, an increasing percentage of CareerStaff's revenues has been
derived from rehabilitation clinics and home healthcare agencies.
PHARMACEUTICAL SERVICES
At December 31, 1997, the Company operated 38 pharmacies and one
pharmaceutical billing and consulting center which together provided
pharmaceutical products and services to 801 long-term and subacute care
facilities in 29 states, 546 of which were operated by nonaffiliated parties.
The Company acquired its first regional pharmacy in the United Kingdom in the
fourth quarter of 1995 and acquired or opened 18 additional pharmacies in the
United Kingdom during 1996 and 1997. The Company intends to pursue opportunities
to expand its pharmaceutical business through acquisitions and internal growth.
Pharmaceutical services include dispensing pharmaceuticals for such purposes
as infusion therapy, pain management, antibiotic therapy and parenteral
nutrition. Additional services include providing consultant pharmacists and
assistance in preparation of billing documentation. These services are typically
provided to nonaffiliated and affiliated facilities, including subacute and
skilled nursing care facilities, assisted living facilities, group houses,
correctional facilities, mental health facilities and home healthcare companies.
ASSISTED LIVING
As of December 31, 1997, the Company has advanced $32.8 million of an
expected total of $47.0 million under a revolving subordinated credit agreement
("Financing Facility") to a developer for the development, construction and
operation of assisted living facilities, which facilities are intended to serve
the elderly who do not need the full-time nursing care provided by long-term and
subacute care facilities but who do need some assistance with the activities of
daily living. Any advances under the Financing Facility have been and are
expected to be funded by borrowings under the Company's credit facility and will
be subject to certain conditions, including the approval of each project by the
Company. The developer
5
has obtained a commitment for mortgage financing to fund 50% of the cost of each
project. The Company's advances under the Financing Facility are subordinate to
the mortgage financing. The Financing Facility with respect to each facility
bears interest at 9% or 13%, depending on the percentage of completion of the
facility under construction. All amounts advanced are due in full on November 1,
2001. As of December 31, 1997, five assisted living facilities were under
development. Construction was completed on one facility in 1997. In addition,
the Company has entered into a purchase option agreement with the developer
whereby the Company will pay the developer $50,000 for each option to purchase
any of the facilities. The option will grant the Company the right to purchase
any of the facilities, after a specified time period, at the greater of the
estimated fair market value of the property or the total amount invested by the
developer. See "Item 7--Management's Discussion and Analysis of Financial
Condition and Results of Operations--Liquidity and Capital Resources."
ACQUISITIONS
The Company agreed in February 1997 to acquire (the "RCA Merger") Retirement
Care Associates, Inc. ("Retirement Care"), which as of December 31, 1997
operated 106 skilled nursing facilities and assisted living centers in seven
states in the Southeastern United States. Retirement Care also owns (and Sun
would acquire) approximately 65% of Contour Medical, Inc. ("Contour"), a
national provider of medical/surgical supplies. The amended terms of the RCA
Merger provide for a purchase price of approximately $152.1 million in Common
Stock (based upon the closing price of Sun's Common Stock as of March 22, 1998)
and the assumption of approximately $192.9 million of indebtedness, including
$19.8 million of long-term indebtedness which will be eliminated in
consolidation (based on Retirement Care's December 31, 1997 balance sheet).
Specifically, the agreement, as amended, calls for the Company to issue shares
of common stock having a value equal to $10 in exchange for each outstanding
share of Retirement Care common stock (subject to a 10% collar centered on a $22
share price for Sun Common Stock). The Company expects that the RCA Merger will
be accounted for as a pooling of interests. Sun has also agreed to acquire the
remaining 35% of Contour not presently owned by Retirement Care for
approximately $35 million, payable in Common Stock or cash, at Sun's option (the
"Contour Merger"). The Contour Merger will be accounted for as a purchase. While
there can be no assurance the RCA Merger and/or the Contour Merger will be
consummated, the Company expects them to close in the second quarter of 1998.
See "Certain Additional Business Risks--Risks Related to RCA and Contour
Mergers."
In October 1997, Sun acquired (the "Regency Merger") Regency Health
Services, Inc. ("Regency"), an operator of skilled nursing facilities and a
diversified provider of rehabilitation therapy, institutional pharmacy and home
health services, for approximately $575 million, including approximately $345
million in cash (approximately $22.00 per Regency share) and the assumption or
refinancing of approximately $230 million of Regency's indebtedness. Pursuant to
the Regency Merger, Sun acquired 111 long-term care facilities with 11,346 beds,
26 outpatient rehabilitation therapy clinics and ten pharmacies.
Sun financed the Regency Merger, as well as the repayment of Sun's
outstanding borrowing under Sun's old credit facility, through borrowing under a
new $1.2 billion credit facility (the "Credit Facility") and $83 million of net
proceeds received from Sun's sale and leaseback of 30 facilities owned by
Regency prior to the Regency Merger. In connection with the Regency Merger, Sun
also acquired in a tender offer $160 million of Regency's subordinated debt,
which debt was subsequently retired. See "Item 7-- Management's Discussion and
Analysis of Financial Condition and Results of Operation--Liquidity and Capital
Resources."
Sun's other recent significant acquisitions include: (i) the acquisition in
January 1998 of a majority interest in Heim Plan--Uternehmensgruppe, an operator
of 11 facilities with 930 licensed beds in Germany, (ii) the acquisition from
Moran of a majority interest in six hospitals in Australia in November 1997,
(iii) the acquisition in August 1997 of 38% of the equity of Alpha, a publicly
held acute care provider that operated ten long-term care facilities with 686
licensed beds in Australia, (iv) the acquisition
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of a majority interest in Eurosar, a privately owned operator of eight nursing
homes with 1,328 licensed beds in Spain in July 1997, (v) the acquisition of
Hospital Therapy Services, a provider of respiratory care in September 1997, and
(vi) the acquisition of the remaining 71% interest in Ashbourne PLC, a long-term
care provider in the United Kingdom, during the first quarter of 1997, which
followed the Company's acquisition of a 29% ownership interest in Ashbourne
during 1996 and 1995.
In total, during the year ended December 31, 1997, the Company developed or
acquired from various third parties the net ownership of leasehold rights to or
the management contracts of 161 long-term care facilities in the United States,
62 long-term care facilities in the United Kingdom, 11 facilities in Germany,
six facilities in Australia and eight facilities in Spain. Included in the new
domestic facilities are 18 skilled nursing facilities acquired from Health Care
Capital, Inc. in December 1997 for $14.6 million in cash plus the assumption of
liabilities associated with leases in the amount of $13.2 million per year. Also
during the year ended December 31, 1997, the Company acquired a net of 20
pharmacies in the United States and 13 pharmacies in the United Kingdom.
Expansion through the use of leases and management agreements has permitted
the Company to increase the size of its operations and earnings capacity without
significant capital expenditures, except in certain cases payments have been
required in connection with the restructuring of lease arrangements, and it is
common for a security deposit or a letter of credit to be required at the
inception of a lease term. In addition, in certain cases the Company is required
to expend significant sums immediately following acquisitions to finance such
facilities' operations until payments are received from payor sources for
services rendered by the Company. The Company has also in the past made and
expects to continue to make acquisitions through the use of its own stock as
consideration, thereby avoiding expenditure of cash. Regulatory approval is
generally required in connection with the Company's assumption of operating
responsibility for new facilities.
The Company continually evaluates, and discusses with third parties,
opportunities to acquire or develop its healthcare operations. In evaluating
opportunities, the Company considers among other factors, location (including
synergies with existing Company operations), demographics, price, the
availability of financing on acceptable terms (including lease terms and the
ability to use Sun common stock as acquisition consideration), the competitive
and regulatory environment and the opportunity to improve performance through
the implementation of the Company's operating strategy. Potential acquisition
candidates generally include companies or facilities in geographic proximity to
facilities operated by the Company, those with similar operations or those that
fit within the Company's operating strategy. In addition, the Company intends to
continue to explore international acquisitions. While the Company regularly
considers and evaluates opportunities for expansion, certain of which, if
completed, would be material, and is regularly engaged in discussions with
various parties regarding acquisitions, it does not have any firm agreements
with respect to material acquisitions or expansion except for the Company's
pending acquisitions of Retirement Care and Contour as previously discussed.
There can be no assurance that any future acquisitions will be completed or that
the Company's historical rate of growth in assets, revenues or net earnings will
be sustained.
Sun's growth strategy relies heavily on the acquisition of long-term and
subacute care facilities. In October 1997, the Company acquired Regency, its
largest acquisition to date. Acquisitions present problems of integrating the
acquired operations with existing operations, including the loss of key
personnel and institutional memory of the acquired business, difficulty in
integrating corporate, accounting, financial reporting and management
information systems and strain on existing levels of personnel to operate such
acquired businesses. In addition, certain assumptions regarding the financial
condition of an acquired business may later prove to be incorrect. For example,
in connection with Sun's acquisition of Mediplex in June 1994, a significant
percentage of Mediplex's receivables proved to be uncollectible, which resulted
in significant write-offs in Sun's 1994, 1995 and 1996 fiscal years. In
addition, Sun's net earnings for its 1995 and 1996 fiscal years were adversely
affected by an impairment loss to certain goodwill associated with the
acquisition of Mediplex and negative revenue adjustments resulting primarily
from
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changes in accounting estimates based on events occurring in 1996. See "Item
7--Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Certain Additional Business Risks--Difficulty of Integrating
Acquired Operations." Sun's ability to manage its growth effectively will
require it to continue to improve its corporate accounting, financial reporting
and management information systems, and to attract, train, motivate and manage
its employees effectively. See "Certain Additional Business Risks--Management of
Growth."
The integration of the operations of Retirement Care and Contour, to the
extent consummated, will require the dedication of management resources which
will detract attention from Sun's day-to-day business. The difficulties of
integration may be increased by the necessity of coordinating geographically-
separated organizations, integrating personnel with disparate business
backgrounds and combining different corporate cultures. As part of the RCA and
Contour Mergers, Sun is expected to seek to reduce expenses by eliminating
duplicative or unnecessary personnel, corporate functions and other expenses.
There can be no assurance that Sun will be able to reduce expenses in this
fashion or that there will not be high costs associated with such activities or
that there will not be other material adverse effects of such activities. Such
events could materially and adversely affect Sun's financial condition and
results of operations. There can be no assurance that Sun will be able to
successfully integrate acquired operations or to successfully manage any growth;
failure to do so effectively and on a timely basis could have a material adverse
effect upon Sun's financial condition and results of operations. See "Certain
Additional Business Risks--Risks Related to RCA and Contour Mergers" and
"--Difficulty of Integrating Operations."
If Sun is unable to effectively integrate the operations of an acquired
entity with Sun's existing operations, Sun may elect to divest some or all of
the acquired operations. In the second quarter of 1996, Sun sold its ambulatory
surgery subsidiary. Sun's decision to sell its ambulatory surgery subsidiary was
influenced in part by the market's resistance to the integration of subacute
care with ambulatory surgery. In addition, in February 1998 Sun announced that
it had recognized a $7 million loss in anticipation of the sale and divestiture
of its outpatient rehabilitation therapy clinics in Canada, which were primarily
acquired through the acquisitions of Columbia in 1995. The Company currently
anticipates also selling its outpatient rehabilitation therapy clinics in the
United States, which were primarily acquired as part of Sun's acquisitions of
Mediplex and Regency.
REVENUE SOURCES
The Company derives its revenues from a combination of (i) state Medicaid
programs for indigent patients, (ii) the Federal Medicare program for certain
elderly and disabled patients, (iii) private payment sources, which includes
payments for therapy and pharmaceutical services provided to nonaffiliated long-
term and subacute care facilities, (iv) foreign operations in the United
Kingdom, Germany, Spain, Australia and Canada and (v) other miscellaneous
sources. Such private pay sources may themselves derive all or a portion of
their revenues from Medicaid and/or Medicare. See "Certain Additional Business
Risks--Potential Adverse Effect of Change in Revenue Sources."
The following table sets forth the percentage of total revenues by payor
source for the Company for the periods indicated:
YEAR ENDED DECEMBER 31,
-------------------------------------
SOURCES OF REVENUES 1995 1996 1997
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Medicaid................................................................. 34% 31% 29%
Medicare................................................................. 23 23 24
Private pay and other (1)................................................ 41 41 37
Foreign operations....................................................... 2 5 10
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(1) Includes revenues from therapy services, which includes payments for
rehabilitation and respiratory therapy, temporary therapy staffing services
and pharmaceutical services provided to nonaffiliated
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long-term and subacute facilities and not directly charged to Medicaid or
Medicare. Such private pay sources may themselves derive all or a portion of
their revenues from Medicaid and/or Medicare.
UNITED STATES REVENUE SOURCES
The Company's revenues from long-term and subacute care services are
determined by a number of factors, including: (i) the licensed bed capacity of
its facilities, (ii) the occupancy rates of its facilities, (iii) the mix of
patients and the rates of reimbursement among payor categories (Medicaid,
Medicare and private pay and other) and (iv) the extent to which subacute care
and certain ancillary services available in the Company's facilities are
utilized by the patients and paid for by the respective payor sources. The
Company utilizes reimbursement specialists and retains outside reimbursement
consultants to monitor both Medicaid and Medicare regulatory developments and to
assist in compliance with all program requirements with a view to obtaining all
lawful reimbursement. See "Certain Additional Business Risks-- Potential
Reduction of Reimbursement Rates from Third Party Payors and Possible Adverse
Impact on Future Operating Results," "--Risks Associated with Reimbursement
Process and Collectibility of Certain Accounts Receivable," "--Potential
Liability for Reimbursements Paid to Operators of Acquired Facilities," "--Risks
Associated with Related Party Transactions," "--Potential Adverse Effect of
Change in Revenue Sources," "--Potential Adverse Impact from Extensive
Regulation," "--Risks Related to Prospective Payment System" and "--Risks of
Adverse Effect of Future Healthcare Reform."
MEDICAID. The Medicaid program is a program created by the Social Security
Act to benefit indigent persons who are aged, blind or disabled. Payment is made
under state-administered reimbursement programs governed by Federal guidelines.
Although Medicaid programs vary from state to state, typically they provide for
fixed rate payments to healthcare providers at levels designed to compensate an
efficiently and economically operated facility. Reimbursement rates are
typically determined by the state from "cost reports" filed annually by each
facility, on a prospective or retrospective basis. Under most state Medicaid
programs, individual facilities are reimbursed on a prospective rate system,
subject to retroactive adjustment. Under a prospective system, per diem rates
are established (generally on an annual basis) based upon certain historical
costs of providing services during the prior year, adjusted to reflect factors
such as inflation and any additional services required to be performed.
Retroactive adjustments, if any, are based on a recomputation of the applicable
reimbursement rate following an audit of cost reports. Providers must accept
reimbursement from Medicaid as payment in full for the services rendered. The
provider may not bill the patient for services covered by the Medicaid program
but may bill the patient for noncovered services. There can be no assurance that
Medicaid reimbursement will be sufficient to cover actual costs incurred by the
Company with respect to Medicaid services rendered. State Medicaid plans also
require that providers must be subject to governmental audit to ensure the
propriety of costs incurred, which are used as the basis for payments.
MEDICARE. Medicare is a federally funded and administered health insurance
program that provides coverage for beneficiaries who require certain intensive
rehabilitation therapy services or skilled nursing and certain related medical
services, such as rehabilitation therapy, pharmaceuticals, medical supplies and
ancillary, diagnostic and other necessary services of the type provided by
skilled nursing facilities. Medicare inpatient benefits are not available for
patients requiring intermediate and custodial levels of care. In general,
Medicare payments for skilled nursing services and rehabilitative care are
currently based on allowable costs. With certain exceptions, Medicare pays on an
interim basis, subject to year-end cost settlement. Through fiscal year 1998 for
the Company, each facility receives interim payments during the year. Total
incurred costs are later adjusted upward or downward to reflect actual allowable
direct and indirect costs of services based on the submission of a cost report
at the end of each year. If allowable cost is less than the interim payments,
depending on the effective date of the adjustment, the Company could be required
to refund prospectively the excess of amounts it receives over such allowable
costs. If such refund were required to be made, it would be due shortly
following notice from Medicare, and would likely require the Company to borrow
under the Credit Facility. There can be no assurance that Medicare reimbursement
will be sufficient to cover actual costs incurred by the Company with respect to
Medicare
9
services rendered. As of December 31, 1997, 297 of the Company's long-term and
subacute care facilities in the United States (or 93% of such facilities) were
certified to receive payment for costs incurred while providing benefits covered
under Medicare.
Medicare reimbursement for services provided in skilled nursing facilities
is currently based upon the lesser of (i) actual allowable routine and ancillary
operating costs and capital costs or (ii) charges. Facilities that have been in
operation longer than three full cost reporting periods are subject to limits on
their actual routine per diem costs. The routine service cost limits, which are
regionally adjusted for labor costs, are required to be updated biannually by
HCFA. However, these limits were frozen by HCFA for the three fiscal years ended
September 30, 1995. The Balanced Budget Act of 1997 ("BBA") extends current
routine cost limits to the fiscal year ended December 31, 1998.
In the BBA, Congress passed numerous changes to the reimbursement policies
applicable to exempt hospital services, skilled nursing, therapy and other
ancillary services.
The BBA generally provides for a phase-in of a prospective payment system
("PPS") for skilled nursing facilities over a four year period, effective for
the Company's facilities on January 1, 1999. Under PPS, Medicare will pay
skilled nursing facilities a fixed fee per patient day based on the acuity level
of the patient to cover all post-hospital extended care routine service costs
(i.e. Medicare Part A patients), including ancillary and capital related costs
for beneficiaries receiving skilled services. The per diem rate will also cover
substantially all items and services furnished during a covered stay for which
reimbursement is currently made separately under Medicare. Such services are
currently reimbursed on a "pass through" basis. During the phase-in, payments
will be based on a blend of the facility's historical costs and a federally
established per diem rate. Since, among other things, the federally established
per diem rates have not been finalized, it is unclear what impact PPS will have
on the Company. There can be no assurance that PPS will not have a material
adverse effect on the results of operations and financial condition of the
Company.
The Company's revenues from its inpatient facilities will be significantly
affected by the size of the federally established per diem rate. There can be no
assurance that the per diem rate will not be less than the amount the Company's
inpatient facilities currently receive for treating the patients currently in
its care. Moreover, since the Company treats a greater percentage of higher
acuity patient than many nursing homes, the Company may also be adversely
impacted if the federal per diem rates for higher acuity patients does not
adequately compensate the Company for the additional expenses and risks for
caring for such patients. As a result, there can be no assurance that the
Company's financial condition and results of operations will not be materially
and adversely affected.
The Company is responding to the implementation of PPS by establishing
SunSolution-Registered Trademark-. SunSolution will offer to provide ancillary
services for a fixed fee to nonaffiliated facilities. There can be no assurance
that there will be a market for the SunSolution products and services or whether
a change in the demand for the Company's services following the imposition of
PPS will not adversely affect the Company's revenues. Even if SunSolution is
successful, no assurance can be given that the costs of providing the contracted
for services will be less than the fixed fee received by the Company for such
services. Given the relative profitability of Sun's ancillary services, there
can be no assurance that the Company's margins and ultimately the Company's
results of operations and financial condition will not be materially and
adversely affected.
In addition, for all Medicare patients not receiving post-hospital extended
care services (i.e. Medicare Part B patients), effective July 1, 1998,
reimbursement for ancillary services, including rehabilitation therapy, medical
supplies, pharmacy, temporary staffing for rehabilitation therapy, and other
ancillary services, will be made pursuant to yet-to-be developed fee schedules.
In addition, effective January 1, 1999, there will be an annual per beneficiary
cap of $1,500 on reimbursement for outpatient physical therapy and speech
therapy and an annual per beneficiary cap of $1,500 on reimbursement for
occupational therapy. Facilities will be permitted to bill patients directly for
services rendered in excess of these caps; provided however, there can be no
assurance as to whether the Company will receive any payments in excess of
10
these caps. There can be no assurance whether such yet-to-be developed fee
schedules or caps will not have a material adverse effect on the Company.
Hospitals that provide acute care are paid for non-physician services to
Medicare inpatients under the Federal prospective payment system, under which
payments are based on standard amounts adjusted for the patient's diagnosis
without regard to the hospital's actual inpatient operating costs. Medicare
payments for inpatient services provided by rehabilitation and psychiatric
hospitals or units that meet the requirements to be exempted from the the
Federal prospective payment system are generally reimbursed on a reasonable cost
basis, subject to certain limits and exceptions. Medicare payment for most
outpatient ancillary services provided in non-acute care facilities is based
upon the lesser of reasonable costs or charges.
Rehabilitation hospitals or units in acute care hospitals must meet certain
eligibility requirements for exclusion from the Federal prospective payment
system. Rehabilitation hospitals must show that they provided services to an
inpatient population of whom at least 75% required intensive rehabilitative
services for the treatment of conditions that fell within ten specified
categories of injury and disease. The rehabilitation facilities meeting these
requirements are reimbursed by Medicare for their portion of the actual
allowable operating and capital costs for the first three full cost reporting
periods under current or previous ownership. After this period, the facilities
will be subject to limits on their actual operating costs per discharge. The
cost limits were imposed under regulations adopted under the Tax Equity and
Fiscal Responsibility Act of 1982 ("TEFRA"). The TEFRA limit is determined based
upon actual Medicare allowable operating costs per discharge incurred in a base
year, and is updated annually by an amount approved by HCFA. The annual payment
update reflects changes in the hospital market basket and budgetary policy.
As amended by the BBA, the new Medicare Program precludes HCFA from updating
TEFRA limits in fiscal year 1998 and puts additional limits on updates to the
TEFRA limits for the fiscal years beginning in 1999 and ending in 2002.
Rehabilitation facilities subject to TEFRA limits will be reimbursed at the
lesser of their actual allowable operating and capital costs or the TEFRA limit
plus capital costs. The BBA also reduces the payments for capital costs by 15%
in each year from fiscal year 1998 to fiscal year 2002 and reduces the bonus or
incentive payments formerly available. If a facility's actual allowable
operating costs are less than the TEFRA limit, it will receive in addition to
its actual costs an "incentive" payment which is equivalent to the lesser of 15%
of the difference between the TEFRA amount and actual operating costs or 5% of
the TEFRA amount. The BBA requires the establishment of a prospective payment
system for inpatient rehabilitation hospital services based on patient mix.
Prospective payment rates would be phased in between October 1, 2000 and October
1, 2002.
The Company's respiratory therapy subsidiary derives a significant
percentage of its net revenues and net operating earnings from the provision of
respiratory therapy services and related supplies, equipment and medical gases
to beneficiaries of the Medicare and Medicaid programs who reside in long-term
and subacute care facilities. In general, long-term and subacute care facilities
that contract with an outside provider for the furnishing of respiratory therapy
services are reimbursed under Part A of the Medicare program through the annual
facility cost reporting process. Reimbursement is currently made under
Medicare's reasonable cost principles, subject to salary equivalency guidelines
that operate as cost limits. Respiratory therapy services furnished under a
contract with an outside provider are Medicare covered services and reimbursable
under Medicare Part A only if furnished by a "transfer hospital" with which the
long-term and subacute care facility has entered into a "transfer agreement."
SunCare has entered into contracts with a number of hospitals that participate
in the Federal Medicare program and the hospitals have established transfer
agreements with a number of skilled nursing facilities. Pursuant to SunCare's
contract, the hospitals rent necessary respiratory therapy equipment from
SunCare and receive comprehensive and specific management services from SunCare.
The hospitals pay SunCare monthly rental payments for the equipment, and certain
other fees for the management, administrative and other related services that
SunCare renders.
11
In the BBA, Congress has provided that as of July 1998 all services may be
billed directly to the nursing home, which will eliminate the need for transfer
hospitals.
Current Medicare regulations that apply to transactions between related
parties, such as the Company's subsidiaries, are relevant to the amount of
Medicare reimbursement that the Company is entitled to receive for the
rehabilitation and respiratory therapy and pharmaceutical services that it
provides to Company-operated facilities. These related party regulations require
that, among other things, (i) the Company's rehabilitation and respiratory and
pharmaceutical subsidiaries must each be a bona fide separate organization; (ii)
a substantial part of the services of each such subsidiary is transacted with
nonaffiliated entities, and there is an open, competitive market for such
services; (iii) the services provided by such subsidiary commonly are obtained
by long-term and subacute care facilities from other organizations and are not a
basic element of patient care provided by such facilities; and (iv) the prices
charged to the Company's long-term and subacute care facilities by such
subsidiaries and pharmaceutical subsidiary are in line with the charges for such
services in the open market and no more than the prices charged by its
rehabilitation and respiratory therapy services and pharmaceutical subsidiaries
under comparable circumstances to nonaffiliated long-term and subacute care
facilities. The related party regulations do not indicate a specific level of
services that must be provided to nonaffiliated entities in order to satisfy the
"substantial part" requirement of such regulations. In instances where this
issue has been litigated by others, no consensus has emerged as to the
appropriate threshold necessary to satisfy the "substantial part" requirement.
Sun believes that it satisfies the requirements of these regulations
regarding non-affiliated businesses. Sun's net revenues from rehabilitation
therapy services, including net revenues from temporary therapy staffing
services, provided to nonaffiliated facilities represented 70%, 71% and 74% of
total rehabilitation and temporary therapy staffing services net revenues for
the years ended December 31, 1997, 1996 and 1995, respectively. Respiratory
therapy services provided to nonaffiliated facilities represented 63%, 58%, and
55% of total respiratory therapy services net revenues for the years ended
December 31, 1997, 1996 and the period from the date of acquisition of SunCare
on May 5, 1995 to December 31, 1995, respectively. Sun's respiratory therapy
operations did not provide services to affiliated facilities prior to the
acquisition of SunCare on May 5, 1995. Net revenues from pharmaceutical services
billed to nonaffiliated facilities represented 79%, 78% and 78% of total
pharmaceutical services revenues for the years ended December 31, 1997, 1996 and
1995, respectively. If, upon audit by Federal or state reimbursement agencies,
such agencies find that these regulations have not been satisfied for these
periods, and if, after appeal, such findings are sustained, Sun could be
required to refund the difference between its cost of providing these services
to any related entity found to be subject to the related party regulations and
the higher amount actually received. See "Certain Additional Business
Risks--Risks Associated with the Development and Expansion of Ancillary
Services."
If Sun fails to satisfy these regulations in the future, the reimbursement
that Sun receives for rehabilitation and respiratory therapy and pharmaceutical
services provided to its own facilities would be significantly reduced and as a
result, Sun's financial condition and results of operations would be materially
and adversely affected. While Sun believes that it has satisfied and will
continue to satisfy these regulations, there can be no assurance that its
position would prevail if contested by relevant reimbursement agencies. The
foregoing statements with respect to Sun's ability to satisfy these regulations
are forward looking and could be affected by a number of factors, including the
interpretation of Medicare regulations by Federal or state reimbursement
agencies and Sun's ability to provide services to nonaffiliated facilities. When
the salary equivalency guidelines, PPS and the fee schedules are implemented,
the Medicare impact of the related party rule will be significantly reduced. See
"Certain Additional Business Risks--Risks Associated with Related Party
Transactions."
PRIVATE PAY SOURCES. Private pay revenues include payments from individuals
who pay directly for services without governmental assistance, revenues from
nonaffiliated facilities, served by the Company's ancillary therapy and pharmacy
operations, commercial insurers, Blue Cross organizations, HMOs,
12
preferred provider organizations, workers' compensation programs and other
similar payment sources. Payments from these private pay sources may be
charge-based, cost-based or based on periodically renewable contracts negotiated
with these payors. Some medical conditions treated with rehabilitation therapy
services are covered by liability insurance, rather than health benefits
policies. In such cases, reimbursement rates are established on a case-by-case
basis.
Although the level of charges by the Company to private patients in its
facilities is not subject to the same regulatory control as with Medicaid or
Medicare, its charges are still generally limited to customary and reasonable
charges for such healthcare services. In addition, many managed care
organizations and other non-governmental payors are under pressure to contain or
reduce costs through increasing case management review of services, lowering
reimbursement rates and negotiating reduced contract pricing.
THERAPY SERVICES TO NONAFFILIATES. Revenues from therapy services to
nonaffiliates are derived from the Company's therapy business which provides
rehabilitation and respiratory therapy, and respiratory products and supplies,
to patients at long-term and subacute care facilities not operated by the
Company. In general, payments for these therapy services are received directly
from the long-term care facilities, which in turn are paid by Medicare or other
payors. Revenues from therapy services provided to affiliated facilities are
included in the Medicaid, Medicare and private pay sources of revenues of the
Company. The Company's charges to nonaffiliates, though not directly regulated,
are effectively limited by regulatory reimbursement policies imposed on the
long-term and subacute care facilities that receive these therapy services, as
well as competitive market factors. The Company's contracts with the
nonaffiliated facilities are generally terminable on 30 to 60 days' notice, so
that if reimbursement policies changed in such a way that contract therapy rates
owed by such facilities to the Company exceeded reimbursement paid by Medicare
or other payors to such facilities, they would be able to terminate their
contractual relationships with the Company. In addition, in substantially all
instances, the Company may be contractually required to indemnify the
nonaffiliated facility for amounts it has been paid which are subsequently
disallowed by Medicare. See "Certain Additional Business Risks--Potential
Reduction of Reimbursement Rates from Third Party Payors and Impact on Future
Operating Results."
CareerStaff revenues are included in the Private and Other category, since
all CareerStaff revenues are derived from billings to facilities served, rather
than directly from Medicare or Medicaid; although Medicare or Medicaid may
reimburse the facilities for the cost of services provided to CareerStaff.
PHARMACEUTICAL SERVICES TO NONAFFILIATES. Revenues from the Company's
pharmaceutical services are derived from the provision of such services to
patients at long-term and subacute care facilities, most of which are not
operated by the Company. The Company enters into non-exclusive contracts with
nonaffiliated facilities, and personnel at such facilities submit prescriptions
to the Company on behalf of patients at such facilities. The Company is in most
cases paid directly by Medicare, Medicaid or private pay sources, and not by the
long-term care facility. The amounts that can be charged for prescriptions are
often limited by Medicaid regulations.
UNITED KINGDOM REVENUE SOURCES
The Company derives its revenues in the United Kingdom from a combination of
(i) income support payments by the United Kingdom Department of Social Security
(the "United Kingdom DSS"), (ii) local authority payments and (iii) private
payor sources. The majority of residents in nursing and residential care homes
in the United Kingdom are funded by income support payments by the United
Kingdom DSS or by local authorities.
UNITED KINGDOM DSS INCOME SUPPORT. The United Kingdom DSS income support is
paid without any assessment of care need. Under the DSS income support system,
if an individual had less than a minimum level in assets and insufficient income
to cover the cost of home care, that individual is eligible for the United
Kingdom DSS income support for nursing or residential home care. A single set of
national
13
rates is applied throughout the United Kingdom (except in London where an
additional premium is payable). The United Kingdom DSS income support levels are
reviewed annually and generally are increased with United Kingdom inflation
rates. Residents receiving income support who entered homes before April 1993
will continue to have their fees paid until they leave the home. Consequently,
the funding changes introduced by the National Health Service and Community Care
Act 1990 will take effect gradually as those who receive payments from the
United Kingdom DSS under the pre-April 1993 system are replaced by residents who
now receive local authority funding.
LOCAL AUTHORITY FUNDING. Since implementation of the National Health
Service and Community Care Act 1990, if an individual is assessed by a local
authority as requiring nursing or residential care home care, the local
authority will, with that individual's consent, place that individual in a
nursing or residential care home with which it has contracted (or a home of the
individual's choice). Depending on the level of the individual's assets and
income, the individual may be required to reimburse the local authority for all
or part of the costs of nursing or residential care home care. The local
authority is free to contract with any nursing or residential care home and may
agree to any fee with the operator of the home. The rates paid by local
authorities to residential care and nursing home operators is normally reviewed
annually. An individual may choose to go to a different home than the one
offered by the local authority, provided the extra cost, or "top up," if any, is
borne by the individual or by a third party.
PRIVATE PAYOR SOURCES. Privately funded residents typically pay more than
the United Kingdom DSS or local authority-funded residents. The Company believes
that the financial resources of the elderly are projected to increase in the
future. The majority of privately funded residents pay for the cost of nursing
or residential care home care with the proceeds from the sale of their home.
Health insurance and other financial products that provide financing for
long-term nursing care are in their infancy in the United Kingdom and it is
unlikely that these products will account for a significant portion of nursing
or residential care home revenues in the near future. See "Certain Additional
Business Risks--Risk of Expansion of International Operations; Foreign Exchange
Risk."
NEW GOVERNMENT. On May 1, 1997, the United Kingdom elected a new
government. The new government has embarked upon a wholesale review of the
British health care and welfare system. There can be no assurance that upon
completion of its review, the new government will not enact reforms or that such
reforms, if enacted, will not have a material adverse effect on the Company.
OTHER INTERNATIONAL REVENUE SOURCES
AUSTRALIA REVENUE SOURCES. The Company primarily derives its revenues in
Australia from a combination of (i) private health insurance from one of 44
registered health insurance funds, (ii) "Medicare" payments from the Health
Insurance Commission, (iii) compulsory private insurance covering injuries
incurred in the workplace or in motor vehicle accidents, (iv) payments from the
department of veteran affairs and (v) payments from other private sources such
as cash payors.
GERMANY REVENUE SOURCES. The Company derives its revenues in Germany from a
variety of sources, including (i) grants directly from the states, (ii)
indirectly from subsidies paid to residents, (iii) private payor sources, (iv)
the nursing insurance and welfare authorities (rates are based on the acuity
level of the patients) and (v) with regard to injuries in the workplace or due
to automobile accidents, statutory third party liability insurance.
SPAIN REVENUE SOURCES. The company derives its revenues in Spain from a
combination of (i) income support payments from the Spain National Institute of
Social Services (the "INSERSO") directly to facilities and through the Regional
Social and Health Services departments of certain regional governments, (ii)
local authority payments and (iii) private payor sources. In general, INSERSO
and the local authorities provide support to residents with limited assets and
income.
14
GOVERNMENT REGULATION
REGULATION. The healthcare industry is subject to substantial federal,
state and local regulation. The various layers of governmental regulation affect
the Company's business by controlling its growth, requiring licensure or
certification of its facilities, regulating the use of its properties and
controlling reimbursement to the Company for services provided. See "Revenue
Sources." Licensing, certification and other applicable governmental regulations
vary from jurisdiction to jurisdiction, are revised periodically, and vary among
the nursing home, therapy and pharmacy operations. See "Certain Additional
Business Risks--Potential Adverse Impact from Extensive Regulation."
In recent years, an increasing number of legislative proposals have been
introduced or proposed in Congress and in some state legislatures that would
effect major changes in the healthcare system, either nationally or at the state
level. Among the proposals under consideration are cost controls on hospitals,
insurance market reforms to increase the availability of group health insurance
to small businesses, and requirements that all businesses offer health insurance
coverage to their employees. It is not clear at this time whether any proposals
will be adopted, or, if adopted, what effect, if any, such proposals would have
on the Company's business. There can be no assurance that currently proposed or
future healthcare legislation or other changes in the administration or
interpretation of governmental healthcare programs will not have a material
adverse effect on the financial results or operations of the Company.
Reimbursement for therapy services is currently evaluated under Medicare's
reasonable cost principles. Under current law, the reasonable costs for physical
therapy and respiratory services may not exceed an amount equal to the salary
that would reasonably have been paid to a therapist for providing the services
(together with certain additional costs) within each geographical area. Salary
equivalency guidelines are the amounts published by the Health Care Financing
Administration ("HCFA") which reflect the prevailing salary, fringe benefit and
expense factors as determined by HCFA. HCFA then uses the salary equivalency
guidelines to determine the reimbursement rates for physical therapy and
respiratory therapy costs. Although salary equivalency guidelines will no longer
be effective following the implementation of PPS and fee schedule reimbursement,
HCFA has published new salary equivalency guidelines.
On January 30, 1998, HCFA revised salary equivalency guidelines for
respiratory therapy and physical therapy, and for the first time published new
salary equivalency guidelines for speech therapy and occupational therapy. HCFA
has indicated that the new salary equivalency guidelines would apply to all
services rendered on or after April 1, 1998. Implementation of these guidelines
will increase reimbursement rates for respiratory therapy and physical therapy,
but reduce reimbursement rates for speech therapy and occupational therapy. The
implementation of these new guidelines in the middle of a facility's fiscal year
may be contrary to HCFA's own regulations, and a request has been submitted to
HCFA to clarify the implementation schedule. If implemented, the effect of the
changes could have a material adverse impact on the Company's results of
operations. The salary equivalency guidelines rates will have no continuing
impact on reimbursement for therapy services rendered to a Medicare patient
receiving post-hospital extended care services following the commencement of
PPS, because under PPS, therapy services will be bundled into each facility's
per diem reimbursement from Medicare. In addition, the salary equivalency
guidelines will have no continuing impact on therapy services rendered to all
other Medicare patients after the institution of fee schedule reimbursement for
therapy services, which the BBA provides will be effective on July 1, 1998.
In 1995, and periodically since then, HCFA has provided information to
intermediaries for use in determining reasonable costs for occupational and
speech therapy. This information, although not intended to impose limits on such
costs, suggests that fiscal intermediaries should carefully review costs which
appear to be in excess of what a "prudent buyer" would pay for those services.
While the effect of these directives is still uncertain, they are a factor
considered by such intermediaries in evaluating the reasonableness of amounts
paid by providers for the services of the Company's rehabilitation therapy
subsidiary. When salary equivalency guidelines, PPS and fee schedules are
implemented, reimbursement
15
for these services will no longer be on a "pass through" basis and the HCFA
directives and reasonable cost guidelines discussed in this paragraph will
become moot as to services rendered after their effectiveness. In addition, some
intermediaries require facilities to justify the cost of contract therapists
versus employed therapists as an aspect of the "prudent buyer" analysis. With
respect to rehabilitation therapy services provided to affiliated facilities, a
retroactive adjustment of Medicare reimbursement could be made for some prior
periods. With respect to nonaffiliated facilities, an adjustment of
reimbursement rates for therapy services could result in indemnity claims
against the Company, based on the terms of substantially all of the Company's
existing contracts with such facilities, for payments previously made by such
facilities to the Company that are reduced by Medicare in the audit process. Any
change in reimbursement rates resulting from implementation of the HCFA
directives or a reduction in reimbursement as a result of a change in
application of reasonable cost guidelines could have a material adverse effect
on the Company's financial condition and results of operations (depending on the
rates adopted) and customers' ability to pay for prior and continuing services.
When PPS with respect to Medicare Part A (effective for the Company's facilities
on January 1, 1999) and fee schedules with respect to Medicare Part B (effective
July 1, 1998) are implemented, the Company's facilities' reimbursement will no
longer be affected by salary equivalency guidelines and the cost reporting
settlement process for services rendered after their effectiveness. See "Certain
Additional Business Risks--Risks Related to Prospective Payment System" and "--
Risk of Adverse Effect of Future Healthcare Reform."
Additional measures are likely to be adopted in the future as Federal and
state governments attempt to control escalating healthcare costs. The BBA
imposes, among other things, a prospective payment system and an annual per
beneficiary cap initially set at $1,500 for total Part B outpatient physical and
speech rehabilitation therapy and a similar $1,500 per beneficiary cap on Part B
occupational rehabilitation therapy beginning in January 1999. See "Certain
Additional Business Risks--Risks Associated with Reimbursement Process and
Collectability of Certain Accounts Receivable" and "--Risks Related to the
Prospective Payment System." Any reductions in reimbursement levels under
Medicaid, Medicare or private payor programs and any changes in applicable
government regulations or interpretations of programs are subject to statutory
and regulatory changes, retroactive rate adjustments to incurred costs,
administrative rulings and government funding restrictions, all of which may
materially affect the rate of payment to facilities and the Company's therapy
and pharmaceutical businesses. There can be no assurance that payments under
government or private payor programs will remain at levels comparable to present
levels or will be adequate to cover the costs of providing services to patients
eligible for assistance under such programs. Significant decreases in
utilization of therapy services and limits on reimbursement for therapy services
could have a material adverse effect on the Company's financial condition and
results of operations. See "Certain Additional Business Risks--Potential
Reduction of Reimbursement Rates from Third Party Payors and Possible Adverse
Impact on Future Operating Results."
Many of the states in which the Company operates have adopted Certificates
of Need ("CON") statutes applicable to the services provided by the Company.
Such statutes provide generally that, prior to the construction of new beds, the
addition of new services or the making of certain capital expenditures exceeding
defined levels, a state agency must determine that a need exists for such
proposed activities. Failure to obtain the necessary state approval can result
in the inability to provide the service, operate the facility or complete the
addition or other change, and can also result in the imposition of sanctions or
adverse action in respect of the facility's license and reimbursement. See
"Certain Additional Business Risks--Potential Adverse Impact from Extensive
Regulation."
All of the Company's long-term and subacute care facilities in the United
States are licensed under applicable state law where licensure is required. As
of December 31, 1997, 297 of the Company's 321 long-term and subacute care
facilities in the United States (or 93% of such facilities) were certified to
receive benefits provided under Medicare and as providers under Medicaid. Both
initial and continuing qualification of a facility to participate in the
Medicaid or Medicare program depend upon many factors, including accommodations,
equipment, services, patient care, safety, personnel, physical environment and
adequate
16
policies, procedures and controls. In order to participate in the Medicare
program, a facility must be licensed and certified as a provider of skilled
nursing services. Effective October 1, 1990, the Omnibus Budget Reconciliation
Act of 1987 eliminated the different certification standards for "skilled" and
"intermediate care" nursing facilities under the Medicaid program in favor of a
single "nursing facility" standard. This standard requires, among other things,
that the Company have at least one registered nurse on each day shift and one
licensed nurse on each other shift, and increases training requirements for
nurse's aides by requiring a minimum number of training hours and a
certification test before a nurse's aide can commence work. States continue to
be required to certify that nursing facilities provide "skilled care" in order
to obtain Medicare reimbursement. Licensing, certification and other applicable
standards vary from jurisdiction to jurisdiction and are revised periodically.
State agencies survey all long-term care facilities on a regular basis to
determine whether such facilities are in compliance with the requirements for
participation in government sponsored third party payor programs.
The Company believes that its facilities are in substantial compliance with
the various Medicare and Medicaid regulatory requirements of certification.
However, in the ordinary course of its business, the Company receives notices of
deficiencies for failure to comply with various regulatory requirements. The
Company reviews such notices and seeks to take appropriate corrective action. In
most cases, the Company and the reviewing agency will agree upon the measures to
be taken to bring the facility into compliance. In some cases or upon repeat
violations, the reviewing agency has the authority to impose fines, temporarily
suspend admission of new patients to the facility, suspend or decertify from
participation in the Medicare or Medicaid programs and, in extreme
circumstances, revoke a facility's license. These actions would adversely affect
a facility's ability to continue to operate, the ability of the Company to
provide certain services and the facility's eligibility to participate in the
Medicare or Medicaid programs.
The Company's therapy and pharmaceutical businesses provide Medicare and
Medicaid covered services and products to long-term and subacute care facilities
under arrangements with both affiliated and nonaffiliated long-term and subacute
care facilities. Under these arrangements, the Company's therapy subsidiary
bills and is paid by the long-term and subacute care facility for the services
actually rendered and the details of billing the Medicare and Medicaid programs
are handled directly by the long-term and subacute care facility. With certain
exceptions, the Company's pharmaceutical subsidiary bills, and is paid by,
Medicare, Medicaid or the private pay source directly. As a result, the
Company's therapy and temporary therapy staffing business generally (including
SunDance and CareerStaff) is not Medicare and Medicaid certified and does not
enter into provider agreements with the Medicare and Medicaid programs, but the
Company's pharmaceutical business does participate in the Medicare and Medicaid
programs.
Various state and federal laws regulate the relationship between providers
of healthcare services and physicians, including employment or service
contracts, and investment relationships. These laws include the broadly worded
fraud and abuse laws of the Medicare and Medicaid statutes, which prohibit
various transactions involving Medicare or Medicaid covered patients or
services. Violations of these provisions may result in civil or criminal
penalties for individuals or entities and/or exclusion from participation in the
Medicare and Medicaid programs. For example, conviction of abusive or fraudulent
behavior with respect to one facility could subject other facilities under
common control or ownership to exclusion from participation in the Medicare and
Medicaid programs. The full extent of the application of these provisions is not
presently known. However, the Company believes that it has not entered into any
relationship with physicians or other healthcare providers that might be
considered to fall within the coverage of the fraud and abuse laws and other
related state and federal laws. The Company believes that it will be able to
arrange its future business relationships so as to comply with the fraud and
abuse laws or any safe harbor guidelines issued pursuant thereto. See "Certain
Additional Business Risks--Potential Adverse Impact from Extensive Regulation."
All states have adopted a "patient's bill of rights" that sets forth
standards dealing with such issues as using the least restrictive treatment,
patient confidentiality, allowing patient access to the telephone and
17
mail, allowing the patient to see a lawyer and requiring the patient to be
treated with dignity. In addition, the Company, as an operator of health care
facilities, is subject to various federal, state and local consumer protection
laws.
By virtue of the Company's ownership of Exceler, APTA and Ashbourne, certain
of the operations from which the Company may derive income are subject to
national and local regulations in the United Kingdom, including The Community
Care Act 1990 and The Registered Homes Act 1984, as well as various zoning,
health and safety, reimbursement and general corporate regulations. See "Certain
Additional Business Risks--Risk of Expansion of International Operations;
Foreign Exchange Risk."
The Company also is subject to Federal, state and local laws, regulations
and ordinances that govern activities or operations that may have adverse
environmental effects (such as the generation, handling, storage and disposal of
medical and hazardous wastes) or impose liability for the costs of remediation
of contaminated property in certain circumstances without regard to fault. The
Company has incurred or could incur clean-up costs or liability under such laws,
including for the activities of former operators of facilities acquired by the
Company. Certain of the Company's operations routinely involve the handling of
medical wastes, some of which are or may become regulated as hazardous
substances. The Company has not incurred, and does not expect to incur, any
significant expenditures or liabilities for environmental matters. As a result,
the Company believes that its environmental obligations will not materially
affect the Company.
COMPLIANCE PROGRAMS. The Company utilizes several methods to monitor its
compliance with relevant laws and business standards, including a dedicated
staff of licensed nurses and therapists who review clinical quality of care,
internal audit reviews and legal reviews. During 1997, the Company enhanced its
compliance processes and the Board of Directors formally designated a
senior-level corporate compliance officer to assist with such efforts.
Sun has established a toll-free Sun Quality Line accessible to all its
employees to report concerns about legal or ethical matters or quality of care.
Confidentiality of callers is protected to the extent permitted by law, and Sun
has a policy against retaliation or retribution against anyone who in good faith
reports an ethical or legal concern. Sun seeks to ensure that allegations are
investigated thoroughly, objectively and promptly. A code of conduct emphasizing
Sun's commitment to the highest legal and ethical standards has also been issued
to Sun's employees. Every Sun employee has an obligation to adhere to the
standards set forth in the code of conduct.
The Company began a formalized compliance training program for its employees
in 1997 pursuant to which substantially all Sun employees throughout the United
States are expected to receive training by the end of 1998. All new employees
will also receive compliance training. Compliance-related communications to all
employees have been and will continue to be made regularly. In addition, Sun
conducts compliance audits as a part of its overall compliance program.
COMPETITION
The Company operates in a highly competitive industry. The nature of
competition varies by location. Its facilities generally operate in communities
that are also served by similar facilities operated by others. Some competing
facilities are located in buildings that are newer than those operated by the
Company and provide services not offered by the Company, and some are operated
by entities having greater financial and other resources and longer operating
histories than the Company. In addition, some facilities are operated by
nonprofit organizations or government agencies supported by endowments,
charitable contributions, tax revenues and other resources not available to the
Company. Some hospitals that either currently provide long-term and subacute
care services or are converting their under utilized facilities into long-term
and subacute care facilities are also a potential source of competition to the
Company. The Company also competes with other companies in providing
rehabilitation therapy services and pharmaceutical products and services to the
long term care industry and in employing and retaining qualified
18
therapists and other medical personnel. Many of these competing companies have
greater financial and other resources than the Company. There can be no
assurance that Sun will not encounter increased competition in the future that
would adversely affect its financial condition and results of operations.
The Company competes with other facilities based on key competitive factors
such as its reputation for the quality and comprehensiveness of care provided;
the commitment and expertise of its staff; the innovativeness of its treatment
programs; local physician and hospital support; marketing programs; charges for
services; and the physical appearance, location and condition of its facilities.
The range of specialized services, together with the price charged for services,
are also competitive factors in attracting patients from large referral sources.
There is limited, if any, competition in price with respect to Medicaid and
Medicare patients, because revenues for services to such patients are strictly
controlled and based on fixed rates and uniform cost reimbursement principles.
See "Revenue Sources."
The Company may also face competition from other facilities, hospitals or
healthcare companies when it initiates a CON project or seeks to acquire a CON
or a facility covered by an existing CON. CON programs affect the opportunity to
develop or acquire new facilities by creating a regulatory system that can be
used by competitors to delay the implementation of growth strategies. CON laws,
applicable in many of the states in which the Company's facilities are located,
also currently restrict the number of facilities that can compete with the
Company in such states. See "Certain Additional Business Risks-- Potential
Adverse Impact from Extensive Regulation."
EMPLOYEES
As of December 31, 1997, the Company had approximately 68,900 full-time and
part-time employees. Of this total, there were approximately 43,200 employees at
the long-term and subacute care facilities in the United States, 7,400 employees
at the long-term care facilities in the United Kingdom, 600 employees at the
long-term care facilities in Spain, 700 employees involved in providing
long-term care services in Germany, 400 employees involved in providing acute
care services in Australia, 8,800 employees involved in providing rehabilitation
therapy services in the United States, 300 employees providing rehabilitation
therapy services in Canada, 1,500 employees at the pharmaceutical operations in
the United States, 2,400 employees in the temporary therapy staffing business,
2,300 employees of hospitals who are managed by the Company and provide
respiratory therapy services and 1,200 employees at the corporate and regional
offices in the United States and 100 employees at the corporate and regional
offices in the United Kingdom. Certain of the Company's employees in
Connecticut, Massachusetts, California, Washington and New Mexico are covered by
collective bargaining contracts. The Company believes it has satisfactory
relationships with the unions that represent its employees, but it cannot
predict the effect of continued union representation or organizational
activities on its future activities.
Although the Company believes it is able to employ sufficient nurses and
therapists to provide its services, a shortage of healthcare professional
personnel in any of the geographic areas in which it operates could affect the
Company's ability to recruit and retain qualified employees and could increase
its operating costs. The Company competes with other healthcare providers for
both professional and service employees and with non-healthcare providers for
service employees.
INSURANCE
Healthcare companies are subject to medical professional liability, personal
injury and other liability claims that are customary risks inherent in the
operation of health facilities and are generally covered by insurance. The
Company maintains property, liability and professional liability insurance
policies in amounts and with such coverages and deductibles that are deemed
appropriate by the Company, based upon historical claims, industry standards and
the nature and risks of its business. The Company also requires that physicians
practicing at its facilities carry medical professional liability insurance to
cover their respective individual professional liabilities. There can be no
assurance that such insurance will
19
continue to be available at acceptable costs or that claims in excess of the
current insurance coverage or claims not covered by insurance will not be
asserted against Sun.
The Company has self-insured the healthcare risks of employees who have
elected coverage under the Company-sponsored plans. Workers' compensation
coverage is effected through self-insurance, retrospective or high-deductible
insurance policies or other hybrid policies which vary by the states in which
the Company operates except that the Company's long-term and subacute care
subsidiary is a non-subscriber to the workers' compensation program in Texas.
Substantially all of the risk of workers' compensation claims under the high
deductible programs are assumed by Sun and such risks are comparable to those of
a self-insured plan. The high deductible program provides coverage in all states
in which Sun operates with the exception of Arizona, Illinois, Massachusetts,
Washington and Connecticut (which are self-insured), Texas (in which Sun is a
non-subscriber) and Rhode Island, Ohio, Maine, Nevada and Wyoming (in which Sun
is required to utilize the specific programs offered by those states). The costs
of paying for healthcare and workers' compensation claims can fluctuate
depending on the type and number of claims in any given period. There can be no
assurance that the amounts Sun will be required to pay for these types of claims
will not increase.
CERTAIN ADDITIONAL BUSINESS RISKS
The Company's business, financial condition and operating results can be
impacted by a number of factors, including but not limited to those set forth
below, any one of which could cause the Company's actual results to vary
materially from recent results or from the Company's anticipated future results.
RISKS ASSOCIATED WITH THE DEVELOPMENT AND EXPANSION OF ANCILLARY SERVICES
A significant aspect of Sun's operating strategy is to expand its therapy,
temporary therapy staffing and pharmaceutical services and, in particular, to
offer these services to nonaffiliated facilities. Therapy, temporary therapy
staffing and pharmaceutical services provided to nonaffiliated facilities in the
United States, while representing 28%, 31% and 28% of Sun's revenues for the
years ended December 31, 1995, 1996 and 1997, respectively, comprise a much more
significant percentage of its profitability. See "Item 7-- Management's
Discussion and Analysis of Financial Conditions and Results of Operations." As a
result of the Regency Merger and the RCA Merger, if consummated, the percentage
of revenues from services provided to nonaffiliated facilities is expected to
decrease. Regulatory changes, including PPS, are expected to be made which
affect reimbursement for these services, which could adversely affect Sun's
profitability. See "--Risks Related to Prospective Payment System," "--Potential
Reduction of Reimbursement Rates From Third Party Payors and Possible Adverse
Impact on Future Operating Results" and "--Risk of Adverse Effect of Future
Healthcare Reform." From time to time the negative publicity surrounding the
government investigations of Sun has slowed Sun's success in obtaining
additional outside contracts in the rehabilitation therapy business, which has
resulted in higher than required therapist staffing levels and has affected the
private pay enrollment in certain inpatient facilities. In addition, if
government investigations have a negative impact on the future billing practices
related to Sun's rehabilitation therapy subsidiary, the profitability of the
services provided by such subsidiary would be reduced from current levels. See
"--Investigations; Uncertain Impact on Future Operating Results."
RISK OF ADVERSE EFFECT OF FUTURE HEALTHCARE REFORM
In recent years, an increasing number of legislative proposals have been
introduced or proposed in Congress and in some state legislatures that would
effect major changes in the healthcare system, either nationally or at the state
level. Among the proposals under consideration are cost controls on hospitals,
changes in reimbursement by federal and state payors such as Medicare and
Medicaid, limitations on the ability of Sun to maintain or increase the level of
services it provides, insurance market reforms to increase the availability of
group health insurance to small businesses and the requirement that all
businesses offer health insurance coverage to their employees. Some of the
leading proposals would extend temporary
20
reductions in Medicare reimbursement imposed under current law, impose
additional cuts in Medicare reimbursement and substantially restructure
Medicaid. In the Balanced Budget Act of 1997 (the "BBA"), Congress amended the
reimbursement provisions applicable to exempt hospital services, skilled
nursing, therapy and other ancillary services. See "United States Revenue
Sources" and "--Risks Related to Prospective Payment System." These changes
include, but are not limited to, reductions in capital reimbursement; reductions
in certain laboratory reimbursement; limitations on ancillary costs of skilled
nursing facilities; bundling of ancillary services into nursing home payments;
and imposition of a prospective payment system for skilled nursing facility
services and home health services. Additional changes may still be enacted,
which may include amendments similar to those imposed under the BBA as well as
the imposition of salary equivalency for occupational and speech therapy
services. It is not clear at this time when or whether any new proposals will be
adopted, or, if adopted, what effect, if any, such proposals would have on Sun's
business. There can be no assurance that future healthcare legislation or other
changes in the administration or interpretation of governmental healthcare
programs will not have a material adverse effect on Sun's financial condition or
results of operations. See "--Potential Reduction of Reimbursement Rates From
Third Party Payors and Possible Adverse Impact on Future Operating Results,"
"--Risks Associated with Reimbursement Process and Collectibility of Certain
Accounts Receivable," "--Potential Liability for Reimbursements Paid to Former
Operators of Acquired Facilities," and "--Risks Associated with Related Party
Transactions."
RISKS RELATED TO PROSPECTIVE PAYMENT SYSTEM
In the BBA, Congress passed numerous changes to the reimbursement policies
applicable to exempt hospital services, skilled nursing, therapy and other
ancillary services. The BBA provides for a phase-in of a prospective payment
system ("PPS") for skilled nursing facilities over a four year period, effective
for the Company's facilities on January 1, 1999. Under PPS, Medicare will pay
skilled nursing facilities a fixed fee per patient day based on the acuity level
of the patient to cover all post-hospital extended care routine service costs
(i.e., Medicare Part A patients), including ancillary and capital related costs
for beneficiaries receiving skilled services. The per diem rate will also cover
substantially all items and services furnished during a covered stay for which
reimbursement was formerly made separately under Medicare. During the phase-in,
payments will be based on a blend of the facility's historical costs and a
federally established per diem rate. Since the federally established per diem
rates have not been finalized, it is unclear what the impact of PPS will be on
the Company. There can be no assurance that the imposition of PPS will not have
a material adverse effect on the results of operations and financial condition
of the Company. See "United States Revenue Sources--Medicare" and "Item
7--Management's Discussion and Analysis of Financial Condition and Results of
Operations."
POTENTIAL REDUCTION OF REIMBURSEMENT RATES FROM THIRD PARTY PAYORS AND POSSIBLE
ADVERSE IMPACT ON FUTURE OPERATING RESULTS
Various cost containment measures adopted by governmental and private pay
sources have begun to restrict the scope and amount of reimbursable healthcare
expenses and limit increases in reimbursement rates for medical services. Any
reductions in reimbursement levels under Medicaid, Medicare or private payor
programs and any changes in applicable government regulations or interpretations
of existing regulations could significantly affect Sun's profitability.
Furthermore, government programs are subject to statutory and regulatory
changes, retroactive rate adjustments, administrative rulings and government
funding restrictions, all of which may materially affect the rate of payment to
Sun's facilities and its therapy and pharmaceutical businesses. There can be no
assurance that payments under governmental or private payor programs will remain
at levels comparable to present levels or will be adequate to cover the costs of
providing services to patients eligible for assistance under such programs.
Significant decreases in utilization and limits on reimbursement could have
a material adverse effect on Sun's financial condition and results of
operations, including the possible impairment of certain assets. In the BBA,
Congress amended the reimbursement provisions applicable to exempt hospitals
services,
21
skilled nursing, therapy and other ancillary services. See "--Risks Associated
with the Development and Expansion of Ancillary Services." In addition, on
January 30, 1998 HCFA revised salary equivalency guidelines for respiratory
therapy and physical therapy, and for the first time published new salary
equivalency guidelines for speech therapy and occupational therapy. See
"Government Regulation" and "Item 7--Management's Discussion and Analysis of
Financial Condition and Results of Operations-- Effects from Changes in
Reimbursement."
RISKS ASSOCIATED WITH REIMBURSEMENT PROCESS AND COLLECTIBILITY OF CERTAIN
ACCOUNTS RECEIVABLE
The Company derives a substantial percentage of its total revenues from
Medicare, Medicaid and private insurance. The Company's financial condition and
results of operations may be affected by the revenue reimbursement process,
which is complex and can involve lengthy delays between the recognition of
revenue and the time reimbursement amounts are settled. Net revenues realizable
under third-party payor agreements are subject to change due to examination and
retroactive adjustment by payors during the settlement process. Payors may
disallow in whole or in part requests for reimbursement based on determinations
that certain costs are not reimbursable or reasonable or because additional
supporting documentation is necessary. The Company recognizes revenues from
third-party payors and accrues estimated settlement amounts in the period in
which the related services are provided. The Company estimates these settlement
balances by making determinations based on its prior settlement experience and
its understanding of the applicable reimbursement rules and regulations. The
majority of third-party payor balances are settled two to three years following
the provision of services. The Company has experienced differences between the
net amounts accrued and subsequent settlements, which differences are recorded
in operations at the time of settlement. For example, in the fourth quarter of
1997, the Company recorded negative revenue adjustments totalling approximately
$15.0 million resulting from changes in accounting estimates of amounts
realizable from third-party payors. These changes in accounting estimates
primarily arose out of the settlement in late 1997 of certain facility cost
reports for 1994 and 1995 and also include estimated charges for projected
settlements in 1996.
Accounts receivable have also increased in part because the ability of
nonaffiliated facilities to provide timely payments has been impacted by their
receipt of payments from fiscal intermediaries which, in some instances, have
been delayed due to the fiscal intermediaries conducting reviews of facilities'
therapy claims.
The Company's results of operations would be materially and adversely
affected if the amounts actually received from third-party payors in any
reporting period differs materially from the amounts accrued in prior periods.
The Company's financial condition and results of operations may also be affected
by the timing of reimbursement payments and rate adjustments from third-party
payors. The Company has from time to time experienced delays in receiving final
settlement and reimbursement from government agencies. See "Item 7--Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Effects from Changes in Reimbursement."
POTENTIAL LIABILITY FOR REIMBURSEMENTS PAID TO FORMER OPERATORS OF ACQUIRED
FACILITIES
Sun's growth strategy relies heavily on the acquisition of long-term and
subacute care facilities. Regardless of the legal form of the acquisition, the
Medicare and Medicaid programs often require that Sun assume certain obligations
relating to the reimbursement paid to the former operators of facilities
acquired by Sun. From time to time, fiscal intermediaries and Medicaid agencies
examine cost reports filed by such predecessor operators. If, as a result of any
such examination, it is concluded that overpayments to a predecessor operator
were made, the Company, as the current operator of such facilities, may be held
financially responsible for such overpayments. At this time the Company is
unable to predict the outcome of any existing or future examinations. See
"--Difficulty of Integrating Acquired Operations" and "Item 7--Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Effects from Changes in Reimbursement."
22
RISKS ASSOCIATED WITH RELATED PARTY TRANSACTIONS
Current Medicare regulations that apply to transactions between related
parties, such as Sun's subsidiaries, are relevant to the amount of Medicare
reimbursement that Sun is entitled to receive for the rehabilitation and
respiratory therapy and pharmaceutical services that it provides to Sun-operated
facilities. These related party regulations require that, among other things, a
substantial part of the rehabilitation and respiratory therapy services or
pharmaceutical services, as the case may be, of the relevant subsidiary be
transacted with nonaffiliated entities in order for the Company to receive
reimbursement for services provided to Company-operated facilities at the rates
applicable to services provided to nonaffiliated entities. The related party
regulations do not indicate a specific level of services that must be provided
to nonaffiliated entities in order to satisfy the "substantial part" requirement
of such regulations. In instances where this issue has been litigated by others,
no consistent standard has emerged as to the appropriate threshold necessary to
satisfy the "substantial part" requirement. See "United States Revenue
Sources--Medicare." If, upon audit by Federal or state reimbursement agencies,
such agencies find that these regulations have not been satisfied for these
periods, and if, after appeal, such findings are sustained, Sun could be
required to refund the difference between its cost of providing these services
to any entity found to be subject to the related party regulations and the
higher amount actually received. See "--Risks Associated with the Development
and Expansion of Ancillary Services."
If Sun fails to satisfy these regulations in the future, the reimbursement
that Sun receives for rehabilitation and respiratory therapy and pharmaceutical
services provided to its own facilities would be significantly reduced, as a
result of which Sun's financial condition and results of operations would be
materially and adversely affected for so long as Medicare and Medicaid continue
to reimburse on the basis of reasonable cost. While Sun believes that it has
satisfied and will continue to satisfy the requirements of these regulations
regarding non-affiliated businesses, there can be no assurance that its position
would prevail if contested by relevant reimbursement agencies. The foregoing
statements with respect to Sun's ability to satisfy these regulations are
forward looking and could be affected by a number of factors, including the
interpretation of Medicare regulations by Federal or state reimbursement
agencies and Sun's ability to provide services to nonaffiliated facilities. When
the salary equivalency guidelines, PPS and fee schedules are implemented, the
Medicare impact of the related party rule will be significantly reduced. See
"--Risks Related to Prospective Payment System" and "Item 7--Management's
Discussion and Analysis of Financial Condition and Results of Operations."
POTENTIAL ADVERSE EFFECT OF CHANGE IN REVENUE SOURCES
Changes in the mix of patients among the Medicaid, Medicare and private pay
categories, and among different types of private pay sources, can significantly
affect the revenues and the profitability of Sun's operations. There can be no
assurance that Sun will continue to attract and retain private pay patients or
maintain its current payor or revenue mix.
In addition, there can be no assurance that the facilities operated by Sun,
or the provision of services and products by Sun, now or in the future, will
initially meet or continue to meet the requirements for participation in the
Medicare and Medicaid programs, or that Sun will continue to qualify for the
levels of reimbursement it has in the past with respect to reimbursement for
rehabilitation therapy, respiratory therapy and pharmaceutical services provided
by Sun-operated facilities. A loss of Medicare or Medicaid certification or a
change in Sun's reimbursement under Medicare or Medicaid could have an adverse
effect on its financial condition and results of operations. See "--Potential
Reduction of Reimbursement Rates From Third Party Payors and Possible Adverse
Impact on Future Operating Results," "-- Risks Associated with Reimbursement
Process and Collectibility of Certain Accounts Receivables," "--Risks Associated
with Related Party Transactions," "--Risk of Adverse Effect of Future Healthcare
Reform" and "--Investigations; Uncertain Impact on Future Operating Results."
23
INVESTIGATIONS; UNCERTAIN IMPACT ON FUTURE OPERATING RESULTS
The Company's subsidiaries, including those which provide subacute and
long-term care, rehabilitation and respiratory therapy and pharmaceutical
services, are engaged in industries which are extensively regulated. See
"--Potential Adverse Impact from Extensive Regulation." As such, in the ordinary
course of business, the operations of these subsidiaries are continuously
subject to state and Federal regulatory scrutiny, supervision and control. Such
regulatory scrutiny often includes inquiries, investigations, examinations,
audits, site visits and surveys, some of which may be non-routine. If the
Company is ever found to have engaged in improper practices, it could be
subjected to civil, administrative, or criminal fines, penalties or
restitutionary relief. The Company is currently the subject of a pending Federal
investigation by the United States Department of Health and Human Services'
Office of Inspector General and the United States Department of Justice. The
Company is also the subject of an investigation by the Connecticut Attorney
General's Office and the Connecticut Department of Social Services. See "Item
7-- Management's Discussion and Analysis of Financial Condition and Results of
Operations--Regulation."
In 1997, the Company was notified by a law firm representing several
national insurance companies that these companies believed Sun had engaged in
improper billing and other practices in connection with the Company's delivery
of therapy and related services. See "Item 7--Management's Discussion and
Analysis of Financial Condition and Results of Operations--Litigation."
POTENTIAL ADVERSE IMPACT FROM EXTENSIVE REGULATION
Sun is subject to extensive Federal, state and local government regulation
relating to licensure, conduct of operations, ownership of facilities, expansion
of facilities and services and reimbursement for services. As such, in the
ordinary course of business, Sun's operations are continuously subject to state
and Federal regulatory scrutiny, supervision and control. Such regulatory
scrutiny often includes inquiries, investigations, examinations, audits, site
visits and surveys, some of which may be non-routine. All of the facilities
operated or managed by Sun are required to be licensed in accordance with the
requirements of state and local agencies having jurisdiction over their
operations. Most of Sun's facilities are also certified as providers under the
Medicaid and Medicare programs. The failure to obtain or renew any required
regulatory approvals or licenses or to comply with applicable regulations in the
future could adversely affect Sun's financial condition and results of
operations. See "--Investigations; Uncertain Impact on Future Operating Results"
and "Item 7--Management's Discussion and Analysis of Financial Condition and
Results of Operations-- Litigation." To the extent that Certificates of Need
("CONs") or other similar approvals are required for expansion of Sun's
operations, either through acquisitions or additions to or provision of new
services at such facilities, such expansion could be adversely affected by the
failure to obtain such CONs or approvals. See "-- Risks Related to Prospective
Payment System. " There can be no assurance that Sun's business in the future
will not be materially adversely affected by licensing requirements of state and
Federal authorities and by amendments to Federal law, which mandate that nursing
homes provide rehabilitation therapy services to their patients and authorize
Medicare reimbursement for such services, or by new reimbursement rates proposed
by HCFA. See "Government Regulation."
Medicare and Medicaid antifraud and abuse laws prohibit certain business
practices and relationships that might affect the provision and cost of
healthcare services reimbursable under Medicare and Medicaid. Expressly
prohibited are kickbacks, bribes and rebates related to Medicare or Medicaid
referrals. Federal laws also provide civil and criminal penalties for any false
or fraudulent statements, knowingly made, in any claim for payment under a
Federal or state health care program as well as any material omissions in such
claims. In addition, certain states have adopted fraud and abuse and false
claims laws that prohibit specified business practices. Sanctions for violating
these laws include criminal penalties and civil sanctions, including fines and
possible exclusion from the Medicare and Medicaid programs.
24
SUBSTANTIAL LEVERAGE; NEED FOR ADDITIONAL FINANCING
Sun has substantial indebtedness. As of December 31, 1997, Sun had on a
consolidated basis approximately $1.6 billion of indebtedness, including $975
million of indebtedness under the Credit Facility, and approximately $617
million of stockholders' equity. If the RCA Merger and Contour Merger had been
consummated as of December 31, 1997, Sun's consolidated long-term debt
(including current maturities) would have increased by approximately $192.9
million, including $19.8 million of indebtedness which will be eliminated in
consolidation (based on Retirement Care's December 31, 1997 balance sheet), and
assuming Sun acquires the remaining 35% of Contour for Sun Common Stock. At
December 31, 1997, Sun had outstanding commitments for construction and
development costs of approximately $25.9 million in the United States and
approximately L1.0 million (approximately $1.6 million as of December 31, 1997)
in the United Kingdom. Sun also expects to loan up to $47.0 million (of which
$32.8 million has been funded as of December 31, 1997) for the development,
construction and operation of assisted living facilities.
The degree to which Sun is leveraged could have important consequences to
holders of Sun Common Stock, including, but not limited to, the following: (i) a
substantial portion of Sun's cash flow from operations will be required to be
dedicated to debt service and will not be available for other purposes,
including acquisitions; (ii) Sun's ability to obtain additional financing in the
future could be limited; (iii) certain of Sun's borrowing are at variable rates
of interest, which could result in higher interest expense in the event of
increases in interest rates; and (iv) the Company's indenture with respect to
its 9 1/2% Senior Subordinated Notes, the Company's Credit Facility and the
United Kingdom revolving credit facilities generally contain financial and
restrictive covenants that limit the ability of Sun to, among other things,
borrow additional funds, dispose of assets or pay cash dividends. Failure by Sun
to comply with such covenants could result in an event of default which, if not
cured or waived, would have a material adverse effect on Sun. The Company
expects that it may raise additional equity or debt financing in the future.
There can be no assurance that Sun will be successful in raising additional
equity or debt financing on terms favorable to the Company, if at all. See "Item
7--Management's Discussion and Analysis of Financial Condition and Results of
Operations--Liquidity and Capital Resources."
DIFFICULTY OF INTEGRATING ACQUIRED OPERATIONS
Sun's growth strategy relies heavily on the acquisition of long-term and
subacute care facilities. In October 1997, the Company acquired Regency, its
largest acquisition to date. Acquisitions present problems of integrating the
acquired operations with existing operations, including the loss of key
personnel and institutional memory of the acquired business, difficulty in
integrating corporate, accounting, financial reporting and management
information systems and strain on existing levels of personnel to operate such
acquired businesses. In addition, certain assumptions regarding the financial
condition of an acquired business may later prove to be incorrect. See
"Acquisitions" and "Item 7--Management's Discussion and Analysis of Financial
Condition and Results of Operation."
Sun's ability to manage its growth effectively will require it to continue
to improve its corporate accounting, financial reporting and management
information systems, and to attract, train, motivate and manage its employees
effectively. See "Acquisitions," "--Management of Growth" and "--Risks Related
to RCA and Contour Mergers."
RISKS RELATED TO RCA AND CONTOUR MERGERS
In addition to the general acquisition risks described under "--Difficulty
of Integrating Acquired Operations" and "Acquisitions." Sun faces risks specific
to its pending mergers with Retirement Care and Contour, including risks related
to the following:
POSSIBLE ADVERSE EFFECTS ON SUN IF THE RCA AND CONTOUR MERGERS ARE NOT
CONSUMMATED. Since early 1997, Sun has been providing on an arms'-length basis
ancillary services and management, consulting and
25
advisory services to certain facilities owned, leased or managed by Retirement
Care, its affiliates and affiliates of certain principal shareholders of
Retirement Care ("RCA Facilities"). Revenues from the provision of such services
totaled $12.4 million, or 0.6% of Sun's net revenues, for the year ended
December 31, 1997, substantially all of which remained unpaid as of December 31,
1997. In the event the RCA Merger is not consummated there can be no assurance
that RCA would not seek other sources for the provision of such services, and
Sun's potential future revenues therefrom would terminate. In addition,
Retirement Care is indebted to Sun in the principal amount of approximately
$14.8 million, plus accrued and unpaid interest of $1.1 million as of December
31, 1997, pursuant to two loan agreements entered into between Sun and
Retirement Care (the "Loan Agreements"). Amounts outstanding under the Loan
Agreements are secured by a second lien on all of Retirement Care's accounts
receivable and are subordinate to certain other outstanding indebtedness of
Retirement Care. In the event that the RCA Merger is not consummated, Sun's
ability to collect the amounts owed by Retirement Care to Sun for the provision
of services and under the Loan Agreements, which together totalled approximately
$27.9 million as of December 31, 1997, could be impaired, particularly in light
of the recent deterioration of Retirement Care's financial condition and results
of operation subsequent to the execution of the RCA Merger Agreement. In
December 1997, the Company purchased from a third party $5.0 million aggregate
principal amount of 9% Contour convertible debentures (the "Contour Debentures")
which are convertible into one million shares of Contour common stock, for an
aggregate price of $8.4 million in cash. In the event the Contour Merger is not
consummated, the value of the Contour Debentures could be impaired, particularly
in light of the deterioration of Contour's financial condition and results of
operations. See "-- Deterioration of Retirement Care's Recent Financial
Condition" and "--Deterioration of Contour's Recent Financial Condition."
Failure to collect such amounts could require significant charges in the period
in which the RCA Merger is terminated, and Sun's financial condition and results
of operations may be materially and adversely affected in the period in which
such charges are taken.
On the date this Annual Report on Form 10-K was filed, the RCA Merger
Agreement provided that either party has the right to terminate the RCA Merger
if the RCA Merger is not consummated by March 31, 1998. There can be no
assurance that the RCA Merger will be consummated.
RESIGNATION OF RETIREMENT CARE'S AND CONTOUR'S INDEPENDENT ACCOUNTANTS;
RESTATEMENT OF FINANCIAL STATEMENTS. On August 14, 1997, Coopers & Lybrand
L.L.P. ("C&L") resigned as the independent accountants of Retirement Care and
Contour. C&L stated that it resigned as the independent accountants of
Retirement Care as a result of (i) concerns regarding Retirement Care
management's inability to provide adequate support for certain inventory
adjustments; (ii) concern regarding other potential adjustments that may have
required Retirement Care to amend its quarterly financial statements as
previously filed for the first three quarters of fiscal 1997; (iii) concerns
with respect to the realizability of notes and advances due to Retirement Care
from affiliates; and (iv) C&L's view that Retirement Care should increase its
allowances for doubtful accounts and Medicaid/Medicare settlements and increase
its accruals for self-insured workers' compensation matters. Contour has
indicated that it is not aware of any reason for C&L's resignation as its
independent accountants other than Contour's affiliation with Retirement Care.
C&L stated that its audit report on Retirement Care's and Contour's financial
statements for the fiscal year ended June 30, 1996 should not be relied upon
because C&L concluded that it could no longer rely on Retirement Care and
Contour management's representations. Retirement Care and Contour announced
C&L's resignation on August 21, 1997. On September 5, 1997, upon the
recommendation of the independent members of the audit committees of Retirement
Care's and Contour's respective boards of directors, Retirement Care and Contour
each retained Cherry, Bekaert & Holland, L.L.P. ("CB&H") to reaudit Retirement
Care's and Contour's financial statements for the fiscal year ended June 30,
1996 and to audit Retirement Care's and Contour's financial statements for the
fiscal year ended June 30, 1997. On October 14, 1997, Retirement Care and
Contour each filed amended annual reports on Form 10-K/A restating their results
for the fiscal year ended June 30, 1996, and on October 23, 1997, Retirement
Care and Contour each filed amended quarterly reports on Form 10-Q/A restating
their results for the first three quarters of fiscal 1997. In light of C&L's
resignation and the subsequent restatement of
26
RCA and Contour's financial statements, there is an increased risk that
assumptions made by Sun regarding the financial condition of Retirement Care and
Contour may later prove to be incorrect. See "--Difficulty of Integrating
Acquired Operations."
SHAREHOLDER LITIGATION. Terms of the merger agreement with respect to the
RCA Merger (the "RCA Merger Agreement") do not provide for any contractual
indemnification of Sun by Retirement Care's shareholders, nor is Sun retaining
any of the merger consideration as protection against any liabilities, known or
unknown, of Retirement Care for which Sun would, as a consequence of the RCA
Merger, become responsible. As a result, Sun would bear the cost of any such
liabilities of Retirement Care, including any liabilities arising out of the
following litigation, if the RCA Merger is consummated.
Between August 25, 1997 and October 24, 1997, ten putative class action
lawsuits (the "Actions") were filed in the United States District Court for the
Northern District of Georgia on behalf of persons who purchased Retirement
Care's common stock, naming Retirement Care and certain of its officers and
directors as defendants. The complaints allege violations of Federal securities
laws by the defendants for disseminating allegedly false and misleading
financial statements for Retirement Care's fiscal year ended June 30, 1996 and
its first three quarters of fiscal year 1997, which the plaintiffs allege
materially overstated Retirement Care's profitability. Generally, each of the
Actions seeks unspecified compensatory damages, pre-judgment and post-judgment
interest, attorneys' fees and costs and other equitable and injunctive relief.
On November 25, 1997, Retirement Care, Sun and representatives of the
plaintiffs entered into a Memorandum of Understanding ("MOU"), pursuant to which
Sun agreed to pay $9 million into an interest bearing escrow account maintained
by Sun to settle the Actions (the "Settlement"). The Settlement is contingent
upon the closing of the RCA Merger and is subject to, among other things,
confirmatory discovery, the execution of definitive documentation and court
approval. Upon satisfaction of the conditions precedent to the Settlement, all
claims by the class that were or could have been asserted by the plaintiffs
against Retirement Care or any of the other defendants in the Actions will be
settled and released and the Actions will be dismissed in their entirety with
prejudice in exchange for the release of all funds from the escrow account to
the plaintiffs. Court approval of the Settlement will not be sought unless and
until the RCA Merger closes, and therefore, no assurance can be given that such
settlement will become final even if the RCA Merger is consummated.
There can be no assurance that additional class actions will not be filed
against Retirement Care and its officers and directors or that the court will
approve the Settlement or that the Actions will be settled and dismissed on the
terms described herein or at all. In the event that the RCA Merger does close,
but the Settlement is terminated for any reason, the Actions may result in
protracted litigation which may result in a diversion of management and other
resources of Sun as the new owners of Retirement Care. The payment of
substantial legal costs or damages, or the diversion of management and other
resources could have a material and adverse effect on Sun's business, financial
condition and results of operations.
Retirement Care is a party to indemnification agreements with certain of the
other defendants in the actions described above, including Retirement Care's
officers and directors. Retirement Care has also purchased a directors' and
officers' liability insurance policy that provides Retirement Care's directors
and officers with liability coverage of up to $5 million per policy year. The
scope of coverage under the policy is limited, and Retirement Care is currently
engaged in a dispute with the carrier whether the policy provides
indemnification for losses arising from the Actions. Following the RCA Merger,
Sun has agreed to provide indemnification to Retirement Care's officers and
directors under certain circumstances.
DETERIORATION OF RETIREMENT CARE'S RECENT FINANCIAL CONDITION. Retirement
Care has experienced significant operating and net losses for the fiscal year
ended June 30, 1997. Sun has been informed by Retirement Care that Retirement
Care believes the net losses before extraordinary item of approximately
27
$7.0 million* for the fiscal year ended June 30, 1997 and $4.4* million for the
six month period ended December 31, 1997 were incurred in part due to a
deterioration of Retirement Care's operations as a result of the pendency of and
delays associated with the RCA Merger (including higher than normal turnover),
costs associated with the integration and operation of Retirement Care's
recently-acquired Virginia and North Carolina facilities (including certain
regulatory compliance problems) and declines in Medicaid rates and occupancy
rates during fiscal year 1997 without a corresponding reduction in operating
costs.
There can be no assurance that Retirement Care will not experience continued
operating and net losses in the future, and unforeseen expenses, difficulties
and complications could result in greater than anticipated operating losses or
otherwise materially adversely affect Retirement Care's business, financial
condition and results of operations before and after the RCA Merger. As a
result, Sun as the owner of Retirement Care after the RCA Merger, may be
materially and adversely affected by expenses it will incur after the RCA Merger
to resolve problems associated with Retirement Care's deteriorating financial
condition.
Based upon a review of Retirement Care's, Contour's and Sun's publicly
available historical financial statements, the RCA and Contour Mergers would
have had a dilutive impact on Sun's reported earnings per share for the year
ended December 31, 1997. If the RCA Merger and Contour Merger are consummated,
there can be no assurance that the future combined results will not continue to
be dilutive to Sun.
DETERIORATION OF CONTOUR'S RECENT FINANCIAL CONDITION. Contour has
experienced significant operating and net losses for the fiscal year ended June
30, 1997. Contour has informed the Company that it believes that the net loss of
approximately $0.3 million** for the fiscal year ended June 30, 1997 and the
decrease in net income of $.05 million** for the six month period ended December
31, 1997 were primarily due to decreases in gross profit margin historically
earned by Contour's bulk medical supplies operations, increases in operating
expenses associated with the acquisition of AmeriDyne Corporation and Atlantic
Medical Supply Company, Inc. (with respect to the year-ended June 30, 1997) and
increases in certain other operating expenses.
There can be no assurance that Contour will not experience continued
increases in expenses and decreases in gross margins and gross profit in the
future, and other unforeseen expenses, difficulties and complications could
result in greater than anticipated operating losses or otherwise materially and
adversely affect Contour's business, financial condition and results of
operations. As a result, Sun as the owner of Contour after the Contour Merger,
may be materially and adversely affected by expenses it will incur after the
Contour Merger to resolve problem's associated with Contour's deteriorating
financial condition.
Based upon a review of Contour's and Sun's publicly available historical
financial statements, the Contour Merger would have had a dilutive impact on
Sun's reported earnings per share for the year ended December 31, 1997. If the
Contour Merger is consummated, there can be no assurance that the future
combined results will not continue to be dilutive to Sun.
CONFLICTS OF INTEREST AND RELATED PARTY TRANSACTIONS INVOLVING RETIREMENT
CARE. For the fiscal year ended June 30, 1997, Retirement Care received $2.0
million* in revenue from certain related party
- ------------------------
* Each of the amounts described above are based solely on Retirement Care's
Annual Report on Form 10-K for the year ended June 30, 1997 and Quarterly
Reports on Form 10-Q for each of the quarterly periods ended September 30,
1997 and December 31, 1997. Sun makes no representation as to the accuracy
or adequacy of such amounts.
** Each of the amounts described above are based solely on Contour's Annual
Report Form 10-K for the year ended June 30, 1997 and Quarterly Reports on
Form 10-Q for each of the quarterly periods ended September 30, 1997 and
December 31, 1997. Sun makes no representation as to the accuracy or
adequacy of such amounts.
28
transactions and had $5.4 million owed to it by related parties as of December
31, 1997. After the consummation of the RCA Merger, there can be no assurance
that Retirement Care will be able to collect the money owed to it by the related
parties or that such related parties will not seek to terminate their
relationship with Retirement Care and Sun.
Retirement Care's management agreements with non-affiliated facilities are
generally subject to termination on 60 days' notice, with or without cause, by
either Retirement Care or the owner of the facilities. Since seven of the eight
facilities under management agreements are controlled by current officers and
directors of Retirement Care, the continuation of these agreements will be under
the control of such persons. Without the ongoing relationships with the owners
of these facilities maintained by Retirement Care's current officers and
directors, after the RCA Merger, the owners of these facilities may terminate
such management agreements. During the fiscal year ended June 30, 1997 and for
the six months ended December 31, 1997, $2.0 and $1.0, respectively, was
attributable to the management fees paid by affiliates of Retirement Care. In
addition, Sun provided ancillary services to such facilities for the 12 months
ended December 31, 1997. If such management agreements are terminated, no
assurance can be given that such facilities will continue utilizing Sun to
provide those facilities with ancillary services. Such termination would
effectively reduce the benefits Sun expects to realize from the RCA Merger.
OTHER COSTS TO BE INCURRED IN CONNECTION WITH RCA AND CONTOUR
MERGERS. Costs to be incurred in connection with the mergers of Retirement Care
and Contour are expected to be significant and will be charged against earnings
of the combined company. The charge is currently estimated to be approximately
$30 million, and is expected to consist of transaction costs and integration
expenses, including elimination of redundant corporate functions, severance
costs related to headcount reductions and write-off of certain intangibles and
property and equipment and the settlement of certain class action lawsuits. See
"--Shareholder Litigation". Approximately $16 million of these estimated charges
are expected to be charged to operations in the fiscal quarter in which the RCA
Merger is consummated. Approximately $5 million of the estimated charges
relating to the integration expenses are expected to be expensed as incurred as
these costs are expected to benefit future combined operations. Pursuant to the
MOU, Sun has agreed to pay $9 million into an interest bearing account to settle
the Actions. The Settlement will be expensed in the period in which the
conditions to the MOU, including closing of the RCA Merger, are satisfied. These
amounts are preliminary estimates only and are, therefore, subject to change.
MANAGEMENT OF GROWTH
Sun's success will depend in part on its ability to manage the growth of its
operations. Any such growth is expected to place a significant strain on Sun's
managerial, operational and financial resources. Sun's ability to manage growth
effectively will require it to continue to improve its corporate accounting,
financial reporting, internal accounting systems and management information
systems, and to attract, train, motivate and manage its employees effectively.
These demands are expected to require further expenditures for the addition of
new management personnel and the development of additional expertise by existing
management personnel. There can be no assurance that Sun will be able to manage
effectively the expansion of its operations, that its systems, procedures or
controls will be adequate to support Sun's operations or that Sun's management
will be able to exploit opportunities for its services and products. An
inability to manage growth, if any, could have a material adverse effect on
Sun's business, results of operations, financial condition and cash flow.
NO ASSURANCE OF CONTINUED RAPID GROWTH
Since its formation in 1989, Sun has implemented an aggressive program of
expansion of its business through the acquisition of additional long-term and
subacute care facilities and other operations. From January 1994 through
December 31, 1997, Sun acquired or assumed the net operations or management of
266 long-term and subacute care facilities with a total of 40,851 licensed beds
in the United States, the United Kingdom, Spain, Australia and Germany. Sun
intends to continue to pursue its acquisition strategy
29
in the future. In making such acquisitions, Sun competes with other providers,
many of which have greater financial resources than Sun. There can be no
assurance that suitable acquisitions will be identified or completed in the
future.
Because of operating and financing constraints resulting from acquisitions
and internal growth, there can be no assurance that Sun will have adequate cash
or borrowing capacity and other resources to compete effectively for future
acquisitions or will be able in the future to continue to engage as actively in
acquisitions as it has in the past, and uncertainties regarding reimbursement
rates for therapy, the outcome of the government investigation of Sun's
rehabilitation therapy subsidiary or a material reduction in such rates could
limit internal growth of Sun's therapy business. Pursuant to the Senior Credit
Facility, Sun will be required to obtain the consent of its principal bank
lenders in connection with significant future acquisitions. In addition, to the
extent Sun's operational, administrative and financial resources are strained by
its acquisition program, Sun's ability to integrate acquired operations may
become more protracted. See "-- Difficulty of Integrating Acquired Operations."
Although Sun is continuously engaged in discussions regarding future
acquisitions, there can be no assurance that any acquisitions will be completed,
or that Sun's historic rate of growth in assets, revenues or net revenues will
be sustained. See "Acquisitions" and "--Substantial Leverage; Ability to Service
Debt."
FINANCIAL RESULTS SUBJECT TO FLUCTUATION
The Company's financial results may fluctuate on a quarterly basis as a
result of a number of factors, including the timing of acquisitions, any
associated charges to earnings and the financial performance of acquired
companies. A material shortfall in revenue or increase in expenses in a given
quarter, or a delayed or unrealized ability to achieve synergies from
acquisitions, could have a material adverse effect on the Company's earnings.
The Company believes that quarterly comparisons of the Company's revenues and
operating results should not be relied on as necessarily being indicative of
future performance. Operating results in any particular quarter which do not
meet the expectations of securities analysts could cause volatility in the price
of the Common Stock. See "--Difficulty of Integrating Acquired Operations" and
"--Potential Volatility of Stock Price."
RISK OF EXPANSION OF INTERNATIONAL OPERATIONS; FOREIGN EXCHANGE RISK
Sun currently conducts business outside of the United States, in the United
Kingdom, Spain, Germany, Australia and Canada. Foreign operations accounted for
approximately 2%, 4% and 10% of Sun's total net revenues during the years ended
December 31, 1995, 1996 and 1997, respectively, and 13% of Sun's consolidated
total assets as of December 31, 1997. See "--Acquisitions." Sun expects that its
revenues and operations attributable to international operations may increase
and substantially contribute to Sun's growth and earnings in the future.
Accordingly, as Sun's international operations continue to grow, adverse results
from Sun's international operations could adversely effect Sun's financial
condition and results of operations. Sun intends to expand its international
operations through the acquisition of operational facilities and the
construction and development of new facilities. In the past, Sun has constructed
and developed new facilities to a more significant degree in its international
expansion than it has in the United States, where Sun's growth has been
primarily due to the acquisition of operational facilities. In addition to the
capital expenditures involved in the construction and development of new
facilities, Sun expects to incur substantial losses in the first year of
operation of a new facility. As a result, the financial condition and results of
operations of Sun's international operations could be adversely affected in any
period in which a significant number of facilities are being constructed or
developed or are in their first year of operation. The success of Sun's
operations in and expansion into international markets depends on numerous
factors, many of which are beyond its control. Such factors include, but are not
limited to, economic conditions and healthcare regulatory systems in the foreign
countries in which Sun operates. In addition, international operations and
expansion may increase Sun's exposure to certain risks inherent in doing
business outside the United States, including slower payment cycles, unexpected
changes
30
in regulatory requirements, potentially adverse tax consequences, currency
fluctuations, restrictions on the repatriation of profits and assets, compliance
with foreign laws and standards and political risks.
Sun's financial condition and results of operations are subject to foreign
exchange risk. Because of Sun's foreign growth strategies, Sun does not expect
to repatriate funds invested overseas and, therefore, foreign currency
transaction exposure is not normally hedged. Exceptional planned foreign
currency cash flow requirements, such as acquisitions overseas, are hedged
selectively to prevent fluctuations in the anticipated foreign currency value.
Changes in the net worth of Sun's foreign subsidiaries arising from currency
fluctuations are accumulated in the translation adjustments component of
stockholders' equity.
YEAR 2000 DATE CHANGE--POTENTIAL EFFECT ON NETWORKS AND SYSTEMS
For a description of certain risks related to the Year 2000 date change, see
"Item 7 Management's Discussion and Analysis of Financial Condition and Results
of Operations--Year 2000 Issue."
INCREASED LABOR COSTS AND AVAILABILITY OF PERSONNEL
In recent years Sun has experienced increases in its labor costs primarily
due to higher wages and greater benefits required to attract and retain
qualified personnel, increased staffing levels in its long-term and subacute
care facilities due to greater patient acuity and the hiring and retention of
staff therapists. Although Sun expects labor costs to continue to increase in
the future, it is anticipated that any increase in costs will generally result
in higher patient rates in subsequent periods, subject to the time lag in most
states between increases in reimbursable costs and the receipt of related
reimbursement rate increases. Since under PPS and fee schedules payment is no
longer on a "pass-through" basis, increases in costs may no longer result in
increases in payment rates. See "--Potential Reduction of Reimbursement Rates
from Third Party Payors and Possible Adverse Impact on Future Operating
Results," "--Risks Associated with Reimbursement Process and Collectibility of
Certain Accounts Receivable," "--Potential Liability for Reimbursements Paid to
Former Operators of Acquired Facilities," and "--Risks Associated with Related
Party Transactions."
In the past, the healthcare industry, including Sun's long-term and subacute
care facilities, has experienced a shortage of nurses to staff healthcare
operations and, more recently, the healthcare industry has experienced a
shortage of therapists. Sun is not currently experiencing a nursing or therapist
shortage, but it competes with other healthcare providers for nursing and
therapist personnel and may compete with other service industries for persons
serving Sun in other capacities, such as certified nursing assistants. A
nursing, therapist or certified nursing assistant shortage could force Sun to
pay higher salaries and make greater use of higher cost temporary personnel. A
lack of qualified personnel might also require Sun to reduce its census or admit
patients requiring a lower level of care, both of which could adversely affect
operating results.
POTENTIAL CONFLICTS OF INTEREST FROM RELATED PARTY TRANSACTIONS
At December 31, 1997, 63 of Sun's 321 long-term and subacute care facilities
in the United States were leased or subleased from John E. Bingaman or Zev
Karkomi, two of Sun's directors, or from partnerships or corporations in which
such directors are general or limited partners, directors or stockholders or
otherwise have a significant equity holding. Sun believes the terms of all of
the foregoing leases and subleases to which it is a party are as favorable to
Sun as those that could have been obtained in arms' length transactions with
non-affiliated parties at the time of such transactions. However, contractual
relationships with entities affiliated with members of Sun's board of directors
create the potential for conflicts of interest. Sun will likely continue to
enter into leases and subleases with members of its board of directors and their
affiliates. There can be no assurance that these contractual relationships with
members of Sun's board of directors and their affiliates will not create actual
conflicts of interest.
31
RISKS RELATED TO INSURANCE AND SUBSTANTIAL COMPETITION
For a description of certain risks related to adequacy of insurance, see
"Insurance." For a description of certain risks related to the substantial
competition faced by Sun, see "Competition."
CONCENTRATION OF OWNERSHIP
As of January 31, 1998, Mr. Andrew Turner, the Chairman of the Board of
Directors and Chief Executive Officer of Sun, beneficially owned approximately
13.8% of the outstanding Common Stock. While Mr. Turner's percentage ownership
is not sufficient to enable him to control the outcome on matters submitted to
stockholders, his stock ownership, along with his position as Chairman of the
Board of Directors and Chief Executive Officer of Sun, enables him to exert
significant influence on Sun's operations. Mr. Turner's level of ownership may
have the effect of hindering a change of control of Sun.
ANTI-TAKEOVER PROVISIONS; POSSIBLE ISSUANCE OF PREFERRED STOCK
Sun's certificate of incorporation and by-laws contain provisions that may
make it more difficult for a third party to acquire, or discourage acquisition
bids for, Sun. In addition, approximately 4% of the Company's Common Stock is
owned by a grantor stock trust (the "Grantor Trust"), which holds such shares
for issuance under the company's stock option plans and employee stock purchase
plan. Employees and nonemployee directors holding stock options and employee
stock purchase plan participants have the right to vote all of the shares held
by the Grantor Trust. The voting control of such shares of stock by employees
and management may make it more difficult for a third party to acquire (or such
ownership may discourage bids for) Sun. The provisions in the certificate of
incorporation and by-laws, together with ownership of such shares by the Grantor
Trust, could limit the price that certain investors might be willing to pay in
the future for shares of Common Stock. In addition, shares of Sun's preferred
stock may be issued in the future without further stockholder approval and upon
such terms and conditions and having such rights, voting powers, preferences and
relative, participating, optional and other special privileges as the board of
directors may determine. The rights of the holders of Common Stock will be
subject to, and may be adversely affected by, the rights of any holders of
preferred stock that may be issued in the future. The issuance of preferred
stock, while providing desirable flexibility in connection with possible
acquisitions and other corporate purposes, could have the effect of making it
more difficult for a third party to acquire, or discouraging a third party from
acquiring, a majority of the outstanding voting stock of Sun. Sun has no present
plans to issue any shares of its preferred stock, other than the shares of Sun
Preferred Stock to be issued in the RCA Merger. In addition, Sun has adopted a
stockholder rights plan that, along with certain provisions of Sun's certificate
of incorporation, have the effect of discouraging certain transactions involving
a change of control of Sun. See "Description of Capital Stock," "Description of
Preferred Stock" and "Description of Common Stock" in the accompanying
Prospectus.
POTENTIAL VOLATILITY OF STOCK PRICE
There has in the past been significant volatility in the market prices of
securities of healthcare companies. In particular, the market price of the
Common Stock has in the past been subject to heightened volatility resulting
primarily from uncertainties regarding certain Medicare reimbursement policies
and government investigations of Sun. See "--Potential Reduction of
Reimbursement Rates From Third Party Payors and Possible Adverse Impact on
Future Operating Results," "--Investigations; Uncertain Impact on Future
Operating Results" and "Item 7--Management's Discussion and Analysis of
Financial Condition and Results of Operations." Sun believes factors such as
legislative and regulatory developments, continuing uncertainties regarding
certain Medicare reimbursement policies and government investigations of Sun and
quarterly variations in financial results could cause the market price of the
Common Stock to fluctuate substantially. In addition, the stock market has
experienced volatility that has particularly affected the market prices of many
healthcare service companies' stocks and that often has been unrelated to the
operating performance of such companies. These market fluctuations may adversely
affect
32
the price of the Common Stock. See "Item 5--Market for Registrant's Common
Equity and Related Stockholder Matters."
ITEM 2. PROPERTIES
FACILITIES. Most of the Company's long-term and subacute care facilities
are subject to long-term operating leases, subleases, or management agreements.
The Company considers its properties to be in good operating condition and
suitable for the purposes for which they are being used. The Company's
facilities that are leased are subject to long-term operating leases or
subleases, the terms of which range from 5 to 23 years, and require the Company,
among other things, to fund all applicable capital expenditures, taxes,
insurance and maintenance costs. The Company's rights as lessee or sublessee
could be subject to termination upon a foreclosure by the underlying mortgage
lender or termination by the lessor. The annual rent payable under each of the
leases generally increases based on a fixed percentage or increases in the
Consumer Price Index. Many of the leases contain renewal options to extend the
term for between 5 to 40 consecutive years. As of December 31, 1997, 35 of the
Company's facilities were leased from Meditrust. The Meditrust leases generally
provide for a fixed annual 2.5% increase over the prior year's rent and have
initial terms expiring between 2004 and 2011 with renewal options for five
consecutive five year terms. The Meditrust leases contain cross-default
provisions, so that a default under any one of the Meditrust leases may trigger
a default under all mortgages and leases financed by Meditrust. As of December
31, 1997, ten of the Company's long-term and subacute care facilities were
subject to management agreements, which generally provide the Company with
management fees based on a percentage of the revenues of the managed facility
and may also include a fixed fee component.
At December 31, 1997, the Company had an aggregate of $32.3 million of
outstanding mortgages with Meditrust which contain cross-default provisions with
all of such mortgages and leases also financed by Meditrust.
The Company believes that the aggregate occupancy percentages for all of its
facilities were 92%, 91% and 91% in the United States and 89%, 86% and 78% in
the United Kingdom for the years ended December 31, 1995, 1996 and 1997,
respectively. However, the Company believes that occupancy percentages, either
individually or in the aggregate, should not be relied upon alone to determine
the profitability of a facility. Other factors include, among other things, the
sources of payment, terms of reimbursement and the acuity level for each of the
patients in such facilities. The Company also believes there is not a consistent
industry standard as to how occupancy is measured and that the information may
not be comparable among long-term care providers. See "Item 1--Business" and
"Item 7--Management's Discussion and Analysis of Financial Condition and Results
of Operations--Effects from Changes in Reimbursement." The Company computes
average occupancy percentages by dividing the total number of beds sold by the
total number of licensed beds available for use during the periods indicated.
33
FACILITIES IN THE UNITED STATES. The following table sets forth certain
information concerning the long-term and subacute care facilities owned, leased
or managed by the Company in the United States as of December 31, 1997. Unless
otherwise indicated, all facilities listed below are leased by the Company.
NUMBER OF NUMBER OF
STATE FACILITIES LICENSED BEDS(1)
- ---------------------------------------------------------------- ------------- -----------------
California (2).................................................. 100 9,962
Massachusetts (3)............................................... 36 4,753
Texas........................................................... 26 3,212
Washington...................................................... 21 1,843
Connecticut (4)................................................. 15 2,159
Tennessee....................................................... 14 1,864
Illinois........................................................ 12 1,340
North Carolina.................................................. 11 1,364
Arizona......................................................... 10 1,543
Idaho (5)....................................................... 9 933
New Hampshire................................................... 9 888
New Mexico...................................................... 8 646
Louisiana....................................................... 7 1,135
Ohio (5)........................................................ 7 769
West Virginia (5)............................................... 6 619
Alabama......................................................... 5 609
Florida......................................................... 5 775
Kentucky (6).................................................... 5 479
New Jersey (7).................................................. 5 770
Colorado (8).................................................... 2 213
Oklahoma........................................................ 2 135
Oregon.......................................................... 2 195
Indiana......................................................... 1 99
Iowa............................................................ 1 77
Maryland........................................................ 1 170
Missouri........................................................ 1 103
--- ------
321 36,655
--- ------
--- ------
- ------------------------
(1) "Licensed Beds" refers to the number of beds for which a license has been
issued, which may vary in some instances from licensed beds available for
use.
(2) Includes four facilities owned and one facility managed by the Company.
(3) Includes two facilities owned and two facilities managed by the Company.
(4) Includes one facility managed by the Company and is the holder by assignment
of an option to acquire this facility.
(5) Includes one facility owned by the Company.
(6) Includes four facilities managed by the Company.
(7) Includes one facility managed by the Company.
(8) Includes one facility owned by the Company and one facility managed by the
Company.
34
See "Item 1--Certain Additional Business Risks--Potential Conflicts of
Interests from Related Party Transactions" for a description of certain
relationships between certain of the Company directors with respect to leases
for certain of the above facilities in the United States.
FACILITIES IN THE UNITED KINGDOM. The following table sets forth certain
information concerning the long-term care facilities owned or leased by the
Company as of December 31, 1997. Unless otherwise indicated, all facilities
listed below are leased by the Company.
NUMBER OF NUMBER OF
REGION FACILITIES LICENSED BEDS(1)
- ---------------------------------------------------------------- ------------- -----------------
England (2)..................................................... 113 6,307
Scotland (3).................................................... 9 741
Wales (4)....................................................... 7 453
Northern Ireland (5)............................................ 8 336
--- -----
137 7,837
--- -----
--- -----
- ------------------------
(1) "Licensed Beds" refers to the number of beds for which a register has been
issued, which may vary in some instances from registered beds available for
use.
(2) Includes 53 facilities owned by the Company.
(3) Includes four facilities owned by the Company.
(4) Includes two facilities owned by the Company.
(5) Includes one facility owned by the Company.
CONSTRUCTION OF HEALTHCARE FACILITIES IN THE UNITED KINGDOM. As of December
31, 1997, the Company had two facilities with an aggregate of 135 beds under
construction in the United Kingdom.
FACILITIES IN GERMANY, SPAIN AND AUSTRALIA. The following table sets forth
certain information concerning the long-term care facilities owned or leased by
the Company as of December 31, 1997. Unless otherwise indicated, all facilities
listed below are leased by the Company.
NUMBER OF NUMBER OF
COUNTRY FACILITIES LICENSED BEDS(1)
- ---------------------------------------------------------------- --------------- -----------------
Spain (2)....................................................... 8 1,328
Germany (3)..................................................... 11 930
Australia (4)................................................... 6 353
- ------------------------
(1) "Licensed Beds" refers to the number of beds for which a license has been
issued, which may vary in some instances from licensed beds available for
use.
(2) Includes one facility owned by the Company.
(3) Includes one facility owned by the Company and one facility managed by the
Company.
(4) Includes six facilities owned by the Company.
PHARMACEUTICAL SERVICES. As of December 31, 1997, the Company operated 34
regional pharmacies, four in-house long-term care pharmacies, and one
pharmaceutical billing and consulting center in the United States. Also, as of
December 31, 1997, the Company operated 19 pharmacies and one supply
distribution center in the United Kingdom.
35
ITEM 3. LEGAL PROCEEDINGS
The Company is a party to various legal actions and administrative
proceedings and is subject to various claims arising in the ordinary course of
business. The Company does not believe that the ultimate disposition of these
matters will have a material adverse effect on the financial position or results
of operations of the Company.
On or about January 23, 1996, two former stockholders of SunCare, John
Brennan and Susan Bird, filed a lawsuit (the "SunCare Litigation") against the
Company and certain of its officers and directors in the United States District
Court for the Southern District of Indiana. Plaintiffs allege, among other
things, that the Company did not disclose material facts concerning the
investigation by the United States Department of Health and Human Services'
Office of Inspector General ("OIG") and that the Company's financial results
were misstated. The Complaint purports to state claims, INTER ALIA, under
Federal and state securities laws and for breach of contract, including a breach
of the registration rights agreement pursuant to which the Company agreed to
register the shares issued to such former SunCare stockholders in the
acquisition. Plaintiffs purport to seek recession, unspecified compensatory
damages, punitive damages and other relief. The trial is currently scheduled to
begin in the Summer of 1998.
The Company believes the SunCare Litigation will not have a material adverse
impact on its financial condition or results of operations, although the
unfavorable resolution of this action in any reporting period could have a
material adverse impact on the Company's results of operations for that period.
The foregoing statements with respect to the possible outcomes of the SunCare
Litigation are forward looking and could be affected by a number of factors,
including judicial interpretations of applicable law, the uncertainties and
risks inherent in any litigation, particularly a jury trial, the existence and
scope of any subsequently filed complaints, the scope of insurance coverage, and
the outcome of the OIG investigation and all factors that could affect that
outcome.
On September 8, 1995, a derivative action was filed by Brickell Partners
against certain of the Company's current and former directors and officers in
the United States District Court for the District of New Mexico, captioned
BRICKELL PARTNERS V. TURNER, ET AL. The complaint was not served on any
defendant. On June 19, 1996, an amended complaint alleging breach of fiduciary
duty by certain of the Company's current and former directors and officers was
filed and subsequently served on the defendants. On August 5, 1996, the District
Court dismissed this action without prejudice for failure to serve the
defendants within the required time period. The plaintiffs filed a new
complaint, alleging the same claims, on August 19, 1996. In December 1997 the
Company and the plaintiffs reached an agreement in principle to settle the
action for an immaterial amount. The settlement is subject to definitive
documentation and court approval.
In January 1995, the Company learned that it was the subject of a pending
Federal investigation. The investigating agencies are the OIG and the United
States Department of Justice. At this time, the Company does not know the full
scope of the investigation. However, the Company currently believes that the
investigation is focused principally on whether the Company provided and billed
for unnecessary or unordered therapy services to residents of skilled nursing
facilities and whether the Company adequately documented the therapy services
which it provided.
In July 1997, the Criminal Division of the U.S. Department of Justice
informed the Company that it had completed its investigation of the Company, and
that it would not initiate any actions against the Company or any individuals.
The investigation by the Civil Division of the Department of Justice and the OIG
is still proceeding. The government continues to collect information, and the
Company continues to cooperate with the investigators. The Company and the
government have had preliminary discussions, and the Company expects to have
continuing discussions, regarding a possible settlement of the investigation.
The Company is unable to determine at this time when the investigation will
be concluded, how large a monetary settlement the government may seek, the
nature of any other remedies that may be sought by
36
the government, whether or when a settlement will in fact occur or whether any
such settlement or any other outcome of the investigation will have a material
adverse effect on the Company's financial condition or results of operations.
The foregoing statements with respect to the outcome of the investigation are
forward-looking and could be affected by a number of factors, including the
actual scope of the investigation, the government's factual findings and the
interpretation of federal statutes and regulations by the government and federal
courts and whether any such factual findings could serve as a basis for
proceedings by other governmental authorities. From time to time the negative
publicity surrounding the investigation has in the past adversely affected the
private pay enrollment in certain inpatient facilities and slowed the Company's
success in obtaining additional outside contracts in the rehabilitation therapy
business, which resulted in higher than required therapist staffing levels.
Negative publicity in the future could have a similar effect.
In 1996, the Connecticut Attorney General's office and the Connecticut
Department of Social Services ("DSS") began an investigation and initiated a
hearing in order to determine whether the Company's long-term care subsidiary
submitted false and misleading fiscal information on its 1993 and 1994 Medicaid
cost reports. In 1997, the DSS also began an investigation of information
submitted for the 1995 cost year as well as for cost reporting periods prior to
1993. The evidentiary phase of the hearing has concluded, but the proceedings
are is still in progress and the Company is unable to determine at this time
when the proceedings will be concluded or whether the evidence will warrant
further administrative action or Medicaid reimbursement sanctions by DSS.
However, based on the Company's current understanding of the investigation, the
Company does not believe the investigation will have a material adverse effect
on the Company's financial condition or results of operations. The foregoing
statement with regard to the outcome of this investigation is forward-looking
and could be affected by a number of factors, including the factual findings and
interpretation of applicable laws and regulations by the Attorney General and
the DSS and whether any such factual findings could serve as a basis for
proceedings by other governmental authorities in Connecticut or elsewhere.
In 1997, the Company was notified by a law firm representing several
national insurance companies that these companies believed Sun had engaged in
improper billing and other practices in connection with the Company's delivery
of therapy and related services. In response, the Company began discussions
directly with these insurers and hopes to resolve these matters without
litigation; however, the Company is unable at this time to predict whether it
will be able to do so, what the eventual outcome may be or the extent of its
liability, if any, to these insurers.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth
quarter of fiscal 1997.
37
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's common stock is traded on the New York Stock Exchange (the
"NYSE") under the symbol "SHG." The following table shows the high and low sales
prices for the common stock as reported by the NYSE for the periods indicated:
HIGH LOW
--------- ---------
1996
First Quarter............................................................ $ 14.25 $ 11.25
Second Quarter........................................................... 15.63 12.88
Third Quarter............................................................ 14.63 11.63
Fourth Quarter........................................................... 13.63 11.50
1997
First Quarter............................................................ $ 16.25 $ 12.75
Second Quarter........................................................... 20.81 13.88
Third Quarter............................................................ 23.44 19.63
Fourth Quarter........................................................... 22.94 17.25
There were approximately 3,271 holders of record as of March 27, 1998 of the
Company's common stock.
The Company has not paid nor declared any dividends on its common stock
since its inception and anticipates that its future earnings will be retained to
finance the continuing development of its business. The payment of any future
dividends will be at the discretion of the Company's Board of Directors and will
depend upon, among other things, future earnings, the success of the Company's
business activities, regulatory and capital requirements, the general financial
condition of the Company and general business conditions. The Company is
restricted from paying dividends under the Credit Facility. See "Item 7--
Management's Discussion and Analysis of Financial Condition and Result of
Operations--Liquidity and Capital Resources."
38
ITEM 6. SELECTED FINANCIAL DATA
The following Selected Consolidated Financial Data for the years ended
December 31, 1997, 1996, 1995, 1994 and 1993 have been derived from the
Company's Consolidated Financial Statements. The financial data set forth below
should be read in connection with "Item 7. Management's Discussion and Analysis
of Financial Condition and Results of Operations" and with the Company's
Consolidated Financial Statements and related notes thereto.
YEAR ENDED DECEMBER 31,
----------------------------------------------------------------
1997(1) 1996(2) 1995(3)(4)(5) 1994(3) 1993(3)
------------ ------------ ------------ ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Total net revenues............................ $ 2,010,820 $ 1,316,308 $1,135,508 $ 673,354 $ 230,815
Earnings before income taxes and extraordinary
loss........................................ 95,882 52,466 12,794 36,807 22,710
Earnings (loss) before extraordinary loss..... 54,729 21,536 (20,568) 19,561 13,463
Extraordinary loss............................ 19,928 -- 3,413 -- --
------------ ------------ ------------ ---------- ----------
Net earnings (loss)..................... $ 34,801 $ 21,536 $ (23,981) $ 19,561 $ 13,463
------------ ------------ ------------ ---------- ----------
------------ ------------ ------------ ---------- ----------
Net earnings (loss) per common and common
equivalent share(6):
Net earnings (loss) before extraordinary
loss:
Basic..................................... $ 1.18 $ 0.46 $ (0.43) $ 0.63 $ 0.73
Diluted................................... $ 1.12 $ 0.46 $ (0.43) $ 0.61 $ 0.72
Net earnings:
Basic....................................... $ 0.75 $ 0.46 $ (0.51) $ 0.63 $ 0.73
Diluted..................................... $ 0.74 $ 0.46 $ (0.51) $ 0.61 $ 0.72
Weighted average number of common and common
equivalent shares:
Basic....................................... 46,329 46,360 47,419 31,038 18,374
Diluted..................................... 51,851 46,868 47,419 31,830 18,608
Working capital............................... $ 319,519 $ 211,582 $ 237,147 $ 197,150 $ 45,451
Total assets.................................. 2,579,236 1,229,426 1,042,503 1,054,223 110,488
Long-term debt, net of current portion........ 1,488,861 460,501 348,460 398,534 11,967
Stockholders' equity.......................... 617,053 572,137 569,042 550,449 70,361
- ------------------------
(1) Results for the year ended December 31, 1997 include a charge of $7.0
million recognized by the Company in order to reduce the carrying value of
the Canadian operations to fair value based on revised estimates of selling
value and of costs to sell. In addition, in 1997, the Company recorded an
extraordinary charge of $17.9 million, net of the related tax benefit, in
connection with the Company's purchase of Regency's 12.25% Junior
Subordinated Notes due 2003 and of Regency's 9.875% Senior Subordinated
Notes due 2002 and an extraordinary charge of $2.1 million, net of the
related tax benefit, related to the refinancing of the Company's credit
facility.
(2) Results for the year ended December 31, 1996 include a $24.0 million charge
recognized by the Company to settle certain of the lawsuits brought by
shareholders and, as a reduction of this settlement charge, $9.0 million
which was received from the Company's director and officer liability
insurance carrier in connection with the settlement (see Note 15 to the
Consolidated Financial Statements). In addition, in 1996, the Company
recorded additional expenses of $4.3 million related to monitoring and
responding to the continuing investigation by the United States Department
of
39
Health and Human Services' Office of Inspector General ("OIG") and to
responding to the remaining shareholder litigation related to the
announcement of the OIG investigation. The charges do not contain any
estimated amounts for settlement of the OIG investigation or remaining
shareholder litigation matters.
(3) Results for the year ended December 31, 1995 and prior years represent pro
forma amounts to include pro forma taxes of CareerStaff and Golden Care
prior to their conversions to be taxed as C corporations, which occurred in
June 1994 and May 1995, respectively.
(4) Results for the year ended December 31, 1995 include a charge of $3.3
million in connection with the payment of an inducement fee to effect the
conversion in January 1995 of $39.4 million of the 6 1/2% Convertible
Subordinated Debentures and an extraordinary charge of $3.4 million, net of
the related tax benefit, in connection with the tender offer of the 11 3/4%
Senior Subordinated Notes. (See Note 6 to the Consolidated Financial
Statements).
(5) Also included in results for the year ended December 31, 1995 is $5.8
million of transaction-related merger costs incurred in connection with the
merger of the Company with CareerStaff and Golden Care (see Note 2 to the
Consolidated Financial Statements), a $59.0 million impairment loss recorded
by the Company which primarily relates to goodwill associated with six of
the forty facilities acquired in the acquisition of Mediplex (see Note 1(g))
to the Consolidated Financial Statements), $4.0 million related to averting
a strike and negotiating new contracts for certain unionized homes in
Connecticut, and a charge of $5.5 million related to monitoring and
responding to the investigation by the OIG and legal fees resulting from the
shareholder litigation.
(6) See Note 1(o) to the Company's Consolidated Financial Statements for net
earnings (loss) per share information. Also, pro forma net earnings per
share data for the year ended December 31, 1993 is calculated based upon the
number of shares of the Company's common stock issued upon the formation of
Sun Healthcare Group, Inc. on April 15, 1993, which placed under the control
of a single corporation all of the Company's operations and the appropriate
weighted average number of shares of the Company's common stock for common
stock transactions of the Company subsequent to the Company's
preincorporation agreement dated as of April 13, 1993, and also include the
appropriate weighted average number of shares of the Company's common stock
for common stock transactions of CareerStaff and Golden Care for the year
ended December 31, 1993.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
The Company, through its direct and indirect subsidiaries (hereinafter
collectively referred to as the "Company"), is a provider of long-term, subacute
and related specialty healthcare services, including rehabilitation and
respiratory therapy services and pharmaceutical services. Long-term care and
subacute care services and outpatient therapy services are provided through
affiliated facilities. Therapy services and pharmaceutical services are provided
by the Company in both affiliated and nonaffiliated facilities located in the
United States. The Company also provides long-term care services in the United
Kingdom, Spain and Germany and acute care services in Australia and
pharmaceutical services in the United Kingdom and Spain.
The Company's earnings growth has historically resulted from the acquisition
of long-term and subacute care facilities ("facilities"), use of its long-term
and subacute care operations as a base for expansion of its ancillary services,
provision of ancillary services to nonaffiliated facilities and expansion of
ancillary services through acquisitions. Under the current Medicare
reimbursement system, ancillary services, such as rehabilitation and respiratory
therapy services and pharmaceutical services, have significantly higher
operating margins than the margins associated with the provision of routine
services to patients at long-term and subacute care facilities and accordingly
have provided more than half of the
40
Company's operating profits. The higher operating margins from the provision of
ancillary services are primarily attributable to more favorable reimbursement
rates. In addition, a substantial portion of the Company's consolidated interest
expense was attributable to the Company's long-term and sub-acute services and
its foreign operations due to the capital intensive nature of these businesses
and to related acquisitions. The Company believes that when Medicare implements
a prospective payment system ("PPS") for long-term and subacute care services it
may be better able than some of its competitors to respond to the new PPS
environment because it provides more types of ancillary services in-house and to
nonaffiliated facilities than many of its competitors. There can be no assurance
that the Company will be able to maintain its margins or that its margins will
not decrease and that PPS will not have a material adverse effect on the
Company's financial condition or results of operations. See "Effects from
Changes in Reimbursement."
The Company's results of operations for the years ended December 31, 1997,
1996 and 1995 reflect the acquisition of facilities, the growth of the Company's
existing facility operations, the expansion of the Company's therapy service
operations and temporary therapy staffing services, and the growth of the
Company's pharmaceutical service operations.
In October 1997, the Company acquired Regency Health Services, Inc.
("Regency"), an operator of skilled nursing facilities and a diversified
provider of rehabilitation therapy, pharmacy and home health services. At the
date of acquisition, Regency operated 111 long-term care facilities (including
one managed facility) in the United States and provided rehabilitation therapy
and pharmacy services to both affiliated and nonaffiliated facilities.
In February 1997, the Company agreed to acquire Retirement Care Associates,
Inc. ("Retirement Care"), an operator of approximately 106 skilled nursing
facilities and assisted living centers, and its 65% owned subsidiary, Contour
Medical, Inc. ("Contour"), a national provider of medical/surgical supplies. In
addition, the Company agreed to acquire the remaining 35% of Contour not
presently owned by Retirement Care. The acquisition of Retirement Care is
expected to be accounted for as a pooling of interests and the acquisition of
the minority interest of Contour is expected to be accounted for as a purchase.
These transactions are expected to close in the second quarter of 1998.
In January 1997, the Company acquired the portion not previously owned by
the Company of Ashbourne PLC, which as of the date of acquisition, operated 49
nursing and residential support facilities in the United Kingdom.
At December 31, 1997, the Company operated 321 facilities with 36,655
licensed beds in the United States and 137 facilities with 7,837 licensed beds
in the United Kingdom, 8 facilities with 1,328 licensed beds in Spain, 11
facilities with 930 licensed beds in Germany and 6 facilities with 353 licensed
beds in Australia. In addition to Regency and Ashbourne, during 1997, the
Company acquired 54 facilities in the United States and 9 facilities in the
United Kingdom, resulting in a total increase of 6,399 and 476 licensed beds in
the United States and United Kingdom, respectively. Also, in 1997 the Company
developed and opened one facility in the United States and 9 facilities in the
United Kingdom with a total of 154 and 604 licensed beds in the United States
and United Kingdom, respectively. The Company also acquired 38% of the equity of
Alpha Healthcare Limited, an operator of ten acute care facilities in Australia.
At December 31, 1996, the Company operated 160 facilities with 19,321
licensed beds in the United States and 75 facilities with 3,420 licensed beds in
the United Kingdom. During 1996, the Company acquired APTA Healthcare PLC
("APTA") which operated 32 facilities with 1,263 licensed beds in the United
Kingdom. In addition to APTA during 1996, the Company acquired 32 facilities in
the United States and 11 facilities in the United Kingdom, resulting in a total
increase of 3,874 and 486 licensed beds in the United States and United Kingdom,
respectively. In addition, in 1996 the Company developed and opened four
facilities in the United Kingdom with 230 licensed beds.
41
At December 31, 1995, the Company operated 131 facilities with 15,921
licensed beds in the United States and 28 facilities with 1,437 licensed beds in
the United Kingdom.
The Company's therapy service operations include the provision of physical,
occupational and speech therapy, the provision of respiratory care, the
provision of additional ancillary healthcare services, such as dentistry, and
the distribution of related equipment and supplies. As of December 31, 1997, the
Company provided its therapy services to 1,278 nonaffiliated facilities, an
increase of 519 facilities from the 759 nonaffiliated facilities serviced at
December 31, 1996.
The Company's temporary therapy service operations which provide temporary
therapists, had 27, 20, and 18 division offices at December 31, 1997, 1996 and
1995, respectively. During the year ended December 31, 1997, the Company
provided a total of 2,817,000 temporary therapy staffing hours to nonaffiliates,
an increase of 415,000 hours from the 2,402,000 nonaffiliated temporary therapy
staffing hours provided during the year ended December 31, 1996.
The Company's pharmaceutical service operations include the provision of
pharmaceuticals, the distribution of related supplies and home care. As of
December 31, 1997, the Company operated 34 regional pharmacies, four in-house
long-term care pharmacies, 14 home health service agencies, and a pharmaceutical
billing and consulting center.
The Company's foreign operations, in addition to the nursing home facilities
in the United Kingdom, Spain and Germany and acute care facilities in Australia,
include the provision of pharmaceutical services in the United Kingdom and Spain
and outpatient therapy services in Canada. During 1997, the Company announced
its intention to sell and divest itself of its outpatient therapy service
operations in Canada, as well as in the United States. As of December 31, 1997,
the Company operated 19 pharmacies and one supply distribution center in the
United Kingdom and one pharmacy in Spain.
The following table sets forth certain operating data for the Company as of
the dates indicated:
YEAR ENDED DECEMBER 31,
-------------------------------
1997 1996 1995
--------- --------- ---------
Long-term and Subacute Care Facility Operations
Long-term and subacute care facilities (including managed facilities):
Domestic operations.............................................................. 321 160 131
Foreign operations............................................................... 162 75 28
--------- --------- ---------
Total.......................................................................... 483 235 159
--------- --------- ---------
--------- --------- ---------
Licensed beds (including managed facilities):
Domestic operations.............................................................. 36,655 19,321 15,921
Foreign operations............................................................... 10,448 3,420 1,437
--------- --------- ---------
Total.......................................................................... 47,103 22,741 17,358
--------- --------- ---------
--------- --------- ---------
Therapy Service Operations:
Nonaffiliated facilities served.................................................. 1,278 759 643
Affiliated facilities served..................................................... 287 152 125
--------- --------- ---------
Total.......................................................................... 1,565 911 768
--------- --------- ---------
--------- --------- ---------
Temporary Therapy Staffing Service Operations:
Hours billed to nonaffiliates (in thousands)..................................... 2,817 2,402 1,999
--------- --------- ---------
--------- --------- ---------
Pharmaceutical Operations:
Nonaffiliated facilities served.................................................. 546 325 271
Affiliated facilities served..................................................... 255 112 101
--------- --------- ---------
Total.......................................................................... 801 437 372
--------- --------- ---------
--------- --------- ---------
42
RESULTS OF OPERATIONS
The following table sets forth the amount and percentages of certain
elements of total net revenues for the periods presented (dollars in thousands):
YEAR ENDED DECEMBER 31,
-------------------------------------------------------------------------
1997 1996 1995
----------------------- ----------------------- -----------------------
Long-term and subacute care services.............. $ 1,237,746 62% $ 826,780 63% $ 759,459 67%
Therapy services to nonaffiliates................. 301,301 15 220,592 17 170,154 15
Foreign operations................................ 198,154 10 60,985 4 27,072 2
Temporary therapy staffing services to
nonaffiliates................................... 138,556 7 116,818 9 96,500 9
Pharmaceutical services to nonaffiliates.......... 123,411 6 70,673 5 51,409 5
Ambulatory surgery................................ -- -- 11,857 1 26,197 2
Management fees and other......................... 11,652 -- 8,603 1 4,717 --
------------ --- ------------ --- ------------ ---
Total net revenues.............................. $ 2,010,820 100% $ 1,316,308 100% $ 1,135,508 100%
------------ --- ------------ --- ------------ ---
------------ --- ------------ --- ------------ ---
Revenues for long-term and subacute care services include revenues billed to
patients for therapy and pharmaceutical services provided by the Company's
affiliated operations. Revenues for therapy services provided to affiliated
facilities were $180.9 million, $113.9 million and $92.2 million for the years
ended December 31, 1997, 1996 and 1995, respectively. Revenues provided to
domestic affiliated facilities for pharmaceutical services were $32.7 million,
$19.5 million and $14.2 million for the years ended December 31, 1997, 1996 and
1995, respectively.
The following table presents the percentage of total net revenues
represented by certain items for the Company for the periods presented:
YEAR ENDED DECEMBER 31,
-------------------------------
1997 1996 1995
--------- --------- ---------
Total net revenues..................................................... 100% 100% 100%
--- --- ---
Costs and expense:
Operating............................................................ 82.7 84.2 81.9
Corporate general and administrative................................. 4.9 4.7 4.5
Provision for losses on accounts receivable.......................... 0.8 1.1 1.3
Depreciation and amortization........................................ 2.8 2.6 2.4
Interest, net........................................................ 3.7 2.0 1.9
Loss on sale of Canadian operations.................................. 0.3 -- --
Conversion expense................................................... -- -- 0.3
Merger expenses...................................................... -- -- 0.5
Strike costs......................................................... -- -- 0.4
Investigation and litigation costs................................... -- 1.5 0.5
Impairment loss...................................................... -- -- 5.2
--- --- ---
Total costs and expenses........................................... 95.2 96.1 98.9
--- --- ---
Earnings before income taxes and extraordinary loss.................... 4.8 3.9 1.1
Income taxes(1)........................................................ 2.1 2.3 2.9
--- --- ---
Net earnings (loss) before extraordinary loss(1)....................... 2.7 1.6 (1.8)
Extraordinary loss..................................................... 1.0 -- 0.3
--- --- ---
Net earnings (loss)(1)................................................. 1.7% 1.6% (2.1)%
--- --- ---
--- --- ---
- ------------------------
(1) Results for the year ended December 31, 1995 represents pro forma amounts to
include pro forma taxes of SunCare prior to its conversion to be taxed as a
C Corporation, which occurred in May 1995.
43
The results of the Company's ambulatory surgery operations are immaterial to
the Company's consolidated results and, therefore, this discussion excludes the
Company's ambulatory surgery operations. The Company sold its ambulatory surgery
subsidiary in the second quarter of 1996.
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
Total net revenues for the year ended December 31, 1997 increased 53% from
$1,316 million for the year ended December 31, 1996 to $2,011 million.
Net revenues from long-term and subacute care services, which includes
revenues generated from therapy and pharmaceutical services provided at the
Company's facilities, increased from $826.8 million for the year ended December
31, 1996 to $1,237.7 million for the year ended December 31, 1997, a 50%
increase. Net revenues from long-term and subacute care services were negatively
impacted in 1997 and 1996 by certain changes in accounting estimates for
third-party settlements (see "Effects from Changes in Reimbursement" and Note 1
to the Consolidated Financial Statements for information regarding the Company's
revenue recognition policy). In the fourth quarter of 1997, the Company recorded
negative revenue adjustments totaling approximately $15 million resulting from
changes in accounting estimates primarily based on new information arising from
the settlement in late 1997 of substantially all of the Company's facility cost
reports for 1994 and 1995. This charge also includes an estimate for projected
settlements in 1996 based on prior years' settlements. The $15 million of
negative revenue adjustments represents approximately 2% of total Medicare
revenues recognized in the periods settled and 1996. Historically, fiscal
intermediaries have settled the Company's facility cost reports during the
latter half of the year.
In addition, the extinguishment of certain Regency debt during the fourth
quarter of 1997, resulted in an increase in certain reimbursable costs from
Medicare. As a result, the Company recognized $4.0 million of revenues from
Medicare of which $3.5 million was for long-term and subacute care services.
In the fourth quarter of 1996, the Company recorded negative revenue
adjustments totalling approximately $23.0 million resulting from changes in
accounting estimates of amounts realizable from third-party payors. These
changes in accounting estimates primarily arose out of the cost reporting
settlement process in the latter part of 1996, including the settlement of
outstanding Medicare cost reports and the results of Medicare and Medicaid cost
report audits. Approximately $19.4 million of the adjustments related to changes
in estimates out of the settlement of prior years' cost reports including $11.1
million of adjustments from the Company's Mediplex facilities.
Giving effect to the adjustments in 1997 and 1996 (discussed above), net
revenues from long-term and subacute care services increased 50% from $826.8
million for the year ended December 31, 1996 to $1,237.7 million for the year
ended December 31, 1997. Approximately $126.8 million or 31% of this increase
results from the 110 leased or owned facilities acquired from Regency and
approximately $206.4 million or 50% of this increase resulted from an additional
79 leased or owned facilities acquired or opened since December 31, 1995. The
acquisition of Regency occurred in October 1997 and net revenues include the
results of operations since the date of acquisition. The remaining net revenue
increase of $89.2 million, after giving effect to a decrease in net revenues of
approximately $11.4 million relating to three facilities sold during 1996 and
four facilities sold during 1997, is primarily attributable to an increase in
revenue per patient day on a same facility basis for the 123 leased or owned
facilities in operation for all of 1996 and 1997. The increase in revenue per
patient day was a result of payor rate increases and the expansion of the
Company's subacute services.
Net revenues from therapy services to nonaffiliated facilities increased 37%
from $220.6 million for the year ended December 31, 1996 to $301.3 million for
the year ended December 31, 1997 primarily as a result of an increase in the
number of nonaffiliated facilities served from 759 facilities at December 31,
1996 to 1,278 facilities at December 31, 1997. This increase includes 46
nonaffiliated facilities and approximately $10.2 million in net revenues from
therapy services provided to Retirement Care facilities primarily in the latter
half of 1997.
44
Net revenues from foreign operations increased 225% from $61.0 million for
the year ended December 31, 1996 to $198.1 million for the year ended December
31, 1997. Approximately $111.1 million or 81% of this increase was the result of
increased net revenues from the nursing home operations in the United Kingdom.
The increase relating to the nursing home operations in the United Kingdom was
primarily the result of the Company's acquisitions of Ashbourne in January 1997
and APTA in December 1996, which when combined, added approximately $94.0
million or 85% of the increase in net revenues from the nursing home operations
in the United Kingdom during the year ended December 31, 1997. Approximately
$15.1 million or 11% of the total increase was the result of increased net
revenues from the pharmacy operations which was primarily the result of 18
pharmacies and a supply distribution center acquired or opened since December
31, 1995 in the United Kingdom. The remaining increase in net revenues is
attributable to the Company's acquisitions of nursing homes in Spain, acute care
facilities in Australia, and increased revenues from the Company's outpatient
clinics in Canada. As previously discussed, the Company has announced its
intention to sell and divest itself of its outpatient therapy service operations
in Canada.
Net revenues from temporary therapy staffing services to nonaffiliated
facilities increased 19% from $116.8 million for the year ended December 31,
1996 to $138.6 million for the year ended December 31, 1997 primarily as a
result of an increase in service hours billed to nonaffiliates from 2,402,000
hours in the year ended December 31, 1996 to 2,817,000 hours in the year ended
December 31, 1997. The increase in service hours billed was primarily
attributable to acquisitions during 1997 and 1996.
Net revenues from pharmaceutical services to nonaffiliated facilities
increased 75% from $70.7 million for the year ended December 31, 1996 to $123.4
million for the year ended December 31, 1997. Approximately $24.9 million or 47%
of the increase in net revenues was the result of the addition of 10 pharmacies
and 14 home health agencies acquired from Regency. In addition, net revenues
increased by $22.0 million primarily as a result of the increase in
nonaffiliated facilities served as a result of additional acquisitions during
1997 and 1996.
Operating expenses, which includes rent expense of $143.9 million and $91.7
million for the year ended December 31, 1997 and 1996, respectively, increased
50% from $1,107.8 million for the year ended December 31, 1996 to $1,662.8
million for the year ended December 31, 1997. The increase resulted primarily
from the net increase of 62 leased or owned facilities during various times
during the year ended December 31, 1996 and 257 leased or owned facilities
during the year ended December 31, 1997 and the growth in therapy and temporary
therapy staffing services. Operating expenses as a percentage of net revenues
decreased from 84.2% for the year ended December 31, 1996 to 82.7% for the year
ended December 31, 1997. The decrease in operating expenses as a percentage of
net revenues was primarily due to the acquisitions of Ashbourne and APTA whose
facility leases are primarily capital leases and therefore include interest and
depreciation expense instead of rent expense. The decrease is offset by lower
operating margins in the United Kingdom as occupancy rates in the United Kingdom
have been negatively impacted by an excess number of available beds in the
United Kingdom. In addition, since December 31, 1995, the Company has opened 20
long-term care facilities in the United Kingdom which has also negatively
impacted occupancy as well as operating margins.
Corporate general and administrative expenses, which include regional costs
related to the supervision of operations, increased 58% from $62.1 million for
the year ended December 31, 1996 to $98.2 million for the year ended December
31, 1997. As a percentage of net revenues, corporate general and administrative
expenses increased from 4.7% for the year ended December 31, 1996 to 4.9% for
the year ended December 31, 1997. The increase was primarily due to an increase
in costs relating to the expansion of the Company's corporate infrastructure to
support the development of the Company's foreign operations, newly acquired
domestic operations including the acquisition of Regency, and implementation of
new business strategies.
45
The provision for losses on accounts receivable increased 5% from $15.0
million for the year ended December 31, 1996 to $15.8 million for the year ended
December 31, 1997. As a percentage of net revenues, provision for losses on
accounts receivable decreased from 1.1% for the year ended December 31, 1996 to
0.8% for the year ended December 31, 1997. In 1996, the Company experienced
higher than expected write-offs of patient accounts receivable primarily at its
Mediplex facilities acquired in June 1994 and recorded an additional provision
for losses on accounts receivable of approximately $6.6 million. In addition,
beginning in mid 1996, the Company increased its accounts receivable reserve in
response to a slowdown in collections from nonaffiliated facilities for therapy
services due to delays in payment by the nonaffiliated facilities' Medicare
fiscal intermediaries (see "Liquidity and Capital Resources").
Depreciation and amortization increased 67% from $33.8 million for the year
ended December 31, 1996 to $56.6 million for the year ended December 31, 1997.
As a percentage of net revenues, depreciation and amortization expense increased
from 2.6% for the year ended December 31, 1996 to 2.8% for the year ended
December 31, 1997, respectively. The increase is primarily due to the assets
acquired by the Company, including goodwill, of Regency acquired during the
fourth quarter of 1997, of Ashbourne acquired during the first quarter of 1997
and of APTA acquired during the fourth quarter of 1996.
Net interest expense increased 188% from $25.9 million for the year ended
December 31, 1996 to $74.5 million for the year ended December 31, 1997. As a
percentage of net revenues, interest expense increased from 2.0% for the year
ended December 31, 1996 to 3.7% for the year ended December 31, 1997. The
increase was related to (i) an increase in borrowing costs resulting from the
Company's issuance of $250 million of 9 1/2% Senior Subordinated Notes due 2007
in July of 1997, and (ii) an increase in borrowings and borrowing costs under
the Company's credit facility associated with acquisitions during 1996 and 1997
including Regency, Ashbourne and APTA. The increase was also due to interest
expense related to capital leases assumed by the Company as part of the
Company's acquisitions of Ashbourne and APTA.
In 1997, the Company recorded a charge totaling $7.0 million in order to
reduce the carrying value of the Canadian operations to fair value based on
revised estimates of selling value and of costs to sell.
In 1997, the Company recorded an extraordinary charge of $17.9 million net
of the related tax benefit, in connection with the Company's purchase of
Regency's 12.25% Junior Subordinated Notes due 2003 and of Regency's 9.875%
Senior Subordinated Notes due 2002 and an extraordinary charge of $2.1 million,
net of the related tax benefit, related to the refinancing of the Company's
credit facility.
In 1996, the Company reached an agreement in principle to settle certain of
the class-action lawsuits brought by shareholders for $24.0 million and
recognized, as a reduction of the settlement cost, a $9.0 million claim from its
director and officer liability insurance carrier. Although the Company funded
the settlement payment in 1996, the Company did not receive payment from its
insurance carrier until March 1997. In addition, in 1996 the Company accrued
additional charges and expenses of $4.3 million related to monitoring and
responding to the continuing investigation by the U.S. Department of Health and
Human Services' Office of Inspector General ("OIG") and responding to the
remaining shareholder litigation filed after the announcement of the OIG
investigation. The charges do not contain any estimated amounts for settlement
of the OIG investigation or remaining shareholder litigation matters (see
"Effects from Changes in Reimbursement" and "Litigation").
The Company's effective tax rate was 40% for the year ended December 31,
1997 after excluding the loss on the sale of the Canadian operations and was 41%
for the year ended December 31, 1996 after excluding the investigation and
litigation charge. The decrease in the effective tax rate was due to a more
favorable mix of state income in the United States than in the prior year. The
effective tax rate is expected to increase during 1998 primarily due to a less
favorable mix of state income in the United States and the increased amount of
nondeductible goodwill resulting primarily from the acquisition of Regency.
46
Net earnings were $34.8 million for the year ended December 31, 1997 as
compared to net earnings of $21.5 million for the year ended December 31, 1996.
Net earnings were $54.7 million for the year ended December 31, 1997 before the
extraordinary loss, as compared to net earnings of $21.5 million for the year
ended December 31, 1996. As a percentage of net revenues, net earnings before
the extraordinary loss were 2.7% for the year ended December 31, 1997 and 1.6%
for the year ended December 31, 1996. Net earnings before the extraordinary loss
and the loss on sale of the Canadian operations for the year ended December 31,
1997 were $61.7 million or 3.1% as a percentage of net revenues and net earnings
before the investigation and litigation costs for the year ended December 31,
1996 were $42.4 million, or 3.2% as a percentage of net revenues. The margin
decrease was primarily due to the increased costs and lower margins from the
Company's nursing home operations in the United Kingdom, including the borrowing
costs associated with acquisitions in the United Kingdom (discussed above).
YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995
Total net revenues for the year ended December 31, 1996 increased 16% from
$1,135 million for the year ended December 31, 1995 to $1,316 million.
Net revenues from long-term and subacute care facilities were negatively
impacted by certain changes in accounting estimates for third party settlements
(as discussed above). After considering these adjustments, net revenues
increased 9% from $759.5 million for the year ended December 31, 1995 to $826.8
million for the year ended December 31, 1996. Approximately $82.6 million of
this increase resulted from 18 leased or owned facilities acquired during the
year ended December 31, 1996 and 16 facilities acquired or opened at various
times during the year ended December 31, 1995. Net revenues for facilities
opened before January 1, 1995 decreased $15.3 million due to the negative
revenue adjustments previously discussed and the sale of three of these
facilities during 1996. The sold facilities contributed $17.7 million to the
decrease.
Net revenues from therapy services to nonaffiliated facilities increased 30%
from $170.1 million for the year ended December 31, 1995, to $220.6 million for
the year ended December 31, 1996 primarily as a result of an increase in the
number of nonaffiliated facilities served from 643 facilities at December 31,
1995 to 759 facilities at December 31, 1996.
Net revenues from temporary therapy staffing services to nonaffiliated
facilities increased 21% from $96.5 million for the year ended December 31, 1995
to $116.8 million for the year ended December 31, 1996 primarily as a result of
an increase in service hours billed to nonaffiliates from 1,999,000 hours in
1995 to 2,402,000 hours in 1996. The increase in service hours billed was
primarily attributable to the increase of services at division offices open for
over one year and to new offices established through acquisitions.
Net revenues from pharmaceutical services to nonaffiliated facilities
increased 37% from $51.4 million for the year ended December 31, 1995 to $70.7
million for the year ended December 31, 1996. The growth in net revenues was
primarily a result of the increase in the number of nonaffiliated facilities
served from 271 at December 31, 1995 to 325 at December 31, 1996. The increase
in nonaffiliated facilities served was the result of the opening and acquisition
of pharmacies during 1996 and 1995 and the increase in the number of
nonaffiliated facilities served by pharmacies open prior to January 1, 1995.
Net revenues from foreign operations increased 125% from $27.1 million for
the year ended December 31, 1995 to $61.0 million for the year ended December
31, 1996. Net revenue growth of $18.0 million was attributable to the
acquisition of Columbia, a provider of outpatient rehabilitation therapy in
Canada, during November 1995. The remaining net revenue increase of $15.9
million was attributable to the 47 facilities acquired or opened in the United
Kingdom during the year ended December 31, 1996 and the 10 facilities acquired
or opened in the United Kingdom during the year ended December 31, 1995.
47
Operating expenses, which includes rent expense of $91.7 million and $73.7
million for the years ended December 31, 1996 and 1995, respectively, increased
19% from $929.5 million for the year ended December 31, 1995 to $1,107.8 million
for the year ended December 31, 1996. The increase resulted primarily from the
net increase of 62 leased or owned facilities during the year ended December 31,
1996 and 26 leased or owned facilities during the year ended December 31, 1995
and the growth in therapy and temporary therapy staffing services. Operating
expenses as a percentage of net revenues increased from 81.9% for the year ended
December 31, 1995 to 84.2% for the year ended December 31, 1996. This increase
was primarily attributable to negative revenue adjustments recorded by the
Company during the fourth quarter of 1996 (as discussed above). In addition, the
increase can also be attributed to newly developed facilities opened during 1996
and 1995, which, during the start-up period, have experienced lower operating
margins as the Company implements its operating strategies, and to increased
operating costs without a corresponding increase in billing rates due to
competitive pressures. Seasonal declines in therapist productivity during the
holiday season in the fourth quarter also contributed to the decrease. The
Company's operating costs during the holiday season remained relatively constant
despite temporary revenue reductions due to the reduced number of business days
during the fourth quarter in 1996 as compared to 1995.
Corporate general and administrative expenses, which include regional costs
related to the supervision of operations, increased 21% from $51.5 million for
the year ended December 31, 1995 to $62.1 million for the year ended December
31, 1996. As a percentage of net revenues, corporate general and administrative
expenses increased from 4.5% for the year ended December 31, 1995 to 4.7% for
the year ended December 31, 1996. The increase was primarily due to expansion of
the Company's corporate infrastructure to support the operations of fourteen
facilities in California for which the Company entered into a management
agreement during the third quarter of 1996. The increase was also due to an
increase in costs relating to the expansion of the Company's corporate
infrastructure to support the developing foreign operations and implementation
of new business strategies.
The provision for losses on accounts receivable increased 3% from $14.6
million for the year ended December 31, 1995 to $15.0 million for the year ended
December 31, 1996. As a percentage of net revenues, provision for losses on
accounts receivable decreased from 1.3% for the year ended December 31, 1995 to
1.1% for the year ended December 31, 1996. In 1995, $7.6 million of Mediplex
accounts receivable were written-off, of which $3.5 million represented accounts
receivable existing at the date of the acquisition of Mediplex. The write-offs
of Mediplex accounts receivable in 1995 were primarily the result of the
difficulties the Company experienced in integrating Mediplex's accounting and
management information systems which hampered collection efforts, changes in
estimates of amounts realizable from third-party payors (see "Effects from
Changes in Reimbursement") and the recognition of losses on balances retained
from the disposition of five of Mediplex's psychiatric care and substance abuse
facilities and related outpatient centers on September 30, 1995. In 1996, the
Company continued to experience higher than expected write-offs of patient
accounts receivable primarily at its Mediplex facilities and recorded an
additional provision for losses on accounts receivable of approximately $6.6
million. In addition, beginning in mid 1996, the Company increased its accounts
receivable reserve in response to a slowdown in collections from nonaffiliated
facilities for therapy services due to delays in payment by the nonaffiliated
facilities' Medicare fiscal intermediaries (see "Liquidity and Capital
Resources").
Depreciation and amortization increased 22% from $27.7 million for the year
ended December 31, 1995 to $33.8 million for the year ended December 31, 1996.
As a percentage of net revenues, depreciation and amortization expense remained
relatively constant at 2.6% and 2.4% for the years ended December 31, 1996 and
1995, respectively.
Net interest expense increased 19% from $21.8 million for the year ended
December 31, 1995 to $25.9 million for the year ended December 31, 1996. The
increase is primarily related to borrowings associated with the repurchase of
2,030,116 shares of the Company's outstanding common stock and purchase of a
9.9% interest in OmniCell Technologies, Inc. ("OmniCell"). Each of these
purchases was
48
financed by borrowings under the Company's revolving credit facility. As a
percentage of net revenues, interest expense remained relatively constant at
2.0% and 1.9% for the years ended December 31, 1996 and 1995, respectively.
In 1996, the Company reached an agreement in principle to settle certain of
the class-action lawsuits brought by shareholders for $24.0 million and
recognized, as a reduction of the settlement cost, a $9.0 million claim from its
director and officer liability insurance carrier. In addition, in 1996 the
Company accrued additional charges and expenses of $4.3 million related to
monitoring and responding to the continuing investigation by the OIG and
responding to the remaining shareholder litigation filed after the announcement
of the OIG investigation. In 1995, the Company also recorded charges and
expenses of $5.5 million related to monitoring and responding to the continuing
investigation by the OIG and legal fees resulting from shareholder litigation.
The 1995 charges also included costs incurred by the Company in connection with
financing activities which were not concluded due to negative publicity
resulting from the OIG investigation. The charges do not contain any estimated
amounts for settlement of the OIG investigation or remaining shareholder
litigation matters (see "Effects from Changes in Reimbursement" and
"Litigation").
The Company incurred a nonrecurring charge of $3.3 million in connection
with the payment of an inducement fee to effect the conversion in January 1995
of $39.4 million of the 6 1/2% Convertible Debentures. In addition, in 1995 the
Company recorded an extraordinary charge of $3.4 million, net of the related tax
benefit, in connection with the tender offer, completed in January 1995, for
$78.7 million principal amount of the 11 3/4% Senior Subordinated Notes. No
similar charges were recorded during 1996.
In connection with the mergers with CareerStaff and SunCare, formerly known
as Golden Care, the Company recognized $5.8 million of transaction related
merger costs in the second quarter of 1995. These included advisor fees and
transitional costs related to consolidating operations. No similar charges were
recorded during 1996.
During 1995, the Company recorded charges and expenses of $4.0 million
related to averting a strike and negotiating new contracts for certain unionized
nursing homes in Connecticut. No similar charges were recorded during 1996.
The Company periodically evaluates the carrying value of goodwill along with
any other related long-lived assets in relation to the future undiscounted cash
flows of the underlying businesses to assess recoverability. The Company adopted
Statement of Financial Accounting Standards No. 121 (SFAS 121) "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of"
on December 31, 1995. Under SFAS 121, an impairment loss is recognized if the
sum of the expected long-term cash flows is less than the carrying amount of the
goodwill and other assets being evaluated. The difference between the carrying
amount of the goodwill and other assets being evaluated and the estimated fair
market value of the assets represents the impairment loss. The Company
determines fair value using certain multiples of earnings before interest,
taxes, depreciation and amortization based on current prices for comparable
assets. The impairment loss, as determined in accordance with SFAS 121, of $59.0
million recorded by the Company primarily relates to the goodwill associated
with six of the forty facilities acquired in the Mediplex acquisition. The
impairment loss at these six facilities was the result of the following
circumstances: (i) three facilities were organized by the Service Employees
International Union subsequent to the acquisition resulting in significantly
higher labor costs; (ii) two facilities experienced significant declines in
private pay census and revenues due to, in one instance, funding reductions in
certain programs providing private pay patients and, in the other instance, the
opening of two new facilities by competitors; and (iii) the remaining facility
received lower than expected Medicaid rates from the State of Connecticut and
due to the high acuity of the patients treated at the facility, reimbursement
was not adequate. If the Company had not elected early adoption of SFAS 121, the
impairment loss would have been based solely on the difference between the
assets carrying value and cumulative long-term cash flows which would have
resulted in a loss of $48.9 million. The operations of the impaired facilities
are not
49
material to the consolidated earnings or cash flows of the Company, and
therefore, management does not expect future operating results of the impaired
facilities to have a material adverse effect on the Company's financial
condition or results of operations.
The Company's effective tax rate was 41% for the year ended December 31,
1996 after excluding the investigation and litigation charge, and was unchanged
from the pro forma effective tax rate for the year ended December 31, 1995 after
excluding the conversion fee, the merger expenses, the impairment loss and the
deferred tax charge relating to the conversion of SunCare from a S corporation
to a C corporation upon merging with the Company. The pro forma provision for
income taxes for the year ended December 31, 1995 reflects tax expense that
would have been recorded if SunCare had been subject to and liable for Federal
and state income taxes as a C corporation prior to the termination of its S
corporation status in May 1995.
Net earnings were $21.5 million for the year ended December 31, 1996 as
compared to a pro forma net loss of $24.0 million for the year ended December
31, 1995. Net earnings decreased 26% from net earnings of $53.6 million before
the extraordinary loss for early extinguishment of debt, the conversion fee, the
merger expenses, the strike, the investigation and litigation costs, the
impairment loss, and the deferred tax charge (the "extraordinary or unusual
charges") for the year ended December 31, 1995 to $42.4 million for the year
ended December 31, 1996 before the investigation and litigation charge. As a
percentage of net revenues, net earnings were 3.2% for the year ended December
31, 1996 before the investigation and litigation charge, as compared to 4.7% for
the year ended December 31, 1995 before the extraordinary or unusual charges.
The decrease was primarily due to the revenue adjustments recorded by the
Company's long-term and subacute care services (discussed above).
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 1997, the Company had working capital of $319.5 million,
including cash and cash equivalents of $21.0 million, as compared to working
capital of $211.6 million, including cash and cash equivalents of $14.9 million
at December 31, 1996. For the year ended December 31, 1997, net cash provided by
operations was $21.7 million compared to net cash provided by operations for the
year ended December 31, 1996 of $26.8 million. The net cash provided by
operations for the year ended December 31, 1997 reflects the Company's growth in
net earnings, receipt of $9.0 million from the Company's director and officer
liability insurance carrier and timing of certain obligations of the Company.
This was offset by an increase in the net cash used for operations to fund an
increase in accounts receivable.
The Company's accounts receivable have increased since December 31, 1996.
Accounts receivable increased in part because of the growth in the Company's
inpatient, therapy and pharmaceutical services businesses since December 31,
1996. The growth in accounts receivable is also attributable to timing of
third-party reimbursement payments received by the Company subsequent to
year-end and settlement of prior year cost reports during late 1997. In
addition, fiscal intermediaries of long-term care facilities acquired by the
Company are changed to the Company's fiscal intermediary resulting in temporary
delays in timing of third-party payments. The Company is in the process of
changing fiscal intermediaries related to facilities acquired from Regency and
other acquisitions which occurred during the latter half of 1997. This process
could result in delays in receiving reimbursement from third-party payors.
Accounts receivable for therapy services have also increased in part because
the ability of nonaffiliated facilities to provide timely payments has been
impacted by their receipt of payments from fiscal intermediaries which, in some
instances, have been delayed due to the fiscal intermediaries conducting reviews
of facilities' therapy claims.
Accounts receivable also increased during the year ended December 31, 1997
due to the increased number of filings for requests for additional reimbursement
of costs based on exceptions to the Medicare established routine cost
limitations for reimbursement ("RCLs") for which payment has been delayed
pending settlement of the respective cost reports. These exceptions are
permitted under the Medicare
50
regulations to reimburse providers for the costs of treating higher acuity
patients than are routinely seen in a long-term care facility. Included in net
revenues are amounts related to exceptions to the RCLs of $16.6 million, $12.3
million, and $8.9 million for the years ended December 31, 1997, 1996 and 1995,
respectively. These amounts represent management's estimate, based on its prior
experience with the Medicare program's regulations and the Company's records of
services provided, of amounts that will ultimately be approved and paid by its
fiscal intermediaries. Accounts receivable include requests for exceptions to
the RCLs of $28.8 million and $19.1 million as of December 31, 1997 and 1996,
respectively including $11.4 million of RCL's related to facilities acquired
from Regency as of December 31, 1997. Amounts realizable are subject to final
settlement of the respective cost reports and no assurance can be given that
management's estimate will be accurate upon such final settlement. Under PPS,
facilities will still be required to file Medicare cost reports, however since
Medicare will pay nursing facilities on a fixed fee per patient day (as
described below) from the time PPS becomes effective, the Company's revenues
will no longer be tied to such settlement process. (See "Effects from Changes in
Reimbursement").
Other significant operating uses of cash for the year ended December 31,
1997 were payments of $70.8 million for interest and net payments totaling $8.6
million for income taxes.
In May 1997, the Company received court approval of the $24.0 million
settlement of certain class-action shareholder lawsuits captioned IN RE SUN
HEALTHCARE GROUP, INC. LITIGATION which amount was previously paid during the
fourth quarter of 1996. The plaintiffs alleged that the Company and certain
current and former directors and officers misrepresented or failed to disclose
material facts about the OIG investigation and about the Company's operations
and financial results. The Company received $9.0 million during March 1997 from
its director and officer liability insurance carrier for its claims submitted in
connection with the settlement. In addition, the Company accrued additional
charges and expenses of $4.3 million in 1996 and $5.5 million in 1995 related to
monitoring and responding to the continuing OIG investigation and responding to
the shareholder litigation matters. The charges do not contain any estimated
amounts for settlement of the OIG investigation or remaining shareholder
litigation matters (see "Effects from Changes in Reimbursement" and
"Litigation"). As of December 31, 1997, an accrual of $3.0 million related to
the previously recorded charges and expenses remained.
The Company incurred $103.2 million and $76.2 million in capital
expenditures during the years ended December 31, 1997 and 1996, respectively.
Substantially all such expenditures during the year ended December 31, 1997
related to the Company's long-term and subacute care facility operations and
were for the continued development and construction of one facility in the
United States, twelve new facilities in the United Kingdom, and routine capital
expenditures. These routine capital expenditures include expenditures to
refurbish existing and recently acquired facilities. These capital expenditures
were financed through borrowings under the Company's Credit Facility (as defined
below). The Company had capital expenditure commitments, as of December 31,
1997, under various contracts, including approximately $25.9 million in the
United States and L1.0 million ($1.6 million as of December 31, 1997) in the
United Kingdom. These include contractual commitments to improve existing
facilities and to develop, construct and complete a corporate office building
and a long-term care facility in the United States and two long-term care
facilities in the United Kingdom.
The Company paid $564.1 million and $75.6 million for acquisitions during
the years ended December 31, 1997 and 1996, respectively. This includes
approximately $269.3 million, $114.7 million and $19.3 million of net cash paid
by the Company during the year ended December 31, 1997 to acquire Regency,
Ashbourne and APTA, respectively. These acquisitions and the acquisitions
described below were funded by borrowings under the Company's Credit Facility.
The acquisition of Regency was also financed by approximately $83.6 million of
net proceeds received from the sale and leaseback of 30 facilities owned by
Regency prior to its acquisition by the Company.
In July 1997, the Company acquired a majority interest in Eurosar, S.A., a
privately owned operator of eight nursing homes in Spain. In August 1997, the
Company acquired 38% of the equity of Alpha
51
Healthcare Limited, a publicly held acute care provider in Australia. In
addition, in November 1997, the Company acquired from Moran Health Care Pty Ltd.
a majority interest in six hospitals in Australia. In December 1997, the Company
acquired a majority interest in Heim-Plan Unternehmensgruppe, an operator of 11
nursing homes in Germany.
In addition, in April 1997, the Company acquired the lease rights of 13
long-term care facilities which had previously been managed by the Company since
the third quarter of 1996 for a purchase price of $12.6 million, including the
assumption of $10.7 million in long-term debt. The Company has also extended
financing of approximately $14.8 million to the former owners of these
facilities. Also during the year ended December 31, 1997, the Company acquired
the operations of nine domestic long-term care and assisted living facilities
for approximately $12.0 million in addition to the assumption of all the
facilities' leases. In connection with this acquisition, the Company agreed to
provide financing of $5.8 million to the owner of the nine facilities for
expansion of certain of the facilities of which $3.1 million had been advanced
as of December 31, 1997.
In total, during the year ended December 31, 1997, the Company acquired a
total net ownership of, the leasehold rights to, or the management of 161
long-term care facilities in the United States including 111 facilities acquired
in the acquisition of Regency, 62 long-term care facilities in the United
Kingdom, including 49 facilities acquired in the acquisition of Ashbourne, 8
long-term care facilities in Spain, 11 long-term care facilities in Germany and
6 acute care facilities in Australia. The Company also acquired or opened a
total net 20 pharmacies in the United States and 13 pharmacies in the United
Kingdom.
The Company agreed in February 1997 to acquire Retirement Care Associates,
Inc. ("Retirement Care"), an operator of skilled nursing facilities and assisted
living centers. Retirement Care also owns (and the Company would acquire)
approximately 65% of Contour Medical, Inc. ("Contour"), a national provider of
medical/surgical supplies. The amended terms of the merger (the "RCA Merger")
provide for a purchase price of approximately $152.1 million in the Company's
common stock (based upon the closing price of the Company's common stock as of
March 22, 1998) and the assumption of approximately $192.9 million of
indebtedness including $19.8 million of indebtedness which will be eliminated in
consolidation (based on Retirement Care's December 31, 1997 balance sheet).
Specifically, the agreement, as amended, calls for the Company to issue shares
of common stock having a value equal to $10.00 in exchange for each outstanding
share of Retirement Care's common stock (subject to a 10% collar centered on a
$22.00 share price for the Company's common stock). The Company expects that the
RCA Merger will be accounted for as a pooling of interests. The Company has also
agreed to acquire the remaining 35% of Contour not presently owned by Retirement
Care for approximately $35 million, payable in the Company's common stock or
cash, at the option of the Company (the "Contour Merger"). The Contour Merger
will be accounted for as a purchase.
Based upon a review of Retirement Care's, Contour's and the Company's
publicly available historical financial statements, the RCA and Contour Mergers
would have had a dilutive impact on the Company's reported earnings per share
for the year ended December 31, 1997. There can be no assurance that the future
combined results will not continue to be dilutive.
Costs to be incurred in connection with the mergers of Retirement Care and
Contour are expected to be significant and will be charged against earnings of
the combined company. The charge is currently estimated to be approximately $30
million for transaction costs and integration expenses, including elimination of
redundant corporate functions, severance costs related to headcount reductions,
the write-off of certain intangibles and property and equipment and the
settlement of certain class action lawsuits (described below). Approximately $25
million of these estimated charges are expected to be charged to operations in
the fiscal quarter in which the RCA Merger is consummated. Approximately $5
million of the estimated charges relating to the integration expenses are
expected to be expensed as incurred as these costs will benefit future combined
operations. These amounts are preliminary estimates only and are, therefore,
subject to change. In addition, there can be no assurance that the Company will
not incur additional charges in subsequent quarters to reflect costs associated
with the RCA Merger and the Contour Merger. As of December 31, 1997, the Company
has incurred approximately $2.8 million in transaction costs (as described
above).
52
On January 10, 1997, the Company loaned Retirement Care $9.8 million in
order to enable Retirement Care to cause the repayment of certain indebtedness
incurred by Contour in connection with Contour's acquisition of Atlantic Medical
Supply Company, Inc. ("Atlantic") on August 6, 1996. On July 10, 1997, the
Company and Retirement Care amended the terms of the loan to: (i) increase the
applicable interest rate by 2.0%; (ii) extend the maturity date to 120 days
after the termination of the Retirement Care Merger Agreement; and (iii) replace
the collateral securing the loan with a second lien on all of Retirement Care's
accounts receivable. Consistent with Retirement Care's bank line of credit, the
loan is unconditionally and irrevocably guaranteed by certain officers of
Retirement Care. On July 10, 1997, the Company also agreed to loan Retirement
Care an additional $5.0 million which is also secured by a second lien on all of
Retirement Care's accounts receivable and is unconditionally and irrevocably
guaranteed by certain officers of Retirement Care. The interest receivable
related to the promissory notes was $1.0 million as of December 31, 1997. As of
December 31, 1997, Retirement Care owed the Company an additional $12.4 million
in the form of unsecured trade receivables in respect to ancillary and
management services provided by the Company.
On November 25, 1997, the Company, Retirement Care and representatives of
the plaintiffs in certain pending class actions against Retirement Care and its
management reached an agreement in principle to settle these class actions for
$9.0 million. In connection with the agreement in principle, the Company has
escrowed on behalf of the defendants the settlement amount into an escrow fund
which is included in short-term restricted cash as of December 31, 1997. The
settlement is contingent upon the closing of the RCA Merger and is subject to,
among other things, confirmatory discovery, the execution of definitive
documentation and court approval.
On October 9, 1997, the Company purchased 100%, or $50.0 million, of
Regency's 12.25% Junior Subordinated Notes due 2003 for approximately $60.1
million plus interest, and $109.6 million of the $110.0 million of Regency's
9.875% Senior Subordinated Notes due 2002 for approximately $122.0 million plus
interest. As a result of the repurchase of the debt, the Company recorded an
extraordinary loss of $17.9 million, net of the related tax benefit, in the
fourth quarter of 1997. In addition, the Company paid down Regency's revolving
credit facility of $39.0 million. These transactions were funded by borrowings
under the Company's Credit Facility. As of the date of acquisition, and prior to
the tender, Regency had approximately $229.5 million of outstanding
indebtedness.
In December 1997, the Company purchased from a third party $5.0 million
aggregate principal amount of 9% Contour convertible debentures which are
convertible into one million shares of Contour common stock, for an aggregate
price of $8.4 million in cash.
The Company conducts business outside of the United States, in the United
Kingdom, Spain, Australia, Germany and Canada. The foreign operations accounted
for 10%, 4% and 2% of the Company's total net revenues during the year ended
December 31, 1997, 1996 and 1995, respectively, and 13% of the Company's
consolidated total assets as of December 31, 1997. The Company's financial
condition and results of operations are subject to foreign exchange risk.
Because of the Company's foreign growth strategies, the Company does not expect
to repatriate funds invested overseas and, therefore, foreign currency
transaction exposure is not normally hedged. Exceptional planned foreign
currency cash flow requirements, such as acquisitions overseas, are hedged
selectively to prevent fluctuations in the anticipated foreign currency value.
Changes in the net worth of the Company's foreign subsidiaries arising from
currency fluctuations are accumulated in the translation adjustments component
of stockholders' equity.
During the year ended December 31, 1997, the Company sold five of its
long-term and subacute care facilities in the United States for approximately
$31.2 million in cash and approximately $5.6 million in assumption of debt and
leased them back under fourteen-year leases. Also, during the year ended
December 31, 1997, the Company, through its United Kingdom subsidiary, sold 27
of its long-term care facilities for approximately $49.3 million and leased them
back under twelve-year leases.
53
The Company has advanced $32.8 million and expects to lend up to a total of
$47.0 million under a revolving subordinated credit agreement ("Financing
Facility") to a developer of assisted living facilities for the development,
construction and operation of assisted living facilities. Any advances under the
Financing Facility have been and are expected to be funded by borrowings under
the Company's Credit Facility (as defined below) and will be subject to certain
conditions, including the approval of each project by the Company. The developer
has obtained a commitment for mortgage financing to fund 50% of the cost of each
project. The Company's advances under the Financing Facility are subordinate to
the mortgage financing. The Financing Facility with respect to each facility
bears interest at 9% or 13% depending on the percentage of completion of the
facility under construction. All amounts advanced are due in full on November 1,
2001. The advances to the developer totaled approximately $32.8 million and $9.0
million at December 31, 1997 and 1996. As of December 31, 1997, five assisted
living facilities were under development. Construction was completed on one
facility in 1997. In addition, the Company has entered into a purchase option
agreement with the developer whereby the Company will pay the developer $50,000
for each option to purchase any of the facilities. The option will grant the
Company the right to purchase any of the facilities, after a specified time
period, at the greater of the estimated fair market value of the property or the
total amount invested by the developer.
At December 31, 1997, the Company had, on a consolidated basis, $1.6 billion
of outstanding indebtedness including capital lease obligations, including
$975.1 million of indebtedness under its $1.2 billion Credit Facility (as
discussed below). The Company also had $40.2 million of outstanding standby
letters of credit under its Credit Facility as of December 31, 1997.
On July 8, 1997, the Company issued $250 million aggregate principal amount
of 9 1/2% Senior Subordinated Notes due 2007 (the "9 1/2% Notes"). The net
proceeds from the sale of approximately $243 million were used to reduce
outstanding borrowings under the Company's Credit Facility. The 9 1/2% Notes,
which are subject to customary terms and covenants, are redeemable by the
Company at a premium, in whole or in part, after July 1, 2002.
On October 8, 1997 the Company entered into a Credit Agreement with certain
lenders, certain co-agents, and NationsBank of Texas, N.A. as administrative
lender to replace the Company's old revolving credit facility. On November 12,
1997, the Company entered into a First Amendment to Credit Agreement (the
"Credit Facility"). The Credit Facility provides for borrowings by the Company
of up to $1.2 billion consisting of $500 million in a revolving credit facility
which borrowings bear interest at the prevailing prime rate plus 0% to 1% or the
LIBOR rate plus.75% to 2.50%, and $700 million in term loans which bear interest
at the prevailing prime rate plus 0% to 1.5% or the LIBOR rate plus .75% to
3.0%. The revolving credit facility matures in November 2003 and the term loans
begin amortization in March 1998 and reach final maturity in November 2005. In
connection with this refinancing, the Company recorded an extraordinary loss of
$2.1 million, net of related tax benefit, in the fourth quarter of 1997. The
Credit Facility, among other things, (i) requires the Company to maintain
certain financial ratios, (ii) restricts the Company's ability to incur debt and
liens, make investments, liquidate or dispose of assets, merge with another
corporation, create or acquire subsidiaries, and make acquisitions, and (iii)
prohibits the payment of dividends, the acquisition of treasury stock and the
prepayment or modification of certain debts of the Company. The Credit Facility
is collateralized by a pledge of the stock of the majority of the Company's
subsidiaries. As of December 31, 1997, the Company had borrowings of $275.1
million outstanding under the revolving credit facility, $700.0 million
outstanding in term loans, and $40.2 million of outstanding standby letters of
credit under the credit facility. As of December 31, 1997, up to $184.7 million
is available under the credit facility.
Scheduled aggregate principal payments of the Company's long-term debt for
the next five years as of December 31, 1997 are as follows: $56.8 million in
1998, $33.4 million in 1999, $40.6 million in 2000, $49.4 million in 2001, $65.6
million in 2002, and $1.3 billion thereafter. Based on the Company's interest
rates, foreign currency exchange rates, and outstanding borrowings as of
December 31, 1997, aggregate interest payments related to the Company's
long-term debt for the next five years are expected to be
54
approximately: $137 million in 1998, $134 million in 1999, $131 million in 2000,
$127 million in 2001, and $122 million in 2002. The amounts of scheduled
principal and interest payments related to the Company's long-term debt are
subject to changes which may be significant, in outstanding borrowings, interest
rates and foreign currency exchange rates.
The Company's ongoing capital requirements relate to, among other things,
the costs associated with its facilities under construction, routine capital
expenditures, advances under the Financing Facility, potential acquisitions and
implementation of growth strategies.
The Company believes that its current borrowing capacity under its Credit
Facility and cash from operations will be sufficient to satisfy its working
capital needs, capital commitments related to its facilities under construction,
routine capital expenditures, advances under the Financing Facility, current
debt service obligations (including the aforementioned principal and interest
payments) and to fund potential conversions of 6 1/2% Convertible Debentures.
The Company is currently evaluating several financing alternatives, which
include the issuance of debt and/or equity. The Company anticipates that it will
fund its construction commitments as well as its requirements relating to future
growth through (i) the available borrowing capacity under its Credit Facility,
(ii) the use of operating leases and debt or equity related securities in the
future as a means of acquiring facilities and new operations, (iii) the
availability of sale and leaseback financing through real estate investment
trusts and other financing sources and (iv) the sale of debt or equity
securities in the public or private capital markets. There can be no assurance
that the Company will seek or obtain additional sources of financing in the next
twelve months. In addition, such additional financing, if any, may be subject to
certain restrictions including mandatory prepayment provisions in the Credit
Facility or otherwise require approval of various lenders under the Company's
Credit Facility. In November 1997 and in March 1998, the Company amended its
shelf registration statement on Form S-3 to, among other things, increase the
amount of securities which may be sold thereunder to $1 billion, which sales are
subject to the registration statement being declared effective by the Securities
and Exchange Commission. In the event the Company offers securities thereunder,
the Company may be required to repay indebtedness under the Credit Facility. If
such sources of financing are not available, the Company may not be able to
pursue growth opportunities as actively as it has in the past, and may be
required to alter certain of its operating strategies.
EFFECTS FROM CHANGES IN REIMBURSEMENT
The Company derives a substantial percentage of its total revenues from
Medicare, Medicaid and private insurance. The Company's financial condition and
results of operations may be affected by the revenue reimbursement process,
which is complex and can involve lengthy delays between the recognition of
revenue and the time reimbursement amounts are settled. Net revenues realizable
under third-party payor agreements are subject to change due to examination and
retroactive adjustment by payors during the settlement process. Payors may
disallow in whole or in part requests for reimbursement based on determinations
that certain costs are not reimbursable or reasonable or because additional
supporting documentation is necessary. The Company recognizes revenues from
third-party payors and accrues estimated settlement amounts in the period in
which the related services are provided. The Company estimates these settlement
balances by making determinations based on its prior settlement experience and
its understanding of the applicable reimbursement rules and regulations. The
majority of third-party payor balances are settled two to three years following
the provision of services. The Company has experienced differences between the
net amounts accrued and subsequent settlements, which differences are recorded
in operations at the time of settlement. For example, in the fourth quarter of
1997, the Company recorded negative revenue adjustments totalling approximately
$15.0 million resulting from changes in accounting estimates of amounts
realizable from third-party payors. These changes in accounting estimates
primarily arose out of the settlement in late 1997 of certain facility cost
reports for 1994 and 1995 and also include estimated charges for projected
settlements in 1996.
55
Accounts receivable have also increased in part because the ability of
nonaffiliated facilities to provide timely payments has been impacted by their
receipt of payments from fiscal intermediaries which, in some instances, have
been delayed due to the fiscal intermediaries conducting reviews of facilities'
therapy claims.
The Company's results of operations would be materially and adversely
affected if the amounts actually received from third-party payors in any
reporting period differs materially from the amounts accrued in prior periods.
The Company's financial condition and results of operations may also be affected
by the timing of reimbursement payments and rate adjustments from third-party
payors. The Company has from time to time experienced delays in receiving final
settlement and reimbursement from government agencies.
Various cost containment measures adopted by governmental and private pay
sources have begun to restrict the scope and amount of reimbursable healthcare
expenses and limit increases in reimbursement rates for medical services. Any
reductions in reimbursement levels under Medicaid, Medicare or private payor
programs and any changes in applicable government regulations or interpretations
of existing regulations could significantly affect the Company's profitability.
Furthermore, government programs are subject to statutory and regulatory
changes, retroactive rate adjustments, administrative rulings and government
funding restrictions, all of which may materially affect the rate of payment to
the Company's facilities and its therapy and pharmaceutical businesses. There
can be no assurance that payments under governmental or private payor programs
will remain at levels comparable to present levels or will be adequate to cover
the costs of providing services to patients eligible for assistance under such
programs. Significant decreases in utilization, changes in reimbursement,
including salary equivalency and PPS, could have a material adverse effect on
the Company's financial condition and results of operations, including the
possible impairment of certain assets.
In the Balanced Budget Act of 1997 ("BBA"), Congress passed numerous changes
to the reimbursement policies applicable to exempt hospital services, skilled
nursing, therapy and other ancillary services.
The BBA generally provides for a phase-in of a prospective payment system
for skilled nursing facilities over a four year period, effective for the
Company's facilities on January 1, 1999. Under PPS, Medicare will pay skilled
nursing facilities a fixed fee per patient day based on the acuity level of the
patient to cover all post-hospital extended care routine service costs (i.e.
Medicare Part A patients), including ancillary and capital related costs for
beneficiaries receiving skilled services. The per diem rate will also cover
substantially all items and services furnished during a covered stay for which
reimbursement is currently made separately under Medicare. Such services are
currently reimbursed on a "pass through" basis. During the phase-in, payments
will be based on a blend of the facility's historical costs and a federally
established per diem rate. Since, among other things, the federally established
per diem rates have not been finalized, it is unclear what impact PPS will have
on the Company. There can be no assurance that PPS will not have a material
adverse effect on the results of operations and financial condition of the
Company.
The Company's revenues from its inpatient facilities will be significantly
affected by the size of the federally established per diem rate. There can be no
assurance that the per diem rate will not be less than the amount the Company's
inpatient facilities currently receive for treating the patients currently in
its care. Moreover, since the Company treats a greater percentage of higher
acuity patient than many nursing homes, the Company may also be adversely
impacted if the federal per diem rates for higher acuity patients does not
adequately compensate the Company for the additional expenses and risks for
caring for such patients. As a result, there can be no assurance that the
Company's financial condition and results of operations will not be materially
and adversely affected.
The Company is responding to the implementation of PPS by establishing
SunSolution-Registered Trademark-. SunSolution will offer to provide ancillary
services for a fixed fee to nonaffiliated facilities. There can be no assurance
that there will be a market for the SunSolution products and services or whether
a change in the demand
56
for the Company's services following the imposition of PPS will not adversely
affect the Company's revenues. Even if SunSolution is successful, no assurance
can be given that the costs of providing the contracted for services will be
less than the fixed fee received by the Company for such services. Given the
relative profitability of Sun's ancillary services, there can be no assurance
that the Company's margins and ultimately the Company's results of operations
and financial condition will not be materially and adversely affected.
In addition, for all Medicare patients not receiving post-hospital extended
care services (i.e. Medicare Part B patients), effective July 1, 1998,
reimbursement for ancillary services, including rehabilitation therapy, medical
supplies, pharmacy, temporary staffing for rehabilitation therapy, and other
ancillary services, will be made pursuant to yet-to-be developed fee schedules.
In addition, effective January 1, 1999, there will be an annual per beneficiary
cap of $1,500 on reimbursement for outpatient physical therapy and speech
therapy and an annual per beneficiary cap of $1,500 on reimbursement for
occupational therapy. Facilities will be permitted to bill patients directly for
services rendered in excess of these caps; provided however, there can be no
assurance as to whether the Company will receive any payments in excess of these
caps. There can be no assurance whether such yet-to-be developed fee schedules
or caps will not have a material adverse effect on the Company.
The Company's growth strategy relies heavily on the acquisition of long-term
and subacute care facilities. Regardless of the legal form of the acquisition,
the Medicare and Medicaid Programs often require that the Company assume certain
obligations relating to the reimbursement paid to the former operators of the
facilities acquired by the Company. From time to time, fiscal intermediaries and
Medicaid agencies examine cost reports filed by such predecessor operators. The
Company is currently the subject of several such examinations. If, as a result
of any such examinations, it is concluded that overpayments to a predecessor
operator were made, the Company, as the current operator of such facilities, may
be held financially responsible for such overpayments. At this time the Company
is unable to predict the outcome of any existing or future examinations.
Reimbursement for therapy services is currently evaluated under Medicare's
reasonable cost principles. Under current law, the reasonable costs for physical
therapy and respiratory services may not exceed an amount equal to the salary
that would reasonably have been paid to a therapist for providing the services
(together with certain additional costs) within each geographical area. Salary
equivalency guidelines are the amounts published by the Health Care Financing
Administration ("HCFA") which reflect the prevailing salary, fringe benefit and
expense factors as determined by HCFA. HCFA then uses the salary equivalency
guidelines to determine the reimbursement rates for physical therapy and
respiratory therapy costs. Although salary equivalency guidelines will no longer
be effective following the implementation of PPS and fee schedule reimbursement,
HCFA has published new salary equivalency guidelines.
On January 30, 1998, HCFA revised salary equivalency guidelines for
respiratory therapy and physical therapy, and for the first time published new
salary equivalency guidelines for speech therapy and occupational therapy. HCFA
has indicated that the new salary equivalency guidelines would apply to all
services rendered on or after April 1, 1998. Implementation of these guidelines
will increase reimbursement rates for respiratory therapy and physical therapy,
but reduce reimbursement rates for speech therapy and occupational therapy. The
implementation of these new guidelines in the middle of a facility's fiscal year
may be contrary to HCFA's own regulations, and a request has been submitted to
HCFA to clarify the implementation schedule. If implemented, the effect of the
changes could have a material adverse impact on the Company's results of
operations. The salary equivalency guidelines rates will have no continuing
impact on reimbursement for therapy services rendered to a Medicare patient
receiving post-hospital extended care services following the commencement of
PPS, because under PPS, therapy services will be bundled into each facility's
per diem reimbursement from Medicare. In addition, the salary equivalency
guidelines will have no continuing impact on therapy services rendered to all
other Medicare patients after the institution of fee schedule reimbursement for
therapy services, which the BBA provides will be effective on July 1, 1998.
57
Additionally, if the proposed guidelines are adopted, it could have an
adverse effect on the cash flow of the facilities to whom the Company provides
services, thereby potentially adversely affecting the collectibility of amounts
owed to the Company.
In 1995, and periodically since then, HCFA has provided information to
intermediaries for use in determining reasonable costs for occupational and
speech therapy. This information, although not intended to impose limits on such
costs, suggests that fiscal intermediaries should carefully review costs which
appear to be in excess of what a "prudent buyer" would pay for those services.
While the effect of these directives is still uncertain, they are a factor
considered by such intermediaries in evaluating the reasonableness of amounts
paid by providers for the services of the Company's rehabilitation therapy
subsidiary. When salary equivalency guidelines, PPS and fee schedules are
implemented, reimbursement for these services will no longer be on a "pass
through" basis and the HCFA directives and reasonable cost guidelines discussed
in this paragraph will become moot as to services rendered after their
effectiveness. In addition, some intermediaries require facilities to justify
the cost of contract therapists versus employed therapists as an aspect of the
"prudent buyer" analysis. With respect to rehabilitation therapy services
provided to affiliated facilities, a retroactive adjustment of Medicare
reimbursement could be made for some prior periods. With respect to
nonaffiliated facilities, an adjustment of reimbursement rates for therapy
services could result in indemnity claims against the Company, based on the
terms of substantially all of the Company's existing contracts with such
facilities, for payments previously made by such facilities to the Company that
are reduced by Medicare in the audit process. Any change in reimbursement rates
resulting from implementation of the HCFA directives or a reduction in
reimbursement as a result of a change in application of reasonable cost
guidelines could have a material adverse effect on the Company's financial
condition and results of operations (depending on the rates adopted) and
customers' ability to pay for prior and continuing services. When PPS with
respect to Medicare Part A (effective for the Company's facilities on January 1,
1999) and fee schedules with respect to Medicare Part B (effective July 1, 1998)
are implemented, the Company's facilities' reimbursement will no longer be
affected by salary equivalency guidelines and the cost reporting settlement
process for services rendered after their effectiveness.
Current Medicare regulations that apply to transactions between related
parties, such as the Company's subsidiaries, are relevant to the amount of
Medicare reimbursement that the Company is entitled to receive for the
rehabilitation and respiratory therapy and pharmaceutical services that it
provides to Company-operated facilities. These related party regulations require
that, among other things, a substantial part of the rehabilitation and
respiratory therapy services or pharmaceutical services, as the case may be, of
the relevant subsidiary be transacted with nonaffiliated entities in order for
the Company to receive reimbursement for services provided to Company-operated
facilities at the rates applicable to services provided to nonaffiliated
entities. The related party regulations do not indicate a specific level of
services that must be provided to nonaffiliated entities in order to satisfy the
"substantial part" requirement of such regulations. In instances where this
issue has been litigated by others, no consistent standard has emerged as to the
appropriate threshold necessary to satisfy the "substantial part" requirement.
The Company's net revenues from rehabilitation therapy services, including
net revenues from temporary therapy staffing services, provided to nonaffiliated
facilities represented 70%, 71% and 74% of total rehabilitation and temporary
therapy staffing services net revenues for the years ended December 31, 1997,
1996 and 1995, respectively. Respiratory therapy services provided to
nonaffiliated facilities represented 63%, 58%, and 55% of total respiratory
therapy services net revenues for the years ended December 31, 1997, 1996 and
the period from the date of acquisition of SunCare on May 5, 1995 to December
31, 1995, respectively. The Company's respiratory therapy operations did not
provide services to affiliated facilities prior to the acquisition of SunCare on
May 5, 1995. Net revenues from pharmaceutical services billed to nonaffiliated
facilities represented 79%, 78% and 78% of total pharmaceutical services
revenues for the years ended December 31, 1997, 1996 and 1995, respectively. The
Company believes that it satisfies the requirements of these regulations
regarding nonaffiliated business. Consequently, it has
58
claimed and received reimbursement under Medicare for rehabilitation and
respiratory therapy and pharmaceutical services provided to patients in its own
facilities at a higher rate than if it did not satisfy these requirements. If
the Company were deemed to not have satisfied these regulations, the
reimbursement that the Company receives for rehabilitation and respiratory
therapy and pharmaceutical services provided to its own facilities would be
significantly reduced, as a result of which the Company's financial condition
and results of operations would be materially and adversely affected. If, upon
audit by Federal or state reimbursement agencies, such agencies find that these
regulations have not been satisfied, and if, after appeal, such findings are
sustained, the Company could be required to refund some or all of the difference
between its cost of providing these services to any entity found to be subject
to the related party regulations and the higher amount actually received. While
the Company believes that it has satisfied and will continue to satisfy these
regulations, there can be no assurance that its position would prevail if
contested by relevant reimbursement agencies. The foregoing statements with
respect to the Company's ability to satisfy these regulations are forward
looking and could be affected by a number of factors, including the
interpretation of Medicare regulations by Federal or state reimbursement
agencies and the Company's ability to provide services to nonaffiliated
facilities. When the salary equivalency guidelines, PPS and the fee schedules
are implemented, the Medicare impact of the related party rule will be
significantly reduced.
REGULATION
The Company's subsidiaries, including those which provide subacute and
long-term care, rehabilitation and respiratory therapy and pharmaceutical
services, are engaged in industries which are extensively regulated. As such, in
the ordinary course of business, the operations of these subsidiaries are
continuously subject to state and Federal regulatory scrutiny, supervision and
control. Such regulatory scrutiny often includes inquiries, investigations,
examinations, audits, site visits and surveys, some of which may be non-routine.
The Company is currently the subject of several such investigations.
In addition to being subject to the direct regulatory oversight of state and
Federal regulatory agencies, these industries are frequently subject to the
regulatory supervision of fiscal intermediaries. Fiscal intermediaries are
agents of HCFA who interpret and implement applicable laws and regulations and
make decisions about the appropriate reimbursement to be paid under Medicare and
Medicaid. The Company's subsidiaries are subject to the oversight of several
different intermediaries. Those different intermediaries have taken varying
interpretations of the applicable laws and regulations. The lack of uniformity
in the interpretation and implementation of such laws and regulations reflects
in part the fact that the statutory standards are subject to interpretation and
the manuals which are published and utilized by HCFA and the intermediaries in
performing their regulatory functions are often not sufficiently specific to
provide clear guidance in the areas which are the subject of regulatory
scrutiny.
It is the policy of the Company to comply with all applicable laws and
regulations, and the Company believes that its subsidiaries are in substantial
compliance with all material laws and regulations which are applicable to their
businesses. However, given the extent to which the interpretation and
implementation of applicable laws and regulations vary and the lack of clear
guidance in many of the areas which are the subject of regulatory scrutiny,
there can be no assurance that the business activities of the Company's
subsidiaries will not from time to time become the subject of regulatory
scrutiny, or that such scrutiny will not result in interpretations of applicable
laws or regulations by government regulators or intermediaries which differ
materially from those taken by the Company's subsidiaries. In addition, if the
Company is ever found to have engaged in improper practices, it could be subject
to civil, administrative or criminal fines, penalties or restitutionary relief.
In January 1995, the Company learned that it was the subject of a pending
Federal investigation. The investigating agencies are the United States
Department of Health and Human Services' Office of Inspector General ("OIG") and
the United States Department of Justice. At this time, the Company does
59
not know the full scope of the investigation. However, the Company currently
believes that the investigation is focused principally on whether the Company
provided and billed for unnecessary or unordered therapy services to residents
of skilled nursing facilities and whether the Company adequately documented the
therapy services which it provided.
In July 1997, the Criminal Division of the U.S. Department of Justice
informed the Company that it had completed its investigation of the Company, and
that it would not initiate any actions against the Company or any individuals.
The investigation by the Civil Division of the Department of Justice and the OIG
is still proceeding. The government continues to collect information, and the
Company continues to cooperate with the investigators. The Company and the
government have had preliminary discussions, and the Company expects to have
continuing discussions, regarding a possible settlement of the investigation.
The Company is unable to determine at this time when the investigation will
be concluded, how large a monetary settlement the government may seek, the
nature of any other remedies that may be sought by the government, whether or
when a settlement will in fact occur or whether any such settlement or any other
outcome of the investigation will have a material adverse effect on the
Company's financial condition or results of operations. The foregoing statements
with respect to the outcome of the investigation are forward-looking and could
be affected by a number of factors, including the actual scope of the
investigation, the government's factual findings and the interpretation of
Federal statutes and regulations by the government and federal courts and
whether any such factual findings could serve as a basis for proceedings by
other governmental authorities. From time to time the negative publicity
surrounding the investigation has in the past adversely affected the private pay
enrollment in certain inpatient facilities and slowed the Company's success in
obtaining additional outside contracts in the rehabilitation therapy business,
which resulted in higher than required therapist staffing levels. Negative
publicity in the future could have a similar effect.
In 1996, the Connecticut Attorney General's office and the Connecticut
Department of Social Services ("DSS") began an investigation and initiated a
hearing in order to determine whether the Company's long-term care subsidiary
submitted false and misleading fiscal information on its 1993 and 1994 Medicaid
cost reports. In 1997, the DSS began an investigation of information submitted
for the 1995 cost year as well as cost reporting periods prior to 1993. The
evidentiary phase of the hearing has concluded, but the proceedings are still in
progress and the Company is unable to determine at this time when the
investigation will be concluded or whether the evidence will warrant further
administrative action or Medicaid reimbursement sanctions by DSS. However, based
on the Company's current understanding of the investigation, the Company does
not believe the investigation will have a material adverse effect on the
Company's financial condition or results of operations. The foregoing statement
with regard to the outcome of this investigation is forward-looking and could be
affected by a number of factors, including factual findings and the
interpretation of applicable laws and regulations by the Attorney General and
the DSS and whether any such factual findings could serve as a basis for
proceedings by other governmental authorities in Connecticut or elsewhere.
Pursuant to the Health Insurance Portability and Accountability Act of 1996,
Congress has provided additional funding to Medicare and Medicaid enforcement
units to investigate potential cases of reimbursement abuse in the health care
services industry. The Act also sets guidelines to encourage federal, state, and
local law enforcement agencies to share general information and to coordinate
specific law enforcement activities including conducting investigations, audits,
evaluations, and inspections relating to the delivery of and payment for health
care. From time to time enforcement agencies conduct audits, inspections and
investigations with respect to the reimbursement activities of the subsidiaries
of the Company. The Company is currently the subject of several such
investigations. It is the Company's practice to cooperate fully in such matters.
60
LITIGATION
On or about January 23, 1996, two former stockholders of SunCare, John
Brennan and Susan Bird, filed a lawsuit (the "SunCare Litigation") against the
Company and certain of its officers and directors in the United States District
Court for the Southern District of Indiana. Plaintiffs allege, among other
things, that the Company did not disclose material facts concerning the
investigation by the OIG and that the Company's financial results were
misstated. The complaints purport to state claims, INTER ALIA, under Federal and
state securities laws and for breach of contract, including a breach of a
registration rights agreement pursuant to which the Company agreed to register
the shares of the Company's common stock issued to such former stockholders of
SunCare in the acquisition. Plaintiffs purport to seek recision, unspecified
compensatory damages, punitive damages and other relief. The trial is currently
scheduled to begin in the Summer of 1998.
The Company believes the SunCare Litigation will not have a material adverse
impact on its financial condition or results of operations, although the
unfavorable resolution of this action in any reporting period could have a
material adverse impact on the Company's results of operations for that period.
The foregoing statements with respect to the possible outcome of the SunCare
Litigation are forward-looking and could be affected by a number of factors,
including judicial interpretations of applicable law, the uncertainties and risk
inherent in any litigation, particularly a jury trial, the existence and scope
of any subsequently filed complaints, the scope of insurance coverage, and the
outcome of the OIG investigation and all factors that could affect that outcome.
On September 8, 1995, a derivative action was filed by Brickell Partners
against certain of the Company's current and former directors and officers in
the United States District Court for the District of New Mexico, captioned
BRICKELL PARTNERS V. TURNER, ET AL. The complaint was not served on any
defendant. On June 19, 1996, an amended complaint alleging breach of fiduciary
duty by certain of the Company's current and former directors and officers was
filed and subsequently served on the defendants. On August 5, 1996, the District
Court dismissed this action without prejudice for failure to serve the
defendants within the required time period. The plaintiffs filed a new
complaint, alleging the same claims, on August 19, 1996. In December 1997, the
Company and the plaintiffs reached an agreement in principle to settle the
action for an immaterial amount. The settlement is subject to definitive
documentation and court approval.
The Company was notified in 1997 by a law firm representing several national
insurance companies that these companies believed that the Company had engaged
in improper billing and other practices in connection with the Company's
delivery of therapy and related services. In response, the Company began
discussions directly with these insurers and hopes to resolve these matters
without litigation; however, the Company is unable at this time to predict
whether it will be able to do so, what the eventual outcome may be or the extent
of its liability, if any, to these insurers.
YEAR 2000 ISSUE
In common with users of computers around the world, the Company is
investigating if and to what extent the date change from 1999 to 2000 may affect
its networks and systems. The Company has established and implemented a program
designed to minimize the impact of the transition to the year 2000 on the
Company and its customers by seeking to cause the Company's key networks and
systems and the networks and systems of its vendors to be year 2000 compliant
before December 31, 1999. The Company expects to incur internal staff costs,
external consulting costs, and other expenses related to infrastructure and
facility enhancement necessary to prepare the systems for the year 2000.
Although the total cost to the Company of achieving year 2000 compliant systems
is not expected to be material to the Company's operations or financial
condition, there can be no assurance that the costs will be as expected or that
this program will be successful or that the date change from 1999 to 2000 will
not materially adversely affect the Company's business, financial condition and
results of operations. The ability of third parties with
61
which the Company transacts business to adequately address their year 2000
issues is outside the Company's control. Although the Company will seek
alternative vendors, where its current vendors are unwilling or unable to become
year 2000 compliant in a timely manner, there can be no assurance that the
Company's operations will not be materially adversely affected by the ability of
third parties dealing with the Company, including Medicare and Medicaid, to also
manage the effect of the year 2000 date change.
EFFECTS OF INFLATION
Healthcare costs have been rising and are expected to continue to rise at a
rate higher than that anticipated for consumer goods as a whole. The Company's
operations could be adversely affected if it experiences significant delays in
receiving reimbursement rate increases from Medicaid and Medicare sources for
its labor and other costs.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
Not applicable.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Information with respect to Item 8 is contained in the Company's
consolidated financial statements and financial statement schedules and are set
forth herein beginning on Page F-1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
62
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Certain information regarding the directors of the Company is to be
incorporated by reference to the Company's definitive 1998 Proxy Statement. The
executive officers of Sun as of March 20, 1998 were as follows:
Andrew L. Turner, age 51, is Chairman of the Board of Directors and Chief
Executive Officer of the Company. Mr. Turner has served in each of these
capacities for the Company since its formation and served as President of the
Company from the Company's formation until September 1997. Mr. Turner is also
the founder of the Company and has overseen the development of the Company's
business since its inception in 1989. Mr. Turner was also a founder and
previously served as Chief Operating Officer of Horizon Healthcare Corporation,
a healthcare services provider, from 1986 to 1989. Prior to 1986, Mr. Turner
served as a Senior Vice President of Operations of Hillhaven. Mr. Turner has
over 20 years of experience in the long-term care industry. Mr. Turner is also a
member of the Board of Directors of Watson Pharmaceuticals, Inc., a
pharmaceutical products company, and of The Sports Club Company, Inc., an
operator of sports and fitness clubs.
Mark G. Wimer, age 44, became a director of the Company in 1993. Mr. Wimer
became the President and Chief Operating Officer in September 1997. Mr. Wimer
had previously served as Senior Vice President for Inpatient Services from
January 1996 until September 1997. Mr. Wimer previously served as the President
of SunRise Healthcare Corporation ("SunRise"), the Company's subsidiary
responsible for operations of the Company's long-term care facilities effective
July 1993 until December 1995. From February 1988 to July 1993, Mr. Wimer was
President and Chief Executive Officer of Franciscan Eldercare Corporation, a
non-profit organization that develops and manages long-term care facilities.
From November 1984 through February 1988, Mr. Wimer was Regional Vice President
of Operations for The Hillhaven Corporation ("Hillhaven") and had responsibility
for management of long-term care facilities for Hillhaven in Washington, Oregon,
Idaho and Montana.
Robert D. Woltil, age 43, became a director of the Company in March 1996.
Mr. Woltil became the Chief Financial Officer of the Company in February 1996.
From 1982 to January 1996, Mr. Woltil served in various capacities for Beverly
Enterprises, Inc. ("Beverly"), a healthcare services provider. From May 1995
until January 1996, Mr. Woltil was President and Chief Executive Officer of
Pharmacy Corporation of America, a subsidiary of Beverly. From 1992 to May 1995,
Mr. Woltil was the Chief Financial Officer of Beverly, and from 1990 to 1992,
Mr. Woltil was the Vice President--Financial Planning and Control for Beverly.
Mr. Woltil is also a certified public accountant.
Robert A. Levin, age 43, became a director of the Company in April 1993 and
served as the Secretary of the Company from April 1993 to October 1996.
Effective January 1, 1996, Mr. Levin became the Senior Vice President for
Rehabilitation Services. This position includes responsibility for all therapy
services of the Company, including those of SunDance, the Company's
rehabilitation therapy subsidiary. From January 1991 to December 1995, Mr. Levin
was the President and Chief Operating Officer of SunDance. Previously Mr. Levin
was Vice President of National Accounts for Medline Industries, Inc., a
manufacturer and distributor of medical supplies.
Warren C. Schelling, age 45, became a director of the Company in October
1996. Mr. Schelling became the Senior Vice President for Pharmaceutical Services
effective January 1, 1996. This position includes responsibility for all of the
Company's pharmaceutical operations, including those of SunScript, the Company's
pharmacy subsidiary. From July 1994 to December 1995, Mr. Schelling was the
President of SunScript. Prior to joining the Company, Mr. Schelling was the
President and Chief Operating Officer of HPI Health Care Services, Inc., a
subsidiary of Diagnostek, Inc., which provides pharmacy management services to
hospitals, HMOs, long-term care facilities and health systems, from January 1993
to July 1994. From January 1994 to July 1994, Mr. Schelling also served as the
Executive Vice President/Pharmacy
63
Services Officer at Diagnostek, Inc. From September 1985 to January 1993, Mr.
Schelling was a manager in HPI Health Care Services, Inc.
M. Scott Athans, age 52, became Senior Vice President--Inpatient Services,
U.S. in October 1997. This position includes responsibility for all of Sun's
inpatient services, including those of SunRise. Prior to joining Sun, Mr. Athans
was Chief Operating Officer, and later Chief Executive Officer, of GranCare,
Inc., in Atlanta, Georgia, where he directed four operating divisions, including
skilled nursing facilities, pharmacies, management contracting and home care
from November 1993 to October 1997. Formerly, he was Chief Operating Officer of
Healthfield, Inc., a home healthcare company with operations in Georgia,
Tennessee, Alabama, Massachusetts and Florida. He has also held positions as
Chief Executive Officer of Georgia Baptist Medical Center in Atlanta and Senior
Vice President and Regional Director for America Medical International.
Julie Collins, age 50, became Senior Vice President--Administrative Services
in January 1996. This position is responsible for overseeing corporate
communications, human resources, risk management, training and corporate office
facilities management. From September 1994 to December 1995, Ms. Collins was the
Vice President Human Resources. Prior to joining the Company, Ms. Collins was
the Vice President of Human Resources and Support Services for St. Joseph Health
System in Atlanta, Georgia from 1993 to 1994. From July 1991 to September 1993,
Ms. Collins had been the Vice President of SunRise. From 1990 to 1991, Ms.
Collins was Director of Human Resources for Sheperd Spinal Center in Atlanta,
Georgia.
Thomas B. Hamilton, age 42, became Senior Vice President--Inpatient
Operations, Europe in July 1997. Mr. Hamilton has been Chief Executive Officer
of Ashbourne PLC since 1987 and Chairman of the Board of Directors of Ashbourne
PLC since January 1997. From 1983 to 1987, Mr. Hamilton held various positions,
most recently Finance Director, with Stakis plc.
Robert F. Murphy, age 44, became Senior Vice President and the General
Counsel of the Company in November 1995 and Secretary of the Company in October
1996. From 1986 to 1995 Mr. Murphy served in several capacities as an officer
and legal counsel to FHP International Corporation, most recently as Vice
President and Associate General Counsel. Previously Mr. Murphy was in private
practice beginning in 1978.
Kenneth C. Noonan, age 42, became Senior Vice President--Business
Development in July 1997. Prior to joining Sun, Mr. Noonan was Vice President of
Managed Care and Business Development for Manor Care, Inc. from June 1994 to
June 1997, Vice President of Western Operations for Option Care, Inc. from 1992
to May 1994 and Western Region Manager for McGaw, Inc. from 1983 to 1990.
Andrew P. Masetti, age 40, became Vice-President--Finance in October 1997.
From June 1997 to October 1997, Mr. Masetti was a Financial Manager of Sun.
Prior to joining Sun, Mr. Masetti was Divisional Chief Financial Officer of
Harte-Hanks from June 1996 to April 1997, Chief Financial Officer of Vista
Healthcare from September 1995 to June 1996, Chief Financial Officer of
Diagnostek from July 1994 to July 1995 and he held various financial management
positions with Martin Marietta/General Electric from June 1979 to July 1994.
Warren H. McInteer, age 38, became Vice President of Mergers & Acquisitions
in August 1995. Mr. McInteer became the Treasurer of the Company in June 1996.
Prior to joining the Company, Mr. McInteer was the Vice President of Financial
Planning for Continental Medical Systems ("Continental") in Mechanicsburg,
Pennsylvania, from 1993 to 1995. From 1985 to 1993, Mr. McInteer was a
management consultant for Price Waterhouse working from offices in Baltimore,
London and Philadelphia.
William C. Warrick, age 35, became Vice President, Corporate Controller in
March 1994. From July 1991 to March 1994, Mr. Warrick directed financial
reporting for Continental. From July 1990 to June 1991, Mr. Warrick held a
similar position with McCrory Stores, a retail chain store company.
64
Previously Mr. Warrick was an accountant with KPMG Peat Marwick. Mr. Warrick is
a certified public accountant.
ITEM 11. EXECUTIVE COMPENSATION
To be incorporated by reference to the Company's definitive 1998 Proxy
Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
To be incorporated by reference to the Company's definitive 1998 Proxy
Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
To be incorporated by reference to the Company's definitive 1998 Proxy
Statement.
65
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Financial Statements and Financial Statement Schedules
(i) Financial Statements:
Report of Independent Public Accountants
Consolidated Balance Sheets for the years ended December 31, 1997 and
1996
Consolidated Statements of Earnings (Loss) for the years ended
December 31, 1997, 1996 and 1995
Consolidated Statements of Stockholders' Equity as of December 31,
1997, 1996 and 1995
Consolidated Statements of Cash Flows for the years ended December
31, 1997, 1996 and 1995
Notes to Consolidated Financial Statements
(ii) Financial Statement Schedules:
Report of Independent Public Accountants
Schedule II Valuation and Qualifying Accounts for the years ended
December 31, 1997, 1996 and 1995
(All other financial statement schedules required by Rule 5-04 of Regulation
S-X are not applicable or the required information is included in the audited
financial statements.)
(b) Reports on Form 8-K
Report dated October 23, 1997 reporting the acquisition of Regency
Health Services, Inc. ("Regency").
Report dated December 3, 1997 reporting (i) the amendment to the
Agreement and Plan of Merger and Reorganization, dated as of February 17,
1997, as amended by Amendment No. 1 thereto dated as of May 27, 1997 and by
Amendment No. 2 thereto dated as of August 21, 1997, by and among Sun,
Retirement Care Associates, Inc., a Colorado corporation and a wholly-owned
subsidiary of Sun ("RCA Merger Sub"), pursuant to which RCA Merger Sub will
be merged with and into RCA; (ii) an amendment to the Agreement and Plan of
Merger and Reorganization, dated as of February 17, 1997 as amended by
Amendment No. 1 thereto dated as of August 21, 1997, by and among Sun,
Contour Medical, Inc., a Nevada corporation ("Contour"), and Nectarine
Acquisition corporation, a Nevada corporation and wholly-owned subsidiary of
Sun ("Contour Merger Sub"), pursuant to which Contour Merger Sub will be
merged with and into Contour; (iii) an amendment to the Stockholders Stock
Option and Proxy Agreement, dated as of February 17, 1997, by and among Sun
and certain principal stockholders of RCA; and (iv) an amendment to the
Stockholders Stock Option and Proxy Agreement, dated as of February 17, 1997
by and among Sun and RCA, as principal stockholder of Contour.
Report dated December 22, 1997 supplementing the Form 8-K filed by the
Company on October 23, 1997 and including (i) the consolidated financial
statements of Regency and (ii) unaudited pro forma combined financial
statements of Regency and Sun.
66
(c) Exhibits
EXHIBIT NUMBER DESCRIPTION OF EXHIBITS
- ---------------- ------------------------------------------------------------------------------------------------
2.1(1) Preincorporation Agreement dated as of April 13, 1993 between Sun and Andrew L. Turner, Nora L.
Turner and Elizabeth L. Keefer, as Trustee of Turner's Children's Trust No. 3
2.2(16) Agreement and Plan of Merger and Reorganization, dated as of February 17, 1997 among Sun, Peach
Acquisition Corporation and Retirement Care Associates, Inc.
2.3(16) Agreement and Plan of Merger and Reorganization, dated as of February 17, 1997 among Sun,
Nectarine Acquisition Corporation and Contour Medical, Inc.
2.4(21) Amendment No. 1 to the Agreement and Plan of Merger and Reorganization dated as of February 17,
1997 among Sun, Retirement Care Associates, Inc. and Peach Acquisition Corporation
2.5(22) Amendment No. 2 to the Agreement and Plan of Merger and Reorganization dated as of February
17,1997 among Sun, Retirement Care Associates, Inc. and Peach Acquisition Corporation
2.6(22) Amendment No. 1 to the Agreement and Plan of Merger and Reorganization dated as of February 17,
1997 among Sun, Contour Medical, Inc. and Nectarine Acquisition Corporation
2.7(23) Amendment No. 3 to the Agreement and Plan of Merger and Reorganization dated as of February 17,
1997 among Sun, Retirement Care Associates, Inc. and Peach Acquisition Corporation
2.8(23) Amendment No. 2 to the Agreement and Plan of Merger and Reorganization dated as of February 17,
1997 among Sun, Contour Medical, Inc. and Nectarine Acquisition Corporation
2.9(20) Agreement and Plan of Merger, dated as of July 26, 1997, among Sun, Sunreg Acquisition Corp. and
Regency Health Services, Inc.
3.1(1)(5)(13) Certificate of Incorporation of Sun, as amended
3.2(1)(8) Bylaws of Sun, as amended
4.1(2) Fiscal Agency Agreement dated as of March 1, 1994 between Sun and NationsBank of Texas, N.A., as
Fiscal Agent
4.2(5) Amended and Restated Indenture, dated October 1, 1994, among Sun, The Mediplex Group, Inc. and
Fleet Bank of Massachusetts, N.A. as Trustee (6% Convertible Subordinated Debentures due 2004)
4.3(5) Amended and Restated First Supplemental Indenture to Amended and Restated Indenture, dated
October 1, 1994, among Sun, The Mediplex Group, Inc. and Fleet Bank of Massachusetts, N.A. as
Trustee (6 1/2% Convertible Subordinated Debentures due 2003)
4.4(10) Form of Rights Agreement, dated as of June 2, 1995, between Sun and Boatmen's Trust Company,
which includes the form of Certificate of Designations for the Series A Preferred Stock as
Exhibit A, the form of Right Certificate as Exhibit B and the form of Summary of Preferred
Stock Purchase Rights as Exhibit C.
67
EXHIBIT NUMBER DESCRIPTION OF EXHIBITS
- ---------------- ------------------------------------------------------------------------------------------------
4.5(11) First Amendment to Rights Agreement, dated as of August 11, 1995, amending the Rights Agreement,
dated as of June 2, 1995, between Sun and Boatmen's Trust Company
4.6(24) Indenture dated July 8, 1997, related to the 9 1/2% Senior Subordinated Notes due 2007 by and
between Sun, the Guarantors named therein, and First Trust National Association
10.1(3) Lease Agreement dated as of August 31, 1986, by and between Karan Associates ("Lessee") and
Campbell Care of Wylie, Inc., Assignment of Lease dated November 20, 1989 by and between
Campbell Care of Wylie, Inc. and Honorcare Corporation ("Lessee"), with First Lease Addendum
dated August 31, 1986, Second Addendum dated January 9, 1987, Third Addendum dated November
30, 1989 and Fourth Addendum dated July 12, 1993, and Assignment Agreement dated as of July
13, 1993, by and between Honorcare Corporation ("Assignor") and Sun Healthcare Corporation
("Assignee") (Hillcrest Manor Nursing Center)
10.2(13) Lease Agreement for West Magic Care Center dated as of August 1, 1987, between Skyview
Associates ("Lessor") and Don Bybee and A. Keith Holloway ("Lessee")
10.3(1) Lease Agreement for East Mesa Care Center dated as of September 30, 1990, between East Mesa
Associates Limited Partnership ("Lessor") and SunRise ("Lessee")
10.4(1) Assignment and Assumption of Lease with Consent of Lessor for Torrington Extend-A-Care Center
dated as of November 1, 1990, between Beverly Enterprises Connecticut, Inc.
("Assignor/Lessee"), Turner Enterprises, Inc. ("Assignee"), Andrew L. Turner and Nora Turner
("Guarantors"), Harvey J. Angell and Zev Karkomi ("Special Guarantors") and Beverly Investment
Properties, Inc. ("Lessor") (Lease attached)
10.5(1) Lease Agreement for Mercer Island Care Center dated as of July, 1991, among Mercer View
Convalescent Center, Tenants-in-Common ("Lessor"), SunRise ("Lessee") and Andrew L. Turner and
Nora Turner, husband and wife ("Guarantor")
10.6(1) Lease Agreement for Bayside Health and Rehabilitation Center dated as of July 26, 1991, between
Bellingham Associates Limited Partnership ("Lessor") and SunRise ("Lessee")
10.7(1) Lease Agreement for Menlo Park Healthcare Center dated as of November 1, 1991, between Oregon
Associates Limited Partnership ("Lessor") and SunRise ("Lessee")
10.8(1) Sublease Agreement for Hillside Living Center d/b/a Hillside Healthcare Center dated as of March
1, 1992, between Elite Care Corporation ("Sublessor") and Turner Enterprises, Inc.
("Sublessee") (Lease attached as Exhibit)
10.9(1) Sublease Agreement for Crown Manor Living Center d/b/a Crown Manor Healthcare Center dated as of
March 1, 1992, between Elite Care Corporation ("Sublessor") and Turner Enterprises, Inc.
("Sublessee") (Lease attached as Exhibit)
10.10(1) Sublease Agreement for Colonial Manor Living Center d/b/a Colonial Manor Healthcare Center dated
as of March 1, 1992, between Elite Care Corporation ("Sublessor") and Turner Enterprises, Inc.
("Sublessee") (Lease attached as Exhibit)
10.11(1) Sublease Agreement for Douglas Living Center d/b/a Douglas Healthcare Center dated as of March
1, 1992, between Elite Care Corporation ("Sublessor") and Turner Enterprises, Inc.
("Sublessee") (Lease attached as Exhibit)
68
EXHIBIT NUMBER DESCRIPTION OF EXHIBITS
- ---------------- ------------------------------------------------------------------------------------------------
10.12(1) Lease Agreement for Columbia View Nursing Home dated as of June 30, 1992, between Columbia
Associates Limited Partnership ("Lessor") and Turner Enterprises, Inc. ("Lessee")
10.13(1) Lease Agreement for Adams House Healthcare Center dated as of October 1, 1992, between Adams
Connecticut Associates Limited Partnership ("Lessor") and Turner Enterprises, Inc. ("Lessee")
10.14(1) Lease Agreement for San Juan Care Center and Burton Care Center dated as of October 31, 1992, by
and between Zev Karkomi and Jerold Ruskin (collectively, the "Lessors") and SunRise ("Lessee")
10.15(3) Lease Agreement dated as of July 13, 1993, by and between Angelina Associates ("Lessor") and
Honorcare Corporation ("Lessee"), with Assignment Agreement dated as of July 13, 1993 by and
between Honorcare Corporation ("Assignor") and Sun Healthcare Corporation ("Assignee")
(Angelina Facility)
10.16(3) Lease Agreement dated as of July 13, 1993, by and between July Associates IV ("Lessor") and
Honorcare Corporation ("Lessee"), with Assignment Agreement dated as of July 13, 1993, by and
between Honorcare Corporation ("Assignor") and Sun Healthcare Corporation ("Assignee") (Park
Plaza)
10.17(3) Lease Agreement dated as of July 13, 1993, by and between Angelina Associates ("Lessor") and
Honorcare Corporation ("Lessee"), with Assignment Agreement dated as of July 13, 1993, by and
between Honorcare Corporation ("Assignor") and Sun Healthcare Corporation ("Assignee") (Wells)
10.18(3) Lease Agreement dated as of July 13, 1993, by and between Angelina Associates ("Lessor") and
Honorcare Corporation ("Lessee"), with Assignment Agreement dated as of July 13, 1993, by and
between Honorcare Corporation ("Assignor") and Sun Healthcare Corporation ("Assignee")
(Pineywood)
10.19(3) Lease Agreement dated as of July 13, 1993, by and between Golden Age Associates ("Lessor") and
Honorcare Corporation ("Lessee") (Golden Age)
10.20(3) Lease Agreement dated as of July 13, 1993, by and between July Associates III ("Lessor") and
Honorcare Corporation ("Lessee") (High Plains)
10.21(7) Lease Agreement dated as of July 30, 1993 between Zev Karkomi, Thunderbird Associated Limited
Partnership and SunRise Healthcare Corporation
10.22(7) Lease Agreement dated as of September 22, 1993, as amended, between Carlinville Associates and
SunRise Healthcare Corporation
10.23(4) Lease Agreement dated October 1993, by and between Salem Associates, Ltd. ("Lessor") and SunRise
("Lessee") (Doctors Nursing Home)
10.24(4) Lease Agreement dated as of December 6, 1993, by and between Massachusetts Nursing Homes Limited
Partnership ("Lessor") and SunRise ("Lessee")
10.25(3) Lease Assignment and Transfer of Operations Agreement dated as of December 30, 1993, by and
between HEA of New Mexico, Inc. and SunRise (Lease attached) (Country Life Manor)
10.26(3) Lease Agreement dated as of January 1, 1994, by and between October Associates ("Lessor") and
SunRise ("Lessee") (Stanton Nursing Home)
69
EXHIBIT NUMBER DESCRIPTION OF EXHIBITS
- ---------------- ------------------------------------------------------------------------------------------------
10.27(3) Lease Agreement dated as of January 1, 1994, by and between Whitewright Associates ("Lessor")
and SunRise ("Lessee") (Campbell Care of Whitewright)
10.28(3) Lease Agreement dated as of January 1, 1994, by and between October Associates ("Lessor") and
SunRise ("Lessee") (Valley Mills Care Center)
10.29(3) Lease Agreement dated as of January 1, 1994, by and between October Associates ("Lessor") and
SunRise ("Lessee") (Moody Care Center)
10.30(6) Lease Agreement dated as of April 26, 1994, by and between Sumner Nursing Home, L.L.C. and
SunRise
10.31(5) Lease Agreement by and between Bellingham II Associates Limited Partnership and SunRise
Healthcare Corporation, dated May 31, 1994
10.32(12) Lease Agreement for Wheeler Care Center, dated as of July 24, 1995, by and between Wheeler
Healthcare Associates, L.L.C., a Texas limited liability company ("Lessor") and SunRise
Healthcare Corporation ("Lessee").
10.33(12) Agreement with Respect to and Second Amendment of Lease Agreement, dated as of September 1,
1995, by and between Massachusetts Nursing Homes Limited Partnership ("Lessor") and SunRise
Healthcare Corporation ("Lessee").
10.34(12) Third Amendment of Lease Agreement, dated as of September 1, 1995, by and between Massachusetts
Nursing Homes Limited Partnership ("Lessor") and SunRise Healthcare Corporation ("Lessee").
10.35(12) Lease Agreement for Clifton Care Center, dated as of September 13, 1995, between Missouri
Associates ("Lessor") and SunRise Healthcare Corporation ("Lessee").
10.36(17) Lease Agreement for Heritage Heights dated as of March 1, 1996, by and between Tor Associates
("Lessor") and SunRise Healthcare Corporation ("Lessee").
10.37(15) Second Amendment to Lease, dated as of June 1, 1996, by and between East Mesa Associates Limited
Partnership ("Lesser") and SunRise Healthcare Corporation ("Lessee").
10.38(14) Lease Agreement dated July 1, 1996 between Oak/Jones, Inc. and SunRise Healthcare Corporation
for Oaks Health & Rehabilitation Center.
10.39(14) Lease Agreement dated July 1, 1996 between Oak/Jones, Inc. and SunRise Healthcare Corporation
for Jones Health & Rehabilitation Center.
10.40(15) Sub-Sublease Agreement, dated as of August 22, 1996, by and between Yuba Nursing Homes, Inc.
("Lessor") and SunRise Healthcare Corporation ("Lessee").
10.41(17) Lease Agreement for Casa del Sol Nursing Home dated as of November 26, 1996, by and between
Raton Property Limited Company ("Lessor") and SunRise Healthcare Corporation ("Lessee").
10.42(17) Lease Agreement for Blue Mountain Convalescent Center dated as of November 30, 1996, by and
between Washington Associates ("Lessor") and SunRise Healthcare Corporation ("Lessee").
10.43(17) Lease Agreement for Payette Lakes Care Center dated as of November 30, 1996, by and between
Idaho Associates L.L.C. ("Lessor") and SunRise Healthcare Corporation ("Lessee").
70
EXHIBIT NUMBER DESCRIPTION OF EXHIBITS
- ---------------- ------------------------------------------------------------------------------------------------
10.44(17) Lease Agreement for Valley Rehabilitation and Living Center dated as of November 30, 1996, by
and between Idaho Associates L.L.C. ("Lessor") and SunRise Healthcare Corporation ("Lessee").
10.45(17) Unconditional Guaranty of Lease dated as of November 30, 1996 given by Sun Healthcare Group,
Inc. ("Guarantor") to Idaho Associates, L.L.C. ("Lessor") relating to Magic Valley Manor.
10.46(17) Unconditional Guaranty of Lease dated as of November 30, 1996 given by Sun Healthcare Group,
Inc. ("Guarantor") to Idaho Associates, L.L.C. ("Lessor") relating to Valley Rehabilitation
and Living Center.
10.47(3) Form of Management Agreement between GF/Massachusetts, Inc. and SunRise
10.48(5) Amendment and Restatement of Loan Agreement [Brookline] by and between Mediplex of
Massachusetts, Inc. and Meditrust Mortgage Investments, Inc., dated June 23, 1994
10.49(5) Amendment and Restatement of Loan Agreement [Columbus] by and between Mediplex Rehabilitation of
Massachusetts, Inc. and Meditrust Mortgage Investments, Inc., dated June 23, 1994
10.50(5) Loan Agreement [Denver] by and between Mediplex of Colorado, Inc. and Valley View Psychiatric
Services, Inc. and Meditrust Mortgage Investments, Inc., dated June 23, 1994
10.51(13) Omnibus Amendment to Loan Agreements, dated as of March 28, 1996, by and between certain
subsidiaries of The Mediplex Group, Inc. and certain subsidiaries of Sun
10.52(19) Credit Agreement among Sun, certain lenders, certain co-agents, and NationsBank of Texas, N.A.,
as Administrative Lender, dated October 8, 1997
10.53(19) Form of First Amendment to Credit Agreement dated October 8, 1997 among Sun, certain lenders,
certain co-agents, and NationsBank of Texas, N.A., as Administrative Lender, to be dated as of
November 12, 1997
10.54(9) First Amendment to Sun 1992 Director Stock Option Plan
10.55(1) Sun 1993 Combined Incentive and Nonqualified Stock Option Plan
10.56(1) Sun 1993 Directors Stock Option Plan
10.57(9) Amendments to Sun 1993 Combined Incentive and Nonqualified Stock Option Plan
10.58(13) Sun 1995 Non-Employee Directors' Stock Option Plan
10.59(13) Sun Employee Stock Purchase Plan
10.60(13) 1996 Combined Incentive and Nonqualified Stock Option Plan
10.61(1) Tax Indemnity Agreement between Sun, SunDance Rehabilitation Corporation, Turner Enterprises,
Inc. and Andrew L. Turner and Nora L. Turner
10.62(1) Form of Indemnity Agreement between Sun and each of Sun's Directors before July 3, 1996
10.63(25) Form of Indemnity Agreement between Sun and each of Sun's Directors from and after July 3, 1996
71
EXHIBIT NUMBER DESCRIPTION OF EXHIBITS
- ---------------- ------------------------------------------------------------------------------------------------
10.64(1) Employment Agreement between Sun and Andrew L. Turner
10.65(1) Agreement as of May 5, 1993, between SunDance Rehabilitation Corporation and Andrew L. Turner
10.66(3) Employment Agreement between Sun and John E. Bingaman
10.67(5) Termination of Employment Agreement and Consulting Agreement by and between Sun Healthcare Group
and John E. Bingaman
10.68(17) Severance Agreement between Sun and Andrew L. Turner dated January 1, 1997
10.69(17) Form of Severance Agreement entered into between Sun and its President, Chief Financial Officer
and Senior Vice Presidents
10.70(18) Sun 1997 Non-Employee Directors' Stock Plan
10.71(18) Sun 1997 Stock Incentive Plan
10.72(18) Lease Agreement for Casa Loma Convalescent Center dated as of February 24, 1997 by and between
Idaho Associates, LLC ("Lessor") and SunRise Healthcare Corporation ("Lessee")
10.73(19) Lease Agreement for Evergreen Nursing and Convalescent Centre dated as of June 5, 1997, between
Effingham Associates, L.L.C. ("Lessor") and SunRise Healthcare Corporation ("Lessee")
21* Subsidiaries of the Registrant
23* Consent of Arthur Andersen LLP
27* Financial Data Schedule
- ------------------------
* Filed herewith
(1) Incorporated by reference from exhibits to the Company's Registration
Statement (No. 33-62670) on Form S-1.
(2) Incorporated by reference from exhibits to the Company's Form 8-K dated
March 11, 1994.
(3) Incorporated by reference from exhibits to the Company's Annual Report on
Form 10-K for the fiscal year ended December 31, 1993.
(4) Incorporated by reference from exhibits to the Company's Form 10-Q/A-1 for
the quarter ended September 30, 1993.
(5) Incorporated by reference from exhibits to the Company's Form 10-Q for the
quarter ended September 30, 1994.
(6) Incorporated by reference from exhibits to the Company's Registration
Statement (No. 33-77522) on Form S-1.
(7) Incorporated by reference from exhibits to the Company's Registration
Statement (No. 33-77272) on Form S-4.
(8) Incorporated by reference from exhibits to the Company's Registration
Statement (No. 33-77870) on Form S-1.
(9) Incorporated by reference from exhibits to the Company's Annual Report on
Form 10-K for the fiscal year ended December 31, 1994.
72
(10) Incorporated by reference from exhibits to the Company's Form 8-A filed
June 6, 1995.
(11) Incorporated by reference from exhibits to the Company's Form 8-A/A-1 filed
August 17, 1995.
(12) Incorporated by reference from exhibits to the Company's Annual Report on
Form 10-K for the fiscal year ended December 31, 1995.
(13) Incorporated by reference from exhibits to the Company's Form 10-Q for the
quarter ended March 31, 1996.
(14) Incorporated by reference from exhibits to the Company's Form 10-Q for the
quarter ended June 30, 1996.
(15) Incorporated by reference from exhibits to the Company's Form 10-Q for the
quarter ended September 30, 1996.
(16) Incorporated by reference from exhibits to the Company's Form 8-K dated
February 17, 1997.
(17) Incorporated by reference from exhibits to the Company's Annual Report on
Form 10-K for the fiscal year ended December 31, 1996.
(18) Incorporated by reference from exhibits to the Company's Form 10-Q for the
quarter ended March 31, 1997.
(19) Incorporated by reference from exhibits to the Company's Form 10-Q for the
quarter ended September 30, 1997
(20) Incorporated by reference from exhibits to the Company's Form 8-K dated
October 8, 1997.
(21) Incorporated by reference from exhibits to the Company's Form 8-K dated May
27, 1997.
(22) Incorporated by reference from exhibits to the Company's Form 8-K dated
August 21, 1997.
(23) Incorporated by reference from exhibits to the Company's Form 8-K dated
November 25, 1997.
(24) Incorporated by reference from exhibits to the Company's Form 10-Q for the
quarter ended June 30, 1997.
73
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
SUN HEALTHCARE GROUP, INC.
By: /s/ ANDREW L. TURNER
-----------------------------------------
Andrew L. Turner
CHIEF EXECUTIVE OFFICER
March 27, 1998
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant on March 27, 1998 in the capacities indicated.
SIGNATURES TITLE
- ------------------------------ --------------------------
Chairman of the Board of
/s/ ANDREW L. TURNER Directors and Chief
- ------------------------------ Executive Officer
Andrew L. Turner (Principal Executive
Officer)
/s/ ROBERT D. WOLTIL Chief Financial Officer
- ------------------------------ and Director (Principal
Robert D. Woltil Financial Officer)
/s/ ANDREW P. MASETTI Vice President--Finance
- ------------------------------ (Principal Accounting
Andrew P. Masetti Officer)
/s/ JOHN E. BINGAMAN
- ------------------------------ Director
John E. Bingaman
/s/ ZEV KARKOMI
- ------------------------------ Director
Zev Karkomi
/s/ ROBERT A. LEVIN
- ------------------------------ Director
Robert A. Levin
/s/ MARTIN G. MAND
- ------------------------------ Director
Martin G. Mand
74
SIGNATURES TITLE
- ------------------------------ --------------------------
/s/ WARREN C. SCHELLING
- ------------------------------ Director
Warren C. Schelling
/s/ LOIS SILVERMAN
- ------------------------------ Director
Lois Silverman
/s/ JAMES R. TOLBERT
- ------------------------------ Director
James R. Tolbert
/s/ MARK G. WIMER
- ------------------------------ Director
Mark G. Wimer
/s/ R. JAMES WOOLSEY
- ------------------------------ Director
R. James Woolsey
75
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Stockholders and Board of Directors of
Sun Healthcare Group, Inc.:
We have audited the accompanying consolidated balance sheets of Sun
Healthcare Group, Inc. (a Delaware corporation) and subsidiaries as of December
31, 1997 and 1996, and the related consolidated statements of earnings (loss),
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 1997. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Sun Healthcare Group, Inc.
and subsidiaries as of December 31, 1997 and 1996, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1997, in conformity with generally accepted accounting principles.
/s/ Arthur Andersen LLP
ARTHUR ANDERSEN LLP
Albuquerque, New Mexico
February 24, 1998
F-1
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31,
--------------------------
1997 1996
------------ ------------
(IN THOUSANDS,
EXCEPT SHARE DATA)
ASSETS
Current assets:
Cash and cash equivalents........................................................... $ 21,020 $ 14,880
Restricted cash..................................................................... 14,160 2,236
Accounts receivable, net of allowance for doubtful accounts of $34,433 and $16,877
as of December 31, 1997 and 1996, respectively.................................... 523,161 282,268
Other receivables................................................................... 33,550 33,430
Prepaids and other assets........................................................... 36,774 17,618
Deferred tax assets................................................................. 16,546 12,716
------------ ------------
Total current assets.............................................................. 645,211 363,148
------------ ------------
Property and equipment, net......................................................... 631,102 305,720
Goodwill, net....................................................................... 1,030,893 432,505
Notes receivable.................................................................... 91,062 21,733
Other assets........................................................................ 159,404 93,323
Deferred tax assets................................................................. 21,564 12,997
------------ ------------
Total assets...................................................................... $ 2,579,236 $ 1,229,426
------------ ------------
------------ ------------
(Continued on next page)
F-2
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (CONTINUED)
AS OF DECEMBER 31,
--------------------------
1997 1996
------------ ------------
(IN THOUSANDS,
EXCEPT SHARE DATA)
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt................................................... $ 56,817 $ 27,701
Current portion of obligations under capital leases................................. 2,054 1,281
Accounts payable.................................................................... 61,873 39,180
Accrued compensation and benefits................................................... 78,960 29,718
Accrued interest.................................................................... 20,451 4,426
Accrued self-insurance obligations.................................................. 34,354 12,079
Payable to APTA shareholders........................................................ -- 23,545
Other accrued liabilities........................................................... 71,183 13,636
------------ ------------
Total current liabilities......................................................... 325,692 151,566
------------ ------------
Long-term debt, net of current portion................................................ 1,488,861 460,501
Obligations under capital leases, net of current portion.............................. 79,110 22,952
Other long-term liabilities........................................................... 42,428 14,813
Deferred tax liabilities.............................................................. 9,807 4,760
------------ ------------
Total liabilities................................................................. 1,945,898 654,592
------------ ------------
Minority interest..................................................................... 16,285 2,697
Commitments and contingencies......................................................... -- --
Stockholders' equity:
Preferred stock of $.01 par value, authorized 5,000,000 shares, none issued......... -- --
Common stock of $.01 par value, authorized 100,000,000 shares, 51,697,914 and
51,142,729 shares issued and outstanding as of December 31, 1997 and 1996,
respectively...................................................................... 517 511
Additional paid-in capital.......................................................... 639,637 611,434
Retained earnings................................................................... 57,114 22,313
Cumulative translation adjustment................................................... 1,766 3,718
------------ ------------
699,034 637,976
------------ ------------
Less:
Unearned compensation............................................................. 14,203 --
Common stock held in treasury, at cost, 2,053,207 and 2,030,116 shares as of
December 31, 1997 and 1996, respectively........................................ 25,574 25,069
Grantor stock trust, at market, 2,178,315 and 3,019,993 shares as of December 31,
1997 and 1996, respectively..................................................... 42,204 40,770
------------ ------------
Total stockholders' equity........................................................ 617,053 572,137
------------ ------------
Total liabilities and stockholders' equity........................................ $ 2,579,236 $ 1,229,426
------------ ------------
------------ ------------
The accompanying notes are an integral part of these consolidated balance
sheets.
F-3
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS (LOSS)
YEAR ENDED DECEMBER 31,
----------------------------------------
1997 1996 1995
------------ ------------ ------------
(IN THOUSANDS, EXCEPT SHARE DATA)
Total net revenues...................................................... $ 2,010,820 $ 1,316,308 $ 1,135,508
------------ ------------ ------------
Costs and expenses:
Operating............................................................. 1,662,818 1,107,821 929,493
Corporate general and administrative.................................. 98,169 62,085 51,468
Provision for losses on accounts receivable........................... 15,839 14,970 14,623
Depreciation and amortization......................................... 56,630 33,817 27,734
Interest, net......................................................... 74,482 25,899 21,829
Loss on sale of Canadian operations................................... 7,000 -- --
Conversion expense.................................................... -- -- 3,256
Merger expenses....................................................... -- -- 5,800
Strike costs.......................................................... -- -- 4,006
Investigation and litigation costs.................................... -- 19,250 5,505
Impairment loss....................................................... -- -- 59,000
------------ ------------ ------------
Total costs and expenses............................................ 1,914,938 1,263,842 1,122,714
------------ ------------ ------------
Earnings before income taxes and extraordinary loss..................... 95,882 52,466 12,794
Income taxes............................................................ 41,153 30,930 33,132
------------ ------------ ------------
Net earnings (loss) before extraordinary loss......................... 54,729 21,536 (20,338)
Extraordinary loss from early extinguishment of debt, net of income tax
benefit of $9,815 and $2,372 in 1997 and 1995, respectively........... 19,928 -- 3,413
------------ ------------ ------------
Net earnings (loss)................................................... $ 34,801 $ 21,536 $ (23,751)
------------ ------------ ------------
------------ ------------ ------------
Net earnings (loss) per common and common equivalent share:
Net earnings (loss) before extraordinary loss:
Basic............................................................... $ 1.18 $ 0.46 $ (0.43)
------------ ------------ ------------
------------ ------------ ------------
Diluted............................................................. $ 1.12 $ 0.46 $ (0.43)
------------ ------------ ------------
------------ ------------ ------------
Net earnings (loss):
Basic............................................................... $ 0.75 $ 0.46 $ (0.51)
------------ ------------ ------------
------------ ------------ ------------
Diluted............................................................. $ 0.74 $ 0.46 $ (0.51)
------------ ------------ ------------
------------ ------------ ------------
Weighted average number of common and common equivalent shares
outstanding:
Basic............................................................... 46,329 46,360 47,419
------------ ------------ ------------
------------ ------------ ------------
Diluted............................................................. 51,851 46,868 47,419
------------ ------------ ------------
------------ ------------ ------------
The accompanying notes are an integral part of these consolidated financial
statements.
F-4
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEAR ENDED DECEMBER 31,
-------------------------------------------------------------------
1997 1996 1995
--------------------- --------------------- ---------------------
SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT
--------- ---------- --------- ---------- --------- ----------
(IN THOUSANDS)
COMMON STOCK
Issued and outstanding at beginning of year..... 51,143 $ 511 47,916 $ 479 45,021 $ 450
Issuance of common stock for employee
benefits...................................... 487 5 106 1 283 3
Conversion of 6 1/2% Convertible Subordinated
Debentures due 2003........................... 68 1 -- -- 1,583 16
Issuance of common stock in connection with
establishment of the Grantor Stock Trust...... -- -- 3,050 30 -- --
Common stock issued in connection with
acquisitions.................................. -- -- 71 1 339 3
Common stock issued in connection with
immaterial poolings........................... -- -- -- -- 690 7
--------- ---------- --------- ---------- --------- ----------
Issued and outstanding at end of year........... 51,698 517 51,143 511 47,916 479
--------- ---------- --------- ---------- --------- ----------
ADDITIONAL PAID-IN CAPITAL
Balance at beginning of year.................... 611,434 568,054 521,614
Issuance of common stock for employee
benefits...................................... 5,518 1,206 2,973
Tax benefit of stock options exercised.......... 1,741 99 --
Conversion of 6 1/2% Convertible Subordinated
Debentures due 2003........................... 1,109 -- 30,059
Consideration recorded for the fair value of
warrants issued in connection with
acquisitions.................................. 191 -- 1,095
Adjustment to market value of common stock held
by the Grantor Stock Trust.................... 19,644 3,445 --
Issuance of common stock in connection with the
establishment of the Grantor Stock Trust...... -- 37,670 --
Common stock issued in connection with
acquisitions.................................. -- 960 174
Common stock issued in connection with
immaterial poolings........................... -- -- 8,231
Reclassification of retained earnings as
additional paid-in capital to reflect the
change in tax status of Golden Care, Inc...... -- -- 3,908
--------- ---------- --------- ---------- --------- ----------
Additional paid-in capital at end of year....... 639,637 611,434 568,054
--------- ---------- --------- ---------- --------- ----------
RETAINED EARNINGS
Balance at beginning of year.................... 22,313 777 28,165
Net earnings (loss)............................. 34,801 21,536 (23,751)
(continued on next page)
F-5
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31,
-------------------------------------------------------------------
1997 1996 1995
--------------------- --------------------- ---------------------
SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT
--------- ---------- --------- ---------- --------- ----------
(IN THOUSANDS)
Distribution of prior S corporation earnings.... -- -- (333)
Reclassification of retained earnings as
additional paid-in capital to reflect the
change in tax status of Golden Care, Inc...... -- -- (3,908)
Common stock issued in connection with
immaterial poolings........................... -- -- 604
--------- ---------- --------- ---------- --------- ----------
Retained earnings at end of year................ 57,114 22,313 777
--------- ---------- --------- ---------- --------- ----------
CUMULATIVE TRANSLATION ADJUSTMENT
Balance at beginning of year.................... 3,718 (268) 220
Aggregate translation adjustment................ (1,952) 3,986 (488)
--------- ---------- --------- ---------- --------- ----------
Cumulative translation at end of year........... 1,766 3,718 (268)
--------- ---------- --------- ---------- --------- ----------
Total........................................... 51,698 699,034 51,143 637,976 47,916 569,042
--------- ---------- --------- ---------- --------- ----------
UNEARNED COMPENSATION
Balance at beginning of year.................... -- -- --
Issuance of shares of restricted common stock... (17,458) -- --
Amortization of stock issued under restricted
stock option plan............................. 3,255 -- --
--------- ---------- --------- ---------- --------- ----------
Unearned compensation at end of year............ (14,203) -- --
--------- ---------- --------- ---------- --------- ----------
COMMON STOCK IN TREASURY
Balance at beginning of year.................... (25,069) -- --
Acquired at cost................................ (505) (25,069) --
--------- ---------- --------- ---------- --------- ----------
Common stock in treasury at end of year......... (25,574) (25,069) --
GRANTOR STOCK TRUST
Balance at beginning of year.................... (40,770) -- --
Issuance of common stock in connection with
establishment of the Grantor Stock Trust...... -- (37,700) --
Issuance of common stock from the Grantor Stock
Trust......................................... 752 375 --
Issuance of shares of restricted common stock... 17,458 -- --
Adjustment to market value of common stock held
by the Grantor Stock Trust.................... (19,644) (3,445) --
--------- ---------- --------- ---------- --------- ----------
Grantor stock trust at end of year.............. (42,204) (40,770) --
--------- ---------- --------- ---------- --------- ----------
Total stockholders' equity...................... 51,698 $ 617,053 51,143 $ 572,137 47,916 $ 569,042
--------- ---------- --------- ---------- --------- ----------
--------- ---------- --------- ---------- --------- ----------
The accompanying notes are an integral part of these consolidated financial
statements.
F-6
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31,
-----------------------------------
1997 1996 1995
----------- ---------- ----------
(IN THOUSANDS)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net earnings (loss)....................................................... $ 34,801 $ 21,536 $ (23,751)
Adjustments to reconcile net earnings (loss) to net cash provided by
operating activities--
Extraordinary loss...................................................... 29,743 -- 5,785
Loss on sale of Canadian operations..................................... 7,000 -- --
Conversion expense...................................................... -- -- 3,256
Litigation settlement................................................... -- (4,750) --
Depreciation and amortization........................................... 56,630 33,817 27,734
Provision for losses on accounts receivable............................. 15,839 14,970 14,623
Impairment loss......................................................... -- -- 59,000
Other, net.............................................................. 3,312 (2,032) (2,220)
Changes in operating assets and liabilities:
Accounts receivable................................................... (164,966) (57,059) (90,887)
Other current assets.................................................. (6,323) (6,696) 970
Other current liabilities............................................. 24,228 3,262 (6,334)
Income taxes payable.................................................. 21,469 23,764 18,610
----------- ---------- ----------
Net cash provided by operating activities............................. 21,733 26,812 6,786
----------- ---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures, net................................................. (103,162) (76,223) (73,497)
Acquisitions, net of cash acquired........................................ (564,134) (75,579) (74,041)
Purchase of minority interest in OmniCell Technologies, Inc............... -- (25,332) --
Net proceeds from sale of SunSurgery Corporation.......................... -- 24,828 --
Proceeds (expenditures) from operations and sale of assets
held for sale........................................................... -- (3,810) 36,878
Proceeds from sale and leaseback of property and equipment................ 80,457 34,603 105,534
Increase in long-term note receivables.................................... (57,431) (8,665) (12,479)
Other assets expenditures................................................. (35,851) (12,011) (10,169)
----------- ---------- ----------
Net cash used for investing activities................................ (680,121) (142,189) (27,774)
----------- ---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Long-term debt borrowings................................................. 1,837,062 137,155 185,299
Long-term debt repayments................................................. (966,024) (4,273) (115,730)
Repurchase of 12.25% Junior Subordinated Notes and 9.875% Senior
Subordinated Notes...................................................... (182,070) -- --
Repurchase of 11 3/4% Senior Subordinated Notes........................... -- -- (89,370)
Conversion of 6 1/2% Convertible Subordinated Debentures.................. -- -- (16,859)
Net proceeds from issuance of common stock................................ 6,275 1,582 2,976
Purchases of treasury stock............................................... (505) (25,069) --
Financing fees paid....................................................... (33,411) (1,776) (1,762)
----------- ---------- ----------
Net cash provided by (used for) financing activities.................. 661,327 107,619 (35,446)
----------- ---------- ----------
Effect of exchange rate on cash and cash equivalents........................ 3,201 (464) 798
----------- ---------- ----------
Net increase (decrease) in cash and cash equivalents........................ 6,140 (8,222) (55,636)
Cash and cash equivalents at beginning of year.............................. 14,880 23,102 78,738
----------- ---------- ----------
Cash and cash equivalents at end of year.................................... $ 21,020 $ 14,880 $ 23,102
----------- ---------- ----------
----------- ---------- ----------
The accompanying notes are an integral part of these consolidated financial
statements.
F-7
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1997
(1) SUMMARY OF SIGNIFICANT ACCOUNTING AND FINANCIAL REPORTING POLICIES
(a) NATURE OF BUSINESS
Sun Healthcare Group, Inc., through its direct and indirect subsidiaries
(hereinafter collectively referred to as "Sun" or the "Company"), is a provider
of long-term, subacute and related specialty healthcare services including
rehabilitation and respiratory therapy services and pharmaceutical services.
Long-term and subacute care and outpatient therapy services are provided through
Company-operated facilities. Therapy services and pharmaceutical services are
provided both in Company-operated and in other nonaffiliated facilities located
in the United States. The Company also provides long-term care services in the
United Kingdom, Spain and Germany and acute care services in Australia,
pharmaceutical services in the United Kingdom and Spain, and outpatient
rehabilitation therapy services in Canada.
(b) PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company
and its greater than 50% owned subsidiaries. Investments in affiliates, in which
the Company owns 20% to 50%, are carried on the equity method. Investments in
companies owned less than 20% are carried at cost. All significant intercompany
accounts and transactions have been eliminated in consolidation.
(c) CASH EQUIVALENTS
The Company considers all highly liquid, unrestricted investments with
original maturities of three months or less to be cash equivalents. Cash
equivalents are stated at cost.
(d) NET REVENUES
Net revenues consist of long-term and subacute care revenues, therapy
services revenues, temporary therapy staffing services revenues and
pharmaceutical services revenues. Net revenues are recognized as services are
provided. Net revenues are recorded net of provisions for discount arrangements
with commercial payors and contractual allowances with third-party payors,
primarily Medicare and Medicaid. Net revenues realizable under third-party payor
agreements are subject to change due to examination and retroactive adjustment.
Estimated third-party payor settlements are recorded in the period the related
services are rendered. The methods of making such estimates are reviewed
frequently, and differences between the net amounts accrued and subsequent
settlements or estimates of expected settlements are reflected in current
earnings.
The Company has submitted to the Health Care Financing Administration
("HCFA") various requests for exceptions to the Medicare established routine
cost limitations for reimbursement ("RCLs"). These exceptions are permitted
under the Medicare regulations to allow providers to treat higher acuity
patients. Included in net revenues are amounts related to exceptions to the RCLs
of $16.6 million, $12.3 million and $8.9 million for the years ended December
31, 1997, 1996 and 1995 respectively. These amounts are net of adjustments to
record management's estimate, based on its prior experience with the Medicare
program's regulations and the Company's records of service provided, of amounts
that will ultimately be approved by HCFA. Accounts receivable include requests
for exceptions to the RCLs of $28.8 million, and $19.1 million at December 31,
1997 and 1996, respectively. Amounts realizable are subject to final settlement
of the respective cost reports. Differences between the net amounts accrued and
subsequent settlements or estimates of expected settlements are recorded in
operations at the time of settlement.
F-8
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(1) SUMMARY OF SIGNIFICANT ACCOUNTING AND FINANCIAL REPORTING POLICIES
(CONTINUED)
(e) ACCOUNTS RECEIVABLE
The Company receives payment for services rendered from Federal and state
governments under the Medicare and Medicaid programs and private pay payors,
including third party insurers, workers' compensation plans, healthcare
providers and individuals. The following table summarizes the percent of
accounts receivable by payor category as of December 31:
1997 1996
----- -----
Government...................................................................... 49% 44%
Private and other............................................................... 51 56
--- ---
100% 100%
--- ---
--- ---
Management does not believe that there are any credit risks associated with
receivables from governmental agencies. Private and other receivables consist of
receivables from a large number of payors involved in diverse activities and
subject to differing economic conditions, which management believes do not
represent any concentrated credit risks to the Company. In certain instances,
the collection of amounts from healthcare providers for therapy services has
slowed because payment is primarily dependent upon such facilities' receipt of
payment from fiscal intermediaries. In addition, fiscal intermediaries of
long-term care facilities acquired by the Company are changed to the Company's
fiscal intermediary resulting in temporary delays in timing of third-party
payments.
(f) PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Major renewals or improvements
are capitalized, whereas ordinary maintenance and repairs are expensed as
incurred. Depreciation and amortization is computed using the straight-line
method over the estimated useful lives of the assets as follows: buildings and
improvements--5 to 40 years; leasehold improvements--the shorter of the
estimated useful lives of the assets or the life of the lease; equipment--3 to
20 years. Amortization of property and equipment held under capital leases is
included in depreciation and amortization expense.
The Company capitalizes certain costs associated with developing and
acquiring healthcare facilities and related outpatient programs. Capitalized
costs include site investigation, negotiation, development, acquisition and
preconstruction costs; indirect and general expenses related to such activities
are expensed as incurred. Preconstruction costs include the direct costs of
securing control of the development site, obtaining the requisite certificate of
need and other approvals, as well as the direct costs of preparing for actual
development and construction. The capitalized costs are transferred to
construction in progress and depreciable asset categories as construction is
begun and completed, respectively. The Company capitalizes interest directly
related to the development and construction of new facilities as a cost of the
related asset.
(g) GOODWILL/IMPAIRMENT LOSS
The excess of the purchase price over the fair value of the net assets of
the businesses acquired by the Company is amortized using the straight-line
method over periods ranging from 20 to 40 years. Accumulated amortization of
such costs was $47.9 million and $28.9 million as of December 31, 1997 and 1996,
respectively.
F-9
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(1) SUMMARY OF SIGNIFICANT ACCOUNTING AND FINANCIAL REPORTING POLICIES
(CONTINUED)
The Company periodically evaluates the carrying value of goodwill along with
any other related long-lived assets in relation to the future undiscounted cash
flows of the underlying businesses to assess recoverability. The Company adopted
Statement of Financial Accounting Standards No. 121 (SFAS 121) "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of"
on December 31, 1995. Under SFAS 121, an impairment loss is recognized if the
sum of the expected long-term cash flows is less than the carrying amount of the
goodwill and other assets being evaluated. The difference between the carrying
amount of the goodwill and other assets being evaluated and the estimated fair
market value of the assets represents the impairment loss. The Company
determines fair value using certain multiples of earnings before interest,
taxes, depreciation and amortization based on current prices for comparable
assets.
The impairment loss, as determined in accordance with SFAS 121, of $59.0
million recorded by the Company in 1995 primarily relates to the goodwill
associated with six of the forty facilities acquired in the Mediplex
acquisition. The impairment loss at these six facilities was the result of the
following circumstances: (i) three facilities were organized by the Service
Employees International Union subsequent to the acquisition resulting in
significantly higher labor costs; (ii) two facilities experienced significant
declines in private pay census and revenues due to, in one instance, funding
reductions in certain programs providing private pay patients and, in the other
instance, the opening of two new facilities by competitors; and (iii) the
remaining facility received lower than expected Medicaid rates from the State of
Connecticut and due to the high acuity of the patients treated at the facility,
reimbursement was not adequate. If the Company had not elected early adoption of
SFAS 121 during 1995, the impairment loss would have been based solely on the
difference between the assets carrying value and cumulative long-term cash flows
which would have resulted in a loss of $48.9 million.
(h) OTHER ASSETS
Costs incurred in obtaining debt financing are amortized as interest expense
over the terms of the related indebtedness. The Company amortizes preopening
costs (start-up costs related to new facilities, specialty units within a
facility, new rehabilitation regions and pharmacies) over a period ranging from
one year (for costs not reimbursed by third-party payors) to five years (for
costs reimbursed by third-party payors, including the Medicare and Medicaid
programs). Other assets also includes equity and cost-based investments (see
Note 2).
(i) ACCRUED SELF-INSURANCE OBLIGATIONS
It is the policy of the Company to self-insure for certain insurable risks
including general and professional liability, workers' compensation, and certain
employee benefits through the use of self-insurance or retrospective and high
deductible insurance policies and other hybrid policies which vary by the states
in which the Company operates. Provisions for estimated settlements are provided
in the period of the related coverage. These provisions are based on internal
evaluations of the merits of individual claims and the reserves assigned by the
Company's independent insurance carriers. The methods of making such estimates
and establishing the resulting accrued liabilities are reviewed frequently, and
any adjustments resulting therefrom are reflected in current earnings. Claims
are paid over varying periods, which generally range from one to five years.
Accrued liabilities for future claims are not discounted.
F-10
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(1) SUMMARY OF SIGNIFICANT ACCOUNTING AND FINANCIAL REPORTING POLICIES
(CONTINUED)
(j) INVESTIGATION AND LITIGATION COSTS
In 1996, the Company reached an agreement in principle to settle certain
class-action lawsuits brought by shareholders for $24.0 million and recognized,
as a reduction of the settlement cost, a $9.0 million claim from its director
and officer liability insurance carrier for its claim submitted in connection
with the settlement. In addition, in 1996 the Company recorded additional
charges and expenses of $4.3 million related to monitoring and responding to the
continuing investigation by the U.S. Department of Health and Human Services'
Office of Inspector General ("OIG") and responding to the remaining shareholder
litigation filed after the announcement of the OIG investigation. In 1995, the
Company recorded charges and expenses of $5.5 million related to monitoring and
responding to the continuing OIG investigation and legal fees resulting from
shareholder litigation (see Note 14). The 1995 charges also included costs
incurred by the Company in connection with financing activities which were not
concluded due to negative publicity resulting from the OIG investigation. The
charges do not contain any estimated amounts for settlement of the OIG
investigation or remaining shareholder litigation matters.
(k) STRIKE COSTS
During 1995, the Company recorded charges and expenses of $4.0 million
related to averting a strike and negotiating new contracts for certain unionized
nursing homes in Connecticut.
(l) INCOME TAXES
Income tax expense is based on reported earnings before income taxes.
Deferred income taxes reflect the impact of temporary differences between the
amount of assets and liabilities recognized for financial reporting purposes and
such amounts recognized for tax purposes.
Prior to converting to a C corporation, SunCare, formerly known as Golden
Care, had elected S corporation status whereby income taxes are paid by the
stockholders rather than by the entity. Accordingly, there is a pro forma
provision of $230,000 in 1995 for income taxes for this entity equal to the
Federal and state income tax provisions that would have been recorded if this
entity had been a C corporation for all of 1995 (see Note 2).
(m) CUMULATIVE TRANSLATION ADJUSTMENT
The financial position and results of operations of the Company's foreign
subsidiaries are measured using local currency as the functional currency.
Assets and liabilities of these subsidiaries are translated at the exchange rate
in effect at each year end. Statement of earnings accounts are translated at the
average rate of exchange prevailing during the year. Translation adjustments
arising from differences in exchange rates from period to period are included in
the cumulative translation adjustment account in stockholders' equity.
(n) STOCK-BASED COMPENSATION
The Company accounts for stock-based compensation using the intrinsic value
method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issued to Employees," and related Interpretations. Accordingly,
compensation cost for stock options is measured as the excess, if any, of the
quoted market price of the Company's stock at the date of the grant over the
amount an employee must pay to acquire the stock. Statement of Financial
Accounting Standards No. 123 "Accounting for Stock-
F-11
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(1) SUMMARY OF SIGNIFICANT ACCOUNTING AND FINANCIAL REPORTING POLICIES
(CONTINUED)
Based Compensation" ("SFAS 123") was issued in 1995 and the Company has adopted
the disclosure requirements of SFAS 123 (see Note 11).
(o) NET EARNINGS (LOSS) PER SHARE
Basic net earnings (loss) per share is based upon the weighted average
number of common shares outstanding during the period.
Diluted net earnings per share in periods of earnings is based upon the
weighted average number of common shares outstanding during the period plus the
number of incremental shares of common stock contingently issuable upon exercise
of stock options and, if dilutive, including the assumption that the Company's
convertible debentures were converted as of the beginning of the period. Net
earnings, if conversion of the debentures is assumed, is adjusted for the
interest on the debentures, net of interest related to additional assumed
borrowings to fund the cash consideration on conversion of certain convertible
debentures and the related income tax benefits. In periods of loss, diluted net
earnings per share is based upon the weighted average number of common shares
outstanding during the period. See Note 12 for calculation of earnings per share
data for the years ended December 31, 1997, 1996 and 1995.
The Company adopted Statement of Financial Accounting Standards No. 128
"Earnings per Share" ("SFAS 128") in 1997. All prior period earnings per common
share data have been restated to conform to the provisions of this statement.
(p) FINANCIAL STATEMENT PREPARATION AND PRESENTATION
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities, the
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. Actual results could differ from those estimates.
Certain amounts in the 1996 and 1995 consolidated financial statements and
notes have been reclassified to conform to the 1997 presentation.
(2) MERGERS AND ACQUISITIONS
In October 1997, the Company acquired the capital stock of Regency Health
Services, Inc. ("Regency"), an operator of skilled nursing facilities and a
provider of related specialty healthcare services, including rehabilitation
therapy, pharmacy and home health services in the United States. Total
consideration for the shares acquired was approximately $350.6 million. The
total fair value of Regency's assets acquired, including goodwill of
approximately $422.6 million, was approximately $661.9 million, and liabilities
assumed totaled approximately $370.4 million.
On October 9, 1997, the Company, completed a tender offer for 100%, or $50.0
million, of Regency's 12.25% Junior Subordinated Notes due 2003 for
approximately $60.1 million plus accrued interest, and $109.6 million of the
$110.0 million of Regency's 9.875% Senior Subordinated Notes due 2002 for
approximately $122.0 million plus accrued interest. As a result of the
repurchase of this debt, the Company recorded an extraordinary loss of $17.9
million, net of the related tax benefit, in the fourth quarter of 1997. In
addition, the Company repaid Regency's revolving credit facility of
approximately $39.0 million. In addition, the extinguishment of certain Regency
debt during the fourth quarter of 1997 resulted in an
F-12
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(2) MERGERS AND ACQUISITIONS (CONTINUED)
increase in certain reimbursable costs from Medicare. As a result, the Company
recognized $4.0 million of revenues from Medicare during 1997.
The acquisition of Regency, including certain transaction costs, and the
tender offer for its debt, described above, were financed by borrowings under
the Company's Credit Facility (as described below) and approximately $83.6
million of net proceeds received from the sale and leaseback of 30 facilities
owned by Regency prior to its acquisition by the Company.
The acquisition of Regency was accounted for as a purchase and the operating
results of Regency have been included in the consolidated statements of earnings
from the date of acquisition. The following unaudited pro forma results assume
that the acquisition occurred as of January 1, 1996 (in thousands, except per
share data):
1997 1996
------------ ------------
Net revenues.................................................... $ 2,500,832 $ 1,874,358
Net earnings (loss) from continuing operations.................. 33,531 (6,895)
Net earnings (loss)............................................. 13,603 (6,895)
Net earnings per share from continuing operations:
Net earnings (loss) from continuing operations:
Basic....................................................... 0.72 (0.15)
Diluted..................................................... 0.71 (0.15)
Net earnings (loss):
Basic and Diluted............................................. 0.29 (0.15)
The allocation of the purchase price of Regency is preliminary and will be
finalized upon completion of asset valuations. In addition, the Company is still
evaluating certain obligations of Regency prior to the merger and further
adjustments to the preliminary purchase price allocation may result.
The Company agreed in February 1997, to acquire Retirement Care Associates,
Inc. ("Retirement Care"), an operator of skilled nursing facilities and assisted
living centers. Retirement Care also owns (and the Company would acquire)
approximately 65% of Contour Medical, Inc. ("Contour"), a national provider of
medical/surgical supplies. The amended terms of the merger (the "RCA Merger")
provide for a purchase price of approximately $156.3 million in common stock
(based upon the closing price of the Company's common stock as of December 31,
1997) and the assumption of approximately $192.9 million of indebtedness
including $19.8 million of indebtedness which will be eliminated in
consolidation (based on Retirement Care's December 31, 1997 balance sheet).
Specifically, the agreements, as amended, call for the Company to issue shares
of common stock having a value equal to $10.00 in exchange for each outstanding
share of Retirement Care's common stock (subject to a 10% collar centered on a
$22.00 share price for the Company's common stock). The Company expects that the
RCA Merger will be accounted for as a pooling of interests. The Company has also
agreed to acquire the remaining 35% of Contour not presently owned by Retirement
Care for approximately $35 million, payable in common stock or cash, at the
option of the Company (the "Contour Merger"). The Contour Merger will be
accounted for as a purchase.
Costs to be incurred in connection with the mergers of Retirement Care and
Contour are expected to be significant and will be charged against earnings of
the combined company. The charge is currently estimated to be approximately $30
million for transaction costs and integration expenses, including elimination of
redundant corporate functions, severance costs related to headcount reductions,
write-off of
F-13
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(2) MERGERS AND ACQUISITIONS (CONTINUED)
certain intangibles and property and equipment and the settlement of certain
class action lawsuits (described below). Approximately $25 million of these
estimated charges are expected to be charged to operations in the fiscal quarter
in which the merger with Retirement Care is consummated. Approximately $5
million of the estimated charges relating to the integration expenses are
expected to be expensed as incurred as these costs will benefit future combined
operations. These amounts are preliminary estimates only and are, therefore,
subject to change. In addition, there can be no assurance that the Company will
not incur additional charges in subsequent quarters to reflect costs associated
with the RCA Merger and the Contour Merger.
On January 10, 1997, the Company loaned Retirement Care $9.8 million in
order to enable Retirement Care to cause the repayment of certain indebtedness
incurred by Contour in connection with Contour's acquisition of Atlantic Medical
Supply Company, Inc. ("Atlantic") on August 6, 1996. On July 10, 1997, the
Company and Retirement Care amended the terms of the loan to: (i) increase the
applicable interest rate by 2.0%; (ii) extend the maturity date to 120 days
after the termination of the Retirement Care Merger Agreement; and (iii) replace
the collateral securing the loan with a second lien on all of Retirement Care's
accounts receivable. Consistent with Retirement Care's bank line of credit, the
loan is unconditionally and irrevocably guaranteed by certain officers of
Retirement Care. On July 10, 1997, the Company also agreed to loan Retirement
Care an additional $5.0 million which is also secured by a second lien on all of
Retirement Care's accounts receivable and is unconditionally and irrevocably
guaranteed by certain officers of Retirement Care. The interest receivable
related to the promissory notes was $1.0 million as of December 31, 1997. As of
December 31, 1997, Retirement Care owed the Company an additional $12.4 million
in the form of unsecured trade receivables in respect to ancillary and
management services provided by the Company.
In December 1997, the Company purchased from a third party $5.0 million
aggregate principal amount of 9% Contour convertible debentures which are
convertible into one million shares of Contour common stock, for an aggregate
purchase price of $8.4 million in cash.
On November 25, 1997 the Company, Retirement Care and representatives of the
plaintiffs in certain pending class actions against Retirement Care and its
management reached an agreement in principle to settle these class actions for
$9.0 million. In connection with the agreement in principle, the Company has
escrowed on behalf of the defendants the settlement amount into an escrow fund
which is included in short-term restricted cash as of December 31, 1997. The
settlement is contingent upon the closing of the RCA Merger and is subject to,
among other things, confirmatory discovery, the execution of definitive
documentation and court approval.
On January 30, 1997, the Company acquired all of the capital stock not
previously owned by the Company of Ashbourne PLC ("Ashbourne") which as of the
date of acquisition provided healthcare services to patients through 49 nursing
facilities in the United Kingdom. Pursuant to the acquisition, the Company paid
approximately L67.3 million ($110.1 million as of the respective dates of
payment) for the portion of Ashbourne totaling 70.8% not previously owned by the
Company. The Company had previously acquired a 9% minority interest for $10.2
million in 1996 and a 20% minority interest for $25.9 million in 1995. The
acquisition was accounted for as a purchase and Ashbourne's results of
operations have been included in the Company's financial statements from the
date of acquisition on January 30, 1997. The total fair value of 100% of
Ashbourne's assets acquired, including goodwill of approximately $61.3 million,
was approximately $300.0 million and liabilities assumed totaled approximately
$147.7 million.
F-14
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(2) MERGERS AND ACQUISITIONS (CONTINUED)
In July 1997, the Company acquired a majority interest in Eurosar, S.A.
("Eurosar"), a privately owned operator of eight nursing homes in Spain. In
August 1997, the Company acquired 38% of the equity of Alpha Healthcare Limited,
a publicly held acute care provider in Australia. In addition, in November 1997,
Sun acquired from Moran Healthcare Group Pty Ltd. ("Moran") a majority interest
in six hospitals in Australia. In December 1997, the Company acquired a majority
interest in Heim-Plan Unternehmensgruppe ("Heim-Plan"), an operator of 11
nursing homes in Germany.
On December 15, 1996, the Company acquired all of the capital stock of APTA
Healthcare PLC ("APTA"), which provided healthcare services to patients through
32 nursing facilities in the United Kingdom. The Company paid cash totaling
approximately L11.3 million ($19.3 million as of the respective dates of
payment) to former stockholders of APTA and issued notes with a maturity not to
exceed five years, totaling approximately L2.5 million ($4.0 million as of
December 31, 1997) to the remaining stockholders of APTA who elected not to
receive cash as consideration. The fair market value of assets acquired,
including goodwill of $17.9 million, was $72.7 million and liabilities assumed
totaled $49.2 million. Also in 1996, the Company purchased a 9.9% investment in
OmniCell Technologies, Inc. ("OmniCell") for $25.3 million.
On June 21, 1995, the Company merged with and into CareerStaff Unlimited,
Inc. ("CareerStaff"). CareerStaff provides temporary staffing of physical,
occupational and speech therapists to the healthcare industry. Under the terms
of the merger agreement, the Company issued 6,080,600 shares of its common stock
in exchange for all the outstanding common stock of CareerStaff. The merger was
accounted for as a pooling of interests and, accordingly, the Company's
financial statements have been restated to include the accounts and operations
of CareerStaff for periods prior to the merger.
On May 5, 1995, the Company merged with and into SunCare. SunCare provides
respiratory therapy services to long-term and subacute care facilities. Under
the terms of the merger agreement, the Company issued 2,106,904 shares of its
common stock in exchange for all of the outstanding common stock of SunCare. In
connection with the merger, SunCare terminated its S corporation status and
recorded a deferred income tax provision of $1.5 million. The merger was
accounted for as a pooling of interests and, accordingly, the Company's
financial statements have been restated to include the accounts and operations
of SunCare for periods prior to the merger.
In connection with the mergers of the Company with CareerStaff and SunCare,
the Company recognized $5.8 million of merger costs. These costs include
transaction costs and advisory fees and transitional costs related to
consolidating operations.
Between 1995 and 1997, the Company acquired 80% of the common stock of
Columbia Health Care Inc. ("Columbia"), a provider of outpatient rehabilitation
therapy services in Canada, for $8.5 million. In addition, the Company issued
warrants to former owners of Columbia to purchase 500,000 shares of the
Company's common stock with an exercise price of $15.375 per share which had a
value of $1.1 million at the date of acquisition. As of December 31, 1997, the
warrants were exercisable and, if unexercised, will expire in approximately four
years. The Columbia acquisition was accounted for as a purchase.
The effects of the Company's acquisitions during 1997, 1996 and 1995,
excluding Regency, individually and in the aggregate, are immaterial to the
results of the Company and, therefore, pro forma information is not provided.
F-15
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(3) DISPOSITION
In May 1997, the Company announced its intent to sell and divest itself of
its outpatient rehabilitation clinics in the United States, as well as in
Canada. The sale of the United States operations is expected to close in the
first half of 1998, and to result in no material gain or loss. The Company
recorded a $7.0 million loss in 1997 in order to reduce the carrying value of
the Canadian operations to fair value based on revised estimates of selling
value and of costs to sell. The results of operations of these businesses are
immaterial.
In June 1996, the Company completed the sale of all of the outstanding stock
of SunSurgery Corporation, its ambulatory surgery subsidiary, for approximately
$27.9 million in cash and the assumption of $5.6 million in debt by the buyer.
As of the date of sale, SunSurgery Corporation had approximately $3.1 million in
cash which was retained by the buyer. The sale resulted in no material gain or
loss to the Company.
(4) PROPERTY AND EQUIPMENT
Property and equipment consists of the following as of December 31 (in
thousands):
1997 1996
---------- ----------
Land.................................................................. $ 64,280 $ 21,983
Buildings and improvements............................................ 368,350 148,530
Leasehold improvements................................................ 64,826 52,630
Equipment............................................................. 142,837 76,812
Construction in progress.............................................. 45,314 34,097
---------- ----------
Total............................................................... 685,607 334,052
Less accumulated depreciation and amortization........................ (54,505) (28,332)
---------- ----------
Property and equipment, net......................................... $ 631,102 $ 305,720
---------- ----------
---------- ----------
In 1997, the Company sold five of its long-term and subacute care facilities
in the United States for approximately $31.2 million in cash and approximately
$5.6 million in assumption of debt and leased them back under fourteen year
leases. Also in 1997, the Company sold 27 of its long-term care facilities in
the United Kingdom for approximately $49.3 million and leased them back under
twelve-year leases. These transactions produced no material gain or loss.
During 1996, the Company sold three of its long-term and subacute care
facilities for $11.9 million including the assumption of debt totaling $3.2
million and leased them back under fifteen year leases. Also during 1996, the
Company sold ten of its long-term care facilities in the United Kingdom for
$25.8 million and leased them back under twelve year leases. These transactions
produced no material gain or loss.
In 1995, the Company sold five of its long-term and subacute care facilities
for $70.0 million and leased them back under ten year leases. Also in 1995, the
Company sold fifteen of its long-term care facilities in the United Kingdom for
$35.5 million and leased them back under twelve year leases. These transactions
produced no material gain or loss.
F-16
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(5) ASSETS HELD FOR SALE
As a result of the acquisition of the Mediplex Group, Inc. ("Mediplex") in
1994, the Company acquired certain facilities providing psychiatric, substance
abuse and transitional living services. On September 30, 1995, the Company sold
five of the operating psychiatric care and substance abuse treatment facilities,
all of the related outpatient facilities and a transitional living facility for
a sales price of $39.9 million consisting of cash and the assumption of
indebtedness secured by one of the facilities. The sale of the transitional
living facility was completed in 1996 at a net cost to the Company of $3.8
million. As part of the sale, the Company provided a five-year $12.5 million
working capital line of credit to the buyer, which is secured by the accounts
receivable of the facilities sold and is restricted to a borrowing base
determined by the amount of accounts receivable of the facilities. Under the
terms of the working capital line of credit, principal is due in full on
September 30, 2000 and interest accrues at either LIBOR plus 2.5% or Prime plus
1.5%. As of December 31, 1997, $12.5 million had been advanced on the working
capital line of credit. In 1995, the Company subleased two operating
transitional living facilities and sold the working capital of these facilities
to the current administrator of one of these facilities, who has assumed
responsibility for approximately 60% of the Company's obligations under the
present leases and will pay the Company a total of $13.4 million over the term
of such leases. Also in 1995, the Company completed the sale of two of the
closed facilities for $2.0 million and $2.5 million, respectively. As of
December 31, 1997, the Company continues to own an interest in a substance abuse
facility which was closed in 1992.
F-17
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(6) LONG-TERM DEBT
Long-term debt consists of the following as of December 31 (dollars in
thousands):
1997 1996
------------ ------------
Revolving Credit Facility (see below)................................................. $ 275,075 $ 279,300
Credit Facility Term Loans (see below)................................................ 700,000 --
Senior Subordinated Notes due 2007, interest at 9 1/2% per annum...................... 250,000 --
Convertible Subordinated Debentures due 2004, interest at 6% per annum................ 83,300 83,300
Convertible Subordinated Debentures due 2003, interest at 6 1/2% per annum, includes
unamortized premium of $2,314 and $2,728 as of December 31, 1997 and 1996,
respectively........................................................................ 23,029 25,137
Senior Subordinated Notes due 2002, interest at 11 3/4% per annum, includes
unamortized premium of $122 and $126 as of December 31, 1997 and 1996,
respectively........................................................................ 6,283 6,287
Mortgage notes payable due at various dates through 2005, interest at rates from 8.5%
to 14%, collateralized by various facilities........................................ 45,285 38,939
Mortgage notes payable in Spanish pesetas and due at various dates through 2017,
interest at rates from 5.6% to 13.3%, collateralized by various facilities in
Spain............................................................................... 13,498 --
Mortgage notes payable in pound sterling and due at various dates through 2017,
interest at rates from 2.5% to 4% plus the FHBR rate ("Finance House Base Rate"),
collateralized by various facilities in the United Kingdom.......................... 8,904 31,543
Mortgage notes payable in German marks and due at various dates through 2022, interest
at rates from 8.5% to 9%, collateralized by various facilities in Germany........... 7,778 --
Revolving lines of credit with a bank due 1997, payable in pound sterling, interest at
rates from 8.7% to 9% plus the FHBR rate, collateralized by the assets of various
facilities.......................................................................... 90,473 20,309
Other long-term debt.................................................................. 42,053 3,387
------------ ------------
Total long-term debt................................................................ 1,545,678 488,202
Less current portion.................................................................. (56,817) (27,701)
------------ ------------
Long-term debt, net of current portion.............................................. $ 1,488,861 $ 460,501
------------ ------------
------------ ------------
Annual maturities for the next five years as of December 31, 1997 are as
follows (in thousands):
1998........................................................ $ 56,817
1999........................................................ 33,351
2000........................................................ 40,565
2001........................................................ 49,357
2002........................................................ 65,583
Thereafter.................................................. 1,300,005
------------
$ 1,545,678
------------
------------
F-18
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(6) LONG-TERM DEBT (CONTINUED)
On July 8, 1997, the Company issued $250 million aggregate principal amount
of 9 1/2% Senior Subordinated Notes due 2007 (the "9 1/2% Notes"). The net
proceeds from the sale, approximately $243 million, were used to reduce
outstanding borrowings under the Company's credit facility. The 9 1/2% Notes,
which are subject to customary terms and covenants, are redeemable by the
Company at a premium, in whole or in part, after July 1, 2002.
On October 8, 1997, the Company entered into a Credit Agreement with certain
lenders, certain co-agents, and NationsBank of Texas, N.A. as administrative
lender to replace the Company's old revolving credit facility. On November 12,
1997, the Company entered into a First Amendment to Credit Agreement (the
"Credit Facility"). The Credit Facility provides for borrowings by the Company
of up to $1.2 billion consisting of $500 million in a revolving credit facility
which borrowings bear interest at the prevailing prime rate plus 0% to 1% or the
LIBOR rate plus .75% to 2.50%, and $700 million in term loans which bear
interest at the prevailing prime rate plus 0% to 1.5% or the LIBOR rate plus
.75% to 3.0%. One month LIBOR was 5.7% as of December 31, 1997. The revolving
credit facility matures in November 2003 and the term loans begin amortization
in March 1998 and reach final maturity in November 2005. In connection with this
refinancing, the Company recorded an extraordinary loss of $2.1 million, net of
the related tax benefit, in the fourth quarter of 1997. The Credit Facility,
among other things, (i) requires the Company to maintain certain financial
ratios, (ii) restricts the Company's ability to incur debt and liens, make
investments, liquidate or dispose of assets, merge with another corporation,
create or acquire subsidiaries, and make acquisitions, and (iii) prohibits the
payment of dividends, the acquisition of treasury stock and the prepayment or
modification of certain debts of the Company. The Credit Facility is
collateralized by a pledge of the stock of the majority of the Company's
subsidiaries. The Company had borrowings of $275.1 million outstanding under the
revolving Credit Facility, $700.0 million outstanding in term loans, and $40.2
million of outstanding standby letters of credit under the Credit Facility as of
December 31, 1997.
Holders of the 6 1/2% Convertible Subordinated Debentures due 2003 (the
"6 1/2% Debentures") are entitled under the indenture to receive the Mediplex
acquisition consideration in respect of each share of Mediplex common stock into
which the 6 1/2% Debentures would have been convertible at the time of the
acquisition of Mediplex. The Company has agreed to be a co-obligor of the 6 1/2%
Debentures. In January 1995, $39.4 million of the 6 1/2% Debentures were
converted. Pursuant to the conversion terms under the indenture, the Company
paid $13.6 million and issued 1,582,905 shares of the Company's common stock to
the converting holder. In addition, the Company paid accrued interest plus a
conversion fee of $3.3 million to the converting holder, which was expensed in
the first quarter of 1995, to induce conversion. Conversion of the remaining
$20.7 million of outstanding 6 1/2% Debentures would require the issuance of an
additional 831,197 shares of the Company's common stock and a payment of $7.1
million in cash pursuant to the conversion terms under the indenture relating to
the 6 1/2% Debentures.
In January 1995, the Company completed a tender offer for $78.7 million of
the 11 3/4% Senior Subordinated Notes due 2002 (the "11 3/4% Notes") at a price
of $1,120 per $1,000 of principal amount of the notes. The Company recorded an
extraordinary loss, net of the related tax benefit, of $3.4 million as a result
of the extinguishment of such debt. Concurrent with the tender offer, the
Company deleted by amendment certain covenants contained in the original
indenture that restricted the Company from fully integrating Mediplex into its
operations. In addition, the amendments modified certain provisions relating to
mergers and consolidations and events of default. In conjunction with the
amendments, the Company became a co-obligor on the 11 3/4% Notes.
F-19
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(6) LONG-TERM DEBT (CONTINUED)
In 1994, the Company issued $83.3 million aggregate principal amount of 6%
Convertible Subordinated Debentures due 2004 which are convertible into shares
of the Company's common stock at a conversion price of $21.84 or 3,814,102
shares of the Company's common stock.
The Company has $32.3 million of mortgages with Meditrust as of December 31,
1997 which contain less restrictive covenants than the Credit Facility and which
include cross default provisions with all of such mortgages and leases also
financed by Meditrust. The Company also is the obligor on an outstanding letter
of credit with a bank of $3.8 million as of December 31, 1997 to guarantee
outstanding debt obligations for a partnership through which the Company
acquired a 50% interest. The partnership owns a long-term care facility which is
leased to a third-party operator.
(7) COMMITMENTS AND CONTINGENCIES
(a) LEASE COMMITMENTS
The Company has various noncancelable operating leases for facilities with
initial lease terms generally ranging from 5 to 23 years and renewal options of
5 to 40 years. Certain of the lease agreements provide for payment escalations
coincident with increases in certain economic indices.
The Company has various facilities and equipment under capital lease
agreements. Property and equipment, net includes the following amounts for
assets held under capital leases as of December 31 (in thousands):
1997 1996
--------- ---------
Land..................................................................... $ 7,282 $ 2,154
Building and improvements................................................ 65,536 19,383
Equipment................................................................ 6,409 3,912
--------- ---------
Total.................................................................. 79,227 25,449
Less accumulated depreciation............................................ (5,208) (785)
--------- ---------
Property and equipment, net............................................ $ 74,019 $ 24,664
--------- ---------
--------- ---------
Future minimum lease payments under noncancelable leases as of December 31,
1997 are as follows (in thousands):
CAPITAL OPERATING
LEASES LEASES
----------- -----------
1998................................................................ $ 9,237 $ 122,921
1999................................................................ 8,785 122,468
2000................................................................ 8,588 121,514
2001................................................................ 8,809 115,709
2002................................................................ 8,425 113,291
Thereafter.......................................................... 263,536 730,958
----------- -----------
Total minimum lease payments...................................... 307,380 $ 1,326,861
-----------
-----------
Less amount representing interest................................... (226,216)
-----------
Present value of net minimum lease payments under capital
leases.......................................................... $ 81,164
-----------
-----------
F-20
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(7) COMMITMENTS AND CONTINGENCIES (CONTINUED)
Rent expense under operating leases totaled $143.9 million, $91.7 million,
and $73.7 million in 1997, 1996 and 1995, respectively.
The Company leases or subleases 63 facilities from affiliates of two
directors of the Company as of December 31, 1997, which is included in the
information above. The aggregate lease expense for these facilities was
approximately $20.2 million, $16.7 million, and $13.8 million in 1997, 1996 and
1995, respectively. Future minimum lease commitments related to these facilities
total approximately $177.3 million at December 31, 1997. The Company's
management believes the terms of all of the foregoing leases are as favorable to
the Company as those that could have been obtained from nonrelated parties.
(b) CONSTRUCTION COMMITMENTS
The Company had capital commitments, as of December 31, 1997, under various
contracts, including approximately $25.9 million in the United States and L1.0
million ($1.6 million as of December 31, 1997) in the United Kingdom. These
include contractual commitments to improve existing facilities and to develop,
construct and complete a corporate office building and a long-term care facility
in the United States and two long-term care facilities in the United Kingdom.
(c) FINANCING COMMITMENTS
The Company has advanced $32.8 million and expects to lend up to a total of
$47.0 million under a revolving subordinated credit agreement ("Financing
Facility") to a developer of assisted living facilities for the development,
construction and operation of assisted living facilities. Any advances under the
Financing Facility have been and are expected to be funded by borrowings under
the Company's credit facility and will be subject to certain conditions,
including the approval of each project by the Company. The developer has
obtained a commitment for mortgage financing to fund 50% of the cost of each
project. The Company's advances under the Financing Facility are subordinate to
the mortgage financing. The Financing Facility with respect to each assisted
living facility bears interest at 9% or 13% depending on the percentage of
completion of the facility under construction. All amounts advanced are due in
full on November 1, 2001. The advances to the developer totaled approximately
$32.8 million and $9.0 million at December 31, 1997 and 1996, respectively. As
of December 31, 1997, five assisted living facilities were under development.
Construction was completed on one facility in 1997. In addition, the Company has
entered into a purchase option agreement with the developer whereby the Company
will pay the developer $50,000 for each option to purchase any of the
facilities. The option will grant the Company the right to purchase the
facility, after a specified time period, at the greater of the estimated fair
market value of the property or the total amount invested by the developer.
(d) LITIGATION
The Company is a party to various legal actions and administrative
proceedings and subject to various claims arising in the ordinary course of
business (see Notes 1(j) and 14).
F-21
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(8) INCOME TAXES
Income tax expense (benefit) on earnings (loss) before extraordinary loss
consists of the following for the year ended December 31 (in thousands):
1997 1996 1995
--------- --------- ---------
Current:
Federal.................................................... $ 18,441 $ 12,790 $ (212)
State...................................................... 5,918 4,835 (102)
--------- --------- ---------
24,359 17,625 (314)
--------- --------- ---------
Deferred:
Federal.................................................... 13,604 11,037 27,744
State...................................................... 3,190 2,268 5,702
--------- --------- ---------
16,794 13,305 33,446
--------- --------- ---------
Total.................................................... $ 41,153 $ 30,930 $ 33,132
--------- --------- ---------
--------- --------- ---------
Actual tax expense differs from the "expected" tax expense on earnings
before extraordinary loss, computed by applying the U.S. Federal corporate
income tax rate of 35% to earnings before income taxes and extraordinary loss of
the Company as follows for the year ended December 31 (in thousands):
1997 1996 1995
--------- --------- ---------
Computed "expected" tax expense.................................................. $ 33,559 $ 18,363 $ 4,478
Adjustments in income taxes resulting from:
Amortization of goodwill....................................................... 3,765 3,045 3,235
Impairment loss................................................................ -- -- 15,452
Increase in valuation allowance................................................ 2,450 7,615 3,038
Conversion fee................................................................. -- -- 1,139
Merger expenses................................................................ -- -- 1,199
S corporation earnings not taxable to the Company (at Federal rates)........... -- -- (230)
State income tax expense, net of Federal income tax benefit.................... 3,041 4,617 3,332
Loss on sale of subsidiary stock............................................... -- (2,458) --
Recognition of deferred income taxes for former S corporations................. -- -- 1,487
Other.......................................................................... (1,662) (252) 2
--------- --------- ---------
$ 41,153 $ 30,930 $ 33,132
--------- --------- ---------
--------- --------- ---------
F-22
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(8) INCOME TAXES (CONTINUED)
Deferred tax assets (liabilities) were comprised of the following as of
December 31 (in thousands):
1997 1996
---------- ----------
Deferred tax assets:
Accounts receivable..................................................................... $ -- $ 8,045
Accrued liabilities..................................................................... 22,057 3,629
Property and equipment.................................................................. -- 3,270
Intangible assets....................................................................... 18,175 8,154
Carryforward of deductions limited by Internal Revenue Code Section 382................. 6,250 9,222
Write-down of assets held for sale and reserve for estimated costs of disposal and
future operating losses............................................................... 6,513 5,714
Deferred income......................................................................... 2,840 2,275
Shareholder settlement.................................................................. 1,051 7,571
Alternative minimum tax credit.......................................................... 3,453 425
Jobs credit carryforwards............................................................... 3,477 --
Capital loss carryforwards.............................................................. 4,023 1,573
State net operating loss carryforwards.................................................. 7,313 5,156
United Kingdom trading loss carryforwards............................................... 7,895 --
Other................................................................................... 2,676 523
---------- ----------
85,723 55,557
---------- ----------
Less valuation allowance:
Federal................................................................................. (31,195) (24,843)
State................................................................................... (5,115) (3,810)
---------- ----------
(36,310) (28,653)
---------- ----------
Total deferred tax assets................................................................. 49,413 26,904
---------- ----------
Deferred tax liabilities:
Property and equipment attributable to United Kingdom operations........................ (15,234) (4,760)
Property and equipment attributable to United States operations......................... (989) --
Accounts receivable..................................................................... (1,527) --
Partnership investments................................................................. (522) --
Changes in certain subsidiaries' methods of accounting for income taxes from cash to
accrual basis......................................................................... (370) (1,191)
Other................................................................................... (2,468) --
---------- ----------
(21,110) (5,951)
---------- ----------
Deferred tax asset, net................................................................... $ 28,303 $ 20,953
---------- ----------
---------- ----------
Various subsidiaries have state net operating loss ("NOL") carryforwards
totaling $138.1 million with expiration dates through the year 2012. In
addition, the Company has capital loss carryforwards of approximately $11.0
million of which $4.0 million will expire in 2001 and $7.0 million will expire
in 2003. United Kingdom trading loss carryforwards of $25.5 million and the
alternative minimum tax credit carryforwards of $3.5 million have no expiration
dates. The $3.5 million of jobs tax credit carryforwards will
F-23
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(8) INCOME TAXES (CONTINUED)
expire beginning in 2007. Because there is a risk that certain of these NOL and
capital loss carryforwards may expire unutilized, a valuation allowance has been
established against them.
In connection with the deferred tax assets acquired in the acquisition of
Mediplex, the Company recorded an $18.0 million valuation allowance. The Company
recorded a $5.2 million valuation allowance in the current year related to the
deferred tax assets acquired in the acquisition of Regency. Accordingly, any tax
benefits recognized in future periods attributable to these portions of the
valuation allowance will be allocated to reduce goodwill. The additional $2.5
million increase in the valuation allowance in 1997 relates to the realizability
of capital loss carryforwards.
Upon merging with the Company on May 5, 1995, SunCare terminated its S
Corporation status for Federal and state income tax purposes. In connection with
this termination, the Company recorded a deferred income tax provision and
liability of $1.5 million.
(9) SUPPLEMENTARY INFORMATION RELATING TO STATEMENTS OF CASH FLOWS
Supplementary information for the consolidated statements of cash flows is
set forth below for the year ended December 31 (in thousands):
1997 1996 1995
--------- --------- ---------
Cash paid during the year ended December 31 for:
Interest, net of $2,023, $2,472 and $2,839 capitalized
during 1997, 1996 and 1995, respectively................. $ 68,814 $ 26,821 $ 26,951
Income taxes............................................... 8,553 7,608 12,150
The Company's acquisitions during 1997, 1996 and 1995 involved the following
for the year ended December 31 (in thousands):
1997 1996 1995
------------ ---------- ---------
Fair value of assets acquired............................ $ 1,159,012 $ 145,652 $ 66,575
Liabilities assumed...................................... (613,988) (55,741) (9,079)
Cash payments or payables to former APTA shareholders.... 19,300 (23,545) --
Fair value of stock and warrants issued.................. (190) (961) (9,329)
------------ ---------- ---------
Cash payments made, net of cash received from others..... $ 564,134 $ 65,405 $ 48,167
------------ ---------- ---------
------------ ---------- ---------
In January 1995, the Company issued 1,582,905 shares of its common stock
upon the conversion of $39.4 million principal amount of 6 1/2% Debentures (see
Note 6).
F-24
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(10) FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair values of the Company's financial instruments as of
December 31 are as follows (in thousands):
1997 1996
-------------------------- ----------------------
CARRYING CARRYING
AMOUNT FAIR VALUE AMOUNT FAIR VALUE
------------ ------------ ---------- ----------
Cash and cash equivalents.................................... $ 21,020 $ 21,020 $ 14,880 $ 14,880
Long-term debt and capital lease obligations including
current portion............................................ 1,626,842 1,640,814 512,435 510,400
The cash and cash equivalents carrying amount approximates fair value
because of the short maturity of these instruments. The fair value of the
Company's long-term debt was estimated based on the quoted market prices for the
same or similar issues or on the current rates offered to the Company for debt
of the same remaining maturities.
(11) CAPITAL STOCK
(a) COMMON STOCK REPURCHASE
In the first quarter of 1996, the Company repurchased 2,030,116 shares of
its outstanding common stock at a cost, including commissions, of $25.1 million.
In 1997, the Company repurchased 23,091 shares of its outstanding common stock
at a cost of $.5 million.
(b) STOCK OPTION PLANS
STOCK INCENTIVE PLANS
The Company has stock incentive plans for certain employees, officers, and
consultants of the Company. Awards made under the plans may be in the form of
stock options, stock appreciation rights, stock awards, performance share
awards, or other stock-based awards. The Board of Directors or a committee
appointed by the Board of Directors determines the vesting schedule and the
option price which is generally not to be less than the fair market value per
share of the Company's common stock at the date of grant. Options granted prior
to March 1996 generally vest at the end of three years and expire ten years from
the date of grant. Options granted during and after March 1996 generally vest
ratably over three years and expire ten years from the date of grant. At
December 31, 1997, options for 3,123,124 shares were outstanding, options for
1,051,260 shares were vested and 3,589,500 shares were available for future
grants under the stock incentive plans for officers, certain employees, and
consultants. Exercise prices of outstanding options to purchase shares of the
Company's common stock range from $9.50 to $24.00. During the year ended
December 31, 1997, the Company awarded an aggregate of 783,000 shares of
restricted stock to ten senior executives which will be expensed over the
vesting period. As of December 31, 1997, 106,800 of the restricted shares have
vested and the remainder vest ratably over four to five years.
DIRECTOR STOCK INCENTIVE PLANS
The Company has stock incentive plans for nonemployee directors, which
provide for the grant of nonqualified options, stock appreciation rights, stock
awards, performance share awards, or other stock-
F-25
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(11) CAPITAL STOCK (CONTINUED)
based awards. Beginning in 1997, all nonemployee directors will receive an
annual grant of options for 4,000 shares at a price not less than fair market
value of the Company's common stock at the date of grant and an annual grant of
2,000 restricted stock awards. All awards vest ratably over three years and
stock option awards expire ten years after the date of grant. Exercise prices of
outstanding options to purchase shares of common stock range from $9.50 to
$21.88. Nonemployee directors have the option of electing to receive a portion
of their annual board compensation in the form of restricted stock awards which
vest in quarterly increments over one year. During the year ended December 31,
1997, the Company awarded an aggregate of 15,080 shares of restricted stock to
nonemployee directors which will be expensed over the vesting period. As of
December 31, 1997, 770 of the restricted shares are vested and the remainder
vest ratably over one to three years. As of December 31, 1997, options for
110,500 shares were outstanding, options for 67,000 shares have vested and
360,920 shares were available for future grant under the stock incentive plans
for nonemployee directors.
The following is a summary of the status of the Company's Stock Incentive
Plans, the Director Stock Incentive Plans and assumed option plans from
acquisitions as of December 31, 1997, 1996 and 1995, and changes during the
years ending on those dates is presented below (shares in thousands):
1997 1996 1995
-------------------------- -------------------------- --------------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
----------- ------------- ----------- ------------- ----------- -------------
Outstanding at beginning of year......... 3,348 $ 15.91 3,648 $ 16.12 3,007 $ 15.79
Granted
Price equals fair value................ 814 18.06 441 13.74 1,508 16.82
Price is less than fair value.......... -- -- 15 11.00 23 11.00
Exercised................................ (487) 11.25 (106) 11.09 (283) 12.78
Cancelled................................ (336) 17.28 (650) 16.54 (607) 17.07
----- ----- -----
Outstanding at year-end.................. 3,339 16.90 3,348 15.91 3,648 16.12
----- ----- -----
----- ----- -----
Options exercisable at year-end.......... 1,210 17.25 796 11.53 628 11.62
----- ----- -----
----- ----- -----
Options available for future grant....... 3,950 3,022 330
----- ----- -----
----- ----- -----
Weighted average fair value of options
granted during the year................ $ 5.89 $ 5.41 $ 7.04
----- ----- -----
----- ----- -----
The fair value of each option granted in 1997, 1996 and 1995 is estimated at
the date of grant using the Black-Scholes option pricing model with the
following weighted-average assumptions:
1997 1996 1995
--------- --------- ---------
Expected Life (in years).............................................. 4 4 4
Risk-free Interest Rate............................................... 6.26% 5.37% 6.22%
Expected Volatility................................................... 42% 41% 41%
Dividend Yield........................................................ -- -- --
F-26
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(11) CAPITAL STOCK (CONTINUED)
Had compensation cost for the Company's 1997, 1996 and 1995 option grants
been determined consistent with SFAS 123 (see Note 1(n)) which establishes fair
value as the measurement basis for stock-based awards, the Company's net
earnings and net earnings per share for 1997, 1996 and 1995 would approximate
the pro forma amounts below (in thousands, except per share data):
1997 1996 1995
------------------------ ------------------------ ------------------------
AS REPORTED PRO FORMA AS REPORTED PRO FORMA AS REPORTED PRO FORMA
----------- ----------- ----------- ----------- ----------- -----------
Net earnings (loss)................. $ 34,801 $ 32,804 $ 21,536 $ 19,548 $ (23,751) $ (25,229)
Net earnings (loss) per share:
Basic............................. $ 0.75 $ 0.71 $ 0.46 $ 0.42 $ (0.51) $ (0.53)
Diluted........................... $ 0.74 $ 0.70 $ 0.46 $ 0.42 $ (0.51) $ (0.53)
The effects of applying SFAS 123 in this pro forma disclosure are not
indicative of future amounts. SFAS 123 does not apply to options granted prior
to 1995, and additional option grants in future years are anticipated.
The following table summarizes information about stock options outstanding
as of December 31, 1997 (shares in thousands):
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------------------- ----------------------------
WEIGHTED WEIGHTED
WEIGHTED AVERAGE AVERAGE AVERAGE
NUMBER REMAINING EXERCISE NUMBER EXERCISE
RANGE OF EXERCISE PRICE OUTSTANDING CONTRACTUAL LIFE PRICE OUTSTANDING PRICE
- -------------------------------------- ------------- ------------------- ------------- ------------- -------------
$ 7.75 - $10.13....................... 376 7.55 $ 9.45 34 $ 8.99
11.00 - 15.84....................... 1,090 7.66 13.60 395 12.35
16.07 - 19.00....................... 834 6.81 18.31 459 18.87
20.50 - 24.00....................... 1,039 8.05 21.92 322 21.78
----- --- ------ ----- ------
3,339 7.56 16.90 1,210 17.25
----- -----
----- -----
OPTIONS ISSUED IN CONNECTION WITH THE SUNCARE MERGER
During 1995, the Company issued options to purchase a total of 234,100
shares of the Company's common stock with a total exercise price of $.5 million
as part of the consideration in the Company's merger with SunCare. These options
represent 10% of the total shares of the Company's common stock issued in
connection with the SunCare merger. These options replaced options granted to an
employee in 1994 under an employment agreement in which former SunCare
stockholders granted an option to an employee to acquire 10% of their holdings.
All such options vested as of the date of the merger.
(c) GRANTOR STOCK TRUST
In the first quarter of 1996, the Company sold 3,050,000 newly issued shares
of the Company's common stock to a newly established Grantor Stock Trust
("Trust") for approximately $37.7 million. The Trust was created to fund future
obligations under certain of the Company's benefit plans, including, but not
limited to, stock option plans, a stock purchase plan, health insurance plans
and employee compensation. The sale of the shares to the Trust was recorded as
an increase in stockholders' equity with a
F-27
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(11) CAPITAL STOCK (CONTINUED)
corresponding reduction for the value of the shares held by the Trust. As stock
is released from the Trust to satisfy certain employee compensation and benefit
plans, the number and the related fair value of shares held by the Trust is
reduced and stockholders' equity correspondingly increases in accordance with
SOP 93-6. As of December 31, 1997, the Trust held 2,178,315 shares of the
Company's common stock.
The Trust delivered to the Company a promissory note for approximately $37.7
million. The cash portion of the purchase price of approximately $31,000
represents the par value of the shares of the Company's common stock sold to the
Trust. Amounts owed by the Trust will be repaid periodically with cash received
from the Company or will be forgiven by the Company thereby enabling the release
of shares from the Trust to satisfy the Company's obligations for certain
employee compensation and benefit plans.
(12) EARNINGS PER SHARE
Earnings per share is calculated as follows for the year ended December 31
(in thousands, except per share data):
1997 1996 1995(1)
--------- --------- ---------
BASIC:
Net earnings (loss) before extraordinary loss................................... $ 54,729 $ 21,536 $ (20,568)
Net earnings (loss)............................................................. 34,801 21,536 (23,981)
Weighted average shares outstanding............................................. 46,329 46,360 47,419
Earnings (loss) per share:
Net earnings (loss) before extraordinary loss................................. $ 1.18 $ 0.46 $ (0.43)
Net earnings (loss)........................................................... $ 0.75 $ 0.46 $ (0.51)
DILUTED:
Net earnings (loss) before extraordinary loss used in basic calculation......... $ 54,729 $ 21,536 $ (20,568)
Income impact of assumed conversions............................................ 3,410 -- --
--------- --------- ---------
Adjusted net earnings (loss) before extraordinary loss.......................... 58,139 21,536 (20,568)
Extraordinary loss.............................................................. 19,928 -- 3,413
--------- --------- ---------
Net earnings (loss)............................................................. $ 38,211 $ 21,536 $ (23,981)
--------- --------- ---------
--------- --------- ---------
Weighted average shares used in basic calculation............................... 46,329 46,360 47,419
Effect of dilutive securities:
Stock options and warrants.................................................... 832 508 --
Assumed conversion of convertible debt........................................ 4,690 -- --
--------- --------- ---------
Weighted average common and common equivalent shares outstanding................ 51,851 46,868 47,419
--------- --------- ---------
--------- --------- ---------
Earnings (loss) per share:
Net earnings (loss) before extraordinary loss................................. $ 1.12 $ 0.46 $ (0.43)
Net earnings (loss)........................................................... $ 0.74 $ 0.46 $ (0.51)
- ------------------------
(1) Results for the year ended December 31, 1995 represent pro forma amounts to
include pro forma taxes of SunCare prior to its conversion to be taxed as a
C Corporation, which occurred in May 1995 (See Note 1(l).
F-28
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(13) PREFERRED STOCK PURCHASE RIGHTS
On June 2, 1995, the Board of Directors declared a dividend of one preferred
stock purchase right ("Right") for each outstanding share of common stock of the
Company for stockholders of record on June 15, 1995 and for all future issuances
of common stock. The Rights are currently not exercisable or transferable apart
from the common stock and have no voting rights. Each Right entitles the
registered holder to purchase from the Company one one-hundredth of a share of
Series A Preferred Stock, par value $0.01 per share. The Rights become
exercisable ten business days following the date a person or group of affiliated
persons acquires 15% or more of the Company's common stock, or announces a
tender or exchange offer which would result in the beneficial ownership by a
person or group of affiliated persons of 15% or more of the outstanding
Company's common stock. The Rights also become exercisable if any person, who is
the beneficial owner of 15% or more of the Company's common stock as of the date
of record, acquires an additional 1% or more of the outstanding Company's common
stock. The Rights may be redeemed by the Company at a price of $.001 per Right
before their expiration on June 2, 2005.
In the event that the Company is acquired in a merger or other business
combination or certain other events occur, provision shall be made so that each
holder of a Right, excluding the Rights beneficially owned by the acquiring
persons, shall have the right to receive, upon exercise thereof at the then
current exercise price, that number of shares of common stock of the surviving
company which at the time of such transaction will have a market value of two
times the exercise price of the Right.
(14) OTHER EVENTS
(a) GOVERNMENT INVESTIGATION
In January 1995, the Company learned that it was the subject of a pending
Federal investigation. The investigating agencies are the United States
Department of Health and Human Services' Office of Inspector General ("OIG") and
the United States Department of Justice. At this time, the Company does not know
the full scope of the investigation. However, the Company currently believes
that the investigation is focused principally on whether the Company provided
and billed for unnecessary or unordered therapy services to residents of skilled
nursing facilities and whether the Company adequately documented the therapy
services which it provided.
In July 1997, the Criminal Division of the U.S. Department of Justice
informed the Company that it had completed its investigation of the Company, and
that it would not initiate any actions against the Company or any individuals.
The Investigation by the Civil Division of the Department of Justice and the OIG
is still proceeding. The government continues to collect information, and the
Company continues to cooperate with the investigators. The Company and the
government have had preliminary discussions, and the Company expects to have
continuing discussions, regarding a possible settlement of the investigation.
The Company is unable to determine at this time when the investigation will
be concluded, how large a monetary settlement the government may seek, the
nature of any other remedies that may be sought by the government, whether or
when a settlement will in fact occur or whether any such settlement or any other
outcome of the investigation will have a material adverse effect on the
Company's financial condition or results of operations. From time to time the
negative publicity surrounding the investigation has in the past adversely
affected the private pay enrollment in certain inpatient facilities and slowed
the Company's success in obtaining additional outside contracts in the
rehabilitation therapy business, which resulted in higher than required
therapist staffing levels. Negative publicity in the future could have a similar
effect.
F-29
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(14) OTHER EVENTS (CONTINUED)
(b) LITIGATION
Prior to the Company's acquisition of CareerStaff, a holder of CareerStaff's
common stock filed a lawsuit (the "CareerStaff Litigation") as a purported class
action against CareerStaff and the directors of CareerStaff alleging breach of
fiduciary duty in entering into a merger agreement with the Company and against
the Company alleging that the Company aided and abetted the alleged breach of
fiduciary duty by the CareerStaff directors. The CareerStaff Litigation was
voluntarily dismissed without prejudice on May 8, 1996.
On June 30, 1995, two civil class-action complaints were filed against the
Company and certain of its current and former directors and officers in the
United States District Court for the District of New Mexico. Two more
complaints, based on the same underlying events, were filed on August 30, 1995.
On October 6 and October 10, 1995, two additional complaints were filed, also
based on the same underlying events. These six complaints were consolidated by a
court order dated November 27, 1995 and an amended class action complaint,
captioned IN RE SUN HEALTHCARE GROUP, INC. LITIGATION (the "Complaint"), was
filed in the United States District Court for the District of New Mexico on
January 26, 1996. The Complaint was purportedly brought on behalf of all persons
who either purchased shares of the Company's common stock between October 26,
1994 and June 27, 1995, or who exchanged their shares of common stock of
CareerStaff for shares of the Company's common stock pursuant to merger
agreement between CareerStaff and the Company. The Complaints allege that
defendants misrepresented or failed to disclose material facts about the OIG
investigation and about the Company's operations and financial results, which
plaintiffs contend artificially inflated the price of the Company's securities.
In May 1997, the Company received court approval of the $24.0 million
settlement of certain class-action shareholder lawsuits which was previously
paid in the fourth quarter of 1996. The Company received $9.0 million during
March 1997, from its director and officer liability insurance carrier for its
claim submitted in connection with the settlement.
On or about January 23, 1996, two former stockholders of SunCare, John
Brennan and Susan Bird, filed a lawsuit (the "SunCare Litigation") against the
Company and certain of its officers and directors in the United States District
Court for the Southern District of Indiana. Plaintiffs allege, among other
things, that the Company did not disclose material facts concerning the
investigation by the OIG and that the Company's financial results were
misstated. The complaints purport to state claims, INTER ALIA, under Federal and
state securities laws and for breach of contract, including a breach of a
registration rights agreement pursuant to which the Company agreed to register
the shares of the Company's common stock issued to such former stockholders of
SunCare in the acquisition. Plaintiffs purport to seek recision, unspecified
compensatory damages, punitive damages and other relief. By Order dated October
11, 1996, the court granted in part and denied in part defendants' motion to
dismiss.
The Company believes the SunCare Litigation will not have a material adverse
impact on its financial condition or results of operations, although the
unfavorable resolution of this action in any reporting period could have a
material adverse impact on the Company's results of operations for that period.
On September 8, 1995, a derivative action was filed by Brickell Partners
against certain of the Company's current and former directors and officers in
the United States District court for the district of New Mexico, captioned
BRICKELL PARTNERS V. TURNER, ET AL. The complaint was not served on any
defendant. On June 19, 1996, an amended complaint alleging breach of fiduciary
duty by certain of the Company's
F-30
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(14) OTHER EVENTS (CONTINUED)
current and former directors and officers was filed and subsequently served on
the defendants. On August 5, 1996, the District Court dismissed this action
without prejudice for failure to serve the defendants within the required time
period. The plaintiffs filed a new complaint, alleging the same claims, on
August 19, 1996. In December 1997, the Company and the plaintiffs reached an
agreement in principle to settle the action for an immaterial amount. The
settlement is subject to definitive documentation and court approval.
(c) OTHER INQUIRIES
From time to time, fiscal intermediaries and Medicaid agencies examine cost
reports filed by such predecessor operators. The Company is currently the
subject of several such examinations. If, as a result of any such examination,
it is concluded that overpayments to a predecessor operator were made, the
Company, as the current operator of such facilities, may be held financially
responsible for such overpayments. At this time the Company is unable to predict
the outcome of any existing or future examinations.
The Company was notified in 1997 by a law firm representing several national
insurance companies that these companies believed that the Company had engaged
in improper billing and other practices in connection with the Company's
delivery of therapy and related services. In response, the Company began
discussions directly with these insurers and hopes to resolve these matters
without litigation; however, the Company is unable at this time to predict
whether it will be able to do so, what the eventual outcome may be or the extent
of its liability, if any, to these insurers.
(d) LEGISLATION, REGULATIONS AND MARKET CONDITIONS
The Company is subject to extensive Federal, state and local government
regulation relating to licensure, conduct of operations, ownership of
facilities, expansion of facilities and services and reimbursement for services.
As such, in the ordinary course of business, the Company's operations are
continuously subject to state and Federal regulatory scrutiny, supervision and
control. Such regulatory scrutiny often includes inquiries, investigations,
examinations, audits, site visits and surveys, some of which may be non-routine.
The Company believes that it is in substantial compliance with the applicable
laws and regulations. However, if the Company is ever found to have engaged in
improper practices, it could be subjected to civil, administrative or criminal
fines, penalties or restitutionary relief.
F-31
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(15) SUMMARIZED FINANCIAL INFORMATION
The Company acquired Mediplex on June 23, 1994 and became a co-obligor with
Mediplex with respect to the 6 1/2% Debentures and the 11 3/4% Debentures
subsequent to the acquisition. Summarized financial information of Mediplex is
provided below (in thousands):
YEAR ENDED DECEMBER 31,
--------------------------
1997 1996
----------- -----------
Current assets.................................... $ 108,232 $ 103,629
Noncurrent assets................................. 391,048 429,555
Current liabilities............................... 26,016 21,904
Noncurrent liabilities............................ 72,373 83,370
Due to parent..................................... 165,207 152,447
YEAR ENDED DECEMBER 31,
----------------------------------
1997 1996 1995
---------- ---------- ----------
Net revenues................................................................. $ 507,750 $ 457,748 $ 448,254
---------- ---------- ----------
Costs and expenses........................................................... 486,541 438,799 436,930
Impairment loss.............................................................. -- -- 52,621
---------- ---------- ----------
Earnings (loss) before intercompany charges, income taxes and extraordinary
loss....................................................................... 21,209 18,949 (41,297)
Intercompany charges(1)...................................................... 78,957 50,133 35,005
---------- ---------- ----------
Earnings (loss) before income taxes and extraordinary loss................... (57,748) (31,184) (76,302)
Income tax benefit........................................................... (18,326) (9,757) (7,432)
---------- ---------- ----------
Net loss before extraordinary loss........................................... (39,422) (21,427) (68,870)
Extraordinary loss, net of income tax benefit................................ -- -- 3,413
---------- ---------- ----------
Net loss..................................................................... $ (39,422) $ (21,427) $ (72,283)
---------- ---------- ----------
---------- ---------- ----------
- ------------------------
(1) Through various intercompany agreements entered into by Sun and Mediplex,
Sun provides management services, licenses the use of its trademarks and
acts on behalf of Mediplex to make financing available for its operations.
Sun charged Mediplex for management services totaling $32.3 million, $29.0
million and $20.5 million for the years ended December 31, 1997, 1996 and
1995, respectively. Royalty fees charged to Mediplex for the years ended
December 31, 1997, 1996 and 1995, for the use of Sun trademarks were $7.4
million, $6.7 million and $4.7 million, respectively. Intercompany interest
charged to Mediplex for the years ended December 31, 1997, 1996 and 1995,
for advances from Sun was $39.3 million, $14.4 million and $9.8 million,
respectively.
F-32
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(16) QUARTERLY FINANCIAL DATA (UNAUDITED)
The Company's unaudited consolidated quarterly financial information follows
(in thousands, except per share data)(1)(2):
YEAR ENDED DECEMBER 31, 1997
-----------------------------------------------
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER(3)
---------- ---------- ---------- -----------
Total net revenues............................................... $ 398,636 $ 447,545 $ 486,172 $ 678,466
Earnings before income taxes and extraordinary loss.............. 26,127 29,214 31,836 8,704
Net earnings before extraordinary loss........................... 15,937 17,821 19,420 1,551
Extraordinary loss............................................... -- -- -- 19,928
---------- ---------- ---------- -----------
Net earnings (loss).............................................. 15,937 17,821 19,420 (18,377)
---------- ---------- ---------- -----------
---------- ---------- ---------- -----------
Net earnings (loss) per common and common equivalent share:
Net earnings before extraordinary loss:
Basic.......................................................... 0.35 0.39 0.42 0.03
Diluted........................................................ 0.33 0.36 0.39 0.03
Net earnings (loss):
Basic.......................................................... 0.35 0.39 0.42 (0.39)
Diluted........................................................ 0.33 0.36 0.39 (0.39)
YEAR ENDED DECEMBER 31, 1996
------------------------------------------------
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER(4) QUARTER(5)
---------- ---------- ----------- -----------
Total net revenues............................................... $ 320,291 $ 325,452 $ 340,508 $ 330,057
Earnings (loss) before income taxes.............................. 25,565 27,276 4,231 (4,606)
Net earnings (loss).............................................. 15,339 16,366 (5,562) (4,607)
Net earnings (loss) per share:
Basic.......................................................... 0.32 0.36 (0.12) (0.10)
Diluted........................................................ 0.31 0.34 (0.12) (0.10)
- ------------------------
(1) The Company adopted SFAS 128 "Earnings per Share" in 1997. All prior period
earnings per common share data have been restated to conform to the
provisions of this statement.
(2) Earnings per share are computed independently for each of the quarters
presented and therefore may not sum to the totals for the year (See Note
1(o)).
(3) The fourth quarter of 1997 includes a charge of $7.0 million recognized by
the Company in order to reduce the carrying value of the Canadian operations
to fair value based on revised estimates of selling value and of costs to
sell. In addition, in 1997, the Company recorded an extraordinary charge of
$17.9 million, net of the related tax benefit, in connection with the
Company's purchase of Regency's 12.25% Junior Subordinated Notes due 2003
and of Regency's 9.875% Senior Subordinated Notes due 2002 and an
extraordinary charge of $2.1 million, net of the related tax benefit,
related to the refinancing of the Company's credit facility.
F-33
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(16) QUARTERLY FINANCIAL DATA (UNAUDITED) (CONTINUED)
(4) The third quarter of 1996 includes a $24.0 million charge to settle certain
of the lawsuits brought by shareholders (see Note 14).
(5) The fourth quarter of 1996 includes a net $4.8 million benefit which
consists of $9.0 million the Company received from its director and officers
liability insurance carrier in 1997 and a $4.3 million charge related to
continuing litigations and investigation costs (see Note 14).
(17) GEOGRAPHIC SEGMENT INFORMATION
The Company operates predominantly in the long-term care segment of the
healthcare industry. The Company is a provider of long-term, subacute and
related ancillary care services to nursing home patients. In addition to the
services provided in the United States, the Company provides services in the
United Kingdom, Spain, Germany, Australia and Canada.
A summary of the Company's operations by geographic area is presented below
(in thousands):
YEAR ENDED DECEMBER 31, 1997
------------------------------------------------------
UNITED
STATES UNITED KINGDOM OTHER CONSOLIDATED
------------ --------------- --------- ------------
Net revenues............................................. $1,812,666 $ 168,306 $ 29,848 $2,010,820
Operating profits........................................ 168,745 8,275 (6,656) 170,364
Interest expense, net.................................... 74,482
------------
Consolidated earnings before income taxes and
extraordinary loss..................................... 95,882
------------
------------
Total assets............................................. 2,249,795 259,665 69,776 2,579,236
Capital expenditures..................................... 51,931 52,370 1,835 106,136
Depreciation and amortization............................ 41,121 13,142 2,367 56,630
YEAR ENDED DECEMBER 31, 1996
------------------------------------------------------
UNITED
STATES UNITED KINGDOM OTHER CONSOLIDATED
------------ --------------- --------- ------------
Net revenues............................................. $1,255,323 $ 42,156 $ 18,829 $1,316,308
Operating profits........................................ 74,894 2,179 (382) 76,691
Equity in earnings of Ashbourne.......................... -- -- -- 1,674
Interest expense, net.................................... -- -- -- 25,899
------------
Consolidated earnings before income taxes................ 52,466
------------
------------
Total assets............................................. 1,033,804 168,578 27,044 1,229,426
Capital expenditures..................................... 56,962 18,699 562 76,223
Depreciation and amortization............................ 30,436 1,851 1,530 33,817
F-34
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(18) SUMMARIZED CONSOLIDATING INFORMATION
In connection with the Company's offering of $250,000,000 aggregate
principal amount of 9 1/2% Senior Subordinated Notes due 2007 (the "9 1/2%
Notes") in July 1997, all direct and indirect subsidiaries of the Company other
than the Company's direct and indirect foreign subsidiaries, CareerStaff and its
direct and indirect subsidiaries, and certain other immaterial subsidiaries of
the Company (the "Guarantors") have, jointly and severally, unconditionally
guaranteed the Notes. These guarantees are subordinated to all existing and
future senior debt and guarantees of the Guarantors and are unsecured.
The Company conducts all of its business through and derives virtually all
of its income from its subsidiaries. Therefore, the Company's ability to make
required payments with respect to its indebtedness (including the 9 1/2% Notes)
and other obligations depends on the financial results and condition of its
subsidiaries and its ability to receive funds from its subsidiaries. There are
no restrictions on the ability of any of the Company's subsidiaries to transfer
funds to the Company, except as provided by appropriate law.
Pursuant to Rule 3-10 of Regulation S-X, the following summarized
consolidating information is for the Company, the Guarantors, and the Company's
non-Guarantor subsidiaries with respect to the 9 1/2% Notes. This summarized
financial information has been prepared from the books and records maintained by
the Company, the Guarantors and the non-Guarantor subsidiaries. The summarized
financial information may not necessarily be indicative of results of operations
or financial position had the Guarantors or non-Guarantor subsidiaries operated
as independent entities.
F-35
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(18) SUMMARIZED CONSOLIDATING INFORMATION (CONTINUED)
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATING BALANCE SHEET
AS OF DECEMBER 31, 1997
COMBINED COMBINED
PARENT GUARANTOR NON-GUARANTOR
COMPANY SUBSIDIARIES SUBSIDIARIES ELIMINATION CONSOLIDATED
------------ ----------- -------------- ----------- ------------
(IN THOUSANDS)
Current assets:
Cash and cash equivalents............... $ (1,581) $ 20,010 $ 2,591 $ -- $ 21,020
Restricted cash......................... 9,000 1,823 3,337 -- 14,160
Accounts receivable, net................ -- 465,137 58,341 (317) 523,161
Other receivables....................... 11,288 13,848 8,414 -- 33,550
Prepaids and other assets............... 596 29,579 6,599 -- 36,774
Deferred tax assets..................... 16,546 -- -- -- 16,546
------------ ----------- -------------- ----------- ------------
Total current assets.................. 35,849 530,397 79,282 (317) 645,211
------------ ----------- -------------- ----------- ------------
Property and equipment, net............. 30,805 207,488 392,809 -- 631,102
Goodwill, net........................... -- 861,492 169,401 -- 1,030,893
Notes receivable........................ 60,080 17,534 13,448 -- 91,062
Other assets, net....................... 80,193 58,715 20,496 -- 159,404
Investment in subsidiaries.............. 611,846 -- -- (611,846) --
Deferred tax assets..................... 19,077 -- 2,487 -- 21,564
------------ ----------- -------------- ----------- ------------
Total assets.......................... $ 837,850 $1,675,626 $ 677,923 $(612,163) $2,579,236
------------ ----------- -------------- ----------- ------------
------------ ----------- -------------- ----------- ------------
Current liabilities:
Current portion of long-term debt....... $ 5,000 $ 12,933 $ 38,884 $ -- $ 56,817
Current portion of obligations under
capital leases........................ 262 1,415 377 -- 2,054
Accounts payable........................ 34,031 21,379 6,780 (317) 61,873
Accrued compensation and benefits....... 21,870 50,465 6,625 -- 78,960
Accrued interest........................ 16,477 1,233 2,741 -- 20,451
Accrued self-insurance obligations...... 369 34,187 (202) -- 34,354
Other accrued liabilities............... 6,028 29,876 35,279 -- 71,183
------------ ----------- -------------- ----------- ------------
Total current liabilities............. 84,037 151,488 90,484 (317) 325,692
------------ ----------- -------------- ----------- ------------
Long-term debt, net of current portion.... 1,303,377 93,514 91,970 -- 1,488,861
Obligations under capital leases, net of
current portion......................... 17 2,311 76,782 -- 79,110
Other long-term liabilities............... -- 41,755 673 -- 42,428
Deferred tax liabilities.................. (2,480) -- 12,287 -- 9,807
------------ ----------- -------------- ----------- ------------
Total liabilities..................... 1,384,951 289,068 272,196 (317) 1,945,898
------------ ----------- -------------- ----------- ------------
Intercompany payables/(receivables)....... (1,164,154) 1,058,101 113,895 (7,842) --
Minority interest......................... -- -- 16,285 -- 16,285
Total stockholders' equity................ 617,053 328,457 275,547 (604,004) 617,053
------------ ----------- -------------- ----------- ------------
Total liabilities and stockholders'
equity.............................. $ 837,850 $1,675,626 $ 677,923 $(612,163) $2,579,236
------------ ----------- -------------- ----------- ------------
------------ ----------- -------------- ----------- ------------
F-36
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(18) SUMMARIZED CONSOLIDATING INFORMATION (CONTINUED)
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATING BALANCE SHEET
AS OF DECEMBER 31, 1996
COMBINED COMBINED
PARENT GUARANTOR NON-GUARANTOR
COMPANY SUBSIDIARIES SUBSIDIARIES ELIMINATION CONSOLIDATED
--------- ----------- -------------- ----------- ------------
(IN THOUSANDS)
Current assets:
Cash and cash equivalents.................. $ 2,226 $ 10,870 $ 1,784 $ -- $ 14,880
Restricted cash............................ -- 2,236 -- -- 2,236
Accounts receivable, net................... -- 254,659 28,376 (767) 282,268
Other receivables.......................... 28,343 4,263 824 -- 33,430
Prepaids and other assets.................. 691 15,276 1,651 -- 17,618
Deferred tax assets........................ 12,716 -- -- -- 12,716
--------- ----------- -------------- ----------- ------------
Total current assets..................... 43,976 287,304 32,635 (767) 363,148
--------- ----------- -------------- ----------- ------------
Property and equipment, net................ 48,072 145,157 112,491 -- 305,720
Goodwill, net.............................. -- 363,934 68,571 -- 432,505
Notes receivable........................... 21,687 46 -- -- 21,733
Other assets, net.......................... 34,361 54,118 4,844 -- 93,323
Investment in subsidiaries................. 426,898 -- -- (426,898) --
Deferred tax assets........................ 12,997 -- -- -- 12,997
--------- ----------- -------------- ----------- ------------
Total assets............................. $ 587,991 $ 850,559 $ 218,541 $(427,665) $1,229,426
--------- ----------- -------------- ----------- ------------
--------- ----------- -------------- ----------- ------------
Current liabilities:
Current portion of long-term debt.......... $ -- $ 2,092 $ 25,609 $ -- $ 27,701
Current portion of obligations under
capital leases........................... 289 635 357 -- 1,281
Accounts payable........................... 26,407 3,822 9,718 (767) 39,180
Accrued compensation and benefits.......... 11,203 14,918 3,597 -- 29,718
Accrued interest........................... 3,538 822 66 -- 4,426
Payable to APTA shareholders............... -- -- 23,545 -- 23,545
Accrued self-insurance obligations......... (748) 12,990 (163) -- 12,079
Other accrued liabilities.................. 5,186 6,653 1,797 -- 13,636
--------- ----------- -------------- ----------- ------------
Total current liabilities................ 45,875 41,932 64,526 (767) 151,566
--------- ----------- -------------- ----------- ------------
Long-term debt, net of current portion....... 362,601 70,768 27,132 -- 460,501
Obligations under capital leases, net of
current portion............................ 279 1,387 21,286 -- 22,952
Other long-term liabilities.................. -- 13,716 1,097 -- 14,813
Deferred tax liabilities..................... -- -- 4,760 -- 4,760
--------- ----------- -------------- ----------- ------------
Total liabilities........................ 408,755 127,803 118,801 (767) 654,592
--------- ----------- -------------- ----------- ------------
Intercompany payables/(receivables).......... (392,901) 372,771 20,130 -- --
Minority interest............................ -- -- 2,697 -- 2,697
Total stockholders' equity................... 572,137 349,985 76,913 (426,898) 572,137
--------- ----------- -------------- ----------- ------------
Total liabilities and stockholders'
equity................................. $ 587,991 $ 850,559 $ 218,541 $(427,665) $1,229,426
--------- ----------- -------------- ----------- ------------
--------- ----------- -------------- ----------- ------------
F-37
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(18) SUMMARIZED CONSOLIDATING INFORMATION (CONTINUED)
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATING STATEMENTS OF EARNINGS
FOR THE YEAR ENDED DECEMBER 31, 1997
COMBINED COMBINED
PARENT GUARANTOR NON-GUARANTOR
COMPANY SUBSIDIARIES SUBSIDIARIES ELIMINATION CONSOLIDATED
----------- ------------ -------------- ----------- ------------
(IN THOUSANDS)
Total net revenues......................... $ 2,337 $ 1,671,369 $ 337,114 $ -- $2,010,820
----------- ------------ -------------- ----------- ------------
Costs and expenses:
Operating................................ -- 1,376,767 286,051 -- 1,662,818
Corporate general and administrative..... 61,687 22,643 13,839 -- 98,169
Provision for losses on accounts
receivable............................. (750) 15,733 856 -- 15,839
Depreciation and amortization............ 4,574 35,301 16,755 -- 56,630
Interest, net............................ 52,244 5,646 16,592 -- 74,482
Loss on sale of Canadian operations...... 7,000 -- -- -- 7,000
Equity interest in (earnings) loss of
subsidiaries........................... 22,925 -- -- (22,925) --
----------- ------------ -------------- ----------- ------------
Total costs and expenses............... 147,680 1,456,090 334,093 (22,925) 1,914,938
----------- ------------ -------------- ----------- ------------
Earnings (loss) before income taxes and
intercompany charges..................... (145,343) 215,279 3,021 22,925 95,882
Intercompany charges(1).................... (221,738) 217,578 4,160 -- --
----------- ------------ -------------- ----------- ------------
Earnings (loss) before income taxes........ 76,395 (2,299) (1,139) 22,925 95,882
Income taxes............................... 39,544 935 674 -- 41,153
----------- ------------ -------------- ----------- ------------
Earnings (loss) before extraordinary
loss..................................... 36,851 (3,234) (1,813) 22,925 54,729
Extraordinary loss......................... 2,050 17,878 -- -- 19,928
----------- ------------ -------------- ----------- ------------
Net earnings (loss)........................ $ 34,801 $ (21,112) $ (1,813) $ 22,925 $ 34,801
----------- ------------ -------------- ----------- ------------
----------- ------------ -------------- ----------- ------------
F-38
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(18) SUMMARIZED CONSOLIDATING INFORMATION (CONTINUED)
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATING STATEMENTS OF EARNINGS
FOR THE YEAR ENDED DECEMBER 31, 1996
COMBINED COMBINED
PARENT GUARANTOR NON-GUARANTOR
COMPANY SUBSIDIARIES SUBSIDIARIES ELIMINATION CONSOLIDATED
----------- ------------ -------------- ----------- ------------
(IN THOUSANDS)
Total net revenues......................... $ 2,373 $ 1,140,879 $ 178,906 $ (5,850) $1,316,308
----------- ------------ -------------- ----------- ------------
Costs and expenses:
Operating................................ -- 957,831 155,840 (5,850) 1,107,821
Corporate general and administrative..... 40,769 14,224 7,092 -- 62,085
Provision for losses on accounts
receivable............................. -- 14,699 271 -- 14,970
Depreciation and amortization............ 3,614 25,911 4,292 -- 33,817
Interest, net............................ 20,770 4,160 969 -- 25,899
Investigation and litigation costs....... 19,250 -- -- -- 19,250
Equity interest in (earnings) loss of
subsidiaries........................... (6,757) -- -- 6,757 --
----------- ------------ -------------- ----------- ------------
Total costs and expenses............... 77,646 1,016,825 168,464 907 1,263,842
----------- ------------ -------------- ----------- ------------
Earnings (loss) before income taxes and
intercompany charges..................... (75,273) 124,054 10,442 (6,757) 52,466
Intercompany charges(1).................... (115,085) 113,361 1,724 -- --
----------- ------------ -------------- ----------- ------------
Earnings (loss) before income taxes........ 39,812 10,693 8,718 (6,757) 52,466
Income taxes............................... 18,276 8,338 4,316 -- 30,930
----------- ------------ -------------- ----------- ------------
Net earnings (loss)........................ $ 21,536 $ 2,355 $ 4,402 $ (6,757) $ 21,536
----------- ------------ -------------- ----------- ------------
----------- ------------ -------------- ----------- ------------
F-39
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(18) SUMMARIZED CONSOLIDATING INFORMATION (CONTINUED)
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATING STATEMENTS OF EARNINGS
FOR THE YEAR ENDED DECEMBER 31, 1995
COMBINED COMBINED
PARENT GUARANTOR NON-GUARANTOR
COMPANY SUBSIDIARIES SUBSIDIARIES ELIMINATION CONSOLIDATED
---------- ------------ -------------- ----------- ------------
(IN THOUSANDS)
Total net revenues.......................... $ 1,032 $ 1,010,904 $ 126,235 $ (2,663) $1,135,508
---------- ------------ -------------- ----------- ------------
Costs and expenses:
Operating................................. -- 826,538 105,618 (2,663) 929,493
Corporate general and administrative...... 32,807 13,388 5,273 -- 51,468
Provision for losses on accounts
receivable.............................. -- 14,632 (9) -- 14,623
Depreciation and amortization............. 1,646 23,545 2,543 -- 27,734
Interest, net............................. 8,138 11,075 2,616 -- 21,829
Conversion expense........................ -- 3,256 -- -- 3,256
Merger expenses........................... 5,800 -- -- -- 5,800
Strike costs.............................. -- 4,006 -- -- 4,006
Investigation and litigation costs........ 5,505 -- -- -- 5,505
Impairment loss........................... -- 59,000 -- -- 59,000
Equity interest in (earnings) loss of
subsidiaries............................ 39,465 -- -- (39,465) --
---------- ------------ -------------- ----------- ------------
Total costs and expenses................ 93,361 955,440 116,041 (42,128) 1,122,714
---------- ------------ -------------- ----------- ------------
Earnings (loss) before extraordinary loss,
income taxes and intercompany charges..... (92,329) 55,464 10,194 39,465 12,794
Intercompany charges(1)..................... (74,103) 74,103 -- -- --
---------- ------------ -------------- ----------- ------------
Earnings (loss) before extraordinary loss
and income taxes.......................... (18,226) (18,639) 10,194 39,465 12,794
Income taxes(2)............................. 5,525 22,973 4,634 -- 33,132
---------- ------------ -------------- ----------- ------------
Earnings (loss) before extraordinary loss... (23,751) (41,612) 5,560 39,465 (20,338)
Extraordinary loss from early extinguishment
of debt................................... -- (3,413) -- -- (3,413)
---------- ------------ -------------- ----------- ------------
Net earnings (loss)......................... $ (23,751) $ (45,025) $ 5,560 $ 39,465 $ (23,751)
---------- ------------ -------------- ----------- ------------
---------- ------------ -------------- ----------- ------------
F-40
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(18) SUMMARIZED CONSOLIDATING INFORMATION (CONTINUED)
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATING STATEMENTS OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 1997
COMBINED COMBINED
PARENT GUARANTOR NON-GUARANTOR
COMPANY SUBSIDIARIES SUBSIDIARIES ELIMINATION CONSOLIDATED
----------- ----------- -------------- ----------- ------------
(IN THOUSANDS)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net earnings (loss).............................. $ 34,801 $ (21,112) $ (1,813) $ 22,925 $ 34,801
Adjustments to reconcile net earnings (loss) to
net cash provided by (used for) operating
activities--
Equity in earnings of subsidiaries............. 22,925 -- -- (22,925) --
Extraordinary loss............................. 3,059 26,684 -- -- 29,743
Loss on Sale of Canadian operations............ 7,000 -- -- -- 7,000
Depreciation and amortization.................. 4,574 35,301 16,755 -- 56,630
Provision for losses on accounts receivable.... -- 14,983 856 -- 15,839
Other, net..................................... 5,353 (1,697) (344) -- 3,312
Changes in operating assets and liabilities:
Accounts receivable.......................... -- (143,875) (21,091) -- (164,966)
Other current assets......................... 10,960 (8,939) (8,344) -- (6,323)
Other current liabilities.................... 38,152 (22,303) 8,379 -- 24,228
Income taxes payable......................... 30,654 (7,861) (1,324) -- 21,469
----------- ----------- -------------- ----------- ------------
Net cash provided by (used for) operating
activities..................................... 157,478 (128,819) (6,926) -- 21,733
----------- ----------- -------------- ----------- ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures, net........................ (2,900) (47,893) (52,369) -- (103,162)
Acquisitions, net of cash acquired............... -- (346,054) (218,080) -- (564,134)
Proceeds (expenditures) from the sale and
leaseback of property and equipment............ -- 31,179 49,278 -- 80,457
Increase in long-term notes receivables.......... (38,392) (5,590) (13,449) -- (57,431)
Other asset expenditures......................... (24,489) (16,285) 4,923 -- (35,851)
----------- ----------- -------------- ----------- ------------
Net cash used for investing activities......... (65,781) (384,643) (229,697) -- (680,121)
----------- ----------- -------------- ----------- ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Long-term debt borrowings........................ 1,793,711 4,508 38,843 -- 1,837,062
Long-term debt repayments........................ (847,114) (53,035) (65,875) -- (966,024)
Repurchase of certain Regency debt............... -- (182,070) -- -- (182,070)
Net proceeds from issuance of common stock....... 6,275 -- -- -- 6,275
Purchases of treasury stock...................... (505) -- -- -- (505)
Other financing activities....................... (33,369) -- (42) -- (33,411)
Intercompany advances............................ (1,014,502) 753,199 261,303 -- --
----------- ----------- -------------- ----------- ------------
Net cash provided by (used for) financing
activities................................... (95,504) 522,602 234,229 -- 661,327
----------- ----------- -------------- ----------- ------------
Effect of exchange rate on cash and cash
equivalents...................................... -- -- 3,201 -- 3,201
----------- ----------- -------------- ----------- ------------
Net increase (decrease) in cash and cash
equivalents...................................... (3,807) 9,140 807 -- 6,140
Cash and cash equivalents at beginning of period... 2,226 10,870 1,784 -- 14,880
----------- ----------- -------------- ----------- ------------
Cash and cash equivalents at end of period......... $ (1,581) $ 20,010 $ 2,591 $ -- $ 21,020
----------- ----------- -------------- ----------- ------------
----------- ----------- -------------- ----------- ------------
F-41
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(18) SUMMARIZED CONSOLIDATING INFORMATION (CONTINUED)
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATING STATEMENTS OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 1996
COMBINED COMBINED
PARENT GUARANTOR NON-GUARANTOR
COMPANY SUBSIDIARIES SUBSIDIARIES ELIMINATION CONSOLIDATED
----------- ----------- -------------- ----------- ------------
(IN THOUSANDS)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net earnings (loss)................................ $ 21,536 $ 2,355 $ 4,402 $ (6,757) $ 21,536
Adjustments to reconcile net earnings (loss) to net
cash provided by (used for) operating
activities--
Equity in earnings of subsidiaries............... (6,757) -- -- 6,757 --
Depreciation and amortization.................... 3,614 25,911 4,292 -- 33,817
Provision for losses on accounts receivable...... -- 14,699 271 -- 14,970
Litigation settlement............................ (4,750) -- -- -- (4,750)
Other, net....................................... 668 (2,927) 227 -- (2,032)
Changes in operating assets and liabilities:
Accounts receivable............................ -- (50,266) (6,793) -- (57,059)
Other current assets........................... (5,964) (1,782) 1,050 -- (6,696)
Other current liabilities...................... 8,824 (6,344) 782 -- 3,262
Income taxes payable........................... 22,422 (620) 1,962 -- 23,764
----------- ----------- -------------- ----------- ------------
Net cash provided by (used for) operating
activities....................................... 39,593 (18,974) 6,193 -- 26,812
----------- ----------- -------------- ----------- ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures, net.......................... (11,292) (23,410) (41,521) -- (76,223)
Acquisitions, net of cash acquired................. -- (28,779) (46,800) -- (75,579)
Investment in OmniCell Technologies, Inc........... (25,332) -- -- -- (25,332)
Net proceeds from sale of SunSurgery Corporation... -- 24,828 -- -- 24,828
Proceeds from operations and sale of assets held
for sale......................................... -- (3,810) -- -- (3,810)
Proceeds (expenditures) from the sale and leaseback
of property and equipment........................ -- 8,766 25,837 -- 34,603
Increase in long-term notes receivables............ (9,188) 523 -- -- (8,665)
Other asset expenditures........................... (2,426) (4,678) (4,907) -- (12,011)
----------- ----------- -------------- ----------- ------------
Net cash used for investing activities........... (48,238) (26,560) (67,391) -- (142,189)
----------- ----------- -------------- ----------- ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Long-term debt borrowings.......................... 101,678 955 34,522 -- 137,155
Long-term debt repayments.......................... (255) (2,110) (1,908) -- (4,273)
Net proceeds from issuance of common stock......... 1,582 -- -- -- 1,582
Purchases of treasury stock........................ (25,069) -- -- -- (25,069)
Other financing activities......................... (1,835) 11 48 -- (1,776)
Intercompany advances.............................. (58,583) 29,957 28,626 -- --
----------- ----------- -------------- ----------- ------------
Net cash provided by (used for) financing
activities..................................... 17,518 28,813 61,288 -- 107,619
----------- ----------- -------------- ----------- ------------
Effect of exchange rate on cash and cash
equivalents...................................... -- -- (464) -- (464)
----------- ----------- -------------- ----------- ------------
Net increase (decrease) in cash and cash
equivalents...................................... 8,873 (16,721) (374) -- (8,222)
Cash and cash equivalents at beginning of period... (6,647) 27,591 2,158 -- 23,102
----------- ----------- -------------- ----------- ------------
Cash and cash equivalents at end of period......... $ 2,226 $ 10,870 $ 1,784 $ -- $ 14,880
----------- ----------- -------------- ----------- ------------
----------- ----------- -------------- ----------- ------------
F-42
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(18) SUMMARIZED CONSOLIDATING INFORMATION (CONTINUED)
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATING STATEMENTS OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 1995
COMBINED COMBINED
PARENT GUARANTOR NON-GUARANTOR
COMPANY SUBSIDIARIES SUBSIDIARIES ELIMINATION CONSOLIDATED
---------- ----------- -------------- ----------- ------------
(IN THOUSANDS)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net earnings (loss)....................... $ (23,751) $ (45,025) $ 5,560 $ 39,465 $ (23,751)
Adjustments to reconcile net earnings
(loss) to net cash provided by (used
for) operating activities--
Equity in loss of subsidiaries.......... 39,465 -- -- (39,465) --
Extraordinary loss...................... -- 5,785 -- -- 5,785
Conversion expense...................... -- 3,256 -- -- 3,256
Depreciation and amortization........... 1,646 23,545 2,543 -- 27,734
Provision for losses on accounts
receivable............................ -- 14,632 (9) -- 14,623
Impairment loss......................... -- 59,000 -- -- 59,000
Other, net.............................. -- (2,220) -- -- (2,220)
Changes in operating assets and
liabilities:
Accounts receivable................... -- (85,381) (5,506) -- (90,887)
Other current assets.................. (1,651) 2,511 110 -- 970
Other current liabilities............. 4,543 (14,672) 3,795 -- (6,334)
Income taxes payable.................. 8,396 9,530 684 -- 18,610
---------- ----------- -------------- ----------- ------------
Net cash provided by (used for) operating
activities.............................. 28,648 (29,039) 7,177 -- 6,786
---------- ----------- -------------- ----------- ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures, net................. (22,811) (15,393) (35,293) -- (73,497)
Acquisitions, net of cash acquired........ (9,638) 1,513 (65,916) -- (74,041)
Proceeds from operations and sale of
assets held for sale.................... -- 36,878 -- -- 36,878
Proceeds from the sale and leaseback of
property and equipment.................. -- 69,988 35,546 -- 105,534
Increase in long-term notes receivables... (12,500) 21 -- -- (12,479)
Other assets expenditures................. (4,074) (7,519) 1,424 -- (10,169)
---------- ----------- -------------- ----------- ------------
Net cash provided by (used for)
investing activities.................. (49,023) 85,488 (64,239) -- (27,774)
---------- ----------- -------------- ----------- ------------
F-43
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(18) SUMMARIZED CONSOLIDATING INFORMATION (CONTINUED)
COMBINED COMBINED
PARENT GUARANTOR NON-GUARANTOR
COMPANY SUBSIDIARIES SUBSIDIARIES ELIMINATION CONSOLIDATED
---------- ----------- -------------- ----------- ------------
(IN THOUSANDS)
CASH FLOWS FROM FINANCING ACTIVITIES:
Long-term debt borrowings................. 177,029 3,634 4,636 -- 185,299
Long-term debt repayments................. (537) (94,017) (21,176) -- (115,730)
Repurchase of 11.75% Senior Subordinated
Notes due 2002.......................... -- (89,370) -- -- (89,370)
Conversion of Convertible Subordinated
Debentures due 2003..................... -- (16,859) -- -- (16,859)
Net proceeds from issuance of common
stock................................... 2,976 -- -- -- 2,976
Other financing activities................ (1,179) (472) (111) -- (1,762)
Intercompany advances..................... (213,653) 145,351 68,302 -- --
---------- ----------- -------------- ----------- ------------
Net cash provided by (used for)
financing activities.................. (35,364) (51,733) 51,651 -- (35,446)
---------- ----------- -------------- ----------- ------------
Effect of exchange rate on cash and cash
equivalents............................... -- -- 798 -- 798
---------- ----------- -------------- ----------- ------------
Net increase (decrease) in cash and cash
equivalents............................... (55,739) 4,716 (4,613) -- (55,636)
Cash and cash equivalents at beginning of
period.................................... 49,092 22,875 6,771 -- 78,738
---------- ----------- -------------- ----------- ------------
Cash and cash equivalents at end of
period.................................... $ (6,647) $ 27,591 $ 2,158 $ -- $ 23,102
---------- ----------- -------------- ----------- ------------
---------- ----------- -------------- ----------- ------------
Through various intercompany agreements entered into by the Company, the
Guarantors and certain of the non-Guarantor subsidiaries, Sun provides
management services, and acts on behalf of the Guarantors and certain of the
non-Guarantor subsidiaries to make financing available for their operations. The
Company charged the Guarantors for management services totaling $75.7 million,
$82.7 million and $58.3 million for the years ended December 31, 1997, 1996 and
1995, respectively. The Company charged the non-Guarantor subsidiaries for
management services totaling $1.5 million and $1.2 million for the years ended
December 31, 1997 and 1996, respectively. Intercompany interest charged to the
Guarantors for the years ended December 31, 1997, 1996 and 1995 for advances
from the Company were $141.8 million, $30.6 million and $15.8 million,
respectively. Intercompany interest charged to the non-Guarantor subsidiaries
for the years ended December 31, 1997 and 1996 for advances from the Company was
$2.7 million and $.6 million, respectively.
F-44
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Stockholders and Board of Directors of
Sun Healthcare Group, Inc.:
We have audited in accordance with generally accepted auditing standards the
consolidated financial statements of Sun Healthcare Group, Inc. and subsidiaries
in this Form 10-K and have issued our report thereon dated February 24, 1998.
Our audits were made for the purpose of forming an opinion on the basic
consolidated financial statements taken as a whole. The schedule listed as Item
14(a)(ii) in the index of financial statements is the responsibility of the
Company's management and is presented for purposes of complying with the
Securities and Exchange Commission's rules and is not part of the basic
consolidated financial statements. This schedule has been subjected to the
auditing procedures applied in our audits of the basic consolidated financial
statements and, in our opinion, fairly states in all material respects the
financial data required to be set forth therein in relation to the basic
consolidated financial statements taken as a whole.
/s/ Arthur Andersen LLP
ARTHUR ANDERSEN LLP
Albuquerque, New Mexico
February 24, 1998
F-45
SCHEDULE II
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS
COLUMN C
---------------------------
COLUMN B ADDITIONS COLUMN E
----------- --------------------------- COLUMN D -----------
COLUMN A BALANCE AT CHARGED TO CHARGED TO ----------- BALANCE AT
- ------------------------------------------------ BEGINNING COSTS AND OTHER ACCOUNTS DEDUCTIONS END OF
DESCRIPTION OF PERIOD EXPENSES DESCRIBE(1) DESCRIBE PERIOD
- ------------------------------------------------ ----------- ----------- -------------- ----------- -----------
(IN THOUSANDS)
Year ended December 31, 1997:
Allowance for doubtful accounts................. $ 16,877 $ 15,839 $ 10,241 $ (8,524) $ 34,433
----------- ----------- ------- ----------- -----------
----------- ----------- ------- ----------- -----------
Year ended December 31, 1996:
Allowance for doubtful accounts................. $ 11,035 $ 14,970 $ 1,394 $ (10,522) $ 16,877
----------- ----------- ------- ----------- -----------
----------- ----------- ------- ----------- -----------
Year ended December 31, 1995:
Allowance for doubtful accounts................. $ 9,508 $ 14,623 $ 743 $ (13,839) $ 11,035
----------- ----------- ------- ----------- -----------
----------- ----------- ------- ----------- -----------
- ------------------------
(1) Represents the allowance for doubtful accounts of acquired entities at the
date of acquisition.
F-46