Attached files

file filename
EX-32 - EXHIBIT 32 - NATIONAL MENTOR HOLDINGS, INC.c04434exv32.htm
EX-31.2 - EXHIBIT 31.2 - NATIONAL MENTOR HOLDINGS, INC.c04434exv31w2.htm
EX-31.1 - EXHIBIT 31.1 - NATIONAL MENTOR HOLDINGS, INC.c04434exv31w1.htm
EX-31.3 - EXHIBIT 31.3 - NATIONAL MENTOR HOLDINGS, INC.c04434exv31w3.htm
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2010
OR
     
o   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: 333-129179
NATIONAL MENTOR HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
     
Delaware
(State or other jurisdiction of
incorporation or organization)
 
31-1757086
(I.R.S. Employer Identification No.)
     
313 Congress Street, 6th Floor
Boston, Massachusetts 02210

(Address of principal executive offices,
including zip code)
  (617) 790-4800
(Registrant’s telephone number,
including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes o No þ
The Company is a voluntary filer of reports required of companies with public securities under Sections 13 or 15(d) of the Securities Exchange Act of 1934 and has filed all reports which would have been required of the Company during the past 12 months had it been subject to such provisions.
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
             
Large accelerated filer o   Accelerated filer o   Non-accelerated filer þ   Smaller reporting company o
        (Do not check if smaller reporting company)    
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
As of August 13, 2010, there were 100 shares outstanding of the registrant’s common stock, $.01 par value.
 
 

 

 


 

Index
National Mentor Holdings, Inc.
         
    Page  
 
       
       
 
       
    3  
 
       
    3  
 
       
    4  
 
       
    5  
 
       
    6  
 
       
    16  
 
       
    27  
 
       
    28  
 
       
       
 
       
    29  
 
       
    30  
 
       
    39  
 
       
    40  
 
       
    40  
 
       
    40  
 
       
    40  
 
       
    41  
 
       
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 31.3
 Exhibit 32

 

2


Table of Contents

PART I. FINANCIAL INFORMATION
Item 1.  
Financial Statements.
National Mentor Holdings, Inc.
Condensed Consolidated Balance Sheets
(In thousands)
(Unaudited)
                 
    June 30,     September 30,  
    2010     2009  
Assets
               
Current assets
               
Cash and cash equivalents
  $ 21,880     $ 23,650  
Restricted cash
    6,442       5,192  
Accounts receivable, net
    124,407       118,969  
Deferred tax assets, net
    9,972       13,897  
Prepaid expenses and other current assets
    16,250       16,868  
 
           
Total current assets
    178,951       178,576  
Property and equipment, net
    141,222       145,876  
Intangible assets, net
    433,962       440,202  
Goodwill
    224,821       206,699  
Other assets
    14,395       16,047  
Investment in related party debt securities
    10,040       8,210  
 
           
Total assets
  $ 1,003,391     $ 995,610  
 
           
Liabilities and shareholder’s equity
               
Current liabilities
               
Accounts payable
  $ 19,614     $ 19,819  
Accrued payroll and related costs
    62,838       58,388  
Other accrued liabilities
    53,267       45,000  
Obligations under capital lease, current
    74       118  
Current portion of long-term debt
    3,667       7,415  
 
           
Total current liabilities
    139,460       130,740  
Other long-term liabilities
    14,469       13,462  
Deferred tax liabilities, net
    121,460       125,237  
Obligations under capital lease, less current portion
    1,628       1,680  
Long-term debt, less current portion
    501,716       500,763  
 
           
Total liabilities
    778,733       771,882  
Shareholder’s equity
               
Common stock
           
Additional paid-in-capital
    250,581       250,038  
Other comprehensive loss
    (1,332 )     (7,115 )
Accumulated deficit
    (24,591 )     (19,195 )
 
           
Total shareholder’s equity
    224,658       223,728  
 
           
Total liabilities and shareholder’s equity
  $ 1,003,391     $ 995,610  
 
           
See accompanying notes.

 

3


Table of Contents

National Mentor Holdings, Inc.
Condensed Consolidated Statements of Operations
(In thousands)
(Unaudited)
                                 
    Three Months Ended     Nine Months Ended  
    June 30,     June 30,  
    2010     2009     2010     2009  
Net revenue
  $ 259,706     $ 244,679     $ 761,084     $ 721,731  
Cost of revenue
    199,054       182,792       581,418       545,551  
 
                       
Gross profit
    60,652       61,887       179,666       176,180  
Operating expenses:
                               
General and administrative
    33,756       32,435       102,419       99,367  
Depreciation and amortization
    14,650       16,378       43,062       42,346  
 
                       
Total operating expenses
    48,406       48,813       145,481       141,713  
 
                       
Income from operations
    12,246       13,074       34,185       34,467  
Other income (expense):
                               
Management fee of related party
    (279 )     (273 )     (842 )     (755 )
Other expense, net
    (221 )     (182 )     (347 )     (895 )
Interest income
    4       29       35       173  
Interest income from related party
    480       605       1,425       722  
Interest expense
    (11,595 )     (11,784 )     (34,996 )     (35,965 )
 
                       
Income (loss) from continuing operations before income taxes
    635       1,469       (540 )     (2,253 )
Provision (benefit) for income taxes
    1,435       234       63       (502 )
 
                       
(Loss) income from continuing operations
    (800 )     1,235       (603 )     (1,751 )
Income (loss) from discontinued operations, net of tax
    99       (1,725 )     (4,793 )     (2,261 )
 
                       
Net loss
  $ (701 )   $ (490 )   $ (5,396 )   $ (4,012 )
 
                       
See accompanying notes.

 

4


Table of Contents

National Mentor Holdings, Inc.
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
                 
    Nine Months Ended  
    June 30,  
    2010     2009  
Operating activities
               
Net loss
  $ (5,396 )   $ (4,012 )
Adjustments to reconcile net loss to cash provided by operating activities:
               
Accounts receivable allowances
    8,949       7,060  
Depreciation and amortization of property and equipment
    17,479       18,833  
Amortization of other intangible assets
    26,036       24,768  
Amortization of deferred financing costs
    2,401       2,456  
Accretion of investment in related party debt securities
    (721 )     (357 )
Stock-based compensation
    638       1,232  
Deferred income taxes
    (8,734 )     167  
Loss on disposal of assets
    399       928  
Non-cash changes in contingent consideration
    1,072        
Non-cash impairment charge and other charges from discontinued operations
    6,556       3,170  
Non-cash interest income from related party
    (704 )     (365 )
Changes in operating assets and liabilities:
               
Accounts receivable
    (11,407 )     (18,691 )
Other assets
    (26 )     7,206  
Accounts payable
    (410 )     (4,460 )
Accrued payroll and related costs
    3,414       (4,273 )
Other accrued liabilities
    8,082       1,090  
Other long-term liabilities
    1,007       1,470  
 
           
Net cash provided by operating activities
    48,635       36,222  
Investing activities
               
Cash paid for acquisitions
    (32,776 )     (23,250 )
Purchases of property and equipment
    (14,465 )     (22,259 )
Purchase of related party debt securities
          (6,555 )
Changes in restricted cash
    (1,247 )      
Cash proceeds from sale of assets
    479       1,104  
Cash proceeds from discontinued operations
    590       3,203  
 
           
Net cash used in investing activities
    (47,419 )     (47,757 )
Financing activities
               
Repayments of long-term debt
    (2,795 )     (2,802 )
Repayments of capital lease obligations
    (96 )     (168 )
Dividend to parent
    (95 )     (7,306 )
Parent capital contribution
          452  
Payments of deferred financing costs
          (42 )
 
           
Net cash used in financing activities
    (2,986 )     (9,866 )
Net decrease in cash and cash equivalents
    (1,770 )     (21,401 )
Cash and cash equivalents at beginning of period
    23,650       38,908  
 
           
Cash and cash equivalents at end of period
  $ 21,880     $ 17,507  
 
           
See accompanying notes.

 

5


Table of Contents

National Mentor Holdings, Inc.
Notes to Condensed Consolidated Financial Statements
June 30, 2010
(Unaudited)
1. Basis of Presentation
National Mentor Holdings, Inc., through its wholly owned subsidiaries (collectively, the “Company”), is a leading provider of home and community-based health and human services to adults and children with intellectual and/or developmental disabilities, acquired brain injury and other catastrophic injuries and illnesses; and to youth with emotional, behavioral and medically complex challenges. Since the Company’s founding in 1980, the Company has grown to provide services to approximately 24,000 clients in 36 states. The Company designs customized service plans to meet the unique needs of its clients in home- and community-based settings. Most of the Company’s services involve residential support, typically in small group home or host home settings, designed to improve the clients’ quality of life and to promote client independence and participation in community life. Other services that the Company provides include day programs, vocational services, case management, early intervention, family-based services, post-acute treatment and neurorehabilitation services, among others. The Company’s customized services offer its clients as well as the payors of these services, an attractive, cost-effective alternative to human services provided in large, institutional settings.
The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and pursuant to the applicable rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The unaudited condensed consolidated financial statements herein should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2009, which is on file with the SEC. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments, consisting of normal and recurring accruals, necessary to present fairly the financial statements in accordance with GAAP. All significant intercompany balances and transactions between the Company and its subsidiaries have been eliminated in consolidation. Operating results for the three and nine months ended June 30, 2010 may not necessarily be indicative of results to be expected for any other interim period or for the full year.
The preparation of financial statements in conformity with GAAP requires the appropriate application of certain accounting policies, many of which require the Company to make estimates and assumptions about future events and their impact on amounts reported in the financial statements and related notes. Since future events and the impact of those events cannot be determined with certainty, the actual results may differ from the Company’s estimates. These differences could be material to the financial statements.
2. Comprehensive Income (Loss)
The components of comprehensive income (loss) and related tax effects are as follows:
                                 
    Three Months Ended     Nine Months Ended  
    June 30,     June 30,  
(in thousands)   2010     2009     2010     2009  
Net loss
  $ (701 )   $ (490 )   $ (5,396 )   $ (4,012 )
Changes in unrealized gain (losses) on derivatives
    3,440       3,919       9,300       (2,172 )
Changes in unrealized gain (losses) on available-for-sale debt securities
    55       (206 )     408       (206 )
Income tax effect
    (1,414 )     (1,502 )     (3,925 )     962  
 
                       
Comprehensive income (loss)
  $ 1,380     $ 1,721     $ 387     $ (5,428 )
 
                       

 

6


Table of Contents

3. Long-Term Debt
The Company’s long-term debt consists of the following:
                 
    June 30,     September 30,  
(in thousands)   2010     2009  
Senior term B loan, principal and interest due in quarterly installments through June 29, 2013
  $ 321,600     $ 324,113  
Senior revolver, due June 29, 2012; quarterly cash interest payments at a variable interest rate
           
Senior subordinated notes, due July 1, 2014; semi-annual cash interest payments due each
January 1st and July 1st (interest rate of 11.25%)
    180,000       180,000  
Term loan mortgage, principal and interest due in monthly installments through June 29, 2012; variable interest rate (4.75% at June 30, 2010 and September 30, 2009)
    3,783       4,065  
 
           
 
    505,383       508,178  
Less current portion
    3,667       7,415  
 
           
Long-term debt
  $ 501,716     $ 500,763  
 
           
Senior secured credit facilities
The Company’s senior credit facility consists of a $335.0 million seven-year senior secured term B loan facility (the “term B loan”), a $125.0 million six-year senior secured revolving credit facility (the “senior revolver”) and a $20.0 million six-year senior secured synthetic letter of credit facility (together, the “senior secured credit facilities”).
The senior secured credit facilities and the term loan mortgage have priority in right of payment over all of the Company’s other long-term debt. The senior credit facilities are guaranteed by the Company’s subsidiaries, except for the captive insurance subsidiary, and are secured by substantially all of the assets of the Company.
Total cash paid for interest on the Company’s debt amounted to $5.7 million and $6.0 million for the three months ended June 30, 2010 and 2009, respectively, and $27.5 million and $28.8 million for the nine months ended June 30, 2010 and 2009, respectively.
Term B loan
The $335.0 million term B loan amortizes one percent per year, paid quarterly, for the first six years, with the remaining balance due in the seventh year. The senior credit agreement also includes a provision for the prepayment of a portion of the outstanding term loan amounts at any year-end equal to an amount ranging from 0-50% of a calculated amount, depending on the Company’s leverage ratio, if the Company generates certain levels of cash flow. The variable interest rate on the term B loan is equal to LIBOR plus 2.00% or Prime plus 1.00%, at the Company’s option.
To reduce the interest rate exposure on the term B loan, the Company is a party to interest rate swap agreements with respect to $288.9 million of the $321.6 million outstanding as of June 30, 2010. Effective August 31, 2006, the Company fixed a portion of the term B loan at 5.32% plus 2.00%. This swap expired on June 30, 2010 and the Company has not entered into any replacement swap agreements for this portion of the debt. Effective August 31, 2007, the Company fixed an additional portion of the term B loan debt at 4.89% plus 2.00%. This swap expires on September 30, 2010 and the Company is considering its options for addressing interest rate exposure as these swap agreements terminate.
The fair value of the swap agreements, representing the price that would be paid to transfer the liability in an orderly transaction between market participants, was $3.1 million at June 30, 2010 and $12.4 million at September 30, 2009. The fair value was recorded in current liabilities under Other accrued liabilities and was determined based on pricing models and independent formulas using current assumptions.
The Company accounts for these interest rate swaps as cash flow hedges. The effectiveness of the hedge relationships is assessed on a quarterly basis during the term of the hedge by comparing whether the critical terms of the hedge continue to match the terms of the debt. Under this approach, the Company exactly matches the terms of the interest rate swap to the terms of the underlying debt and, therefore, assumes 100% hedge effectiveness. The entire change in fair market value is recorded in shareholder’s equity, net of tax, on the condensed consolidated balance sheets as other comprehensive loss.

 

7


Table of Contents

Senior revolver and synthetic letter of credit facility
The Company had no borrowings and $115.1 million of availability under the $125.0 million senior revolver as of June 30, 2010. The Company had $29.9 million in standby letters of credit outstanding as of June 30, 2010 related to the Company’s workers’ compensation insurance coverage. Of these letters of credit, $20.0 million were issued under the Company’s synthetic letter of credit facility, and $9.9 million were issued under the Company’s $125.0 million senior revolver. Letters of credit in excess of the $20.0 million synthetic letter of credit facility reduce availability under the Company’s senior revolver. The interest rates for any senior revolver borrowings are equal to either LIBOR plus 2.00% or Prime plus 1.00%, at the Company’s option, and subject to reduction depending on the Company’s leverage ratio.
Senior subordinated notes
The Company issued $180.0 million of 11.25% senior subordinated notes due 2014 (the “senior subordinated notes”) in connection with the merger of NMH MergerSub, Inc., a wholly-owned subsidiary of NMH Investment, LLC (“NMH Investment”), with and into the Company, with the Company as the surviving corporation, on June 29, 2006 (the “Merger”). The senior subordinated notes are guaranteed by the Company’s subsidiaries, except for the captive insurance subsidiary and are secured by substantially all of the assets of the Company.
Term loan mortgage
In January 2010, the Company entered into an agreement to extend the term of its mortgage facility through June 29, 2012, the maturity date of the senior credit agreement. As a result of this extension, the majority of the term loan mortgage balance has been classified as long-term debt. The term loan mortgage is secured by certain buildings and land of the Company.
Covenants
The senior credit agreement and the indenture governing the senior subordinated notes contain negative financial and non-financial covenants, including limitations on the Company’s ability to incur additional debt, sell material assets, retire, redeem or otherwise reacquire capital stock, acquire the capital stock or assets of another business and pay dividends.
4. Acquisitions
Anchor Inne
On June 30, 2010, the Company acquired the assets of Anchor Inne, Inc. (“Anchor Inne”) for $3.4 million. Anchor Inne has operations in Pennsylvania and serves individuals who have sustained a traumatic brain injury.
As a result of the Anchor Inne acquisition, the Company recorded $1.3 million of goodwill in the Post-Acute Specialty Rehabilitation Services segment, which is expected to be deductible for tax purposes. The acquired intangible assets included $1.9 million of agency contracts with a weighted average useful life of eleven years and $0.2 million of licenses and permits with a weighted average useful life of ten years.

 

8


Table of Contents

The purchase price for this acquisition has been initially allocated as follows:
         
(in thousands)   Anchor Inne  
Property and equipment
  $ 55  
Identifiable intangible assets
    2,072  
Goodwill
    1,284  
 
     
 
  $ 3,411  
 
     
Also in fiscal 2010, the Company acquired the assets of Springbrook, Inc. and an affiliate (together, “Springbrook”) for $6.3 million, subject to increase based on earnout provisions. Springbrook provides residential and mental health services to individuals with developmental disabilities and behavioral issues and is included in the Human Services segment.
In a purchase of stock and assets, the Company acquired a provider of neurobehavioral and supported living programs (“NeuroRestorative”) for $17.0 million. NeuroRestorative serves individuals who have sustained a traumatic brain injury and is included in the Post-Acute Specialty Rehabilitation Services segment.
In addition to Springbrook and NeuroRestorative, the Company acquired two California facilities (together, “Villages”), engaged in neurorehabilitation services for total consideration of $6.0 million. Villages is included in the Post-Acute Specialty Rehabilitation Services segment.
Pro forma Results of Operations
The operating results of the businesses acquired during fiscal 2010, including Anchor Inne, Springbrook, NeuroRestorative and Villages, were included in the consolidated statements of operations from the date of acquisition. The Company accounted for the acquisitions under the purchase method of accounting and, as a result, the purchase price was allocated to the assets acquired and liabilities assumed based upon their respective fair values. The excess of the purchase price over the estimated fair market value of net tangible assets was allocated to specifically identified intangible assets, with the residual being allocated to goodwill.
The unaudited pro forma results of operations provided below for the nine months ended June 30, 2010 and 2009 is presented as though the acquisitions had occurred at the beginning of the earliest period presented. The pro forma information presented below does not intend to indicate what the Company’s results of operations would have been if the acquisitions had in fact occurred at the beginning of the earliest period presented nor does it intend to be a projection of the impact on future results or trends.
                 
    Nine months ended  
    June 30,     June 30,  
    2010     2009  
Net revenue
  $ 785,268     $ 742,449  
Income from operations
    36,272       36,478  
Contingent consideration
Authoritative guidance has recently been updated governing the requirements for the recognition and measurement of contingent consideration at their fair value on the acquisition date. The Company is required to remeasure the fair value of the earnout at each reporting date until the contingency is resolved and changes to the fair value are recognized in earnings in the period of the change. The Company adopted this guidance on October 1, 2009 and the statement applies prospectively for business combinations incurred on or after that date.
On January 15, 2010, the Company acquired the assets of Springbrook for $6.3 million, subject to increase based on earnout provisions. Pursuant to the acquisition agreement, the Company agreed to pay up to an additional $3.5 million in cash based upon achieving certain earnings targets (the “earnout”). The fair value of the cash earnout on the date of acquisition was $1.6 million which was initially accrued for as contingent consideration. During the third quarter of fiscal 2010, the Company recorded an additional $1.1 million to the contingent consideration obligation as a result of adjustments to the forecasted financial performance of Springbrook. This increase resulted in a liability due to seller of $2.7 million at June 30, 2010. The increase in contingent consideration is included in general and administrative expenses in the consolidated statements of operations.
During fiscal 2009, the Company acquired the stock of Institute for Family Centered Services, Inc. (“IFCS”) for approximately $11.5 million, which was subject to increase based on earnout provisions. During the third quarter of fiscal 2010, the Company recorded an additional $6.6 in contingent consideration related to this acquisition. Since IFCS was acquired prior to October 1, 2009, the contingent consideration was recorded as additional goodwill.
5. Discontinued Operations
During fiscal 2010, the Company discontinued its business operations in the state of Colorado (“REM Colorado”) and certain business operations in the state of Maryland (“REM Maryland”), both of which are reported under the Human Services segment.

 

9


Table of Contents

REM Colorado
During fiscal 2010, the Company closed REM Colorado and recognized a pre-tax loss of $0.1 million and $3.1 million for the three and nine months ended June 30, 2010, respectively. The operations of REM Colorado are presented as discontinued operations in the consolidated statements of operations and the prior periods have been reclassified. Loss from discontinued operations for the nine months ended June 30, 2010 included a $2.5 million impairment charge.
REM Maryland
Also during fiscal 2010, the Company adopted a plan to sell REM Maryland. The operations of REM Maryland are presented as discontinued operations in the consolidated statements of operations and the prior periods have been reclassified. Loss from discontinued operations for the nine months ended June 30, 2010 included a $4.2 million impairment charge. At June 30, 2010, there was $1.8 million of property and equipment held for sale which is immaterial to the Company and, as a result, is not reported separately as assets held for sale in the Company’s financial statements.
REM Maryland’s and REM Colorado’s net revenue and loss before taxes for the three and nine months ended June 30, 2010 and 2009 are summarized as follows:
                                 
    Three Months Ended     Nine Months Ended  
    June 30     June 30  
(in thousands)   2010     2009     2010     2009  
Net revenue
  $ 800     $ 2,454     $ 3,751     $ 7,372  
Loss before taxes
  $ (639 )   $ (1,107 )   $ (8,639 )   $ (2,388 )
6. Goodwill and Intangible Assets
Goodwill
The changes in goodwill for the nine months ended June 30, 2010 are as follows:
                         
            Post-Acute        
            Specialty        
    Human     Rehabilitation        
(in thousands)   Services     Services     Total  
Balance as of September 30, 2009
  $ 166,273     $ 40,426     $ 206,699  
Goodwill acquired through acquisitions
    1,449       9,963       11,412  
Goodwill written off related to disposal of businesses
    (435 )           (435 )
Adjustments to goodwill
    6,832       313       7,145  
 
                 
Balance as of June 30, 2010
  $ 174,119     $ 50,702     $ 224,821  
 
                 
The adjustments to goodwill primarily included $6.6 million related to the earnout associated with the Springbrook acquisition. The remaining adjustments related to the finalization of the purchase price for acquisitions.
Intangible Assets
Intangible assets consist of the following as of June 30, 2010:
                         
    Gross              
(in thousands)   Carrying     Accumulated     Intangible  
Description   Value     Amortization     Assets, Net  
Agency contracts
  $ 455,875     $ 106,086     $ 349,789  
Non-compete/non-solicit
    1,044       352       692  
Relationship with contracted caregivers
    12,804       5,629       7,175  
Trade names
    4,039       1,358       2,681  
Trade names (Indefinite life)
    47,700             47,700  
Licenses and permits
    39,856       14,695       25,161  
Intellectual property
    904       140       764  
 
                 
 
  $ 562,222     $ 128,260     $ 433,962  
 
                 
Intangible assets consist of the following as of September 30, 2009:
                         
    Gross              
(in thousands)   Carrying     Accumulated     Intangible  
Description   Value     Amortization     Assets, Net  
Agency contracts
  $ 439,793     $ 86,067     $ 353,726  
Non-compete/non-solicit
    618       227       391  
Relationship with contracted caregivers
    12,886       4,611       8,275  
Trade names
    3,637       1,058       2,579  
Trade names (Indefinite life)
    47,700             47,700  
Licenses and permits
    38,994       12,324       26,670  
Intellectual property
    904       43       861  
 
                 
 
  $ 544,532     $ 104,330     $ 440,202  
 
                 
Amortization expense was $8.8 million and $7.7 million for the three months ended June 30, 2010 and 2009, respectively and $25.8 million and $23.8 million for the nine months ended June 30, 2010 and 2009, respectively.
7. Related Party Transactions
Investment in Related Party Debt Securities
During fiscal 2009, the Company purchased $11.5 million in aggregate principal amount of senior floating rate toggle notes due 2014 (the “NMH Holdings notes”) issued by the Company’s indirect parent company, NMH Holdings, Inc. (“NMH Holdings”), for $6.6 million. The security was classified as an available-for-sale debt security and was recorded on the Company’s condensed consolidated balance sheets as Investment in related party debt securities. Cash interest on the NMH Holdings notes accrues at a rate per annum, reset quarterly, equal to LIBOR plus 6.375%, and PIK Interest (defined below) accrues at the cash interest rate plus 0.75%. NMH Holdings may elect to pay interest on the NMH Holdings notes (a) entirely in cash, (b) entirely by increasing the principal amount of the NMH Holdings notes or issuing new notes (“PIK Interest”) or (c) 50% in cash and 50% in PIK Interest.
NMH Holdings is a holding company with no direct operations. Its principal assets are the direct and indirect equity interests it holds in its subsidiaries, including the Company, and all of its operations are conducted through the Company and the Company’s subsidiaries. As a result, NMH Holdings will be dependent upon dividends and other payments from the Company to generate the funds necessary to meet its outstanding debt service and other obligations, including its obligations on the notes held by the Company.
NMH Holdings has paid all of the interest payments to date on the NMH Holdings notes entirely in PIK Interest which has increased the principal amount by $54.9 million since they were issued. The Company recorded interest income related to the NMH Holdings notes of $0.5 million and $0.6 million for the three months ended June 30, 2010 and 2009, respectively and $1.4 million and $0.7 million for the nine months ended June 30, 2010 and 2009, respectively. This interest income is recorded under Interest income from related party in the condensed consolidated statements of operations and includes PIK Interest as well as the accretion of the purchase discount on the securities. Total PIK Interest included in the balance of available-for-sale debt security totals $0.7 million as of June 30, 2010.
As of June 30, 2010, the Company’s investment in related-party debt securities had a carrying value of $9.1 million, and an approximate fair value of $10.0 million which is reflected on the Company’s condensed consolidated balance sheets as Investment in related party debt securities. As a result, the Company has recorded $0.9 million of unrealized holding gain in other comprehensive loss, $0.4 million of which was recorded during the nine months ended June 30, 2010. The debt security is scheduled to mature on June 15, 2014, but actual maturities may differ from the contractual or expected maturities since borrowers have the right to prepay obligations with or without prepayment penalties.

 

10


Table of Contents

The Company evaluates available-for-sale securities for other-than-temporary impairment at least quarterly. If the fair value of a security is less than its cost, an other-than-temporary impairment is required to be recognized if either of the following criteria is met: (1) if the Company intends to sell the security; or (2) if it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis less any current period credit loss. There were no securities impaired on an other than temporary basis at June 30, 2010.
Lease Agreements
The Company leases several offices, homes and other facilities from its employees, or from relatives of employees, primarily in the states of Minnesota, California and Nevada, which have various expiration dates extending out as far as May 2016. In connection with the acquisition of NeuroRestorative in the second quarter of fiscal 2010, the Company entered into a lease of a treatment facility in Arkansas with a former shareholder and executive who is providing consulting services. The lease is an operating lease with an initial ten-year term, and the total expected minimum lease commitment is $7.0 million.
Related party lease expense was $1.1 million and $0.9 million for the three months ended June 30, 2010 and 2009, respectively and $2.9 million and $2.6 million for the nine months ended June 30, 2010 and 2009, respectively.
8. Fair Value Measurements
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.
A three-level hierarchy for disclosure has been established to show the extent and level of judgment used to estimate fair value measurements, as follows:
Level 1:  
Quoted market prices in active markets for identical assets or liabilities.
Level 2:  
Significant other observable inputs (quoted prices in active markets for similar assets or liabilities, quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability).
Level 3:  
Significant unobservable inputs for the asset or liability. These values are generally determined using pricing models which utilize management estimates of market participant assumptions.
Valuation techniques for assets and liabilities measured using Level 3 inputs may include methodologies such as the market approach, the income approach or the cost approach, and may use unobservable inputs such as projections, estimates and management’s interpretation of current market data. These unobservable inputs are only utilized to the extent that observable inputs are not available or cost-effective to obtain.
A description of the valuation methodologies used for instruments measured at fair value as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.
Assets and liabilities recorded at fair value at June 30, 2010 consist of:
                                 
            Quoted     Significant Other     Significant  
            Market Prices     Observable Inputs     Unobservable Inputs  
(in thousands):   Total     (Level 1)     (Level 2)     (Level 3)  
Cash equivalents
  $ 15,900     $ 15,900     $     $  
Interest rate swap agreements
  $ (3,139 )   $     $ (3,139 )   $  
Investment in related party debt securities
  $ 10,040     $     $ 10,040     $  
Contingent consideration
  $ (2,689 )   $     $     $ (2,689 )
Assets and liabilities recorded at fair value at September 30, 2009 consist of the following:
                                 
            Quoted     Significant Other     Significant  
            Market Prices     Observable Inputs     Unobservable Inputs  
(in thousands):   Total     (Level 1)     (Level 2)     (Level 3)  
Cash equivalents
  $ 17,000     $ 17,000     $     $  
Interest rate swap agreements
  $ (12,439 )   $     $ (12,439 )   $  
Investment in related party debt securities
  $ 8,210     $     $ 8,210     $  
Cash equivalents. Cash equivalents consist primarily of money market funds and the carrying value of cash equivalents approximates fair value.
Interest rate swap agreements. The fair value of the swap agreements was recorded in current liabilities (under Other accrued liabilities). The fair value of these agreements was determined based on pricing models and independent formulas using current assumptions that included swap terms, interest rates and forward LIBOR curves.

 

11


Table of Contents

Investment in related party debt securities. The fair value of the investment in related party debt securities was recorded in long-term assets (under Investment in related party debt securities). The fair value measurements consider observable market data that may include, among other data, credit ratings, credit spreads, future interest rates and risk free rates of return.
Contingent consideration. The fair value of the earnout was accrued for and classified as contingent consideration. The fair value was determined based on unobservable inputs, namely management’s estimate of expected performance based on current information.
The following table provides a reconciliation of the beginning and ending balances for the liability measured at fair value using significant unobservable inputs (Level 3). The fair value of the Springbrook earnout on January 15, 2010, the date of acquisition, was $1.6 million and there was no change in fair value for the quarter ended March 31, 2010. During the third quarter of fiscal 2010, the Company recorded an additional $1.1 million to the contingent consideration obligation.
         
    Due to Seller  
Balance at March 31, 2010
  $ (1,617 )
Change in fair value of contingent consideration
    (1,072 )
 
     
Balance at June 30, 2010
  $ (2,689 )
 
     
At June 30, 2010, the carrying values of cash, accounts receivable and accounts payable approximated fair value. The carrying value and fair value of the Company’s debt instruments are set forth below:
                                 
    June 30, 2010     September 30, 2009  
    Carrying     Fair     Carrying     Fair  
(in thousands):   Amount     Value     Amount     Value  
Senior subordinated notes
  $ 180,000     $ 180,450     $ 180,000     $ 175,500  
The Company estimated the fair value of the debt instruments using market quotes and calculations based on current market rates available.
9. Income Taxes
The Company’s effective income tax rate for the interim periods was based on management’s estimate of the Company’s annual effective tax rate for the applicable year. For the three months ended June 30, 2010, the Company’s effective income tax rate was 226.0% compared to an effective tax rate of 15.9% for the three months ended June 30, 2009. For the nine months ended June 30, 2010, the Company’s effective income tax rate was (11.7)% compared to an effective tax rate of 22.3% for the nine months ended June 30, 2009. These rates differ from the federal statutory income tax rate primarily due to nondeductible permanent differences such as meals and nondeductible compensation, net operating losses not benefited and changes in the applicability of certain employment tax credits.
The Company files a federal consolidated return and files various state income tax returns and, generally, the Company is no longer subject to income tax examinations by the taxing authorities for years prior to September 30, 2003. The Company’s reserve for uncertain income tax positions at June 30, 2010 is $5.0 million. There has been no change in unrecognized tax benefits in the three or nine months ended June 30, 2010 and the Company does not expect any significant changes to unrecognized tax benefits within the next twelve months. The Company’s policy is to recognize interest and penalties related to unrecognized tax benefits as income tax.
10. Segment Information
The Company has two reportable segments, Human Services and Post-Acute Specialty Rehabilitation Services (“SRS”).
The Human Services segment provides home and community-based human services to adults and children with intellectual and/or developmental disabilities and to youth with emotional, behavioral and medically complex challenges. Human Services is organized in a reporting structure composed of two operating segments which are aggregated into one reportable segment based on similarity of the economic characteristics and services provided.

 

12


Table of Contents

The SRS segment provides a mix of health care and community-based health and human services to individuals with acquired brain injuries and other catastrophic injuries and illnesses. This segment is organized in a reporting structure composed of two operating segments which are aggregated based on similarity of economic characteristics and services provided.
Activities classified as “Corporate” in the table below relate primarily to unallocated home office items.
The Company generally evaluates the performance of its operating segments based on income from operations. The following is a financial summary by reportable operating segment for the periods indicated.
                                 
            Post-Acute              
            Specialty              
(in thousands)   Human     Rehabilitation              
For the three months ended June 30,   Services     Services     Corporate     Consolidated  
2010
                               
Net revenue
  $ 223,081     $ 36,625     $     $ 259,706  
Income (loss) from operations
    21,055       3,709       (12,518 )     12,246  
Total assets
    806,563       140,524       56,304       1,003,391  
Depreciation and amortization
    10,840       2,610       1,200       14,650  
 
                               
2009
                               
Net revenue
  $ 221,348     $ 23,331     $     $ 244,679  
Income (loss) from operations
    20,503       3,212       (10,641 )     13,074  
Depreciation and amortization
    13,513       1,665       1,200       16,378  
                                 
            Post-Acute              
            Specialty              
(in thousands)   Human     Rehabilitation              
For the nine months ended June 30,   Services     Services     Corporate     Consolidated  
2010
                               
Net revenue
  $ 663,975     $ 97,109     $     $ 761,084  
Income (loss) from operations
    60,201       10,564       (36,580 )     34,185  
Total assets
    806,563       140,524       56,304       1,003,391  
Depreciation and amortization
    32,836       6,689       3,537       43,062  
Purchases of property and equipment
    8,587       4,394       1,484       14,465  
2009
                               
Net revenue
  $ 652,787     $ 68,944     $     $ 721,731  
Income (loss) from operations
    56,784       10,775       (33,092 )     34,467  
Depreciation and amortization
    34,542       4,649       3,155       42,346  
Purchases of property and equipment
    10,477       7,448       4,334       22,259  
11. Stock-Based Compensation
Under its equity-based compensation plan adopted in 2006, NMH Investment has issued units of limited liability company interests consisting of Class B Units, Class C Units, Class D Units and Class E Units. The units are limited liability company interests and are available for issuance to the Company’s employees and members of the Board of Directors for incentive purposes. As of June 30, 2010, there were 192,500 Class B Units, 202,000 Class C Units, 388,881 Class D Units and 6,375 Class E Units authorized for issuance under the plan. These units derive their value from the value of the Company.
On June 4, 2010, NMH Investment amended the terms of the Class B and Class D Units. As a result of the amendment, the vesting period of the Class B Units was shortened from 61 months to 48 months. Assuming continued employment of the employee with the Company, 40 percent of the Class B Units vest at the end of 37 months from the relevant measurement date, and the remaining 60 percent vest ratably each month over the remainder of the term. Assuming continued employment, the Class C Units and Class D Units vest after three years, subject to certain performance conditions and/or investment return conditions being met or achieved. For the Class C Units, the performance conditions relate to the Company achieving certain financial targets for the fiscal years ended September 30, 2007, 2008 and 2009, all of which were met. For the Class D Units, the performance conditions relate to the Company achieving certain financial targets for the same fiscal years, and the amendment created two additional performance conditions for the fiscal years ended September 30, 2010 and 2011 because the Company failed to achieve the 2008 and 2009 targets. For both the Class C Units and the Class D Units, the investment return conditions relate to Vestar receiving a specified multiple on its investment upon a liquidation event. The amendment resulted in a modification charge of approximately $0.3 million which is being recognized in the third quarter of fiscal 2010 and is included in general and administrative expense in the accompanying consolidated statements of operations.

 

13


Table of Contents

If an employee holder’s employment is terminated, NMH Investment may repurchase the holder’s Class B, C and D units. If the termination occurs within 12 months after the relevant measurement date, all of the B units will be repurchased at the initial purchase price, or cost. If the termination occurs during the following three-year period, the proportion of the B units that may be purchased at fair market value will be determined depending on the circumstances of the holder’s departure and the date of termination. From month 13 to month 48, if the holder is terminated without cause, or resigns for good reason, he or she is entitled to receive a higher proportion of the purchase price at fair market value than if he or she resigns voluntarily. This proportion increases ratably each month. For the C and D units, the holder is entitled to receive fair market value if he or she is terminated without cause or resigns for good reason or, after the third anniversary of the relevant measurement date, upon termination for any reason except for cause. Before the third anniversary, all the C and D units are callable at cost if the holder resigns without good reason. In the event of a termination for cause at any time, all of the units would be callable at cost. The Class E Units vest over time given continued service of the director as a member of the Board of Directors of the Company.
For purposes of determining the compensation expense associated with these grants, management valued the business enterprise using a variety of widely accepted valuation techniques which considered a number of factors such as the financial performance of the Company, the values of comparable companies and the lack of marketability of the Company’s equity. The Company then used the option pricing method to determine the fair value of the units granted.
The fair value of the units issued during the quarter ended March 31, 2010 was calculated using the following assumptions:
         
Risk-free interest rate
    0.67 %
Expected term
  1.7 years  
Expected volatility
    55.0 %
The estimated fair value of the units, less an assumed forfeiture rate of 9.6%, was recognized in expense in the Company’s consolidated financial statements on a straight-line basis over the requisite service periods of the awards. The assumed forfeiture rate is based on an average of the Company’s historical forfeiture rates, which the Company estimates is indicative of future forfeitures. For E Units, the requisite service period is five years, for the Class B Units, the requisite service period is four years and for Class C and D Units, the requisite service period is three years.
The Company recorded $0.4 million of stock-based compensation expense for the three months ended June 30, 2010 and 2009, and recorded $0.6 million and $1.2 million of stock-based compensation for the nine months ended June 30, 2010 and 2009, respectively. Stock-based compensation expense is included in general and administrative expense in the accompanying consolidated statements of operations. The summary of activity under the plan is presented below:
                 
            Weighted Average  
    Units     Grant-Date  
(in thousands)   Outstanding     Fair Value  
Nonvested balance at September 30, 2009
  $ 178,114     $ 6.70  
Granted
    38,031       2.93  
Forfeited
    (1,785 )     8.33  
Vested
    (101,932 )     6.86  
 
           
Nonvested balance at June 30, 2010
  $ 112,428     $ 4.09  
 
             
As of June 30, 2010, there was $0.2 million of total unrecognized compensation expense related to the units. These costs are expected to be recognized over a weighted average period of 3.4 years.

 

14


Table of Contents

12. Accruals for Self-Insurance and Other Commitments and Contingencies
The Company maintains insurance for employment practices liability, professional and general liability, workers’ compensation liability, automobile liability and health insurance liabilities that include self-insured retentions. The Company intends to maintain such coverage in the future and is of the opinion that its insurance coverage is adequate to cover potential losses on asserted claims. Employment practices liability is fully self-insured and professional and general liability has a self-insured retention of $1.0 million per claim and $2.0 million in the aggregate, with additional insurance coverage above the retention. In connection with the Merger on June 29, 2006, subject to the same retentions, the Company purchased additional insurance for certain claims relating to pre-Merger periods. For workers’ compensation, the Company has a $350 thousand per claim retention with statutory limits. Automobile liability has a $100 thousand per claim retention, with additional insurance coverage above the retention. The Company purchases specific stop loss insurance as protection against extraordinary claims liability for health insurance claims. Stop loss insurance covers claims that exceed $300 thousand on a per member basis.
The Company’s wholly-owned subsidiary captive insurance company provides coverage for the Company’s self-insured portion of professional and general liability claims and its employment practices liability. The accounts of the captive insurance company are fully consolidated with those of the other operations of the Company in the accompanying condensed consolidated financial statements.
The Company is in the health and human services business and, therefore, has been and reasonably expects it will continue to be subject to claims alleging that the Company, its independently contracted host-home caregivers (“Mentors”), or its employees failed to provide proper care for a client as well as claims by the Company’s clients, Mentors, employees or community members against the Company for negligence, intentional misconduct or violation of applicable law. Included in the Company’s recent claims are claims alleging personal injury, assault, battery, abuse, wrongful death and other charges. Regulatory agencies may initiate administrative proceedings alleging that the Company’s programs, employees or agents violate statutes and regulations and seek to impose monetary penalties on the Company. The Company could be required to incur significant costs to respond to regulatory investigations or defend against civil lawsuits and, if the Company does not prevail, the Company could be required to pay substantial amounts of money in damages, settlement amounts or penalties arising from these legal proceedings.
The Company accrues for costs related to contingencies when a loss is probable and the amount is reasonably estimable. While the Company believes the provision for contingencies is adequate, the outcome of the legal and other such proceedings is difficult to predict and the Company may settle claims or be subject to judgments for amounts that differ from the Company’s estimates.

 

15


Table of Contents

Item 2.  
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion of our financial condition and results of operations should be read in conjunction with the historical consolidated financial statements and the related notes included elsewhere in this report. This discussion may contain forward-looking statements about our markets, the demand for our services and our future results. We based these statements on assumptions that we consider reasonable. Actual results may differ materially from those suggested by our forward-looking statements for various reasons, including those discussed in the “Risk factors” and “Forward-looking statements” sections of this report.
Overview
Founded in 1980, we are a leading provider of home and community-based health and human services to adults and children with intellectual and/or developmental disabilities (“I/DD”), acquired brain injury and other catastrophic injuries and illnesses; and to youth with emotional, behavioral and medically complex challenges, or at risk youth (“ARY”). As of June 30, 2010, we provided our services to approximately 24,000 clients in 36 states through approximately 17,200 full-time equivalent employees. Most of our services involve residential support, typically in small group homes, Intermediate Care Facilities for the Mentally Retarded (“ICFs-MR”) or host home settings, designed to improve our clients’ quality of life and to promote client independence and participation in community life. Our non-residential services consist primarily of day programs and periodic services in various settings. We derive most of our revenue from state and county governmental payors as well as smaller amounts from non-public payors, mostly for services provided to persons with acquired brain injury and other catastrophic injuries and illnesses.
The largest part of our business is the delivery of services to adults and children with intellectual and/or developmental disabilities. Our I/DD programs include residential support, day habilitation, vocational services, case management, home health care and personal care. We also provide a variety of services to youth with emotional, behavioral and medically complex challenges. Our ARY services include therapeutic foster care, independent living, family reunification, family preservation, alternative schools and adoption services. We also provide a range of post-acute specialty rehabilitation treatment and care services to adults and children with an acquired brain injury and other catastrophic injuries and illnesses. Our specialty rehabilitation services range from post-acute care to assisted independent living and include neurobehavioral rehabilitation, neurorehabilitation, adolescent integration, outpatient or day treatment and pre-vocational services.
We operate our business in two reportable segments, Human Services and Post-Acute Specialty Rehabilitation Services (“SRS”). The Human Services segment provides home and community-based human services to adults and children with intellectual and/or developmental disabilities and to youth with emotional, behavioral and medically complex challenges. The SRS segment provides a mix of health care and community-based health and human services to individuals with acquired brain injuries and other catastrophic injuries and illnesses.
Factors affecting our operating results
Demand for Home and Community-Based Human Services
Our growth in revenue has historically been related to increases in the rates we receive for our services as well as increases in the number of individuals served. This growth has depended largely upon development-driven activities, including the maintenance and expansion of existing contracts and the award of new contracts, and upon acquisitions. We also attribute the continued growth in our client base to certain trends that are increasing demand in our industry, including demographic, medical and political developments.
Demographic trends have a particular impact on our I/DD business. Increases in the life expectancy of individuals with I/DD, we believe, have resulted in steady increases in the demand for I/DD services. In addition, caregivers currently caring for their relatives at home are aging and may soon be unable to continue with these responsibilities. Each of these factors affects the size of the I/DD population in need of services. Similarly, growth for our ARY services has been driven by favorable demographics. Demand for our specialty rehabilitation services has also grown as faster emergency response and improved medical techniques have resulted in more people surviving a traumatic brain injury.
Political and economic trends can also affect our operations. In particular, state budgetary pressures, especially within Medicaid programs, may influence the overall level of payments for our services, the number of clients and the preferred settings for many of the services we provide. Since the beginning of the current economic downturn, our government payors in several states have responded to deteriorating revenue collections by implementing provider rate reductions. In addition, the volume of referrals to our programs has also been constrained in many markets as payors have taken steps to reduce spending. We cannot be certain whether there will be further rate reductions in the coming months as state governments address revenue shortfalls.

 

16


Table of Contents

Historically, pressure from client advocacy groups for the populations we serve has generally helped our business, as these groups generally seek to pressure governments to fund residential services that use our small group home or host home models, rather than large, institutional models. In addition, our ARY services have historically been positively affected by the trend toward privatization of these services. Furthermore, we believe that successful lobbying by these groups has preserved I/DD and ARY services and, therefore, our revenue base, from significant cutbacks as compared with certain other human services, although we have suffered rate reductions in the current recessionary environment. In addition, a number of states have developed community-based waiver programs to support long-term care services for survivors of a traumatic brain injury.
Expansion
We have grown our business through expansion of existing markets and programs as well as through acquisitions.
Organic Growth
We believe that our future growth will depend heavily on our ability to expand existing service contracts and to win new contracts. Our organic expansion activities consist of both new program starts in existing markets and geographical expansion in new markets. Our new program starts typically require us to fund operating losses for a period of approximately 18-24 months. If a new program start does not become profitable during such period, we may terminate it. During the 12 months ended June 30, 2010, losses on new program starts for programs started within the last 18 months that generated operating losses were $3.6 million.
Acquisitions
As of June 30, 2010, we have completed 34 acquisitions since 2004, including several acquisitions of rights to government contracts or fixed assets from small providers, which we integrate with our existing operations. We have pursued larger strategic acquisitions in markets with significant opportunities. Acquisitions could have a material impact on our consolidated financial statements.
On June 30, 2010, we acquired the assets of Anchor Inne, Inc. (“Anchor Inne”) for $3.4 million. Anchor Inne has operations in Pennsylvania and serves individuals who have sustained a traumatic brain injury.
Divestitures
We regularly review and consider the divestiture of underperforming or non-strategic businesses to improve our operating results and better utilize our capital. We have made divestitures from time to time and expect that we may make additional divestitures in the future. Divestitures could have a material impact on our consolidated financial statements.
Net revenue
Revenue is reported net of allowances for unauthorized sales and estimated sales adjustments by business units. Revenue is also reported net of any state provider taxes or gross receipts taxes levied on services we provide. For the nine months ended June 30, 2010, we derived approximately 90% of our net revenue from state and local government payors. The payment terms and rates of these contracts vary widely by jurisdiction and service type, and may be based on per person per diems, rates established by the jurisdiction, cost-based reimbursement, hourly rates and/or units of service. We bill most of our residential services on a per diem basis, and we bill most of our non-residential services on an hourly basis. Some of our revenue is billed pursuant to cost-based reimbursement contracts, under which the billed rate is tied to the underlying costs. Lower than expected cost levels may require us to return previously received payments after cost reports are filed. Reserves are provided when estimable and probable. In addition, our revenue may be affected by adjustments to our billed rates as well as adjustments to previously billed amounts. Revenue in the future may be affected by changes in rate-setting structures, methodologies or interpretations that may be proposed in states where we operate or by the federal government which provides matching funds. We cannot determine the impact of such changes or the effect of any possible governmental actions.
Occasionally, timing of payment streams may be affected by delays by the state related to bill processing systems, staffing or other factors. While these delays have historically impacted our cash position in particular periods, they have not resulted in long-term collections problems.

 

17


Table of Contents

Expenses
Expenses directly related to providing services are classified as cost of revenue. Direct costs and expenses principally include salaries and benefits for service provider employees, per diem payments to our Mentors, residential occupancy expenses, which are primarily comprised of rent and utilities related to facilities providing direct care, certain client expenses such as food, medicine and transportation costs for clients requiring services. General and administrative expenses primarily include salaries and benefits for administrative employees, or employees that are not directly providing services, administrative occupancy and insurance costs as well as professional expenses such as consulting, legal and accounting services. Depreciation and amortization includes depreciation for fixed assets utilized in both facilities providing direct care and administrative offices, and amortization related to intangible assets.
Wages and benefits to our employees and per diem payments to our Mentors constitute the most significant operating cost in each of our operations. Most of our employee caregivers are reimbursed on an hourly basis, with hours of work generally tied to client need. Our Mentors are paid on a per diem basis, but only if the Mentor is currently caring for a client. Our labor costs are generally influenced by levels of service and these costs can vary in material respects across regions.
Occupancy costs represent a significant portion of our operating costs. As of June 30, 2010, we owned 402 facilities and one office, and we leased 898 facilities and 278 offices. We incur no facility costs for services provided in the home of a Mentor.
Expenses incurred in connection with liability insurance and third-party claims for professional and general liability totaled 0.3% and 0.6% of our net revenue for the three months ended June 30, 2010 and 2009, respectively and 0.4% and 0.5% of our net revenue for the nine months ended June 30, 2010 and 2009, respectively. We have incurred professional and general liability claims and insurance expense for professional and general liability of $0.9 million and $1.4 million for the three months ended June 30, 2010 and 2009, respectively and $3.1 million and $3.6 million for the nine months ended June 30, 2010 and 2009, respectively. Claims paid by us and our insurers for professional and general liability have increased sharply in recent years. We have historically insured through our wholly-owned captive insurance company professional and general liability claims for amounts of up to $1.0 million per claim and up to $2.0 million in the aggregate. Effective in the quarter ending September 30, 2010, we will be self-insured to higher limits and have less excess coverage available. Effective October 1, 2010, we expect to renew our professional and general liability policies at substantially higher self-insured retentions and higher premiums. We also insure through our wholly-owned captive insurance company employment practices liability claims of up to $240 thousand per claim and up to $1.0 million in the aggregate.
Our ability to maintain our margin in the future is dependent upon obtaining increases in rates and/or controlling our expenses. In fiscal 2008 and 2009, we invested in our infrastructure initiatives and business process improvements, which had a negative impact on our margin. As we continue to invest in our infrastructure initiatives and business process improvements our margin may continue to be negatively impacted.
Results of Operations
                                 
            Post-Acute Specialty              
            Rehabilitation              
Three Months Ended June 30,   Human Services     Services     Corporate     Consolidated  
(in thousands)                                
2010
                               
Net revenue
  $ 223,081     $ 36,625     $     $ 259,706  
Income (loss) from operations
    21,055       3,709       (12,518 )     12,246  
Operating margin
    9.4 %     10.1 %           4.7 %
2009
                               
Net revenue
  $ 221,348     $ 23,331     $     $ 244,679  
Income (loss) from operations
    20,503       3,212       (10,641 )     13,074  
Operating margin
    9.3 %     13.8 %           5.3 %

 

18


Table of Contents

                                 
            Post-Acute Specialty              
            Rehabilitation              
Nine Months Ended June 30,   Human Services     Services     Corporate     Consolidated  
(in thousands)                                
2010
                               
Net revenue
  $ 663,975     $ 97,109     $     $ 761,084  
Income (loss) from operations
    60,201       10,564       (36,580 )     34,185  
Operating margin
    9.1 %     10.9 %           4.5 %
2009
                               
Net revenue
  $ 652,787     $ 68,944     $     $ 721,731  
Income (loss) from operations
    56,784       10,775       (33,092 )     34,467  
Operating margin
    8.7 %     15.6 %           4.8 %
Three months ended June 30, 2010 compared to three months ended June 30, 2009
Consolidated
Consolidated revenue for the three months ended June 30, 2010 increased by $15.0 million, or 6.1%, compared to revenue for the three months ended June 30, 2009. Revenue increased $14.9 million related to acquisitions that closed during the period from April 1, 2009 to June 30, 2010 and $2.0 million related to organic growth, including growth related to new programs. Revenue growth was partially offset due to a reduction in revenue of $1.9 million from businesses we divested during the same period, rate reductions in certain states, including Minnesota, Arizona and Indiana, and the imposition of service limitations by the state of Indiana.
Consolidated income from operations decreased from $13.1 million, or 5.3% of revenue, for the three months ended June 30, 2009 to $12.2 million, or 4.7% of revenue, for the three months ended June 30, 2010. Income from operations was negatively impacted by rate reductions in certain states, including Minnesota (2.6%), our largest state, Arizona (10%) and Indiana (5%) as well as the imposition of service limitations by the state of Indiana. Our operating margin also decreased due to a $2.3 million increase in our workers’ compensation costs and a $0.8 million increase in our health insurance costs as well as a $0.8 million increased investment in growth initiatives. Income from operations for the third quarter of fiscal 2010 also included an additional $1.1 million of expense related to contingent earn-out charges from the Springbrook acquisition. Contingent consideration issued in a business combination is recorded at fair value at the date of acquisition and any changes in fair value of the liability after the acquisition are recognized as an operating expense.
Income from operations was positively impacted by a decrease of $1.7 million in depreciation and amortization from the third quarter of fiscal 2009. In the third quarter of fiscal 2009, we recorded an additional $3.4 million of depreciation expense related to disposals of assets pertaining to periods prior to 2009 and for the reduction in the estimated useful life on furniture and fixtures and client home furnishings.
Discontinued operations for all periods presented include the operations of REM Health, REM Maryland and REM Colorado, all of which are included in the Human Services segment. Loss from discontinued operations for the third quarter of fiscal 2009 included an additional $0.8 million, net of tax, related to the loss on disposal of certain business operations in the state of Utah (“REM Utah”).

 

19


Table of Contents

Human Services
Human Services revenue for the three months ended June 30, 2010 increased by $1.7 million, or 0.8% compared to the three months ended June 30, 2009. Revenue increased $5.7 million related to acquisitions that closed during the period from April 1, 2009 to June 30, 2010, but was partially offset by a reduction in revenue of $1.9 million from businesses we divested during the same period. Revenue from existing programs decreased $2.1 million due to a reduction in revenue from programs we closed during the period, rate reductions in certain states, including Minnesota, Arizona and Indiana, and the imposition of service limitations by the state of Indiana.
Income from operations increased from $20.5 million, or 9.3% of revenue, for the three months ended June 30, 2009 to $21.1 million, or 9.4% of revenue, for the three months ended June 30, 2010. Our margin increased primarily due to a decrease of $2.7 million in depreciation and amortization expense. Operating margin was negatively impacted by rate reductions in certain states, including Minnesota, Arizona and Indiana, and the imposition of service limitations by the state of Indiana. In addition, our workers’ compensation costs increased $1.6 million and our health insurance costs increased $0.4 million.
Post-Acute Specialty Rehabilitation Services
Post-Acute Specialty Rehabilitation Services revenue for the three months ended June 30, 2010 increased by $13.3 million, or 57.0%, compared to the three months ended June 30, 2009. Revenue growth of $9.1 million was related to acquisitions that closed during the period from April 1, 2009 to June 30, 2010, and the remaining $4.2 million related to organic growth.

 

20


Table of Contents

Income from operations increased from $3.2 million for the three months ended June 30, 2009 to $3.7 million for the three months ended June 30, 2010, while operating margin decreased from 13.8% to 10.1% for the same periods. Our margin decreased primarily due to a $0.8 million increased investment in growth initiatives, namely $0.6 million related to increased infrastructure and $0.2 million related to new or expanded facilities. Operating margin also decreased due to a $0.7 million increase in our workers’ compensation costs and a $0.4 million increase in health insurance costs.
Corporate
Total corporate general and administrative expenses increased by $1.9 million to $12.5 million for the three months ended June 30, 2010 primarily due to an increase of $1.1 million related to the valuation of the Springbrook contingent earn-out. In addition, in consolidating our cash disbursement function from disparate field locations to a centralized shared services center, we transferred certain associated costs from the Human Services and Post-Acute Specialty Rehabilitation Services segments to corporate, and corporate expense increased $0.4 million.
Nine months ended June 30, 2010 compared to nine months ended June 30, 2009
Consolidated
Consolidated revenue for the nine months ended June 30, 2010 increased by $39.4 million, or 5.5%, compared to revenue for the nine months ended June 30, 2009. Revenue increased $37.4 million related to acquisitions that closed during fiscal 2009 and the first three quarters of fiscal 2010 and $8.6 million related to organic growth, including growth related to new programs. Revenue growth was partially offset due to a reduction in revenue of $6.6 million from businesses we divested during the same period, rate reductions in certain states, including Minnesota, Arizona and Indiana, and the imposition of service limitations by the state of Indiana.
Consolidated income from operations decreased from $34.5 million, or 4.8% of revenue, for the nine months ended June 30, 2009 to $34.2 million, or 4.5% of revenue, for the nine months ended June 30, 2010. Income from operations was negatively impacted by rate reductions in certain states, including Minnesota (2.6%), our largest state, Arizona (10%) and Indiana (5%) as well as the imposition of service limitations by the state of Indiana. Our operating margin also decreased due to a $3.4 million increase in our workers’ compensation costs and a $3.2 million increase in our health insurance costs as well as a $3.1 million increased investment in growth initiatives. Income from operations for the nine months ended June 30, 2010 also included an additional $1.1 million of expense related to contingent earn-out charges from the Springbrook acquisition.
Depreciation and amortization expense increased $0.7 million during the nine months ended June 30, 2010 due to the reduction in the useful life of certain assets as well as an increase in amortizable assets resulting from acquisitions in the period.
These decreases in operating margin were partially offset by an increased expense reduction from our cost-containment efforts.
Loss from discontinued operations, net of tax increased $2.5 million from the nine months ended June 30, 2009. Discontinued operations for all periods presented include the operations of REM Health, REM Maryland and REM Colorado, all of which are included in the Human Services segment. Loss from discontinued operations for the nine months ended June 30, 2010 included an additional $4.1 million, net of tax, related to the impairment charges recorded to close our business operations in REM Colorado and to write-down the REM Maryland assets to fair value. Loss from discontinued operations for the nine months ended June 30, 2009 included an additional $0.8 million, net of tax, related to the loss on disposal of REM Utah.
Human Services
Human Services revenue for the nine months ended June 30, 2010 increased by $11.2 million, or 1.7% compared to the nine months ended June 30, 2009. Revenue increased $19.4 million related to acquisitions that closed during fiscal 2009 and the first three quarters of fiscal 2010 but was partially offset by a reduction in revenue of $6.6 million from businesses we divested during the same period. Revenue from existing programs decreased $1.6 million due to a reduction in revenue from programs we closed during the period, rate reductions in certain states, including Minnesota, Arizona and Indiana, and the imposition of service limitations by the state of Indiana.
Income from operations increased from $56.8 million, or 8.7% of revenue, during the nine months ended June 30, 2009 to $60.2 million, or 9.1% of revenue, during the nine months ended June 30, 2010. The increase was primarily due to our ongoing cost-containment efforts as well as a $1.7 million decrease in depreciation and amortization expense. Operating margin was negatively impacted by rate reductions in certain states, including Minnesota, Arizona and Indiana, and the imposition of service limitations by the state of Indiana. In addition, our workers’ compensation costs increased $2.4 million and our health insurance costs increased $2.0 million.

 

21


Table of Contents

Post-Acute Specialty Rehabilitation Services
Post-Acute Specialty Rehabilitation Services revenue for the nine months ended June 30, 2010 increased by $28.2 million, or 40.9%, compared to the nine months ended June 30, 2009. This increase was due to growth of $18.0 million related to acquisitions that closed during fiscal 2009 and the first three quarters of fiscal 2010 and $10.2 million related to organic growth.
Income from operations decreased from $10.8 million, or 15.6% of revenue, for the nine months ended June 30, 2009 to $10.6 million, or 10.9% of revenue, for the nine months ended June 30, 2010. This decrease was primarily due to a $3.1 million increased investment in growth initiatives, namely $2.4 million related to increased infrastructure and $0.7 million related to new or expanded facilities. Operating margin also decreased due to a $2.0 million increase in depreciation and amortization expense, $1.2 million increase in our health insurance costs and a $1.0 million increase in our workers’ compensation costs.
Corporate
Total corporate general and administrative expenses increased by $3.5 million from the nine months ended June 30, 2009 to $36.6 million for the nine months ended June 30, 2010. In consolidating our cash disbursement function from disparate field locations to a centralized shared services center, we transferred certain associated costs from the Human Services and Post-Acute Specialty Rehabilitation Services segments to corporate, and corporate expense increased $1.2 million. In addition, corporate expense increased $1.1 million related to the valuation of the Springbrook contingent earn-out and $0.8 million related to expensed transaction costs from acquisitions.
Liquidity and Capital Resources
Our principal uses of cash are to meet working capital requirements, fund debt obligations and finance capital expenditures and acquisitions. Cash flows from operations have historically been sufficient to meet these cash requirements. Our principal sources of funds are cash flows from operating activities and available borrowings under our senior credit facilities.
Operating activities
Cash flows provided by operating activities for the nine months ended June 30, 2010 were $48.6 million compared to $36.2 million for the nine months ended June 30, 2009. Our days sales outstanding remained constant at 46 days from September 30, 2009 to June 30, 2010.
Investing activities
Net cash used in investing activities, primarily consisting of purchases of property and equipment and cash paid for acquisitions, was $47.4 million for the nine months ended June 30, 2010 compared to $47.8 million for the nine months ended June 30, 2009.
Cash paid for acquisitions for the nine months ended June 30, 2010 was $32.8 million, primarily reflecting the acquisitions of NeuroRestorative for $17.0 million, Springbrook for $6.3 million, Villages for $6.0 million and Anchor Inne for $3.4 million.
Cash paid for acquisitions for the nine months ended June 30, 2009 was $23.3 million, primarily reflecting the earnout payment of $12.0 million associated with the CareMeridian acquisition, the acquisition of Institute for Family Centered Services, Inc. for $11.5 million and the acquisition of RIA, Inc. for $0.9 million. Also during the nine months ended June 30, 2009, we received $1.2 million related to an escrow settlement from a prior acquisition.
Cash paid for property and equipment for the nine months ended June 30, 2010 was $14.5 million, or 1.9% of net revenue, and included $0.9 million related to the purchase of real estate and $0.2 million related to the implementation of a new billing system. Cash paid for property and equipment was $22.3 million, or 3.1% of net revenue, for the nine months ended June 30, 2009 and included $4.4 million related to the purchase of real estate and $2.1 million related to the implementation of a new billing system.

 

22


Table of Contents

Investing activities for the nine months ended June 30, 2009 also included the purchase of $11.5 million of senior floating rate toggle notes due 2014 (the “NMH Holdings notes”) from our indirect parent company, NMH Holdings, Inc. (“NMH Holdings”) for $6.6 million.
Financing activities
Net cash used in financing activities was $3.0 million for the nine months ended June 30, 2010 compared to $9.9 million for the nine months ended June 30, 2009. Our financing activities for both the nine months ended June 30, 2010 and 2009, included the repayment of long term debt of $2.8 million.
During the nine months ended June 30, 2009, we paid a dividend of $7.0 million to our direct parent company, which used the proceeds to make a distribution to NMH Holdings and NMH Holdings used the proceeds of the distribution to repurchase an aggregate principal amount of $13.9 million of the NMH Holdings notes.
We may seek to purchase a portion of our outstanding debt or the debt of NMH Holdings from time to time. The amount of debt that may be purchased, if any, would be decided at the discretion of our Board of Directors and management and will depend on market conditions, prices, contractual restrictions, our liquidity and other factors.
As mentioned above, our principal sources of funds are cash flows from operating activities and available borrowings under the $125.0 million senior revolver. As of June 30, 2010, we did not have any borrowings under our senior revolver which expires on June 29, 2012. The availability on the senior revolver was reduced by $9.9 million to $115.1 million as letters of credit in excess of $20.0 million under our synthetic letters of credit facility were outstanding. For a description of the senior credit facilities, see note 3 to the condensed consolidated financial statements. We believe that these funds will provide sufficient liquidity and capital resources to meet our near-term and future financial obligations, including scheduled principal and interest payments as well as to provide funds for working capital, capital expenditures and other needs for the foreseeable future. No assurance can be given, however, that this will be the case.
However, as of June 30, 2010, our indirect parent company, NMH Holdings had $216.0 million aggregate principal amount of the NMH Holdings notes outstanding (including the $13.0 million of which was held by us). These notes are not guaranteed by the Company. NMH Holdings is a holding company with no direct operations. Its principal assets are the direct and indirect equity interests it holds in its subsidiaries, including us, and all of its operations are conducted through us and our subsidiaries. As a result, absent other sources of liquidity, NMH Holdings will be dependent upon dividends and other payments from us to generate the funds necessary to meet its outstanding debt service and other obligations, including its obligations on the notes held by us. NMH Holdings has paid all of the interest payments to date on the notes entirely in PIK Interest (defined below) which has increased the principal amount by $54.9 million since the date of issuance, including the PIK Interest issued to us. NMH Holdings currently expects to elect to make interest payments entirely by increasing the NMH Holdings notes or issuing new notes (“PIK Interest”) through June 15, 2012. Beginning September 15, 2012, interest payments must be made in cash, including the accrued PIK Interest. NMH Holdings expects the September 2012 payment to be in the range of $95.0 million to $100.0 million depending on interest rates.
Our senior credit agreement and the indenture governing our senior subordinated notes limit our ability to pay dividends to our parent companies. We do not currently expect to have the ability under our debt agreements to make a dividend payment in an amount sufficient to enable NMH Holdings to satisfy their payment that comes due in September 2012. In order to fund this payment, NMH Holdings may pursue various financing alternatives, including modifying the terms of our existing indebtedness or the indebtedness of NMH Holdings, raising new capital through debt or equity financing, retiring or purchasing our outstanding debt or the debt of NMH Holdings through exchanges for newly issued debt or equity securities or a combination of these alternatives. Any financings, repurchases or exchanges would be approved by the Board of Directors and will depend on market conditions, prices, contractual restrictions, our liquidity and other factors. Such financings, repurchases or exchanges could have a material impact on our liquidity and could also require amendments to the agreements governing our outstanding debt obligations or those of NMH Holdings. Additional financing may not be available or, if available, may not be made on terms favorable to us.

 

23


Table of Contents

Covenants
The senior credit agreement and the indenture governing the senior subordinated notes contain negative covenants, including limitations on our ability to incur additional debt, sell material assets, retire, redeem or otherwise reacquire capital stock, acquire the capital stock or assets of another business and pay dividends. In addition, in the case of the senior credit agreement, we are required to maintain a consolidated leverage ratio of no more than 5.00 to 1.00 as of June 30, 2010 and a consolidated interest coverage ratio of no less than 2.00 to 1.00 for the four consecutive fiscal quarters ended June 30, 2010. The leverage ratio is defined as the ratio of total debt, net of cash and cash equivalents, to consolidated adjusted EBITDA, as defined in the senior credit agreement, for the most recently completed four fiscal quarters. The consolidated interest coverage ratio is defined as the ratio of consolidated adjusted EBITDA to consolidated interest expense, both as defined under the senior credit agreement, for the most recently completed four fiscal quarters. Beginning with the quarter ending December 31, 2010, we will be required to maintain a consolidated leverage ratio of no more than 4.50 to 1.00 and a consolidated interest coverage ratio of no less than 2.25 to 1.00 for the four consecutive fiscal quarters ending December 31, 2010.
As of June 30, 2010, our consolidated leverage ratio was 4.32 to 1.00, as calculated in accordance with the senior credit agreement and our consolidated interest coverage ratio was 2.62 to 1.00, as calculated in accordance with the senior credit agreement. As of June 30, 2010, total debt, net of cash and cash equivalents, was $494.5 million. Under the senior credit agreement, consolidated adjusted EBITDA is defined as net income before interest expense and interest income, income taxes, depreciation and amortization, further adjusted to add back, among other items, permitted start up losses, acquired EBITDA from acquisitions and certain unusual and non- recurring expenses.
Set forth below is a reconciliation of consolidated adjusted EBITDA, as calculated under the credit agreement, to net loss for the most recently completed four fiscal quarters ended June 30, 2010:
         
(in thousands)      
Net loss
  $ (6,842 )
Loss from discontinued operations, net of tax
    4,760  
Benefit for income taxes
    (802 )
Interest income
    (56 )
Interest income from related party
    (1,905 )
Interest expense
    47,286  
Depreciation and amortization
    57,515  
Management fee of related party
    1,233  
Loss on disposal of assets
    487  
Stock based compensation
    712  
Predecessor company claims
    1,008  
Acquisition costs
    841  
Non-cash contingent consideration
    1,072  
Restructuring
    130  
Acquired EBITDA from acquisitions
    4,994  
Permitted start up losses
    3,639  
Non-recurring fees and expenses
    144  
Other
    310  
 
     
Consolidated adjusted EBITDA per the senior credit agreement
  $ 114,526  
 
     
Set forth below is a calculation of interest expense, as calculated under the credit agreement, for the most recently completed four fiscal quarters ended June 30, 2010:
         
(in thousands)      
Interest rate swap agreements
  $ 14,229  
Unused line of credit
    602  
Senior term B loan
    7,777  
Letters of credit
    616  
Senior subordinated notes
    20,250  
Term loan mortgage
    189  
Capital leases
    171  
Interest income
    (56 )
 
     
Interest expense per the senior credit agreement
  $ 43,778  
 
     
The consolidated leverage ratio and the consolidated interest coverage ratios are material components of the senior credit agreement and non-compliance with these ratios could prevent us from borrowing under the senior revolver and would result in a default under the senior credit agreement.

 

24


Table of Contents

Contractual Commitments Summary
The following table summarizes our contractual obligations and commitments as of June 30, 2010:
                                         
            Less than                     More than  
(in thousands)   Total     1 year     1-3 years     3-5 years     5 years  
Long-term debt obligations(1)
  $ 505,383     $ 3,667     $ 321,716     $ 180,000     $  
Operating lease obligations(2)
    144,406       37,599       52,299       30,498       24,010  
Capital lease obligations
    1,702       74       126       151       1,351  
Contingent consideration
    9,329       6,009       3,320              
Standby letters of credit
    29,899       29,899                    
 
                             
Total obligations and commitments
  $ 690,719     $ 77,248     $ 377,461     $ 210,649     $ 25,361  
 
                             
 
     
(1)  
Does not include interest on long-term debt or the $214.8 million of senior floating rate toggle notes due 2014, net of discount, issued by NMH Holdings. We hold $13.0 million of the outstanding senior floating rate toggle notes.
 
(2)  
Includes the fixed rent payable under the leases and does not include additional amounts, such as taxes, that may be payable under the leases.
Off-balance sheet arrangements
We do not have any off-balance sheet transactions or interests.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of financial statements in conformity with GAAP requires the appropriate application of certain accounting policies, many of which require us to make estimates and assumptions about future events and their impact on amounts reported in the financial statements and related notes. Since future events and the impact of those events cannot be determined with certainty, the actual results may differ from our estimates. These differences could be material to the financial statements.
We believe our application of accounting policies, and the estimates inherently required therein, are reasonable. These accounting policies and estimates are constantly reevaluated, and adjustments are made when facts and circumstances dictate a change.
As of June 30, 2010, there has been no material change in our accounting policies or the underlying assumptions or methodology used to fairly present our financial position, results of operations and cash flows for the periods covered by this report. In addition, no triggering events have come to our attention pursuant to our review of goodwill and long-lived assets that would indicate impairment of these assets as of June 30, 2010.
For further discussion of our critical accounting policies see management’s discussion and analysis of financial condition and results of operations contained in our Form 10-K for the year ended September 30, 2009.

 

25


Table of Contents

Forward-Looking Statements
Some of the matters discussed in this report may constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).
These statements relate to future events or our future financial performance, and include statements about our expectations for future periods with respect to demand for our services, the political climate and budgetary environment, our expansion efforts and the impact of our recent acquisitions, our plans for divestitures, investments in our infrastructure and business process improvements, our margins, our liquidity and our financing plans. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or “continue,” the negative of such terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially.
The information in this report is not a complete description of our business or the risks associated with our business. There can be no assurance that other factors will not affect the accuracy of these forward-looking statements or that our actual results will not differ materially from the results anticipated in such forward-looking statements. While it is impossible to identify all such factors, factors that could cause actual results to differ materially from those estimated by us include, but are not limited to, those factors or conditions described under “Part II. Item 1A. Risk Factors” in this report as well as the following:
   
changes in Medicaid funding or changes in budgetary priorities by state and local governments;
 
   
our significant amount of debt, our ability to meet our debt service obligations and our ability to incur additional debt;
 
   
current credit and financial market conditions;
 
   
legal proceedings;
 
   
the size of our self-insurance accruals and changes in the insurance market that affect our ability to obtain coverage at reasonable rates;
 
   
our ability to control operating costs and collect accounts receivable;
 
   
our ability to maintain, expand and renew existing services contracts and to obtain additional contracts;

 

26


Table of Contents

   
our ability to attract and retain experienced personnel, including members of our senior management team;
 
   
our ability to acquire new licenses or to maintain our status as a licensed service provider in certain jurisdictions;
 
   
government regulations and our ability to comply with such regulations or the interpretations thereof;
 
   
our ability to establish and maintain relationships with government agencies and advocacy groups;
 
   
increased or more effective competition;
 
   
changes in reimbursement rates, policies or payment practices by our payors;
 
   
changes in interest rates;
 
   
successful integration of acquired businesses; and
 
   
possible conflict between the interests of our majority equity holder and those of the holders of our notes.
Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, we do not assume responsibility for the accuracy and completeness of the forward-looking statements. All written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the “Risk Factors” and other cautionary statements included herein. We are under no duty to update any of the forward-looking statements after the date of this report to conform such statements to actual results or to changes in our expectations.
Item 3.  
Quantitative and Qualitative Disclosures about Market Risk.
To reduce the interest rate exposure on the term B loan, the Company is a party to interest rate swap agreements with respect to $288.9 million of the $321.6 million outstanding as of June 30, 2010. Effective August 31, 2006, the Company fixed a portion of the term B loan at 5.32% plus 2.00%. This swap expired on June 30, 2010 and the Company has not entered into any replacement swap agreements for this portion of debt. Effective August 31, 2007, the Company fixed an additional portion of the term B loan debt at 4.89% plus 2.00%. This swap expires on September 30, 2010 and the Company is considering its options for addressing interest rate exposure as these swap agreements terminate.
As a result of the interest rate swap agreements, the variable rate debt outstanding was effectively reduced from $325.4 million outstanding to $36.5 million outstanding as of June 30, 2010. The variable rate debt outstanding relates to the term B loan, which has an interest rate based on LIBOR plus 2.00% or Prime plus 1.00%, the senior revolver, which has an interest rate based on LIBOR plus 2.00% or Prime plus 1.00%, subject to reduction depending on our leverage ratio, and the term loan mortgage, which has an interest rate based on Prime plus 1.50%. A 1% increase in the interest rate on our floating rate debt would increase cash interest expense of the floating rate debt by $0.4 million.

 

27


Table of Contents

Item 4.  
Controls and Procedures.
(a) Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the rules and forms of the SEC, and is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, to allow for timely decisions regarding required disclosure. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. As of June 30, 2010, the end of the period covered by this Quarterly Report on Form 10-Q, our management, with the participation of our principal executive officers and principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. Based on that evaluation, our principal executive officers and principal financial officer concluded that our disclosure controls and procedures were not effective as of June 30, 2010, because they are not yet able to conclude that we have remediated the material weaknesses in internal control over financial reporting identified in Item 9A(T) of our Annual Report on Form 10-K for the fiscal year ended September 30, 2009.
As reported in Item 9A(T) of our Annual Report on Form 10-K for the fiscal year ended September 30, 2009, our management, with the participation of the principal executive officers and principal financial officer, evaluated the effectiveness of our internal control over financial reporting as of September 30, 2009 (management’s most recent assessment of internal control over financial reporting). In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). In connection with this assessment, management identified material weaknesses in our internal control over financial reporting as of September 30, 2009.
A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our financial statements will not be prevented or detected on a timely basis. Our material weaknesses relate to our revenue and accounts receivable balances, as detailed below:
Revenue
As reported in Item 9A(T) of our Annual Report on Form 10-K for the fiscal year ended September 30, 2009, as of fiscal year-end, we had ineffective controls over the accuracy of revenue and accounts receivable balances. As of June 30, 2010, we continued to have the following material weaknesses.
   
We have insufficient segregation of duties within our new billing and accounts receivable system and insufficient controls to ensure appropriate access to our new billing and accounts receivable system and data. This material weakness increases the risk that erroneous or unauthorized revenue transactions could occur and the risk that they would not be detected on a timely basis if they do occur. Management is currently designing processes and controls to limit system access to appropriate personnel and segregate incompatible duties.
   
We have insufficient controls over the accuracy and validity of the billing rates used to calculate revenue recorded in our consolidated financial statements. We previously addressed this material weakness within our legacy accounts receivable system. However, our new billing and accounts receivable system is not yet able to generate timely reports to identify changes to billing rates for periodic review. Therefore, as of June 30, 2010, we have insufficient controls to verify that changes to billing rates entered into the new system were valid and accurate. This control deficiency increases the risk of errors in the invoicing and recording of billings to payors.
   
During the fourth quarter of fiscal 2009, we completed implementation of our new billing and accounts receivable system and related controls, in a majority of our operations, representing a substantial portion of our revenue. As of June 30, 2010, these controls continue to be evaluated for operating effectiveness.

 

28


Table of Contents

The following item was first disclosed in our Form 10-Q for the quarterly period ended December 31, 2007. It has not been fully remediated and continues to exist.
   
We have insufficient controls over revenue recognition and revenue reserves for unauthorized sales. We maintain a revenue recognition policy in accordance with U.S. generally accepted accounting principles. However, we lacked controls to ensure definitive, consistent and documented application of the revenue recognition criteria regarding varying local payor contract requirements, specifically with respect to payor service authorization requirements. During the quarter ended September 30, 2009, management undertook a process to remediate the control design by documenting, reviewing and approving local application of revenue recognition requirements and developing a process to assess contract terms in each state to ensure that revenue recognition criteria are being consistently and appropriately interpreted and applied. However, we continue to have insufficient controls to ensure that all unauthorized sales are identified and reserved appropriately in the consolidated financial statements. Generally, if we provide services without a current, valid authorization from the payor agency to provide those services, revenue associated with the unauthorized services may need to be either reserved until such authorization is received, or ultimately written off if authorization is not granted. Management expects our new billing and accounts receivable system, when remediated, to capture more complete and accurate data related to authorizations, which will improve our controls over identifying and reserving for unauthorized sales.
  (b)  
Changes in Internal Control over Financial Reporting
As discussed above, during the quarter ended September 30, 2009, we completed implementation of our new billing and accounts receivable system in a majority of our operations. This billing and accounts receivable system has affected, and will continue to affect, the processes that impact our internal control over financial reporting. As we optimize and remediate the system, we will review the related controls and may take further steps to ensure that they are effective and integrated appropriately.
Except for the continuing optimization and remediation of our billing and accounts receivable system, during the most recent fiscal quarter, there were no significant changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1.  
Legal Proceedings.
We are in the health and human services business and, therefore, we have been and continue to be subject to claims alleging that we, our employees or our Mentors failed to provide proper care for a client. We are also subject to claims by our clients, our employees, our Mentors or community members against us for negligence, intentional misconduct or violation of applicable laws. Included in our recent claims are claims alleging personal injury, assault, battery, abuse, wrongful death and other charges. Regulatory agencies may initiate administrative proceedings alleging that our programs, employees or agents violate statutes and regulations and seek to impose monetary penalties on us. We could be required to incur significant costs to respond to regulatory investigations or defend against civil lawsuits and, if we do not prevail, we could be required to pay substantial amounts of money in damages, settlement amounts or penalties arising from these legal proceedings.
We reserve for costs related to contingencies when a loss is probable and the amount is reasonably estimable. While we believe our provision for legal contingencies is adequate, the outcome of the legal proceedings is difficult to predict and we may settle legal claims or be subject to judgments for amounts that differ from our estimates.
See “Part I. Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Part II. Item 1A. Risk Factors” for additional information.

 

29


Table of Contents

Item 1A.  
Risk Factors.
Reductions or changes in Medicaid funding or changes in budgetary priorities by the state and local governments that pay for our services could have a material adverse effect on our revenue and profitability.
We derive the vast majority of our revenue from contracts with state and local governments. These governmental payors fund a significant portion of their payments to us through Medicaid, a joint federal/state health insurance program through which state expenditures are matched by federal funds ranging from, for federal fiscal year 2010, 65% to more than 82% of total costs, a number based largely on a state’s per capita income. Our revenue, therefore, is determined by the level of federal, state and local governmental spending for the services we provide. Budgetary pressures, particularly during recessionary periods as well as other economic, industry, political and other factors, could cause the federal and state governments to limit spending, which could significantly reduce our revenue, referrals, margins and profitability and adversely affect our growth strategy. Governmental agencies generally condition their contracts with us upon a sufficient budgetary appropriation. If a government agency does not receive an appropriation sufficient to cover its contractual obligations with us, it may terminate a contract or defer or reduce our reimbursement. In addition, there is risk that previously appropriated funds could be reduced through subsequent legislation. Many states in which we operate have been experiencing unprecedented budgetary deficits and constraints and have implemented or are considering initiating service reductions, rate freezes and/or rate reductions, including states such as Minnesota, California, Indiana and Arizona. Similarly, programmatic changes such as conversions to managed care with related contract demands regarding billing and services, unbundling of services, governmental efforts to increase consumer autonomy and reduce provider oversight, coverage and other changes under state Medicaid plans, may cause unanticipated costs and risks to our service delivery. The loss or reduction of or changes to reimbursement under our contracts could have a material adverse effect on our business, financial condition and operating results.
Reductions in reimbursement rates or failure to obtain increases in reimbursement rates could adversely affect our revenue, cash flows and profitability.
Our revenue and operating profitability depend on our ability to maintain our existing reimbursement levels and to obtain periodic increases in reimbursement rates to meet higher costs and demand for more services. Twelve percent of our revenue is derived from contracts based on a cost reimbursement model where we are reimbursed for our services based on our costs plus an agreed-upon margin. If we are not entitled to, do not receive or cannot negotiate increases in reimbursement rates, or are forced to accept a reduction in our reimbursement rates at approximately the same time as our costs of providing services increase, including labor costs and rent, our margins and profitability could be adversely affected. Changes in how federal and state government agencies operate reimbursement programs can also affect our operating results and financial condition. Some states have, from time to time, revised their rate-setting or methodologies in a manner that has resulted in rate decreases. In some instances, changes in rate-setting methodologies have resulted in third-party payors disallowing, in whole or in part, our requests for reimbursement. Any reduction in or the failure to maintain or increase our reimbursement rates could have a material adverse effect on our business, financial condition and results of operations. Changes in the manner in which state agencies interpret program policies and procedures or review and audit billings and costs could also adversely affect our business, financial condition and operating results and our ability to meet obligations under our indebtedness.
Our level of indebtedness could adversely affect our ability to raise additional capital to fund our operations, and limit our ability to react to changes in the economy or our industry.
We have a significant amount of indebtedness. As of June 30, 2010, we had total indebtedness of $507.1 million, no borrowings under our senior revolver and $115.1 million of availability under our senior revolver. The senior secured credit facilities also include a $20.0 million synthetic letter of credit facility, all of which has been fully utilized. The availability under our senior revolver was reduced from $125.0 million as $9.9 million of letters of credit in excess of $20.0 million under our synthetic letters of credit facility were outstanding under the senior credit agreement.
Our substantial degree of leverage could have important consequences, including the following:
   
it may limit our ability to obtain additional debt or equity financing for working capital, capital expenditures, debt service requirements, acquisitions, and general corporate or other purposes;

 

30


Table of Contents

   
a substantial portion of our cash flows from operations will be dedicated to the payment of principal and interest on our indebtedness and will not be available for other purposes, including our operations, future business opportunities and capital expenditures;
 
   
the debt service requirements of our indebtedness could make it more difficult for us to satisfy our financial obligations;
 
   
a portion of our variable interest rate borrowings under the senior secured credit facilities has not been hedged, exposing us to the risk of increased interest rates;
 
   
it may limit our ability to adjust to changing market conditions and place us at a competitive disadvantage compared to our competitors that have less debt and a lower degree of leverage; and
 
   
we may be vulnerable if the current downturn in general economic conditions continues or if there is a downturn in our business, or we may be unable to carry out activities that are important to our growth.
In addition to our indebtedness noted above, our indirect parent company, NMH Holdings had $216.0 million aggregate principal amount of the NMH Holdings notes outstanding as of June 30, 2010 (including the $13.0 million of which was held by us). These notes are not guaranteed by the Company. NMH Holdings is a holding company with no direct operations. Its principal assets are the direct and indirect equity interests it holds in its subsidiaries, including us, and all of its operations are conducted through us and our subsidiaries. As a result, absent other sources of liquidity, NMH Holdings will be dependent upon dividends and other payments from us to generate the funds necessary to meet its outstanding debt service and other obligations, including its obligations on the notes held by us. NMH Holdings has paid all of the interest payments to date on the notes entirely in PIK Interest (defined below) which increased the principal amount by $54.9 million, including the PIK Interest issued to us. NMH Holdings currently expects to elect to make interest payments entirely by increasing the principal amount of the NMH Holdings notes or issuing new NMH Holdings notes (“PIK Interest”) through June 15, 2012. Beginning September 15, 2012, interest payments must be made in cash, including the accrued PIK Interest. NMH Holdings expects the September 2012 payment to be in the range of $95.0 million to $100.0 million depending on interest rates. Our senior credit agreement and the indenture governing our senior subordinated notes limit our ability to pay dividends to our parent companies. We do not currently expect to have the ability under our debt agreements to make a dividend payment in an amount sufficient to enable NMH Holdings to satisfy their payment due in September 2012. NMH Holdings may pursue various financing alternatives to fund this payment, any of which could have a material impact on our liquidity and could also require amendments to the agreements governing our outstanding debt obligations or those of NMH Holdings. Additional financing may not be available or, if available, may not be made on terms favorable to us.
Subject to restrictions in the indentures governing our senior subordinated notes and the NMH Holdings notes and the credit agreement governing our senior secured credit facilities, we may be able to incur more debt in the future, which may intensify the risks described in this risk factor. All of the borrowings under the senior secured credit facilities are secured by substantially all of the assets of the Company and its subsidiaries. The NMH Holdings notes are structurally subordinated to the senior subordinated notes and the senior secured credit facilities.
In addition to our high level of indebtedness, we have significant rental obligations under our operating leases for our group homes, other service facilities and administrative offices. For the nine months ended June 30, 2010, our aggregate rental payments for these leases, including taxes and operating expenses, was $33.4 million. These obligations could further increase the risks described above.
Current credit and economic conditions could have a material adverse effect on our cash flows, liquidity and financial condition.
Due to the tightening of the credit markets over the last several years, our government payors or other counterparties that owe us money could be delayed in obtaining, or may not be able to obtain, necessary funding and/or financing to meet their cash-flow needs. Moreover, tax revenue continues to be down in many jurisdictions due to the economic recession and high rates of unemployment, and government payors may not be able to pay us for our services until they collect sufficient tax revenue. Delays in payment could have a material adverse effect on our cash flows, liquidity and financial condition. In addition, in the event that our payors or other counterparties delay payments to us, our financial condition could be further impaired if we are unable to borrow additional funds under our senior credit agreement to finance our operations.

 

31


Table of Contents

Our variable cost structure is directly related to our labor costs, which may be adversely affected by labor shortages, a deterioration in labor relations or increased unionization activities.
Our variable cost structure and operating profitability are directly related to our labor costs. Labor costs may be adversely affected by a variety of factors, including a limited supply of qualified personnel in any geographic area, local competitive forces, the ineffective utilization of our labor force, increases in minimum wages, health care costs and other personnel costs, and adverse changes in client service models. We have incurred higher labor costs in certain markets from time to time because of difficulty in hiring qualified direct service staff. These higher labor costs have resulted from increased wages and overtime and the costs associated with recruitment and retention, training programs and use of temporary staffing personnel. In part to help with the challenge of recruiting and retaining direct care employees, we offer these employees a benefits package that includes paid time off, health insurance, dental insurance, vision coverage, life insurance and a 401(k) plan, and these costs can be significant. In addition, The Patient Protection and Affordable Care Act signed into law on March 23, 2010 will impose new mandates on employers. Given the composition of our workforce, these mandates could be material to our costs, and we are studying the potential impact of these mandates.
Although our employees are generally not unionized, sixteen of our employees were represented by a labor union until September 30, 2009, when our only unionized program closed. Future unionization activities could result in an increase of our labor and other costs. The Employee Free Choice Act (“EFCA”) of 2009 (H.R. 1409) seeks to amend the National Labor Relations Act to make it easier for workers to be represented by labor unions. If the EFCA or a variation of this legislation becomes law, it could result in increased unionization activities. We may not be able to negotiate labor agreements on satisfactory terms with any future labor unions. If employees covered by a collective bargaining agreement were to engage in a strike, work stoppage or other slowdown, we could experience a disruption of our operations and/or higher ongoing labor costs, which could adversely affect our business, financial condition and results of operations.
Covenants in our debt agreements restrict our business in many ways.
The credit agreement governing the senior secured credit facilities and the indentures governing the senior subordinated notes and the indenture governing the NMH Holdings notes contain various covenants that limit our ability and/or our subsidiaries’ ability to, among other things:
   
incur additional debt or issue certain preferred shares;
 
   
pay dividends on or make distributions in respect of capital stock or make other restricted payments;
 
   
make certain investments;
 
   
sell certain assets;
 
   
create liens on certain assets to secure debt;
 
   
enter into agreements that restrict dividends from subsidiaries;
 
   
consolidate, merge, sell or otherwise dispose of all or substantially all of our assets; and
 
   
enter into certain transactions with our affiliates.
The credit agreement governing the senior secured credit facilities also contains restrictive covenants and requires the Company and its subsidiaries to maintain specified financial ratios and satisfy other financial condition tests. Our ability to meet those financial ratios and tests may be affected by events beyond our control, and we cannot assure you that we will meet those tests. The breach of any of these covenants or financial ratios could result in a default under the senior secured credit facilities and the lenders could elect to declare all amounts borrowed thereunder, together with accrued interest, to be due and payable and could proceed against the collateral securing that indebtedness.

 

32


Table of Contents

The nature of our operations could subject us to substantial claims, some of which may not be fully insured against or reserved for.
We are in the health and human services business and, therefore, we have been and continue to be subject to claims alleging that we, our employees or our Mentors failed to provide proper care for a client as well as claims by our clients, our employees, our Mentors or community members against us for negligence, intentional misconduct or violation of applicable law. Included in our recent claims are claims alleging personal injury, assault, battery, abuse, wrongful death and other charges, and our claims for professional and general liability coverage have increased sharply in recent years. Regulatory agencies may initiate administrative proceedings alleging that our programs, employees or agents violate statutes and regulations and seek to impose monetary penalties on us. The Patients Protection and Affordable Care Act provides a mandate for more vigorous and widespread enforcement activity. We could be required to incur significant costs to respond to regulatory investigations or defend against civil lawsuits and, if we do not prevail, we could be required to pay substantial amounts of money in damages, settlement amounts or penalties arising from these legal proceedings. We have historically insured through our captive subsidiary amounts of up to $1.0 million per claim and up to $2.0 million in the aggregate. Effective in the quarter ending September 30, 2010, we will be self-insured to higher limits and have less excess coverage available. Effective October 1, 2010, we expect to renew our professional and general liability policies at substantially higher self insured retentions and higher premiums. Awards for punitive damages may be excluded from our insurance policies either contractually or by operation of state law.
We also are subject to potential lawsuits under the False Claims Act or other federal and state whistleblower statutes designed to combat fraud and abuse in the health care industry. These lawsuits can involve significant monetary awards and bounties to private plaintiffs who successfully bring these suits. Finally, we are also subject to employee-related claims under state and federal law, including claims for discrimination, wrongful discharge or retaliation; claims for wage and hour violations under the Fair Labor Standards Act or state wage and hour laws; and novel intentional tort claims.
A litigation award excluded by, or in excess of, our third-party insurance limits and self-insurance reserves could have a material adverse impact on our operations and cash flow and could adversely impact our ability to continue to purchase appropriate liability insurance. Even if we are successful in our defense, civil lawsuits or regulatory proceedings could also irreparably damage our reputation.
Because a substantial portion of NMH Holdings’ and our indebtedness bears interest at rates that fluctuate with changes in certain prevailing short-term interest rates, we are vulnerable to interest rate increases.
A substantial portion of our indebtedness, including borrowings under the senior revolver, the portion of our borrowings under the senior secured term loan facility for which the Company has not hedged its interest rate exposure under interest rate swap agreements, and the indebtedness of NMH Holdings under the NMH Holdings notes, bears interest at rates that fluctuate with changes in certain short-term prevailing interest rates. Certain of our swap agreements have expired or will be expiring soon, and we may not be able to replace them on acceptable terms. If interest rates increase, our and NMH Holdings’ debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same.
As of June 30, 2010, we had $36.5 million of floating rate debt outstanding after giving effect to interest rate swaps. As of June 30, 2010, NMH Holdings had $214.8 million of floating rate debt outstanding, net of discount, excluding the debt of its subsidiaries. A 1% increase in the interest rate on our floating rate debt would have increased cash interest expense of the floating rate debt by $0.4 million, and a 1% increase in the interest rate on the NMH Holdings notes would increase NMH Holdings’ interest expense on those notes by $2.1 million. If interest rates increase dramatically, NMH Holdings and the Company and its subsidiaries could be unable to service their debt.
The counterparties to our derivative financial instruments are substantial multi-national financial institutions. Although we consider the risk of counterparty nonperformance to be low, we cannot assure you that our counterparties will not default. If a counterparty defaulted, the effect on our results of operations could be material.
The nature of services that we provide could subject us to significant workers’ compensation related liability, some of which may not be fully reserved for.
We use a combination of insurance and self-insurance plans to provide for potential liability for workers’ compensation claims. Because of our high ratio of employees per client, and because of the inherent physical risk associated with the interaction of employees with our clients, many of whom have intensive care needs, the potential for incidents giving rise to workers’ compensation liability is relatively high.

 

33


Table of Contents

We estimate liabilities associated with workers’ compensation risk and establish reserves each quarter based on internal valuations, third-party actuarial advice, historical loss development factors and other assumptions believed to be reasonable under the circumstances. As reported in Part I, Item 2 of this Quarterly Report on Form 10-Q for the nine months ended June 30, 2010, we recorded an increased charge for workers’ compensation expense compared to the nine months ended June 30, 2009. Our results of operations have been adversely impacted and may be adversely impacted in the future if actual occurrences and claims exceed our assumptions and historical trends.
If any of the state and local government agencies with which we have contracts determines that we have not complied with our contracts or have violated any applicable laws or regulations, our revenue may decrease, we may be subject to fines or penalties and we may be required to restructure our billing and collection methods.
We derive the vast majority of our revenue from state and local government agencies, and a substantial portion of this revenue is state-funded with federal Medicaid matching dollars. As a result of our participation in these government-funded programs, we are routinely subject to governmental reviews, audits and investigations to verify our compliance with applicable laws and regulations. As a result of these reviews, audits and investigations, these governmental payors may be entitled to, in their discretion:
   
require us to refund amounts we have previously been paid;
 
   
terminate or modify our existing contracts;
 
   
suspend or prevent us from receiving new contracts or extending existing contracts;
 
   
impose referral holds on us;
 
   
impose fines, penalties or other sanctions on us; and
 
   
reduce the amount we are paid under our existing contracts.
As a result of past reviews and audits of our operations, we have been subject to some of these actions from time to time. While we do not currently believe that our existing audit proceedings will have a material adverse effect on our financial condition or significantly harm our reputation, we cannot assure you that similar actions in the future will not do so. In addition, such proceedings could have a material adverse impact on our results of operations in a future reporting period.
In some states, we operate on a cost reimbursement model in which revenue is recognized at the time costs are incurred. In these states, payors audit our historical costs on a regular basis, and if it is determined that our historical costs are insufficient to justify our rates, our rates may be reduced, or we may be required to return fees paid to us in prior periods. In some cases we have experienced negative audit adjustments which are based on subjective judgments of reasonableness, necessity or allocation of costs in our services provided to clients. These adjustments are generally required to be negotiated as part of the overall audit resolution and may result in paybacks to payors and adjustments of our rates. We cannot assure you that our rates will be maintained, or that we will be able to keep all payments made to us, until an audit of the relevant period is complete. Moreover, if we are required to restructure our billing and collection methods, these changes could be disruptive to our operations and costly to implement.
If we fail to establish and maintain relationships with state and local government agencies, we may not be able to successfully procure or retain government-sponsored contracts, which could negatively impact our revenue.
To facilitate our ability to procure or retain government-sponsored contracts, we rely in part on establishing and maintaining relationships with officials of various government agencies. These relationships enable us to maintain and renew existing contracts and obtain new contracts and referrals. The effectiveness of our relationships may be reduced or eliminated with changes in the personnel holding various government offices or staff positions. We also may lose key personnel who have these relationships and such personnel are generally not subject to non-compete or non-solicitation covenants. Any failure to establish, maintain or manage relationships with government and agency personnel may hinder our ability to procure or retain government-sponsored contracts, and could negatively impact our revenue.

 

34


Table of Contents

Negative publicity or changes in public perception of our services may adversely affect our ability to obtain new contracts and renew existing ones.
Our success in obtaining new contracts and renewals of our existing contracts depend upon maintaining our reputation as a quality service provider among governmental authorities, advocacy groups, families of our clients and the public. Negative publicity, changes in public perception, legal proceedings and government investigations with respect to our operations could damage our reputation and hinder our ability to retain contracts and obtain new contracts, and could reduce referrals, increase government scrutiny and compliance costs, or generally discourage clients from using our services. Any of these events could have a material adverse effect on our business, financial condition and operating results.
We face substantial competition in attracting and retaining experienced personnel, and we may be unable to maintain or grow our business if we cannot attract and retain qualified employees.
Our success depends to a significant degree on our ability to attract and retain qualified and experienced human service professionals who possess the skills and experience necessary to deliver quality services to our clients and manage our operations. We face competition for certain categories of our employees, particularly service provider employees, based on the wages, benefits and other working conditions we offer. Contractual requirements and client needs determine the number, education and experience levels of human service professionals we hire. Our ability to attract and retain employees with the requisite credentials, experience and skills depends on several factors, including, but not limited to, our ability to offer competitive wages, benefits and professional growth opportunities. The inability to attract and retain experienced personnel could have a material adverse effect on our business.
We may not realize the anticipated benefits of any future acquisitions and we may experience difficulties in integrating these acquisitions.
As part of our growth strategy, we intend to make selective acquisitions. Growing our business through acquisitions involves risks because with any acquisition there is the possibility that:
   
we may be unable to maintain and renew the contracts of the acquired business;
 
   
unforeseen difficulties may arise in integrating the acquired operations, including information systems and accounting controls;
 
   
we may not achieve operating efficiencies, synergies, economies of scale and cost reductions as expected;
 
   
the business we acquire may not continue to generate income at the same historical levels on which we based our acquisition decision;
 
   
management may be distracted from overseeing existing operations by the need to integrate the acquired business;
 
   
we may acquire or assume unexpected liabilities or there may be other unanticipated costs;
 
   
we may encounter unanticipated regulatory risk;
 
   
we may experience problems entering new markets or service lines in which we have limited or no experience;
 
   
we may fail to retain and assimilate key employees of the acquired business;
 
   
we may finance the acquisition by incurring additional debt and further increase our leverage ratios; and
 
   
the culture of the acquired business may not match well with our culture.
As a result of these risks, there can be no assurance that any future acquisition will be successful or that it will not have a material adverse effect on our financial condition and results of operations.

 

35


Table of Contents

A loss of our status as a licensed service provider in any jurisdiction could result in the termination of existing services and our inability to market our services in that jurisdiction.
We operate in numerous jurisdictions and are required to maintain licenses and certifications in order to conduct our operations in each of them. Each state and local government has its own regulations, which can be complicated, and each of our service lines can be regulated differently within a particular jurisdiction. As a result, maintaining the necessary licenses and certifications to conduct our operations can be cumbersome. Our licenses and certifications could be suspended, revoked or terminated for a number of reasons, including:
   
the failure by our employees or Mentors to properly care for clients;
 
   
the failure to submit proper documentation to the applicable government agency, including documentation supporting reimbursements for costs;
 
   
the failure by our programs to abide by the applicable regulations relating to the provision of human services; or
 
   
the failure of our facilities to comply with the applicable building, health and safety codes and ordinances.
From time to time, some of our licenses or certifications are temporarily placed on probationary status or suspended. If we lost our status as a licensed provider of human services in any jurisdiction or any other required certification, we would be unable to market our services in that jurisdiction, and the contracts under which we provide services in that jurisdiction would be subject to termination. Moreover, such an event could constitute a violation of provisions of contracts in other jurisdictions, resulting in other contract, license or certification terminations. Any of these events could have a material adverse effect on our operations.
We are subject to extensive governmental regulations, which require significant compliance expenditures, and a failure to comply with these regulations could adversely affect our business.
We must comply with comprehensive government regulation of our business, including statutes, regulations and policies governing the licensing of our facilities, the maintenance and management of our work place for our employees, the quality of our service, the revenue we receive for our services, and reimbursement for the cost of our services. Compliance with these laws, regulations and policies is expensive, and if we fail to comply with these laws, regulations and policies, we could lose contracts and the related revenue, thereby harming our financial results. State and federal regulatory agencies have broad discretionary powers over the administration and enforcement of laws and regulations that govern our operations. A material violation of a law or regulation could subject us to fines and penalties and in some circumstances could disqualify some or all of the facilities and programs under our control from future participation in Medicaid or other government programs. The Health Insurance Portability and Accountability Act of 1996 (as amended, “HIPAA”), which requires the establishment of privacy standards for health care information storage, retrieval and dissemination as well as electronic transmission and security standards, could result in potential penalties in certain of our businesses if we fail to comply with these privacy and security standards.
Expenses incurred under governmental agency contracts for any of our services as well as management contracts with providers of record for such agencies, are subject to review by agencies administering the contracts and services. Representatives of those agencies visit our group homes to verify compliance with state and local regulations governing our home operations. A negative outcome from any of these examinations could increase government scrutiny, increase compliance costs or hinder our ability to obtain or retain contracts. Any of these events could have a material adverse effect on our business, financial condition and operating results.

 

36


Table of Contents

We have identified material weaknesses in our internal control over financial reporting.
In connection with our internal controls assessment required by the Sarbanes-Oxley Act of 2002 and as reported in Item 9A(T) of our Annual Report on Form 10-K for the fiscal year ended September 30, 2009, we identified material weaknesses in our internal control over financial reporting. Management concluded that as of September 30, 2009, our internal control over financial reporting was not effective and, as a result, our disclosure controls and procedures were not effective. Descriptions of the material weaknesses are included in Item 4 of this Quarterly Report on Form 10-Q. We also reported material weaknesses in our prior year assessment, for the fiscal year ended September 30, 2008, including a material weakness in controls to verify the existence of our fixed asset balances. In connection with this material weakness, we identified errors during the quarter ended June 30, 2009 which resulted in an adjustment to reduce property and equipment by $1.8 million. While we have taken action and continue to take actions to remediate our identified material weaknesses, our new policies and procedures, when implemented, may not be effective in remedying all of the deficiencies in our internal control over financial reporting. The decentralized nature of our operations and the manual nature of many of our controls make compliance with the requirements of Section 404 and remediation of our material weaknesses especially challenging. The continuing optimization and remediation of our new billing and accounts receivable system and the consolidation of our cash disbursement function at one centralized location have affected and will continue to affect a number of processes that impact our internal control over financial reporting, and we may identify additional material weaknesses or significant deficiencies in connection with these changes. A failure to remedy our material weaknesses in internal control over financial reporting could result in material misstatements in our financial statements and could impede an upgrade to our credit rating, even if our creditworthiness otherwise improves. Moreover, any future disclosures of additional material weaknesses, or errors as a result of those weaknesses, may result in a negative reaction in the financial markets if there is a loss of confidence in the reliability of our financial reporting.
We have extensive work remaining to remedy the material weaknesses in our internal control over financial reporting, and until our remediation efforts are completed, management will continue to devote significant time and attention to these efforts. We will continue to incur costs associated with implementing additional processes, including fees for additional auditor services and consulting services, and may be required to incur additional costs in improving our internal controls and hiring additional personnel, which could negatively affect our financial condition and operating results.
The high level of competition in our industry could adversely affect our contract and revenue base.
We compete with a wide variety of competitors, ranging from small, local agencies to a few large, national organizations. Competitive factors may favor other providers and reduce our ability to obtain contracts, which would hinder our growth. Not-for-profit organizations are active in all states and range from small agencies serving a limited area with specific programs to multi-state organizations. Smaller local organizations may have a better understanding of the local conditions and may be better able to gain political and public acceptance. Not-for-profit providers may be affiliated with advocacy groups, health organizations or religious organizations that have substantial influence with legislators and government agencies. Increased competition may result in pricing pressures, loss of or failure to gain market share or loss of clients or payors, any of which could harm our business.
We rely on third parties to refer clients to our facilities and programs.
We receive substantially all of our clients from third-party referrals and are governed by the federal anti-kickback/non-self referral statute. Our reputation and prior experience with agency staff, care workers and others in positions to make referrals to us are important for building and maintaining our operations. Any event that harms our reputation or creates negative experiences with such third parties could impact our ability to receive referrals and grow our client base.
Home and community-based human services may become less popular among our targeted client populations and/or state and local governments, which would adversely affect our results of operations.
Our growth depends on the continuation of trends in our industry toward providing services to individuals in smaller, community-based settings and increasing the percentage of individuals served by non-governmental providers. The continuation of these trends and our future success are subject to a variety of political, economic, social and legal pressures, all of which are beyond our control. A reversal in the downsizing and privatization trends could reduce the demand for our services, which could adversely affect our revenue and profitability.
Regulations that require ARY services to be provided through not-for-profit organizations could harm our revenue or gross margin.
Two percent of our net revenue for the nine months ended June 30, 2010 was derived from contracts with affiliates of Alliance Health and Human Services Inc. (“Alliance”), an independent not-for-profit organization that has licenses and contracts from several state and local agencies to provide ARY services.

 

37


Table of Contents

Historically, some state governments interpreted federal law to preclude them from receiving federal reimbursement under Title IV-E of the Social Security Act for ARY services provided under a contract with a proprietary organization. However, in 2005 the Fair Access Foster Care Act of 2005 was signed into law, thereby allowing states to seek reimbursement from the federal government for ARY services provided by proprietary organizations. In some jurisdictions that interpreted the prior federal law to preclude them from seeking reimbursement for ARY services provided under a contract with a proprietary provider, or in others that prefer to contract with not-for-profit providers, we provide ARY services as a subcontractor of Alliance. We do not control Alliance, and none of our employees or agents has a role in the management of Alliance. Although Edward M. Murphy, our Chief Executive Officer, was an officer and director of Alliance immediately prior to becoming our President in September 2004, Mr. Murphy has no role in the management of Alliance. Our ARY business could be harmed if Alliance chooses to discontinue all or a portion of its service agreements with us. Our ARY business could also be harmed if the state or local governments that prefer that ARY services be provided by not-for-profit organizations determine that they do not want the service performed indirectly by for-profit companies like us on behalf of not-for-profit organizations. We cannot assure you that our contracts with Alliance will continue, and if these contracts are terminated without our consent, it could have an adverse effect on our business, financial condition and operating results. Alliance and its subsidiaries are organized as non-profit corporations and are recognized as tax-exempt under section 501(c)(3) of the Internal Revenue Code. As such, Alliance is subject to the public charity regulations of the states in which it operates and to the federal regulations governing tax-exempt entities. If Alliance fails to comply with the laws and regulations of the states in which it operates or with the federal regulations, it could be subject to penalties and sanctions, including the loss of tax-exempt status, which could preclude it from continuing to contract with certain state and local governments. Our business could be harmed if Alliance lost its contracts and was therefore unable to continue to contract with us.
Government reimbursement procedures are time-consuming and complex, and failure to comply with these procedures could adversely affect our liquidity, cash flows and operating results.
The government reimbursement process is time-consuming and complex, and there can be delays before we receive payment. Government reimbursement, group home credentialing and Medicaid recipient eligibility and service authorization procedures are often complicated and burdensome, and delays can result from, among other things, securing documentation and coordinating necessary eligibility paperwork between agencies. These reimbursement and procedural issues occasionally cause us to have to resubmit claims several times before payment is remitted. If there is a billing error, the process to resolve the error may be time-consuming and costly. To the extent that complexity associated with billing for our services causes delays in our cash collections, we assume the financial risk of increased carrying costs associated with the aging of our accounts receivable as well as increased potential for write-offs. We can provide no assurance that we will be able to collect payment for claims at our current levels in future periods. The risks associated with third-party payors and the inability to monitor and manage accounts receivable successfully could have a material adverse effect on our liquidity, cash flows and operating results.
We conduct a significant percentage of our operations in Minnesota and, as a result, we are particularly susceptible to any reduction in budget appropriations for our services or any other adverse developments in that state.
For the nine months ended June 30, 2010, 16% of our revenue was generated from contracts with government agencies in the state of Minnesota. Accordingly, any reduction in Minnesota’s budgetary appropriations for our services, whether as a result of fiscal constraints due to recession, changes in policy or otherwise, could result in a reduction in our fees and possibly the loss of contracts. Last year, Minnesota enacted a rate cut of 2.6%, which took effect July 1, 2009. We cannot assure you that we will not receive further rate reductions this year or in the future. The concentration of our operations in Minnesota also makes us particularly susceptible to many of the other risks described above occurring in this state, including:
   
the failure to maintain and renew our licenses;
 
   
the failure to maintain important relationships with officials of government agencies; and
 
   
any negative publicity regarding our operations.
Any of these adverse developments occurring in Minnesota could result in a reduction in revenue or a loss of contracts, which could have a material adverse effect on our results of operations, financial position and cash flows.
We depend upon the continued services of certain members of our senior management team, without whom our business operations could be significantly disrupted.
Our success depends, in part, on the continued contributions of our senior officers and other key employees. Our management team has significant industry experience and would be difficult to replace. If we lose or suffer an extended interruption in the service of one or more of our senior officers, our financial condition and operating results could be adversely affected. The market for qualified individuals is highly competitive and we may not be able to attract and retain qualified personnel to replace or succeed members of our senior management or other key employees, should the need arise.

 

38


Table of Contents

Our success depends on our ability to manage growing and changing operations.
Since 1998, our business has grown significantly in size and complexity. This growth has placed, and is expected to continue to place, significant demands on our management, systems, internal controls and financial and physical resources. Our operations are highly decentralized, with many billing, accounting and collection functions being performed at the local level. This requires us to expend significant resources implementing and monitoring compliance at the local level. In addition, we expect that we will need to further develop our financial and managerial controls and reporting systems to accommodate future growth. This will require us to incur expenses for hiring additional qualified personnel, retaining professionals to assist in developing the appropriate control systems and expanding our information technology infrastructure. The nature of our business is such that qualified management personnel can be difficult to find. Our inability to manage growth effectively could have a material adverse effect on our results of operations, financial position and cash flows.
We may be more susceptible to the effects of a public health catastrophe than other businesses due to the vulnerable nature of our client population.
Our primary clients are individuals with developmental disabilities, brain injuries, or emotionally, behaviorally or medically complex challenges, many of whom may be more vulnerable than the general public in a public health catastrophe. For example, in a flu pandemic, we could suffer significant losses to our client population and, at a high cost, be required to hire replacement staff and Mentors for workers who drop out of the workforce in very tight labor markets. Accordingly, certain public health catastrophes such as a flu pandemic could have a material adverse effect on our financial condition and results of operations.
We are controlled by our principal equityholder, which has the power to take unilateral action.
Vestar controls our business affairs and policies. Circumstances may occur in which the interests of Vestar could be in conflict with the interests of our debt holders. In addition, Vestar may have an interest in pursuing acquisitions, divestitures or other transactions that, in their judgment, could enhance their equity investment, even though such transactions might involve risks to our debt holders. For example, we may pursue various financing alternatives in order to fund required cash payments on the NMH Holdings notes, accrued interest for which will be due and payable in cash beginning September 15, 2012. Vestar is in the business of making investments in companies and may from time to time acquire and hold interests in businesses that compete directly or indirectly with us. Vestar may also pursue acquisition opportunities that may be complementary to our business and, as a result, those acquisition opportunities may not be available to us. So long as investment funds associated with or designated by Vestar continue to own a significant amount of our equity interests, even if such amount is less than 50%, Vestar will continue to be able to significantly influence or effectively control our decisions.
Item 2.  
Unregistered Sales of Equity Securities and Use of Proceeds.
Unregistered Sales of Equity Securities
No equity securities of the Company or of its indirect parent, NMH Investment, LLC, were sold during the three months ended June 30, 2010.

 

39


Table of Contents

Repurchases of Equity Securities
No equity securities of the Company were repurchased during the three months ended June 30, 2010.
The following table sets forth information in connection with repurchases made by NMH Investment of its common equity units during the three months ended June 30, 2010:
                                 
                            (d) Maximum  
                            Number (or  
                    (c) Total Number     Approximate Dollar  
                    of Units Purchased     Value) of Shares (or  
    (a) Class and             as Part of Publicly     Units) that May Yet  
    Total Number of     (b) Average Price     Announced Plans     be Purchased Under  
    Units Purchased     Paid per Unit     or Programs     the Plans or Programs  
Month #1 (April 1, 2010 through April 30, 2010)
                       
 
                               
Month #2 (May 1, 2010 through May 31, 2010)
  1,443.75 B Units   $ 0.05             N/A  
 
  1,515.00 C Units   $ 0.03             N/A  
 
  1,605.00 D Units   $ 0.01             N/A  
 
                               
Month #3 (June 1, 2010 through June 30, 2010)
  7,500.00 A Units   $ 10.00             N/A  
 
  2,406.25 B Units   $ 0.05             N/A  
 
  2,525.00 C Units   $ 0.03             N/A  
 
  2,675.00 D Units   $ 0.01             N/A  
The Company did not repurchase any of its common stock as part of an equity repurchase program during the third quarter of fiscal 2010. NMH Investment purchased all of the units listed in the table from two of its employees upon their departures.
Item 3.  
Defaults Upon Senior Securities.
None.
Item 4.  
(Removed and Reserved).
Item 5.  
Other Information.
None.
Item 6.  
Exhibits.
The Exhibit Index is incorporated herein by reference.

 

40


Table of Contents

SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
         
  NATIONAL MENTOR HOLDINGS, INC.
 
 
August 13, 2010  By:   /s/ Denis M. Holler    
    Denis M. Holler   
  Its:   Executive Vice President, Chief Financial Officer, Treasurer and duly authorized officer   

 

41


Table of Contents

EXHIBIT INDEX
             
Exhibit No.   Description    
  3.1    
Amended and Restated Certificate of Incorporation of National Mentor Holdings, Inc.
  Incorporated by reference to Exhibit 3.1 of National Mentor Holdings, Inc. Form 10-Q for the quarterly period ended March 31, 2007 (the “March 2007 10-Q”)
       
 
   
  3.2    
By-Laws of National Mentor Holdings, Inc.
  Incorporated by reference to Exhibit 3.2 of the March 2007 10-Q
       
 
   
  31.1    
Certification of principal executive officer.
  Filed herewith
       
 
   
  31.2    
Certification of principal executive officer.
  Filed herewith
       
 
   
  31.3    
Certification of principal financial officer.
  Filed herewith
       
 
   
  32    
Certifications furnished pursuant to 18 U.S.C. Section 1350.
  Filed herewith

 

42