UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 8-K
CURRENT REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Date of report (Date of earliest event reported): November 19, 1997
Merit Behavioral Care Corporation
(Exact Name of Registrant as Specified in Charter)
Delaware
(State or Other Jurisdiction of Incorporation)
33-80987 22-3236927
(Commission (IRS Employer
File Number) Identification No.)
One Maynard Drive, Park Ridge, New Jersey 07656
(Address of Principal Executive Offices) (Zip Code)
(201) 391-8700
(Registrant's telephone number, including area code)
N/A
(Former Name or Former Address, if Changed Since Last Report)
<PAGE>
ITEM 5. OTHER EVENTS
Merit Behavioral Care Corporation ("MBC" or the "Company") files as
Exhibit 99.1 hereto the information required by Item 7 of Form 10-K for Annual
Reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
("Form 10-K") as well as the financial statements required by Item 14 of Form
10-K.
ITEM 7. FINANCIAL STATEMENTS, PRO FORMA FINANCIAL INFORMATION
AND EXHIBITS
(a) Financial Statements of Business Acquired.
Not Applicable.
(b) Pro Forma Financial Information.
Not Applicable.
(c) Exhibits.
The following exhibit is filed with this Report on
Form 8-K.
Exhibit Number Exhibit
99.1 Management's Discussion and
Analysis of Financial
Condition and Results of
Operations and the Company's
audited financial statements
for the 12 months ended
September 30, 1997.
<PAGE>
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 hereunto duly authorized.
MERIT BEHAVIORAL CARE CORPORATION
/s/ John A. Budnick
------------------------------------
John A. Budnick
Executive Vice President and
Chief Financial Officer
Date: November 19, 1997
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
Revenue
Typically, Merit Behavioral Care Corporation ("MBC" or the "Company")
charges each of its health maintenance organization ("HMO"), Blue Cross/Blue
Shield organization, insurance company, corporate, union, governmental and other
customers a flat monthly capitation fee for each beneficiary enrolled in such
customer's behavioral health managed care plan or employee assistance program
("EAP"). This capitation fee is generally paid to MBC in the current month.
Contract revenue billed in advance of performing related services is deferred
and recognized ratably over the period to which it applies. For a number of the
Company's behavioral health managed care programs, the capitation fee is divided
into outpatient and inpatient fees, which are recognized separately. Outpatient
revenue is recognized monthly as it is received; inpatient revenue is recognized
monthly and in most cases is (i) paid to the Company monthly (in cases where the
Company is responsible for the payment of inpatient claims) or in certain cases
(ii) retained by the customer for payment of inpatient claims. When the customer
retains the inpatient revenue, actual inpatient costs are periodically
reconciled to amounts retained and the Company receives the excess of the
amounts retained over the cost of services, or reimburses the customer if the
cost of services exceeds the amounts retained. In certain instances, such excess
or deficiency is shared between the Company and the customer.
Direct Service Costs and Margins
Direct service costs are comprised principally of expenses associated
with managing, supervising and providing the Company's services, including
third-party network provider charges, various charges associated with the
Company's staff offices, inpatient facility charges, costs associated with
members of management principally engaged in the Company's clinical operations
and their support staff, and rent for certain offices maintained by the Company
in connection with the delivery of services. Direct service costs are recognized
in the month in which services are expected to be rendered. Network provider and
facility charges for authorized services that have not been reported and billed
to the Company (known as incurred but not reported expenses, or "IBNR") are
estimated and accrued based on historical experience, current enrollment
statistics, patient census data, adjudication decisions, and other information.
The Company has experienced an increase in direct service costs as a
percentage of revenue (which have been offset to varying degrees by various
initiatives described below) primarily as a result of changing product mix and
pricing pressure associated with both the competitive bid process for new
contracts and negotiations to extend existing contracts. The portion of MBC's
revenue attributable to capitated managed care programs has continuously been
increasing. Because capitated managed care programs require the Company to incur
greater direct service costs than EAP and administrative services only ("ASO")
managed care programs, the direct profit margins attributable to such programs
are lower than the direct profit margins attributable to the Company's EAP and
ASO programs. The Company is continuing to focus on reducing direct service
costs. Efforts intended to reduce these costs include: (i) negotiating better
rates and/or different compensation arrangements (such as retainer arrangements,
volume discounts, case rates and capitation of fees) with third-party network
providers and treatment facilities; (ii) contracting with treatment facilities
that provide a broader spectrum of treatment programs in an effort to expand
beneficiary access to a broader continuum of care, thereby achieving more
cost-effective treatment; (iii) focusing management and clinical care techniques
on patients requiring more intensive treatment services to assure that such
patients receive the appropriate level of care in a cost- efficient and
effective manner; (iv) implementing a new information system intended to enable
MBC to improve the productivity and efficiency of its operations; and (v)
increasing the overall efficiency of MBC's staff provider system by closing or
consolidating less efficient staff offices, streamlining operations and
increasing the efficiency of remaining staff offices.
Selling, General and Administrative Expenses
Selling, general and administrative expenses are comprised principally
of corporate and regional overhead expenses, such as marketing and sales, legal,
finance, information systems and administrative expenses, as well as
professional and consulting fees, and the compensation of members of the
Company's senior management. The Company expects selling, general and
administrative expenses to grow over the near term, primarily due to growth in
information systems expenses related to the implementation of AMISYS(R) as well
as increases in regional administration and sales and marketing operations
necessary to support the growth of the Company's business; however, the Company
expects selling, general and administrative expenses to grow at a rate less than
that of anticipated revenue growth in the future. There can be no assurance,
however, that anticipated revenue growth will occur or that any such revenue
growth will occur at a rate greater than the rate of growth in selling, general
and administrative expenses.
Amortization of Intangibles
As a result of Merck's acquisition of Medco Containment Services, Inc.
in November 1993, the Company's financial statements include an allocation by
Merck of the excess of its cost over fair market value of the net assets
acquired. Accordingly, goodwill and other acquisition-related intangibles in the
amount of $160.0 million were recorded on the Company's balance sheet as of
November 1993 and are being amortized over various periods. A noncurrent
deferred tax liability of $47.8 million was established to reflect the tax
consequences of the difference between the financial and tax reporting bases of
the identified intangibles. The Company's total goodwill also includes goodwill
associated with the Company's acquisitions of Group Plan Clinic, Inc., and of
BenesYs, Inc. (collectively, "BenesYs"), a Houston-based behavioral health
managed care organization, and CMG Health, Inc. ("CMG"), a Maryland-based
behavioral health managed care company. In addition, the payment made to Empire
Blue Cross and Blue Shield ("Empire") in connection with the Company's joint
venture with Empire in September 1995 (the "Empire Joint Venture"), the
acquisition of ProPsych, Inc. ("ProPsych") in December 1995, and various
contingent consideration payments, together with the goodwill recognized from
the BenesYs and CMG transactions, resulted in the incurrence of additional
goodwill of approximately $117.8 million. Amortization of acquisition-related
intangibles was $20.1 million in fiscal 1995, $23.0 million in fiscal 1996, and
$23.8 million in fiscal 1997.
The Company also capitalizes certain start-up expenses related to new
contracts and amortizes these amounts over the life of the contracts. When the
Company enters into a new contract or significantly expands services for an
existing customer, the Company typically incurs up-front start-up costs that
historically have ranged from $50,000 to $2.5 million per program. These
start-up costs include, among other things, the costs of recruiting,
interviewing and training providers and support staff, establishing offices and
other facilities, acquiring furniture, computers and other equipment, and
implementing information systems. As of September 30, 1997, the Company's
balance sheet reflected $9.0 million of deferred start-up costs, net of
amortization, categorized under long-term assets.
Liquidity
The Company's liquidity is affected by the one-to-four-month lag
between the time the Company receives cash from capitation payments under new
contracts and the time when the Company pays the claims for services rendered by
third-party network providers and treatment facilities relating to such
capitation payments. During the first few months of a new contract, the Company
builds cash balances as capitation payments are received and also builds a
payables balance as direct service costs are accrued based on expected levels of
service. After the first several months of a contract, monthly claims payments
typically increase to normal levels and the contract generates cash commensurate
with the expected profit margin for that contract. When a contract is
terminated, monthly capitation payments cease on contract termination, but
claims for services rendered prior to termination continue to be received and
paid for several months. This post contract termination period is often referred
to as the "run-off" period. To date, contract terminations have not had a
material impact on the Company's liquidity.
Recent Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board issued SFAS No.
131, Disclosures about Segments of an Enterprise and Related Information, which
will be effective for the Company beginning October 1, 1998. SFAS No. 131
redefines how operating segments are determined and requires disclosure of
certain financial and descriptive information about a company's operating
segments. The Company has not yet completed its analysis with respect to which
operating segments of its business it will provide such information.
RESULTS OF OPERATIONS
Selected Operating Results
The following table sets forth certain statement of operations items of MBC
expressed as a percentage of revenue:
<TABLE>
<CAPTION>
Fiscal Year Ended September 30,
-------------------------------------------
<S> <C> <C> <C>
1995 1996 1997
Revenue......................................... 100.0% 100.0% 100.0%
Direct service costs............................ 79.1 79.0 80.9
Direct profit margin.......................... 20.9 21.0 19.1
Selling, general and administrative
expenses...................................... 13.8 14.1 12.2
Amortization of intangibles..................... 5.9 5.7 4.8
Restructuring charge............................ --- 0.6 ---
Operating Income............................. 1.2 0.6 2.1
Other income.................................... 0.4 0.6 0.6
Interest expense................................ --- (5.2) (4.5)
Loss on disposal of subsidiary.................. --- --- (1.2)
Merger costs and special charges................ --- (0.8) (0.2)
Income (loss) before income taxes and
cumulative effect of accounting change........ 1.6 (4.8) (3.2)
Provision (benefit) for income taxes............ 1.2 (1.1) (0.7)
Income (loss) before cumulative effect
of accounting change........................ 0.4% (3.7)% (2.5)%
Adjusted EBITDA margin.......................... 9.4% 9.9% 9.8%
</TABLE>
Fiscal 1997 Compared to Fiscal 1996
Revenue. Revenue increased by $97.9 million, or 21.4%, to $555.7
million for fiscal 1997 from $457.8 million for fiscal 1996. Of this increase,
$71.3 million was attributable to the inclusion of revenue from certain
contracts that commenced during the prior fiscal year as well as additional
revenue from existing customers generated by an increase in both the number of
programs managed by the Company on behalf of such customers and an increase in
the number of beneficiaries enrolled in such customers' programs; and $65.8
million was attributable to new customers commencing service in the current
year, a significant portion of which was derived from the Company's contract
relating to the Civilian Health and Medical Program of the Uniformed Services
("CHAMPUS") for CHAMPUS Regions 7 and 8, under which services commenced on April
1, 1997. In addition, the Company's acquisition of CMG on September 12, 1997
contributed an additional $7.0 million in revenue for fiscal 1997. These revenue
increases were partially offset by a $46.2 million decrease in revenue as a
result of the termination of certain contracts, $29.1 million of which was due
to contract terminations that occurred in various periods of the prior fiscal
year. Contract price increases were not a material factor in the increase in
revenue.
Direct Service Costs. Direct service costs increased by $87.9 million,
or 24.3%, to $449.6 million for fiscal 1997 from $361.7 million for fiscal 1996.
As a percentage of revenue, direct service costs increased from 79.0% in the
prior year period to 80.9% in the current year period. The increase in cost as a
percentage of revenue was due primarily to the lower than average direct profit
margin earned on the TennCare Partners and the Delaware County Medicaid
programs, partially offset by a year over year decline in healthcare treatment
services utilization in the Company's overall business. In addition, the
Delaware County carve-out program replaced a program under which beneficiaries
previously received their mental health benefit through membership in various
HMOs servicing this area. Direct profit margins under contracts that the Company
held with certain of these HMOs, which terminated or membership in which
decreased substantially as a result of the Delaware County program, were higher
than the direct profit margins for the Delaware County program and the Company's
overall average direct profit margins. Excluding the effect of the TennCare
Partners and the Delaware County contracts, however, the Company experienced a
decline in the direct service cost percentage as a result of overall lower
healthcare utilization in the current year period as compared to the prior year
period, due to the Company's continued development and deployment of alternative
treatment programs designed to achieve more cost-effective treatment and the
Company's increased focus on clinical care techniques directed at patients
requiring more intensive treatment services. Also positively impacting the
direct cost percentage were the effect of (i) a nationwide recontracting program
with providers which began in the second quarter of fiscal 1996, and (ii) the
closing of certain underperforming staff offices pursuant to a plan implemented
by MBC in the fourth quarter of 1996.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased by $2.9 million, or 4.5%, to $67.4 million for
fiscal 1997 from $64.5 million for fiscal 1996. The increase in total selling,
general and administrative expenses was primarily attributable to (i) growth in
marketing and sales administrative staff, corporate and regional management and
support systems associated with the higher sales volume, (ii) expenses
associated with the expansion of both the Company's national service center
("National Service Center") located in St. Louis, Missouri and the Company's
headquarters located in Park Ridge, New Jersey, (iii) expenses related to the
planned deployment of the Company's new information systems, and (iv) inclusion
of CMG's results of operations since the acquisition date. As a percentage of
revenue, selling, general and administrative expenses decreased from 14.1% in
the prior year period to 12.2% in the current year period primarily as a result
of these expenses being allocated over a larger revenue base. Contributing
significantly to this decrease were the TennCare Partners and the Delaware
County programs, which are large, self-contained programs requiring minimal
selling, general and administrative expenses or Company operational support,
thereby mitigating, in large part, the effects of their lower than average
direct service cost margins described above.
Amortization of Intangibles. Amortization of intangibles increased by
$1.0 million, or 4.0%, to $26.9 million for fiscal 1997 from $25.9 million for
fiscal 1996. The increase was primarily due to an increase in amortization of
goodwill recognized in connection with the acquisitions of ProPsych and CMG as
well as to increases in the amortization of deferred contract start-up costs
related to new contracts.
Other Income (Expense). For fiscal 1997, other income and expense
consisted of (i) interest expense of $25.1 million related to debt incurred as a
result of the merger of the Company and an affiliate of Kohlberg Kravis Roberts
& Co. ("KKR") in October 1995 (the "Merger"), (ii) interest and other income of
$3.5 million relating primarily to investment earnings on the Company's
short-term marketable securities and restricted cash and investment balances,
(iii) a loss of $6.9 million recognized in September 1997 on the disposal of
Choate Health Management, Inc. and certain related companies (collectively,
"Choate"), (iv) $0.7 million of expenses associated with uncompleted acquisition
transactions, and (v) $0.6 million of nonrecurring employee benefit costs
associated with the exercise of stock options by employees of the Company under
plans administered by Merck. The year over year increase in interest expense of
$1.2 million was primarily attributable to (i) the full period impact of the
indebtedness incurred in October 6, 1995 by the Company in connection with the
Merger; (ii) the full period impact of the Company's 11 1/2% Senior Subordinated
Notes due 2005 (the "Notes"), which bore interest at a higher rate than the
bridge financing facility that the Notes replaced, and (iii) the increase in the
senior credit facility as a result of the acquisition of CMG. The year over year
increase in interest income of $0.7 million was primarily attributable to both
an increase in average invested cash balances as compared to the prior year
period and interest earned on advances to certain joint ventures.
Income Taxes. The Company recorded a benefit for income taxes during
fiscal 1997, based upon the Company's pre-tax loss in such period.
Fiscal 1996 Compared to Fiscal 1995
Revenue. Revenue increased by $96.3 million, or 26.6%, to $457.8
million for fiscal 1996 from $361.5 million for fiscal 1995. Of this increase,
$87.7 million was attributable to the inclusion of revenue for the entire period
from certain contracts that commenced during the prior fiscal year as well as
additional revenue from existing customers generated by an increase in both the
number of programs managed by the Company on behalf of such customers and an
increase in the number of beneficiaries enrolled in such customers' programs;
and $26.4 million was attributable to new customers commencing service in the
current year, the majority of which was derived from two contracts totaling
$20.9 million. In addition, the Company's acquisitions of Choate and ProPsych
contributed an additional $18.4 million in revenue for fiscal 1996. These
revenue increases were partially offset by a $36.2 million decrease in revenue
as a result of the termination of certain contracts, five of which accounted for
$21.1 million of such decrease. Certain of these contracts had terminated in
various periods of the prior fiscal year. Contract price increases were not a
material factor in the increase in revenue.
Direct Service Costs. Direct service costs increased by $75.7 million,
or 26.5%, to $361.7 million for fiscal 1996 from $286.0 million for fiscal 1995.
As a percentage of revenue, direct service costs decreased from 79.1% for fiscal
1995 to 79.0% for fiscal 1996. This net decrease in the direct service cost
percentage was due to a variety of largely offsetting factors. The direct
service cost percentage was positively impacted by lower inpatient utilization
in fiscal 1996 as compared to the prior year related to a significant contract
with an HMO focused on the Medicaid beneficiary population. Such decrease
resulted from the implementation of changes in program management and
modification of the clinical treatment protocols applicable to such contract. In
addition, the Company started to realize the benefits in fiscal 1996 of a
nationwide recontracting program with providers which began in the second
quarter of such year. The Company is continuing its efforts to reduce direct
service costs to mitigate the effects of pricing pressure, which is expected to
continue in fiscal 1997, associated with the competitive bid process for new
contracts and negotiations to extend existing contracts. The direct service cost
percentage was adversely impacted by the loss in the fourth quarter of fiscal
1995 of two contracts with higher than average direct profit margins and a
renewal of a significant contract on lower pricing terms. In addition, the
Company earned a lower than average direct profit margin on a significant state
Medicaid program which was not in effect for the entire twelve month period in
the prior year. Furthermore, in the fourth quarter of fiscal 1996, the Company
commenced providing services under the TennCare Partners program. Due to the
unusual structure of the TennCare Partners program, the direct profit margin
under such contract was lower than the Company's average direct profit margin
for fiscal 1996 and is expected to continue to be lower in future periods.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased by $14.7 million, or 29.5%, to $64.5 million
for fiscal 1996 from $49.8 million for fiscal 1995. The increase in total
selling, general and administrative expenses was primarily attributable to (i)
growth in marketing and sales administrative staff, corporate and regional
management and support systems associated with the higher sales volume, (ii)
expenses associated with the expansion of the National Service Center, which
will allow for growth beyond MBC's current needs, and (iii) expenses related to
the planned deployment of the Company's new information systems. As a percentage
of revenue, selling, general and administrative expenses increased to 14.1% for
fiscal 1996 from 13.8% for fiscal 1995. The increase in such expenses, coupled
with unanticipated delays in the planned start dates of significant new
contracts (including the TennCare Partners program) secured by the Company,
contributed to the increase in selling, general and administrative expenses as a
percentage of revenue.
Amortization of Intangibles. Amortization of intangibles increased by
$4.5 million, or 21.0%, to $25.9 million for fiscal 1996 from $21.4 million for
fiscal 1995. The increase was primarily due to an increase in amortization of
goodwill recognized in connection with the acquisitions of Choate and ProPsych
and the Empire Joint Venture, as well as to increases in the amortization of
deferred contract start-up costs related to new contracts.
Restructuring Charge. The Company recorded a pre-tax restructuring
charge of $3.0 million related to a plan, adopted and approved in the fourth
quarter of 1996, to restructure its staff offices by exiting certain geographic
markets and streamlining the field and administrative management organization of
Continuum Behavioral Healthcare Corporation, a subsidiary of the Company. This
decision was in response to the results of underperforming locations affected by
the lack of sufficient patient flow in the geographic areas serviced by these
offices and the Company's ability to purchase healthcare services at lower rates
from its provider network. In addition, it was determined that the Company would
be able to expand beneficiary access to specialists and other providers thereby
achieving more cost-effective treatment and to favorably shift a portion of the
economic risk, in some cases, of providing outpatient healthcare to the provider
through the use of case rates and other alternative reimbursement methods. The
restructuring charge was comprised primarily of accruals for employee severance,
real property lease terminations and write-off of certain assets in geographic
markets which were being exited. The restructuring plan was substantially
completed during fiscal 1997.
Other Income (Expense). For fiscal 1996, other income and expense
consisted of (i) interest expense of $23.8 million incurred as a result of the
increase in long-term debt resulting from the Merger; (ii) merger expenses of
$4.0 million consisting primarily of professional and advisory fees; and (iii)
interest and other income of $2.8 million relating primarily from investment
earnings on the Company's short-term investments and restricted cash balances.
Income Taxes. The Company recorded a benefit for income taxes during
fiscal 1996 based upon the Company's pre-tax loss in such period. The resulting
income tax benefit has been partially offset by the nondeductible nature of
certain merger costs.
Cumulative Effect of Accounting Change
Effective October 1, 1995, the Company changed its method of accounting
for deferred start-up costs related to new contracts or expansion of existing
contracts (i) to expense costs relating to start-up activities incurred after
commencement of services under the contract, and (ii) to limit the amortization
period for deferred start-up costs incurred prior to the commencement of
services to the initial contract period. Prior to October 1, 1995, the Company
capitalized start-up costs related to the completion of the provider networks
and reporting systems beyond commencement of contracts and, in limited
instances, amortized the start-up costs over a period that included the initial
renewal term associated with the contract. Under the new policy, the Company
does not defer contract start-up costs after contract commencement or include
the initial renewal term in the amortization period. The change was made to
increase the focus on controlling costs associated with contract start-ups.
The Company recorded a pre-tax charge of $1.8 million ($1.0 million
after taxes) in the first quarter of fiscal 1996 as a cumulative effect of a
change in accounting. The pro forma impact of this change for the year ended
September 30, 1995 would be to increase costs and expenses by $1.8 million ($1.0
after taxes). There was no pro forma effect on periods prior to fiscal 1995. The
effect of the change on fiscal 1996 cannot be reasonably estimated.
Liquidity and Capital Resources
General. For fiscal 1997, operating activities provided cash of $26.9
million, investing activities used cash of $62.1 million and financing
activities provided cash of $75.2 million, resulting in a net increase in cash
and cash equivalents of $40.0 million. Investing activities in fiscal 1997
consisted principally of (i) capital expenditures of $24.0 million related
primarily to the continued development of the Company's new information systems
and expansion of the National Service Center, (ii) payments totaling $35.2
million (net of cash acquired) for the acquisition of CMG, (iii) payments
totaling $2.6 million for funding under joint venture agreements, primarily with
Empire Community Delivery Systems, LLC and Community Sector Systems, Inc., and
(iv) expenditures of $4.1 million for the purchase of short-term investments
made to satisfy obligations under contracts held by the Company.
Acquisition. On September 12, 1997, the Company acquired all of the
outstanding capital stock of CMG for $48.7 million in cash and 739,358 shares of
the Company's common stock valued at $5.5 million. In addition, the Company
agreed to absorb certain expenses and other obligations of CMG totaling up to
$5.4 million. CMG is a Maryland-based national managed care company serving over
30 customers through a network consisting of approximately 7,000 providers in 34
states. CMG currently provides behavioral health managed care services to 2.5
million people under full risk capitation, ASO and other funding arrangements.
The clients include state and local governments, Blue Cross /Blue Shield
organizations, HMOs and insurance companies. As additional consideration for the
acquisition, the Company may be required to make certain future contingent cash
payments over the next two years to the former shareholders of CMG based upon
the performance of certain CMG customer contracts. Such contingent payments are
subject to an aggregate maximum of $23.5 million. The acquisition was accounted
for using the purchase method. Accordingly, the purchase price was allocated to
assets acquired based on their estimated fair values. This treatment resulted in
approximately $64.7 million of cost in excess of net tangible assets acquired as
of September 30, 1997. Such excess is being amortized on a straight line basis
over periods ranging up to 40 years. The inclusion of CMG from the date of
acquisition did not have a significant impact on the Company's results of
operations.
Senior Indebtedness. As of September 30, 1997, $30.0 million of
revolving loans and $8.3 million of letters of credit were outstanding under the
revolving credit facility of the Company's Credit Agreement with The Chase
Manhattan Bank, N.A. (the "Senior Credit Facility"), and approximately $46.7
million was available for future borrowing.
Adjusted EBITDA. Adjusted EBITDA, a financial measure used in the
Senior Credit Facility and the indenture for the Notes (the "Indenture"),
increased by $9.6 million, or 21.3%, to $54.7 million for fiscal 1997 from $45.1
million for 1996.
Cash in Claims Funds and Restricted Cash. As of September 30, 1997, the
Company had total cash, cash equivalents and investment balances of $95.2
million, of which $51.3 million was restricted under certain contractual,
fiduciary and regulatory requirements; moreover, of such amount, $3.7 million
was classified as a long-term asset on the Company's balance sheet. Under
certain contracts, the Company is required to establish segregated claims funds
into which a portion of its capitation fee is held until a reconciliation date
(which reconciliation typically occurs annually). Until that time, cash funded
under these arrangements is unavailable to the Company for purposes other than
the payment of claims. In addition, California and Illinois state regulatory
requirements restrict access to cash held by the Company's subsidiaries in such
states. As of September 30, 1997, the Company also held surplus cash balances,
classified as cash and cash equivalents and short-term marketable securities, as
required by the contracts held by the Company relating to Medicaid programs for
the States of Iowa and Montana and the TennCare Partners and Delaware County
Medicaid programs described above.
Availability of Cash. Prior to the Merger, the Company funded its
operations primarily with cash generated from operations and through the funding
of certain acquisitions, investments and other transactions by its former
parent, Merck & Co., Inc. The Company currently and in the future expects to
finance is capital requirements through existing cash balances, cash generated
from operations and borrowings under the revolving credit facility of the Senior
Credit Facility. Based upon the current level of cash flow from operations and
anticipated growth, the Company believes that available cash, together with
available borrowings under the revolving credit facility and other sources of
liquidity, will be adequate to meet the Company's anticipated future
requirements for working capital, capital expenditures and scheduled payments of
principal and interest on its indebtedness for the foreseeable future.
Pending Acquisition of MBC. On October 24, 1997, the Company signed a
definitive merger agreement under which a subsidiary of Magellan Health
Services, Inc. ("Magellan") will merge into the Company. As a result of this
merger, the Company will become a wholly owned subsidiary of Magellan. Under the
terms of the merger agreement, Magellan will purchase all of the Company's
outstanding stock and other equity interests for approximately $460 million in
cash and refinance the Company's existing debt. Completion of the merger
transaction is subject to a number of conditions, including Magellan's receipt
of financing for the transaction, the expiration or early termination of the
waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1974,
the receipt of certain healthcare and insurance regulatory approvals, and other
conditions.
<PAGE>
To the Board of Directors
Merit Behavioral Care Corporation
We have audited the accompanying consolidated balance sheets of Merit Behavioral
Care Corporation (the "Company") as of September 30, 1997 and 1996, and the
related consolidated statements of operations, stockholders' equity, and cash
flows for each of the three years in the period ended September 30, 1997. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Merit Behavioral Care
Corporation as of September 30, 1997 and 1996, and the results of its operations
and its cash flows for each of the three years in the period ended September 30,
1997, in conformity with generally accepted accounting principles.
As discussed in Note 4 to the financial statements, effective October 1, 1995,
the Company changed its method of accounting for deferred contract start-up
costs related to new contracts or expansion of existing contracts.
/s/ Deloitte & Touche LLP
Deloitte & Touche LLP
November 14, 1997
New York, New York
<PAGE>
<TABLE>
<CAPTION>
MERIT BEHAVIORAL CARE CORPORATION
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
September 30,
<S> <C> <C>
1997 1996
ASSETS
Current Assets:
Cash and cash equivalents.............................................. $ 87,368 $ 47,375
Accounts receivable, net of allowance for doubtful accounts of $2,603
and $1,996............................................................ 41,884 28,383
Short-term marketable securities....................................... 4,111 ---
Deferred income taxes.................................................. 6,616 2,296
Other current assets.................................................. 13,129 2,481
Total current assets............................................... 153,108 80,535
Property, plant and equipment, net..................................... 83,312 67,880
Goodwill and other intangibles, net of accumulated amortization of
$82,637 and $59,781............................................... 195,192 162,849
Restricted cash and investments........................................ 3,727 5,668
Deferred financing costs, net of accumulated amortization of $2,484
and $1,142........................................................ 10,634 11,362
Other assets........................................................... 22,772 16,507
Total assets........................................................... $468,745 $344,801
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable....................................................... $ 11,347 $ 5,888
Claims payable........................................................ 102,834 57,611
Deferred revenue....................................................... 8,131 6,577
Accrued interest....................................................... 5,161 5,008
Current portion of long-term debt...................................... 6,498 500
Other current liabilities.............................................. 18,386 13,079
Total current liabilities........................................ 152,357 88,663
Long-term debt......................................................... 323,002 253,500
Deferred income taxes.................................................. 15,388 30,669
Other long-term liabilities............................................ 3,862 1,451
Commitments and Contingencies (See Note 11)
Stockholders' Equity:
Common stock (40,000,000 shares authorized, $0.01 par value,
29,396,158 and 28,398,800 shares issued)............................ 294 284
Additional paid in capital............................................. 8,949 (9,756)
Accumulated deficit.................................................... (28,307) (14,435)
Notes receivable from officers......................................... (6,800) (5,470)
(25,864) (29,377)
Less common stock in treasury (21,000 shares)......................... --- (105)
Total stockholders' equity.......................................... (25,864) (29,482)
Total liabilities and stockholders' equity............................. $468,745 $344,801
The accompanying notes are an integral part of these statements.
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
MERIT BEHAVIORAL CARE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED SEPTEMBER 30,
(dollars in thousands)
<S> <C> <C> <C>
1997 1996 1995
Revenue..................................... $555,717 $457,830 $361,549
Expenses:
Direct service costs...................... 449,563 361,684 286,001
Selling, general and administrative....... 67,450 64,523 49,823
Amortization of intangibles............... 26,897 25,869 21,373
Restructuring charge...................... --- 2,995 ---
543,910 455,071 357,197
Operating income............................ 11,807 2,759 4,352
Other income (expense):
Interest income and other................. 3,497 2,838 1,498
Interest expense.......................... (25,063) (23,826) ---
Loss on disposal of subsidiary............ (6,925) --- ---
Merger costs and special charges.......... (1,314) (3,972) ---
(29,805) (24,960) 1,498
(Loss) income before income taxes and
cumulative effect of accounting change.. (17,998) (22,201) 5,850
(Benefit) provision for income taxes........ (4,126) (5,332) 4,521
(Loss) income before cumulative effect
of accounting change...................... (13,872) (16,869) 1,329
Cumulative effect of accounting change
for deferred contract start-up costs, net
of tax benefit of $757.................... --- (1,012) ---
Net (loss) income........................... $ (13,872) $ (17,881) $ 1,329
Pro forma net (loss) income assuming the new
method of accounting for deferred
contract start-up costs was applied
retroactively............................. $ (13,872) $ (16,869) $ 317
The accompanying notes are an integral part of these statements.
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
MERIT BEHAVIORAL CARE CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(dollars in thousands)
Retained Earnings Notes
Common Stock Additional (Accumulated Receivable Common Stock
<S> <C> <C> <C> <C> <C> <C>
Shares Amount Paid In Capital Deficit) from Officers in Treasury
Balance September 30, 1994.................. 1,000,000$ 10 $ 118,877 $ 2,117 $ --- $
Net income.................................. --- --- --- 1,329 --- ---
---
Balance September 30, 1995.................. 1,000,000 10 118,877 3,446 --- ---
Recapitalization from merger:
Redemption of common stock................ (915,754) (9) (258,129) --- --- ---
Merger with MDC Acquisition Corp.......... 415,023 4 104,996 --- --- ---
Stock dividend............................ 24,763,531 247 (247) --- --- ---
Issuance of stock to management........... 3,156,000 32 15,748 --- (5,800) ---
Deferred taxes associated with merger..... --- --- 7,594 --- --- ---
Tax benefit from exercise of Merck
stock options............................. --- --- 1,505 --- --- ---
Repayment of notes receivable............... --- --- --- --- 265 ---
Cancellation of note receivable............. (20,000) --- (100) --- 100 ---
Repurchase of common stock.................. --- --- --- --- --- (600)
Sale of common stock........................ --- --- --- --- (35) 495
Net loss.................................... --- --- --- (17,881 --- ---
Balance September 30, 1996.................. 28,398,800 284 (9,756) (14,435) (5,470) (105)
Issuance of stock for CMG acquisition....... 739,358 7 5,538 --- --- ---
Tax benefit from exercise of Merck
stock options........................... --- --- 11,630 --- --- ---
Repayment of notes receivable............... --- --- --- --- 250 ---
Repurchase of common stock.................. --- --- --- --- --- (30)
Sale of common stock........................ 258,000 3 1,537 --- (1,580) 135
Net loss.................................... --- --- --- (13,872) --- ---
Balance September 30, 1997.................. 29,396,158 $ 294 $ 8,949 $(28,307) $ (6,800) $ ---
The accompanying notes are an integral part of these statements.
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
MERIT BEHAVIORAL CARE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED SEPTEMBER 30,
(dollars in thousands)
<S> <C> <C> <C>
1997 1996 1995
CASH FLOWS FROM OPERATING
ACTIVITIES:
Net (loss) income................................ $(13,872) $(17,881) $ 1,329
Adjustments to reconcile net (loss) income to
net cash provided by operating activities:
Loss on sale of subsidiary..................... 6,925 --- ---
Cumulative effect of accounting change......... --- 1,012 ---
Depreciation and amortization.................. 39,400 36,527 28,150
Amortization of deferred financing costs....... 1,342 1,142 ---
Deferred taxes and other....................... (4,409) (6,068) 379
Restructuring charge........................... --- 2,995 ---
Changes in operating assets and liabilities, net
of the effect of acquisitions:
Accounts receivable............................ (9,781) 265 (8,545)
Other current assets........................... (2,854) 536 (995)
Deferred contract start-up costs.............. (6,067) (4,816) (6,231)
Accounts payable and accrued liabilities...... 16,224 14,864 11,982
Net cash provided by operating activities........ 26,908 28,576 26,069
CASH FLOWS FROM INVESTING
ACTIVITIES:
Purchases of property, plant and equipment..... (23,951) (23,808) (31,529)
Cash used for acquisitions, net of cash
acquired................................... (35,645) (12,676) (9,580)
Investments in and advances to joint ventures.. (2,595) (2,931) (14,860)
Repayments of advances from joint ventures..... 675 420 ---
Sales (purchases) of marketable securities..... (4,111) 1,143 3,533
Long-term restrictions removed from
(placed on) cash............................ 1,941 (2,183) (211)
Change in non-current assets and other.......... 1,558 (1,282) (1,503)
Net cash used for investing activities.......... (62,128) (41,317) (54,150)
CASH FLOWS FROM FINANCING
ACTIVITIES:
Proceeds from capital contribution............. --- 114,980 ---
Borrowings from parent......................... --- --- 32,882
Proceeds from bridge loan...................... --- 75,000 ---
Proceeds from revolving credit facility........ 187,500 163,500 ---
Proceeds from senior term loans................ 80,000 120,000 ---
Proceeds from sale of notes.................... --- 100,000 ---
Redemption of common stock..................... --- (258,138) ---
Repayment of due to parent..................... --- (67,878) ---
Repayment of bridge loan....................... --- (75,000) ---
Repayment of senior term loans................. (500) --- ---
Repayment of revolving credit facility......... (191,500) (129,500) ---
Payment of financing costs..................... (602) (12,504) ---
Other.......................................... 315 125 ---
Net cash provided by financing activities...... 75,213 30,585 32,882
INCREASE IN CASH AND
CASH EQUIVALENTS............................... 39,993 17,844 4,801
Cash and cash equivalents at beginning
of year........................................ 47,375 29,531 24,730
CASH AND CASH EQUIVALENTS AT
END OF YEAR.................................... $ 87,368 $ 47,375 $29,531
The accompanying notes are an integral part of these statements.
</TABLE>
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1997, 1996 AND 1995
(dollars in thousands)
1. ORGANIZATION
Merit Behavioral Care Corporation (the "Company") was incorporated in the State
of Delaware in March 1993 as a wholly-owned subsidiary of Medco Containment
Services, Inc. ("Medco"). The Company manages behavioral healthcare programs for
payors across all segments of the healthcare industry, including health
maintenance organizations, Blue Cross/Blue Shield organizations and other
insurance companies, corporations and labor unions, federal, state and local
governmental agencies, and various state Medicaid programs. Behavioral
healthcare involves the treatment of a variety of behavioral health conditions
such as emotional and mental health problems, substance abuse and other personal
concerns that require counseling, outpatient therapy or more intensive treatment
services.
On November 18, 1993, Merck & Co., Inc. ("Merck") acquired all of the
outstanding shares of Medco (See Note 3).
On October 6, 1995, the Company completed a merger (the "Merger") with MDC
Acquisition Corp. ("MDC"), a company formed by Kohlberg Kravis Roberts & Co.,
L.P. ("KKR"), whereby MDC was merged with and into the Company. In connection
with the Merger, the Company changed its name from Medco Behavioral Care
Corporation to Merit Behavioral Care Corporation (See Note 2).
2. MERGER
Prior to the Merger, the Company was a wholly-owned subsidiary of Merck & Co.,
Inc. ("Merck"). As a result of the Merger, KKR and Company management and
related entities obtained approximately 85% of the post-Merger common stock of
the Company. In connection with the Merger, Merck received $326,016 in cash
(which reflects various final purchase price adjustments) and retained
approximately 15% of the common stock of the post-Merger Company. The Merger was
accounted for as a recapitalization which resulted in a charge to equity of
$258,138 to reflect the redemption of common stock. In conjunction with the
Merger, the Company paid a stock dividend of approximately 49.6 shares for each
share of the Company's stock then outstanding.
The Merger was financed with $114,980 of new cash equity, consisting of $105,000
from affiliates of KKR and $9,980 from Company management and related entities
("Management"). Management acquired an additional $5,800 of equity which was
funded by loans from the Company. The balance of the transaction was funded with
a $75,000 bridge loan (the "Bridge Loan") provided by an affiliate of KKR and
$155,000 of initial borrowings under a $205,000 senior credit facility among the
Company, The Chase Manhattan Bank, N.A. and Bankers Trust Company (the "Senior
Credit Facility"). The aforementioned proceeds were utilized to redeem common
stock for $258,138, repay amounts due Merck of $67,878, and pay certain fees and
expenses related to the Merger. Of the total fees and expenses, $5,500 was paid
to KKR.
3. BASIS OF PRESENTATION
On November 18, 1993, Merck acquired all the outstanding shares of Medco in a
transaction accounted for by the purchase method. As a result of this
acquisition, a new basis of accounting was established and as such, the
appraised value of the Company's assets and liabilities was recognized as of
November 18, 1993.
<PAGE>
3. BASIS OF PRESENTATION--(Continued)
The appraisal determined that identified intangible assets, consisting
principally of customer contracts, had an appraised value of $112,000 and
related deferred taxes of $47,800 at the acquisition date. These identified
intangible assets are being amortized on a straight line basis over a weighted
average life of 12 years. Based on the allocation of the purchase price to the
net tangible and identified intangible assets and liabilities of the Company, an
excess of the allocated purchase price over the fair value of net assets
acquired of approximately $47,988 was recorded as goodwill. Such goodwill is
being amortized on a straight line basis over 40 years.
Certain prior year amounts have been reclassified to conform to the current year
presentation.
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and
its majority-owned subsidiaries. All significant intercompany balances and
transactions have been eliminated.
Cash and Cash Equivalents
The Company considers all liquid investment instruments with an original
maturity of three months or less to be the equivalent of cash for purposes of
balance sheet presentation.
Included in cash and cash equivalents at September 30, 1997 and 1996 is $11,020
and $11,713, respectively, of cash held under the terms of certain customer
contracts that require a claims fund to be established and segregated for the
purpose of paying customer behavioral healthcare claims. Under these
arrangements, a reconciliation process is typically conducted annually between
the customer and the Company to determine the amount of unexpended funds, if
any, accruing to the Company. This cash is unavailable to the Company for
purposes other than the payment of customer claims until such reconciliation
process has been completed. The amount of cash held under such arrangements in
excess of anticipated customer claims at September 30, 1997 and 1996 was $6,197
and $4,267, respectively.
The Company held surplus cash balances of $29,325 and $13,715 as of September
30, 1997 and 1996, respectively, as required by contracts with various state and
local governmental entities. In addition, at September 30, 1997 and 1996, the
Company held surplus cash balances of $3,137 and $1,214, respectively, as
required by various other contracts. These contracts require the segregation of
such cash as financial assurance that the Company can meet its obligations
thereunder.
The Company has a subsidiary organized in the State of Missouri that is licensed
to do business as a foreign corporation in the State of California and is
subject to regulation by the Department of Corporations of the State of
California. Pursuant to these regulatory requirements, certain amounts of cash
are required to be retained for the use of this subsidiary. Included in cash and
cash equivalents at September 30, 1997 and 1996 is $0 and $900, respectively,
under such requirements.
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(Continued)
Short-Term Marketable Securities
Short-term marketable securities consist of treasury notes and certificates of
deposit, carried at amortized cost which approximates fair value. All of the
Company's short-term marketable securities are classified as held-to-maturity.
The Company held short-term marketable securities in the amount of $4,011 at
September 30, 1997 as required by the Company's contract with a governmental
entity.
Restricted Cash
At September 30, 1997 and 1996, $6,623 and $7,168, respectively, of cash and
marketable securities were held by subsidiaries of the Company that are
organized and regulated under state law as insurance companies. Such insurance
companies are required to maintain certain minimum statutory deposits and
reserves with respect to the payment of future claims. The amount of cash in
excess of the liabilities of such subsidiaries and not available for dividend to
the Company without prior regulatory approval was $3,559 and $5,510 at September
30, 1997 and 1996, respectively. As a result, such amounts of cash held by these
subsidiaries have been classified as a long-term asset in the accompanying
consolidated balance sheets.
All of the Company's long-term marketable investments are classified as
held-to-maturity; in addition, such investments are carried at amortized cost
which approximates fair value.
Property, Plant and Equipment
Property, plant and equipment are stated at cost. For financial reporting
purposes, depreciation is provided principally on a straight line basis over the
estimated useful lives of the assets as follows:
<TABLE>
<CAPTION>
<S> <C> <C> <C> <C> <C> <C>
Machinery and equipment.............................. 5 Years
Integrated managed care information system........... 7 Years
Furniture and fixtures............................... 15 Years
Leasehold improvements............................... Life of lease
</TABLE>
Expenditures for maintenance, repairs and renewals of minor items are charged to
operations as incurred. Major betterments are capitalized.
The integrated managed care information system (the "System") represents costs
incurred in the development and adaptation of AMISYS(R) software for use in the
Company's business. In addition to purchased hardware and software costs, the
payroll and related benefits of employees who are exclusively engaged in the
development and deployment of the System are capitalized. The System was
substantially complete in October 1995 at which time the Company began
installing the System in various area and regional offices in the Company's
service delivery system. As the System is installed in an office, the office is
allocated a ratable portion of the total cost of the System, at which time the
allocated cost is depreciated over an estimated useful life of 7 years.
Goodwill and Other Intangibles
The Company amortizes costs in excess of the net assets of businesses acquired
on a straight line basis over periods not to exceed 40 years. Contingent
consideration is charged to goodwill when paid and is amortized over the
remaining life of such goodwill, not to exceed 40 years. The Company
periodically reviews the carrying value of goodwill to assess recoverability and
other than temporary impairments.
<PAGE>
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(Continued)
Goodwill and intangible assets consisted of the following at September 30, 1997
and 1996:
<TABLE>
<CAPTION>
<S> <C> <C>
1997 1996
---- ----
Customer Contracts.......................... $ 88,074 $ 80,000
Provider Network............................ 12,000 12,000
Trade Names and other....................... 20,000 20,000
Goodwill.................................... 157,755 110,630
$277,829 $222,630
</TABLE>
Deferred Contract Start-up Costs
The Company defers contract start-up costs related to new contracts or expansion
of existing contracts that require the implementation of separate, dedicated
service delivery teams, provider networks and delivery systems or the
establishment of a local clinical organization in a new geographic area to
service the new program. The Company defers only costs which (i) are separately
identified, incremental and segregated from ordinary operating expenses; (ii)
provide a direct, quantifiable benefit to future periods; and (iii) are fully
recoverable from contract revenues directly attributable to such benefit. The
incremental costs deferred by the Company include, among other things,
consulting fees, salary costs, travel costs, office costs and network and
reporting system development costs. Consulting fees deferred by the Company
relate primarily to the recruitment, credentialling and contracting of the
particular customer's provider network. The salary costs relate primarily to
employees of the Company dedicated to clinical protocol design, network
development activities and program reporting and information systems
customization for the specific customer. These contract start-up costs are
capitalized and amortized on a straight line basis over the initial term of the
related contract. The amortization periods range from one to five years, with a
weighted-average life at September 30, 1997 and 1996 of 4.3 and 3.3 years,
respectively. Amortization of deferred contract start-up costs was $3,096,
$2,848, and $1,315 for the periods ended September 30, 1997, 1996, and 1995,
respectively. During the periods ended September 30, 1997, 1996, and 1995, the
Company deferred contract start-up costs of $6,067, $4,816, and $6,231,
respectively. Other non-current assets include $9,036 and $6,077 of unamortized
deferred contract start-up costs at September 30, 1997 and 1996, respectively.
Effective October 1, 1995, the Company changed its method of accounting for
deferred start-up costs related to new contracts or expansion of existing
contracts (i) to expense costs relating to start-up activities incurred after
commencement of services under the contract, and (ii) to limit the amortization
period for deferred start-up costs to the initial contract period. Prior to
October 1, 1995, the Company capitalized start-up costs related to the
completion of the provider networks and reporting systems beyond commencement of
contracts and, in limited instances, amortized the start-up costs over a period
that included the initial renewal term associated with the contract. Under the
new policy, the Company does not defer contract start-up costs after contract
commencement, or amortize start-up costs beyond the initial contract period. The
change was made to increase the focus on controlling costs associated with
contract start-ups.
The pro forma effect of the change, had the Company adopted this new accounting
policy in prior years, is to decrease total assets by $1,769 and decrease total
liabilities by $757 as of September 30, 1995, and to increase costs and expenses
by $1,769 ($1,012 after taxes) for the year ended September 30, 1995. The effect
of the change on fiscal 1996 and 1997 cannot be reasonably estimated.
Revenue Recognition
Typically, the Company charges each of its customers a flat monthly capitation
fee for each beneficiary enrolled in such customer's behavioral health managed
care plan or Employee Assistance Program ("EAP"). This capitation fee is
generally paid to the Company in the current month. Contract revenue billed in
advance of performing related services is deferred and recognized ratably over
the period to which it applies. For a number of the Company's
<PAGE>
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(Continued)
behavioral health managed care programs, the capitation fee is divided into
outpatient and inpatient fees, which are recognized separately.
Outpatient revenue is recognized monthly as it is received; inpatient revenue is
recognized monthly and is in most cases (i) paid to the Company monthly (in
cases where the Company is responsible for the payment of inpatient claims) or
in certain cases (ii) retained by the customer for payment of inpatient claims.
When the customer retains the inpatient revenue, actual inpatient costs are
periodically reconciled to amounts retained and the Company receives the excess
of the amounts retained over the cost of services, or reimburses the customer if
the cost of services exceeds the amounts retained. In certain instances, such
excess or deficiency is shared between the Company and the customer. A
significant portion of the Company's revenue is derived from capitated
contracts.
Direct Service Costs
Direct service costs are comprised principally of expenses associated with
managing, supervising and providing the Company's services, including
third-party network provider charges, various charges associated with the
Company's staff offices, inpatient facility charges, costs associated with
members of management principally engaged in the Company's clinical operations
and their support staff, and rent for certain offices maintained by the Company
in connection with the delivery of services. Direct service costs are recognized
in the month in which services are expected to be rendered. Network provider and
facility charges for authorized services that have not been reported and billed
to the Company (known as incurred but not reported expenses, or "IBNR") are
estimated and accrued based on historical experience, current enrollment
statistics, patient census data, adjudication decisions and other information.
Such costs are included in the caption "Claims payable" in the accompanying
consolidated balance sheets.
Income Taxes
Deferred taxes are provided for the expected future income tax consequences of
events that have been recognized in the Company's financial statements. Deferred
tax assets and liabilities are determined based on the temporary differences
between the financial statement carrying amounts and the tax bases of assets and
liabilities using enacted tax rates in effect in the years in which the
temporary differences are expected to reverse.
Long-Lived Assets
The Financial Accounting Standards Board issued SFAS No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, in
March 1995. The general requirements of this statement are applicable to the
properties and intangible assets of the Company and require impairment to be
considered whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. If the sum of expected
future cash flows (undiscounted and without interest charges) is less than the
carrying amount of the asset, an impairment loss is recognized. The Company
adopted this standard on October 1, 1996. No impairment losses have been
identified by the Company.
Stock-Based Compensation Plans
During fiscal 1997, the Company adopted SFAS No. 123, Accounting for Stock-Based
Compensation ("SFAS 123"). The new standard defines a fair value method of
accounting for stock options and similar equity instruments. Under the fair
value method, compensation cost is measured at the grant date based on the fair
value of the award and is recognized over the service period, which is usually
the vesting period. As permitted by SFAS 123, however, the Company has elected
to continue to recognize and measure compensation for its stock rights and stock
option plans in accordance with the existing provisions of Accounting Principles
Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25"). See
Note 16 for pro forma disclosures of net loss as if the fair value-based method
prescribed by SFAS No. 123 had been applied.
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(Continued)
Disclosure of Fair Value of Financial Instruments
The carrying amount reported in the consolidated balance sheets for cash and
cash equivalents, accounts receivable, accounts payable and accrued liabilities
approximates fair value because of the immediate or short-term maturity of these
financial instruments. The Company's short-term marketable securities and
long-term marketable investments are carried at amortized cost which
approximates fair value. The carrying amount of loans made to certain joint
ventures engaged in the development of Medicaid programs (Note 9) approximates
fair value which was estimated by discounting future cash flows using rates at
which similar loans would be made to borrowers with similar credit ratings. The
carrying value for the variable rate debt outstanding under the Senior Credit
Facility (as described in Note 6) approximates the fair value. The fair value of
the Company's senior subordinated notes (see Note 6) is estimated to be $109,000
at September 30, 1997 (based on quoted market prices) which compares to the
carrying value of $100,000.
Concentrations of Credit Risk
Financial instruments that potentially subject the Company to concentrations of
credit risk consist principally of trade receivables. Concentrations of credit
risk with respect to trade receivables are limited due to the large number of
customers comprising the Company's customer base and the dispersion of such
customers across different businesses and geographic regions.
5. PROPERTY, PLANT, AND EQUIPMENT
Property, plant and equipment consisted of the following at September 30:
<TABLE>
<CAPTION>
<S> <C> <C>
1997 1996
---- ----
Machinery and equipment.............................. $ 58,988 $ 44,896
Integrated managed care information system........... 38,914 28,349
Furniture and fixtures............................... 16,665 12,795
Leasehold improvements............................... 3,443 2,977
118,010 89,017
Accumulated depreciation and
amortization....................................... (34,698) (21,137)
$83,312 $67,880
Depreciation and amortization related to property, plant and equipment was $12,503, $10,658, and $6,776 for the periods
ended September 30, 1997, 1996, and 1995, respectively.
</TABLE>
6. LONG TERM DEBT
Long-term debt consisted of the following at September 30:
<TABLE>
<CAPTION>
<S> <C> <C>
1997 1996
---- ----
Revolving Loans ................... $ 30,000 $ 34,000
Senior Term Loan A................. 70,000 70,000
Senior Term Loan B................. 129,500 50,000
Notes.............................. 100,000 100,000
329,500 254,000
Less current portion............... (6,498) (500)
$323,002 $253,500
</TABLE>
<PAGE>
6. LONG-TERM DEBT--(Continued)
Senior Credit Facility - In October 1995, the Company entered into a credit
agreement (the "Credit Agreement"), which provided for secured borrowings from a
syndicate of lenders. The Senior Credit Facility consisted initially of (i) a
six and one-half year revolving credit facility (the "Revolving Credit
Facility") providing for up to $85,000 in revolving loans, which includes
borrowing capacity available for letters of credit of up to $20,000, and (ii) a
term loan facility providing for up to $120,000 in term loans, consisting of a
$70,000 senior term loan with a maturity of six and one-half years ("Senior Term
Loan A"), and a $50,000 senior term loan with a maturity of eight years ("Senior
Term Loan B"). On September 12, 1997, the Senior Term Loan B was increased by
$80,000 to $130,000 with the maturity extended one and one-half years. The
additional borrowings from Senior Term Loan B were primarily obtained to fund
the acquisition of CMG Health, Inc. ("CMG"), as discussed in Note 8. At
September 30, 1997, $30,000 of revolving loans and five letters of credit
totaling $8,313 were outstanding under the Revolving Credit Facility, and
approximately $46,687 was available for future borrowing. At September 30, 1996,
$34,000 of revolving loans and three letters of credit totaling $425 were
outstanding under the Revolving Credit Facility, and approximately $50,575 was
available for future borrowings.
In October 1996, a scheduled repayment of $500 was made on Senior Term Loan B.
The annual amortization schedule of the Senior Term Loans is $6,498 in 1998,
$10,000 in 1999, $12,500 in 2000, $20,000 in 2001, $25,000 in 2002 and $125,502
thereafter. The Senior Term Loans are subject to mandatory prepayment (i) with
the proceeds of certain asset sales and (ii) on an annual basis with 50% of the
Company's Excess Cash Flow (as defined in the Credit Agreement) for so long as
the ratio of the Company's Total Debt (as defined in the Credit Agreement) to
annual Earnings Before Interest, Taxes, Depreciation and Amortization ("EBITDA"
as defined in the Credit Agreement) is greater than 3.5 to 1.0. Proceeds in the
amount of $4,735 received in October 1997 as a result of the disposal of one of
the Company's subsidiaries (See Note 17) have been classified as current in
accordance with the mandatory prepayment loan provision. At September 30, 1997,
approximately $662 has been classified as current in accordance with mandatory
prepayment requirements for Excess Cash Flow.
The Company is charged a commitment fee calculated at an EBITDA-dependent rate
ranging from 0.250% to 0.500% per annum of the commitment under the Revolving
Credit Facility in effect on each day. The Company is charged a letter of credit
fee calculated at an EBITDA-dependent rate ranging from 0.375% to 1.750% per
annum of the face amount of each letter of credit and a fronting fee calculated
at a rate equal to 0.250% per annum of the face amount of each letter of credit.
Loans under the Credit Agreement bear interest at EBITDA-dependent floating
rates, which are, at the Company's option, based upon (i) the higher of the
Federal funds rate plus 0.5%, or bank prime rates, or (ii) Eurodollar rates.
Rates on borrowing outstanding under the Senior Credit Facility averaged 8.1%
and 8.3% for the years ended September 30, 1997 and 1996, respectively.
Notes - On November 22, 1995, the Company issued $100,000 aggregate principal
amount of 11 1/2% senior subordinated notes due 2005 (the "Private Notes"), the
net proceeds of which were applied to repay the Bridge Loan (including accrued
interest) and a portion of the Revolving Credit Facility. On March 20, 1996, the
Company exchanged the Private Notes for $100,000 aggregate principal amount of
11 1/2% Senior Subordinated Notes due 2005 that are registered under the
Securities Act of 1933 (the "Notes"). The Notes are senior subordinated,
unsecured obligations of the Company.
The Company may be obligated to purchase at the holders' option all or a portion
of the Notes upon a change of control or asset sale, as defined in the indenture
for the Notes (the "Notes Indenture"). The Notes are not redeemable at the
Company's option prior to November 15, 2000, except that at any time on or prior
to November 15, 1998, under certain conditions the Company may redeem up to 35%
of the initial principal amount of the Notes originally issued with the net
proceeds of a public offering of the common stock of the Company. The redemption
price is equal to 111.50% of the principal amount if the redemption is on or
prior to November 15, 1997, and 110.50% if the redemption is on or prior to
November 15, 1998. From and after November 15, 2000, the Notes will be subject
to redemption at the option of the Company, in whole or in part, at various
redemption prices, declining from 105.75% of the principal amount to par on and
after November 15, 2004. The Notes mature on November 15, 2005.
<PAGE>
6. LONG-TERM DEBT-- (Continued)
The Credit Agreement and the Notes Indenture contain restrictive covenants that,
among other things and under certain conditions, limit the ability of the
Company to incur additional indebtedness, to acquire (including a limitation on
capital expenditures) or to dispose of assets or operations, to incur liens on
its property or assets, to make advances, investments and loans, and to pay any
dividends. The Company must also satisfy certain financial covenants and tests.
Borrowings under the Credit Agreement are secured by a first priority lien on
the capital stock of certain of the Company's subsidiaries.
7. NOTES RECEIVABLE FROM OFFICERS
In October 1995, the Company loaned several officers an aggregate of $5,800 for
the purchase of common stock of the Company; subsequent to the Merger,
additional loans totaling $1,615 were made to officers for the purchase of
shares of common stock. Each loan is represented by a promissory note which
bears interest at a rate of 6.5% per annum.
These notes are full recourse obligations of the officers, are collateralized by
the pledge of common stock of the Company held by such officers and may be
prepaid in part or in full without notice or penalty. Notes receivable totaling
$250 and $265 were repaid during the periods ended September 30, 1997 and 1996,
respectively. Also a note for $100 was canceled in January 1996 for receipt of
shares of common stock. The remaining outstanding notes are due as follows: $20
in 1998 and $6,780 in 2001. The notes are shown as a reduction of stockholders'
equity in the accompanying consolidated balance sheets.
8. ACQUISITIONS
On September 12, 1997, the Company paid an initial $48,740 and issued 739,358
shares of Company common stock to acquire all of the capital stock of CMG, a
Maryland-based provider of managed behavioral healthcare services. The
acquisition was accounted for as a purchase transaction. The consolidated
financial statements of the Company include the operating results of CMG from
the date of the acquisition. The purchase price for CMG was allocated to the net
assets acquired based upon their estimated fair values. The Company common stock
issued in the acquisition was assigned a value of $7.50 per share based on a
valuation analysis performed by an independent third party. The excess of the
purchase price over the net tangible assets acquired amounted to $64,715 and is
being amortized over periods up to 40 years using the straight-line method. The
purchase price allocation was based on preliminary estimates and may be revised
upon final valuation. The Company is obligated to make contingent payments to
the former shareholders of CMG if the financial results of certain contracts
exceed specified base-line amounts. Such contingent payments are subject to an
aggregate maximum of $23,500. Any such additional payments will be recorded as
goodwill.
The following summary of the unaudited pro forma consolidated results of
operations of the Company for the years ended September 30, 1997 and 1996
assumes the CMG acquisition occurred as of the beginning of the respective
periods. The pro forma results include the combined historical results of the
Company and CMG, and pro forma adjustments to reflect (i) interest expense
associated with the debt incurred to finance the acquisition, (ii) changes to
depreciation and amortization related to the allocation of the cost of CMG to
the assets acquired and liabilities assumed and (iii) reductions of salaries,
benefits and certain other costs included in the historical results of CMG which
will be eliminated as a result of the acquisition. These pro forma results have
been prepared for comparative purposes only and do not purport to be indicative
of the results of operations which actually would have resulted had the
acquisition occurred at the beginning of the respective periods, or which may
result in the future.
<TABLE>
<CAPTION>
Unaudited
<S> <C> <C>
1997 1996
Revenue............................ $653,477 $522,857
Net loss........................... (15,048) (16,939)
</TABLE>
<PAGE>
8. ACQUISITIONS--(Continued)
In August 1996, the Company paid approximately $340 to acquire Orion Life
Insurance Company ("Orion"), a Delaware life and health insurance company. Orion
holds insurance licenses in 17 states and provides the Company with the ability
to underwrite future business in those states should a customer require that a
licensed insurance entity underwrite its behavioral health program.
On December 19, 1995, the Company paid an initial $50 with a subsequent payment
of $2,950 in January 1996 to acquire ProPsych, Inc. ("ProPsych"), a
Florida-based behavioral health managed care company. As of September 30, 1996,
the Company recorded additional goodwill in the amount of $400 for a final
contingent payment made to the former shareholders of ProPsych in November 1996.
On October 5, 1995, the Company paid an initial $8,730 to acquire Choate Health
Management, Inc. and certain related entities ("Choate"), a Massachusetts-based
integrated behavioral healthcare organization. The Company made a contingent
consideration payment of $1,278 to the former shareholders of Choate in July
1996; such payment was recorded as goodwill. In June 1997, the Company and the
former Choate shareholders signed an agreement which provided for the settlement
of the contingent consideration related to Choate. Such agreement required no
further payments by the Company. Choate was sold by the Company in September
1997 (See Note 17).
In September 1995, a contingent payment of $8,550 was made to the former
shareholders of BenesYs, a subsidiary of the Company, in full settlement of any
and all contingent consideration due to such former shareholders. In April 1995,
a final payment of $650 was made related to the acquisition of the clinical
protocols of the Washton Institute.
9. JOINT VENTURES
CMG, which was acquired on September 12, 1997, is a 50% partner in CHOICE
Behavioral Health Partnership ("Choice"), a managed behavioral healthcare
company. The Company reports its investment in Choice using the equity method.
Although the Company reports its share of earnings from the joint venture, the
financial statements of Choice are not consolidated with those of the Company.
All revenue of the joint venture is from a contract for the Civilian Health and
Medical Program of the Uniformed Services ("CHAMPUS") with Humana, Inc.
Summarized financial information of the joint venture, representing 100% of its
business, as of September 30, 1997 and for the period from September 12, 1997
through September 30, 1997, is as follows:
<TABLE>
<CAPTION>
<S> <C> <C>
Current Assets $ 38,286 Net Revenues $ 3,333
Non-Current Assets 700 Cost of Providing Services 2,973
Total Assets $ 38,986
=========
Gross Profit 360
Total Liabilities $ 37,141
Partners' Capital 1,845 Other Expenses 106
Total Liabilities & P.C. $ 38,986 Net Income $ 254
========= ========
</TABLE>
In March 1994, the Company entered into a joint venture partnership with
Community Sector Systems, Inc. ("CSS"), a software development company, to
market a proprietary clinical information, communications and case documentation
software package. The Company contributed $125 in capital, loaned $1,375 to CSS
in 1994 and made an additional loan of $300 to CSS in 1995. In December 1996,
the Company converted the $1,375 loan and the accrued interest receivable on the
loan of $369 into an equity interest in CSS, and made an additional capital
contribution of $500. Additionally, in February 1997 the Company contributed
capital of $350 and loaned CSS $150. As of September 30, 1997, the Company has a
net loan receivable from CSS of $450 and an equity investment in CSS of $2,719.
9. JOINT VENTURES--(Continued)
In April 1995, the Company entered into a contractual arrangement with Community
Health Network of Connecticut, Inc. ("CHN"), an organization consisting of 11
not-for-profit health centers in Connecticut, under which the Company has agreed
to provide CHN with up to a total of $4,000 in unsecured debt to help finance
CHN's Medicaid program development costs. As of September 30, 1997 and 1996, the
Company had net advances to CHN outstanding of $1,732 and $2,079, respectively.
Also, in April 1995, the Company entered into a joint venture with Neighborhood
Health Providers, LLC ("NHP"), an organization consisting of five hospitals
located in Brooklyn and Queens, New York, under which the Company agreed to fund
a portion of NHP's Medicaid program development costs in the form of $1,500 in
unsecured debt. As of September 30, 1997 and 1996, the Company had net advances
of $1,500 to NHP.
In September 1995, the Company paid $12,010 to Empire Blue Cross and Blue Shield
("Empire") for the right to provide behavioral health managed care services to
approximately 750,000 Empire enrollees in the State of New York for a period of
eight years. In connection therewith, the Company formed a limited liability
company (the "Empire Joint Venture") with the Company and Empire receiving
ownership interests of 80% and 20%, respectively. The payment was charged to
goodwill and is being amortized over the life of the underlying contract.
In January 1996, the Company formed a joint venture with the hospital sponsors
of NHP under the name Royal Health Care LLC ("Royal"), in which the Company and
NHP each holds a 50% equity interest. Royal has management services contracts
with certain organizations including NHP and Empire Community Delivery Systems
LLC ("ECDS"). During fiscal 1996, the Company made an equity contribution and an
unsecured working capital loan to Royal in the amounts of $200 and $228,
respectively. During fiscal 1997, the Company made an additional capital
contribution of $100 to Royal.
ECDS, which was formed in fiscal 1996, is a joint venture company in which the
Company, NHP and Empire hold interests of approximately 16.7%, 16.7%, and 66.6%,
respectively. The Company made capital contributions to ECDS in 1997 and 1996 of
$667 and $458, respectively. Also, in 1997 and 1996 the Company provided loans
to NHP, the proceeds of which were used to fund NHP's capital contributions to
ECDS, of $667 and $458, respectively. The loans to NHP are secured by NHP's
interest in ECDS. Empire and ECDS have entered into an agreement under which
ECDS will exclusively manage and operate, on behalf of Empire, health care
benefit programs (covering all services except behavioral healthcare and vision
care) in the five New York City boroughs for Medicaid beneficiaries enrolled in
Empire plans. Each of Empire and Royal will provide specified administrative and
management services to ECDS to support its delivery of services to Empire under
such agreement. Moreover, each of ECDS and Royal will hold specified equity
interests in certain independent practice associations (IPAs) providing
treatment services to the Empire Medicaid beneficiaries. In addition, Empire has
entered into an agreement with the Empire Joint Venture to exclusively provide,
on behalf of Empire, all behavioral healthcare services in New York City to such
Empire Medicaid enrollees. The Royal and ECDS joint ventures and related
agreements have five year terms, with up to three five-year renewals (subject to
applicable regulatory approvals). Each such venture and agreement also contains
customary termination provisions.
The receivables from, and the investments in, CSS, NHP, CHN, Royal and ECDS are
reflected in "other assets" in the accompanying balance sheets.
<PAGE>
10. INCOME TAXES
Prior to the Merger, the Company filed a consolidated federal income tax return
with Merck. Though no formal tax sharing agreement existed between the Company
and Merck, the Company computed federal income taxes on a separate return basis
and recorded such taxes in the caption "Due to parent".
The components of income tax expense (benefit) for the periods ended September
30, are as follows:
<TABLE>
<CAPTION>
<S> <C> <C> <C>
1997 1996 1995
---- ---- ----
Current:
Federal................................ $ --- $ --- $3,030
State.................................. 283 736 1,112
283 736 4,142
Deferred :
Federal ............................... (4,848) (5,495) 200
State.................................. 439 (573) 179
(4,409) (6,068) 379
Total....................................... $(4,126) $ (5,332) $4,521
</TABLE>
The differences between the U.S. federal statutory tax rate and the Company's
effective tax rate are as follows:
<TABLE>
<CAPTION>
<S> <C> <C> <C>
1997 1996 1995
---- ---- ----
U.S. federal statutory tax rate............. (35.0)% (35.0)% 35.0%
State income taxes (net of federal benefit). 0.6 0.4 14.4
Capital loss................................ 6.9 --- ---
Merger expenses............................. --- 5.8 ---
Goodwill.................................... 3.1 2.3 13.1
Expenses without tax benefit............... 1.6 2.0 13.9
Other....................................... (0.1) 0.5 0.9
Effective tax rate.......................... (22.9)% (24.0)% 77.3%
===== ===== ====
</TABLE>
At September 30, 1997 and 1996, the Company had $46,733 and $23,707,
respectively, of deferred income tax assets and $55,505 and $52,080,
respectively, of deferred income tax liabilities which have been netted for
presentation purposes. The significant components of these amounts are shown on
the balance sheet as follows:
<TABLE>
<CAPTION>
<S> <C> <C>
1997 1996
Current Non Current Current Non Current
Asset Liability Asset Liability
Provision for estimated expenses............ $ 7,023 $ 507 $ 2,630 $ 2,161
Capitalized expenses........................ (407) (1,224) (334) (1,436)
Net operating loss carryforwards............ --- 28,502 --- 9,170
Accelerated depreciation.................... --- (20,194) --- (14,605)
Intangible asset differences................ --- (22,979) --- (25,959)
$ 6,616 $ (15,388) $ 2,296 $(30,669)
======== ========= ========= ========
</TABLE>
Management believes that the deferred tax assets will be fully realized based on
future reversals of existing taxable temporary differences and projected
operating results of the Company. As a result, no valuation allowance has been
provided. At September 30, 1997, the Company had U.S. federal net operating loss
carryforwards of approximately $76,630 for tax purposes. Approximately $5,920 of
the carryforwards expire in 2010, $21,460 expire in 2011 and $49,250 expire in
2012.
<PAGE>
11. COMMITMENTS AND CONTINGENCIES
a. Leases
The Company leases office facilities and equipment under various noncancelable
operating leases.
At September 30, 1997, the minimum aggregate rental commitments under
noncancelable leases, excluding renewal options, are as follows:
<TABLE>
<CAPTION>
<S> <C> <C>
1998................................................. $13,469
1999................................................. 11,606
2000................................................. 9,892
2001................................................. 8,699
2002................................................. 6,382
Thereafter........................................... 18,219
Minimum lease payments............................... 68,267
Less amounts representing sublease income............ (2,060)
$66,207
</TABLE>
Several of the leases contain escalation provisions due to increased maintenance
costs and taxes. Scheduled rent increases are amortized on a straight-line basis
over the lease term. Total rent expense for the periods ended September 30,
1997, 1996 and 1995 amounted to $15,842, $13,059 and $10,115, respectively.
b. Employment Agreements
The Company and certain of its subsidiaries have employment agreements with
various officers and certain other management personnel that provide for salary
continuation for a specified number of months under certain circumstances. The
aggregate commitment for future salaries at September 30, 1997, excluding
bonuses, was approximately $2,735.
c. Legal Proceedings
In October 1996, a group of eight plaintiffs purporting to represent an
uncertified class of psychiatrists and clinical social workers brought an action
under the federal antitrust laws in the United States District Court for the
Southern District of New York against nine behavioral health managed care
organizations, including the Company (collectively, "Defendants"). The complaint
alleges that Defendants violated section 1 of the Sherman Act by engaging in a
conspiracy to fix the prices at which Defendants purchase services from mental
healthcare providers such as plaintiffs. The complaint further alleges that
Defendants engaged in a group boycott to exclude mental healthcare providers
from Defendants' networks in order to further the goals of the alleged
conspiracy. The complaint also challenges the propriety of Defendents'
capitation arrangements with their respective customers, although it is unclear
from the complaint whether plaintiffs allege that Defendants unlawfully
conspired to enter into capitation arrangements with their respective customers.
The complaint seeks treble damages against Defendants in an unspecified amount
and a permanent injunction prohibiting Defendants from engaging in the alleged
conduct which forms the basis of the complaint, plus costs and attorneys' fees.
In January 1997, Defendants filed a motion to dismiss the complaint. On July 21,
1997, a court-appointed magistrate judge issued a report and recommendation to
the District Court recommending that Defendants' motion to dismiss the complaint
with prejudice be granted. On August 5, 1997, plaintiffs filed objections to the
magistrate judge's report and recommendation; such objections have not yet been
heard. The Company intends to vigorously defend itself in this litigation. No
amounts are recorded on the books of the Company in anticipation of a loss as a
result of this contingency.
11. COMMITMENTS AND CONTINGENCIES--(Continued)
The Company is engaged in various other legal proceedings that have arisen in
the ordinary course of its business. The Company believes that the ultimate
outcome of such proceedings will not have a material effect on the Company's
financial position, liquidity or results of operations.
d. Insurance
Under the Company's professional liability insurance policy, coverage is limited
to the period in which a claim is asserted, rather than when the incident giving
rise to such claim occurred. The Company has obtained professional liability
insurance through October 6, 1998; however, in the event the Company was unable
to obtain professional liability insurance at the expiration of the current
policy period, it is possible that the Company would be uninsured for claims
asserted after the expiration of the current policy period. Historical
experience of the Company does not indicate that losses, if any, arising from
claims asserted after the expiration of the current professional liability
policy period would have a material effect on the Company's financial position,
liquidity or results of operations.
e. CHAMPUS Contract
On April 1, 1997, the Company began providing mental health and substance abuse
services, as a subcontractor, to beneficiaries of CHAMPUS in the Southwestern
and Midwestern United States, designated as CHAMPUS Regions 7 and 8. The fixed
monthly amounts that the Company receives for medical costs and records as
revenue are subject to a one-time retroactive adjustment scheduled to be
determined in August 1998 based upon actual healthcare utilization during the
period known as the "data collection period". The data collection period is the
year ended March 31, 1997. Because of the inherent uncertainty surrounding
factors included in the determination of the final retroactive adjustment,
management has not been able to quantify a range of potential adjustment, and
accordingly no adjustments have been recorded as of September 30, 1997. As a
result, the amount of recorded revenue and income from the CHAMPUS contract may
differ significantly from the amount that would have been recorded had the
actual factors been known.
12. RELATED PARTY TRANSACTIONS
During the period ended September 30, 1997, the Company paid consulting fees and
board fees to KKR totaling approximately $500. During the period ended September
30, 1996, the Company paid consulting fees and board fees to KKR totaling
approximately $5,900; of such amount, $5,500 related to the Merger and
associated financing transactions.
Prior to the merger, Medco disbursed funds on behalf of the Company for the
payment of certain of the Company's U.S. federal, state and local income taxes
and certain acquisition transactions described in Note 8.
Included in expense for the periods ended September 30, 1997, 1996 and 1995 are
charges totaling $1,467, $1,218 and $703, respectively, related to a
prescription drug benefit program administered by Medco.
<PAGE>
12. RELATED PARTY TRANSACTIONS--(Continued)
The average balance due to the parent (Medco) for fiscal 1995 was $40,996; such
balance was repaid in full on October 6, 1995 in connection with the Merger. A
summary of intercompany activity with the parent is as follows:
<TABLE>
<CAPTION>
<S> <C> <C>
Due to parent, October 1, 1994....................... $ 37,931
Allocation of costs from parent...................... 379
Intercompany purchases............................... 659
Income taxes paid by parent.......................... 3,795
Cash transfer from parent............................ 28,049
Due to parent, September 30,1995..................... 70,813
Adjustment to income taxes paid by parent ........... (2,935)
Repayment made in connection with the Merger......... (67,878)
Due to parent, September 30,1996..................... $ ---
</TABLE>
13. RESTRUCTURING CHARGE
The Company recorded a pre-tax restructuring charge of $2,995 related to a plan,
adopted and approved in the fourth quarter of 1996, to restructure its staff
offices by exiting certain geographic markets and streamlining the field and
administrative management organization of Continuum Behavioral Healthcare
Corporation, a subsidiary of the Company. This decision was in response to the
results of underperforming locations affected by the lack of sufficient patient
flow in the geographic areas serviced by these offices and the Company's ability
to purchase healthcare services at lower rates from the network. In addition, it
was determined that the Company would be able to expand beneficiary access to
specialists and other providers, thereby achieving more cost-effective
treatment, and to favorably shift a portion of the economic risk, in some cases,
of providing outpatient healthcare to the provider through the use of case rates
and other alternative reimbursement methods. The restructuring charge was
comprised primarily of accruals for employee severance, real property lease
terminations and write-off of certain assets in geographic markets which were
being exited. The restructuring plan was substantially completed during fiscal
1997.
14. MAJOR CUSTOMERS
For fiscal 1997, revenue derived from a state Medicaid contract accounted for
approximately 12% of the Company's operating revenues. For fiscal 1996 and 1995,
no customer accounted for more than 10% of the Company's operating revenues.
15. EMPLOYEE BENEFIT PLAN
The Company has a 401(k) savings plan covering substantially all employees who
have completed one year of active employment during which 1,000 hours of service
has been credited. Under the plan, an employee may elect to contribute on a
pre-tax basis to a retirement account up to 15% of the employee's compensation
up to the maximum annual contributions permitted by the Internal Revenue Code.
The Company matches employee contributions at the rate of 50% (25% for periods
prior to January 1, 1997) of the employee's contributions to the 401(k) savings
plan, up to a maximum of 6% of an employee's annual compensation. The Company's
401(k) savings plan contribution recognized as expense for the periods ended
September 30, 1997, 1996 and 1995 was $1,289, $542 and $330, respectively.
16. STOCK OPTIONS AND AWARDS
Effective October 1, 1996, the Company adopted SFAS No. 123. As permitted by the
standard, the Company has elected to continue following the guidance of APB 25
for measurement and recognition of stock-based transactions with employees.
Accordingly, no compensation cost has been recognized for the Company's option
plans. Had the determination of compensation cost for these plans been based on
the fair value as of the grant dates for awards under these plans, the Company's
net loss for the years ending September 30, 1997 and 1996 would have increased
to the pro forma amounts indicated below:
<TABLE>
<CAPTION>
<S> <C> <C>
1997 1996
---- ----
Net loss:
As reported............................... $(13,872) $(17,881)
Pro forma (unaudited)..................... (15,729) (19,428)
</TABLE>
The resulting compensation expense may not be representative of compensation
expense to be incurred on a pro forma basis in future years.
In October 1995, the Company adopted the 1995 Stock Purchase and Option Plan for
Employees of Merit Behavioral Care Corporation and Subsidiaries (the "1995
Option Plan"). The 1995 Option Plan permits the issuance of common stock and the
grant of up to 8,561,000 non-qualified stock options (the "1995 Options") to
purchase shares of common stock to key employees of the Company. The exercise
price of 1995 Options will not be less than 50% of the fair market value per
share of common stock on the date of such grant. Such options vest at the rate
of 20% per year over a period of five years. An option's maximum term is 10
years.
In January 1996, the Company adopted a second stock option plan, the Merit
Behavioral Care Corporation Employee Stock Option Plan ("1996 Employee Option
Plan"). The 1996 Employee Option Plan covers all employees not included in the
1995 Option Plan whose employment commenced prior to January 1, 1997. The 1996
Employee Option Plan permits the grant of up to 1,000,000 non-qualified stock
options (the "1996 Employee Options") to purchase shares of common stock. The
1996 Employee Options vest on the fourth anniversary of the date of grant,
provided that the employee remains employed with the Company on such date. The
1996 Employee Options are exercisable after an initial public offering of common
stock of the Company meeting certain requirements. An option's maximum term is
10 years.
The fair value of each option grant is estimated on the date of grant by using
the Black-Scholes option-pricing model. The following weighted-average
assumptions were used for grants in the years ending September 30, 1997 and
1996:
<TABLE>
<CAPTION>
<S> <C> <C>
1997 1996
---- ----
Expected dividend yield.......................... 0.00% 0.00%
Expected volatility.............................. 1.00% 1.00%
Risk-free interest rates......................... 6.44% 6.08%
Expected option lives (years).................... 7.0 7.0
</TABLE>
<PAGE>
16. STOCK OPTIONS AND AWARDS--(Continued)
Information regarding the Company's stock option plans is summarized below:
<TABLE>
<CAPTION>
1995 Option Plan 1996 Employee Option Plan
Weighted average Weighted average
<S> <C> <C> <C> <C> <C> <C>
Shares Exercise Price Shares Exercise Price
Outstanding at October 1, 1995....... --- ---
Granted.............................. 5,698,000 $5.00 835,175 $7.50
Canceled............................. (585,000) $5.00 (119,625) $7.50
Outstanding at September 30, 1996.... 5,113,000 $5.00 715,550 $7.50
Granted.............................. 1,327,075 $7.22 254,400 $7.50
Exercised............................ (3,000) $5.00 --- ---
Canceled............................. (202,000) $5.74 (212,300) $7.50
Outstanding at September 30, 1997.... 6,235,075 $5.45 757,650 $7.50
</TABLE>
The weighted-average fair values of options granted during fiscal 1997 and 1996
for the 1995 Option Plan were $1.42 and $1.72, respectively. The
weighted-average fair values of options granted during fiscal 1997 and 1996 for
the 1996 Employee Option Plan were $0.87 and $0.01, respectively.
The following table summarizes information about stock options outstanding as of
September 30, 1997:
<TABLE>
<CAPTION>
<S> <C> <C>
1995 Option Plan 1996 Employee Option Plan
Range of exercise price $5.00-$7.50 $7.50
Weighted-average remaining
contracted life (years) 8.38 8.51
</TABLE>
As of September 30, 1997, 993,600 shares pertaining to the 1995 Option Plan were
exercisable with an exercise price of $5.00. No shares were exercisable for the
1996 Employee Option Plan as of September 30, 1997.
Prior to the Merger, employees of the Company participated in stock option plans
administered by Merck. Pursuant to these plans, options were granted at the fair
market value of Merck common stock on the date of grant and generally vest over
a period of five years. The Company realizes an income tax benefit when Company
employees exercise either (a) nonqualified Merck stock options; or (b) Merck
incentive stock options, assuming the underlying common stock is sold within one
year from the date that the incentive stock option was exercised. This benefit
results in a decrease in tax liabilities and an increase in additional paid in
capital. During 1997 and 1996, the Company recorded tax benefits of $11,630 and
$1,505, respectively, from the exercise of Merck options. Information regarding
the options outstanding under these plans held by employees of the Company at
September 30, 1997 and 1996 is as follows:
<TABLE>
<CAPTION>
Shares Option Price Per Share
<S> <C> <C> <C> <C>
1997 1996 1997 1996
Vested............................. 497,353 905,504 $ 3.78 to $25.87 $3.78 to $35.75
Unvested........................... 127,472 391,169 $21.93 to $22.24 $3.78 to $35.75
Total.............................. 624,825 1,296,673
</TABLE>
16. STOCK OPTIONS AND AWARDS--(Continued)
Through September 30, 1995, employees of the Company participated in an Employee
Stock Purchase Plan administered by Merck. The stock plan permitted employees of
the Company to purchase Merck common stock at the end of each quarter at a price
equal to 85% of the fair market value at that date.
17. DISPOSAL OF SUBSIDIARY
In September 1997, the Company sold Choate for approximately $4,775 ($4,735 of
which was received in October 1997.) The Company recognized a loss of
approximately $6,925 relating to the transaction.
18. MERGER COSTS AND SPECIAL CHARGES
In fiscal 1997, the Company recognized approximately $733 of expenses associated
with uncompleted acquisition transactions. Also, the Company incurred other
special charges of approximately $581 related to nonrecurring employee benefit
costs associated with the exercise of stock options by employees of the Company
under plans administered by Merck. A significant number of these stock options,
which were granted prior to the Merger, required exercise by September 30, 1997.
19. SUPPLEMENTAL INFORMATION
Supplemental cash flow information and noncash investing and financing
activities are as follows:
<TABLE>
<CAPTION>
<S> <C> <C> <C>
1997 1996 1995
---- ---- ----
Supplemental Cash Flow Information:
Cash (received) paid for income taxes.. $ (596) $1,100 $2,167
Cash paid for interest................. 23,568 17,676 ---
Supplemental Noncash Investing and
Financing Activities:
Record deferred taxes associated
with the Merger..................... --- 7,594 ---
Exercise of Merck stock options........ 11,630 1,505 ---
Acquisitions:
Fair value of assets acquired,
other than cash.................. 82,412 14,360 ---
Liabilities assumed................ (41,622) (2,962) ---
Total consideration paid........... 40,790 11,398 ---
Stock consideration paid........... (5,545) --- ---
Cash consideration paid............ 35,245 11,398 ---
Contingent consideration........... 400 1,278 9,580
Cash used for acquisitions,
net of cash acquired................. $35,645 $ 12,676 $ 9,580
</TABLE>
<PAGE>
20. RECENTLY ISSUED ACCOUNTING STANDARD
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131,
Disclosures about Segments of an Enterprise and Related Information, which will
be effective for the Company beginning October 1, 1998. SFAS No. 131 redefines
how operating segments are determined and requires disclosure of certain
financial and descriptive information about a company's operating segments. The
Company has not yet completed its analysis with respect to which operating
segments of its business it will provide such information
21. SUBSEQUENT EVENT
On October 24, 1997, the Company signed a definitive merger agreement under
which a subsidiary of Magellan Health Services, Inc. ("Magellan") will merge
into the Company. As a result of this merger, the Company will become a wholly
owned subsidiary of Magellan. Under the terms of the merger agreement, Magellan
will purchase all of the Company's outstanding stock and other equity interests
for approximately $460 million in cash and refinance the Company's existing
debt. In addition, all options outstanding under the 1995 Option Plan and the
1996 Employee Option Plan will fully vest upon closing of the transaction.
Completion of the merger transaction is subject to a number of conditions,
including Magellan's receipt of sufficient financing for the transaction, the
expiration or early termination of the waiting period under the
Hart-Scott-Rodino Antitrust Improvements Act of 1974, the receipt of certain
healthcare and insurance regulatory approvals, and other conditions.
