<PAGE>
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
FORM 10-Q
AMENDMENT NO. 3
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
(MARK ONE)
<TABLE>
<S> <C>
/X/ QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 1998
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
</TABLE>
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NO. 1-6639
MAGELLAN HEALTH SERVICES, INC.
(Exact name of Registrant as specified in its charter)
<TABLE>
<S> <C>
DELAWARE 58-1076937
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
</TABLE>
3414 PEACHTREE ROAD, NE, SUITE 1400
ATLANTA, GEORGIA 30326
(Address of principal executive offices)
(Zip Code)
(404) 841-9200
(Registrant's telephone number, including area code)
------------------------
NOT APPLICABLE
(Former name, former address and former fiscal year,
if changed since last report)
------------------------
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No / /
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Sections 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes / / No / /
The number of shares of the Registrant's Common Stock outstanding as of
April 30, 1998, was 31,509,504.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE>
FORM 10-Q
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
INDEX
<TABLE>
<CAPTION>
PAGE NO.
-------------
<S> <C>
PART I--FINANCIAL INFORMATION:
Condensed Consolidated Balance Sheets--September 30, 1997 and March 31, 1998.......................... 2
Condensed Consolidated Statements of Operations--For the Three Months and the Six Months ended March
31, 1997 and 1998................................................................................... 4
Condensed Consolidated Statements of Cash Flows--For the Six Months ended March 31, 1997 and 1998..... 5
Notes to Condensed Consolidated Financial Statements.................................................. 6
Management's Discussion and Analysis of Financial Condition and Results of Operations................. 20
PART II--OTHER INFORMATION:
Item 1.--Legal Proceedings............................................................................ 30
Item 4.--Submission of Matters to a Vote of Security Holders.......................................... 30
Item 6.--Exhibits and Reports on Form 8-K............................................................. 30
Signatures............................................................................................ 32
</TABLE>
<PAGE>
The undersigned Registrant hereby amends the Condensed Consolidated Balance
Sheet and the Condensed Consolidated Statement of Cash Flows as of and for the
six months ended March 31, 1998 to PART I--Financial Information of its Report
on Form 10-Q for the quarterly period ended March 31, 1998.
<PAGE>
MAGELLAN HEALTH SERVICES, INC.
QUARTERLY REPORT UNDER SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
PART I--FINANCIAL INFORMATION
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS)
<TABLE>
<CAPTION>
SEPTEMBER 30, MARCH 31,
1997 1998
------------- ------------
<S> <C> <C>
ASSETS
Current Assets:
Cash and cash equivalents........................................................ $ 372,878 $ 103,411
Accounts receivable, net......................................................... 107,998 181,622
Restricted cash and investments.................................................. -- 57,575
Refundable income taxes.......................................................... 2,466 1,361
Other current assets............................................................. 23,696 42,335
------------- ------------
Total Current Assets........................................................... 507,038 386,304
Assets restricted for settlement of unpaid claims and other long-term liabilities.... 87,532 69,226
Property and equipment:
Land............................................................................. 11,667 11,477
Buildings and improvements....................................................... 70,174 75,580
Equipment........................................................................ 63,719 131,013
------------- ------------
145,560 218,070
Accumulated depreciation......................................................... (37,038) (46,169)
------------- ------------
108,522 171,901
Construction in progress......................................................... 692 1,078
------------- ------------
Total property and equipment................................................... 109,214 172,979
------------- ------------
Deferred income taxes................................................................ 1,158 75,651
Investment in CBHS................................................................... 16,878 --
Other long-term assets............................................................... 20,893 45,906
Goodwill, net........................................................................ 114,234 919,500
Other intangible assets, net......................................................... 38,673 243,332
------------- ------------
$ 895,620 $ 1,912,898
------------- ------------
------------- ------------
</TABLE>
The accompanying Notes to Condensed Consolidated Financial Statements are an
integral part of these balance sheets.
2
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
SEPTEMBER 30, MARCH 31,
1997 1998
------------- ------------
<S> <C> <C>
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable................................................................... $ 45,346 $ 42,478
Accrued liabilities................................................................ 170,429 382,626
Current maturities of long-term debt and capital lease obligations................. 3,601 10,131
------------- ------------
Total Current Liabilities.................................................... 219,376 435,235
Long-term debt and capital lease obligations......................................... 391,693 1,208,715
Reserve for unpaid claims............................................................ 49,113 36,642
Deferred credits and other long-term liabilities..................................... 16,110 19,710
Minority interest.................................................................... 61,078 30,619
Commitments and contingencies
Stockholders' Equity:
Preferred Stock, without par value
Authorized--10,000 shares Issued and outstanding--none........................... -- --
Common Stock, par value $0.25 per share
Authorized--80,000 shares Issued and outstanding--33,439 shares at September 30,
1997 and 33,625 shares at March 31, 1998....................................... 8,361 8,407
Other Stockholders' Equity
Additional paid-in capital....................................................... 340,645 351,858
Accumulated deficit.............................................................. (129,955) (157,634)
Warrants outstanding............................................................. 25,050 25,050
Common Stock in Treasury, 4,424 shares at September 30, 1997 and 2,137 shares at
March 31, 1998................................................................. (82,731) (42,413)
Cumulative foreign currency adjustments.......................................... (3,120) (3,291)
------------- ------------
Total stockholders' equity................................................... 158,250 181,977
------------- ------------
$ 895,620 $ 1,912,898
------------- ------------
------------- ------------
</TABLE>
The accompanying Notes to Condensed Consolidated Financial Statements are an
integral part of these balance sheets.
3
<PAGE>
MAGELLAN HEALTH SERVICES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
FOR THE THREE MONTHS FOR THE SIX MONTHS
ENDED ENDED
MARCH 31, MARCH 31,
---------------------- ----------------------
<S> <C> <C> <C> <C>
1997 1998 1997 1998
---------- ---------- ---------- ----------
Net revenue...................................................... $ 349,922 $ 372,223 $ 696,741 $ 588,320
---------- ---------- ---------- ----------
Costs and expenses:
Salaries, cost of care and other operating expenses............ 282,210 324,507 566,333 500,128
Bad debt expense............................................... 15,140 686 35,375 1,756
Depreciation and amortization.................................. 13,088 12,956 26,187 19,925
Interest, net.................................................. 13,153 17,526 26,722 24,927
Stock option expense (credit).................................. 829 420 1,433 (3,539)
Managed Care integration costs................................. -- 11,074 -- 11,074
Equity in loss of CBHS......................................... -- 5,575 -- 17,063
Unusual Items.................................................. 1,395 49 1,395 49
---------- ---------- ---------- ----------
325,815 372,793 657,445 571,383
---------- ---------- ---------- ----------
Income (loss) before provision for income taxes, minority
interest and extraordinary items............................... 24,107 (570) 39,296 16,937
Provision for income taxes....................................... 9,643 630 15,718 7,633
---------- ---------- ---------- ----------
Income (loss) before minority interest and extraordinary items... 14,464 (1,200) 23,578 9,304
Minority interest................................................ 2,572 1,092 4,545 3,968
---------- ---------- ---------- ----------
Income (loss) before extraordinary items......................... 11,892 (2,292) 19,033 5,336
Extraordinary items--losses on early extinguishments of debt (net
of income tax benefit of $1,967 in 1997 and $22,010 in 1998)... -- (33,015) (2,950) (33,015)
---------- ---------- ---------- ----------
Net income (loss)................................................ $ 11,892 $ (35,307) $ 16,083 $ (27,679)
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
Average number of common shares outstanding--basic............... 28,726 31,012 28,657 29,995
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
Average number of common shares outstanding--diluted............. 29,343 31,012 29,155 30,587
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
Income (loss) per common share--basic:
Income (loss) before extraordinary items....................... $ 0.41 $ (0.07) $ 0.66 $ 0.18
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
Extraordinary losses on early extinguishments of debt.......... $ -- $ (1.06) $ (0.10) $ (1.10)
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
Net income (loss).............................................. $ 0.41 $ (1.14) $ 0.56 $ (0.92)
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
Income (loss) per common share--diluted:
Income (loss) before extraordinary items....................... $ 0.41 $ (0.07) $ 0.65 $ 0.17
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
Extraordinary losses on early extinguishments of debt.......... $ -- $ (1.06) $ (0.10) $ (1.08)
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
Net income (loss).............................................. $ 0.41 $ (1.14) $ 0.55 $ (0.90)
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
</TABLE>
The accompanying Notes to Condensed Consolidated Financial Statements are an
integral part of these statements.
4
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
<TABLE>
<CAPTION>
FOR THE SIX MONTHS
ENDED
MARCH 31,
-----------------------
1997 1998
---------- -----------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)..................................................................... $ 16,083 $ (27,679)
---------- -----------
Adjustments to reconcile net income (loss)
to net cash used in operating activities:
Depreciation and amortization................................................. 26,187 19,925
Equity in loss of CBHS........................................................ -- 17,063
Stock option expense (credit)................................................. 1,433 (3,539)
Non-cash interest expense..................................................... 882 1,110
Loss (gain) on sale of assets................................................. (3,302) 49
Impairment of long-lived assets............................................... -- 2,160
Extraordinary losses on early extinguishments of debt......................... 4,917 55,025
Cash flows from changes in assets and liabilities, net of effects from sales
and acquisitions of businesses:
Accounts receivable, net.................................................. (2,474) (8,933)
Other assets.............................................................. (4,214) (8,210)
Restricted cash and investments........................................... -- (5,295)
Accounts payable and other accrued liabilities............................ (30,981) (25,475)
Reserve for unpaid claims................................................. (13,694) (12,815)
Income taxes payable and deferred income taxes............................ 4,638 (23,275)
Other liabilities......................................................... (15,154) (4,126)
Minority interest, net of dividends paid.................................. 5,219 2,705
Other..................................................................... (1,063) (1,026)
---------- -----------
Total adjustments..................................................... (27,606) 5,343
---------- -----------
Net cash used in operating activities............................... (11,523) (22,336)
---------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures.................................................................. (14,373) (13,467)
Acquisitions and investments in businesses, net of cash acquired...................... (12,962) (988,943)
Decrease in assets restricted for settlement of unpaid claims......................... 8,626 18,007
Proceeds from sale of assets.......................................................... 10,386 5,983
Crescent Transaction costs............................................................ -- (5,865)
---------- -----------
Net cash used in investing activities............................... (8,323) (984,285)
---------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of debt, net of issuance costs................................. 126,825 1,171,681
Payments on debt and capital lease obligations........................................ (117,521) (425,433)
Proceeds from exercise of stock options and warrants.................................. 3,842 3,362
Purchases of treasury stock........................................................... -- (12,456)
---------- -----------
Net cash provided by financing activities........................... 13,146 737,154
---------- -----------
Net decrease in cash and cash equivalents............................................... (6,700) (269,467)
Cash and cash equivalents at beginning of period........................................ 120,945 372,878
---------- -----------
Cash and cash equivalents at end of period.............................................. $ 114,245 $ 103,411
---------- -----------
---------- -----------
</TABLE>
The accompanying Notes to Condensed Consolidated Financial Statements are an
integral part of these statements.
5
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1998
(UNAUDITED)
NOTE A--BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q.
Accordingly, they do not include all of the information and footnotes required
by generally accepted accounting principles for complete financial statements.
In the opinion of management, all adjustments, consisting of normal recurring
adjustments considered necessary for a fair presentation, have been included.
These financial statements should be read in conjunction with the audited
consolidated financial statements of the Company for the year ended September
30, 1997, included in the Company's Annual Report on Form 10-K.
NOTE B--NATURE OF BUSINESS
The Company's 50% owned hospital business, Charter Behavioral Health
Systems, LLC ("CBHS"), is seasonal in nature, with a reduced demand for certain
services generally occurring in the first fiscal quarter around major holidays,
such as Thanksgiving and Christmas, and during the summer months comprising the
fourth fiscal quarter. The Company's businesses are also subject to general
economic conditions and other factors. Accordingly, the results of operations
for the interim periods are not necessarily indicative of the actual results
expected for the year.
NOTE C--SUPPLEMENTAL CASH FLOW INFORMATION
Below is supplemental cash flow information related to the six months ended
March 31, 1997 and 1998:
<TABLE>
<CAPTION>
FOR THE SIX
MONTHS ENDED
MARCH 31,
--------------------
1997 1998
--------- ---------
(In thousands)
<S> <C> <C>
Income taxes paid, net of refunds received........................................ $ 9,064 $ 8,095
Interest paid, net of amounts capitalized......................................... 28,704 40,747
Non-cash transactions:
Common Stock in Treasury issued in connection with the purchase of the remaining
39% interest in Green Spring Health Services, Inc............................. $ -- $ 63,496
</TABLE>
Restricted cash and investments at March 31, 1998 include approximately
$57.6 million that is held for the payment of claims under the terms of certain
behavioral managed care contracts and for regulatory purposes related to the
payment of claims in certain jurisdictions.
6
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1998
(UNAUDITED)
NOTE D--LONG-TERM DEBT AND LEASES
Information with regard to the Company's long-term debt and capital lease
obligations at September 30, 1997 and March 31, 1998 is as follows (in
thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, MARCH 31,
1997 1998
------------- ------------
<S> <C> <C>
Credit Agreement due through 2002.......................................... $ -- $ --
New Credit Agreement:
Revolving Facility (7.94% at March 31, 1998) due through 2004............ -- 30,000
Term Loan Facility (7.94% to 8.44% at March 31, 1998) due through 2006... -- 550,000
11.25% Series A Senior Subordinated Notes.................................. 375,000 --
9.0% Senior Subordinated Notes due 2008.................................... -- 625,000
6.81% to 11.5% Mortgage and other notes payable through 2005............... 7,721 7,406
7.5% Swiss Bonds........................................................... 6,443 --
3.65% Capital lease obligations due through 2014........................... 6,438 6,440
------------- ------------
395,602 1,218,846
Less amounts due within one year......................................... 3,601 10,131
Less debt service funds.................................................. 308 --
------------- ------------
$ 391,693 $ 1,208,715
------------- ------------
------------- ------------
</TABLE>
In connection with the acquisition of Merit Behavioral Care Corporation
("Merit") on February 12, 1998, the Company (i) terminated its Credit Agreement;
(ii) repaid all loans outstanding pursuant to Merit's existing credit agreement;
(iii) completed a tender offer for its 11.25% Series A Senior Subordinated Notes
due 2004 (the "Old Notes"); (iv) completed a tender offer for Merit's 11.50%
Senior Subordinated Notes due 2005 (the "Merit Outstanding Notes"); (v) entered
into a new senior secured bank credit agreement (the "New Credit Agreement")
with the Chase Manhattan Bank and a syndicate of financial institutions,
providing for Credit Facilities of up to $700 million, and (vi) issued $625
million in 9.0% Senior Subordinated Notes due 2008 (the "New Notes"). See Note H
- --"Acquisitions--Merit Acquisition."
The Company recognized a net extraordinary loss from the early
extinguishment of debt of approximately $33.0 million, net of income tax
benefit, during the quarter and the six months ended March 31, 1998, to write
off unamortized deferred financing costs related to terminating the Credit
Agreement and extinguishing the Old Notes, to record the tender premium and
related costs of extinguishing the Old Notes and to record the gain on
extinguishment of the 7.5% Swiss Bonds.
The New Credit Agreement provides for a Term Loan Facility in an aggregate
principal amount of $550 million, consisting of an approximately $183.3 million
Tranche A Term Loan (the "Tranche A Term Loan"), an approximately $183.3 million
Tranche B Term Loan (the "Tranche B Term Loan") and an approximately $183.3
million Tranche C Term Loan (the "Tranche C Term Loan"), and a Revolving
Facility providing for revolving loans to the Company and the "Subsidiary
Borrowers" (as defined therein) and the issuance of letters of credit for the
account of the Company and the Subsidiary Borrowers in an aggregate principal
amount (including the aggregate stated amount of letters of credit) of $150
million.
7
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1998
(UNAUDITED)
NOTE D--LONG-TERM DEBT AND LEASES (CONTINUED)
The Tranche A Term Loan and the Revolving Facility mature on February 12,
2004. The Tranche B Term Loan matures on February 12, 2005 and the Tranche C
Term Loan matures on February 12, 2006. The Tranche A Term Loan amortizes in
installments in each fiscal year in amounts equal to $16.5 million in 1999,
$28.0 million in 2000, $34.5 million in 2001, $45.0 million in 2002, $48.0
million in 2003 and $11.3 million in 2004. The Tranche B Term Loan amortizes in
installments in amounts equal to $1.7 million in 1999, $2.2 million in each of
2000 through 2002, $41.8 million in 2003, $103.4 million in 2004 and $29.8
million in 2005. The Tranche C Term Loan amortizes in installments in each
fiscal year in amounts equal to $1.7 million in 1999, $2.2 million in each of
2000 through 2003, $41.8 million in 2004, $101.9 million in 2005 and $29.1
million in 2006. In addition, the Credit Facilities are subject to mandatory
prepayment and reductions (to be applied first to the Term Loan Facility) in an
amount equal to (a) 100% of the net proceeds of certain offerings of equity
securities by the Company or any of its subsidiaries, (b) 100% of the net
proceeds of certain debt issues of the Company or any of its subsidiaries, (c)
75% of the Company's excess cash flow, as defined, and (d) 100% of the net
proceeds of certain asset sales or other dispositions of property of the Company
and its subsidiaries, in each case subject to certain limited exceptions.
The New Credit Agreement contains a number of covenants that, among other
things restrict the ability of the Company and its subsidiaries to dispose of
assets, incur additional indebtedness, incur or guarantee obligations, prepay
other indebtedness or amend other debt instruments (including the Indenture for
the New Notes), pay dividends, create liens on assets, make investments, make
loans or advances, redeem or repurchase common stock, make acquisitions, engage
in mergers or consolidations, change the business conducted by the Company and
its subsidiaries and make capital expenditures. In addition, the New Credit
Agreement requires the Company to comply with specified financial ratios and
facts, including minimum coverage ratios, maximum leverage ratios, maximum
senior debt ratios, minimum "EBITDA" (as defined in the New Credit Agreement)
and minimum net worth tests.
At the Company's election, the interest rates per annum applicable to the
loans under the New Credit Agreement are a fluctuating rate of interest measured
by reference to either (a) an adjusted London inter-bank offered rate ("LIBOR")
plus a borrowing margin or (b) an alternate base rate ("ABR") (equal to the
higher of the Chase Manhattan Bank's published prime rate or the Federal Funds
effective rate plus 1/2 of 1%) plus a borrowing margin. The borrowing margins
applicable to the Tranche A Term Loan and loans under the Revolving Facility are
currently 1.25% for ABR loans and 2.25% for LIBOR loans, and are subject to
reduction if the Company's financial results satisfy certain leverage tests. The
borrowing margins applicable to the Tranche B Term Loan and the Tranche C Term
Loan are 1.50% and 1.75%, respectively, for ABR loans and 2.50% and 2.75%,
respectively, for LIBOR loans, and are not subject to reduction. Amounts
outstanding under the credit facilities not paid when due bear interest at a
default rate equal to 2.00% above the rates otherwise applicable to each of the
loans under the Term Loan Facility and the Revolving Facility.
The obligations of the Company and the Subsidiary Borrowers under the New
Credit Agreement are unconditionally and irrevocably guaranteed by, subject to
certain exceptions, each wholly owned domestic subsidiary and, subject to
certain exceptions, each foreign subsidiary of the Company. In addition, the
Credit Facilities and the guarantees are secured by security interests in and
pledges of or liens on substantially all the material tangible and intangible
assets of the guarantors, subject to certain exceptions.
8
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1998
(UNAUDITED)
NOTE D--LONG-TERM DEBT AND LEASES (CONTINUED)
The New Notes are general unsecured senior subordinated obligations of the
Company. The New Notes are limited in aggregate principal amount to $625 million
and will mature on February 15, 2008. Interest on the New Notes will accrue at
the rate of 9.0% per annum and will be payable semi-annually on each February 15
and August 15, commencing on August 15, 1998, to the holders of record on the
immediately preceding February 1 and August 1, whether or not a business day.
The New Notes are not redeemable at the option of the Company prior to
February 15, 2003. The New Notes will be redeemable at the option of the Company
on or after such date, in whole or in part, at the redemption prices (expressed
as a percentage of the principal amount) set forth below, plus accrued and
unpaid interest, during the twelve-month period beginning on February 15 of the
years indicated below:
<TABLE>
<CAPTION>
REDEMPTION
YEAR PRICES
- ------------------------------------------------------------- -------------
<S> <C>
2003......................................................... 104.5%
2004......................................................... 103.0%
2005......................................................... 101.5%
2006 and thereafter.......................................... 100.0%
</TABLE>
In addition, at any time and from time to time prior to February 15, 2001,
the Company may, at its option, redeem up to 35% of the original aggregate
principal amount of New Notes at a redemption price (expressed as a percentage
of the principal amount) of 109%, plus accrued and unpaid interest with the net
cash proceeds of one or more equity offerings; provided that at least 65% of the
original aggregate principal amount of New Notes remains outstanding immediately
after the occurrence of such redemption and that such redemption occurs within
60 days of the date of the closing of any such equity offering.
The Indenture for the New Notes limits, among other things: (i) the
incurrence of additional indebtedness by the Company and its Restricted
Subsidiaries (as defined); (ii) the payment of dividends on, and redemption or
repurchase of, capital stock of the Company and its Restricted Subsidiaries and
the redemption of certain Subordinated Obligations of the Company; (iii) certain
other restricted payments, including investments; (iv) sales of assets; (v)
certain transactions with affiliates; (vi) the creation of liens; and (vii)
consolidations, mergers and transfers of all or substantially all the Company's
assets. The Indenture on the New Notes also prohibits certain restrictions on
distributions from Restricted Subsidiaries. However, all such limitations and
prohibitions are subject to certain qualifications and exceptions.
9
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1998
(UNAUDITED)
NOTE E--ACCRUED LIABILITIES
Accrued liabilities consist of the following (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, MARCH 31,
1997 1998
------------- ----------
<S> <C> <C>
Salaries, wages and other benefits........................................... $ 21,647 $ 21,153
Amounts due health insurance programs........................................ 14,126 9,775
Medical claims payable....................................................... 36,508 196,575
Interest..................................................................... 19,739 9,537
Crescent Transactions........................................................ 14,648 7,719
Other........................................................................ 63,761 137,867
------------- ----------
$ 170,429 $ 382,626
------------- ----------
------------- ----------
</TABLE>
NOTE F--INCOME PER COMMON SHARE
The Company adopted Statement of Financial Accounting Standards No. 128,
"Earnings per Share" ("FAS 128"), effective October 1, 1997. Income per common
share for the three months and the six months ended March 31, 1997 have been
restated to conform to FAS 128 as required. The effect of adopting FAS 128 was
not material.
The following table presents the components of weighted average common
shares outstanding-- diluted (in thousands):
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
March 31, March 31,
---------------------- ----------------------
1997 1998 1997 1998
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Weighted average common shares outstanding--basic........... 28,726 31,012 28,657 29,995
Common stock equivalents--stock options..................... 600 0 481 575
Common stock equivalents--warrants.......................... 17 0 17 17
---------- ---------- ---------- ----------
Weighted average common shares outstanding--diluted......... 29,343 31,012 29,155 30,587
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
</TABLE>
Options to purchase approximately 471,000 shares of common stock at $24.56
to $31.41 per share were outstanding during the six months ended March 31, 1998
but were not included in the computation of diluted EPS because the options'
exercise price was greater than the average market price of the common shares.
The options, which expire between fiscal 2006 and 2008, were still outstanding
at March 31, 1998.
Warrants to purchase approximately 4,713,000 shares of common stock at
$26.15 to $38.70 per share were outstanding during the six months ended March
31, 1998 but were not included in the computation of diluted EPS because the
warrants' exercise price was greater than the average market price of the common
shares. The warrants, which expire between fiscal 2000 and 2009, were still
outstanding at March 31, 1998.
Common stock equivalents of approximately 452,000 were excluded from the
income per common share calculation for the three months ended March 31, 1998
due to their anti-dilutive nature as a result of the Company's loss for such
period.
10
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1998
(UNAUDITED)
NOTE G--INVESTMENT IN CBHS
The Company became a 50% owner of CBHS upon consummation of the Crescent
Transactions (as defined) on June 17, 1997, which are further described in the
Company's Annual Report on Form 10-K for the year ended September 30, 1997. The
Company accounts for its investment in CBHS using the equity method.
A summary of financial information for CBHS is as follows (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, MARCH 31,
1997 1998
------------- -----------
<S> <C> <C>
Current assets.............................................................. $ 148,537 $ 147,700
Property and equipment, net................................................. 18,424 17,815
Other noncurrent assets..................................................... 8,633 8,294
------------- -----------
Total Assets.............................................................. $ 175,594 $ 173,809
------------- -----------
------------- -----------
Current liabilities......................................................... $ 68,497 $ 90,066
Long-term debt.............................................................. 65,860 65,831
Other noncurrent liabilities................................................ 7,481 23,138
Members' capital (deficiency)............................................... 33,756 (5,226)
------------- -----------
Total Liabilities and Members' Capital.................................... $ 175,594 $ 173,809
------------- -----------
------------- -----------
</TABLE>
<TABLE>
<CAPTION>
THREE MONTHS SIX MONTHS
ENDED ENDED
MARCH 31, MARCH 31,
1998 1998
------------- -----------
<S> <C> <C>
Net revenue................................................................. $ 187,384 $ 365,442
------------- -----------
Operating expenses.......................................................... 200,278 399,942
Interest, net............................................................... 1,305 2,675
------------- -----------
Net loss before preferred member distribution............................. $ (14,199) $ (37,175)
------------- -----------
------------- -----------
Cash used in operating activities........................................... $ (9,517)
-----------
-----------
Magallan's portion of net loss.............................................. (7,100) (18,588)
Intercompany loss elimination(1)............................................ 1,525 1,525
------------- -----------
Magellan equity loss........................................................ $ (5,575) $ (17,063)
------------- -----------
------------- -----------
</TABLE>
11
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1998
(UNAUDITED)
NOTE G--INVESTMENT IN CBHS (CONTINUED)
The Company's transactions with CBHS and related balances are as follows (in
thousands):
<TABLE>
<CAPTION>
THREE MONTHS SIX MONTHS
ENDED ENDED
MARCH 31, 1998 MARCH 31, 1998
-------------- --------------
<S> <C> <C>
Franchise Fee revenue(1)......................................................... $ 16,525 $ 36,100
------- -------
Costs:
Accounts receivable collection fees............................................ $ 560 $ 1,614
Hospital-based joint venture management fees................................... 1,853 3,483
<CAPTION>
SEPTEMBER 30, MARCH 31,
1997 1998
-------------- --------------
<S> <C> <C>
Due (to) from CBHS, net (2)...................................................... $ (5,090) $ 1,789
------- -------
------- -------
Franchise fees receivable (3).................................................... $ -- $ 10,000
------- -------
------- -------
Prepaid CHARTER call center management fees...................................... $ -- $ 4,921
------- -------
------- -------
</TABLE>
- ------------------------
(1) Based on the terms of the CBHS Transactions (as defined), the Franchise Fees
were reduced to $5.0 million per month from approximately $6.5 million per
month, effective February 1, 1998, through the consummation date of the CBHS
Transactions. In the event that the CBHS Transactions are not consummated,
no adjustment will be made to the Franchise Fees. The Company's Franchise
Fee revenue for the quarter and the six months ended March 31, 1998,
reflects the reduced Franchise Fee revenue, since February 1, 1998, while
CBHS recorded Franchise Fee expense of approximately $6.5 million per month
in its financial statements. Accordingly, the Company has eliminated the
intercompany loss for the proportionate share of the difference between
Franchise Fee revenue and expense reflected in the Company's financial
statements and CBHS' financial statements.
(2) The nature of hospital accounts receivable billing and collection processes
have resulted in the Company and CBHS receiving remittances from payors
which belong to the other party. Additionally, the Company and CBHS have
established a settlement and allocation process for the accounts receivable
related to those patients who were not yet discharged from their treatment
on June 16, 1997. In an effort to settle these amounts on a timely basis,
and in light of CBHS start up operations and cash flow requirements, the
Company made advances to CBHS periodically during the three months and the
six months ending March 31, 1998, most of which have been repaid by CBHS.
Such advances, net of all settlement activity and certain other amounts due
to CBHS for certain shared services and related matters, resulted in the
amount shown above as due from CBHS. In addition, the Company has recorded
equity in loss of CBHS in excess of its investment balance of approximately
$0.2 million, which has been applied against the advances.
(3) CBHS did not pay its Franchise Fee obligation for February 1998 and March
1998. CBHS will be required to pay all Franchise Fees and other amounts due
to the Company within six months of consummating the CBHS Transactions.
CBHS TRANSACTIONS. On March 3, 1998, the Company and certain of its wholly
owned subsidiaries entered into definitive agreements with Crescent Operating,
Inc. ("COI") and CBHS pursuant to which
12
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1998
(UNAUDITED)
NOTE G--INVESTMENT IN CBHS (CONTINUED)
the Company will, among other things, sell the Company's franchise operations,
certain domestic provider operations and certain other assets and operations.
The definitive agreements include: (i) an equity purchase agreement between the
Company and COI (the "Equity Purchase Agreement"); (ii) a purchase agreement
between the Company, certain of its wholly owned subsidiaries and CBHS (the
"Purchase Agreement"); and (iii) a support agreement between the Company and COI
(the "Support Agreement"). Pursuant to the Equity Purchase Agreement, the
Company agreed to sell to COI the Company's common and preferred equity interest
in CBHS. Pursuant to the Purchase Agreement, the Company and certain of its
wholly owned subsidiaries agreed to sell to CBHS: (i) Charter Advantage, LLC,
the entity that conducts the Company's franchise operations; (ii) Charter
System, LLC, which owns the intellectual property comprising the "CHARTER"
system of behavioral healthcare; (iii) Group Practice Affiliates, Inc., the
Company's physician practice management business; (iv) certain behavioral staff
model operations; (v) the Company's Puerto Rican provider management business;
(vi) Golden Isle Assurance Company, Ltd., one of the Company's captive insurance
companies; and (vii) Strategic Advantage, Inc., which owns certain intellectual
property used by the Company to monitor clinical results. The obligations of
CBHS and the Company to consummate the transactions contemplated by the Purchase
Agreement are also subject to, among other things, the execution of either (i) a
Joint Venture Purchase Agreement pursuant to which the Company will sell to
CBHS, for no additional consideration, its interest in six hospital-based joint
ventures that are managed by CBHS on behalf of the Company (the "Joint
Ventures") or (ii) amendments to the services agreement between the Company and
certain subsidiaries of CBHS relating to the Joint Ventures pursuant to which
the Company will transfer to CBHS all rights to receive certain distributions
with respect to the Joint Ventures and pursuant to which CBHS would assume all
obligations of the Company with respect to the Joint Ventures arising after
consummation of the CBHS Transactions.
Among other things, the Support Agreement obligates COI to provide CBHS
assistance in obtaining financing for its payment obligation under the Purchase
Agreement, including its agreement to: (i) provide assistance in the preparation
of any offering documents required in connection with CBHS's efforts to obtain
financing; (ii) reimburse CBHS for all expenses incurred in connection with
obtaining financing, whether or not the CBHS Transactions are consummated; and
(iii) purchase up to $25.0 million of CBHS securities, if necessary, to permit
CBHS to obtain the required financing. The Support Agreement also obligates COI,
under certain circumstances, to pay the Company a termination fee equal to $2.5
million in cash and the number of shares of COI common stock obtained by
dividing $2.5 million by the average closing price of a share of COI common
stock for the five trading days prior to the termination of the Purchase
Agreement and for the five trading days after the termination of the Purchase
Agreement (the "Termination Fee"), if the CBHS Transactions are not consummated
as a result of the failure of CBHS to obtain sufficient financing for its
payment obligations under the Purchase Agreement.
Upon consummation of the CBHS Transactions, the Company will receive $280.0
million in cash, pursuant to the Purchase Agreement and, pursuant to the Equity
Purchase Agreement, the number of shares of COI common stock obtained by
dividing $30.0 million by the average closing price of a share of COI common
stock for the ten trading days preceding consummation of the CBHS Transactions.
The Company expects to use the cash proceeds, after transaction costs of
approximately $8.0 million, to repay indebtedness outstanding under the Term
Loan Facility. The CBHS Transactions are expected to close in the fourth quarter
of fiscal 1998. There can be no assurance that the Company will consummate the
CBHS Transactions.
13
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1998
(UNAUDITED)
NOTE G--INVESTMENT IN CBHS (CONTINUED)
The obligations of the Company and CBHS to consummate the transactions
contemplated by the Equity Purchase Agreement and the Support Agreement are
conditioned upon the execution and delivery of a services purchase agreement
(the "Services Purchase Agreement"). It is expected that the Services Purchase
Agreement would obligate the Company to purchase from CBHS a designated minimum
amount of behavioral healthcare services for gate-kept risk-based covered lives
if CBHS meets certain standards required of it pursuant to the Provider Services
Agreement (as defined). If the CBHS Transactions are consummated, the Company
also expects to enter into a provider services agreement (the "Provider Services
Agreement") with CBHS pursuant to which the Company would grant CBHS status as a
national preferred provider of behavioral healthcare services to the Company for
ten years provided that CBHS complies during the term of the Provider Services
Agreement with enhanced clinical, quality assurance, reporting and customer
service standards in addition to the standards currently required of other
providers of such services to the Company.
NOTE H--ACQUISITIONS
ALLIED HEALTH GROUP, INC. ACQUISITION. On December 5, 1997, the Company
purchased the assets of Allied Health Group, Inc. and certain affiliates
("Allied"). Allied provides specialty risk-based products and administrative
services to a variety of insurance companies and other customers for its 3.7
million members. Allied has over 80 physician networks across the eastern United
States. Allied's networks include physicians specializing in cardiology,
oncology and diabetes. The Company paid $70 million for Allied, of which $50
million was paid to the sellers at closing with the remaining $20 million placed
in escrow.
The Company funded the acquisition of Allied with cash on hand and has
accounted for the acquisition of Allied using the purchase method of accounting.
The escrowed amount of the purchase price is payable in one-third increments if
Allied achieves specified earnings targets during each of the three years
following the closing. Additionally, the purchase price may be increased during
the three year period by up to $40 million if Allied's performance exceeds
specified earnings targets. The maximum purchase price payable is $110 million.
The preliminary allocation of the Allied purchase price to goodwill and
identifiable intangible assets was based on the Company's preliminary
valuations, which are subject to change upon receiving independent appraisals of
identifiable intangible assets. The Company expects the Allied purchase price
allocation to be finalized by September 30, 1998.
HAI ACQUISITION. On December 4, 1997, the Company acquired the outstanding
common stock of Human Affairs International, Incorporated ("HAI"), a
wholly-owned subsidiary of Aetna Insurance Company of Connecticut and a unit of
Aetna U.S. Healthcare ("Aetna"), for approximately $122.1 million. HAI provides
managed care services to approximately 16.3 million covered lives, primarily
through employee assistance programs and other managed behavioral healthcare
plans. The Company funded the acquisition of HAI with cash on hand and has
accounted for the acquisition of HAI using the purchase method of accounting.
The Company may be required to make additional contingent payments of up to
$300 million to Aetna (the "Contingent Payments") over the five-year period
(each year a "Contract Year") subsequent to closing. The amount and timing of
the Contingent Payments will depend upon HAI's receipt of additional
14
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1998
(UNAUDITED)
NOTE H--ACQUISITIONS (CONTINUED)
covered lives as computed under two separate calculations. Under the first
calculation, the Company may be required to pay up to $25 million per year for
each of five years following the acquisition based on the net annual growth in
the number of lives covered in specified HAI products. Under the second
calculation, the Company may be required to pay up to $35 million per Contract
Year, based on the net cumulative increase in lives covered by certain other HAI
products.
The preliminary allocation of the HAI purchase price to goodwill and
identifiable intangible assets was based on the Company's preliminary
valuations, which are subject to change upon receiving independent appraisals of
identifiable intangible assets. The Company expects the HAI purchase price
allocation to be finalized by September 30, 1998.
MERIT ACQUISITION. On February 12, 1998, the Company acquired all of the
outstanding stock of Merit for approximately $448.9 million in cash plus the
repayment of Merit's debt. The Company refinanced its $375 million 11.25% Series
A Senior Subordinated Notes as part of the Merit acquisition. The Company
accounted for the Merit acquisition using the purchase method of accounting.
Merit provides managed care services to approximately 21.6 million covered lives
across all segments of the healthcare industry, including HMOs, Blue Cross/Blue
Shield organizations and other insurance companies, corporations and labor
unions, federal, state and local government agencies, and various state Medicaid
programs.
The following table sets forth the sources and uses of funds for the Merit
acquisition and related transactions (the "Transactions") at closing (in
thousands):
<TABLE>
<S> <C>
SOURCES:
Cash and cash equivalents............................................... $ 59,290
New Credit Agreement:
Revolving Facility (1)................................................ 20,000
Term Loan Facility.................................................... 550,000
The New Notes........................................................... 625,000
---------
Total sources......................................................... $1,254,290
---------
---------
USES:
Cash paid to Merit Shareholders......................................... $ 448,867
Repayment of Merit existing credit agreement (2)........................ 196,357
Purchase of the Old Notes (3)........................................... 432,102
Purchase of Merit Outstanding Notes (4)................................. 121,651
Transaction costs (5)................................................... 55,313
---------
Total uses.......................................................... $1,254,290
---------
---------
</TABLE>
- ------------------------
(1) The Revolving Facility provides for borrowings of up to $150.0 million. The
Company had $112.5 million available for borrowing pursuant to the Revolving
Facility after consummating the Transactions, excluding approximately $17.5
million of availability reserved for certain letters of credit.
(2) Includes principal amount of $193.6 million and accrued interest of $2.7
million.
15
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1998
(UNAUDITED)
NOTE H--ACQUISITIONS (CONTINUED)
(3) Includes principal amount of $375.0 million, tender premium of $43.4 million
and accrued interest of $13.7 million.
(4) Includes principal amount of $100.0 million, tender premium of $18.9 million
and accrued interest of $2.8 million.
(5) Transaction costs include, among other things, expenses associated with the
debt tender offers, the New Notes offering, the Merit acquisition and the
New Credit Agreement.
The purchase price allocation for the Merit acquisition is tentative and
subject to adjustment pending final valuations on property and equipment and
identifiable intangible assets, determination of final valuation allowances on
deferred tax assets, integration plan matters (see Note J) and certain other
matters. The Company expects the Merit purchase price allocation to be finalized
by September 30, 1998.
GREEN SPRING MINORITY SHAREHOLDER CONVERSION. The four minority
shareholders of Green Spring converted their ownership interests into 2,831,516
shares of Magellan common stock in accordance with the terms in the Green Spring
Exchange Agreement at various dates during January 1998. The Company accounted
for the Green Spring Minority Shareholder Conversion as a purchase of the
minority interests in Green Spring at the fair value of the consideration paid
of approximately $63.5 million.
The following unaudited pro forma information for the six months ended March
31, 1997 and 1998 has been prepared assuming the Crescent Transactions (as
defined), Allied acquisition, HAI acquisition, the Transactions and the Green
Spring Minority Shareholder Conversion were consummated on October 1, 1996. The
unaudited pro forma information does not purport to be indicative of the results
that would have actually been obtained had such transactions been consummated,
or which may be attained in future periods (in thousands, except per share
data):
<TABLE>
<CAPTION>
PRO FORMA
FOR THE SIX MONTHS
ENDED
----------------------
<S> <C> <C>
MARCH 31, MARCH 31,
1997 1998
---------- ----------
Net revenue............................................................................... $ 752,648 $ 899,280
Income before extraordinary item(1)....................................................... 7,154 4,622
Net income(1)(2).......................................................................... 4,204 4,947
Income per common share--basic:
Income before extraordinary item........................................................ 0.23 0.15
Net income.............................................................................. 0.13 0.16
Income per common share--diluted:
Income before extraordinary item........................................................ 0.22 0.14
Net income.............................................................................. 0.13 0.15
</TABLE>
- ------------------------
(1) Excludes expected cost savings related to the Integration Plan and Managed
Care integration costs. See Note J.
(2) Excludes the extraordinary losses on early extinguishments of debt for the
six months ended March 31, 1998, that were directly attributable to the
consummation of the Transactions.
16
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1998
(UNAUDITED)
NOTE I--CONTINGENCIES
The Company is self-insured for a substantial portion of its general and
professional liability risks. The reserves for self-insured general and
professional liability losses, including loss adjustment expenses, are based on
actuarial estimates that are discounted at an average rate of 6% to their
present value based on the Company's historical claims experience adjusted for
current industry trends. The reserve for unpaid claims is adjusted periodically
as such claims mature, to reflect changes in actuarial estimates based on actual
experience. During the quarter and the six months ended March 31, 1997 and the
six months ended March 31, 1998, the Company recorded reductions in malpractice
claim reserves of approximately $5.0 million and $4.1 million, respectively, as
a result of updated actuarial estimates. This reduction resulted primarily from
updates to actuarial assumptions regarding the Company's expected losses for
more recent policy years. These revisions are based on changes in expected
values of ultimate losses resulting from the Company's claim experience, and
increased reliance on such claim experience. While management and its actuaries
believe that the present reserve is reasonable, ultimate settlement of losses
may vary from the amount provided.
Certain of the Company's subsidiaries are subject to claims, civil suits,
and governmental investigations and inquiries relating to their operations and
certain alleged business practices. In the opinion of management, based on
consultation with counsel, resolution of these matters will not have a material
adverse effect on the Company's financial position or results of operations.
On August 1, 1996, the United States Department of Justice, Civil Division,
filed an Amended Complaint in a civil QUI TAM action initiated in November 1994
against the Company and its Orlando South hospital subsidiary ("Charter
Orlando") by two former employees. The First Amended Complaint alleges that
Charter Orlando violated the federal False Claims Act (the "Act") in billing for
inpatient treatment provided to elderly patients. The Court granted the
Company's motion to dismiss the government's First Amended Complaint yet granted
the government leave to amend its First Amended Complaint. The government filed
a Second Amended Complaint on December 12, 1996 which, similar to the First
Amended Complaint, alleges that the Company and its subsidiary violated the Act
in billing for the treatment of geriatric patients. Like the First Amended
Complaint, the Second Amended Complaint is based on disputed clinical and
factual issues which the Company believes do not constitute a violation of the
Act.
On the Company's motion, the Court ordered the parties to participate in
mediation of the matter. The parties have reached a tentative settlement of this
matter. Pursuant to the tentative settlement, the Company would pay
approximately $4.8 million, which has been accrued. Furthermore, Charter Orlando
(now operated by CBHS) would agree not to seek reimbursement for services
provided to patients covered under the Medicare program for a period of up to
fifteen months. The Company has agreed to reimburse CBHS for the resulting loss
of revenues during such period. The Company has an accrued obligation of $2.2
million for this reimbursement.
In October 1996, a group of eight plaintiffs purporting to represent an
uncertified class of psychiatrists, psychologists 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 Merit, CMG, Green Spring and HAI
(collectively, the "Defendants"). The complaint alleges that the Defendants
violated Section 1 of the Sherman Act by engaging in a conspiracy to fix the
prices at which the Defendants purchase services from mental healthcare
providers
17
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1998
(UNAUDITED)
NOTE I--CONTINGENCIES (CONTINUED)
such as the plaintiffs. The complaint further alleges that the Defendants
engaged in a group boycott to exclude mental healthcare providers from the
Defendants' networks in order to further the goals of the alleged conspiracy.
The complaint also challenges the propriety of the Defendants' capitation
arrangements with their respective customers, although it is unclear from the
complaint whether the plaintiffs allege that the Defendants unlawfully conspired
to enter into capitation arrangements with their respective customers. The
complaint seeks treble damages against the Defendants in an unspecified amount
and a permanent injunction prohibiting the Defendants from engaging in the
alleged conduct which forms the basis of the complaint, plus costs and
attorneys' fees. On May 12, 1998, the District Court granted the Defendants'
motion to dismiss the complaint with prejudice. On May 27, 1998, the plaintiffs
filed a notice of appeal of the District Court's dismissal of their complaint
with the United States Second Circuit Court of Appeals. The Defendants intend to
vigorously contest this appeal and to further defend themselves in this matter.
The Company does not believe this matter will have a material adverse effect on
its financial position or results of operations.
NOTE J--MANAGED CARE INTEGRATION PLAN AND COSTS
INTEGRATION PLAN
The Company owns three behavioral managed care organizations ("BMCOs"),
Green Spring, HAI and Merit, as a result of acquisitions consummated in fiscal
1996 (Green Spring) and fiscal 1998 (HAI and Merit). The Company also owns two
other specialty managed care organizations, Allied and Care Management
Resources, Inc. ("CMR"). Management has approved and committed the Company to a
plan to combine and integrate the operations of its BMCOs and other specialty
managed care organizations (the "Integration Plan") that will result in the
elimination of duplicative functions and will standardize business practices and
information technology platforms. The Company expects to achieve approximately
$60 million of cost savings on an annual basis by August 1999 at its BMCOS and
approximately $3 million of cost savings on an annual basis at CMR as a result
of the Integration Plan.
The Integration Plan will result in the elimination of approximately 1,000
positions during fiscal 1998 and fiscal 1999. Approximately 110 employees had
been involuntarily terminated pursuant to the Integration Plan as of March 31,
1998 and approximately 100 additional employees had been specifically identified
for involuntary termination. Approximately 200 positions have been eliminated by
normal attrition through April 30, 1998. The remaining positions to be
eliminated have been identified, and will be eliminated through a combination of
normal attrition and involuntary termination.
The employee groups of the BMCOs that are primarily affected include
executive management, finance, human resources, information systems and legal
personnel at the various BMCOs corporate headquarters and regional offices and
credentialing, claims processing, contracting and marketing personnel at various
operating locations. The Company expects to complete the specific identification
of all personnel who will be involuntarily terminated by September 30, 1998 and
will complete its involuntary terminations by April 1999.
The Integration Plan will also result in the closure of approximately 40 to
45 leased facilities at the BMCOs during fiscal 1998 and fiscal 1999. As of
March 31, 1998, 17 offices had been specifically identified for closure and 23
to 28 additional offices are under consideration for closure. The Company
expects to complete the specific identification of remaining office closures by
September 30, 1998.
18
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1998
(UNAUDITED)
NOTE J--MANAGED CARE INTEGRATION PLAN AND COSTS (CONTINUED)
The Company has recorded approximately $18.3 million of liabilities related
to the Integration Plan, of which $11.7 million was recorded as part of the
Merit purchase price allocation and $6.6 million was recorded in the statement
of operations under "Managed Care integration costs". These amounts represent
those portions of the Integration Plan obligations that were measurable as of
March 31, 1998. The Company expects to record additional liabilities as a result
of the Integration Plan in fiscal 1998 and fiscal 1999 as final decisions
regarding office closures and other contractual obligation terminations are
made.
The following table provides a rollforward of liabilities resulting from the
Integration Plan (in thousands):
<TABLE>
<CAPTION>
BALANCE BALANCE
SEPTEMBER 30, MARCH 31,
TYPE OF COST 1997 ADDITIONS PAYMENTS (1) 1998
- --------------------------------------------------- --------------- ----------- ------------- -----------
<S> <C> <C> <C> <C>
Employee termination benefits...................... $ -- $ 12,763 $ (613) $ 12,150
Facility closing costs............................. -- 5,279 -- 5,279
Other.............................................. -- 244 -- 244
----- ----------- ----- -----------
$ -- $ 18,286 $ (613) $ 17,673
----- ----------- ----- -----------
----- ----------- ----- -----------
</TABLE>
- ------------------------
(1) Includes $0.5 million in payments related to Merit
OTHER INTEGRATION COSTS
The Integration Plan will result in additional incremental costs that must
be expensed as incurred in accordance with Emerging Issues Task Force Consensus
94-3, "Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)"
that are not described above and certain other charges. Other integration costs
include, but are not limited to, outside consultants, costs to relocate closed
office contents and long-lived asset impairments. Other integration costs are
reflected in the statement of operations under "Managed Care integration costs".
During the quarter and the six months ended March 31, 1998, the Company
incurred approximately $4.5 million in other integration costs, including
long-lived asset impairments of approximately $2.2 million and outside
consulting costs of approximately $2.0 million. The asset impairments relate
primarily to identifiable intangible assets that no longer have value and have
been written off as a result of the Integration Plan.
19
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
MARCH 31, 1998
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
This Quarterly Report on Form 10-Q includes "forward-looking statements"
within the meaning of Section 27A of the Securities Act and Section 21E of the
Exchange Act. Although the Company believes that its plans, intentions and
expectations reflected in such forward-looking statements are reasonable, it can
give no assurance that such plans, intentions or expectations will be achieved.
Important factors that could cause actual results to differ materially from the
Company's forward-looking statements are set forth in the Company's Annual
Report on Form 10-K for the fiscal year ended September 30, 1997. All forward-
looking statements attributable to the Company or persons acting on behalf of
the Company are expressly qualified in their entirety by the cautionary
statements set forth in the Company's Annual Report on Form 10-K for the fiscal
year ended September 30, 1997.
OVERVIEW
The Company has historically derived the majority of its revenue from
providing healthcare services in an inpatient setting. Payments from third-party
payors are the principal source of revenue for most healthcare providers. In the
early 1990's, many third-party payors sought to control the cost of providing
care to their patients by instituting managed care programs or seeking the
assistance of managed care companies. Providers participating in managed care
programs agree to provide services to patients for a discount from established
rates, which generally results in pricing concessions by the providers and lower
margins. Additionally, managed care programs generally encourage alternatives to
inpatient treatment settings and reduce utilization of inpatient services. As a
result, third-party payors established managed care programs or engaged managed
care companies in many areas of healthcare, including behavioral healthcare. The
Company, which until June 1997 was the largest operator of psychiatric hospitals
in the United States, was adversely affected by the adoption of managed care
programs by third-party payors.
Prior to the first quarter of fiscal 1996, the Company was not a provider of
behavioral managed care services. During the first quarter of fiscal 1996, the
Company acquired a 61% ownership interest in Green Spring. At that time, the
Company intended to become a fully integrated behavioral healthcare provider by
combining the managed behavioral healthcare products offered by Green Spring
with the direct treatment services offered by the Company's psychiatric
hospitals. The Company believed that an entity that participated in both the
managed care and provider segments of the behavioral healthcare industry could
more efficiently provide and manage behavioral healthcare for insured
populations than an entity that was solely a managed care company. The Company
also believed that earnings from its managed care business would offset, in
part, the negative impact on the financial performance of its psychiatric
hospitals caused by managed care. Green Spring was the Company's first
significant involvement in managed behavioral healthcare. During the first
quarter of fiscal 1998, the minority shareholders of Green Spring converted
their interests in Green Spring into an aggregate of 2,831,516 shares of Company
Common Stock (the "Green Spring Minority Shareholder Conversion").
Subsequent to the Company's acquisition of Green Spring, the growth of the
managed behavioral healthcare industry accelerated. Under the Company's majority
ownership, Green Spring increased its base of covered lives from 12.0 million as
of the end of calendar year 1995 to 21.1 million as of the end of calendar year
1997, a compound annual growth rate of over 32%. While growth in the industry
was accelerating, the managed behavioral healthcare industry also began to
consolidate. The Company concluded that consolidation presented an opportunity
for the Company to enhance its stockholder value by increasing its participation
in the managed behavioral healthcare industry, which the Company believed
offered growth and earnings prospects superior to those of the psychiatric
hospital industry. Therefore, the
20
<PAGE>
Company decided to sell its domestic psychiatric facilities to obtain capital
for expansion in the managed behavioral healthcare business.
During the third quarter of fiscal 1997, the Company sold substantially all
of its domestic acute-care psychiatric hospitals and residential treatment
facilities (the "Psychiatric Hospital Facilities") to Crescent Real Estate
Equities Limited Partnership ("Crescent") for $417.2 million in cash (before
costs of approximately $16.0 million) and certain other consideration (the
"Crescent Transactions"). Simultaneously with the sale of the Psychiatric
Hospital Facilities, the Company and COI, an affiliate of Crescent, formed CBHS,
a joint venture, to operate the Psychiatric Hospital Facilities and certain
other facilities transferred to CBHS by the Company. The Company retained a 50%
ownership of CBHS; the other 50% of the equity of CBHS is owned by COI.
In related transactions, (i) Crescent leased the Psychiatric Hospital
Facilities to CBHS and (ii) the Company entered into a master franchise
agreement (the "Master Franchise Agreement") with CBHS and a franchise agreement
with each of the Psychiatric Hospital Facilities and the other facilities
operated by CBHS (collectively, the "Franchise Agreements"). The Company's sale
of the Psychiatric Hospital Facilities and the related transactions described
above are referred to as the "Crescent Transactions." Pursuant to the Franchise
Agreements, the Company franchises the "CHARTER" System of behavioral healthcare
to each of the Psychiatric Hospital Facilities and other facilities operated by
CBHS. In exchange, CBHS agreed to pay the Company, pursuant to the Master
Franchise Agreement, annual franchise fees (the "Franchise Fees") of
approximately $78.3 million. However, CBHS's obligation to pay the Franchise
Fees is subordinate to its obligation to pay rent for the Psychiatric Hospital
Facilities to Crescent. The sale of the Psychiatric Hospital Facilities provided
the Company with approximately $200 million of net cash proceeds, after debt
repayment, for use in implementing its business strategy. The Company used the
net cash proceeds to finance the acquisitions of HAI and Allied in December
1997. The Company further implemented its business strategy through the Merit
acquisition. See Note H--"Acquisitions -- Merit Acquisition". On March 3, 1998,
the Company entered into definitive agreements with COI and CBHS to, among other
things, sell the Company's franchise operations, certain domestic provider
operations and certain other assets and operations for $280.0 million, subject
to certain adjustments, in cash and $30.0 million in COI common stock.
If the CBHS Transactions are consummated, the Company will have completed
the divestiture of substantially all of its domestic provider business and will
have transformed the Company into almost entirely a specialty managed healthcare
company. The Company undertook the transformation because it believed that the
specialty managed healthcare industry offers growth and earnings prospects
superior to those available to the psychiatric hospital industry because, among
other things, third party payors for healthcare services are continuing to seek
to control the cost of providing care to their patients by instituting managed
care programs or seeking the assistance of managed care companies. Furthermore,
government payors are continuing to reduce reimbursement rates or coverage in an
effort to control costs.
As a result of the Merit acquisition, the Company generates a significant
portion of its revenue and earnings from its managed care business. The
percentage of the Company's revenue derived from its managed care business, in
general, and its risk-based products, in particular, will increase further if
the CBHS Transactions are consummated.
A significant portion of the Company's managed care revenue and earnings are
generated from risk-based products. The Company believes enrollment in
risk-based products will continue to grow through new covered lives and the
transition of covered lives in ASO and EAP products to higher revenue risk-based
products. Risk-based products typically generate significantly higher amounts of
revenue than other managed behavioral healthcare products. Because the Company
is responsible for the cost of care, risk-based products typically have lower
margins than non-risk-based products. Furthermore, under risk-based contracts,
the Company assumes all or a portion of the responsibility for the cost of
providing a full or specified range of specialty healthcare treatment services
to a specified beneficiary population. In order for
21
<PAGE>
such contracts to be profitable, the Company must accurately estimate the rate
of service utilization by beneficiaries enrolled in programs managed by the
Company and control the unit cost of such services. If the Company is unable to
either estimate the rate of service utilization or control the cost of such
services, its risk-based contracts may be unprofitable.
RESULTS OF OPERATIONS
REVENUE. Managed care revenue increased 214.9% to $289.8 million for the
quarter ended March 31, 1998 from $92.0 million in the same period in fiscal
1997 and increased 142.3% to $426.8 million for the six months ended March 31,
1998 from $176.2 million in the same period in fiscal 1997. The increases
resulted primarily from the acquisitions of HAI, Allied and Merit in fiscal 1998
and the continued revenue growth at Green Spring. HAI, Allied and Merit's
aggregate revenues were approximately $174.2 million and $201.9 million for the
quarter and the six months ended March 31, 1998, respectively. Green Spring
revenues were positively impacted by the award of several new contracts and
acquisitions in fiscal 1997 and fiscal 1998, resulting in a 45.7% increase in
covered lives to 22.6 million as of March 31, 1998 as compared to March 31,
1997.
Public sector revenue increased 55.6% to $32.8 million for the quarter ended
March 31, 1998 from $21.1 million in the same period in fiscal 1997 and
increased 43.1% to $59.1 million for the six months ended March 31, 1998 from
$41.3 million in the same period in fiscal 1997. The increases were primarily
attributable to a 21.3% increase in placements in Mentor homes since March 31,
1997 to 3,100 individuals and fiscal 1998 acquisitions.
Healthcare franchising revenue was $16.5 million and $36.1 million for the
quarter and the six months ended March 31, 1998, respectively. The healthcare
franchising revenue consisted of the Franchise Fees.
Provider business revenue decreased 86.0% to $33.2 million for the quarter
ended March 31, 1998 from $236.9 million in the same period in fiscal 1997 and
decreased 86.2% to $66.3 million for the six months ended March 31, 1998 from
$479.3 million in the same period in fiscal 1997. The decreases resulted
primarily from the effect of the consummation of the Crescent Transactions on
June 17, 1997, following which revenue from the Psychiatric Hospital Facilities
and other facilities transferred to CBHS was no longer recorded as part of the
Company's revenue. During the quarters ended March 31, 1997 and 1998, the
Company recorded revenue of $2.8 million and $1.4 million, respectively, for
settlements and adjustments related to reimbursement issues with respect to
psychiatric hospitals owned or formerly owned by the Company. During the six
months ended March 31, 1997 and 1998, the Company recorded revenue of $13.8
million and $2.2 million, respectively, related to reimbursement issues. During
fiscal 1997, the Company recorded $27.4 million for such settlements. Management
anticipates that revenue related to such settlements will decline significantly
for fiscal 1998.
SALARIES, COST OF CARE AND OTHER OPERATING EXPENSES. Salaries, cost of care
and other operating expenses attributable to the managed care business increased
215.5% to $260.0 million for the quarter ended March 31, 1998 from $82.4 million
in the same period in fiscal 1997 and increased 142.2% to $383.1 million for the
six months ended March 31, 1998 from $158.2 million in the same period in fiscal
1997. The increases resulted primarily from the acquisitions of HAI, Allied and
Merit, which had aggregate expenses of $154.1 million and $178.5 million for the
quarter and the six months ended March 31, 1998, respectively, and from
continued growth at Green Spring.
Public sector salaries, cost of care and other operating expenses increased
62.6% to $29.7 million for the quarter ended March 31, 1998 from $18.3 million
in the same period in fiscal 1997 and increased 48.2% to $53.6 million for the
six months ended March 31, 1998 from $36.1 million in the same period in fiscal
1997. The increases were due primarily to internal growth, increases in costs
related to expansion and new product development and fiscal 1998 acquisitions.
22
<PAGE>
Healthcare franchising operating expenses were $2.7 million and $5.0 million
for the quarter and the six months ended March 31, 1998. The Company recorded no
expenses with respect to the healthcare franchising business during the quarter
and the six months ended March 31, 1997 because the Crescent Transactions were
not consummated until the third quarter of fiscal 1997.
Salaries, cost of care and other operating expenses attributable to the
provider business decreased 84.2% to $27.5 million for the quarter ended March
31, 1998 from $173.7 million in the same period in fiscal 1997 and decreased
86.1% to $49.7 million for the six months ended March 31, 1998 from $358.4
million in the same period in fiscal 1997. The decreases resulted primarily from
the effect of the consummation of the Crescent Transactions, following which
operating expenses of the Psychiatric Hospital Facilities and other facilities
transferred to CBHS were no longer accounted for as part of the Company's
operating expenses. During the quarter and the six months ended March 31, 1997,
the Company recorded reductions of expenses of approximately $5.0 million
compared to reductions of $4.1 million for the six months ended March 31, 1998,
as a result of updated actuarial estimates related to malpractice claim
reserves. These reductions resulted primarily from updates to actuarial
assumptions regarding the Company's expected losses for more recent policy
years. These revisions are based on changes in expected values of ultimate
losses resulting from the Company's claim experience, and increased reliance on
such claim experience. While management and its actuaries believe that the
present reserve is reasonable, ultimate settlement of losses may vary from the
amount recorded and result in additional fluctuations in income in future
periods.
BAD DEBT EXPENSE. Bad debt expense, which is primarily attributable to the
provider business, decreased 95.5%, or $14.5 million, for the quarter ended
March 31, 1998 compared to the same period in fiscal 1997 and decreased 95.0% or
$33.6 million for the six months ended March 31, 1998 compared to the same
period in fiscal 1997. The decreases were primarily attributable to the effect
of the consummation of the Crescent Transactions, following which the bad debt
expense incurred by the Psychiatric Hospital Facilities and other facilities
transferred to CBHS was no longer accounted for as part of the Company's bad
debt expense.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization decreased
1.0%, or $0.1 million, for the quarter ended March 31, 1998 compared to the same
period in fiscal 1997 and decreased 23.9% or $6.3 million for the six months
ended March 31, 1998 compared to the same period in fiscal 1997. The decreases
were primarily attributable to the effect of the consummation of the Crescent
Transactions, whereby the Psychiatric Hospital Facilities were sold to Crescent,
offset by increases in depreciation and amortization resulting from the HAI,
Allied and Merit acquisitions of $6.4 million and $6.9 million, in aggregate,
for the quarter and the six months ended March 31, 1998, respectively.
INTEREST, NET. Interest expense, net, increased 33.2%, or $4.4 million, for
the quarter ended March 31, 1998 compared to the same period in fiscal 1997 and
decreased 6.7% or $1.8 million for the six months ended March 31, 1998 compared
to the same period in fiscal 1997. The changes were primarily the result of
lower interest expense due to lower average borrowings and higher interest
income due to temporary investments of the cash received in the Crescent
Transactions through February 12, 1998, offset by interest expense incurred on
borrowings used to fund the Merit acquisition and related transactions.
OTHER ITEMS. Stock option expense for the quarter and the six months ended
March 31, 1998 decreased $0.4 million and $5.0 million, respectively, from the
prior year periods primarily due to fluctuations in the market price of the
Company's common stock.
The Company recorded Managed Care integration costs of $11.1 million for the
quarter and the six months ended March 31, 1998. See Note J--"Managed Care
Integration Plan and Costs".
The Company recorded equity in the loss of CBHS of $5.6 million and $17.1
million for the quarter and the six months ended March 31, 1998, respectively,
representing the Company's proportionate (50%) loss in CBHS. See Note
G--"Investment in CBHS".
23
<PAGE>
The Company recorded unusual items, net, of $1.4 million, during the quarter
and the six months ended March 31, 1997, which consisted of a $2.8 million
pre-tax gain on the sale of two psychiatric hospitals offset by a $4.2 million
charge for the closure of three psychiatric hospitals and one general hospital.
The Company recorded unusual items, net, of $0.1 million, during the quarter and
the six months ended March 31, 1998 for the net loss on the sale of four
hospitals that were previously closed.
The Company's effective income tax rate increased to 45.1% for the six
months ended March 31, 1998, respectively, compared to 40% in the fiscal 1997
periods. The increase was primarily attributable to non-deductible goodwill
amortization of approximately $2.1 million resulting from the Merit acquisition
in fiscal 1998.
Minority interest decreased $1.5 million and $0.6 million during the quarter
and the six months ended March 31, 1998, respectively, compared to the same
periods in fiscal 1997. The decreases were primarily attributable to the Green
Spring Minority Shareholder Conversion in January 1998 offset by Green Spring's
net income growth in fiscal 1998 through January 1998.
The Company recorded extraordinary losses on early extinguishment of debt,
net of tax, of $3.0 million and $33.0 million during the quarters ended December
31, 1996 and March 31, 1998, respectively, related primarily to the termination
of its then existing credit agreement in fiscal 1997 and the termination of the
Credit Agreement and extinguishment of the Old Notes in fiscal 1998. See Note D
- -"Long-Term Debt and Leases".
IMPACT OF CRESCENT TRANSACTIONS ON RESULTS OF OPERATIONS
The Company owns a 50% equity interest in CBHS, from which it receives the
Franchise Fees. The Franchise Fees represent a significant portion of the
Company's earnings and cash flows. The following is a discussion of certain
matters related to the Company's ownership of CBHS that may have a bearing on
the Company's future results of operations.
CBHS may consolidate services in selected markets by closing facilities
depending on market conditions and evolving business strategies. For example,
during fiscal 1995 and 1996, the Company consolidated, closed or sold 15 and 9
psychiatric hospitals, respectively. During fiscal 1997, the Company
consolidated or closed three psychiatric hospitals, prior to the Crescent
Transactions. If CBHS closes additional psychiatric hospitals, it could result
in charges to income for the costs attributable to the closures, which would
result in additional losses in the equity in earnings of CBHS for the Company.
The Company's Joint Venture Hospitals and CBHS' hospitals continue to
experience a shift in payor mix to managed care payors from other payors, which
contributed to a reduction in revenue per equivalent patient day in fiscal 1996
and a decline in average length of stay in fiscal 1995, 1996 and 1997.
Management anticipates a continued shift in hospital payor mix towards managed
care payors as a result of changes in the healthcare marketplace. Future shifts
in hospital payor mix to managed care payors could result in lower revenue per
equivalent patient day and lower average length of stay in future periods for
the Company's Joint Venture Hospitals and CBHS' hospitals, which could result in
lower equity in earnings from CBHS for the Company and cash flows to pay the
Franchise Fees. The hospitals currently managed or operated by CBHS, including
hospitals closed or sold in 1997, reported a 10% reduction in equivalent patient
days, a 7% reduction in average length of stay and a 4% decrease in admissions
in fiscal 1997 compared to fiscal 1996.
The Balanced Budget Act of 1997 (the "Budget Act"), which was enacted by
Congress in August 1997, includes provisions that eliminated the TEFRA bonus
payment and reduced reimbursement of certain costs previously paid by Medicare
and eliminated the Medicaid "disproportionate share" program. These provisions,
along with other provisions in the Budget Act, will reduce the amount of revenue
and earnings that CBHS hospitals will receive for the treatment of Medicare
patients. CBHS management estimates
24
<PAGE>
that such reductions will approximate $10 million in fiscal 1998, and due to the
phase-in effects of the Budget Act, approximately $15 million annually in
subsequent fiscal years.
Based on projections of fiscal 1998 operations prepared by management of
CBHS and results of operations through March 31, 1998, the Company believes that
CBHS will be unable to pay the full amount of the Franchise Fees it is
contractually obligated to pay the Company during fiscal 1998. The Company
currently estimates that CBHS will be able to pay approximately $58.0 million to
$68.0 million of the Franchise Fees in fiscal 1998, a $10.0 million to $20.0
million shortfall relative to amounts payable under the Master Franchise
Agreement. The Company may be required to record bad debt expense related to
Franchise Fees receivable from CBHS, in fiscal 1998 or future periods if CBHS's
operating performance does not allow for payment of Franchise Fees. Based on the
amount of unpaid Franchise Fees, the Company has certain rights under the Master
Franchise Agreement. The Company will pursue all remedies available to it under
the Master Franchise Agreement, as appropriate.
IMPACT OF THE MERIT ACQUISITION ON RESULTS OF OPERATIONS
As a result of the Merit acquisition, the Company has over 60 million
covered lives under managed behavioral healthcare contracts and manages
behavioral healthcare programs for over 4,000 customers. The Company believes it
also now has the number one market position in each of the major product markets
in which it competes. The Company believes that the Merit acquisition creates
opportunities for the Company to achieve significant cost savings in its managed
behavioral healthcare business. Management believes that cost saving
opportunities will result from leveraging fixed overhead over a larger revenue
base and an increased number of covered lives and from reducing duplicative
corporate and regional selling, general and administrative expenses. As a
result, the Company expects to achieve approximately $60.0 million of cost
savings in its managed behavioral healthcare business on an annual basis within
eighteen months following the consummation of the Merit acquisition. The Company
expects to spend approximately $30.0 million during the eighteen months
following the consummation of the Merit acquisition in connection with achieving
such costs.
The Company expects to record additional managed care integration costs
during future quarters to the extent the Integration Plan results in additional
facility closures at HAI and Green Spring and for integration plan costs
incurred that benefit future periods.
The full implementation of the Integration Plan is expected to take eighteen
months. The Merit acquisition and related transactions are expected to be
dilutive to earnings during the remaining quarters of fiscal 1998.
IMPACT OF THE CBHS TRANSACTIONS ON RESULTS OF OPERATIONS
If the CBHS Transactions are consummated, the Company will no longer conduct
its franchising operations. Accordingly, the Company will no longer receive
Franchise Fees or incur expenses related to the Franchise Fees. In addition, if
the CBHS Transactions are consummated, the Company will sell substantially all
of its domestic provider operations, including its ownership interests in CBHS.
The net proceeds from the CBHS Transactions would be used to repay approximately
$272.0 million of the Term Loans, which would reduce annual interest expense by
approximately $22.5 million. The CBHS Transactions, if consummated, would reduce
the Company's future earnings because the earnings of the Company attributable
to the franchise operations and the domestic provider operations, including
CBHS, which would be sold in the CBHS Transactions, would exceed the decrease in
interest expense as a result of debt repayment. See Note G--"Investment in
CBHS."
HISTORICAL LIQUIDITY AND CAPITAL RESOURCES
OPERATING ACTIVITIES. The Company's net cash used in operating activities
was approximately $11.5 million and $22.3 million for the six months ended March
31, 1997 and 1998, respectively. Operating cash
25
<PAGE>
flows for the six months ended March 31, 1998 were adversely affected by unpaid
Franchise Fees of $10.0 million, the change in due to/from CBHS of $6.9 million,
the prepayment of CHARTER call center management fees to CBHS of $5.9 million,
insurance settlement payments of $8.8 million and the prepayment of accrued
interest of $13.7 million on the Old Notes as a result of the Transactions.
INVESTING ACTIVITIES. The Company utilized $988.9 million in funds, net of
cash acquired, for acquisitions and investments in businesses, including the
Allied, HAI and Merit acquisitions, during the six months ended March 31, 1998.
In addition, the Company paid approximately $5.9 million of Crescent Transaction
costs during the six months ended March 31, 1998. The Company expects to fund an
additional $15 million for transaction costs and construction costs related to
the Crescent Transactions and transaction costs related to Allied, HAI and Merit
during the remainder of fiscal 1998.
FINANCING ACTIVITIES. The Company borrowed approximately $126.8 million,
net of issuance costs, in the first quarter of fiscal 1997, primarily to
refinance its then existing credit agreement. The Company borrowed approximately
$1.2 billion during the six months ended March 31, 1998 primarily to fund the
Transactions. Also, the Company extinguished the Old Notes for approximately
$418.4 million during the six months ended March 31, 1998. The Company
repurchased approximately 545,000 shares of its common stock for approximately
$12.5 million during the six months ended March 31, 1998.
As of March 31, 1998, the Company had approximately $102.5 million of
availability under the Revolving Facility of the New Credit Agreement. The
Company was in compliance with all debt covenants as of March 31, 1998.
OUTLOOK--LIQUIDITY AND CAPITAL RESOURCES
The interest payments on the New Notes and interest and principal payments
on indebtedness outstanding pursuant to the New Credit Agreement represent
significant liquidity requirements for the Company. The Company believes that
the operating cash flows generated from its businesses will provide the Company
with the liquidity required to make such interest and principal payments.
Borrowings under the New Credit Agreement will bear interest at floating rates
and will require interest payments on varying dates depending on the interest
rate option selected by the Company. Borrowings pursuant to the New Credit
Agreement include $550 million in Term Loans and up to $150 million under the
Revolving Facility. Commencing in the second quarter of fiscal 1999, the Company
will be required to make principal payments with respect to the Term Loans. The
Company will be required to repay the principal amount of borrowings outstanding
under the Term Loan Facilities provided for in the New Credit Agreement and the
principal amount of the New Notes in the years and amounts set forth in the
following table:
<TABLE>
<CAPTION>
FISCAL YEAR PRINCIPAL AMOUNT
- ------------- -----------------
<S> <C>
1999...... $ 19.9
2000...... 32.4
2001...... 38.9
2002...... 49.4
2003...... 92.0
2004...... 156.5
2005...... 131.7
2006...... 29.2
2007...... --
2008...... 625.0
</TABLE>
In addition, any amounts outstanding under the Revolving Credit Facility created
by the New Credit Agreement mature in 2004.
The Company has finalized its plans for the integration of the businesses of
Green Spring, HAI and Merit. The Company expects to achieve approximately $60.0
million of cost savings on an annual basis
26
<PAGE>
within eighteen months following the consummation of the Merit acquisition. Such
cost savings are measured relative to the combined budgeted amounts of the
Company, Merit and HAI for the current fiscal year prior to the cost savings
initiatives. The Company expects to spend approximately $30.0 million during the
eighteen months following the consummation of the Merit acquisition in
connection with achieving such cost savings, including expenses related to
reducing duplicative personnel in its managed care organizations, contractual
terminations for eliminating excess real estate (primarily locations under
operating leases) and other related costs in connection with the integration
plan. Certain of such costs will be capital expenditures.
During December 1997, the Company purchased HAI and Allied for approximately
$122.1 million and $70.0 million, respectively, excluding transaction costs. In
addition, the Company incurred the obligation to make contingent payments to the
former owners of HAI and Allied. With respect to HAI, the Company may be
required to make additional contingent payments of up to $60.0 million annually
to Aetna over the five-year period subsequent to closing. The Company is
obligated to make contingent payments under two separate calculations. Under the
first calculation, the amount and timing of the contingent payments will be
based on growth in the number of lives covered by certain HAI products during
the next five years. The Company may be required to make contingent payments of
up to $25.0 million per year for each of the five years following the HAI
acquisition depending on the net annual growth in the number of lives covered by
such HAI products. The amount to be paid per incremental covered life decreases
during the five-year term of the Company's contingent payment obligation. Under
the second calculation, the Company may be required to make contingent payments
of up to $35.0 million per year for each of five years based on the net
cumulative growth in the number of lives covered by certain other HAI products.
Aetna will receive a specified amount per net incremental life covered by such
products. The amount to be paid per incremental covered life increases with the
number of incremental covered lives.
The Company may be required to pay up to $40.0 million in one-third
increments during each of the three years following the closing of the Allied
acquisition based on Allied's performance relative to certain earnings targets.
In connection with Merit's acquisition of CMG Health, Inc. ("CMG"), the Company,
by acquiring Merit, 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 Revolving Facility will provide the Company with revolving loans and
letters of credit in an aggregate principal amount at any time not to exceed
$150.0 million. At March 31, 1998, the Company had approximately $102.5 million
of availability under the Revolving Facility. The Company believes that the cash
flow generated from its operations together with amounts available for borrowing
under the New Credit Agreement, should be sufficient to fund its debt service
requirements, anticipated capital expenditures, contingent payments, if any,
with respect to HAI, Allied and CMG and other investing and financing
activities. The CBHS Transactions, if consummated, would result in an estimated
annual reduction in cash flows from operations provided by franchise operations,
offset, in part, by reduced interest payments as a result of repayment of
indebtedness with the proceeds received by the Company from the CBHS
Transactions. The Company currently estimates that it will spend approximately
$50.0 million for capital expenditures in fiscal 1998. On a combined basis, the
Company (excluding its provider business), Merit and HAI spent approximately
$40.0 million for capital expenditures during fiscal 1997. The majority of the
Company's budgeted capital expenditures relate to management information systems
and related equipment. The Company's future operating performance and ability to
service or refinance the New Notes or to extend or refinance the indebtedness
outstanding pursuant to the New Credit Agreement will be subject to future
economic conditions and to financial, business and other factors, many of which
are beyond the Company's control.
27
<PAGE>
RECENT ACCOUNTING PRONOUNCEMENTS
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants ("AICPA") issued Statement of Position
98-1, "Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use" ("SOP 98-1"). SOP 98-1 establishes accounting
guidance for internal-use software. SOP 98-1 requires the following:
- Computer software costs that are incurred in the preliminary project stage
(as described in SOP 98-1) should be expensed as incurred. Once the
capitalization criteria of SOP 98-1 have been met, external direct costs
of materials and services consumed in developing or obtaining internal-use
computer software; payroll and payroll-related costs for employees who are
directly associated with and who devote time to the internal-use computer
software project (to the extent of the time spent directly on the
project); and interest costs incurred when developing computer software
for internal use should be capitalized. Training costs and data conversion
costs should generally be expensed as
incurred.
- Internal costs incurred for upgrades and enhancements should be expensed
or capitalized in accordance with SOP 98-1. Internal costs incurred for
maintenance should be expensed as incurred. Entities that cannot separate
internal costs on a reasonably cost-effective basis between maintenance
and relatively minor upgrades and enhancements should expense such costs
as incurred.
- External costs incurred under agreements related to specified upgrades and
enhancements should be expensed or capitalized in accordance with SOP
98-1. However, external costs related to maintenance, unspecified upgrades
and enhancements, and costs under agreements that combine the costs of
maintenance and unspecified upgrades and enhancements should be recognized
in expense over the contract period on a straight-line basis unless
another systematic and rational basis is more representative of the
services received.
- Impairment should be recognized and measured in accordance with the
provisions of FASB Statement No. 121, ACCOUNTING FOR THE IMPAIRMENT OF
LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF.
- The capitalized costs of computer software developed or obtained for
internal use should be amortized on a straight-line basis unless another
systematic and rational basis is more representative of the software's
use.
SOP 98-1 becomes effective for financial statements for fiscal years
beginning after December 15, 1998. The provisions of SOP 98-1 should be applied
to internal-use software costs incurred in those fiscal years for all projects,
including those projects in progress upon initial application of SOP 98-1. Costs
incurred prior to the initial application of SOP 98-1, whether capitalized or
not, should not be adjusted to the amounts that would have been capitalized had
SOP 98-1 been in effect when those costs were incurred.
The Company must adopt SOP 98-1 no later than October 1, 1999. Each of the
Company's operating units maintains its own information systems, which includes
internal-use software as defined by SOP 98-1. The care management and claims
processing systems used in the managed care segment are the Company's most
significant internal-use software applications. The Company is in the process of
evaluating the requirements of SOP 98-1 versus its internal-use software
capitalization policies. The Company does not believe SOP 98-1 will have a
material impact on its financial position or results of operations.
In April 1998, the AICPA issued Statement of Position 98-5, "Reporting on
the Costs of Start-up Activities" ("SOP 98-5"). SOP 98-5 requires all
nongovernmental entities to expense costs of start-up activities as those costs
are incurred. Start-up costs, as defined by SOP 98-5, include pre-operating
costs, pre-opening costs and organization costs.
SOP 98-5 becomes effective for financial statements for fiscal years
beginning after December 31, 1998. At adoption, a company must record a
cumulative effect of a change in accounting principle to write
28
<PAGE>
off any unamortized start-up costs remaining on the balance sheet when SOP 98-5
is adopted. Prior year financial statements cannot be restated. The Company must
adopt SOP 98-5 no later than October 1, 1999. The Company does not believe SOP
98-5 will have a material impact on its financial position or results of
operations.
MODIFICATION OF COMPUTER SOFTWARE FOR THE YEAR 2000
The Company and its subsidiaries have internally developed computer software
systems that process transactions based on storing two digits for the year of a
transaction (i.e., "97" for 1997) rather than four digits, which will be
required for year 2000 transaction processing. CBHS expects to spend $1.0
million in the aggregate during fiscal 1998 and fiscal 1999 to modify internal
use software. The Company expects to spend approximately $1.6 million in the
aggregate during fiscal 1998 and fiscal 1999 to modify internal use software.
The Company does not anticipate incurring any other significant costs for year
2000 software modification. The cost of modifying internal use software for the
year 2000 is charged to expense as incurred.
29
<PAGE>
PART II -- OTHER INFORMATION
ITEM 1. -- LEGAL PROCEEDINGS
Certain of the Company's subsidiaries are subject to or parties to claims,
civil suits and governmental investigations and inquiries relating to their
operations and certain alleged business practices. In the opinion of management,
based on consultation with counsel, resolution of these matters will not have a
material adverse effect on the Company's financial position or results of
operations.
ITEM 4. -- SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company held an annual meeting of stockholders on February 6, 1998.
The tabulation of votes with respect to each matter voted upon at the
meeting is as follows:
<TABLE>
<CAPTION>
VOTES CAST
-------------------------------------
<S> <C> <C> <C>
AUTHORITY
FOR WITHHELD ABSTAIN
------------ ---------- -----------
Election of:
Andre C. Dimitriadis as a Director (term expiring in
2001)................................................... 24,790,545 47,418 N/A
A.D. Frazier, Jr. as a Director (term expiring in 2001)... 24,666,312 171,651 N/A
G. Fred DiBona as a Director (term expiring in 2001)...... 24,798,888 39,075 N/A
<CAPTION>
FOR AGAINST ABSTAIN
------------ ---------- -----------
<S> <C> <C> <C>
Approval of :
1998 Stock Option Plan.................................... 23,669,563 1,039,876 8,797
</TABLE>
ITEM 6. -- EXHIBITS AND REPORTS ON FORM 8-K
<TABLE>
<S> <C>
(a) Exhibits
2(a) Agreement and Plan of Merger, dated October 24, 1997, among the Company, Merit
Behavioral Care Corporation and MBC Merger Corporation, which was filed as
Exhibit 2(g) to the Company's Quarterly Report on Form 10-Q for the quarterly
period ended December 31, 1997, and is incorporated herein by reference.
2(b) Purchase Agreement, dated March 3, 1998, between the Company, Charter Behavioral
Corporation, Charter Behavioral Health Systems, Inc., Green Spring Health
Services, Inc., Advantage Behavioral Systems, Inc. and Charter Behavioral Health
Systems, LLC, which was filed as Exhibit 2(f) to the Company's Registration
Statement on Form S-4 filed on April 3, 1998, and is incorporated herein by
reference.
2(c) Equity Purchase Agreement, dated March 3, 1998, between the Company, Charter
Behavioral Health Systems, Inc. and Crescent Operating, Inc., which was filed as
Exhibit 2(g) to the Company's Registration Statement on Form S-4 filed on April
3, 1998, and is incorporated herein by reference.
2(d) Support Agreement, dated March 3, 1998, between the Company and Crescent
Operating, Inc., which was filed as Exhibit 2(h) to the Company's Registration
Statement on Form S-4 filed on April 3, 1998, and is incorporated herein by
reference.
</TABLE>
30
<PAGE>
<TABLE>
<S> <C>
4(a) Indenture, dated as of February 12, 1998, between the Company and Marine Midland
Bank, as Trustee, relating to the 9% Senior Subordinated Notes due February 15,
2008 of the Company, which was filed as Exhibit 4(a) to the Company's Current
Report on Form 8-K, as amended, dated April 3, 1998, and is incorporated herein
by reference.
4(b) Purchase Agreement, dated February 5, 1998, between the Company and Chase
Securities Inc., which was filed as Exhibit 4(b) to the Company's Current Report
on Form 8-K, as amended, dated April 3, 1998, and is incorporated herein by
reference.
4(c) Exchange and Registration Rights Agreement, dated February 12, 1998, between the
Company and Chase Securities Inc., which was filed as Exhibit 4(c) to the
Company's Current Report on Form 8-K, as amended, dated April 3, 1998, and is
incorporated herein by reference.
4(d) Credit Agreement, dated as of February 12, 1998, among the Company, certain of
the Company's subsidiaries listed therein and The Chase Manhattan Bank, as
administrative agent, which was filed as Exhibit 4(d) to the Company's Current
Report on Form 8-K, as amended, dated April 3, 1998, and is incorporated herein
by reference.
10(a) 1998 Stock Option Plan of the Company, which was filed as Exhibit 10(ay) to the
Company's Registration Statement on Form S-4 filed on April 3, 1998, and is
incorporated herein by reference.
10(b) Letter Agreement, dated May 7, 1997, between Green Spring Health Services, Inc.
and John J. Wider, Jr., Executive Vice President and Chief Operating Officer of
Green Spring Health Services, Inc., which was filed as Exhibit 10(az) to the
Company's Registration Statement on Form S-4 filed on April 3, 1998, and is
incorporated herein by reference.
10(c) Employment Agreement, dated March 12, 1997, between Green Spring Health
Services, Inc. and Clarissa C. Marques, Chief Clinical Officer of Green Spring
Health Services, Inc., which was filed as Exhibit 10(ba) to the Company's
Registration Statement on Form S-4 filed April 3, 1998, and is incorporated
herein by reference.
10(d) Letter Agreement, dated February 2, 1995, between Green Spring Health Services,
Inc. and Clarissa C. Marques, Senior Vice President of Green Spring Health
Services, Inc., which was filed as Exhibit 10(bb) to the Company's Registration
Statement on Form S-4 filed April 3, 1998, and is incorporated herein by
reference.
27 Financial Data Schedule
</TABLE>
(b) Report on Form 8-K
The following current reports on Form 8-K were filed by the Registrant with
the Securities and Exchange Commission during the quarter ended March 31, 1998.
<TABLE>
<CAPTION>
FINANCIAL
DATE OF REPORT ITEM REPORTED AND DESCRIPTION STATEMENTS FILED
- --------------------------------- --------------------------------- ---------------------------------
<S> <C> <C>
February 27, 1998 Acquisition--Merit Acquisition No(1)
</TABLE>
- ------------------------
(1) Amended on April 3, 1998 to include audited financial statements for the
three years in the period ended September 30, 1997, unaudited financial
statements for the three months ended December 31, 1997 and 1996 and as of
December 31, 1997, unaudited pro forma statements of operations for the year
ended September 30, 1997 and the three months ended December 31, 1997 and
unaudited pro forma balance sheet as of December 31, 1997.
31
<PAGE>
FORM 10-Q
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
<TABLE>
<S> <C>
MAGELLAN HEALTH SERVICES, INC.
(Registrant)
Date: July 28, 1998 /s/ CRAIG L. MCKNIGHT
--------------------------------------------
Craig L. McKnight
EXECUTIVE VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER
Date: July 28, 1998 /s/ JEFFREY T. HUDKINS
--------------------------------------------
Jeffrey T. Hudkins
VICE PRESIDENT AND CONTROLLER
(PRINCIPAL ACCOUNTING OFFICER)
</TABLE>
32
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONDENSED CONSOLIDATED BALANCE SHEETS AND CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS FOUND ON PAGES 2, 3, AND 4 OF THE COMPANY'S FORM 10-Q FOR THE
YEAR-TO-DATE, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL
STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> SEP-30-1998
<PERIOD-END> MAR-31-1998
<CASH> 160,986,000
<SECURITIES> 0
<RECEIVABLES> 181,622,000
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 386,304,000
<PP&E> 219,148,000
<DEPRECIATION> 46,169,000
<TOTAL-ASSETS> 1,912,898,000
<CURRENT-LIABILITIES> 435,235,000
<BONDS> 1,208,715,000
0
0
<COMMON> 8,407,000
<OTHER-SE> 173,570,000
<TOTAL-LIABILITY-AND-EQUITY> 1,912,898,000
<SALES> 588,320,000
<TOTAL-REVENUES> 588,320,000
<CGS> 0
<TOTAL-COSTS> 500,128,000
<OTHER-EXPENSES> 44,572,000
<LOSS-PROVISION> 1,756,000
<INTEREST-EXPENSE> 24,927,000
<INCOME-PRETAX> 16,937,000
<INCOME-TAX> 7,633,000
<INCOME-CONTINUING> 5,336,000
<DISCONTINUED> 0
<EXTRAORDINARY> (33,015,000)
<CHANGES> 0
<NET-INCOME> (27,679,000)
<EPS-PRIMARY> (0.92)
<EPS-DILUTED> (0.90)
</TABLE>
