<PAGE>
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
FORM 10-Q
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 JUNE 30, 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 July
31, 1998, was 31,608,037.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<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 June 30, 1998........................... 2
Condensed Consolidated Statements of Operations--For the Three Months and the Nine Months ended June
30, 1997 and 1998................................................................................... 4
Condensed Consolidated Statements of Cash Flows--For the Nine Months ended June 30, 1997 and 1998..... 5
Notes to Condensed Consolidated Financial Statements.................................................. 6
Management's Discussion and Analysis of Financial Condition and Results of Operations................. 23
PART II--OTHER INFORMATION:
Item 1.--Legal Proceedings............................................................................ 34
Item 6.--Exhibits and Reports on Form 8-K............................................................. 34
Signatures............................................................................................ 35
</TABLE>
<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, JUNE 30,
1997 1998
------------- ------------
<S> <C> <C>
ASSETS
Current Assets:
Cash and cash equivalents........................................................ $ 372,878 $ 89,846
Accounts receivable, net......................................................... 107,998 204,137
Restricted cash and investments.................................................. -- 60,548
Refundable income taxes.......................................................... 2,466 --
Other current assets............................................................. 23,696 34,847
------------- ------------
Total current assets........................................................... 507,038 389,378
Assets restricted for settlement of unpaid claims and other long-term liabilities.... 87,532 40,253
Property and equipment:
Land............................................................................. 11,667 10,817
Buildings and improvements....................................................... 70,174 75,425
Equipment........................................................................ 63,719 144,448
------------- ------------
145,560 230,690
Accumulated depreciation......................................................... (37,038) (53,720)
------------- ------------
108,522 176,970
Construction in progress......................................................... 692 746
------------- ------------
Total property and equipment................................................... 109,214 177,716
------------- ------------
Deferred income taxes................................................................ 1,158 68,614
Investment in CBHS................................................................... 16,878 --
Other long-term assets............................................................... 20,893 49,194
Goodwill, net........................................................................ 114,234 934,651
Other intangible assets, net......................................................... 38,673 242,405
------------- ------------
$ 895,620 $ 1,902,211
------------- ------------
------------- ------------
</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, JUNE 30,
1997 1998
------------- ------------
<S> <C> <C>
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable................................................................... $ 45,346 $ 42,148
Accrued liabilities................................................................ 170,429 381,666
Current maturities of long-term debt and capital lease obligations................. 3,601 16,585
------------- ------------
Total current liabilities.................................................... 219,376 440,399
Long-term debt and capital lease obligations......................................... 391,693 1,189,131
Reserve for unpaid claims............................................................ 49,113 33,374
Deferred credits and other long-term liabilities..................................... 16,110 16,244
Minority interest.................................................................... 61,078 32,268
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 33,686 shares at June 30, 1998........................................ 8,361 8,423
Other Stockholders' Equity
Additional paid-in capital....................................................... 340,645 353,125
Accumulated deficit.............................................................. (129,955) (150,224)
Warrants outstanding............................................................. 25,050 25,050
Common Stock in Treasury, 4,424 shares at September 30, 1997 and 2,137 shares at
June 30, 1998.................................................................. (82,731) (42,413)
Cumulative foreign currency adjustments.......................................... (3,120) (3,166)
------------- ------------
Total stockholders' equity................................................... 158,250 190,795
------------- ------------
$ 895,620 $ 1,902,211
------------- ------------
------------- ------------
</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
FOR THE THREE NINE
MONTHS MONTHS
ENDED ENDED
JUNE 30, JUNE 30,
------------------ ----------
<S> <C> <C> <C>
1997 1998 1997
-------- -------- ----------
Net revenue..................................................................................... $324,921 $474,779 $1,021,662
-------- -------- ----------
Costs and expenses:
Salaries, cost of care and other operating expenses........................................... 263,915 409,225 830,248
Bad debt expense.............................................................................. 12,081 1,216 47,456
Depreciation and amortization................................................................. 12,044 17,724 38,231
Interest, net................................................................................. 12,602 24,409 39,324
Stock option expense (credit)................................................................. 1,781 12 3,214
Managed Care integration costs................................................................ -- 1,240 --
Equity in loss of CBHS........................................................................ 399 7,158 399
Loss on Crescent Transactions................................................................. 59,868 -- 59,868
Unusual items................................................................................. (1,038) (3,049) 357
-------- -------- ----------
361,652 457,935 1,019,097
-------- -------- ----------
Income (loss) before provision for income taxes, minority interest and extraordinary items...... (36,731) 16,844 2,565
Provision for (benefit from) income taxes....................................................... (14,693) 8,339 1,025
-------- -------- ----------
Income (loss) before minority interest and extraordinary items.................................. (22,038) 8,505 1,540
Minority interest............................................................................... 2,403 1,095 6,948
-------- -------- ----------
Income (loss) before extraordinary items........................................................ (24,441) 7,410 (5,408)
Extraordinary items--losses on early extinguishments of debt (net of income tax benefit of
$1,536 and $3,503 for the three months and nine months ended June 30, 1997, respectively, and
$22,010 for the nine months ended June 30, 1998).............................................. (2,303) -- (5,253)
-------- -------- ----------
Net income (loss)............................................................................... $(26,744) $ 7,410 $ (10,661)
-------- -------- ----------
-------- -------- ----------
Average number of common shares outstanding--basic.............................................. 28,830 31,523 28,715
-------- -------- ----------
-------- -------- ----------
Average number of common shares outstanding--diluted............................................ 28,830 32,131 28,715
-------- -------- ----------
-------- -------- ----------
Income (loss) per common share--basic:
Income (loss) before extraordinary items...................................................... $ (0.85) $ 0.24 $ (0.19)
-------- -------- ----------
-------- -------- ----------
Extraordinary losses on early extinguishments of debt......................................... $ (0.08) $ -- $ (0.18)
-------- -------- ----------
-------- -------- ----------
Net income (loss)............................................................................. $ (0.93) $ 0.24 $ (0.37)
-------- -------- ----------
-------- -------- ----------
Income (loss) per common share--diluted:
Income (loss) before extraordinary items...................................................... $ (0.85) $ 0.23 $ (0.19)
-------- -------- ----------
-------- -------- ----------
Extraordinary losses on early extinguishments of debt......................................... $ (0.08) $ -- $ (0.18)
-------- -------- ----------
-------- -------- ----------
Net income (loss)............................................................................. $ (0.93) $ 0.23 $ (0.37)
-------- -------- ----------
-------- -------- ----------
<CAPTION>
<S> <C>
1998
----------
Net revenue..................................................................................... $1,063,099
----------
Costs and expenses:
Salaries, cost of care and other operating expenses........................................... 909,353
Bad debt expense.............................................................................. 2,972
Depreciation and amortization................................................................. 37,649
Interest, net................................................................................. 49,336
Stock option expense (credit)................................................................. (3,527)
Managed Care integration costs................................................................ 12,314
Equity in loss of CBHS........................................................................ 24,221
Loss on Crescent Transactions................................................................. --
Unusual items................................................................................. (3,000)
----------
1,029,318
----------
Income (loss) before provision for income taxes, minority interest and extraordinary items...... 33,781
Provision for (benefit from) income taxes....................................................... 15,972
----------
Income (loss) before minority interest and extraordinary items.................................. 17,809
Minority interest............................................................................... 5,063
----------
Income (loss) before extraordinary items........................................................ 12,746
Extraordinary items--losses on early extinguishments of debt (net of income tax benefit of
$1,536 and $3,503 for the three months and nine months ended June 30, 1997, respectively, and
$22,010 for the nine months ended June 30, 1998).............................................. (33,015)
----------
Net income (loss)............................................................................... $ (20,269)
----------
----------
Average number of common shares outstanding--basic.............................................. 30,505
----------
----------
Average number of common shares outstanding--diluted............................................ 31,099
----------
----------
Income (loss) per common share--basic:
Income (loss) before extraordinary items...................................................... $ 0.42
----------
----------
Extraordinary losses on early extinguishments of debt......................................... $ (1.08)
----------
----------
Net income (loss)............................................................................. $ (0.66)
----------
----------
Income (loss) per common share--diluted:
Income (loss) before extraordinary items...................................................... $ 0.41
----------
----------
Extraordinary losses on early extinguishments of debt......................................... $ (1.06)
----------
----------
Net income (loss)............................................................................. $ (0.65)
----------
----------
</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 NINE MONTHS
ENDED
JUNE 30,
--------------------------
1997 1998
----------- -------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss............................................................................ $ (10,661) $ (20,269)
----------- -------------
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation and amortization............................................... 38,231 37,649
Equity in loss of CBHS...................................................... 399 24,221
Stock option expense (credit)............................................... 3,214 (3,527)
Non-cash interest expense................................................... 1,297 1,984
Gain on sale of assets...................................................... (5,747) (3,000)
Impairment of long-lived assets............................................. -- 2,160
Loss on Crescent Transactions............................................... 59,868 --
Extraordinary losses on early extinguishments of debt....................... 8,756 55,025
Cash flows from changes in assets and liabilities, net of effects from sales
and acquisitions of businesses:
Accounts receivable, net................................................ 18,521 (28,360)
Other assets............................................................ 8,409 (7,992)
Restricted cash and investments......................................... -- (8,268)
Accounts payable and other accrued liabilities.......................... (67,540) (18,428)
Reserve for unpaid claims............................................... (20,679) (16,083)
Income taxes payable and deferred income taxes.......................... (17,985) (16,544)
Other liabilities....................................................... (17,400) (7,239)
Minority interest, net of dividends paid................................ 7,498 4,354
Other................................................................... (965) (1,084)
----------- -------------
Total adjustments................................................... 15,877 14,868
----------- -------------
Net cash provided by (used in) operating activities............... 5,216 (5,401)
----------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures................................................................ (28,113) (26,938)
Acquisitions and investments in businesses, net of cash acquired.................... (28,840) (1,033,155)
Proceeds from sale of property and equipment to Crescent and CBHS, net of
transaction costs................................................................. 384,041 (6,070)
Decrease in assets restricted for settlement of unpaid claims....................... 12,551 46,943
Proceeds from sale of assets........................................................ 15,463 18,088
----------- -------------
Net cash provided by (used in) investing activities............... 355,102 (1,001,132)
----------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of debt, net of issuance costs............................... 203,643 1,169,887
Payments on debt and capital lease obligations...................................... (389,406) (438,563)
Proceeds from issuance of warrants.................................................. 25,000 --
Proceeds from exercise of stock options and warrants................................ 5,743 4,633
Purchases of treasury stock......................................................... -- (12,456)
----------- -------------
Net cash provided by (used in) financing activities............... (155,020) 723,501
----------- -------------
Net increase (decrease) in cash and cash equivalents.................................. 205,298 (283,032)
Cash and cash equivalents at beginning of period...................................... 120,945 372,878
----------- -------------
Cash and cash equivalents at end of period............................................ $ 326,243 $ 89,846
----------- -------------
----------- -------------
</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
JUNE 30, 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 nine months ended
June 30, 1997 and 1998:
<TABLE>
<CAPTION>
FOR THE NINE
MONTHS ENDED
JUNE 30,
--------------------
1997 1998
--------- ---------
(IN THOUSANDS)
<S> <C> <C>
Income taxes paid, net of refunds received........................................ $ 14,419 $ 8,572
Interest paid, net of amounts capitalized......................................... 53,945 53,686
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
Investment in CBHS.............................................................. 5,281 --
</TABLE>
6
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 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 June 30, 1998 is as follows (in
thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, JUNE 30,
1997 1998
------------- ------------
<S> <C> <C>
Credit Agreement due through 2002.......................................... $ -- $ --
New Credit Agreement:
Revolving Facility (7.91% at June 30, 1998) due through 2004............. -- 20,000
Term Loan Facility (7.91% to 8.41% at June 30, 1998) due through 2006.... -- 550,000
11.25% Series A Senior Subordinated Notes.................................. 375,000 --
9.0% Senior Subordinated Notes due 2008.................................... -- 625,000
6.71% to 11.50% Mortgage and other notes payable through 2005.............. 7,721 4,278
7.5% Swiss Bonds........................................................... 6,443 --
3.9% Capital lease obligations due through 2014............................ 6,438 6,438
------------- ------------
395,602 1,205,716
Less amounts due within one year......................................... 3,601 16,585
Less debt service funds.................................................. 308 --
------------- ------------
$ 391,693 $ 1,189,131
------------- ------------
------------- ------------
</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 nine months ended June 30, 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)
JUNE 30, 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
tests, 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)
JUNE 30, 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 accrues at the
rate of 9.0% per annum and is payable semi-annually on each February 15 and
August 15, commencing on August 15, 1998. The Company entered into an Exchange
and Registration Rights Agreement in connection with the issuance of the New
Notes. The Company agreed, pursuant to such agreement, to use its reasonable
best efforts to file with the Securities and Exchange Commission (the
"Commission") an exchange offer registration statement and to have this
registration statement declared effective as promptly as practicable after
filing it. Furthermore, the Company agreed to offer to the holders of the New
Notes the opportunity to exchange the New Notes for an issue of a second series
of notes that are identical in all material respects to the New Notes and that
would be registered under the Securities Act of 1933, as amended (the
"Securities Act"). Under the Commission's interpretations of the Securities Act,
holders of the New Notes who accept the exchange offer would receive, subject to
certain exceptions, securities that could be freely transferred. The Company
also agreed that, if the exchange offer were not consummated by July 13, 1998,
it would pay liquidated damages in an amount equal to $0.192 per week per $1,000
principal amount of the New Notes commencing on July 13, 1998, and continuing
until such exchange offer is consummated. The Company has not had its exchange
offer registration statement declared effective by the Commission and,
therefore, could not consummate the exchange offer on the scheduled date.
Therefore, the Company became obligated to pay the liquidated damages on the New
Notes on July 13, 1998 and will continue to be obligated to pay such liquidated
damages until the exchange offer is consummated.
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,
9
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)
NOTE D--LONG-TERM DEBT AND LEASES (CONTINUED)
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 for
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.
NOTE E--ACCRUED LIABILITIES
Accrued liabilities consist of the following (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, JUNE 30,
1997 1998
------------- ----------
<S> <C> <C>
Salaries, wages and other benefits........................................... $ 21,647 $ 18,928
Amounts due health insurance programs........................................ 14,126 10,457
Medical claims payable....................................................... 36,508 198,558
Interest..................................................................... 19,739 22,915
Crescent Transactions........................................................ 14,648 4,385
Other........................................................................ 63,761 126,423
------------- ----------
$ 170,429 $ 381,666
------------- ----------
------------- ----------
</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 nine months ended June 30, 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 NINE MONTHS ENDED
JUNE 30, JUNE 30,
---------------------- ----------------------
1997 1998 1997 1998
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Weighted average common shares outstanding--basic........... 28,830 31,523 28,715 30,505
Common stock equivalents--stock options..................... -- 570 -- 578
Common stock equivalents--warrants.......................... -- 38 -- 16
---------- ---------- ---------- ----------
Weighted average common shares outstanding--diluted......... 28,830 32,131 28,715 31,099
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
</TABLE>
Options to purchase approximately 457,000 shares of common stock at $25.16
to $31.06 per share were outstanding during the nine months ended June 30, 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 fiscal 2008, were still
outstanding at June 30, 1998.
10
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)
NOTE F--INCOME PER COMMON SHARE (CONTINUED)
Warrants to purchase approximately 4,713,000 shares of common stock at
$26.15 to $38.70 per share were outstanding during the nine months ended June
30, 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 fiscal 2009, were
still outstanding at June 30, 1998.
Common stock equivalents of approximately 843,000 and 582,000 were excluded
from the income per common share calculation for the three months and the nine
months ended June 30, 1997, respectively, due to their anti-dilutive nature as a
result of the Company's losses for such periods.
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 fiscal year ended September 30,
1997. The Company accounts for its investment in CBHS using the equity method.
11
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)
NOTE G--INVESTMENT IN CBHS (CONTINUED)
A summary of financial information for CBHS is as follows (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, JUNE 30,
1997 1998
------------- ------------
<S> <C> <C>
Current assets............................................................. $ 148,537 $ 156,385
Property and equipment, net................................................ 18,424 14,917
Other noncurrent assets.................................................... 8,633 10,211
------------- ------------
Total Assets............................................................. $ 175,594 $ 181,513
------------- ------------
------------- ------------
Current liabilities........................................................ $ 68,497 $ 112,681
Long-term debt............................................................. 65,860 65,000
Other noncurrent liabilities............................................... 7,481 28,889
Members' capital (deficiency).............................................. 33,756 (25,057)
------------- ------------
Total Liabilities and Members' Capital................................... $ 175,594 $ 181,513
------------- ------------
------------- ------------
</TABLE>
<TABLE>
<CAPTION>
THREE MONTHS NINE MONTHS
ENDED ENDED
JUNE 30, 14 DAYS ENDED JUNE 30,
1998 JUNE 30, 1997 1998
------------- ------------- -----------
<S> <C> <C> <C>
Net revenue........................................................................... $187,928 $29,865 $553,370
------------- ------------- -----------
Operating expenses.................................................................... 205,520 30,565 605,462
Interest, net......................................................................... 1,300 98 3,975
------------- ------------- -----------
Net loss before preferred member distribution....................................... $(18,892) $ (798) $(56,067)
------------- ------------- -----------
------------- ------------- -----------
Cash used in operating activities..................................................... $(13,996) $ (4,553)
------------- -----------
------------- -----------
Magellan's portion of net loss........................................................ (9,446) (399) (28,034)
Intercompany loss elimination(1)...................................................... 2,288 -- 3,813
------------- ------------- -----------
Magellan equity loss.................................................................. $ (7,158) $ (399) $(24,221)
------------- ------------- -----------
------------- ------------- -----------
</TABLE>
12
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 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 NINE MONTHS
ENDED 14 DAYS ENDED ENDED
JUNE 30, 1998 JUNE 30, 1997 JUNE 30, 1998
------------- ------------- -------------
<S> <C> <C> <C>
Franchise Fee revenue(1)............................................................ $15,000 $3,164 $51,100
------------- ------ -------------
Costs:
Accounts receivable collection fees............................................... $ 248 1,426 $ 1,862
Hospital-based joint venture management fees...................................... 1,708 417 5,191
</TABLE>
<TABLE>
<CAPTION>
SEPTEMBER 30, JUNE 30,
1997 1998
------------- -------------
<S> <C> <C>
Due to CBHS, net (2)................................................................................ $(5,090) $(4,384)
------------- -------------
------------- -------------
Franchise fees receivable (3)....................................................................... $ -- $20,500
------------- -------------
------------- -------------
Equity in loss of CBHS in excess of investment...................................................... $ -- $(7,344)
------------- -------------
------------- -------------
Prepaid CHARTER call center management fees......................................................... $ -- $ 3,937
------------- -------------
------------- -------------
</TABLE>
- ------------------------
(1) Based on the original 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 nine months ended
June 30, 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 nine months ending
June 30, 1998, 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 to
CBHS.
(3) CBHS has not paid its Franchise Fee obligation in full for February 1998
through June 30, 1998.
13
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)
NOTE G--INVESTMENT IN CBHS (CONTINUED)
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 the Company would have, among other
things, sold the Company's franchise operations, certain domestic provider
operations and certain other assets and operations. On July 15, 1998, the
Company announced that the terms of the CBHS Transactions were being revised to
reflect the current capital market environment and the continued pressure on
psychiatric hospital revenues and profitability. On August 6, 1998, the Company
announced that it was continuing negotiations with COI regarding the terms for a
sale of its ownership interest in CBHS to COI and that it was also considering
other alternatives for the disposition or retention of its ownership interest in
CBHS. If the Company elects to retain its ownership interest in CBHS, the
related franchise agreement would remain in effect. There can be no assurance
that the Company will be able to negotiate suitable revised terms to the CBHS
Transactions or be able to consummate the CBHS Transactions on such revised
terms.
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 5.0
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 if Allied achieves
specified earnings targets during 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 purchase price the Company paid for Allied is subject to increase or
decrease based on the operating performance of Allied during the three year
period following the closing. The adjustments will be computed based on EBITDA
(as defined in the Allied Purchase Agreement) from the consolidated operations
of Allied during each of the Year 1 Earn-Out Period, the Year 2 Earn-Out Period
and the Year 3 Earn-Out Period (each, as defined). "EBITDA," as defined in the
Allied Purchase Agreement, means the aggregate net revenue from the operations
of Allied, minus all expenses incurred in operating the business of Allied but
before interest, income taxes, depreciation and amortization, prepared in
accordance with generally accepted accounting principles, consistently applied,
subject to specified adjustments. "Year 1 Earn-Out Period" means the 12-month
period ending on November 30, 1998. "Year 2 Earn-Out Period" means the 12 month
period ending on November 30, 1999. "Year 3 Earn-Out Period" means the 12-month
period ending on November 30, 2000.
14
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)
NOTE H--ACQUISITIONS (CONTINUED)
With respect to the Year 1 Earn-Out Period, in the event the EBITDA for the
Year 1 Earn-Out Period (the "Year 1 EBITDA") is less than $10.0 million, then
the adjustment to the purchase price with respect to such period is an amount
equal to seven multiplied by the difference between the Year 1 EBITDA and $10.0
million. Such amount shall be paid to the Company from the portion of the
purchase price paid for Allied that was placed in escrow. In the event the Year
1 EBITDA is equal to or less than $11.0 million and equal to or greater than
$10.0 million, then there will be no adjustment to the purchase price with
respect to such period. In the event the Year 1 EBITDA is greater than $11.0
million, then the adjustment to the purchase price with respect to such period
is an amount equal to six multiplied by the difference between the Year 1 EBITDA
and $11.0 million. Such amount shall be paid in escrow for the benefit of the
sellers.
With respect to the Year 2 Earn-Out Period, in the event the EBITDA for the
Year 2 Earn-Out Period (the "Year 2 EBITDA") is equal to or less than the
greater of (i) $11.0 million or (ii) the Year 1 EBITDA (the greater of which
being the "Year 2 Threshold"), then the adjustment to the purchase price with
respect to such period is an amount equal to the sum of (i) six multiplied by
the difference between the Year 2 Threshold and the greater of (x) $11.0 million
or (y) the Year 2 EBITDA, plus (ii) an amount equal to seven multiplied by the
amount, if any, by which the Year 2 EBITDA is less than $10.0 million. Such
amount shall be paid to the Company from the portion of the purchase price paid
for Allied that was placed in escrow. In the event the Year 2 EBITDA is greater
than the Year 2 Threshold, then the adjustment to the purchase price with
respect to such period is the amount equal to six multiplied by the difference
between the Year 2 EBITDA and the Year 2 Threshold. Such amount shall be paid in
escrow for the benefit of the Sellers. If the Year 2 EBITDA is equal to or
greater than $10.0 million but less than or equal to $11.0 million, there will
be no adjustment to the purchase price with respect to such period.
With respect to the Year 3 Earn-Out Period, in the event the EBITDA for the
Year 3 Earn-Out Period (the"Year 3 EBITDA") is equal to or less than the greater
of (i) $11.0 million, (ii) the Year 1 EBITDA, or (iii) the Year 2 EBITDA (the
greatest of which being the "Year 3 Threshold"), then the adjustment to the
purchase price with respect to such period is an amount equal to the sum of (i)
four multiplied by the difference between the Year 3 Threshold and the greater
of (x) $11.0 million or (y) the Year 3 EBITDA, plus (ii) an amount equal to
seven multiplied by the amount, if any, by which the Year 3 EBITDA is less than
$10.0 million. Such amount shall be paid to the Company from the portion of the
purchase price paid for Allied that was placed in escrow. In the event the Year
3 EBITDA is greater than the Year 3 Threshold, then the adjustment to the
purchase price with respect to such period is the amount equal to four
multiplied by the difference between the Year 3 EBITDA and the Year 3 Threshold.
Such amount shall be paid to the Seller. If the Year 3 EBITDA is equal to or
greater than $10.0 million but less than or equal to $11.0 million, there will
be no adjustment to the purchase price with respect to such period.
The Company would record contingent consideration payable, if any, as
additional goodwill.
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.
15
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)
NOTE H--ACQUISITIONS (CONTINUED)
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 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 Company is obligated to make contingent payments under two separate
calculations (as previously described) as follows: in respect of each Contract
Year, the Company may be required to pay to Aetna the "Tranche 1 Payments" (as
defined) and the "Tranche 2 Payments" (as defined).
Upon the expiration of each Contract Year, the Tranche 1 Payment shall vest
with respect to such Contract Year in an amount equal to the product of (i) the
Tranche 1 Cumulative Incremental Members (as defined) for such Contract Year and
(ii) the Tranche 1 Multiplier (as defined) for such Contract Year. The vested
amount of Tranche 1 Payment shall be zero with respect to any Contract Year in
which the Tranche 1 Cumulative Incremental Members is a negative number.
Furthermore, in the event that the number of Tranche 1 Cumulative Incremental
Members with respect to any Contract Year is a negative number due to a decrease
in the number of Tranche 1 Cumulative Incremental Members for such Contract Year
(as compared to the immediately preceding Contract Year), Aetna will forfeit the
right to receive a certain portion (which may be none or all) of the vested and
unpaid amounts of the Tranche 1 Payment relating to preceding Contract Years.
"Tranche 1 Cumulative Incremental Members" means, with respect to any
Contract Year, (i) the number of Equivalent Members (as defined) serviced by the
Company during such Contract Year for Tranche 1 Members, minus (ii)(A) for each
Contract Year other than the initial Contract Year, the number of Equivalent
Members serviced by the Company for Tranche 1 Members during the immediately
preceding Contract Year or (B) for the initial Contract Year, the number of
Tranche 1 Members as of September 30, 1997, subject to certain upward
adjustments. There were 3,761,253 Tranche 1 Members for the initial Contract
Year, prior to such upward adjustments. "Tranche 1 Members" are members of
managed behavioral healthcare plans for whom the Company provides services in
any of specified categories of products or services. "Equivalent Members" for
any Contract Year equals the aggregate Member Months for which the Company
provides services to a designated category or categories of members during the
applicable Contract Year divided by 12. "Member Months" means, for each member,
the number of months for which the Company provides services and is compensated.
The "Tranche 1 Multiplier" is $80, $50, $40, $25, and $20 for the Contract Years
1998, 1999, 2000, 2001, and 2002, respectively.
For each Contract Year, the Company is obligated to pay to Aetna the lesser
of (i) the vested portion of the Tranche 1 Payment for such Contract Year and
the vested and unpaid amount relating to prior
16
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)
NOTE H--ACQUISITIONS (CONTINUED)
Contract Years as of the end of the immediately preceding Contract Year or (ii)
$25.0 million. To the extent that the vested and unpaid portion of the Tranche 1
Payment exceeds $25.0 million, the Tranche 1 Payment remitted to Aetna shall be
deemed to have been paid first from any vested but unpaid amounts from previous
Contract Years in order from the earliest Contract Year for which vested amounts
remain unpaid to the most recent Contract Year at the time of such calculation.
Except with respect to the Contract Year ending in 2002, any vested but unpaid
portion of the Tranche 1 Payment shall be available for payment to Aetna in
future Contract Years, subject to certain exceptions. All vested but unpaid
amounts of Tranche 1 Payments shall expire following the payment of the Tranche
1 Payment in respect to the Contract Year ending in 2002, subject to certain
exceptions. In no event shall the aggregate Tranche 1 Payments to Aetna exceed
$125.0 million.
Upon the expiration of each Contract Year, the Tranche 2 Payment shall be an
amount equal to the lesser of (a)(i) the product of (A) the Tranche 2 Cumulative
Members (as defined) for such Contract Year and (B) the Tranche 2 Multiplier (as
defined) applicable to such number of Tranche 2 Cumulative Members, minus (ii)
the aggregate of the Tranche 2 Payments paid to Aetna for all previous Contract
Years or (b) $35.0 million. The amount shall be zero with respect to any
Contract Year in which the Tranche 2 Cumulative Members is a negative number.
"Tranche 2 Cumulative Members" means, with respect to any Contract Year; (i)
the Equivalent Members serviced by the Company during such Contract Year for
Tranche 2 Members, minus (ii) the Tranche 2 Members as of September 30, 1997,
subject to certain upward adjustments. There were 936,391 Tranche 2 Members
prior to such upward adjustments. "Tranche 2 Members" means Members for whom the
Company provides products or services in the HMO category. The "Tranche 2
Multiplier" with respect to each Contract Year is $85 in the event that the
Tranche 2 Cumulative Members are less than 2,100,000, and $70 if more than of
equal to 2,100,000.
For each Contract Year, the Company shall pay to Aetna the amount of Tranche
2 Payment payable for such Contract Year. All rights to receive Tranche 2
Payment shall expire following the payment of the Tranche 2 Payment in respect
to the Contract Year ending in 2002, subject to certain exceptions.
Notwithstanding anything herein to the contrary, in no event shall the aggregate
Tranche 2 Payment to Aetna exceed $175.0 million, subject to certain exceptions.
The Company would record contingent consideration payable, if any, as
goodwill and identifiable intangible assets.
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.
17
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)
NOTE H--ACQUISITIONS (CONTINUED)
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.
(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 December 31, 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 nine months ended June
30, 1997 and 1998 has been prepared assuming the Crescent Transactions (as
defined), Allied acquisition, HAI acquisition,
18
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)
NOTE H--ACQUISITIONS (CONTINUED)
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 NINE MONTHS ENDED
--------------------------
<S> <C> <C>
JUNE 30, JUNE 30,
1997 1998
------------ ------------
Net revenue........................................................................... $ 1,158,515 $ 1,374,059
Income before extraordinary item(1)................................................... 12,466 12,776
Net income(1)(2)...................................................................... 9,516 12,776
Income per common share--basic:
Income before extraordinary item.................................................... 0.40 0.40
Net income.......................................................................... 0.30 0.40
Income per common share--diluted:
Income before extraordinary item.................................................... 0.39 0.40
Net income.......................................................................... 0.30 0.40
</TABLE>
- ------------------------
(1) Excludes expected unrealized cost savings related to the Integration Plan,
Managed Care integration costs (See Note J) and Loss on Crescent
Transactions.
(2) Excludes the extraordinary losses on early extinguishments of debt for the
nine months ended June 30, 1998, that were directly attributable to the
consummation of the Transactions.
PUBLIC SECTOR ACQUISITIONS
During fiscal 1998, the Company has acquired six businesses in its public
sector segment for an aggregate purchase price of approximately $53.0 million
(collectively, the "Public Sector Acquisitions"). The Public Sector Acquisitions
have been accounted for using the purchase method of accounting. The Public
Sector Acquisitions provide various residential and day services for individuals
with acquired brain injuries and for individuals with mental retardation and
developmental disabilities.
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 nine months ended June 30, 1997, and the
nine months ended June 30, 1998, the Company recorded reductions in malpractice
claim reserves of approximately $2.5 million and $7.5 million (fiscal 1997) and
$4.1 million (fiscal 1998), respectively, as a result of updated actuarial
estimates. 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
19
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)
NOTE I--CONTINGENCIES (CONTINUED)
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 which the Company expects to be finalized in the near future. Pursuant to
the tentative settlement, the Company would pay approximately $4.8 million,
which has been accrued. Furthermore, Charter Orlando (now operated by CBHS) will
enter into a Corporate Integrity Agreement with the Department of Health and
Human Services and will not 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 (the "Antitrust Case") 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 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
20
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)
NOTE I--CONTINGENCIES (CONTINUED)
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.
On May 26, 1998, the counsel representing the plaintiffs in the Antitrust
Case filed an action in the United States District Court for the District of New
Jersey on behalf of a group of thirteen plaintiffs who also purport to represent
an uncertified class of psychiatrists, psychologists and clinical social
workers. This complaint alleges substantially the same violations of federal
antitrust laws by the same nine managed behavioral healthcare organizations that
are the defendants in the Antitrust Case. The Defendants believe the factual and
legal issues involved in this case are substantially similar to those involved
in the Antitrust Case. The Defendants intend to vigorously defend themselves in
this litigation. 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 200 employees had
been involuntarily terminated pursuant to the Integration Plan as of June 30,
1998, and approximately 250 positions had been eliminated by normal attrition
through June 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 December 31, 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 June
30, 1998, 20 offices had been specifically identified for closure and 20 to 25
additional offices are under consideration for closure. The Company expects to
complete the specific identification of remaining office closures by December
31, 1998.
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
21
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)
NOTE J--MANAGED CARE INTEGRATION PLAN AND COSTS (CONTINUED)
represent those portions of the Integration Plan obligations that were
measurable as of June 30, 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, JUNE 30,
TYPE OF COST 1997 ADDITIONS PAYMENTS (1) 1998
- ---------------------------------------------------- --------------- ----------- ------------ ---------
<S> <C> <C> <C> <C>
Employee termination benefits....................... $ -- $ 12,763 $ (3,520) $ 9,243
Facility closing costs.............................. -- 5,279 (188) 5,091
Other............................................... -- 244 (75) 169
----- ----------- ------------ ---------
$ -- $ 18,286 $ (3,783) $ 14,503
----- ----------- ------------ ---------
----- ----------- ------------ ---------
</TABLE>
- ------------------------
(1) Includes $2.7 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 nine months ended June 30, 1998, the Company
incurred approximately $1.2 million and $5.7 million, respectively, in other
integration costs, including long-lived asset impairments of approximately $2.2
million during the nine months ended June 30, 1998, and outside consulting costs
of approximately $0.9 million and $3.1 million for the quarter and the nine
months ended June 30, 1998, respectively. 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.
22
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
JUNE 30, 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 of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. 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
23
<PAGE>
offered growth and earnings prospects superior to those of the psychiatric
hospital industry. Therefore, the 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". The Company
undertook this 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 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.
24
<PAGE>
RESULTS OF OPERATIONS
REVENUE. Managed care revenue increased 301.1% to $389.3 million for the
quarter ended June 30, 1998, from $97.1 million in the same period in fiscal
1997 and increased 198.7% to $816.1 million for the nine months ended June 30,
1998 from $273.2 million in the same period in fiscal 1997. The increases
resulted primarily from the acquisitions of HAI, Allied and Merit in fiscal 1998
and revenue growth at Green Spring. The aggregate revenues of HAI, Allied and
Merit were approximately $260.7 million and $462.9 million for the quarter and
the nine months ended June 30, 1998, respectively. Green Spring revenues were
positively impacted by the award of several new contracts and acquisitions in
fiscal 1997 and fiscal 1998 and significant improvements in negotiated rates in
its TennCare contract in fiscal 1998.
Public sector revenue increased 61.9% to $37.4 million for the quarter ended
June 30, 1998, from $23.1 million in the same period in fiscal 1997 and
increased 49.8% to $96.5 million for the nine months ended June 30, 1998, from
$64.4 million in the same period in fiscal 1997. The increases were primarily
attributable to a 22.9% increase in placements in Mentor homes since June 30,
1997, to 3,270 individuals and revenue from fiscal 1998 acquisitions.
Healthcare franchising revenue was $15.0 million and $51.1 million for the
quarter and the nine months ended June 30, 1998, respectively, compared to $3.2
million for the quarter and the nine months ended June 30, 1997. The increase
resulted from the effect of the consummation of the Crescent transaction on June
17, 1997, resulting in only 14 days of franchise revenues in the fiscal 1997
periods.
Provider business revenue decreased 83.6% to $33.1 million for the quarter
ended June 30, 1998, from $201.5 million in the same period in fiscal 1997 and
decreased 85.4% to $99.4 million for the nine months ended June 30, 1998, from
$680.9 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 June 30, 1997 and 1998, the Company
recorded revenue of $2.5 million and $0.6 million, respectively, for settlements
and adjustments related to reimbursement issues with respect to psychiatric
hospitals owned or formerly owned by the Company. During the nine months ended
June 30, 1997 and 1998, the Company recorded revenue of $16.2 million and $2.7
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
286.0% to $342.3 million for the quarter ended June 30, 1998, from $88.7 million
in the same period in fiscal 1997 and increased 193.9% to $725.4 million for the
nine months ended June 30, 1998, from $246.8 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 $233.3 million and $414.9
million for the quarter and the nine months ended June 30, 1998, respectively,
and from continued growth at Green Spring.
Public sector salaries, cost of care and other operating expenses increased
64.6% to $33.2 million for the quarter ended June 30, 1998, from $20.1 million
in the same period in fiscal 1997 and increased 54.1% to $86.7 million for the
nine months ended June 30, 1998, from $56.3 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 expenses from fiscal 1998
acquisitions.
Healthcare franchising operating expenses were $1.8 million and $6.7 million
for the quarter and the nine months ended June 30, 1998. The Company recorded
$0.5 million of expenses with respect to the healthcare franchising business
during the quarter and the nine months ended June 30, 1997, after the
consummation of the Crescent Transactions.
25
<PAGE>
Salaries, cost of care and other operating expenses attributable to the
provider business decreased 80.9% to $27.9 million for the quarter ended June
30, 1998, from $145.7 million in the same period in fiscal 1997 and decreased
84.7% to $77.3 million for the nine months ended June 30, 1998 from $504.2
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 nine months ended June 30, 1997,
the Company recorded reductions of expenses of approximately $2.5 million and
$7.5 million, respectively, compared to reductions of $4.1 million for the nine
months ended June 30, 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 89.9%, or $10.9 million, for the quarter ended June
30, 1998, compared to the same period in fiscal 1997 and decreased 93.7% or
$44.5 million for the nine months ended June 30, 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 increased
47.2%, or $5.7 million, for the quarter ended June 30, 1998, compared to the
same period in fiscal 1997 and decreased 1.5% or $0.6 million for the nine
months ended June 30, 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 $10.5 million and $16.7 million, in
aggregate, for the quarter and the nine months ended June 30, 1998,
respectively.
INTEREST, NET. Interest expense, net, increased 93.7%, or $11.8 million,
for the quarter ended June 30, 1998, compared to the same period in fiscal 1997
and increased 25.5% or $10.0 million for the nine months ended June 30, 1998,
compared to the same period in fiscal 1997. The increases were primarily the
result of interest expense incurred on borrowings used to fund the Merit
acquisition and related transactions offset by 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.
OTHER ITEMS. Stock option expense for the quarter and the nine months ended
June 30, 1998, decreased $1.8 million and $6.7 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 $1.2 million and
$12.3 million for the quarter and the nine months ended June 30, 1998. See Note
J--"Managed Care Integration Plan and Costs".
The Company recorded equity in the loss of CBHS of $7.2 million and $24.2
million for the quarter and the nine months ended June 30, 1998, respectively
compared to $0.4 million for the quarter and the nine months ended June 30,
1997. See Note G--"Investment in CBHS".
The Company recorded unusual items, net, of $(1.0) million and $0.4 million,
during the quarter and the nine months ended June 30, 1997, respectively, which
consisted of a $2.6 million and a $5.4 million pre-tax gain on the sale of
previously closed psychiatric hospitals during the quarter and the nine months
ended
26
<PAGE>
June 30, 1997, respectively, offset by a $4.2 million charge for the closure of
three psychiatric hospitals and one general hospital during the nine months
ended June 30, 1997, and a $1.6 million charge related to the termination of an
agreement to sell the Company's European Hospitals during the quarter and the
nine months ended June 30, 1997. The Company recorded unusual items, net, of
$(3.0) million, during the quarter and the nine months ended June 30, 1998, for
the net gain on the sale of psychiatric hospitals that were previously closed.
The Company's effective income tax rate increased to 47.3% for the nine
months ended June 30, 1998, respectively, compared to 40% in the fiscal 1997
periods. The increase was primarily attributable to non-deductible goodwill
amortization of approximately $6.2 million resulting from the Merit acquisition
in fiscal 1998.
Minority interest decreased $1.3 million and $1.9 million during the quarter
and the nine months ended June 30, 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 $2.3 million and $5.3 million during the quarter and the nine
months ended June 30, 1997, respectively, and $33.0 million during the nine
months ended June 30, 1998, related primarily to the termination of its then
existing credit agreements 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 would result
in charges to income for the costs attributable to the closures, which would
result in additional losses in the equity in loss 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
27
<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 and fiscal 1999 operations prepared by
management of CBHS and results of operations through June 30, 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 and fiscal
1999. The Company currently estimates that CBHS will be able to pay
approximately $40.0 million to $45.0 million of the Franchise Fees in fiscal
1998, a $33.3 million to $38.3 million shortfall relative to amounts payable
under the Master Franchise Agreement. The Company also estimates that CBHS will
be able to pay $15.0 million to $25.0 million of the Franchise Fees in fiscal
1999, a $53.3 million to $63.3 million shortfall relative to amounts payable
under the Master Franchise Agreement. The Company may record bad debt expense
related to Franchise Fees receivable from CBHS in fiscal 1999 and future periods
if CBHS does not generate sufficient cash flows to 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 has initiated
the exercise of certain rights available to it under the Master Franchise
Agreement. The Company's rights include (i) reducing by 5% the expenses provided
in the CBHS annual operating budget, (ii) monthly approval of expenditures by
CBHS (capital and operating) and (iii) transfer of management of CBHS to the
Company.
The Company may elect to retain its ownership interest in CBHS if it cannot
negotiate suitable revised terms to the CBHS Transactions. If the Company elects
to retain its ownership interest in CBHS, it would be required to record a
charge against earnings of approximately $1.5 million to $2.0 million for CBHS
Transaction costs incurred to date. In addition, the Company's exericse of its
rights under the Master Franchise Agreement may result in charges to CBHS
income, which would result in additional losses in the equity in loss of CBHS
for the Company.
IMPACT OF THE MERIT ACQUISITION ON RESULTS OF OPERATIONS
As a result of the Merit acquisition, the Company has over 61 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 cost savings.
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 until the Integration Plan is completed.
HISTORICAL LIQUIDITY AND CAPITAL RESOURCES
OPERATING ACTIVITIES. The Company's net cash provided by (used in)
operating activities was approximately $5.2 million and $(5.4) million for the
nine months ended June 30, 1997 and 1998, respectively. Operating cash flows for
the nine months ended June 30, 1998, were adversely affected by unpaid
28
<PAGE>
Franchise Fees of $20.5 million, the prepayment of CHARTER call center
management fees to CBHS of $3.9 million, insurance settlement payments of $10.8
million and payments of unpaid claims (primarily medical malpractice) of
approximately $11.4 million.
INVESTING ACTIVITIES. The Company utilized approximately $1.0 billion in
cash, net of cash acquired, for acquisitions and investments in businesses,
including the Allied, HAI, Merit and Public Sector acquisitions, during the nine
months ended June 30, 1998. In addition, the Company consummated the Crescent
Transactions on June 17, 1997, which resulted in approximately $378.0 million of
proceeds, net of transaction costs, through June 30, 1998.
FINANCING ACTIVITIES. The Company borrowed approximately $203.6 million,
net of issuance costs, during the nine months ended June 30, 1997, primarily to
refinance its then existing credit agreements. The Company borrowed
approximately $1.2 billion during the nine months ended June 30, 1998, primarily
to fund the Transactions. Also, the Company extinguished the Old Notes for
approximately $418.4 million during the nine months ended June 30, 1998.
As of June 30, 1998, the Company had approximately $112.5 million of
availability under the Revolving Facility of the New Credit Agreement. The
Company was in compliance with all debt covenants as of June 30, 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. 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...... $ 19.8
2000...... 32.4
2001...... 38.9
2002...... 49.4
2003...... 92.0
2004...... 156.5
2005...... 131.8
2006...... 29.2
2007...... --
2008...... 625.0
</TABLE>
In addition, any amounts outstanding under the Revolving 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 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
29
<PAGE>
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.
POTENTIAL PURCHASE PRICE ADJUSTMENTS. During December 1997, the Company
purchased HAI and Allied for approximately $121.1 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 as follows: In respect of each Contract Year,
the Company may be required to pay to Aetna the Tranche 1 Payments and the
Tranche 2 Payments. "Contract Year" means each of the twelve-month periods
ending on the last day of December in 1998, 1999, 2000, 2001, and 2002.
Upon the expiration of each Contract Year, the Tranche 1 Payment shall vest
with respect to such Contract Year in an amount equal to the product of (i) the
Tranche 1 Cumulative Incremental Members for such Contract Year and (ii) the
Tranche 1 Multiplier for such Contract Year. The vested amount of Tranche 1
Payment shall be zero with respect to any Contract Year in which the Tranche 1
Cumulative Incremental Members is a negative number. Furthermore, in the event
that the number of Tranche 1 Cumulative Incremental Members with respect to any
Contract Year is a negative number due to a decrease in the number of Tranche 1
Cumulative Incremental Members for such Contract Year (as compared to the
immediately preceding Contract Year), Aetna will forfeit the right to receive a
certain portion (which may be none or all) of the vested and unpaid amounts of
the Tranche 1 Payment relating to preceding Contract Years.
Tranche 1 Cumulative Incremental Members means, with respect to any Contract
Year, (i) the number of Equivalent Members (as defined) serviced by the Company
during such Contract Year for Tranche 1 Members, minus (ii) (A) for each
Contract Year other than the initial Contract Year, the number of Equivalent
Members serviced by the Company for Tranche 1 Members during the immediately
preceding Contract Year or (B) for the initial Contract Year, the number of
Tranche 1 Members as of September 30, 1997, subject to certain upward
adjustments. There were 3,761,253 Tranche 1 Members for the initial Contract
Year, prior to such upward adjustments. Tranche 1 Members are members of managed
behavioral healthcare plans for whom the Company provides services in any of
specified categories of products or services. Equivalent Members for any
Contract Year equals the aggregate Member Months for which the Company provides
services to a designated category or categories of members during the applicable
Contract Year divided by 12. Member Months means, for each member, the number of
months for which the Company provides services and is compensated. The Tranche 1
Multiplier is $80, $50, $40, $25, and $20 for the Contract Years 1998, 1999,
2000, 2001, and 2002, respectively.
For each Contract Year, the Company is obligated to pay to Aetna the lesser
of (i) the vested portion of the Tranche 1 Payment for such Contract Year and
the vested and unpaid amount relating to prior Contract Years as of the end of
the immediately preceding Contract Year or (ii) $25.0 million. To the extent
that the vested and unpaid portion of the Tranche 1 Payment exceeds $25.0
million, the Tranche 1 Payment remitted to Aetna shall be deemed to have been
paid first from any vested but unpaid amounts from previous Contract Years in
order from the earliest Contract Year for which vested amounts remain unpaid to
the most recent Contract Year at the time of such calculation. Except with
respect to the Contract Year ending in 2002, any vested but unpaid portion of
the Tranche 1 Payment shall be available for payment to Aetna in future Contract
Years, subject to certain exceptions. All vested but unpaid amounts of Tranche 1
Payments shall expire following the payment of the Tranche 1 Payment in respect
to the Contract Year ending in 2002, subject to certain exceptions. In no event
shall the aggregate Tranche 1 Payments to Aetna exceed $125.0 million.
30
<PAGE>
Upon the expiration of each Contract Year, the Tranche 2 Payment shall be an
amount equal to the lesser of (a) (I) the product of (A) the Tranche 2
Cumulative Members (as defined) for such Contract Year and (B) the Tranche 2
Multiplier (as defined) applicable to such number of Tranche 2 Cumulative
Members, minus (II) the aggregate of the Tranche 2 Payments paid to Aetna for
all previous Contract Years or (b) $35.0 million. The amount shall be zero with
respect to any Contract Year in which the Tranche 2 Cumulative Members is a
negative number.
Tranche 2 Cumulative Members means, with respect to any Contract Year, (i)
the Equivalent Members serviced by the Company during such Contract Year for
Tranche 2 Members, minus (ii) the Tranche 2 Members as of September 30, 1997,
subject to certain upward adjustments. There were 936,391 Tranche 2 Members
prior to such upward adjustments. Tranche 2 Members means Members for whom the
Company provides products or services in the HMO category. The Tranche 2
Multiplier with respect to each Contract Year is $65 in the event that the
Tranche 2 Cumulative Members are less than 2,100,000, and $70 if more than or
equal to 2,100,000.
For each Contract Year, the Company shall pay to Aetna the amount of Tranche
2 Payment payable for such Contract Year. All rights to receive Tranche 2
Payment shall expire following the payment of the Tranche 2 Payment in respect
to the Contract Year ending in 2002, subject to certain exceptions.
Notwithstanding anything herein to the contrary, in no event shall the aggregate
Tranche 2 Payment to Aetna exceed $175.0 million, subject to certain exceptions.
The purchase price the Company paid for Allied is subject to increase or
decrease based on the operating performance of Allied during the three year
period following the closing. The Company may be required to pay up to $40.0
million during the three years following the closing of the Allied acquisition
based on Allied's performance relative to certain earnings targets. The
adjustments will be computed based on EBITDA (as defined in the Allied Purchase
Agreement) from the consolidated operations of Allied during each of the Year 1
Earn-Out Period, the Year 2 Earn-Out Period and the Year 3 Earn-Out period.
"EBITDA," as defined in the Allied Purchase Agreement, means the aggregate net
revenue from the operations of Allied, minus all expenses incurred in operating
the business of Allied but before interest, income taxes, depreciation and
amortization, prepared in accordance with generally accepted accounting
principles, consistently applied, subject to specified adjustments. "Year 1
Earn-Out Period means the 12-month period ending on November 30, 1998. Year 2
Earn-Out Period means the 12-month Period ending on November 30, 1999. Year 3
Earn-Out Period means the 12-month period ending on November 30, 2000.
With respect to the Year 1 Earn-Out Period, in the event the EBITDA for the
Year 1 Earn-Out Period is less than $10.0 million, then the adjustment to the
purchase price with respect to such period is an amount equal to seven
multiplied by the difference between the Year 1 EBITDA and $10.0 million. Such
amount shall be paid to the Company from the portion of the purchase price paid
for Allied that was placed in escrow. In the event the Year 1 EBITDA is equal to
or less than $11.0 million and equal to or greater than $10.0 million, then
there will be no adjustment to the purchase price with respect to such period.
In the event the Year 1 EBITDA is greater than $11.0 million, then the
adjustment to the purchase price with respect to such period is an amount equal
to six multiplied by the difference between the Year 1 EBITDA and $11.0 million.
Such amount shall be paid in escrow for the benefit of the sellers.
With respect to the Year 2 Earn-Out Period, in the event the EBITDA for the
Year 2 Earn-Out Period is equal to or less than the greater of (i) $11.0 million
or (ii) the Year 1 EBITDA (the greater of which being the Year 2 Threshold),
then the adjustment to the purchase price with respect to such period is an
amount equal to the sum of (i) six multiplied by the difference between the Year
2 Threshold and the greater of (x) $11.0 million or (y) the Year 2 EBITDA, plus
(ii) an amount equal to seven multiplied by the amount, if any, by which the
Year 2 EBITDA is less than $10.0 million. Such amount shall be paid to the
Company from the portion of the purchase price paid for Allied that was placed
in escrow. In the event the Year 2 EBITDA is greater than the Year 2 Threshold,
then the adjustment to the purchase price with
31
<PAGE>
respect to such period is the amount equal to six multiplied by the difference
between the Year 2 EBITDA and the Year 2 Threshold. Such amount shall be paid in
escrow for the benefit of the sellers. If the Year 2 EBITDA is equal to or
greater than $10.0 million but less than or equal to $11.0 million, there will
be no adjustment to the purchase price with respect to such period.
With respect to the Year 3 Earn-Out Period, in the event the EBITDA for the
Year 3 Earn-Out Period is equal to or less than the greater of (i) $11.0
million, (ii) the Year 1 EBITDA, or (iii) the Year 2 EBITDA (the greatest of
which being the Year 3 Threshold), then the adjustment to the purchase price
with respect to such period is an amount equal to the sum of (i) four multiplied
by the difference between the Year 3 Threshold and the greater of (x) $11.0
million of (y) the Year 3 EBITDA, plus (ii) an amount equal to seven multiplied
by the amount, if any, by which the Year 3 EBITDA is less than $10.0 million.
Such amount shall be paid to the Company from the portion of the purchase price
paid for Allied that was placed in escrow. In the event the Year 3 EBITDA is
greater than the Year 3 Threshold, then the adjustment to the purchase price
with respect to such period is the amount equal to four multiplied by the
difference between the Year 3 EBITDA and the Year 3 Threshold. Such amount shall
be paid to the sellers. If the Year 3 EBITDA is equal to or greater than $10.0
million but less than or equal to $11.0 million, there will be no adjustment to
the purchase price with respect to such period.
In connection with Merit's acquisition of 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 June 30, 1998, the Company had approximately $112.5 million
of availability under the Revolving Facility. The Company currently estimates
that it will spend approximately $50.0 million for capital expenditures in
fiscal 1999. The majority of the Company's anticipated capital expenditures
relate to management information systems and related equipment. The Company
believes that the cash flow generated from its operations, together with amounts
available for borrowing under the New Credit Agreement and its ability to issue
debt and equity securities, which the Company believes it could issue under
current market conditions, 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. However, 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.
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.
32
<PAGE>
- 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 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 1999 to modify internal use
software. The Company expects to spend approximately $1.6 million in the
aggregate during fiscal 1998 and 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.
33
<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 6. -- EXHIBITS AND REPORTS ON FORM 8-K
<TABLE>
<S> <C>
(a) Exhibits
10(a) Employment Agreement, dated June 25, 1998 between the Company and Henry T.
Harbin, M.D., President and Chief Executive Officer of the Company.
27 Financial Data Schedule
</TABLE>
(b) Reports on Form 8-K
None
34
<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: August 12, 1998 /s/ CRAIG L. MCKNIGHT
--------------------------------------------
Craig L. McKnight
EXECUTIVE VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER
Date: August 12, 1998 /s/ JEFFREY T. HUDKINS
--------------------------------------------
Jeffrey T. Hudkins
VICE PRESIDENT AND CONTROLLER
(PRINCIPAL ACCOUNTING OFFICER)
</TABLE>
35
<PAGE>
EMPLOYMENT AGREEMENT
THIS EMPLOYMENT AGREEMENT ("Agreement") is made and entered into by and
between Henry T. Harbin, M.D., an individual ("Officer"), and Magellan Health
Services, Inc., a Delaware corporation ("Employer").
WHEREAS, Employer desires to retain the services of Officer and Officer
desires to render services to Employer; and
WHEREAS, Officer has been employed by Green Spring Health Services, Inc.
("Green Spring") and, in that regard, has entered into written agreements with
Green Spring including, but not limited to, that certain Employment Agreement of
February 28, 1996, that certain letter agreement of November 9, 1993, and that
certain amendment to the letter agreement which amendment is dated September 19,
1994; and
WHEREAS, Officer likewise has entered into a certain Compensation Agreement
with Employer dated September 30, 1996; and
WHEREAS, Officer and Employer intend to enter into this Agreement for
purposes of, among other things, documenting the terms of Officer's employment
with Employer and terminating any and all remaining obligations of Green Spring
or Employer as set forth in prior agreements;
NOW, THEREFORE, in consideration of the mutual covenants contained in this
Agreement, the parties agree as follows:
STATEMENT OF AGREEMENT
1. Employment. Employer agrees to employ Officer, and Officer accepts
such employment in accordance with the terms of this Agreement, for an initial
term of three years commencing as of March 18, 1998 and ending, unless
terminated earlier in accordance with the provisions of this Agreement, on March
17, 2001.
2. Position and Duties of Officer. Officer will serve as President and
Chief Executive Officer of Employer and, subject to election by the shareholders
of Employer, a member of the Board of Directors. Employer agrees that Officer's
duties under this Agreement will be the usual and customary duties of a Chief
Executive Officer and, consistent with the foregoing, as are determined from
time to time by the Board of Directors, and will not be inconsistent with the
provisions of the Certificate of Incorporation of Employer or applicable law.
<PAGE>
3. Time Devoted and Location of Officer.
(a) Officer will devote his full business time and energy to the
business affairs and interests of Employer and will use his best efforts and
abilities to promote Employer's interests. Officer agrees that he will
diligently endeavor to perform services contemplated by this Agreement in a
manner consistent with his corporate title and in accordance with the policies
and directives established by Employer's Board of Directors.
(b) Officer's primary business office will be located in Columbia,
Maryland.
(c) Officer may serve as an officer, director, agent or employee
of any direct or indirect subsidiary or other affiliate of Employer but may
not serve as an officer, director, agent or employee of any other business
enterprise without the written approval of the Board; provided, that Officer
may make and manage personal business investments of his choice (and, in so
doing, may serve as an officer, director, agent or employee of entities and
business enterprises that are related to such personal business investments)
and serve in any capacity with any civic, educational or charitable
organization, or any governmental entity or trade association, without
seeking or obtaining such written approval of the Board, if such activities
and services do not significantly interfere or conflict with the performance
of his duties under this Agreement.
4. Compensation.
(a) Base Salary. Employer will pay Officer a base salary in the
amount of Seven Hundred Thousand Dollars per year, which amount will be paid
in semi-monthly intervals less appropriate withholdings for federal and state
taxes and other deductions authorized by Officer. Such salary will be
subject to review and adjustment by Employer's Board of Directors, or its
Compensation Committee, from time to time consistent with prevailing
practices of Employer.
(b) Signing and Retention Bonus. Officer will receive a
signing/retention bonus of Seven Hundred Thousand Dollars. This bonus will
be paid in the following manner: fifty percent upon Officer's execution of
this Agreement and fifty percent on March 18, 1999. Officer understands that
he will not be entitled to receive the second payment of this bonus if his
employment with Employer is terminated prior to March 18, 1999 pursuant to
Sections 6(a)(iii), 6(a)(iv) or 6(a)(v).
(c) Annual Bonus. Officer also will be eligible to receive an annual
bonus in an amount between fifty percent and one hundred percent of his base
salary conditioned upon he and/or Employer meeting certain goals or objectives
to be established for this purpose by the Board or its Compensation Committee.
2
<PAGE>
(d) Stock Options. Upon his execution of this Agreement, Officer
will receive a grant for 200,000 stock options under the 1998 Magellan Health
Services, Inc. Stock Option Plan. These stock options will all be priced at
$22.4688 and will vest as follows: 66,667 options on March 18, 1998; 66,666
options on March 18, 1999; and 66,666 options on March 18, 2000. Except as
provided in this Section, the terms and conditions of the stock options awarded
to Officer pursuant to this Agreement will be governed by any applicable stock
option agreement between Officer and Employer and by the 1998 Magellan Health
Services, Inc. Stock Option Plan.
(e) Executive Benefits. Officer will be eligible to participate
in Employer's Executive Benefit Plan commensurate with his position. Officer
will receive separate information detailing the terms of the Executive
Benefit Plan and the terms of that plan will control. Officer also will be
eligible to participate in any applicable annual incentive plan and stock
option plan. Officer will be entitled during the term of this Agreement to
such other benefits of employment with Employer as are now or may later be in
effect for salaried officers of Employer at Officer's level.
5. Expenses. During the term of this Agreement, Employer will
reimburse Officer promptly for all reasonable travel, entertainment, parking,
business meetings and similar expenditures incurred in pursuance and
furtherance of Employer's business upon receipt of reasonable supporting
documentation as required by Employer's policies applicable to its officers
generally.
6. Termination.
(a) Termination Due to Resignation and Termination For Cause.
Except as otherwise set forth in this Agreement, this Agreement, Officer's
employment, and all of Officer's rights to receive compensation and benefits
from Employer, will terminate upon the occurrence of any of the following
events: (i) the effective date of Officer's resignation without good reason,
or (ii) termination for cause at the discretion of Employer under the
following circumstances:
(i) The death of Officer;
(ii) The disability of Officer as defined in Section 6(d);
(iii) The deliberate and intentional refusal to perform
Officer's duties for Employer as provided in Sections 2 or 3. If Employer
determines that Officer has deliberately or intentionally failed to perform
his duties for Employer as provided in Sections 2 or 3, Employer will notify
Officer in writing of the reasons for its determination and will provide
Officer a reasonable period in which to either contest the determination or
to correct the defects in performance, but in no event more than thirty days;
(iv) Officer has breached or otherwise failed to comply with
the provisions of Section 9; or
3
<PAGE>
(v) Officer has committed an act of dishonesty, fraud,
misrepresentation or other acts of moral turpitude which in the reasonable
opinion of the Board of Directors of Employer causes it to conclude that the
continuation of employment is not in the best interest of Employer.
(b) Termination Without Cause. Employer may terminate this
Agreement without cause at any time by giving thirty days' prior written
notice to Officer. If Employer terminates this Agreement without cause,
Employer may direct Officer to immediately cease providing services. If
Employer terminates this Agreement without cause, Employer will pay to
Officer an amount equal to three times his base salary. This amount will be
paid as follows: (i) Officer will receive a lump sum payment in an amount
equal to two times his base salary, less taxes and other normal withholdings,
immediately upon the effective date of his termination, and (ii) Officer
will receive an amount equal to his base salary, less taxes and other normal
withholdings, to be paid in accordance with Employer's normal payroll
procedures over a period of one year immediately following the effective date
of Officer's termination. In addition, any stock option or other stock-based
compensation plan will be governed by the terms of such plans (and any
related stock option or similar agreements) and the portion or portions of
any bonus or other cash incentive compensation that had been accrued with
respect to Officer on the books of Employer through the date of termination
pursuant to this Section 6(b) or otherwise will be paid to Officer in
accordance with the applicable plan.
(c) Termination by Officer for Good Reason. Officer may terminate
this Agreement, and his employment with Employer, for "good reason" upon the
occurrence of any of the following:
(i) the assignment to Officer of any duties inconsistent with
the status of President and Chief Executive Officer of Employer, or a
substantial alteration in the nature or status of his responsibilities from
those in effect upon his execution of this Agreement;
(ii) a reduction by Employer of Officer's annual base salary
as in effect from time to time during the term of this Agreement;
(iii) the failure of Employer to comply with Section 4; or
(iv) any material breach of this Agreement by Employer.
Prior to terminating this Agreement pursuant to this Section, Officer
will give to Employer written notice of his "good reason" for terminating
this Agreement and provide Employer with a reasonable period in which to
contest or correct the "good reason", but in no event less than thirty days.
In the event of a termination for "good reason" pursuant to this Section,
Officer will be entitled to receive all compensation and benefits provided
for in this Agreement for a termination by Employer without cause.
4
<PAGE>
(d) Disability. Officer will be deemed to be "disabled" or to
suffer from a "disability" within the meaning of Section 6(a)(ii) if, because
of a physical or mental impairment, Officer has been unable to perform the
essential functions of his position for a period of 180 consecutive days, or
if Officer reasonably can be expected to be unable to perform the essential
functions of his position for such period. "Essential duties" include,
without limitation, travel to company meetings and functions, and all other
duties customarily performed by corporate executives generally occupying
similar positions as Officer. Upon termination of Officer's employment
pursuant to Section 6(a)(ii), Officer will be entitled to receive from
Employer an amount equal to sixty percent of Officer's base salary payable
over the greater of the two years immediately following Officer's termination
or the remainder of the term of this Agreement.
(e) Effect of Termination. Except as otherwise provided for in
this Section 6, upon termination of this Agreement, all rights and
obligations under this Agreement will cease except for the rights and
obligations under Sections 4 and 5 to the extent Officer has not been
compensated or reimbursed for services performed prior to termination (the
amount to be prorated for the portion of the pay period prior to
termination); the rights and obligations under Sections 7, 8, 9, 10 and 11;
and all procedural and remedial provisions of this Agreement. A termination
of this Agreement will constitute a termination of Officer's employment with
Employer.
(f) Termination Upon a Change of Control. Officer will be entitled
to terminate this Agreement upon a change of control and, subject to Section
7 hereof, will be entitled to all of the salary, benefits and other rights
provided in this Agreement as though the termination had been initiated by
Employer without cause. For purposes of this Agreement, a change of control
will take place upon the occurrence of any of the following events: (a) the
acquisition after the beginning of the term of this Agreement in one or more
transactions of beneficial ownership (within the meaning of Rule 13d-3(a)(1)
under the Securities Exchange Act of 1934, as amended (the "Exchange Act"))
by any person or entity (other than Officer) or any group of persons or
entities (other than Officer) who constitute a group (within the meaning of
Rule 13d-5 of the Exchange Act) of any securities of Employer such that as a
result of such acquisition such person or entity or group beneficially owns
(within the meaning of Rule 13d-3(a)(1) under the Exchange Act) more than
fifty percent of Employer's then outstanding voting securities entitled to
vote on a regular basis for a majority of the Board of Directors of Employer;
or (b) the sale of all or substantially all of the assets of Employer
(including, without limitation, by way of merger, consolidation, lease or
transfer) in a transaction (except for a sale-leaseback transaction) where
Employer or the holders of common stock of Employer do not receive (i) voting
securities representing a majority of the voting power entitled to vote on a
regular basis for the Board of Directors of the acquiring entity or of an
affiliate which controls the acquiring entity, or (ii) securities
representing a majority of the equity interest in the acquiring entity or of
an affiliate that controls the acquiring entity, if other than a corporation.
5
<PAGE>
7. Mandatory Reduction of Payments in Certain Events if a Change of
Control Occurs prior to January 1, 1999.
(a) Anything in this Agreement to the contrary notwithstanding, in
the event a Change of Control shall occur prior to January 1, 1999 and it
shall be determined that any payment or distribution by Employer to or for
the benefit of Officer (whether paid or payable or distributed or
distributable pursuant to the terms of this Agreement or otherwise) (a
"Payment") would be subject to the excise tax (the "Excise Tax") imposed by
Section 4999 of the Internal Revenue Code of a 1986, as amended (the "Code"),
then, prior to the making of any Payment to Officer, a calculation shall be
made comparing (i) the net benefit to Officer of the Payment after payment of
the Excise Tax, to (ii) the net benefit to Officer if the Payment had been
limited to the extent necessary to avoid being subject to the Excise Tax. If
the amount calculated under (i) above is less than the amount calculated
under (ii) above, then the Payment shall be limited to the extent necessary
to avoid being subject to the Excise Tax (the "Reduced Amount"). In that
event, Officer shall direct which Payments are to be modified or reduced.
(b) The determination of whether an Excise Tax would be imposed,
the amount of such Excise Tax, and the calculation of the amounts referred to
Section 7(a)(i) and (ii) above shall be made by Employer's regular
independent accounting firm or, at the election of Officer, another
nationally recognized independent accounting firm (the "Accounting Firm")
which shall provide detailed supporting calculations. All fees and expenses
of the Accounting Firm shall be borne solely by Employer. Any determination
by the Accounting Firm shall be binding upon Employer and Officer. As a
result of the uncertainty in the application of Section 4999 of the Code at
the time of the initial determination by the Accounting Firm hereunder, it is
possible that Payments which Officer was entitled to, but did not receive
pursuant to Section 7(a), could have been made without the imposition of the
Excise Tax ("Underpayment"). In such event, the Accounting Firm shall
determine the amount of the Underpayment that has occurred and any such
Underpayment shall be promptly paid by Employer to or for the benefit of
Officer, together with interest at the applicable federal rate provided for
in Section 7872(f)(2) of the Code.
8. Certain Additional Payments by Employer in the event of a Change of
Control on or after January 1, 1999.
(a) Anything in this Agreement to the contrary notwithstanding and
except as set forth below, in the event a Change of Control shall occur on or
after January 1, 1999 and it shall be determined that any payment or
distribution by Employer to or for the benefit of Officer (whether paid or
payable or distributed or distributable pursuant to the terms of this
Agreement or otherwise, but determined without regard to any additional
payments required under this Section 8) (a "Payment") would be subject to the
excise tax imposed by Section 4999 of the Code or any interest or penalties
are incurred by Officer with respect to such excise tax (such excise tax,
together with any such interest and penalties, are hereinafter collectively
referred to as the "Excise Tax"), then Officer shall be entitled to receive
an additional payment (a "Gross-Up Payment") in an amount such that
6
<PAGE>
after payment by Officer of all taxes (including any interest or penalties
imposed with respect to such taxes), including, without limitation, any
income taxes (and any interest and penalties imposed with respect thereto)
and Excise Tax imposed upon the Gross-Up Payment, Officer retains an amount
of the Gross-Up Payment equal to the Excise Tax imposed upon the Payments.
(b) Subject to the provisions of Section 8(c), all determinations
required to be made under this Section 8, including whether and when a
Gross-Up Payment is required and the amount of such Gross-Up Payment and the
assumptions to be utilized in arriving at such determination, shall be made
by Employer's regular independent accounting firm or, at the election of
Officer, another nationally recognized independent accounting firm (the
"Accounting Firm") which shall provide detailed supporting calculations both
to Employer and Officer within 15 business days of the receipt of notice from
Officer that there has been a Payment, or such earlier time as is requested
by Employer. All fees and expenses of the Accounting Firm shall be borne
solely by Employer. Any determination by the Accounting Firm shall be
binding upon Employer and Officer. As a result of the uncertainty in the
application of Section 4999 of the Code at the time of the initial
determination by the Accounting Firm hereunder, it is possible that Gross-Up
Payments which will not have been made by Employer should have been made
("Underpayment"), consistent with the calculations required to be made
hereunder. In the event that Employer exhausts its remedies pursuant to
Section 8(c) and Officer thereafter is required to make a payment of any
Excise Tax, the Accounting Firm shall determine the amount of the
Underpayment that has occurred and any such Underpayment shall be promptly
paid by Employer to or for the benefit of Officer, together with interest,
from the time of payment by Officer of such Excise Tax, at the applicable
federal rate provided for in Section 7872(f)(2) of the Code.
(c) Officer shall notify Employer in writing of any claim by the
Internal Revenue Service that, if successful, would require the payment by
Employer of the Gross-Up Payment. Such notification shall be given as soon
as practicable but no later than ten business days after Officer is informed
in writing of such claim and shall apprise Employer of the nature of such
claim and the date on which such claim is requested to be paid. Officer
shall not pay such claim prior to the expiration of the 30-day period
following the date on which it gives such notice to Employer (or such shorter
period ending on the date that any payment of taxes with respect to such
claim is due). If Employer notifies Officer in writing prior to the
expiration of such period that it desires to contest such claim, Officer
shall:
(i) give Employer any information reasonably requested by
Employer relating to such claim,
(ii) take such action in connection with contesting such claim
as Employer shall reasonably request in writing from time to time, including,
without limitation, accepting legal representation with respect to such claim by
an attorney
7
<PAGE>
reasonably selected by Employer, and designating such attorney as authorized to
act on Officer's behalf with respect to such examination, if necessary, through
a power of attorney,
(iii) cooperate with Employer in good faith in order effectively
to contest such claim, and
(iv) permit Employer to participate in any proceedings relating
to such claim;
provided, however, that Employer shall bear and pay directly all costs and
expenses (including additional interest and penalties) incurred in connection
with such contest and shall indemnify and hold Officer harmless, on an
after-tax basis, for any Excise Tax or income tax (including interest and
penalties with respect thereto) imposed as a result of such representation
and payment of costs and expenses. Without limitation of the foregoing
provisions of this Section 8(c), Employer shall control all proceedings taken
in connection with such contest and, at its sole option, may pursue or forgo
any and all administrative appeals, proceedings, hearings and conferences
with the taxing authority in respect of such claim and may, at its sole
option, either direct Officer to pay the tax claimed and sue for a refund or
contest the claim in any permissible manner, and Officer agrees to prosecute
such contest to a determination before any administrative tribunal, in a
court of initial jurisdiction and in one or more appellate courts, as
Employer shall determine; provided, however, that if Employer directs Officer
to pay such claim and sue for a refund, Employer shall advance the amount of
such payment to Officer, on an interest-free basis and shall indemnify and
hold Officer harmless, on an after-tax basis, from any Excise Tax or income
tax (including interest or penalties with respect thereto) imposed with
respect to such advance or with respect to any imputed income with respect to
such advance; and further provided that any extension of the statute of
limitations relating to payment of taxes for the taxable year of Officer with
respect to which such contested amount is claimed to be due is limited solely
to such contested amount. Furthermore, Employer's control of the contest
shall be limited to issues with respect to which a Gross-Up Payment would be
payable hereunder and Officer shall be entitled to settle or contest, as the
case may be, any other issue raised by the Internal Revenue Service or any
other taxing authority.
(d) If, after the receipt by Officer of an amount advanced by
Employer pursuant to Section 8(c), Officer becomes entitled to receive any
refund with respect to such claim, Officer shall (subject to Employer's
complying with the requirements of Section 8(c)) promptly pay to Employer the
amount of such refund (together with any interest paid or credited thereon
after taxes applicable thereto). If, after the receipt by Officer of an
amount advanced by Employer pursuant to Section 8(c), a determination is made
that Officer shall not be entitled to any refund with respect to such claim
and Employer does not notify Officer in writing of its intent to contest such
denial of refund prior to the expiration of 30 days after such determination,
then such advance shall be forgiven and shall not be required to be repaid
and the amount of such advance shall offset, to the extent thereof, the
amount of Gross-Up Payment required to be paid.
8
<PAGE>
9. Protection of Confidential Information/Non-Competition/
Non-Solicitation.
Officer covenants and agrees as follows:
(a) During the term of this Agreement and continuing for a period
of two years after the expiration or termination of this Agreement for any
reason, Officer will not use or disclose, directly or indirectly, for any
reason whatsoever or in any way, other than at the direction of Employer
during the course of Officer's employment or, thereafter, upon receipt of the
prior written consent of Employer, any confidential business information,
information that derives economic value from not being generally known to the
public, or trade secrets of Employer or any corporate affiliate or
subsidiary, including, but not limited to: lists of past, current or
potential customers; all systems, manuals, materials, processes and other
intellectual property of any type used in connection with business
operations; financial statements, cost reports and other financial
information; contract proposals and bidding information; rate and fee
structures; policies and procedures developed as part of a confidential
business plan; and management systems and procedures, including manuals and
supplements ("Confidential Information"). The obligation not to use or
disclose any of the Confidential Information will not apply, to: (i) any
Confidential Information known by Officer before commencing employment with
Employer and any predecessor or affiliated entities of Employer, or (ii)
Confidential Information which Officer obtains from a third party, provided
Officer has no actual or constructive knowledge or reason to suspect that the
third party obtained the Confidential Information by wrongful or
inappropriate means, or (iii) as to times following the termination of the
employment of Officer with Employer, any information that is or becomes
public knowledge, through no unauthorized action or inaction of Officer, and
that may be utilized by the public without any direct or indirect obligation
to Employer, but the termination of the obligation for non-use or
nondisclosure by reason of such information becoming public knowledge will
run only from the date such information becomes public knowledge. The
provisions above will be without prejudice to any rights or remedies of
Employer under any state or federal law protecting trade secrets or
confidential information.
(b) During the term of this Agreement and continuing for a period
of two years after the expiration or termination of this Agreement for any
reason, Officer will not, within a radius of fifty miles of any operation of
Employer or a corporate affiliate or subsidiary of Employer involved in the
same business as Employer, engage, directly or indirectly, as a manager,
consultant, salesperson, officer, director or in any other role involving
customer relations or senior management duties, in the business of behavioral
or other specialty health managed care services. This prohibition will
relate only to sites of operations of Employer or its corporate affiliates or
subsidiaries existing as of the date of the making of this Agreement. The
parties agree, however, that in consideration of the covenants made by
Employer in this Agreement, Employer will be entitled to provide an updated
list on an annual basis of sites of operations of Employer and its corporate
affiliates and subsidiaries which updated list will then constitute the
pertinent sites for interpreting the geographic scope of the restrictions set
forth in this Section. No failure to provide such a
9
<PAGE>
list, however, will establish a waiver or prejudice Employer's right to
provide a list at a later time.
(c) During the term of this Agreement and continuing for a period
of two years after the expiration or termination of this Agreement for any
reason, Officer will not solicit, or attempt to solicit, any current or
prospective customer of Employer or of any corporate affiliate or subsidiary
of Employer involved in the same business as Employer for the purpose of
promoting the delivery of behavioral or other specialty health managed care
services by an entity or person(s) other than Employer or a corporate
affiliate or subsidiary of Employer. For purposes of this Section, the term
"current customer" is defined as any entity or person(s) with whom Employer
or its corporate affiliates or subsidiaries has provided, or has contracted
to provide, behavioral or other specialty health managed care services during
the year preceding the expiration or termination of Officer's employment with
Employer provided Officer either has had personal contact with such customer
or received confidential business information about such customer. For
purposes of this Section, the term "prospective customer" is defined as (i)
any entity or person(s) with whom Employer or its corporate affiliates or
subsidiaries have actively solicited or made presentations or proposals to,
or negotiated with, to provide behavioral or other specialty health managed
care services during the year preceding the expiration or termination of
Officer's employment with Employer provided Officer had personal contact with
such prospective customer or received confidential business information about
such prospective customer, or (ii) any entity or person(s) with respect to
which Officer was actively engaged in the planning or targeting of such
entity or person(s) for purposes of soliciting behavioral or other specialty
health managed care services during the year preceding the expiration or
termination of Officer's employment with Employer.
(d) During the term of this Agreement and continuing for a period
of one year after the expiration or termination of this Agreement for any
reason, Officer will not, by himself or in conjunction with or on behalf of
any other person or entity, directly or indirectly, solicit or induce any
employee of Employer or any of its corporate affiliates or subsidiaries to
terminate his or her employment with Employer or any of its corporate
affiliates or subsidiaries. This prohibition will apply only to persons
employed by Employer or any of its corporate affiliates or subsidiaries
during the one year immediately prior to the expiration or termination of
this Agreement.
(e) Notwithstanding anything else set forth in this Agreement,
Officer's compliance with the terms of this Section 9 is an express condition
precedent to Officer's entitlement to any of the compensation and benefits
set forth in this Agreement. Absent such compliance, Officer will gain no
ownership or rights to said compensation and benefits.
10. Work Made for Hire. Officer agrees that any written program
materials, protocols, research papers and all other writings (the "Work"),
which Officer develops for the use of Employer or a corporate affiliate or
subsidiary during the term of this Agreement, will be considered "work made
for hire" within the meaning of the United States Copyright Act, Title 17,
United States Code, which vests all copyright interest in and to the Work in
10
<PAGE>
Employer. If, however, any court of competent jurisdiction finally declares
that the Work is not or was not a work made for hire as agreed, Officer
agrees to assign, convey, and transfer to the Employer all right, title and
interest Officer may presently have or may have or be deemed to have in and
to any such Work and in the copyright of such work including, but not limited
to, all rights of reproduction, distribution, publication, public
performance, public display and preparation of derivative works, and all
rights of ownership and possession of the original fixation of the Work and
any and all copies. Additionally, Officer agrees to execute any documents
necessary for Employer to record and/or perfect its ownership of the Work and
the applicable copyright. Notwithstanding anything to the contrary in this
Section 10, Section 10 will not apply to any writings Officer develops which
are not for the use of Employer or a corporate affiliate or subsidiary or are
in each instance specifically excluded in advance of publication from the
coverage of the foregoing by Employer's Board of Directors.
11. Property of Employer. Officer agrees that, upon the termination of
this Agreement, Officer will immediately surrender to Employer all property,
equipment, funds, lists, books, records and other materials of Employer or
any corporate affiliate or subsidiary in Officer's possession or control.
12. Governing Law. This Agreement and all issues relating to the
validity, interpretation and enforcement of this Agreement will be governed
by and interpreted under the laws of the State of Georgia except that the
validity, interpretation and enforcement of the provisions of Section 9 will
be governed by the laws of the State of Maryland.
13. Remedies. Employer and Officer agree that an actual or threatened
violation by Officer of the covenants and obligations set forth in Section 9,
10 and 11 will cause irreparable harm to Employer and that the remedy at law
for any such violation will be inadequate. Officer agrees, therefore, that
Employer will be entitled to appropriate equitable relief, including, but not
limited to, a temporary restraining order and a preliminary injunction,
without the necessity of posting a bond. The provisions of Sections 7, 8, 9,
10 and 11 will survive the termination of this Agreement in accordance with
the terms set forth in each Section.
14. Arbitration. Except for an action for injunctive relief as
described in Section 13, any disputes or controversies arising under this
Agreement will be settled by arbitration in Atlanta, Georgia, through the use
of and in accordance with the applicable rules of the American Arbitration
Association and pursuant to the Federal Arbitration Act. The determination
and findings of such arbitrator(s) will be binding on all parties and may be
enforced, if necessary, in any court of competent jurisdiction.
______
Officer's
Initials
15. Notices. Any notice or other communication required to be given to
any party under this Agreement will be given in writing and will be deemed to
have been fully
11
<PAGE>
given (a) if mailed, first class mail, postage prepaid, five days after it is
sent, (b) if sent by a nationally recognized next day delivery service that
obtains a receipt on delivery, the day after it is sent, and (c) in any other
case, when actually received. In each case, notice will be sent to the
following address (or such other addresses as will be given in writing pursuant
to this notice provision by any party to the other parties):
<TABLE>
<CAPTION>
<S> <C>
To Officer: Henry T. Harbin, M.D.
2002 Sulgrave Avenue
Baltimore, Maryland 21209
To Employer: Magellan Health Services, Inc.
3414 Peachtree Road, N.E.
Suite 1400
Atlanta, Georgia 30326
Attention: Chairman, Board of Directors
With a copy to: Magellan Health Services, Inc.
3414 Peachtree Road, N.E.
Suite 1400
Atlanta, Georgia 30326
Attention: General Counsel
</TABLE>
16. Headings. The headings of the Sections of this Agreement have been
inserted for convenience of reference only and will not be construed or
interpreted to restrict or modify any of the terms or provisions of this
Agreement.
17. Severability. If any provision of this Agreement is held to be
illegal, invalid or unenforceable under present or future laws effective
during the term of this Agreement, such provision will be fully severable and
this Agreement and each separate provision will be construed and enforced as
if such illegal, invalid or unenforceable provision had never comprised a
part of this Agreement, and the remaining provisions of this Agreement will
remain in full force and effect and will not be affected by the illegal,
invalid or unenforceable provision or by its severance from this Agreement.
In addition, in lieu of such illegal, invalid or unenforceable provision,
there will be added automatically as a part of this Agreement a provision as
similar in terms to such illegal, invalid or unenforceable provision as may
be possible and be legal, valid and enforceable, if such reformation is
allowable under applicable law.
18. Binding Effect. This Agreement will be binding upon and will inure
to the benefit of Employer's successors and assigns. This Agreement may not
be assigned by Officer to any other person or entity but may be assigned by
Employer to any subsidiary or affiliate of Employer or to any successor to or
transferree of all, or any part, of the stock or assets of Employer.
12
<PAGE>
19. Employer Policies, Regulations and Guidelines for Officers.
Employer may issue policies, rules, regulations, guidelines, procedures or
other informational material, whether in the form of handbooks, memoranda, or
otherwise, relating to its officers. These materials are general guidelines
for Officer's information and should not be construed to alter, modify or
amend this Agreement for any purpose whatsoever.
20. Negotiated Document. The parties acknowledge and agree that this
Agreement has been arrived at through a process of negotiation and no one
party should be deemed to be the drafter of this Agreement.
21. Entire Agreement. This Agreement embodies the entire agreement and
understanding between the parties with respect to its subject matter and
supersedes all prior agreements and understandings, whether written or oral,
relating to the same subject matter unless expressly provided otherwise
within this Agreement. Officer acknowledges and agrees that this Agreement
supersedes and extinguishes all obligations owed to Officer under any prior
agreement with Green Spring Health Services, Inc. or any other corporate
affiliate or subsidiary of Employer. Officer and Employer acknowledge and
agree that Employer's corporate affiliates and subsidiaries are express third
party beneficiaries of this Agreement. Without limitation, this Agreement
supersedes those agreements referenced in the second and third Whereas
clauses of this Agreement. No amendment or modification of this Agreement
will be valid unless made in writing and signed by each of the parties whose
rights, duties or obligations would in any way be affected by an amendment or
modification. No representations, inducements or agreements have been made
to induce either Officer or Employer to enter into this Agreement other than
those expressly set forth within this Agreement. Except as expressly set
forth herein, this Agreement is the sole source of rights and duties as
between Employer and Officer relating to the subject matter of this Agreement.
(signatures on following page)
13
<PAGE>
IN WITNESS WHEREOF, the parties have executed this Agreement on the 25th
day of June, 1998.
MAGELLAN HEALTH SERVICES, INC.
<TABLE>
<CAPTION>
<S> <C>
/s/ Henry T. Harbin, M.D. By: /s/ Robert W. Miller
_______________________________ _______________________________
HENRY T. HARBIN, M.D. Robert W. Miller
Chairman, Board of Directors
</TABLE>
14
<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> 9-MOS
<FISCAL-YEAR-END> SEP-30-1998
<PERIOD-END> JUN-30-1998
<CASH> 89,846,000
<SECURITIES> 0
<RECEIVABLES> 204,137,000
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 389,378,000
<PP&E> 231,436,000
<DEPRECIATION> 53,720,000
<TOTAL-ASSETS> 1,902,211,000
<CURRENT-LIABILITIES> 440,399,000
<BONDS> 1,189,131,000
0
0
<COMMON> 8,423,000
<OTHER-SE> 182,372,000
<TOTAL-LIABILITY-AND-EQUITY> 1,902,211,000
<SALES> 1,063,099,000
<TOTAL-REVENUES> 1,063,099,000
<CGS> 0
<TOTAL-COSTS> 909,353,000
<OTHER-EXPENSES> 67,657,000
<LOSS-PROVISION> 2,972,000
<INTEREST-EXPENSE> 49,336,000
<INCOME-PRETAX> 33,781,000
<INCOME-TAX> 15,972,000
<INCOME-CONTINUING> 12,746,000
<DISCONTINUED> 0
<EXTRAORDINARY> (33,015,000)
<CHANGES> 0
<NET-INCOME> (20,269,000)
<EPS-PRIMARY> (0.66)
<EPS-DILUTED> (0.65)
</TABLE>
