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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-K/A
AMENDMENT NO. 1
TO
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1998
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ________________ TO ________________
COMMISSION FILE NO. 1-6639
MAGELLAN HEALTH SERVICES, INC.
(Exact name of Registrant as specified in its charter)
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DELAWARE 58-1076937
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(State or other jurisdiction of (I.R.S. Employer
Identification
incorporation or organization) No.)
3414 PEACHTREE ROAD, N.E.
SUITE 1400
ATLANTA, GEORGIA 30326
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(Address of principal executive
offices) (Zip Code)
</TABLE>
Registrant's telephone number, including area code: (404) 841-9200
--------------------------
Securities registered pursuant to Section 12(b) of the Act:
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NAME OF EACH EXCHANGE ON WHICH
TITLE OF EACH CLASS REGISTERED
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Common Stock ($0.25 par value) New York Stock Exchange
</TABLE>
Securities registered pursuant to Section 12(g) of the Act: None
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 if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. /X/
The aggregate market value of the voting stock held by non-affiliates of the
Registrant at November 30, 1998 was approximately $264 million.
Indicate by check mark whether the Registrant has filed all documents and
reports required to be filed by Section 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
November 30, 1998 was 31,612,554.
DOCUMENTS INCORPORATED BY REFERENCE: The Registrant's Definitive Proxy
Materials on Schedule 14A relating to its Annual Meeting of Stockholders on
February 11, 1999 are incorporated by reference into Part III as set forth
herein.
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MAGELLAN HEALTH SERVICES, INC.
ANNUAL REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1998
TABLE OF CONTENTS
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PART I PAGE
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ITEM 1. Business................................................................... 2
ITEM 2. Properties................................................................. 36
ITEM 3. Legal Proceedings.......................................................... 36
ITEM 4. Submission of Matters to a Vote of Security Holders........................ 38
PART II
ITEM 5. Market Price for Registrant's Common Equity and Related Stockholder
Matters.................................................................... 39
ITEM 6. Selected Financial Data.................................................... 39
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations................................................................. 41
ITEM 8. Financial Statements and Supplementary Data................................ 55
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure................................................................. 55
PART III
ITEM 10. Directors and Executive Officers of the Registrant......................... 56
ITEM 11. Executive Compensation..................................................... 56
ITEM 12. Security Ownership of Certain Beneficial Owners and Management............. 56
ITEM 13. Certain Relationships and Related Transactions............................. 56
PART IV
ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K............ 56
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The undersigned Registrant hereby amends Items 8 and 14 of its Annual Report
on Form 10-K for the fiscal year ended September 30, 1998, to include the
audited financial statements of Choice Behavioral Health Partnership for the
year ended December 31, 1998.
PART I
ITEM 1. BUSINESS
Magellan Health Services, Inc. (the "Company"), which was incorporated in 1969
under the laws of the State of Delaware, is an international healthcare company.
The Company operates through five principal segments engaging in (i) the
behavioral managed healthcare business, (ii) the human services business, (iii)
the specialty managed healthcare business, (iv) the healthcare franchising
business and (v) the healthcare provider business. The Company's executive
offices are located at Suite 1400, 3414 Peachtree Road, N.E., Atlanta, Georgia
30326, and its telephone number at that location is (404) 841-9200.
RECENT DEVELOPMENTS
THE MERIT ACQUISITION. On February 12, 1998, the Company consummated the
acquisition of Merit Behavioral Care Corporation ("Merit") for cash
consideration of approximately $448.9 million plus the repayment of Merit's
debt. Merit manages behavioral healthcare programs across all segments of the
healthcare industry, including health maintenance organizations ("HMO's"), Blue
Cross/Blue Shield organizations and other insurance companies, corporations and
labor unions, federal, state and local governmental agencies and various state
Medicaid programs. On September 12, 1997, Merit completed the acquisition of CMG
Health, Inc. ("CMG"). CMG is a national managed behavioral healthcare company.
Merit paid approximately $48.7 million in cash and issued approximately 739,000
shares of Merit common stock as consideration for CMG. The former owners of CMG
may be entitled to additional consideration, depending on CMG's future
performance. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations--Outlook--Liquidity and Capital Resources."
HUMAN AFFAIRS INTERNATIONAL, INCORPORATED ACQUISITION. On December 4, 1997,
the Company consummated the purchase of Human Affairs International,
Incorporated ("HAI"), formerly a unit of Aetna/ U.S. Healthcare ("Aetna"), for
approximately $122.1 million, which the Company funded from cash on hand. HAI
manages behavioral healthcare programs primarily through employee assistance
programs ("EAPs") and other behavioral managed healthcare plans. 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 amount
and timing of the payments will be contingent upon net increases in the number
of HAI's covered lives in specified products. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Outlook--Liquidity
and Capital Resources."
ALLIED HEALTH GROUP, INC. ACQUISITION. On December 5, 1997, the Company
purchased the assets of Allied Health Group, Inc. and certain of its affiliates
("Allied"). Allied provides specialty managed care products, including
risk-based products and administrative services to a variety of insurance
companies and other customers, including Prudential, CIGNA and NYLCare. 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 approximately $70.0 million for Allied, of which $50.0 million
was paid to the seller at closing with the remaining $20.0 million placed in
escrow. The Company may be required to make additional contingent payments to
the former owners of Allied depending on Allied's future performance. On
November 25, 1998, the Company and the former owners of Allied amended the
Allied purchase agreement, which resulted in the repayment of a portion of the
initial escrowed amount to the Company and the reduction of potential future
contingent payments to the former owners of Allied. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations--
Outlook--Liquidity and Capital Resources."
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GREEN SPRING MINORITY STOCK CONVERSION. The minority stockholders of Green
Spring Health Services, Inc. ("Green Spring") converted their interests in Green
Spring into an aggregate of 2,831,516 shares of Company Common Stock during
January 1998. Such conversion is referred to as the "Green Spring Minority
Stockholder Conversion." As a result of the Green Spring Minority Stockholder
Conversion, the Company owns 100% of Green Spring.
HUMAN SERVICES ACQUISITIONS. During fiscal 1998, the Company acquired seven
businesses in its human services segment for an aggregate purchase price of
approximately $57.0 million (collectively, the "Human Services Acquisitions").
The Human Services Acquisitions provide various residential and day services for
individuals with acquired brain injuries and for individuals with mental
retardation and developmental disabilities.
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 Charter Behavioral Health Systems, LLC ("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 August 19, 1998, the Company announced that it had terminated
discussions with COI for the sale of its interest in CBHS. Furthermore, the
Company exercised certain of its limited management rights pursuant to the
Master Franchise Agreement (as defined) and, with CBHS's board support, made
operational and management changes at CBHS. The Company has since restored all
management rights to the CBHS board. See "Cautionary Statements--Subordination
of Franchise Fees." The Company will continue to seek opportunities to divest
its ownership interest in CBHS at a later date.
THE TRANSACTIONS. On February 12, 1998, in connection with the consummation
of the Merit acquisition, the Company consummated certain related transactions
(together with the Merit acquisition, collectively, the "Transactions"), as
follows: (i) the Company terminated its existing credit agreement (the "Magellan
Existing Credit Agreement"); (ii) the Company repaid all loans outstanding
pursuant to and terminated Merit's existing credit agreement (the "Merit
Existing Credit Agreement") (the Magellan Existing Credit Agreement and the
Merit Existing Credit Agreement are hereinafter referred to as the "Existing
Credit Agreements"); (iii) the Company consummated a tender offer for its
11 1/4% Series A Senior Subordinated Notes due 2004 (the "Magellan Outstanding
Notes"); (iv) Merit consummated a tender offer for its 11 1/2% Senior
Subordinated Notes due 2005 (the "Merit Outstanding Notes") (the Magellan
Outstanding Notes and the Merit Outstanding Notes are hereinafter referred to
collectively as the "Outstanding Notes" and such tender offers are hereinafter
referred to collectively as the "Debt Tender Offers"); (v) the Company entered
into a new senior secured bank credit agreement (the "New Credit Agreement"),
providing for a revolving credit facility (the "Revolving Facility") and a term
loan facility (the "Term Loan Facility") which provides for borrowings of up to
$700 million; and (vi) the Company issued the 9% Series A Senior Subordinated
Notes due 2008 (the "Notes") pursuant to an indenture which governs the Notes
("Indenture").
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The following table sets forth the sources and uses of funds for the
Transactions (in millions):
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SOURCES:
Cash and cash equivalents......................................... $ 59.3
New Credit Agreement:
Revolving Facility(1)........................................... 20.0
Term Loan Facility.............................................. 550.0
The Notes......................................................... 625.0
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Total sources................................................. $ 1,254.3
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USES:
Direct Cash Merger Consideration.................................. $ 448.9
Repayment of Merit Existing Credit Agreement(2)................... 196.4
Purchase of Magellan Outstanding Notes(3)......................... 432.1
Purchase of Merit Outstanding Notes(4)............................ 121.6
Transaction costs(5).............................................. 55.3
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Total uses.................................................... $ 1,254.3
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(1) The Revolving Facility provides for borrowings of up to $150.0
million. As of September 30, 1998, the Company had approximately $92.5
million available for borrowing pursuant to the Revolving Facility,
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, costs paid at closing
associated with the Debt Tender Offers, the Notes offering, the Merit
acquisition and the New Credit Agreement.
HISTORY
During the late 1980's and the early to mid 1990's, the healthcare provider
business began a rapid consolidation. The consolidation of the healthcare
provider business was necessitated by the need of hospitals to reduce costs
through economies of scale as a result of pressure on reimbursement rates and
average length of hospital stay by third-party payors. At the time, the Company
had a presence in both the psychiatric hospital industry and the general
hospital industry.
In fiscal 1993, the Company decided to focus solely on the psychiatric
hospital industry and to attempt to acquire additional behavioral healthcare
businesses. Accordingly, the Company sold its general hospitals and related
assets in fiscal 1993 for $338 million with the net proceeds used to reduce
long-term debt. In 1994, the Company acquired 40 psychiatric hospitals
("Acquired Hospitals") for approximately $171 million. The purchase of the
Acquired Hospitals included the refinancing of most of the Company's then
outstanding long-term debt, including the issuance of the Magellan Outstanding
Notes.
The Company has historically derived the majority of its revenue and
earnings 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. 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 as the principal cost control measure of the
third party payors.
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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, a managed care
company specializing in mental health and substance abuse/dependence services.
At that time, the Company intended to become a fully integrated behavioral
healthcare provider by combining the behavioral managed 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 behavorial 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 behavioral managed
healthcare.
Subsequent to the Company's acquisition of Green Spring, the growth of the
behavioral managed 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 1997,
a compound annual growth rate of over 32%. While growth in the industry was
accelerating, the behavioral managed healthcare industry also began to
consolidate. The Company concluded that this consolidation presented an
opportunity for the Company to increase its participation in the behavioral
managed healthcare industry, which the Company believed 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 behavioral managed healthcare business.
The Company took a significant step toward implementing this strategy during
the third quarter of fiscal 1997, when it sold substantially all of its domestic
acute-care psychiatric hospitals and residential treatment facilities
(collectively, 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.
Simultaneously with the sale of the Psychiatric Hospital Facilities, the Company
and COI, an affiliate of Cresent, formed CBHS to conduct the operations of the
Psychiatric Hospital Facilities and certain other facilities transfered 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 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 the 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 of expanding its managed care operations.
The Company used the proceeds to finance the acquisitions of HAI and Allied in
December 1997. The Company further implemented its business strategy through the
Merit acquisition. The Company undertook this transformation because it believed
that the behavioral 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
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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.
INDUSTRY
OVERVIEW
Behavioral healthcare costs have increased significantly in the United
States in recent years. According to industry sources, direct medical costs of
behavioral health problems, combined with the indirect costs, such as lost
productivity due to mental illness and alcohol and drug abuse, were estimated at
more than $300.0 billion in 1990, the latest year for which statistics are
available. In addition, according to industry sources, in 1994 (the most recent
year for which such information was available), direct behavioral healthcare
services treatment costs amounted to approximately $81.0 billion, or
approximately 8% of total healthcare industry spending. These direct costs have
grown, in part, as society has begun to recognize and address behavioral health
concerns and employers have realized that rehabilitation of employees suffering
from substance abuse and relatively mild mental health problems can reduce
losses due to absenteeism and decreased productivity.
In response to these escalating costs, behavioral managed healthcare
companies such as Green Spring, HAI and Merit have been formed. These companies
focus on care management techniques with the goal of arranging for the provision
of an appropriate level of care in a cost-efficient and effective manner by
improving early access to care and assuring an effective match between the
patient and the behavioral healthcare provider's specialty. As the growth of
behavioral managed healthcare has increased, there has been a significant
decrease in occupancy rates and average lengths of stay for inpatient
psychiatric facilities and an increase in outpatient treatment and alternative
care services.
According to an industry trade publication entitled "Managed Behavioral
Health Market Share in the United States 1997-1998" published by Open Minds,
Gettysburg, Pennsylvania (hereinafter referred to as "OPEN MINDS"), as of
January 1997, approximately 149.0 million beneficiaries were covered by some
form of behavioral managed healthcare plan and an additional 19.5 million
beneficiaries were enrolled in internally-managed behavioral healthcare programs
within HMOs. The number of covered beneficiaries has grown from approximately
86.0 million beneficiaries in 1993 to approximately 149.0 million in 1997,
representing an approximate 15% compound annual growth rate since 1993. In
addition, according to OPEN MINDS, beneficiaries covered under risk-based
programs are growing even more rapidly, from approximately 13.6 million as of
January 1993 to approximately 38.9 million as of January 1997, representing a
compound annual growth rate of over 30%. OPEN MINDS estimates that the revenues
of behavioral managed healthcare companies totaled approximately $3.5 billion in
1996.
OPEN MINDS divides the managed behavioral healthcare industry as of January
1997 into the following categories of care, based on services provided, extent
of care management and level of risk assumption:
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BENEFICIARIES PERCENT
CATEGORY OF CARE (IN MILLIONS) OF TOTAL
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Utilization Review/Care Management Programs.............................................. 39.2 26.3%
Risk-Based Network Products.............................................................. 38.9 26.1
Non-Risk-Based Network Products.......................................................... 31.9 21.4
EAPs..................................................................................... 28.3 19.0
Integrated Programs...................................................................... 10.7 7.2
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Total............................................................................ 149.0 100.0%
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Management believes the current trends in the behavioral healthcare industry
include increased utilization of risk-based network managed care products and
the integration of EAPs with such managed
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care products. Management believes that these trends have developed in response
to the attempt by payors to reduce rapidly escalating behavioral healthcare
costs and to limit their risk associated with such costs while continuing to
provide access to high quality care. According to OPEN MINDS, risk-based network
products, integrated programs and EAPs are the most rapidly growing segments of
the behavioral managed healthcare industry.
UTILIZATION REVIEW/CARE MANAGEMENT PRODUCTS. Under utilization review/care
management products, a managed behavioral healthcare company manages and often
arranges for treatment, but does not maintain a network of providers or assume
any of the responsibility for the cost of providing treatment services. The
Company categorizes its products within this segment of the managed behavioral
healthcare industry (as it is defined by OPEN MINDS) as administrative services
only ("ASO") products. The Company does not expect this segment of the industry
to experience significant growth, given the growth of risk-based products.
NON-RISK-BASED NETWORK PRODUCTS. Under non-risk-based network products, the
behavioral managed healthcare company provides a full array of managed care
services, including selecting, credentialing and managing a network of providers
(such as psychiatrists, psychologists, social workers and hospitals), and
performs utilization review, claims administration and care management
functions. The third-party payor remains responsible for the cost of providing
the treatment services rendered. The Company categorizes its products within
this segment of the behavioral managed healthcare industry (as it is defined by
OPEN MINDS) as ASO products.
RISK-BASED NETWORK PRODUCTS. Under risk-based network products, the
behavioral managed healthcare company assumes all or a portion of the
responsibility for the cost of providing a full or specified range of behavioral
healthcare treatment services. Most of these programs have payment arrangements
in which the managed care company agrees to provide services in exchange for a
fixed fee per member per month that varies depending on the profile of the
beneficiary population or otherwise shares the responsibility for providing all
or some portion of the treatment services at a specific cost per person. Under
these products, the behavioral managed healthcare company not only approves and
monitors a course of treatment, but also arranges and pays for the provision of
patient care (either through its third-party network providers or staff
providers or some combination of network and staff providers). Therefore, the
behavioral managed healthcare company must be proficient in contracting with,
credentialing and managing a network of specialized providers and facilities
that covers the complete continuum of care. The behavioral managed healthcare
company must also ensure that the appropriate level of care is delivered in the
appropriate setting. Given the ability of payors of behavioral healthcare
benefits to reduce their risk with respect to the cost of treatment services
through risk-based network products while continuing to provide access to high
quality care, this market segment has grown rapidly in recent years. In addition
to the expected growth in total beneficiaries covered under behavioral managed
healthcare products, this shift of beneficiaries into risk-based network
products should further contribute to revenue growth for the behavioral managed
healthcare industry because such contracts generate significantly higher revenue
than ASO contracts. The higher revenue is intended to compensate the behavioral
managed healthcare company for bearing the financial responsibility for the cost
of delivering care. The Company's risk-based products are risk-based network
products as defined by OPEN MINDS.
EMPLOYEE ASSISTANCE PROGRAMS. An EAP is a worksite-based program designed
to assist in the early identification and resolution of productivity problems
associated with behavioral conditions or other personal concerns of employees
and their dependants. Under an EAP, staff or network providers or other
affiliated clinicians provide assessment and referral services to employee
beneficiaries and their dependants. These services consist of evaluating a
patient's needs and, if indicated, providing limited counseling and/or
identifying an appropriate provider, treatment facility or other resource for
more intensive treatment services. The EAP industry developed largely out of
employers' efforts to combat
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alcoholism and substance abuse problems afflicting workers. A 1990 industry
survey estimated the total costs of this dependency at approximately $98.6
billion per year. Many businesses have implemented alcoholism and drug abuse
treatment programs in the workplace, and in some cases have expanded those
services to cover a wider spectrum of personal problems experienced by workers
and their families. As a result, EAP products now typically include consultation
services, evaluation and referral services, employee education and outreach
services. The Company believes that federal and state "drug-free workplace"
measures and Federal Occupational Health and Safety Act requirements, taken
together with the growing public perception of increased violence in the
workplace, have prompted many companies to implement EAPs. Although EAPs
originated as a support tool to assist managers in dealing with troubled
employees, payors increasingly regard EAPs as an important component in the
continuum of behavioral healthcare services.
INTEGRATED EAP/MANAGED BEHAVIORAL HEALTHCARE PRODUCTS. EAPs are utilized in
a preventive role and in facilitating early intervention and brief treatment of
behavioral healthcare problems before more extensive treatment is required.
Consequently, EAPs often are marketed and sold in tandem with managed behavioral
healthcare programs through "integrated" product offerings. Integrated products
offer employers comprehensive management and treatment of all aspects of
behavioral healthcare. In an effort to both reduce costs and increase
accessibility and ease of treatment, employers are increasingly attempting to
consolidate EAP and behavioral managed healthcare services into a single
product. Although integrated EAP/managed behavioral healthcare products are
currently only a small component of the overall industry, the Company expects
this market segment to grow.
AREAS OF GROWTH
Management believes that the growth of the behavioral managed healthcare
industry will continue, as payors of behavioral healthcare benefits attempt to
reduce the costs of behavioral healthcare while maintaining high quality care.
Management also believes that a number of opportunities exist in the behavioral
managed healthcare industry for continued growth, primarily for risk-based
products. The following paragraphs discuss factors contributing to the growth of
risk-based products and the increase in the number of covered lives in certain
markets.
RISK-BASED PRODUCTS. According to OPEN MINDS, industry enrollment in
risk-based products has grown from approximately 13.6 million covered lives in
1993 to approximately 38.9 million covered lives in 1997, a compound annual
growth rate of over 30%. Despite this growth, only approximately 26% of total
managed behavioral healthcare covered lives were enrolled in risk-based products
in 1997. The Company believes that the market for risk-based products has grown
and will continue to grow as payors attempt to reduce their responsibility for
the cost of providing behavioral healthcare while ensuring an appropriate level
of access to care. Risk-based products can generate significantly greater
revenue per covered life than other non-risk product types. According to the
OPEN MINDS survey, risk-based products account for approximately two-thirds of
total managed behavioral healthcare industry revenue, but, as stated above,
accounted for only approximately 26% of total covered lives in 1997. During
fiscal 1998, risk-based products accounted for approximately 76% of the
Company's behavorial managed healthcare revenue and represented approximately
30% of covered lives as of September 30, 1998. See "Cautionary
Statements--Risk-Based Products."
MEDICAID. Medicaid is a joint state and federal program to provide
healthcare benefits to approximately 33.0 million low income individuals,
including welfare recipients. According to the Health Care Financing
Administration of the United States Department of Health and Human Services
("HCFA"), federal and state Medicaid spending increased from $69.0 billion in
1990 to an estimated $160.0 billion in 1996, at an average annual rate almost
twice as fast as the annual increase in overall healthcare spending.
Furthermore, according to HCFA, from 1991 to 1996 the number of Medicaid
beneficiaries covered under full managed contracts grew at a compound annual
rate of approximately 40% per year.
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The Company expects that the Balanced Budget Act of 1997 (the "Budget Act") will
slow the growth of Medicaid spending by accelerating the trend of state Medicaid
programs toward shifting beneficiaries into managed care programs in order to
control rising costs.
Despite the recent increase in managed care enrollment of Medicaid
beneficiaries, Medicaid managed care enrollment as a percentage of all Medicaid
beneficiaries remains small. As of June 1996, according to the National
Institute for Health Care Management, only approximately 35% of all Medicaid
beneficiaries were enrolled in some form of managed care program, and less than
7% were enrolled in risk-based programs. The Company expects the number of
Medicaid recipients enrolled in managed behavioral healthcare programs to
increase through two avenues: (i) subcontracts with HMOs and (ii) direct
contracts with state agencies. As HMOs increase their penetration of the
Medicaid market, the Company expects that many HMOs will continue to (or begin
to) subcontract with behavioral managed healthcare companies to provide services
for Medicaid beneficiaries. State agencies have also begun to contract directly
with behavioral managed healthcare companies to provide behavioral healthcare
services to their Medicaid beneficiaries. Iowa, Massachusetts, Nebraska,
Maryland, Pennsylvania, Tennessee and Montana have decided to "carve out"
behavioral healthcare from their overall Medicaid managed care programs and have
contracted or are expected to contract directly with behavioral managed
healthcare companies to provide such services. The Company expects that the
Budget Act will accelerate the trend of states contracting directly with
behavioral managed healthcare companies. During fiscal 1998, Medicaid programs
accounted for approximately 23% of the Company's behavorial managed healthcare
revenue and represented approximately 6% of covered lives as of September 30,
1998. Substantially all of the Company's Medicaid Contracts are risk-based. See
"Cautionary Statements--Dependence on Government Spending for Managed
Healthcare; Possible Impact of Healthcare Reform" and "--Risk-Based Products"
and "Business--Regulation--Budget Act."
COMPANY OVERVIEW
GENERAL
According to enrollment data reported in OPEN MINDS, the Company is the
nation's largest provider of behavioral managed healthcare services. As of
September 30, 1998, the Company had approximately 61.6 million covered lives
under behavioral managed healthcare contracts and manages behavioral healthcare
programs for over 3,000 customers. Through its current network of over 35,000
providers and nearly 5,000 treatment facilities, the Company manages behavioral
healthcare programs for HMOs, Blue Cross/Blue Shield organizations and other
insurance companies, corporations, federal, state and local governmental
agencies, labor unions and various state Medicaid programs. The Company believes
it has the largest and most comprehensive behavioral healthcare provider network
in the United States. In addition to the Company's behavioral managed healthcare
segment, the Company offers specialty managed care products related to the
management of certain chronic medical conditions. The Company also offers a
broad continuum of human services to approximately 3,350 individuals who receive
healthcare benefits funded by state and local governmental agencies through
National Mentor, Inc., its wholly-owned human services provider. Furthermore,
the Company franchises the "CHARTER" System of behavioral healthcare to the
Psychiatric Hospital Facilities and other facilities operated by CBHS, an entity
in which the Company owns a 50% equity interest.
The Company's professional care managers coordinate and manage the delivery
of behavioral healthcare treatment services through the Company's network of
providers, which includes psychiatrists, psychologists, licensed clinical social
workers, marriage and family therapists and licensed clinical professional
counselors. The treatment services provided by the Company's behavioral provider
network include outpatient programs (such as counseling and therapy),
intermediate care programs (such as sub-acute emergency care, intensive
outpatient programs and partial hospitalization services), inpatient treatment
services and alternative care services (such as residential treatment, home and
community-based programs and rehabilitative and support services). The Company
provides these services
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through: (i) risk-based products, (ii) EAPs, (iii) ASO products and (iv)
products that combine features of some or all of these products. Under
risk-based products, the Company arranges for the provision of a full range of
behavioral healthcare services for beneficiaries of its customers' healthcare
benefit plans through fee arrangements under which the Company assumes all or a
portion of the responsibility for the cost of providing such services in
exchange for a fixed per member per month fee. Under EAPs, the Company provides
assessment services to employees and dependents of its customers, and if
required, referral services to the appropriate behavioral healthcare service
provider. Under ASO products, the Company provides services such as utilization
review, claims administration and provider network management. The Company does
not assume the responsibility for the cost of providing healthcare services
pursuant to its ASO products.
The Company conducts operations in five business segments: (i) behavioral
managed healthcare, (ii) human services, (iii) specialty managed healthcare,
(iv) healthcare franchising and (v) healthcare provider. The following describes
the Company's five business segments:
BEHAVIORAL MANAGED CARE. The behavioral managed healthcare segment is the
Company's primary operating segment. The Company's behavioral managed care
subsidiaries include Green Spring, HAI, and Merit. The following is a
description of each of these subsidiaries prior to the Company's integration of
its behavioral managed care businesses:
Green Spring was one of the largest companies in the behavioral managed
healthcare industry and was the largest behavioral managed healthcare provider
to the Blue Cross/Blue Shield networks. Green Spring's client base included Blue
Cross/Blue Shield plans, major HMOs and preferred provider organizations
("PPOs"), state employee programs, Fortune 1000 corporations, labor unions and a
growing number of state Medicaid programs.
Merit was one of the leading behavioral managed healthcare providers in the
nation. Merit managed behavioral healthcare programs for clients across all
segments of the healthcare industry, particularly in the corporate and HMO
segment. Merit was also a leading provider to Blue Cross/Blue Shield
organizations and other insurance companies, corporations and labor unions,
federal, state and local governmental agencies and various state Medicaid
programs.
HAI was one of the first and was one of the largest providers of EAP
products. HAI had providers in all 50 states and serves many of the nation's
largest companies, including Aetna, Exxon, JP Morgan, MCI, Northwest Airlines
and Sears.
The behavioral managed healthcare operations are now organized around three
customer segments, as follows: (i) the Health Plan Division, focusing on the
needs of health insurance plans and HMO's and their members; (ii) the Workplace
Division, focusing on self-insured employers and labor unions and their
employees and dependants; and (iii) the Public Sector Division, focusing on the
needs of public purchasers of behavioral healthcare services and their
constituents.
HUMAN SERVICES. The Company's human services business provided specialty
home-based behavioral healthcare services through Mentor to approximately 3,350
individuals in 105 programs in 20 states as of September 30, 1998. Mentor was
founded in 1983 and was acquired by the Company in January 1995. Mentor's
services include specialty home-based behavioral healthcare services, which
feature individualized home and community-based health and human services
delivered in highly structured and professionally monitored family environments
or "mentor" homes. The mentor homes serve clients with chronic behavioral
disorders and disabilities requiring long-term care, including children and
adolescents with behavioral problems, individuals with mental retardation or
developmental disabilities, and individuals with neurological impairment or
other medical and behavioral frailties. As a result of the Human Services
Acquisitions, Mentor also provides various residential and day services for
individuals with acquired brain injuries and for individuals with mental
retardation and developmental disabilities.
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SPECIALTY MANAGED HEALTHCARE. The Company's specialty managed healthcare
business provides specialty risk-based products and administrative services to a
variety of insurance companies and other customers, including Prudential, CIGNA
and NYLCare. Allied has over 80 physician networks across the eastern United
States. Allied's networks include physicians specializing in cardiology,
oncology and diabetes. The specialty managed healthcare operations focus on the
needs of health plans to manage their specialty care networks and disease
management programs in areas such as diabetes, asthma, oncology and cardiology.
HEALTHCARE FRANCHISING. The Company's wholly-owned subsidiary Charter
Advantage, LLC ("Charter Advantage") franchises the "CHARTER" System of
behavioral healthcare to the Psychiatric Hospital Facilities and other
facilities operated by CBHS. See "Business--Charter Advantage."
HEALTHCARE PROVIDER. The Company's provider operations include the
ownership and operation of two psychiatric hospitals in London, England (a
45-bed hospital and a 78-bed hospital) and a 69-bed psychiatric hospital in
Nyon, Switzerland (collectively, the "European Facilities"). The Company's
provider operations also include its interest in six hospital-based joint
ventures ("Joint Ventures"). The Company's joint venture partner in four of the
Joint Ventures is Columbia/HCA Healthcare Corporation. Although the Company is
the managing member of each Joint Venture, it has delegated its management
responsibilities to CBHS. The Company pays CBHS a fee for managing the Joint
Ventures equal to the Company's share of the earnings of the Joint Ventures. The
Company's provider operations also include a Puerto Rican provider management
business.
BUSINESS STRATEGY
INCREASE ENROLLMENT IN BEHAVIORAL MANAGED HEALTHCARE PRODUCTS. The Company
believes it has an opportunity to increase covered lives in all its behavioral
managed healthcare products. The Company believes its market presence will
further enhance its ability to increase ASO and EAP covered lives with large
corporate, HMO and insurance customers. The Company further believes that it has
an opportunity to increase revenues, earnings and cash flows from operations by
increasing lives covered by its risk-based products. The Company is the
industry's leading provider of risk-based products, according to data reported
by OPEN MINDS, and believes that it may benefit from the continuing shift to
risk-based products. According to OPEN MINDS, industry enrollment in risk-based
products has grown from approximately 13.6 million in 1993 to approximately 38.9
million in 1997, representing a compound annual growth rate of over 30%. Despite
this growth, only approximately 26% of total behavioral managed healthcare
enrollees were in risk-based products in 1997. The Company believes that the
market for risk-based products has grown and will continue to grow as payors
attempt to reduce their cost of providing behavioral healthcare while ensuring a
high quality of care and an appropriate level of access to care. The Company
believes enrollment in its risk-based products will increase through growth in
new covered lives and through the transition of covered lives in ASO and EAP
products to higher revenue risk-based products. There are certain risks
associated with increased enrollment in risk-based products. See "Cautionary
Statements--Risk-Based Products."
ACHIEVE SIGNIFICANT INTEGRATION EFFICIENCIES. The Company believes that the
HAI and Merit acquisitions have created opportunities for the Company to achieve
significant cost savings. 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 costs savings on an annual
basis by September 30, 1999. Such cost savings are measured relative to the
combined operating expenses of Green Spring, HAI and Merit prior to the Merit
acquisition. There can be no assurance that the Company will be able to
integrate its operations according to its plan. See "Cautionary
Statements--Integration of Operations."
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PURSUE ADDITIONAL SPECIALTY MANAGED HEALTHCARE OPPORTUNITIES. The Company
believes that significant demand exists for specialty managed healthcare
products related to the management of certain chronic conditions. The Company
believes its large number of covered lives, information systems infrastructure
and experience in managing behavioral healthcare programs position the Company
to provide customers with specialty managed healthcare products. As a first
major step in implementing this strategy, the Company acquired Allied, a
provider of specialty managed care products for cardiology, oncology and
diabetes patients, on December 5, 1997. See "Recent Developments--Allied
Acquisition." The Company's highly leveraged financial position may prevent it
from acquiring additional specialty managed healthcare providers. See
"Cautionary Statements--Substantial Leverage and Debt Service Obligations."
EXPANSION OF HUMAN SERVICES GEOGRAPHIC COVERAGE AND PRODUCT MIX. The human
services industry is a very fragmented, $100 billion industry that continues to
be consolidated by a few competitors. The Company believes it has an opportunity
to increase its geographic coverage and leverage its human services product
offerings on a nationwide basis. The Human Services Acquisitions diversified the
product mix and increased the geographic market penetration of the human
services segment. Mentor plans to launch national brain injury rehabilitation
product lines and expand its product offerings in California as a result of the
Human Services Acquisitions.
EXIT FROM THE HEALTHCARE FRANCHISING AND HEALTHCARE PROVIDER
OPERATIONS. The Company will continue its efforts to sell its three European
hospitals, its 50% interest in CBHS, Charter Advantage and other provider
operations in an effort to reduce the Company's long-term debt and improve
liquidity. The Company is currently involved in negotiations to sell some or all
of the previously mentioned businesses. There can be no assurance that the
Company will be able to sell any of these businesses.
BEHAVIORAL MANAGED HEALTHCARE PRODUCTS AND SERVICES
GENERAL. The following table sets forth the approximate number of covered
lives as of September 30, 1998 and revenue for fiscal 1998 for the types of
behavioral managed healthcare programs offered by the Company:
<TABLE>
<CAPTION>
PROGRAMS COVERED LIVES PERCENT REVENUE PERCENT
- ----------------------------------------------------------------- ----------------- ----------- ---------- -----------
<S> <C> <C> <C> <C>
(IN MILLIONS, EXCEPT PERCENTAGES)
Risk-Based Products.............................................. 18.6 30.2% $ 786.1 75.7%
EAP, ASO and other products...................................... 43.0 69.8 252.9 24.3
--- ----- ---------- -----
Total........................................................ 61.6 100.0% $ 1,039.0 100.0%
--- ----- ---------- -----
--- ----- ---------- -----
</TABLE>
The number of the Company's covered lives fluctuates based on the number of the
Company's customer contracts and as employee, HMO and insurance company
subscriber and government program enrollee populations change from time to time.
On a pro forma basis including HAI and Merit, the number of lives covered by the
Company's managed healthcare products at September 30, 1996 and 1997 would have
been 45.7 million and 51.7 million, respectively.
RISK-BASED PRODUCTS. Under the Company's risk-based products, the Company
typically arranges for the provision of a full range of outpatient, intermediate
and inpatient treatment services to beneficiaries of its customers' healthcare
benefit plans, primarily through arrangements in which the Company assumes all
or a portion of the responsibility for the cost of providing such services in
exchange for a per member per month fee. The Company's experience with
risk-based contracts (including the experience of Green Spring, HAI and Merit)
covering a large number of lives has given it a broad base of data from which to
analyze utilization rates. The Company believes that this broad database permits
it to estimate utilization trends and costs more accurately than many of its
competitors, which allows it to bid effectively. The Company believes that its
experience has also allowed it to develop effective measures for controlling the
cost of providing a unit of care to its covered lives. Among other cost control
measures,
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the Company has developed or acquired clinical protocols, which permit the
Company to assist its network providers to administer effective treatment in a
cost efficient manner, and claims management technology, which permits the
Company to reduce the cost of processing claims. The Company's care managers are
an essential element in its provision of cost-effective care. Except in
emergencies, treatment is required to be authorized by a Company care manager.
Care managers, in consultation with treating professionals, and using the
Company's clinical protocols, authorize an appropriate level and intensity of
services that can be delivered in a cost-efficient manner.
EMPLOYEE ASSISTANCE PROGRAMS. The Company's EAP products typically provide
assessment and referral services to employees and dependents of the Company's
customers in an effort to assist in the early identification and resolution of
productivity problems associated with the employees who are impaired by
behavioral conditions or other personal concerns. For many EAP customers, the
Company also provides limited outpatient therapy (typically limited to eight or
fewer sessions) to patients requiring such services. For these services, the
Company typically is paid a fixed fee per member per month; however, the Company
is usually not responsible for the cost of providing care beyond these services.
If further services are necessary beyond limited outpatient therapy, the Company
will refer the beneficiary to an appropriate provider or treatment facility.
INTEGRATED PRODUCTS. Under its integrated products, the Company typically
establishes an EAP to function as the "front end" of a managed care program that
provides a full range of services, including more intensive treatment services
not covered by the EAP. The Company typically manages the EAP and accepts all or
some of the responsibility for the cost of any additional treatment required
upon referral out of the EAP, thus integrating the two products and using both
the Company's care management and clinical care techniques to manage the
provision of care.
ASO PRODUCTS. Under its ASO products, the Company provides services ranging
from utilization review and claims administration to the arrangement for and
management of a full range of patient treatment services, but does not assume
any of the responsibility for the cost of providing treatment services. Services
include member assistance, management reporting and claims processing in
addition to utilization review and care management.
BEHAVIORAL MANAGED HEALTHCARE CUSTOMERS
GENERAL. The following table sets forth the approximate number of covered
lives as of September 30, 1998 and revenue for fiscal 1998 in each of the
Company's market segments described below:
<TABLE>
<CAPTION>
MARKET COVERED LIVES PERCENT REVENUE PERCENT
- ----------------------------------------------------------------- ----------------- ----------- ---------- -----------
<S> <C> <C> <C> <C>
(IN MILLIONS, EXCEPT PERCENTAGES)
Workplace (Corporations and Labor Unions)........................ 19.7 32.0% $ 141.6 13.6%
Health Plans..................................................... 31.0 50.3 633.4 61.0
Public Sector.................................................... 7.8 12.7 240.3 23.1
Other............................................................ 3.1 5.0 23.7 2.3
--- ----- ---------- -----
Total........................................................ 61.6 100.0% $ 1,039.0 100.0%
--- ----- ---------- -----
--- ----- ---------- -----
</TABLE>
CORPORATIONS AND LABOR UNIONS. Corporations and, to a lesser extent, labor
unions, account for a large number of the Company's contracts to provide
behavioral managed healthcare services and, in particular, EAP and integrated
EAP/managed care services. The Company has structured a variety of fee
arrangements with corporate customers to cover all or a portion of the
responsibility of the cost of providing treatment services. In addition, the
Company operates a number of programs for corporate customers on an ASO basis.
Management believes the corporate market is an area of potential growth for the
Company, as corporations are anticipated to increase their utilization of
behavioral managed healthcare services. In an effort to increase penetration of
the corporate market, the Company intends to
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build upon Merit's experience in managing programs for large corporate customers
(such as IBM, Federal Express and AT&T) and to market integrated programs to
Merit's existing EAP customers and other prospective corporate clients.
HEALTH PLANS. The Company is a leader in the HMO market, providing
behavioral managed healthcare services to HMO beneficiaries. HMO contracts are
full, limited or shared risk contracts in which the Company generally accepts a
fixed fee per member per month from the HMO in exchange for providing a full or
specified range of behavioral healthcare services for a specific portion of the
HMO's beneficiaries. Although certain large HMOs provide their own behavioral
managed healthcare services, many HMOs "carve out" behavioral healthcare from
their general healthcare services and subcontract such services to behavioral
managed healthcare companies such as the Company. The Company anticipates that
its business with HMOs will continue to grow. The Company is also the nation's
leading provider of behavioral managed healthcare services to Blue Cross/Blue
Shield organizations, serving 28 Blue Cross/Blue Shield organizations as of
September 30, 1998.
HAI has contracts with its former owner, Aetna, pursuant to which HAI
provides behavioral managed healthcare products to Aetna, including focused
psychiatric review (a type of utilization review product), risk-based HMO
products, administrative services for Aetna's "Managed Choice" product and
provider network management services.
PUBLIC SECTOR. The Company provides behavioral managed healthcare services
to Medicaid recipients through both direct contracts with state and local
governmental agencies and through subcontracts with HMOs focused on Medicaid
beneficiary populations. In addition to the Medicaid population, other public
entitlement programs, such as Medicare and state insurance programs for the
uninsured, offer the Company areas of potential future growth. The Company
expects that governmental agencies will continue to implement a significant
number of managed care Medicaid programs through contracts with HMOs and that
many HMOs will subcontract with behavioral managed healthcare organizations,
such as the Company, for behavioral healthcare services. The Company also
expects that other states will continue the trend of "carving-out" behavioral
healthcare services from their general healthcare benefit plans and contracting
directly with behavioral managed healthcare companies such as the Company. See
"Industry--Areas of Growth," "Cautionary Statements--Dependence on Government
Spending for Managed Healthcare; Possible Impact of Healthcare Reform" and
"--Regulation--Other Proposed Legislation." The Company also provides EAPs and
other managed care products for employees and their dependents who are
beneficiaries of federal, state and local governmental agencies' healthcare
benefit plans. Governmental agencies' healthcare benefit plans have historically
contracted for managed behavioral healthcare services as part of their general
healthcare contracts with HMOs or indemnity insurers. In turn, HMOs or indemnity
insurers have either provided managed behavioral healthcare services directly or
subcontracted such services to managed behavioral healthcare companies such as
the Company. The Company currently provides services to a number of government
employees either directly pursuant to a contract with the government agency or
as a subcontractor to HMOs. More recently, governmental agencies have begun to
contract directly with managed behavioral healthcare companies to provide these
services. In addition, the Company currently manages contracts for CHAMPUS
beneficiaries and is actively pursuing new contracts and subcontracts under the
CHAMPUS program. In this market, the Company often bids for such contracts
together with HMOs to provide the behavioral healthcare services portion of the
overall CHAMPUS healthcare contract.
BEHAVIORAL MANAGED HEALTHCARE CONTRACTS
The Company's contracts with customers typically have terms of one to three
years, and in certain cases contain renewal provisions (at the customer's
option) for successive terms of between one and two years (unless terminated
earlier). Substantially all of these contracts are immediately terminable with
cause and many are terminable without cause by the customer or the Company
either upon the giving of
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requisite notice and the passage of a specified period of time (typically
between 60 and 180 days) or upon the occurrence of other specified events. In
addition, the Company's contracts with federal, state and local governmental
agencies, under both direct contract and subcontract arrangements with HMOs,
generally are conditioned on legislative appropriations. These contracts,
notwithstanding terms to the contrary, generally can be terminated or modified
by the customer if such appropriations are not made. See "Cautionary
Statements--Risk Based Programs" and "--Reliance on Customer Contracts."
The specific terms of the Company's contracts are determined by whether the
contracts are for risk-based, EAP, integrated or ASO products. Risk-based and
EAP contracts provide for payment of a fixed per member per month fee to the
Company. The customer remits this fee to the Company monthly. With respect to
ASO products, the Company is generally paid on a per member per month basis. The
Company bills its customer for such services on a monthly basis. The Company's
billing arrangements for integrated products vary on a case by case basis.
BEHAVIORAL MANAGED HEALTHCARE NETWORK
The Company's behavioral managed healthcare and EAP treatment services are
provided by a network of third-party providers. The number and type of providers
in a particular area depend upon customer preference, site, geographic
concentration and demographic make-up of the beneficiary population in that
area. Network providers include a variety of specialized behavioral healthcare
personnel, such as psychiatrists, psychologists, licensed clinical social
workers, substance abuse counselors and other professionals.
As of September 30, 1998, the Company had contractual arrangements covering
over 35,000 individual third-party network providers. The Company's network
providers are independent contractors located throughout the local areas in
which the Company's customer's beneficiary population resides. Network providers
work out of their own offices, although the Company's personnel are available to
assist them with consultation and other needs. Network providers include both
individual practitioners, as well as individuals who are members of group
practices or other licensed centers or programs. Network providers typically
execute standard contracts with the Company for which they are typically paid by
the Company on a fee-for-service basis. In some cases, network providers are
paid on a "case rate" basis, whereby the provider is paid a set rate for an
entire course of treatment, or through other risk sharing arrangements. A
network provider's contract with the Company typically has a one-year term, with
automatic renewal at the Company's option for successive one-year terms, and
generally may be terminated without cause by the Company or the provider upon 30
to 90 days notice.
As of September 30, 1998, the Company's behavorial managed healthcare
network included contractual arrangements with approximately 5,000 third-party
treatment facilities, including inpatient psychiatric and substance abuse
hospitals, intensive outpatient facilities, partial hospitalization facilities,
community health centers and other community-based facilities, rehabilitative
and support facilities, and other intermediate care and alternative care
facilities or programs. This variety of facilities enables the Company to offer
patients a full continuum of care and to refer patients to the most appropriate
facility or program within that continuum. Typically, the Company contracts with
facilities on a per diem or fee-for-service basis and, in some cases, on a "case
rate" or capitated basis. The contracts between the Company and inpatient and
other facilities typically are for one year terms and, in some cases, are
automatically renewable at the Company's option. Facility contracts are usually
terminable by the Company or the facility owner upon 30 to 120 days notice. The
Psychiatric Hospital Facilities and other facilities operated by CBHS are
members of the Company's hospital provider network on the same terms as are
generally applicable to unaffiliated third-party treatment facilities.
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COMPETITION
Each segment of the Company's business is highly competitive. With respect to
its managed care businesses, the Company competes with large insurance
companies, HMOs, PPOs, third-party administrators ("TPAs"), independent
practitioner associations ("IPAs"), multi-disciplinary medical groups and other
managed care companies. Many of the Company's competitors are significantly
larger and have greater financial, marketing and other resources than the
Company, and some of the Company's competitors provide a broader range of
services. The Company may also encounter substantial competition in the future
from new market entrants. Many of the Company's customers that are managed care
companies may, in the future, seek to provide behavioral managed healthcare and
EAP services to their employees or subscribers directly, rather than by
contracting with the Company for such services. Because of competition, the
Company does not expect to be able to rely on price increases to achieve revenue
growth and expects to continue experiencing pressure on direct operating
margins. See "Cautionary Statements--Highly Competitive Industry."
The Company's human services operations compete with various for profit and
not-for-profit entities, including, but not limited to: (i) behavioral managed
healthcare companies that have started managing human services for governmental
agencies; (ii) home health care organizations; (iii) proprietary nursing home
companies; and (iv) proprietary human services companies. The Company believes
that the most significant factors in a customer's selection of services include
price, quality of services and outcomes. The pricing aspect of such services is
especially important to attract public sector agencies looking to outsource
public services to the private sector as demand for quality services escalates
while budgeted dollars for healthcare services are reduced. The Company's
management believes that it competes effectively with respect to these factors.
The Company believes it benefits from the competitive strengths described
below:
INDUSTRY LEADERSHIP. The Company is the largest provider of behavioral
managed healthcare services in the United States, according to enrollment data
reported in OPEN MINDS. The Company believes, based on data reported in OPEN
MINDS, that it also now has the number one market position in each of the major
product markets in which it competes. The Company believes its position will
enhance its ability to: (i) provide a consistent level of high quality service
on a nationwide basis; (ii) enter into agreements with behavioral healthcare
providers that allow it to control healthcare costs for its customers; and (iii)
market its behavioral managed care products to large corporate, HMO and
insurance customers, which, the Company believes, increasingly prefer to be
serviced by a single-source provider on a national basis. See "Cautionary
Statements--Highly Competitive Industry" and "--Reliance on Customer Contracts"
for a discussion of the risks associated with the highly competitive nature of
the behavioral managed healthcare industry and the Company's reliance on
contracts with payors of behavioral healthcare benefits, respectively.
BROAD PRODUCT OFFERING AND NATIONWIDE PROVIDER NETWORK. The Company offers
behavioral managed care products that can be designed to meet specific customer
needs, including risk-based and partial risk-based products, integrated EAPs,
stand-alone EAPs and ASO products. The Company's provider network encompasses
over 35,000 providers and nearly 5,000 treatment facilities in all 50 states.
The Company believes that the combination of its product offerings and its
provider network allows the Company to meet its customers needs for behavioral
managed healthcare on a nationwide basis, and positions the Company to capture
incremental revenue opportunities resulting from the continued growth of the
behavioral managed healthcare industry and the continued migration of its
customers from ASO and EAP products to higher revenue risk-based products. See
"Cautionary Statements--Risk-Based Products" for a discussion of the risks
associated with risk-based products, which are the Company's primary source of
revenue.
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BROAD BASE OF CUSTOMER RELATIONSHIPS. The Company believes that the breadth
of its customer relationships are attributable to the Company's broad product
offerings, nationwide provider network, commitment to quality care and ability
to manage behavioral healthcare costs effectively. The Company's customers
include: (i) Blue Cross/Blue Shield organizations; (ii) national HMOs and other
large insurers, such as Aetna/US Healthcare, Humana and Prudential; (iii) large
corporations, such as IBM, Federal Express and AT&T; (iv) state and local
governmental agencies through commercial, Medicaid and other programs; and (v)
the federal government through contracts pursuant to the Civilian Health and
Medical Program of the Uniformed Services ("CHAMPUS") and with the U.S. Postal
Service. This broad base of customer relationships provides the Company with
stable and diverse sources of revenue, earnings and cash flows and an
established base from which to continue to increase covered lives and revenue.
See "Cautionary Statements--Reliance on Customer Contracts" for a discussion of
the risks associated with the Company's reliance on certain contracts with
payors of behavioral healthcare benefits.
PROVEN RISK MANAGEMENT EXPERIENCE. The Company had approximately 18.6
million covered lives under risk-based contracts at September 30, 1998, making
it the nation's industry leader in at-risk behavioral managed healthcare
products, based on data reported in OPEN MINDS. The Company's experience with
risk-based products covering a large number of lives has given it a broad base
of data from which to analyze utilization rates. The Company believes that this
broad database permits it to estimate utilization trends and costs more
accurately than many of its competitors, which allows it to bid effectively. The
Company believes that its experience has also allowed it to develop effective
measures for controlling the cost of providing a unit of care to its covered
lives. Among other cost control measures, the Company has developed or acquired
clinical protocols, which permit the Company to assist its network providers to
administer effective treatment in a cost efficient manner, and claims management
technology, which permits the Company to reduce the cost of processing claims.
As the Company continues to integrate HAI and Merit into its behavioral managed
healthcare operations, it will be able to select from the best practices of its
subsidiaries to further enhance its utilization and cost control methodologies.
See "Cautionary Statements--Integration of Operations" for a discussion of the
risks associated with integrating the Company's recently acquired businesses,
including the managed care operations it acquired in fiscal 1998, with its
existing operations.
The competitive environment affecting the Company's healthcare franchising
and healthcare provider operations are discussed elsewhere. See "Charter
Advantage--Competition."
INSURANCE
The Company maintains a general and professional liability insurance policy with
an unaffiliated insurer. The policy is written on an "occurrence" basis, subject
to a $250,000 deductible per occurrence and an aggregate deductible of $1.0
million for a three-year policy period ending June 2001.
REGULATION
GENERAL. The behavioral managed healthcare industry and the provision of
behavioral healthcare services are subject to extensive and evolving state and
federal regulation. The Company is subject to certain state laws and
regulations, including those governing: (i) the licensing of insurance
companies, HMOs, PPOs, TPAs and companies engaged in utilization review and (ii)
the licensing of healthcare professionals, including restrictions on business
corporations from practicing, controlling or exercising excessive influence over
behavioral healthcare services through the direct employment of psychiatrists
or, in a few states, psychologists and other behavioral healthcare
professionals. These laws and regulations vary considerably among states and the
Company may be subject to different types of laws and regulations depending on
the specific regulatory approach adopted by each state to regulate the managed
care business and the provision of behavioral healthcare treatment services. In
addition, the Company is subject to certain federal laws as a result of the role
the Company assumes in connection
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with managing its customers' employee benefit plans. The regulatory scheme
generally applicable to the Company's managed care operations is described in
this section. The Company's managed care operations are also indirectly affected
by regulations applicable to the operations of behavioral healthcare clinics and
facilities. See "Charter Advantage--Regulation."
The Company believes its operations are structured to comply with applicable
laws and regulations in all material respects and that it has received, or is in
the process of applying for, all licenses and approvals that are material to the
operation of its business. However, regulation of the managed healthcare
industry is evolving, with new legislative enactments and regulatory initiatives
at the state and federal levels being implemented on a regular basis.
Consequently, it is possible that a court or regulatory agency may take a
position under existing or future laws or regulations, or as a result of a
change in the interpretation thereof, that such laws or regulations apply to the
Company in a different manner than the Company believes such laws or regulations
apply. Moreover, any such position may require significant alterations to the
Company's business operations in order to comply with such laws or regulations,
or interpretations thereof. Expansion of the Company's business to cover
additional geographic areas, to serve different types of customers, to provide
new services or to commence new operations could also subject the Company to
additional licensure requirements and/or regulation.
LICENSURE. Certain regulatory agencies having jurisdiction over the Company
possess discretionary powers when issuing or renewing licenses or granting
approval of proposed actions such as mergers, a change in ownership, transfer or
assignment of licenses and certain intracorporate transactions. One or multiple
agencies may require as a condition of such licensure or approval that the
Company cease or modify certain of its operations in order to comply with
applicable regulatory requirements or policies. In addition, the time necessary
to obtain licensure or approval varies from state to state, and difficulties in
obtaining a necessary license or approval may result in delays in the Company's
plans to expand operations in a particular state and, in some cases, lost
business opportunities. Compliance activities, mandated changes in the Company's
operations, delays in the expansion of the Company's business or lost business
opportunities as a result of regulatory requirements or policies could have a
material adverse effect on the Company.
INSURANCE, HMO AND PPO ACTIVITIES. To the extent that the Company operates
or is deemed to operate in one or more states as an insurance company, HMO, PPO
or similar entity, it may be required to comply with certain laws and
regulations that, among other things, may require the Company to maintain
certain types of assets and minimum levels of deposits, capital, surplus,
reserves or net worth. In many states, entities that assume risk under contracts
with licensed insurance companies or HMOs have not been considered by state
regulators to be conducting an insurance or HMO business. As a result, the
Company has not sought licensure as either an insurer or HMO in certain states.
The National Association of Insurance Commissioners (the "NAIC") has undertaken
a comprehensive review of the regulatory status of entities arranging for the
provision of healthcare services through a network of providers that, like the
Company, may assume risk for the cost and quality of healthcare services, but
that are not currently licensed as an HMO or similar entity. As a result of this
review, the NAIC developed a "health organizations risk-based capital" formula,
designed specifically for managed care organizations, that establishes a minimum
amount of capital necessary for a managed care organization to support its
overall operations, allowing consideration for the organization's size and risk
profile. The NAIC initiative also may result in the adoption of a model NAIC
regulation in the area of health plan standards, which could be adopted by
individual states in whole or in part, and could result in the Company being
required to meet additional or new standards in connection with its existing
operations. Individual states have also recently adopted their own regulatory
initiatives that subject entities such as the Company to regulation under state
insurance laws. This includes, but is not limited to, requiring licensure as an
insurance company or HMO and requiring adherence to specific financial solvency
standards. State insurance laws and regulations may limit the ability of the
Company to pay dividends, make certain investments and repay certain
indebtedness. Licensure as an insurance company, HMO or
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similar entity could also subject the Company to regulations governing reporting
and disclosure, mandated benefits, and other traditional insurance regulatory
requirements. PPO regulations to which the Company may be subject may require
the Company to register with a state authority and provide information
concerning its operations, particularly relating to provider and payor
contracting. Based on the information presently available to it, the Company
does not believe that the imposition of requirements related to maintaining
certain types of assets, prescribed levels of deposits, capital, surplus,
reserves or net worth, or complying with other regulatory requirements
applicable to its insurance company, HMO, PPO or similar operations, would have
a material adverse effect on the Company. Notwithstanding the foregoing, the
imposition of such requirements could increase the Company's cost of doing
business and could delay the Company's conduct or expansion of its business in
some areas. The licensure process under state insurance laws can be lengthy and,
unless the applicable state regulatory agency allows the Company to continue to
operate while the licensure process is ongoing, the Company could experience a
material adverse effect on its operating results and financial condition while
its licensure application is pending. In addition, failure by the Company to
obtain and maintain required licenses typically also constitutes an event of
default under the Company's contracts with its customers. The loss of business
from one or more of the Company's major customers as a result of such an event
of default or otherwise could have a material adverse effect on the Company.
UTILIZATION REVIEW AND THIRD-PARTY ADMINISTRATOR ACTIVITIES. Numerous
states in which the Company does business have adopted, or are expected to
adopt, regulations governing entities engaging in utilization review and TPA
activities. Utilization review regulations typically impose requirements with
respect to the qualifications of personnel reviewing proposed treatment,
timeliness and notice of the review of proposed treatment, and other matters.
TPA regulations typically impose requirements regarding claims processing and
payments and the handling of customer funds. Utilization review and TPA
regulations may increase the Company's cost of doing business in the event that
compliance requires the Company to retain additional personnel to meet the
regulatory requirements and to take other required actions and make necessary
filings. Although compliance with utilization review regulations has not had a
material adverse effect on the Company, there can be no assurance that specific
regulations adopted in the future would not have such a result, particularly
since the nature, scope and specific requirements of such provisions vary
considerably among states that have adopted regulations of this type.
There is a trend among states to require licensure or certification of
entities performing utilization review or TPA activities; however, certain
federal courts have held that such licensure requirements are preempted by
ERISA. ERISA preempts state laws that mandate employee benefit structures or
their administration, as well as those that provide alternative enforcement
mechanisms. The Company believes that its TPA activities performed for its
self-insured employee benefit plan customers are exempt from otherwise
applicable state licensing or registration requirements based upon federal
preemption under ERISA and has relied on this general principle in determining
not to seek licensure for certain of its activities in many states. Existing
case law is not uniform on the applicability of ERISA preemption with respect to
state regulation of utilization review or TPA activities. There can be no
assurance that additional licensure will not be required with respect to
utilization review or TPA activities in certain states.
"ANY WILLING PROVIDER" LAWS. Several states in which the Company does
business have adopted, or are expected to adopt, "any willing provider" laws.
Such laws typically impose upon insurance companies, PPOs, HMOs or other types
of third-party payors an obligation to contract with, or pay for the services
of, any healthcare provider willing to meet the terms of the payor's contracts
with similar providers. Compliance with any willing provider laws could increase
the Company's costs of assembling and administering provider networks and could,
therefore, have a material adverse effect on its operations.
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LICENSING OF HEALTHCARE PROFESSIONALS. The provision of behavioral
healthcare treatment services by psychiatrists, psychologists and other
providers is subject to state regulation with respect to the licensing of
healthcare professionals. The Company believes that the healthcare professionals
who provide behavioral healthcare treatment on behalf of or under contracts with
the Company are in compliance with the applicable state licensing requirements
and current interpretations thereof; however, there can be no assurance that
changes in such state licensing requirements or interpretations thereof will not
adversely affect the Company's existing operations or limit expansion. With
respect to the Company's crisis intervention program, additional licensure of
clinicians who provide telephonic assessment or stabilization services to
individuals who are calling from out-of-state may be required if such assessment
or stabilization services are deemed by regulatory agencies to be treatment
provided in the state of such individual's residence. The Company believes that
any such additional licensure could be obtained; however, there can be no
assurance that such licensing requirements will not adversely affect the
Company's existing operations or limit expansion.
PROHIBITION ON FEE SPLITTING AND CORPORATE PRACTICE OF PROFESSIONS. The
laws of some states limit the ability of a business corporation to directly
provide, control or exercise excessive influence over behavioral healthcare
services through the direct employment of psychiatrists, psychologists, or other
behavioral healthcare professionals. In addition, the laws of some states
prohibit psychiatrists, psychologists, or other healthcare professionals from
splitting fees with other persons or entities. These laws and their
interpretations vary from state to state and enforcement by the courts and
regulatory authorities may vary from state to state and may change over time.
The Company believes that its operations as currently conducted are in material
compliance with the applicable laws, however, there can be no assurance that the
Company's existing operations and its contractual arrangements with
psychiatrists, psychologists and other healthcare professionals will not be
successfully challenged under state laws prohibiting fee splitting or the
practice of a profession by an unlicensed entity, or that the enforceability of
such contractual arrangements will not be limited. The Company believes that it
could, if necessary, restructure its operations to comply with changes in the
interpretation or enforcement of such laws and regulations, and that such
restructuring would not have a material adverse effect on its operations.
DIRECT CONTRACTING WITH LICENSED INSURERS. Regulators in several states in
which the Company does business have adopted policies that require HMOs or, in
some instances, insurance companies, to contract directly with licensed
healthcare providers, entities or provider groups, such as IPAs, for the
provision of treatment services, rather than with unlicensed intermediary
companies. In such states, the Company's customary model of contracting directly
with its customers may need to be modified so that, for example, the IPAs
(rather than the Company) contract directly with the HMO or insurance company,
as appropriate, for the provision of treatment services. The Company intends to
work with a number of these HMO customers to restructure existing contractual
arrangements, upon contract renewal or in renegotiations, so that the entity
which contracts with the HMO directly is an IPA. The Company does not expect
this method of contracting to have a material adverse effect on its operations.
OTHER REGULATION OF HEALTHCARE PROVIDERS. The Company's business is
affected indirectly by regulations imposed upon healthcare providers.
Regulations imposed upon healthcare providers include provisions relating to the
conduct of, and ethical considerations involved in, the practice of psychiatry,
psychology, social work and related behavioral healthcare professions and, in
certain cases, the common law duty to warn others of danger or to prevent
patient self-injury. Confidentiality and patient privacy requirements are
particularly strict in the field of behavioral healthcare services, and
additional legislative initiatives relating to confidentiality are expected. The
Health Insurance Portability and Accountability Act of 1996 ("HIPAA") included a
provision that prohibits the wrongful disclosure of certain "individually
identifiable health information." HIPAA requires the Secretary of the Department
to adopt standards relating to the transmission of such health information by
healthcare providers and healthcare plans. Although the Company believes that
such regulations do not at present materially impair the Company's
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operations, there can be no assurance that such indirect regulation will not
have a material adverse effect on the Company in the future.
REGULATION OF CUSTOMERS. Regulations imposed upon the Company's customers
include, among other things, benefits mandated by statute, exclusions from
coverages prohibited by statute, procedures governing the payment and processing
of claims, record keeping and reporting requirements, requirements for and
payment rates applicable to coverage of Medicaid and Medicare beneficiaries,
provider contracting and enrollee rights, and confidentiality requirements.
Although the Company believes that such regulations do not at present materially
impair the Company's operations, there can be no assurance that such indirect
regulation will not have a material adverse effect on the Company in the future.
ERISA. Certain of the Company's services are subject to the provisions of
ERISA. ERISA governs certain aspects of the relationship between
employer-sponsored healthcare benefit plans and certain providers of services to
such plans through a series of complex laws and regulations that are subject to
periodic interpretation by the Internal Revenue Service and the Department of
Labor. In some circumstances, and under certain customer contracts, the Company
may be expressly named as a "fiduciary" under ERISA, or be deemed to have
assumed duties that make it an ERISA fiduciary, and thus be required to carry
out its operations in a manner that complies with ERISA requirements in all
material respects. Although the Company believes that it is in material
compliance with the applicable ERISA requirements and that such compliance does
not currently have a material adverse effect on the Company's operations, there
can be no assurance that continuing ERISA compliance efforts or any future
changes to the applicable ERISA requirements will not have a material adverse
effect on the Company.
OTHER PROPOSED LEGISLATION. In the last five years, legislation has
periodically been introduced at the state and federal level providing for new
regulatory programs and materially revising existing regulatory programs. Any
such legislation, if enacted, could materially adversely affect the Company's
business, financial condition or results of operations. Such legislation could
include both federal and state bills affecting the Medicaid programs which may
be pending in or recently passed by state legislatures and which are not yet
available for review and analysis. Such legislation could also include proposals
for national health insurance and other forms of federal regulation of health
insurance and healthcare delivery. It is not possible at this time to predict
whether any such legislation will be adopted at the federal or state level, or
the nature, scope or applicability to the Company's business of any such
legislation, or when any particular legislation might be implemented. No
assurance can be given that any such federal or state legislation will not have
a material adverse effect on the Company.
CAUTIONARY STATEMENTS--THE COMPANY.
This Form 10-K includes "forward-looking statements" within the meaning of
Section 27A of the Securities Act and Section 21E of the Exchange Act. Although
the Company believes that its plans, intentions and expectations reflected in
such forward-looking statements are reasonable, it can give no assurance that
such plans, intentions or expectations will be achieved. Important factors that
could cause actual results to differ materially from the Company's
forward-looking statements are set forth below and elsewhere in this Form 10-K.
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 below. Additional cautionary statements
regarding the Company's healthcare franchising operations business are set forth
below elsewhere herein. See "--Charter Advantage-- Cautionary Statements--CBHS."
SUBSTANTIAL LEVERAGE AND DEBT SERVICE OBLIGATIONS The Company is currently
highly leveraged, with indebtedness that is substantial in relation to its
stockholders' equity. As of September 30, 1998, the Company's aggregate
outstanding indebtedness was approximately $1.2 billion and the Company's
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stockholders' equity was approximately $187.6 million as of the same date. The
New Credit Agreement and the Indenture permit the Company to incur or guarantee
certain additional indebtedness, subject to certain limitations.
The Company's high degree of leverage could have important consequences to
the Company, including, but not limited to, the following: (i) the Company's
ability to obtain additional financing for working capital, capital
expenditures, acquisitions, general corporate purposes or other purposes may be
impaired in the future; (ii) a substantial portion of the Company's cash flows
from operations must be dedicated to the payment of principal and interest on
its indebtedness; (iii) the Company is substantially more leveraged than certain
of its competitors, which might place the Company at a competitive disadvantage;
(iv) the Company may be hindered in its ability to adjust rapidly to changing
market conditions; and (v) the Company's high degree of leverage could make it
more vulnerable in the event of a downturn in general economic conditions or its
business or in the event of adverse changes in the regulatory environment
applicable to the Company.
The Company's ability to repay or to refinance its indebtedness and to pay
interest on its indebtedness will depend on its financial and operating
performance, which, in turn, is subject to prevailing economic and competitive
conditions and to certain financial, business and other factors, many of which
are beyond the Company's control. These factors could include operating
difficulties, increased operating costs, the actions of competitors, regulatory
developments and delays in implementing strategic projects. The Company's
ability to meet its debt service and other obligations may depend in significant
part on the extent to which the Company can successfully implement its business
strategy. There can be no assurance that the Company will be able to implement
its strategy fully or that the anticipated results of its strategy will be
realized. See "Business--Business Strategy."
If the Company's cash flows and capital resources are insufficient to fund
its debt service obligations, the Company may be forced to reduce or delay
capital expenditures, sell assets or seek to obtain additional equity capital or
to restructure its debt. There can be no assurance that the Company's cash flows
and capital resources will be sufficient for payment of principal of and
interest on its indebtedness in the future, or that any such alternative
measures would be successful or would permit the Company to meet its scheduled
debt service obligations.
In addition, because the Company's obligations under the New Credit
Agreement bear interest at floating rates, an increase in interest rates could
adversely affect, among other things, the Company's ability to meet its debt
service obligations.
RESTRICTIVE FINANCING COVENANTS The New Credit Agreement and the Indenture
contain a number of covenants that restrict the operations of the Company and
its subsidiaries. In addition, the New Credit Agreement requires the Company to
comply with specified financial ratios and tests, including a minimum interest
coverage ratio, a maximum leverage ratio, a minimum net worth test, a maximum
senior debt ratio and a minimum "EBITDA" (as defined in the New Credit
Agreement). There can be no assurance that the Company will be able to comply
with such covenants, ratios and tests in the future. The Company's ability to
comply with such covenants, ratios and tests may be affected by events beyond
its control, including prevailing economic, financial and industry conditions.
The breach of any such covenants, ratios or tests could result in a default
under the New Credit Agreement that would permit the lenders thereunder to
declare all amounts outstanding thereunder to be immediately due and payable,
together with accrued and unpaid interest, and to prevent the Company from
paying principal, premium, interest or other amounts due on any or all of the
Notes until the default is cured or all Senior Indebtedness is paid or satisfied
in full. Furthermore, the commitments of the lenders under the New Credit
Agreement to make further extensions of credit thereunder could be terminated.
If the Company were unable to repay all amounts accelerated, the lenders could
proceed against the Subsidiary Guarantors and the collateral securing the
Company's and the Subsidiary Guarantors' obligations pursuant to the New Credit
Agreement. If the indebtedness outstanding pursuant to the New Credit Agreement
were to be accelerated, there can be no assurance that the assets of the Company
would be
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sufficient to repay such indebtedness and the other indebtedness of the Company.
The value of the Common Stock would be adversely affected if the Company were
unable to repay such indebtedness.
RISK-BASED PRODUCTS Revenues under risk-based contracts are the primary
source of the Company's revenue from its behavioral managed healthcare business.
Such revenues accounted for approximately 52% of the Company's total revenue and
approximately 76% of its behavioral managed healthcare revenue in fiscal 1998.
Under a risk-based contract, the Company assumes all or a portion of the
responsibility for the cost of providing a full or specified range of behavioral
healthcare treatment services to a specified beneficiary population in exchange,
generally, for a fixed fee per member per month. 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 aggregate cost of behavioral
healthcare treatment services provided to a given beneficiary population in a
given period exceeds the aggregate of the per member per month fees received by
the Company with respect to the beneficiary population in such period, the
Company will incur a loss with respect to such beneficiary population during
such period. Furthermore, the Company may be required to pay during any period
amounts with respect to behavioral healthcare treatment services provided to a
given beneficiary population that exceed per member per month fees received with
respect to such beneficiary population during the same period. There can be no
assurance that the Company's assumptions as to service utilization rates and
costs will accurately and adequately reflect actual utilization rates and costs,
nor can there be any assurance that increases in behavioral healthcare costs or
higher-than-anticipated utilization rates, significant aspects of which are
outside the Company's control, will not cause expenses associated with such
contracts to exceed the Company's revenue for such contracts. In addition, there
can be no assurance that adjustments will not be required to the estimates,
particularly those regarding cost of care, made in reporting historical
financial results. See Note 1 to the audited historical consolidated financial
statements of the Company included herein. The Company will attempt to increase
membership in its risk-based products. If the Company is successful in this
regard, the Company's exposure to potential losses from its risk-based products
will also be increased. Furthermore, certain of such contracts and certain state
regulations limit the profits that may be earned by the Company on risk-based
business and may require refunds if the loss experience is more favorable than
that originally anticipated. Such contracts and regulations may also require the
Company or certain of its subsidiaries to reserve a specified amount of cash as
financial assurance that it can meet its obligations under such contracts. As of
September 30, 1998, the Company had restricted cash reserves of $89.2 million
pursuant to such contracts and regulations. Such amounts will not be available
to the Company for general corporate purposes. Furthermore, certain state
regulations restrict the ability of subsidiaries that offer risk-based products
to pay dividends to the Company. Certain state regulations relating to the
licensing of insurance companies may also adversely affect the Company's
risk-based business. See "--Regulation." Although experience varies on a
contract-by-contract basis, historically, the Company's risk-based contracts
have been profitable. However, the degree of profitability varies significantly
from contract to contract. For example, the Company's Medicaid contracts with
governmental entities tend to have direct profit margins that are lower than the
Company's other contracts. The most significant factor affecting the
profitability of risk-based contracts is the ability to control direct service
costs. The Company believes that it will be in a better position to control
direct service costs as a result of the HAI, and Merit acquisitions.
RELIANCE ON CUSTOMER CONTRACTS Approximately 69% of the Company's revenue
in fiscal 1998 was derived from contracts with payors of behavioral healthcare
benefits. The Company's behavioral managed healthcare contracts typically have
terms of one to three years, and in certain cases contain renewal provisions
providing for successive terms of between one and two years (unless terminated
earlier). Substantially all of these contracts are immediately terminable with
cause and many, including some of the Company's most significant contracts, are
terminable without cause by the customer upon the provision of requisite notice
and the passage of a specified period of time (typically between 60 and 180
days), or upon the occurrence of certain other specified events. The Company's
ten largest
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behavioral managed healthcare customers accounted for approximately 55% of the
Company's behavioral managed healthcare revenue for fiscal 1998. The Company's
contract with the State of Tennessee to manage the behavioral healthcare
benefits for the State's TennCare program represented approximately 15% of the
Company's behavioral managed care revenue and approximately 10% of the Company's
consolidated revenue in fiscal 1998. There can be no assurance that such
contracts will be extended or successfully renegotiated or that the terms of any
new contracts will be comparable to those of existing contracts. Loss of all of
these contracts or customers would, and loss of any one of these customers
could, have a material adverse effect on the Company. In addition, price
competition in bidding for contracts can significantly affect the financial
terms of any new or renegotiated contract. The Company's customers may
reevaluate their contractual arrangements with the Company as a result of the
consummation of the Transactions.
DEPENDENCE ON GOVERNMENT SPENDING FOR MANAGED HEALTHCARE; POSSIBLE IMPACT OF
HEALTHCARE REFORM A significant portion of the Company's managed care revenue
is derived, directly or indirectly, from federal, state and local governmental
agencies, including state Medicaid programs. Reimbursement rates vary from state
to state, are subject to periodic negotiation and may limit the Company's
ability to maintain or increase rates. The Company is unable to predict the
impact on the Company's operations of future regulations or legislation
affecting Medicaid or Medicare programs, or the healthcare industry in general,
and there can be no assurance that future regulations or legislation will not
have a material adverse effect on the Company. Moreover, any reduction in
government spending for such programs could also have a material adverse effect
on the Company. In addition, the Company's contracts with federal, state and
local governmental agencies, under both direct contract and subcontract
arrangements, generally are conditioned upon financial appropriations by one or
more governmental agencies, especially with respect to state Medicaid programs.
These contracts generally can be terminated or modified by the customer if such
appropriations are not made. Finally, some of the Company's contracts with
federal, state and local governmental agencies, under both direct contract and
subcontract arrangements, require the Company to perform additional services if
federal, state or local laws or regulations imposed after the contract is signed
so require, in exchange for additional compensation to be negotiated by the
parties in good faith. Government and other third-party payors are generally
seeking to impose lower reimbursement rates and to renegotiate reduced contract
rates with service providers in a trend toward cost control. See
"Industry--Areas of Growth" and "Business-- Business Strategy."
In August 1997, Congress enacted the Budget Act. The Medicare-related
provisions of the Budget Act are designed to reduce Medicare expenditures over
the next five years by $115 billion, compared to projected Medicare expenditures
before adoption of the Budget Act. The Congressional Budget Office projected in
July 1997 that $43.8 billion of the reductions would come from reduced payments
to hospitals, $21.8 billion from increased enrollment in managed care plans and
$11.7 billion from reduced payments to physicians and ambulatory care providers.
The five-year savings in projected Medicare payments to physicians and hospitals
would be achieved under the Budget Act by reduced fee-for-service reimbursement
and by changes in managed care programs designed to increase enrollment of
Medicare beneficiaries in managed care plans. The increase in Medicare
enrollment in managed care plans would be achieved in part by allowing
provider-sponsored organizations and preferred provider organizations to compete
with Medicare HMOs for Medicare enrollees.
The Medicaid-related provisions of the Budget Act are designed to achieve
net federal Medicaid savings of $14.6 billion over the next five years and $56.4
billion over the next ten years. The Budget Act achieves federal Medicaid
savings in three areas. First, two-thirds of the savings over the next ten years
are attributable to limitations on federal matching payments to states for
reimbursements to "disproportionate share" hospitals. The next largest source of
federal savings is a provision allowing states to shift the cost of Medicaid
deductibles and coinsurance requirements for low-income Medicaid beneficiaries
from their Medicaid programs to physicians and other providers. Most of the
remaining savings derive from the repeal of the "Boren Amendment" and other
minimum payment guarantees for hospitals,
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nursing homes and community health centers that serve Medicaid patients. These
changes may have an adverse effect on the Company if they result in reduced
payment levels for providers of managed behavioral healthcare services.
Prior to adoption of the Budget Act, the states were prohibited from
requiring Medicaid recipients to enroll in managed care products that covered
only Medicaid recipients. The Medicaid laws required that the states enroll
Medicaid recipients in products that also covered a specific number of
commercial enrollees. This requirement of the Medicaid laws was intended to
limit the ability of the states to reduce coverage levels for Medicaid
recipients below those offered to commercial enrollees. Under prior law, the
Secretary of the United States Department of Health and Human Services (the
"Department") could waive the prohibition. The Medicaid-related provisions of
the Budget Act give states broad flexibility to require most Medicaid recipients
to enroll in managed care products that only cover Medicaid recipients, without
obtaining a waiver from the Secretary of the Department that was required under
prior law. The Budget Act also allows states to limit the number of managed care
organizations with which the state will contract to deliver care to Medicaid
beneficiaries. These changes could have a positive impact on the Company's
business, if they result in increased enrollment of Medicaid beneficiaries in
managed care organizations and increased Medicaid spending on managed care.
However, these changes also may have an adverse effect on the Company if a
number of states decide to limit the number of managed care organizations with
which they will contract and to select the organization solely on the basis of
the cost of care, which could result in increased cost competition for state
contracts.
The Company cannot predict the effect of the Budget Act, or other healthcare
reform measures that may be adopted by Congress or state legislatures, on its
managed care operations and no assurance can be given that either the Budget Act
or other healthcare reform measures will not have an adverse effect on the
Company.
REGULATION The managed healthcare industry and the provision of behavioral
healthcare services are subject to extensive and evolving state and federal
regulation. The Company is subject to certain state laws and regulations,
including those governing: (i) the licensing of insurance companies, HMOs, PPOs,
TPAs and companies engaged in utilization review and (ii) the licensing of
healthcare professionals, including restrictions on business corporations from
practicing, controlling or exercising excessive influence over behavioral
healthcare services through the direct employment of psychiatrists or, in a few
states, psychologists and other behavioral healthcare professionals. In
addition, the Company is subject to certain federal laws as a result of the role
the Company assumes in connection with managing its customers' employee benefit
plans. The Company's managed care operations are also indirectly affected by
regulations applicable to the establishment and operation of behavioral
healthcare clinics and facilities.
In many states, entities that assume risk under contracts with licensed
insurance companies or HMOs have not been considered by state regulators to be
conducting an insurance or HMO business. As a result, the Company has not sought
licensure as either an insurer or HMO in certain states. Regulators in some
states, however, have determined that risk assuming activity by entities that
are not themselves providers of care is an activity that requires some form of
licensure. There can be no assurance that other states in which the Company
operates will not adopt a similar view, thus requiring the Company to obtain
additional licenses. Such additional licensure might require the Company to
maintain minimum levels of deposits, net worth, capital, surplus or reserves, or
limit the Company's ability to pay dividends, make investments or repay
indebtedness. The imposition of these additional licensure requirements could
increase the Company's cost of doing business or delay the Company's conduct or
expansion of its business.
Regulators may impose operational restrictions on entities granted licenses
to operate as insurance companies or HMOs. For example, the California
Department of Corporations ("DOC") imposed certain restrictions on the Company
in connection with its issuance of an approval of the Company's acquisition of
HAI, including restrictions on the ability of the California subsidiaries of HAI
to fund the Company's
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operations in other states and on the ability of the Company to make certain
operational changes with respect to HAI's California subsidiaries. The DOC
imposed substantially identical restrictions on the Company in connection with
the Company's acquisition of Merit. The Company does not believe such
restrictions will materially impact its integration plan.
In addition, utilization review and TPA activities conducted by the Company
are regulated by many states, which states impose requirements upon the Company
that increase its business costs. The Company believes that its TPA activities
performed for its self-insured employee benefit plan customers are exempt from
otherwise applicable state licensing or registration requirements based upon
federal preemption under the Employee Retirement Income Security Act of 1974, as
amended ("ERISA"), and has relied on this general principle in determining not
to seek licensure for certain of its activities in many states. Existing case
law is not uniform on the applicability of ERISA preemption with respect to
state regulation of utilization review or TPA activities. There can be no
assurance that additional licensure will not be required with respect to
utilization review or TPA activities in certain states. See "Business--
Regulation--Insurance, HMO, and PPO Activities" and "--Utilization Review and
Third-Party Administrator Activities."
State regulatory agencies responsible for the administration and enforcement
of the laws and regulations to which the Company's operations are subject have
broad discretionary powers. A regulatory agency or a court in a state in which
the Company operates could take a position under existing or future laws or
regulations, or change its interpretation or enforcement practices with respect
thereto, that such laws or regulations apply to the Company differently than the
Company believes such laws and regulations apply or should be enforced. The
resultant compliance with, or revocation of, or failure to obtain, required
licenses and governmental approvals could result in significant alteration to
the Company's business operations, delays in the expansion of the Company's
business and lost business opportunities, any of which, under certain
circumstances, could have a material adverse effect on the Company. See
"Business--Regulation--General," "--Licensure," "--Insurance, HMO and PPO
Activities" and "--Utilization Review and Third-Party Administrator Activities."
The laws of some states limit the ability of a business corporation to
directly provide, control or exercise excessive influence over behavioral
healthcare services through the direct employment of psychiatrists,
psychologists, or other behavioral healthcare professionals. In addition, the
laws of some states prohibit psychiatrists, psychologists, or other healthcare
professionals from splitting fees with other persons or entities. These laws and
their interpretations vary from state to state and enforcement by the courts and
regulatory authorities may vary from state to state and may change over time.
The Company believes that its operations as currently conducted are in material
compliance with the applicable laws, however there can be no assurance that the
Company's existing operations and its contractual arrangements with
psychiatrists, psychologists and other healthcare professionals will not be
successfully challenged under state laws prohibiting fee splitting or the
practice of a profession by an unlicensed entity, or that the enforceability of
such contractual arrangements will not be limited. The Company believes that it
could, if necessary, restructure its operations to comply with changes in the
interpretation or enforcement of such laws and regulations, and that such
restructuring would not have a material adverse effect on its operations.
Several states in which the Company does business have adopted, or are
expected to adopt, "any willing provider" laws. Such laws typically impose upon
insurance companies, PPOs, HMOs or other types of third-party payors an
obligation to contract with, or pay for the services of, any healthcare provider
willing to meet the terms of the payor's contracts with similar providers.
Compliance with any willing provider laws could increase the Company's costs of
assembling and administering provider networks and could, therefore, have a
material adverse effect on its operations.
The Company's managed care operations are also generally affected by
regulations applicable to the operations of healthcare clinics and facilities.
See "Charter Advantage--Regulation."
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INTEGRATION OF OPERATIONS As a result of the Company's acquisition of Merit
and HAI, the Company is the largest provider of managed behavioral healthcare
services in the United States, according to the enrollment data reported in OPEN
MINDS. The Company's ability to operate its acquired behavioral managed
healthcare businesses successfully depends on how well and how quickly it
integrates the acquired businesses with its existing operations. The Company
expects to achieve approximately $60.0 million of cost savings on an annual
basis by September 30, 1999. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations." However, as the Company
implements the integration process, it may need to implement enhanced
operational, financial and information systems and may require additional
employees and management, operational and financial resources. There can be no
assurance that the Company will be able to implement and maintain such
operational, financial and information systems successfully or successfully
obtain, integrate and utilize the required employees and management, operational
and financial resources to achieve the successful integration of the acquired
businesses with its existing operations. Failure to implement such systems
successfully and to use such resources effectively could have a material adverse
effect on the Company. Furthermore, implementing such operational, financial and
information systems or obtaining such employees and management could reduce the
cost savings the Company expects to achieve. See "Business-- Business Strategy."
HIGHLY COMPETITIVE INDUSTRY The industry in which the Company conducts its
managed care businesses is highly competitive. The Company competes with large
insurance companies, HMOs, PPOs, TPAs, provider groups and other managed care
companies. Many of the Company's competitors are significantly larger and have
greater financial, marketing and other resources than the Company, and some of
the Company's competitors provide a broader range of services. The Company may
also encounter substantial competition in the future from new market entrants.
Many of the Company's customers that are managed care companies may, in the
future, seek to provide behavioral managed healthcare services to their
employees or subscribers directly, rather than contracting with the Company for
such services. See "Business--Competition."
RISKS RELATED TO AMORTIZATION OF INTANGIBLE ASSETS The Company's total
assets at September 30, 1998 reflect intangible assets of approximately $1.16
billion. At September 30, 1998, net intangible assets were 60.4% of total assets
and 616.9% of total stockholders' equity. Intangible assets include goodwill of
approximately $992.4 million, which is amortized over 25 to 40 years, and other
identifiable intangible assets (primarily customer lists, provider networks and
treatment protocols) of approximately $165.2 million that are amortized over 4
to 30 years. The amortization periods used by the Company may differ from those
used by other registrants. In addition, the Company may be required to shorten
the amortization period for intangible assets in future periods based on the
prospects of acquired companies. There can be no assurance that the value of
such assets will ever be realized by the Company. The Company evaluates, on a
regular basis, whether events and circumstances have occurred that indicate that
all or a portion of the carrying value of intangible assets may no longer be
recoverable, in which case a charge to earnings for impairment losses could
become necessary. Any determination requiring the write-off of a significant
portion of unamortized intangible assets would adversely affect the Company's
results of operations. A write-off of intangible assets could become necessary
if the anticipated undiscounted cash flows of an acquired company do not support
the carrying value of long-lived assets, including intangible assets. At
present, no evidence exists that would indicate impairment losses may be
necessary in future periods.
SUBORDINATION OF FRANCHISE FEES The Company owns a 50% equity interest in
CBHS, from which it receives the Franchise Fees. The Franchise Fees have in the
past represented a significant portion of the Company's earnings and cash flows.
The Franchise Fees payable to the Company by CBHS are subordinated in right of
payment to the $41.7 million initial annual base rent and 5% minimum escalator
rent due to Crescent. The Company is required to provide certain services to
CBHS under the Master Franchise Agreement whether or not CBHS pays the Franchise
Fees. However, the Company has no
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obligation to contribute additional capital or make advances to CBHS. See
"Charter Advantage -- Franchise Operations." If CBHS encounters a decline in
earnings or financial difficulties, such amounts due from CBHS to Crescent will
be paid before any Franchise Fees are paid. The remainder of CBHS's available
cash will then be applied in such order of priority as CBHS may determine, to
all other operating expenses of CBHS, including the current and accumulated
Franchise Fees. The Company will be entitled to pursue all available remedies
for breach of the Master Franchise Agreement, except that the Company does not
have the right to take any action that could reasonably be expected to force
CBHS into bankruptcy or receivership.
As a result of the Crescent Transactions, the Company no longer controls the
operations of the Psychiatric Hospital Facilities and other facilities operated
by CBHS. Accordingly, factors that the Company does not control will likely
influence the amount of Franchise Fees that the Company will realize in the
future.
Based on operational projections prepared by CBHS management for the fiscal
year ended September 30, 1999, and on CBHS' results of operations through
September 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 1999. CBHS paid $40.6 million of Franchise Fees to the
Company during fiscal 1998. The Company estimates that CBHS will be able to pay
$0 to $15.0 million of Franchise Fees in fiscal 1999. Based on the amount of
unpaid Franchise Fees ($38 million as of September 30, 1998), the Company
exercised its limited management rights available to it under the Master
Franchise Agreement and, with CBHS's Board Support, made operational and
management changes aimed at improving profitability and cash flows at CBHS. The
Company has since restored all management rights to the CBHS Board. See "Charter
Advantage--Franchise Operations."
The Company's relationship with CBHS and the business of CBHS are described
elsewhere herein. Such information is relevant to an understanding of the
factors having a bearing on the Company's receipt of Franchise Fees from CBHS.
PROFESSIONAL LIABILITY; INSURANCE The management and administration of the
delivery of behavioral managed healthcare services, like other healthcare
services, entail significant risks of liability. The Company is regularly
subject to lawsuits alleging malpractice and related legal theories, some of
which involve situations in which participants in the Company's programs have
committed suicide. The Company is also subject to claims of professional
liability for alleged negligence in performing utilization review activities, as
well as for acts and omissions of independent contractors participating in the
Company's third-party provider networks. The Company is subject to claims for
the costs of services denied. There can be no assurance that the Company's
procedures for limiting liability have been or will be effective, or that one or
more lawsuits will not have a material adverse effect on the Company in the
future.
The Company carries professional liability insurance, subject to certain
deductibles. There can be no assurance that such insurance will be sufficient to
cover any judgments, settlements or costs relating to present or future claims,
suits or complaints or that, upon expiration thereof, sufficient insurance will
be available on favorable terms, if at all. If the Company is unable to secure
adequate insurance in the future, or if the insurance carried by the Company is
not sufficient to cover any judgments, settlements or costs relating to any
present or future actions or claims, there can be no assurance that the Company
will not be subject to a liability that could have a material adverse effect on
the Company. See "Business-Insurance."
The Company has certain liabilities relating to the self-insurance program
it maintained with respect to its provider business prior to the Crescent
Transactions. See Note 13 to the Company's audited historical consolidated
financial statements included elsewhere herein.
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CHARTER ADVANTAGE
OVERVIEW
On June 17, 1997, the Company consummated the Crescent Transactions,
pursuant to which, among other things, it sold the Psychiatric Hospital
Facilities to Crescent. In addition, the Company and COI, an affiliate of
Crescent, formed a joint venture known as CBHS to operate the Psychiatric
Hospital Facilities and certain other facilities transferred by the Company to
CBHS. The Company and COI each own 50% of the equity interest of CBHS. The
Company obtained its equity interest by contributing approximately $5 million of
net assets, including five leased psychiatric hospitals, to CBHS. In fiscal
1997, subsequent to the initial capitalization of CBHS, the Company and COI each
contributed an additional $17.5 million to the capital of CBHS. The Company has
no obligation to make additional contributions to the capital of CBHS. The
Company accounts for its 50% investment in CBHS under the equity method of
accounting. In connection with the Crescent Transactions, the Company received
approximately $417.2 million in cash (before costs of approximately $16.0
million) and warrants for the purchase of 2.5% of COI's common stock,
exercisable over 12 years. The Company also issued 1,283,311 warrants to
purchase shares of the Company's Common Stock to each of Crescent and COI at an
exercise price of $30 per share. In related agreements, Crescent and CBHS
entered into the facilities lease described below and the Company, CBHS and the
Psychiatric Hospital Facilities and other facilities transferred by the Company
to CBHS entered into the franchise agreements described below. Following the
consummation of the Crescent Transactions, the Company formed a new business
unit, "Charter Advantage," to franchise the "CHARTER" system of behavioral
healthcare to operators of behavioral healthcare facilities. Currently, its
primary customer is CBHS.
The following discussion of Charter Advantage's operations, CBHS and the
psychiatric hospital industry in general is relevant to an assessment of the
factors having a bearing on CBHS's ability to pay Franchise Fees to the Company,
the value of the Company's interest in the equity of CBHS and the future
business prospects of CBHS.
FRANCHISE OPERATIONS
FRANCHISE AGREEMENTS. Charter Advantage franchises the "CHARTER" System of
behavioral healthcare to the Psychiatric Hospital Facilities and other
facilities operated by CBHS. Each facility has entered into a separate Franchise
Agreement with Charter Advantage. Each franchisee is granted the right to engage
in the business of providing behavioral healthcare utilizing the "CHARTER"
System in a defined territory. Each franchisee is authorized to conduct a
"Hospital/RTC Based Behavioral Healthcare Business," which is defined as the
business of the operation of an acute care psychiatric hospital, part of an
acute care general hospital operating an acute care psychiatric unit, a
behavioral healthcare residential treatment center, a part of a facility
operating a behavioral healthcare residential treatment center, or other similar
facility providing 24-hour behavioral healthcare and the delivery of behavioral
healthcare from such facility or other affiliated facilities; such behavioral
healthcare to include inpatient hospitalization, partial hospitalization
programs, outpatient therapy, intensive outpatient therapy, residential
treatment, ambulatory detoxification, behavioral modification programs and
related services. The "CHARTER" System is a system for the operation of
Hospital/RTC Based Behavioral Healthcare Businesses under the "CHARTER" names
and marks, and includes the right to use computer software, treatment programs
and procedures, quality standards, quality assessment methods, performance
improvement and monitoring programs, as well as advertising and marketing
assistance, promotional materials, consultation and other matters relating to
the operation of Hospital/RTC Based Behavioral Healthcare Businesses.
The rights granted under each franchise agreement relate solely to a defined
territory. The rights are non-exclusive except that Charter Advantage may not
grant a franchise for, or itself operate, a facility located within a
franchisee's territory using the "CHARTER" System. Charter Advantage, however,
may
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grant franchises or licenses to individual physicians, psychologists or other
mental healthcare professionals, to operate businesses for the delivery of
behavioral healthcare utilizing the "CHARTER" System at facilities in the
franchisee's territory other than at an in-patient facility. Charter Advantage
also reserves the right to grant franchises to others to operate behavioral
healthcare businesses utilizing the "CHARTER" System other than in the
franchisee's territory and to otherwise use and grant to others the right to use
the "CHARTER" name or any other name for other businesses. In addition, Charter
Advantage reserves the right to: (i) provide behavioral healthcare services
incidental to the managed behavioral healthcare businesses or any other business
the principal purpose of which is not the operation of a Hospital/RTC Based
Behavioral Healthcare Business and (ii) pursuant to contracts with federal,
state and local governmental agencies, provide health and human services,
including behavioral healthcare services, to the mentally retarded, the
developmental disabled, the elderly, persons under the control or supervision of
criminal/juvenile systems and other designated populations.
During the term of each franchise agreement, Charter Advantage provides
franchisees with: (i) advertising and marketing assistance, including
consultation, access to media buying programs and access to broadcast and other
advertising materials produced by Charter Advantage; (ii) risk management
services, including risk financial planning, loss control and claims management;
(iii) outcomes monitoring; (iv) national and regional contracting services; and
(v) consultation by telephone or at Charter Advantage's offices with respect to
matters relating to the franchisee's business in which Charter Advantage has
expertise, including reimbursement, government relations, clinical strategies,
regulatory matters, strategic planning and business development.
FRANCHISE FEES; SUBORDINATION. The Company and CBHS are parties to a Master
Franchise Agreement pursuant to which CBHS pays the Company annual Franchise
Fees for granting the right to utilize the "CHARTER" System to the facilities
operated by CBHS. CBHS is obligated under the Master Franchise Agreement for
annual Franchise Fees equal to the greater of (i) $78.3 million, subject to
increases for inflation, and (ii) $78.3 million, plus 3% of CBHS's gross
revenues over $1 billion and not in excess of $1.2 billion and 5% of CBHS' gross
revenues over $1.2 billion. The Company, CBHS and Crescent have entered into a
Subordination Agreement pursuant to which the Franchise Fees are subordinated to
base rent and minimum escalator rent under the Facilities Lease between Crescent
and CBHS with respect to the facilities operated by CBHS.
Based on operational projections prepared by CBHS management for the fiscal
year ended September 30, 1999, and on CBHS' results of operations through
September 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 1999. CBHS paid $40.6 million of Franchise Fees to the
Company during fiscal 1998. The Company estimates that CBHS will be able to pay
$0 to $15.0 million of Franchise Fees in fiscal 1999. If the aggregate amount of
Franchise Fees not paid exceeds $6.0 million, but is less than $18.0 million,
the Company has the right to prohibit CBHS from paying any incentive
compensation to CBHS's management and may prohibit the vesting of any equity in
CBHS to which management of CBHS may be entitled during the period when
Franchise Fees remain unpaid. If the aggregate amount of Franchise Fees not paid
exceeds $18.0 million, but is less than $24.0 million, the Company has the right
to prohibit any salary increases for key personnel of CBHS, to prohibit any
additional hiring by CBHS and to prohibit CBHS from making any hospital
acquisitions or entering into any hospital joint ventures directly or indirectly
during such period. If the aggregate amount of Franchise Fees not paid exceeds
$24.0 million, the Company may require CBHS to reduce by 5% the expenses
approved in its current budget, to seek approval of expenditures, including
capital and operating expenditures, on a monthly basis, and to transfer control
and management of CBHS and the Psychiatric Hospital Facilities to the Company.
Notwithstanding the foregoing, the Company does not have the right to take any
action, in connection with the exercise of remedies against CBHS, that could
reasonably be expected to force CBHS into bankruptcy or receivership, or similar
proceedings, with respect to any dispute that may arise among the parties with
respect to payment or nonpayment of the Franchise Fees.
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Based on the amount of unpaid Franchise Fees ($38 million as of September 30,
1998), the Company exercised certain of the limited management rights available
to it under the Master Franchise Agreement and, with CBHS' Board support, made
operational and management changes aimed at improving profitability and cash
flows at CBHS. The Company has since restored all management rights to the CBHS
Board.
The initial term of the Facilities Lease is twelve years. CBHS has the right
to renew the lease for four additional terms of five years each. The base rent
for the first year of the initial term was $41.7 million, which increases each
year during the initial term by five percent compounded annually.
Notwithstanding the foregoing, when accrued and unpaid Franchise Fees,
including interest thereon, if any, equal or exceed $15.0 million, then CBHS's
available cash is thereafter first applied to base rent and minimum escalator
rent, under the Facilities Lease. The remainder of CBHS's available cash may
then be applied in such order of priority as CBHS may determine, in the
reasonable discretion of its Board of Directors (half the members of which are
appointed by the Company), to all other operating expenses of CBHS, including,
without limitation, the current and accumulated Franchise Fees, and any other
operating expenses.
CBHS
OVERVIEW. CBHS is the nation's largest operator of acute-care psychiatric
hospitals and other behavioral care treatment facilities. CBHS's psychiatric
hospitals are located in well-populated urban and suburban locations in 32
states. Most of CBHS's hospitals offer a full continuum of behavioral care in
their service area. The continuum includes inpatient hospitalization, partial
hospitalization, intensive outpatient services and, in some markets, residential
treatment services.
CBHS's hospitals provide structured and intensive treatment programs for
mental health and alcohol and drug dependency disorders in children, adolescents
and adults. The specialization of programs enables the clinical staff to provide
care that is specific to the patient's needs and facilitates monitoring of the
patient's progress. A typical treatment program at a CBHS facility integrates
physicians and other patient-care professionals with structured activities,
providing patients with testing, adjunctive therapies (occupational,
recreational and other), group therapy, individual therapy and educational
programs. A treatment program includes one or more of the types of treatment
settings provided by CBHS's continuum of care. For those patients who do not
have a personal psychiatrist or other specialist, the hospital refers the
patient to a member of its medical staff.
A significant portion of hospital admissions are provided by referrals from
former patients, local marketplace advertising, managed care organizations and
physicians. Professional relationships are an important aspect of the ongoing
business of a behavioral care facility. Management believes the quality of
CBHS's treatment programs, staff employees and physical facilities are important
factors in maintaining good professional relationships.
CBHS's hospitals work closely with mental health professionals,
non-psychiatric physicians, emergency rooms and community agencies that come in
contact with individuals who may need treatment for mental illness or substance
abuse. A portion of the Company's marketing efforts is directed at increasing
general awareness of mental health and addictive disease and the services
offered by the Company's franchisees.
INDUSTRY TRENDS. CBHS's hospitals have been adversely affected by factors
influencing the entire psychiatric hospital industry. Such factors include: (i)
the imposition of more stringent length of stay and admission criteria and other
cost containment measures by payors; (ii) the failure of reimbursement rate
increases from certain payors that reimburse on a per diem or other discounted
basis to offset increases in the cost of providing services; (iii) an increase
in the percentage of business that CBHS derives from payors that reimburse on
per diem or other discounted basis; (iv) a trend toward higher deductibles and
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co-insurance for individual patients; (v) a trend toward limited employee
behavioral health benefits, such as reductions in annual and lifetime limits on
behavioral health coverage; and (vi) pricing pressure related to an increasing
rate of claims denials by third party payors. In response to these conditions,
the Company believes that CBHS will (i) strengthen controls to minimize costs
and capital expenditures; (ii) review its portfolio of hospitals and sell, close
or lease hospitals or consolidate operations in certain locations; (iii) develop
strategies to increase outpatient services and partial hospitalization programs
to meet the demands of the marketplace; (iv) implement programs to contest third
party denials relating to valid pre-certified treatment and admissions; and (v)
renegotiate contracts with managed care organizations at increased rates.
SOURCES OF REVENUE. Payments are made to CBHS by patients, by insurance
companies and self-insured employers, by the federal and state governments under
Medicare, Medicaid, CHAMPUS and other programs and by HMOs, PPOs and other
managed care programs. Amounts received from most payors are less than the
hospital's established charges.
COMPETITION. Each of CBHS's hospitals competes with other hospitals, some
of which are larger and have greater financial resources. Some competing
hospitals are owned and operated by governmental agencies, others by nonprofit
organizations supported by endowments and charitable contributions and others by
proprietary hospital corporations. The hospitals frequently draw patients from
areas outside their immediate locale and, therefore, CBHS's hospitals may, in
certain markets, compete with both local and distant hospitals. In addition,
CBHS's hospitals compete not only with other psychiatric hospitals, but also
with psychiatric units in general hospitals, and outpatient services provided by
CBHS compete with private practicing mental health professionals, publicly
funded mental health centers and partial hospitalization and other intensive
outpatient services programs and facilities. The competitive position of a
hospital is, to a significant degree, dependent upon the number and quality of
physicians who practice at the hospital and who are members of its medical
staff. The Company believes that CBHS competes effectively with respect to the
aforementioned factors. However, there can be no assurance that CBHS will be
able to compete successfully in the provider business in the future.
Competition among hospitals and other healthcare providers for patients has
intensified in recent years. During this period, hospital occupancy rates for
inpatient behavioral care patients in the United States have declined as a
result of cost containment pressures, changing technology, changes in
reimbursement, changes in practice patterns from inpatient to outpatient
treatment and other factors. In recent years, the competitive position of
hospitals has been affected by the ability of such hospitals to obtain contracts
with PPO's, HMO's and other managed care programs to provide inpatient and other
services. Such contracts normally involve a discount from the hospital's
established charges, but provide a base of patient referrals. These contracts
also frequently provide for pre-admission certification and for concurrent
length of stay reviews. The importance of obtaining contracts with HMO's, PPO's
and other managed care companies varies from market to market, depending on the
individual market strength of the managed care companies. In certain states,
certificate of need laws place limitations on CBHS's and its competitors'
ability to build new hospitals and to expand existing hospitals and services.
CAUTIONARY STATEMENTS--CBHS
The following factors are relevant to an understanding of the risks
associated with CBHS's business and the ability of CBHS to pay Franchise Fees to
the Company.
POTENTIAL REDUCTIONS IN REIMBURSEMENT BY THIRD-PARTY PAYORS AND CHANGES IN
HOSPITAL PAYOR MIX. CBHS's hospitals have been adversely affected by certain
factors influencing the entire psychiatric hospital industry. See"--Industry
Trends" Any of these factors may result in reductions in the amounts that CBHS's
hospitals can expect to collect per patient day for services provided or the
number of equivalent patient days.
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Changes in the mix of CBHS's patients among the private-pay, Medicare and
Medicaid categories, and among different types of private-pay sources, could
significantly affect the profitability of CBHS's hospital operations. Moreover,
there can be no assurance that payments under governmental and private
third-party payor programs will remain at levels comparable to present levels or
will, in the future, be sufficient to cover the costs of providing care to
patients covered by such programs.
GOVERNMENTAL BUDGETARY CONSTRAINTS AND HEALTHCARE REFORM. In the 1995 and
1996 sessions of the United States Congress, the focus of healthcare legislation
was on budgetary and related funding mechanism issues. Both the Congress and the
Clinton Administration have made proposals to reduce the rate of increase in
projected Medicare and Medicaid expenditures and to change funding mechanisms
and other aspects of both programs. The Budget Act, which was signed into law by
President Clinton in August 1997, reduces federal spending by an estimated $140
billion. The majority of the spending reduction will come from Medicare cuts of
$115.0 billion. The Congressional Budget Office projected in July 1997 that
$43.8 billion of the reductions would come from reduced payments to hospitals,
$21.8 billion from increased enrollment in managed care plans and $11.7 billion
from reduced payments to physicians and ambulatory care providers. The five-year
savings in projected Medicare payments to physicians and hospitals would be
achieved under the Budget Act by reduced fee-for-service reimbursement and by
changes in managed care programs designed to increase enrollment of Medicare
beneficiaries in managed care plans. The increase in Medicare enrollment in
managed care plans would be achieved in part by allowing provider-sponsored
organizations and preferred provider organizations to compete with Medicare HMOs
for Medicare enrollees.
The Medicaid-related provisions of the Budget Act are designed to achieve
net federal Medicaid savings of $14.6 billion over the next five years and $56.4
billion over the next ten years. The Budget Act achieves Federal Medicaid
savings in three areas. First, two-thirds of the savings over the next ten years
are attributable to limitations on federal matching payments to states for
reimbursements to "disproportionate share" hospitals. The next largest source of
federal savings is a provision allowing states to shift the cost of Medicaid
deductibles and coinsurance requirements for low-income Medicaid beneficiaries
from their Medicaid programs to physicians and other providers. Most of the
remaining savings derive from the repeal of the "Boren Amendment" and other
minimum payment guarantees for hospitals, nursing homes and community health
centers that service Medicaid patients.
CBHS management estimates that the Budget Act will reduce the amount of
revenue and earnings that CBHS will receive for the treatment of Medicare and
Medicaid patients. CBHS management estimates that such reductions approximated
$10.0 million in fiscal 1998, and due to the phase in effects of the bill, will
approximate $15.0 million in subsequent fiscal years.
A number of states in which CBHS has operations have either adopted or are
considering the adoption of healthcare reform proposals of general applicability
or Medicaid reform proposals. Where adopted, these state reform laws have often
not yet been fully implemented. The Company cannot predict the effect of these
state healthcare reform proposals on CBHS's operations. The Company cannot
predict the effect of other healthcare reform measures that may be adopted by
Congress on the operations of CBHS and no assurance can be given that other
federal healthcare reform measures will not have an adverse effect on CBHS.
DEPENDENCE ON HEALTHCARE PROFESSIONALS. Physicians traditionally have been
the source of a significant portion of the patients treated at CBHS's hospitals.
Therefore, the success of CBHS's hospitals is dependent in part on the number
and quality of the physicians on the medical staffs of the hospitals and their
admission practices. A small number of physicians account for a significant
portion of patient admissions at some of CBHS's hospitals. There can be no
assurance that CBHS can retain its current physicians on staff or that
additional physician relationships will be developed in the future. Furthermore,
hospital physicians generally are not employees of CBHS and, in general, CBHS
does not
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have contractual arrangements with hospital physicians restricting the ability
of such physicians to practice elsewhere.
POTENTIAL GENERAL AND PROFESSIONAL LIABILITY. In recent years, physicians,
hospitals, and other healthcare professionals and providers have become subject
to an increasing number of lawsuits alleging medical malpractice and related
legal theories. Many of these lawsuits involve large claims and substantial
defense costs. CBHS maintains a general and hospital professional liability
insurance policy with an unaffiliated insurer. In addition, CBHS' hospitals
require all physicians on each hospital's medical staff to maintain professional
liability coverage. Management believes that its coverage limits are adequate,
however, there can be no assurance that a future claim or claims will not exceed
the limits of these existing insurance policies or that a loss or losses for
which insurance is unavailable will not have a material adverse effect on CBHS.
GOVERNMENT REGULATION. The operation of psychiatric hospitals and other
behavioral healthcare facilities and the provision of behavioral healthcare
services are subject to extensive federal, state and local laws and regulations.
These laws and regulations provide for periodic inspections or other reviews by
state agencies, the Department and CHAMPUS to determine compliance with their
respective standards of medical care, staffing, equipment and cleanliness
necessary for continued licensing or participation in the Medicare, Medicaid or
CHAMPUS programs. The admission and treatment of patients at psychiatric
hospitals is also subject to substantial state regulation relating to
involuntary admissions, confidentiality of patient medical information,
patients' rights and federal regulation relating to confidentiality of medical
records of substance abuse patients. CBHS is also subject to state certificate
of need laws that regulate the construction of new hospitals and the expansion
of existing hospital facilities and services.
CBHS also is subject to federal and state laws that govern financial and
other arrangements between healthcare providers. Such laws include the illegal
remuneration provisions of the Social Security Act (the "Anti-Kickback Statute")
and the physician self-referral provisions of the Omnibus Budget Reconciliation
Act of 1993 ("Stark II") and state illegal remuneration and self-referral
statutes and regulations that prohibit payments in exchange for referrals and
referrals by physicians or other healthcare providers to persons or entities
with which the physician or other healthcare provider has a financial
relationship.
The Medicare and Medicaid Patient and Program Protection Act of 1987
expanded the authority of the Department to exclude from participation in the
Medicare and Medicaid programs those individuals and entities that engage in
defined prohibited activities. The Department's exclusion authority was recently
expanded under HIPAA and the Budget Act, which added additional grounds for
exclusion, established minimum exclusion periods for certain offenses and
expanded the scope of the exclusion to include all federal health care programs.
The Department also has the authority to impose civil monetary penalties for
certain prohibited activities. HIPAA increased the amount of authorized
penalties from $2,000 per item or service claimed to $10,000 per item or service
claimed, and increased the assessment to which a person may be subject in lieu
of damages from two times the amount claimed for each item or service to three
times the amount claimed. Both HIPAA and the Budget Act expanded the
Department's authority to impose civil monetary penalties by adding additional
activities for which civil monetary penalties may be imposed.
Provisions contained in HIPAA and the Budget Act also created new criminal
healthcare fraud offenses that are applicable to both government programs and
private health insurance plans and added new programs and increased funding for
fraud and abuse detection and prevention.
CHAMPUS regulations also authorize the exclusion of providers from the
CHAMPUS program, if the provider has committed fraud or engaged in certain
"abusive practices," which are defined broadly to include, among other things,
the provision of medically unnecessary services, the provision of care of
inferior quality and the failure to maintain adequate medical or financial
records.
34
<PAGE>
State regulatory agencies responsible for the administration and enforcement
of the laws and regulations to which CBHS' operations are subject have broad
discretionary powers. A regulatory agency or a court in a state in which CBHS
operates could take a position under existing or future laws or regulations, or
change its interpretation or enforcement practices with respect thereto, that
such laws or regulations apply to CBHS differently than CBHS believes such laws
and regulations apply or should be enforced. The resultant compliance with, or
revocation of, or failure to obtain, required licences and governmental
approvals could result in significant alteration to CBHS' business operations,
delays in the expansion of CBHS' business and lost business opportunities, any
of which, under certain circumstances, could have a material adverse effect on
CBHS.
INTELLECTUAL PROPERTY The Company owns certain intellectual property which
is important to its franchise operation. The Company has registered as
trademarks both the "CHARTER" name and "800-CHARTER." The Company also owns the
"Charter System," which is a system for the operation of businesses specializing
in the delivery of behavioral healthcare under the "CHARTER" names and marks.
The Charter System includes treatment programs and procedures, quality
standards, quality assessment methods, performance improvement and monitoring
programs, advertising and marketing assistance, promotional materials,
consultation and other matters related to the operation of businesses
specializing in the delivery of behavioral healthcare.
EXECUTIVE OFFICERS OF THE REGISTRANT
<TABLE>
<CAPTION>
NAME AGE POSITION
- --------------------------------------- --- ------------------------------------------------------------------
<S> <C> <C>
Henry T. Harbin M.D.................... 51 President, Chief Executive Officer and Director
Craig L. McKnight...................... 47 Executive Vice President and Chief Financial Officer
John J. Wider, Jr...................... 51 President and Chief Operating Officer of Magellan Behavorial
Health
Clarissa C. Marques, Ph.D.............. 46 Executive Vice President of Clinical and Quality Management
Gregory T. Torres...................... 48 President and Chief Executive Officer of Mentor
</TABLE>
HENRY T. HARBIN, M.D. became President, Chief Executive Officer and a
Director of the Company on March 18, 1998. Dr. Harbin served as President and
Chief Executive Officer of Green Spring from 1994 to 1998. Dr. Harbin served as
Executive Vice President of the Company from 1995 until becoming President and
Chief Executive Officer of the Company. Dr. Harbin served as Executive Vice
President and Chief Clinical Officer of Green Spring during 1993 and 1994.
CRAIG L. MCKNIGHT became Executive Vice President and Chief Financial
Officer of the Company in October 1995. From March 1995 through September 1995,
he served as Executive Vice President-- Office of the President and Chairman.
Mr. McKnight practiced public accounting with Coopers & Lybrand L.L.P. from 1985
through 1995. Coopers & Lybrand L.L.P. is an international accounting firm that
provides accounting and auditing services, tax services and consulting services.
As an audit partner at Coopers & Lybrand L.L.P., from 1985 to 1995, Mr. McKnight
had responsibility for a wide range of hospital and managed care engagements, as
well as assisting clients with formulating financing options, financial
restructurings and the purchase and sale of health plans and facilities. Mr.
McKnight is also a director of OrthAlliance, Inc.
JOHN J. WIDER, JR. has served as President and Chief Operating Officer of
Magellan Behavorial Health ("MBH") since March 1998. Mr. Wider served as
Executive Vice President and Chief Operating Officer of Green Spring from 1997
to 1998. Mr. Wider was President and General Manager for Cigna Healthcare
Corporation's ("Cigna") Mid-Atlantic region from 1996 to 1997. Mr. Wider served
as Area Operations Officer for Cigna during 1995 and 1996 and as Vice President
of Sales of Cigna's Midwest region from 1993 to 1995.
35
<PAGE>
CLARISSA C. MARQUES, PH.D. has served as Executive Vice President of
Clinical and Quality Management since March 1998. Dr. Marques served as
Executive Vice President and Chief Clinical Officer of Green Spring during 1997
and 1998. Dr. Marques served as Senior Vice President of Green Spring from 1992
to 1997.
GREGORY T. TORRES is President and Chief Executive Officer of Mentor,
positions he has held since 1996. Mr. Torres served as Senior Vice President for
Public Affairs of Mentor from 1992 until 1996.
EMPLOYEES OF THE REGISTRANT
At September 30, 1998, the Company had approximately 11,600 full-time and
part-time employees, which excludes CBHS. The Company believes it has
satisfactory relations with its employees.
INTERNATIONAL OPERATIONS
The Company owns and operates two psychiatric hospitals in London, England (a
45-bed hospital and a 78-bed hospital) and a 69-bed psychiatric hospital in
Nyon, Switzerland. The Company's international hospital operations are not
material to the Company's overall operations.
ITEM 2. PROPERTIES
GENERAL. The Company's principal executive offices are located in Atlanta,
Georgia; the lease for the Company's headquarters expires in 1999.
BEHAVORIAL MANAGED CARE BUSINESS. MBH leases its 190 offices with terms
expiring between 1998 and 2008. MBH's headquarters are leased and are located in
Columbia, Maryland. The lease for MBH Headquarters expires in 2004.
HUMAN SERVICES BUSINESS. Mentor leases its 174 offices with terms expiring
between 1998 and 2005. Mentor's headquarters are leased and are located in
Boston, Massachusetts with the lease expiring in 2002.
SPECIALITY MANAGED CARE BUSINESS. Allied and CMR lease their 11 offices with
terms expiring between 1999 and 2004.
HEALTHCARE FRANCHISING AND HEALTHCARE PROVIDER BUSINESS. The Company has an
ownership interest in six hospital-based Joint Ventures that operate or manage
10 behavioral healthcare facilities ("JV Hospitals"). The Joint Ventures own six
of the JV Hospitals and lease two of the JV Hospitals from the respective Joint
Venture owners. The remaining two JV Hospitals are owned by the respective Joint
Venture owners.
The Company owns two behavioral healthcare facilities in the United Kingdom
and one in Switzerland. One of the United Kingdom facilities is subject to a
land-lease that expires in 2069.
ITEM 3. LEGAL PROCEEDINGS
The management and administration of the delivery of behavioral managed
healthcare services, and the direct provision of behavioral health treatment
services, entail significant risks of liability. In recent years, the Company
and its respective network providers have been subject to a number of actions
and claims alleging malpractice, professional negligence and other related legal
theories. Many of these actions and claims seek substantial damages and
therefore require the defendant to incur significant fees and costs related to
their defense.
From time to time, the Company is subject to various actions and claims
arising from the acts or omissions of its employees, network providers or other
parties. In the normal course of business, the Company receives reports relating
to suicides and other serious incidents involving patients enrolled in its
programs. Such incidents may give rise to malpractice, professional negligence
and other related actions and claims against the Company or its employees and
network providers. As the number of lives covered by the Company and such other
entities grows, the number of providers under contract
36
<PAGE>
increases and the nature and scope of services provided by them in their
respective managed care and EAP businesses expands, actions and claims against
such entities (and, in turn, possible legal liability) predicated on
malpractice, professional negligence or other related legal theories can be
expected to increase. See "Cautionary Statements--Professional Liability;
Insurance."
To the extent customers of the Company are entitled to indemnification under
their contracts with the relevant entity relating to liabilities they incur
arising from the operation of the relevant entity's programs, such
indemnification may not be covered under the relevant entity's insurance
policies. In addition, to the extent that certain actions and claims seek
punitive and compensatory damages arising from alleged intentional misconduct by
the Company, such damages, if awarded, may not be covered, in whole or in part,
by the relevant entity's insurance policies. In the ordinary course of business,
such entities are also subject to actions and claims with respect to their
respective employees, network providers and suppliers of services. The Company
does not believe that any pending action against it will have a material adverse
effect on the Company. To date, claims and actions against the Company alleging
professional negligence have not resulted in material liabilities; however,
there can be no assurance that pending or future actions or claims for
professional liability (including any judgments, settlements or costs associated
therewith) will not have a material adverse effect on the Company. See
"--Insurance" and "Risk Factors--Professional Liability; Insurance."
From time to time, the Company receives notifications from and engages in
discussions with various governmental agencies concerning its respective
businesses and operations. As a result of these contacts with regulators, the
Company in many instances implements changes to its operations, revises its
filings with such agencies and/or seeks additional licenses to conduct its
business. In recent years, in response to governmental agency inquiries or
discussions with regulators, the Company has determined to seek licensure as a
single service HMO, TPA or utilization review agent in one or more
jurisdictions.
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"), entitled Edward M. Stephens, Jose A.
Yaryura-Tobias, Judith Green, Ph.D., Fugen Neziroglu Ph.D., Ona Robinson, Ph.D.,
Laurie A. Baum, C.S.W., Agnes Wohl, C.S.W., and The On-Step Institute For Mental
Health Research Inc., individually and on behalf of all others similarly
situated v. CMG Health, FHC Options, Inc., Foundation Health PsychCare Services,
Inc., Green Spring Health Services, Inc., Human Affairs International, Inc.,
Merit Behavioral Care Corp., MCC Behavioral Care Inc., United Behavioral
Systems, Inc., and Value Behavioral Health, Inc., 96 Civ. 7798 (KMW) (the
"Stephens Case"). The complaint alleges that the Defendants violated Section 1
of the Sherman Act by engaging in a conspiracy to fix the prices at which the
Defendants purchase services from mental healthcare providers 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. On November 16, 1998, the Second Circuit court issued
a Summary Order affirming the District Court's decision. The plaintiffs have not
filed a petition for rehearing, and the time allotted for doing so has expired.
The plaintiffs have 90 days from the date of judgment to file a petition for
certiorari with the United States Supreme Court. The plaintiffs have not
indicated whether they will file
37
<PAGE>
such a petition. If no petition is filed, or if a filed petition is denied, this
matter will have been concluded. The Company does not believe this matter will
have a material adverse affect on its financial position or results of
operations.
On May 26, 1998, the counsel representing the plaintiffs in the Stephens
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 Stephens Case. This claim is entitled Russell M.
Holstein, Ph.D., Barbara I. Holstein, Ed.D., Tijen B. Eron, Ph.D., Roger Swift,
C.S.W., Chuck Stannard, C.S.W., R. Anthony Moore, M.D., Maria T. Lymberis, M.D.,
the American Association of Private Practice Psychiatrists, Inc., the Black
Psychiatrists of America, Inc. and the New Jersey Society for Clinical Social
Work, Inc., individually and on behalf of their members and all others similarly
situated, v. Green Spring Health Services, Inc., Human Affairs International,
Inc., Merit Behavioral Care Corp., CMG Health, Inc., Options Healthcare, Inc.,
Value Behavioral Health, Inc., United Behavioral Health, Inc., Foundation Health
Systems, Inc., and MCC Behavioral Care, Inc. The Defendants believe the factual
and legal issues involved in this case are substantially similar to those
involved in the Stephens Case. The Defendants intend to vigorously defend
themselves in this matter. On August 28, 1998, the Defendants filed a joint
motion requesting that the case be: (1) transferred to the Southern District of
New York; (2) alternatively, that all proceedings be stayed pending the Second
Circuit's determination of the Stephens appeal, given the res judicata effect of
the Stephens dismissal; and (3) if the Court proceeds with the case, that the
complaint be dismissed for failure to state a claim for substantially the same
reasons as in Stephens. The plaintiffs have opposed this motion, which was
argued on November 23, 1998. At the conclusion of the November 23 hearing, the
court ruled that the case should be transferred to the Southern District of New
York. The Defendants' motion to dismiss was deemed withdrawn without prejudice
to its resubmission in the Southern District. The plaintiffs have stated that
they intend to appeal the courts transfer order to the United States District
Court for the District of New Jersey. The Company does not believe this matter
will have a material adverse affect on its financial position or results of
operations.
The healthcare industry is subject to numerous laws and regulations. The
subjects of such laws and regulations include, but are not limited to, matters
such as licensure, accreditation, government healthcare program participation
requirements, reimbursement for patient services, and Medicare and Medicaid
fraud and abuse. Recently, government activity has increased with respect to
investigations and/or allegations concerning possible violations of fraud and
abuse and false claims statutes and/or regulations by healthcare providers.
Entities that are found to have violated these laws and regulations may be
excluded from participating in government healthcare programs, subjected to
fines or penalties or required to repay amounts received from the government for
previously billed patient services. The Office of the Inspector General of the
Department of Health and Human Services and the United States Department of
Justice and certain other governmental agencies are currently conducting
inquiries and/ or investigations regarding the compliance by the Company and
certain of its subsidiaries and the compliance by CBHS and certain of its
subsidiaries with such laws and regulations. Certain of the inquiries relate to
the operations and business practices of the Psychiatric Hospital Facilities
prior to the consummation of the Crescent Transactions. In addition, the Company
is also subject to or party to litigation, claims and civil suits relating to
its operations and business practices. In the opinion of management, the Company
has recorded reserves that are adequate to cover litigation, claims or
assessments that have been or may be asserted against the Company arising out of
such litigation, civil suits and governmental inquiries. Furthermore, management
believes that the resolution of such litigation, civil suits and governmental
inquiries will not have a material adverse effect on the Company's financial
position or results of operations; however, there can be no assurance in this
regard.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
38
<PAGE>
PART II
ITEM 5. MARKET PRICE FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company has one class of Common Stock, $0.25 par value per share, which
was listed for trading on the American Stock Exchange through December 30, 1996
(ticker symbol "MGL"), and on the New York Stock Exchange, effective December
31, 1996. As of November 30, 1998, there were 9,428 holders of record of the
Company's Common Stock. The following table sets forth the high and low sales
prices of the Company's Common Stock from October 1, 1996 through the fiscal
year ended September 30, 1998 as reported by the American Stock Exchange
(through December 30, 1996) and the New York Stock Exchange (since December 31,
1996):
<TABLE>
<CAPTION>
COMMON STOCK SALES
PRICES
--------------------
CALENDAR YEAR HIGH LOW
--------------------------- --------- ---------
<S> <C> <C>
1996
Fourth Quarter......................................................... 22 5/8 17 1/2
1997
First Quarter.......................................................... 26 20 5/8
Second Quarter......................................................... 29 1/2 24 1/2
Third Quarter.......................................................... 33 3/4 29 9/16
Fourth Quarter......................................................... 31 3/4 20 9/16
1998
First Quarter.......................................................... 26 18 5/8
Second Quarter......................................................... 28 7/16 24
Third Quarter.......................................................... 26 9 5/8
</TABLE>
The Company did not declare any cash dividends during fiscal 1997 or 1998.
As of November 30, 1998, the Company was prohibited from paying dividends on its
Common Stock under the terms of the New Credit Agreement.
Pursuant to the Green Spring Minority Stockholder Conversion, the Company
issued the following number of shares of Common Stock to the following minority
stockholders of Green Spring in exchange for their interests in Green Spring:
<TABLE>
<CAPTION>
<S> <C>
Blue Cross/Blue Shield of New Jersey 889,456
Health Services Corporation 163,148
Independence Blue Cross 889,456
Regence Blue Shield 889,456
</TABLE>
The sale of such Common Stock to the minority stockholders of Green Spring
was made pursuant to the exemption from registration under the Securities Act of
1933, as amended (the "Securities Act"), contained in Section 3(a)(10) of the
Securities Act. As a result of the Green Spring Minority Stockholder Conversion,
the Company owns 100% of Green Spring.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected historical consolidated financial
information of the Company for each of the five years in the period ended
September 30, 1998. The summary of operations and balance sheet data for the
five years ended and as of September 30, 1998, presented below, have been
derived from, and should be read in conjunction with, the Company's audited
consolidated financial statements and the notes thereto. The selected financial
data set forth below should be read in conjunction with the
39
<PAGE>
Company's consolidated financial statements and the notes thereto and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" appearing elsewhere herein.
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
---------------------------------------------------------
1994 1995 1996 1997 1998
--------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C>
(DOLLARS IN THOUSANDS)
STATEMENT OF OPERATIONS DATA:
Net revenue............................................. $ 904,646 $1,151,736 $1,345,279 $1,210,696 $1,512,454
Salaries, cost of care and other operating expenses..... 661,436 863,598 1,064,445 978,513 1,294,481
Bad debt expense........................................ 70,623 92,022 81,470 46,211 4,977
Equity in loss of CBHS.................................. -- -- -- 8,122 31,878
Depreciation and amortization........................... 28,354 38,087 48,924 44,861 54,885
Amortization of reorganization value in excess of
amounts allocable to identifiable assets.............. 31,200 26,000 -- -- --
Interest, net........................................... 39,394 55,237 48,017 45,377 75,375
ESOP expense............................................ 49,197 73,527 -- -- --
Stock option expense (credit)........................... 10,614 (467) 914 4,292 (5,623)
Managed Care integration costs.......................... -- -- -- -- 16,962
Loss on Crescent Transactions........................... -- -- -- 59,868 --
Unusual items, net...................................... 71,287 57,437 37,271 357 458
Income (loss) before income taxes, minority interest and
extraordinary items................................... (57,459) (53,705) 64,238 23,095 39,061
Provision for (benefit from) income taxes............... (10,504) (11,082) 25,695 9,238 20,033
Income (loss) before minority interest and extraordinary
items................................................. (46,955) (42,623) 38,543 13,857 19,028
Minority interest....................................... 48 340 6,160 9,102 5,296
Income (loss) before extraordinary items................ (47,003) (42,963) 32,383 4,755 13,732
Extraordinary items-losses on early extinguishments or
discharge of debt..................................... (12,616) -- -- (5,253) (33,015)
Net income (loss)....................................... $ (59,619) $ (42,963) $ 32,383 $ (498) $ (19,283)
INCOME (LOSS) PER COMMON SHARE--BASIC:
Income (loss) before extraordinary items................ $ (1.78) $ (1.54) $ 1.04 $ 0.17 $ 0.45
Loss from extraordinary items........................... (0.48) -- -- (0.18) (1.07)
Net Income (loss)....................................... $ (2.26) $ (1.54) $ 1.04 $ (0.02) $ (0.63)
INCOME (LOSS) PER COMMON SHARE--DILUTED:
Income (loss) before extraordinary items................ $ (1.78) $ (1.54) $ 1.02 $ 0.16 $ 0.44
Loss from extraordinary items........................... (0.48) -- -- (0.18) (1.06)
Net income (loss)....................................... $ (2.26) $ (1.54) $ 1.02 $ (0.02) $ (0.62)
BALANCE SHEET DATA (END OF PERIOD):
Current assets.......................................... $ 324,627 $ 305,575 $ 338,150 $ 507,038 $ 399,724
Current liabilities..................................... 215,048 214,162 274,316 219,376 454,766
Property and equipment, net............................. 494,345 488,767 495,390 109,214 177,169
Total assets............................................ 961,480 983,558 1,140,137 895,620 1,916,290
Total debt and capital lease obligations................ 536,129 541,569 572,058 395,294 1,225,646
Stockholders' equity.................................... 56,221 88,560 121,817 158,250 187,635
</TABLE>
40
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
SEPTEMBER 30, 1998
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
The Company historically derived the majority of its revenue from providing
behavioral healthcare services in an inpatient setting prior to the consummation
of the Crescent Transactions on June 17, 1997. Payments from third-party payors
are the principal source of revenue for most behavioral 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 the consummation of
the Crescent Transactions on June 17, 1997, was the largest operator of
psychiatric hospitals in the United States, was adversely affected by the
adoption of managed care programs by the third-party payors.
Prior to the first quarter of fiscal 1996, the Company was not a provider of
behavioral managed healthcare 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 behavorial manged 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 the 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 behavioral 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 behavioral managed healthcare. During the first quarter of fiscal
1998, pursuant to the Green Spring Minority Stockholder Conversion, the minority
stockholders of Green Spring converted their interests in Green Spring into an
aggregate of 2,831,516 shares of Magellan Common Stock.
Subsequent to the Company's acquisition of Green Spring, the growth of the
behavioral managed 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 behavioral managed healthcare industry also began to
consolidate. The Company concluded that this consolidation presented an
opportunity for the Company to increase its participation in the behavioral
managed healthcare industry, which the Company believed 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 behavioral managed healthcare business.
On June 17, 1997, the Company sold the Psychiatric Hospital Facilities,
which comprised substantially all of its domestic acute care psychiatric
hospitals and residential treatment facilities, to Crescent for $417.2 million
in cash (before costs of approximately $16.0 million) and certain other
consideration. 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 to increase its
participation in the managed healthcare industry. The Company used the net cash
proceeds of approximately $200 million to finance the acquisitions of HAI and
Allied in December 1997.
41
<PAGE>
The Company further implemented its business strategy through the Merit
acquisition. See "Business--Recent Developments--The Merit Acquisition".
RESULTS OF OPERATIONS
The following tables summarize, for the periods indicated, operating results by
business segment (in thousands).
<TABLE>
<CAPTION>
BEHAVIORAL HUMAN SPECIALTY HEALTHCARE HEALTHCARE CORPORATE
1996 MANAGED CARE SERVICES MANAGED CARE FRANCHISING PROVIDER OVERHEAD CONSOLIDATED
- ---------------------------- -------------- --------- --------------- ------------ ----------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Net revenue................. $ 230,755 $ 69,813 $ -- $ -- $1,044,711 $ -- $ 1,345,279
-------------- --------- ------- ------------ ----------- ----------- -------------
Salaries, cost of care and
other operating expenses.. 203,860 59,670 -- -- 766,129 34,786 1,064,445
Bad debt expense............ 1,306 233 -- -- 79,931 -- 81,470
Equity in loss of CBHS...... -- -- -- -- -- -- --
-------------- --------- ------- ------------ ----------- ----------- -------------
205,166 59,903 -- -- 846,060 34,786 1,415,915
-------------- --------- ------- ------------ ----------- ----------- -------------
Segment profit
(loss)(1)................. $ 25,589 $ 9,910 $ -- $ -- $ 198,651 $ (34,786) $ 199,364
-------------- --------- ------- ------------ ----------- ----------- -------------
-------------- --------- ------- ------------ ----------- ----------- -------------
</TABLE>
<TABLE>
<CAPTION>
BEHAVIORAL HUMAN SPECIALTY HEALTHCARE HEALTHCARE CORPORATE
1997 MANAGED CARE SERVICES MANAGED CARE FRANCHISING PROVIDER OVERHEAD CONSOLIDATED
- ------------------------ -------------- ----------- --------------- ------------- ----------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Net revenue............. $ 369,974 $ 88,331 $ -- $ 22,739 $ 729,652 $ -- $ 1,210,696
-------------- ----------- ------- ------------- ----------- ----------- -------------
Salaries, cost of care
and other operating
expenses.............. 332,877 77,648 2,303 3,653 536,454 25,578 978,513
Bad debt expense........ 78 (12) -- -- 46,145 -- 46,211
Equity in loss of
CBHS.................. -- -- -- 8,122 -- -- 8,122
-------------- ----------- ------- ------------- ----------- ----------- -------------
332,955 77,636 2,303 11,775 582,599 25,578 1,032,846
-------------- ----------- ------- ------------- ----------- ----------- -------------
Segment profit
(loss)(1)............. $ 37,019 $ 10,695 $ (2,303) $ 10,964 $ 147,053 $ (25,578) $ 177,850
-------------- ----------- ------- ------------- ----------- ----------- -------------
-------------- ----------- ------- ------------- ----------- ----------- -------------
</TABLE>
<TABLE>
<CAPTION>
BEHAVIORAL HUMAN SPECIALTY HEALTHCARE HEALTHCARE CORPORATE
1998 MANAGED CARE SERVICES MANAGED CARE FRANCHISING PROVIDER OVERHEAD CONSOLIDATED
- ------------------------ -------------- --------- -------------- ------------- ----------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Net revenue............. $1,039,038 $ 141,032 $ 143,503 $ 55,625 $ 133,256 $ -- $ 1,512,454
-------------- --------- -------------- ------------- ----------- ----------- -------------
Salaries, cost of care
and other operating
expenses.............. 900,478 124,752 140,375 9,071 104,055 15,750 1,294,481
Bad debt expense........ 1,368 787 -- -- 2,822 -- 4,977
Equity in loss of
CBHS.................. -- -- -- 31,878 -- -- 31,878
-------------- --------- -------------- ------------- ----------- ----------- -------------
901,846 125,539 140,375 40,949 106,877 15,750 1,331,336
-------------- --------- -------------- ------------- ----------- ----------- -------------
Segment profit
(loss)(1)............. $ 137,192 $ 15,493 $ 3,128 $ 14,676 $ 26,379 $ (15,750) $ 181,118
-------------- --------- -------------- ------------- ----------- ----------- -------------
-------------- --------- -------------- ------------- ----------- ----------- -------------
</TABLE>
(1) Segment profit is the measure of profitability used by management to assess
the operating performance of each business segment. See Note 15, "Business
Segment Information", to the Company's audited consolidated financial
statements appearing elsewhere herein.
FISCAL 1997 COMPARED TO FISCAL 1998
BEHAVIORAL MANAGED CARE. Revenue increased 180.8% or $669.0 million, to
$1,039.0 million for fiscal 1998 from $370.0 million in fiscal 1997. Salaries,
cost of care and other operating expenses increased 170.5%, or $567.6 million,
to $900.5 million for fiscal 1998 from $332.9 million in fiscal 1997. The
increases resulted primarily from the acquisitions of HAI and Merit in fiscal
1998 and internal growth at Green Spring. The revenues and salaries, cost of
care and other operating expenses of HAI and Merit, in the aggregate, were
$559.8 million and $480.6 million, respectively, for fiscal 1998. Behavioral
managed care revenues and segment profit increased as a result of the award of
several new contracts in fiscal 1997 and 1998 and significant improvements in
negotiated rates and terms of the TennCare contract in fiscal 1998. Bad debt
expense was not significant in fiscal 1997 or 1998.
42
<PAGE>
HUMAN SERVICES. Revenue increased 59.7%, or $52.7 million, to $141.0
million for fiscal 1998 from $88.3 million in fiscal 1997. Salaries, cost of
care and other operating expenses increased 60.7%, or $47.2 million, to $124.8
million in fiscal 1998 from $77.6 million in fiscal 1997. The increases were
attributable to the seven Human Services' Acquisitions consummated in fiscal
1998 and internal growth. Placements in Mentor homes increased 19.6% in fiscal
1998 to 3,350 by September 30, 1998. Bad debt expense was not significant in
fiscal 1997 or 1998.
SPECIALTY MANAGED CARE. Revenue was $143.5 million in fiscal 1998 compared
to $0 in fiscal 1997. Salaries, cost of care and other operating expenses were
$140.4 million in fiscal 1998 compared to $2.3 million in fiscal 1997. The
increase in revenues and salaries, cost of care and other operating expenses
were primarily related to the Allied acquisition. Allied's revenues and
salaries, cost of care and other operating expenses were $142.3 million and
$135.4 million, respectively, for fiscal 1998. Fiscal 1997 salaries, cost of
care and other operating expenses represent start-up costs for CMR, the
Company's initial involvement in the specialty managed care business.
HEALTHCARE FRANCHISING. Revenue increased 144.6%, or $32.9 million, to
$55.6 million in fiscal 1998 from $22.7 million in fiscal 1997. Salaries and
other operating expenses increased 148.3%, or $5.4 million, to $9.1 million in
fiscal 1998 from $3.7 million in fiscal 1997. Equity in loss of CBHS increased
$23.8 million to $31.9 million in fiscal 1998. The increases resulted primarily
from the effect of the consummation of the Crescent Transactions on June 17,
1997, resulting in only 106 days of franchise operations and CBHS operations in
fiscal 1997, offset by declining operating performance at CBHS during the
comparable period in fiscal 1998. See "--Impact of Crescent Transactions on
Results of Operations." Also, see Note 4, "Investment in CBHS," to the Company's
audited consolidated financial statements set forth elsewhere herein.
HEALTHCARE PROVIDER. Revenue decreased 81.7%, or $596.4 million, to $133.3
million in fiscal 1998 from $729.7 million in fiscal 1997. Salaries, cost of
care and other operating expenses decreased 80.6%, or $432.4 million, to $104.1
million in fiscal 1998 from $536.5 million in fiscal 1997. Bad debt expense
decreased $43.3 million to $2.8 million in fiscal 1998 from $46.1 million in
fiscal 1997. The decreases resulted primarily from the effect of the
consummation of the Crescent Transactions on June 17, 1997, following which
revenue, salaries and other operating expenses and bad debt expense from the
Psychiatric Hospital Facilities and other facilities transferred to CBHS were no
longer reflected in the Company's financial statements. During fiscal 1997 and
1998, the Company recorded revenue of $27.4 million and $7.0 million,
respectively, for settlements and adjustments related to reimbursement issues
("Cost Report Settlements") with respect to psychiatric hospitals owned or
formerly owned by the Company. During fiscal 1997 and 1998, the Company recorded
reductions of expenses of $7.5 million and $4.1 million, respectively, 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. The fourth
quarter of fiscal 1997 included increases to income before income taxes and
minority interest of approximately $6.4 million for revenue and bad debt
adjustments related to accounts receivable retained by the Company that were
generated by the hospitals operated by CBHS. Such adjustments reflected a change
in estimates of contractual allowances and allowance for doubtful accounts of
such receivables based on the collection activity subsequent to the completion
of the Crescent Transactions.
CORPORATE OVERHEAD. Salaries and other operating expenses attributable to
the Company's corporate headquarters' decreased 38.4%, or $9.8 million, due
primarily to the transfer of personnel and overhead to CBHS and the healthcare
franchising segment as a result of the Crescent Transactions.
43
<PAGE>
DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased
22.3%, or $10.0 million, to $54.9 million in fiscal 1998 from $44.9 million
fiscal 1997. The increase was primarily attributable to increases in
depreciation and amortization resulting from the HAI, Allied and Merit
acquisitions of $26.8 million, in the aggregate, during 1998, offset by the
effect of the consummation of the Crescent Transactions, whereby the Psychiatric
Hospital Facilities were sold to Crescent.
INTEREST, NET. Interest expense, net, increased 66.1% or $30.0 million to
$75.4 million in fiscal 1998 from $45.4 million in fiscal 1997. The increase was
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 December
5, 1997.
OTHER ITEMS. Stock option expense for fiscal 1998 decreased $9.9 million
compared to fiscal 1997 primarily due to fluctuations in the market price of the
Company's common stock.
The Company recorded Managed Care integration costs of $17.0 million for
fiscal 1998. See Note 11, "Managed Care Integration Plan and Costs," to the
Company's audited consolidated financial statements set forth elsewhere herein.
The Company recorded unusual items, net, of $0.4 million, during fiscal
1997, which consisted of a $5.4 million pre-tax gain on the sale of previously
closed psychiatric hospitals offset by a $4.2 million charge for the closure of
three psychiatric hospitals and one general hospital and a $1.6 million charge
related to the termination of an agreement to sell the Company's European
Hospitals. The Company recorded unusual items, net, of $0.5 million, during
fiscal 1998, for a $3.5 million charge related to the termination of an
agreement to sell CBHS offset by the net gain on the sale of hospitals of $3.0
million that were previously closed.
The Company's effective income tax rate increased to 51.3% for fiscal 1998
compared to 40% in fiscal 1997. The increase was primarily attributable to
non-deductible goodwill amortization of approximately $11.0 million resulting
from the Merit acquisition in fiscal 1998.
Minority interest decreased $3.8 million during fiscal 1998, compared to
fiscal 1997. The decrease was primarily attributable to the Green Spring
Minority Stockholder 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 $5.3 million and $33.0 million during fiscal 1997 and 1998,
respectively, related primarily to the termination of its then existing credit
agreements in fiscal 1997 and 1998 and the extinguishment of the Magellan
Outstanding Notes in fiscal 1998. See Note 7, "Long-Term Debt, Capital Lease
Obligations and Operating Leases," to the Company's audited consolidated
financial statements set forth elsewhere herein.
FISCAL 1996 COMPARED TO FISCAL 1997.
BEHAVIORAL MANAGED CARE. Revenue increased 60.3%, or $139.2 million, to
$370.0 million in fiscal 1997 from $230.8 million in fiscal 1996. Salaries, cost
of care and other operating expenses increased 63.3%, or $129.0 million, to
$332.9 million in fiscal 1997 from $203.9 million in fiscal 1996. The increases
resulted primarily from the inclusion of a full year of Green Spring operations
in fiscal 1997 results and internal growth. Revenue and segment profit increased
as a result of the award of several new contracts in the fourth quarter of
fiscal 1996 and fiscal 1997, resulting in a 22% increase in covered lives to
16.6 million by September 30, 1997. Bad debt expense was not significant in
fiscal 1996 or 1997.
HUMAN SERVICES. Revenue increased 26.5%, or $18.5 million, to $88.3 million
in fiscal 1997 from $69.8 million in fiscal 1996. Salaries, cost of care and
other operating expenses increased 30.1%, or $17.9 million, to $77.6 million in
fiscal 1997 from $59.7 million in fiscal 1996. The increases were primarily
attributable to internal growth. Placements in Mentor homes increased 23% to
2,800 by September 30, 1997, while operating costs reflected program start-up
costs and overhead investments necessary to maintain internal growth. Bad debt
expense was not significant in fiscal 1996 or 1997.
44
<PAGE>
SPECIALTY MANAGED CARE. Fiscal 1997 salaries, cost of care and other
operating expenses represent start-up costs for CMR, the Company's initial
involvement in the specialty managed care business.
HEALTHCARE FRANCHISING. Revenue was $22.7 million for fiscal 1997. Salaries
and other operating expenses were $3.7 million in fiscal 1997. Equity in loss of
CBHS was $8.1 million in fiscal 1997. Operations for fiscal 1997 began with the
consummation of the Crescent Transactions.
HEALTHCARE PROVIDER. Revenue decreased 30.2%, or $315.1 million, to $729.7
million in fiscal 1997 from $1,044.7 million in fiscal 1996. Salaries, and other
operating expenses decreased 30.0%, or $229.7 million, to $536.5 million in
fiscal 1997 from $766.1 million in fiscal 1996. Bad debt expense decreased
42.3%, or $33.9 million, to $46.1 million in fiscal 1997 from $80.0 million in
fiscal 1996. The decrease resulted primarily from: (i) the effect of the
consummation of the Crescent Transactions on June 17, 1997, following which
revenue, salaries and other operating expenses and bad debt expense from the
Psychiatric Hospital Facilities and other facilities transferred to CBHS was no
longer recorded as part of the Company's revenue; (ii) the closure of hospitals
in fiscal 1996 and 1997; and (iii) reduced equivalent patient days at the
Company's operating hospitals as a result of reduced average length of stay.
During fiscal 1996 and 1997, the Company recorded revenue of $28.3 million and
$27.4 million, respectively, for Cost Report Settlements with respect to
Psychiatric Hospital Facilities owned or formerly owned by the Company. The Cost
Report Settlements related primarily to certain reimbursement issues associated
with the Company's financial reorganization in fiscal 1992 and the early
extinguishment of long-term debt in fiscal 1994. During fiscal 1996 and 1997,
the Company recorded reductions of expenses of approximately $15.3 million and
$7.5 million, respectively, 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.
CORPORATE OVERHEAD. Salaries and other operating expenses attributable to
the Company's headquarters decreased 26.5%, or $9.2 million, due primarily to
the transfer of personnel and overhead to CBHS and the healthcare franchising
business as a result of the Crescent Transactions.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization decreased
8.3%, or $4.1 million to $44.9 million in fiscal 1997 from $48.9 million in
fiscal 1996. The decrease was 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 Green Spring acquisition.
INTEREST, NET. Interest, net, decreased 5.5%, or $2.6 million to $45.4
million in fiscal 1997 from $48.0 million in fiscal 1996. The decrease was
primarily the result of lower interest expense due to lower average borrowings
and higher interest income due to temporary investments of the cash received in
the Crescent Transactions. Fiscal 1996 included approximately $5.0 million of
interest income related to income tax refunds from the State of California for
the Company's income tax returns for fiscal 1982 through 1989.
OTHER ITEMS. Stock option expense for fiscal 1997 increased $3.4 million
from fiscal 1996 primarily due to fluctuations in the market price of the
Company's Common Stock.
The Company recorded a loss on the Crescent Transactions of approximately
$59.9 million during fiscal 1997. See Note 3, "Crescent Transactions," to the
Company's audited consolidated financial statements set forth herein.
During fiscal 1996, the Company recorded unusual items of $37.3 million.
Included in the unusual charges was the resolution of a billing dispute in
August 1996 between the Company and a group of insurance carriers that arose in
fiscal 1996 related to matters originating in the 1980's. As part of the
settlement of these claims, certain related payor matters and associated legal
fees, the Company
45
<PAGE>
recorded a charge of approximately $30.0 million. The Company is paying the
insurance settlement in twelve installments over a three-year period. The
Company's remaining obligation to make the settlement payments in fiscal 1999 is
supported by a cash collateralized letter of credit. Other unusual items
included: (i) charges of approximately $4.1 million during fiscal 1996 related
to the closure of psychiatric hospitals; (ii) a charge of approximately $1.2
million related to impairment losses; and (iii) charges of approximately $2.0
million related to severance costs for personnel reductions.
Minority interest increased $2.9 million during fiscal 1997 compared to
fiscal 1996. The increase was primarily due to: (i) the Company acquiring a
controlling interest in Green Spring in December 1995; (ii) Green Spring's
internal growth subsequent to the acquisition date; and (iii) increased net
income from hospital-based joint ventures.
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 potentially represent a significant portion
of the Company's earnings and cash flows.
Based on operational projections prepared by CBHS management for the fiscal
year ended September 30,1999, and based on CBHS's results of operations through
September 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 1999. CBHS paid $40.6 million of Franchise Fees to the Company
during fiscal 1998. The Company estimates that CBHS will be able to pay $0 to
$15.0 million of Franchise Fees in fiscal 1999. The Company expects to reflect
Franchise Fee revenue in its statements of operations for future periods which
is lower in amount than that specified in the Master Franchise Agreement if CBHS
does not generate sufficient cash flows to allow for payment of future Franchise
Fees. Based on the amount of unpaid Franchise Fees ($38 million as of September
30, 1998) the Company exercised the limited management rights available to it
under the Master Franchise Agreement and, with CBHS's board support, assisted in
making operational and management changes at CBHS aimed at improving
profitability and cash flows. The Company has since restored all management
rights to the CBHS board. See "Business--Charter Advantage"
IMPACT OF THE MERIT ACQUISITION ON RESULTS OF OPERATIONS.
As of September 30, 1998, the Company had approximately 61.6 million covered
lives under behavioral managed healthcare contracts. The Company believes it has
the number one market position in each of the major product markets in which it
competes, according to enrollment data reported in OPEN MINDS. The Company
believes that the Merit acquisition creates opportunities for the Company to
achieve significant cost savings in its behavioral managed 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 behavioral managed healthcare
business on an annual basis by September 30, 1999. Such cost savings are
measured relative to the combined operating expenses of Green Spring, HAI and
Merit prior to the Merit acquisition. The Company spent approximately $13.0
million during fiscal 1998 and expects to spend $10.0 million to $15.0 million
during fiscal 1999 in connection with achieving such cost savings.
The Company expects to record additional managed care integration costs
during future periods to the extent the integration of Green Spring, HAI and
Merit results in additional facility closures at HAI and Green Spring and for
integration costs incurred that benefit future periods. The full implementation
of the integration plan is expected to be completed by fiscal 2000.
46
<PAGE>
BEHAVIORAL MANAGED HEALTHCARE RESULTS OF OPERATIONS.
The Company's behavioral managed healthcare segment results of operations
are subject to significant fluctuations on a quarterly basis. These potential
earnings fluctuations may result from: (i) changes in utilization levels by
enrolled members of the Company's risk-based contracts; (ii) performance-based
contractual adjustments to revenue, reflecting utilization results or other
performance measures; (iii) retroactive contractual adjustments under commercial
contracts and CHAMPUS contracts ("CHAMPUS Adjustments"); (iv) retrospective
membership adjustments and (v) timing of implementation of new contracts and
enrollment changes.
HISTORICAL LIQUIDITY AND CAPITAL RESOURCES
OPERATING ACTIVITIES. The Company's net cash provided by (used in)
operating activities was $101.9 million, $73.6 million and $(4.2) million for
fiscal 1996, 1997 and 1998 respectively. The decrease in cash provided by
operating activities in fiscal 1998 compared to fiscal 1997 was primarily the
result of: (i) higher interest payments ($54.4 million and $95.2 million in
fiscal 1997 and 1998, respectively,) as a result of the Merit acquisition; (ii)
reduced cash flows from the provider business, net of Franchise Fees received
and (iii) the funding of liabilities related to the Merit acquisition. The
decrease in net cash provided by operating activities in fiscal 1997 compared to
fiscal 1996 was primarily the result of: (i) higher income tax payments ($9.3
million and $18.4 million in fiscal 1996 and fiscal 1997, respectively; (ii)
$5.0 million of interest income related to income tax refunds from the State of
California in fiscal 1996; (iii) higher insurance settlement payments ($24.6
million in fiscal 1996 and $28.5 million in fiscal 1997); and (iv) reduced cash
flows from the provider business, net of franchise fees received.
INVESTING ACTIVITIES. The Company acquired a 61% ownership interest in
Green Spring during the first quarter of fiscal 1996. The consideration paid for
Green Spring and related acquisition costs resulted in the use of cash of
approximately $87.2 million compared to approximately $50.9 million for
acquisitions and investments in businesses, including CBHS, during fiscal 1997.
The Crescent Transactions resulted in net proceeds of $374.2 million, during
fiscal 1997 and 1998, consisting of $393.7 million related to the sale of
property and equipment to Crescent and CBHS less $19.5 million in costs and
construction obligations.
The Company made $20.0 million of cash capital contributions to CBHS during
fiscal 1997. The Company is not obligated to make any additional capital
contributions or advances to CBHS.
The Company utilized $1.0 billion in funds, net of cash acquired, for
acquisitions and investments in businesses, including the Allied, HAI, Merit and
Human Services Acquisitions during fiscal 1998.
FINANCING ACTIVITIES. The Company borrowed approximately $104.8 million,
$203.6 million and $1.2 billion during fiscal 1996, 1997 and 1998, respectively.
The fiscal 1996 borrowings primarily funded the Green Spring acquisition and
$35.0 million of treasury stock purchases. The fiscal 1997 borrowings primarily
funded the repayment of variable rate secured notes and other long-term debt
(including the refinancing of a previous revolving credit agreement),
acquisitions and working capital needs. The fiscal 1998 borrowings primarily
funded the Merit acquisition and related long-term debt refinancing.
The Company repaid approximately $85.8 million, $390.3 million and $438.6
million of debt and capital lease obligations during fiscal 1996, 1997 and 1998,
respectively. The fiscal 1997 repayments related primarily to a previous
revolving credit agreement and repaying other indebtedness as a result of the
Crescent Transactions. The fiscal 1998 repayments related primarily to the
extinguishment of the Magellan Outstanding Notes as part of the Merit
acquisition.
On January 25, 1996, the Company sold 4.0 million shares of Common Stock
along with the Rainwater-Magellan Warrant pursuant to a private placement. The
Rainwater-Magellan Warrant, which expires in January, 2000, entitles the holders
to purchase 2.0 million shares of Common Stock at a per share price of $26.15,
subject to adjustment for certain dilutive events, and provides registration
rights
47
<PAGE>
for the shares of Common Stock underlying the warrant. The warrant became
exercisable on January 25, 1997. The Company received proceeds of approximately
$68.6 million, net of issuance costs, from the Private Placement. Approximately
$68.0 million of the proceeds were used to repay outstanding borrowings related
to the Green Spring acquisition.
The Company issued approximately 2.6 million warrants to Crescent and COI
for $25.0 million in cash as part of the Crescent Transactions during fiscal
1997.
On September 27, 1996, the Company repurchased approximately 4.0 million
shares of Common Stock for approximately $73.5 million, including transaction
costs, pursuant to a "Dutch Auction" self-tender offer to its stockholders. On
November 1, 1996, the Company announced that its board of directors had approved
the repurchase of an additional 3.0 million shares of Common Stock from time to
time subject to the terms of the Company's then current credit agreements.
During fiscal 1998, the Company repurchased approximately 0.7 million shares of
its Common Stock for approximately $14.4 million.
As of September 30, 1998, the Company had approximately $92.5 million of
availability under the Revolving Facility of the New Credit Agreement, excluding
approximately $17.5 million of availability reserved for certain letters of
credit. The Company was in compliance with all debt covenants as of September
30, 1998.
OUTLOOK-LIQUIDITY AND CAPITAL RESOURCES
The interest payments on the 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
under the Term Loan Facility 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 Loan Facility. The
Company will be required to repay the principal amount of borrowings outstanding
under the Term Loan Facility provided for in the New Credit Agreement and the
principal amount of the 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 Credit Facility of
the New Credit Agreement mature in February 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 by September 30, 1999. Such cost
savings are measured relative to the combined operating expenses of Green
Spring, HAI and Merit prior to the Merit acquisition. The Company spent
approximately $13.0 million during fiscal 1998 in connection with achieving such
cost savings, including expenses related to reducing duplicative personnel in
its managed care organizations, contractual terminations for
48
<PAGE>
eliminating excess real estate (primarily locations under operating leases) and
other related costs. The Company expects to spend another $10.0 million to $15.0
million in fiscal 1999 related to achieving such cost savings.
POTENTIAL PURCHASE PRICE ADJUSTMENTS. During December 1997, the Company
purchased HAI and Allied for approximately $122.1 million and $70.0 million,
respectively, excluding transaction costs. In addition, the Company incurred the
obligation to make contingent payments to the former owners of HAI and Allied.
With respect to HAI, the Company may be required to make additional contingent
payments of up to $60.0 million annually to Aetna over the five-year period
subsequent to closing. The Company is obligated to make contingent payments
under two separate calculations as follows: In respect of each Contract Year (as
defined), the Company may be required to pay to Aetna the "Tranche 1 Payments"
(as defined) and the "Tranche 2 Payments" (as defined). "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 (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 Trance 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 and (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.
49
<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 and (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 originally paid for Allied was subject to
increase or decrease based on the operating performance of Allied during the
three years following the closing. The Company was 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.
On November 25, 1998, the Company and the former owners of Allied amended
the Allied purchase Agreement (the "Allied Amendment"). The Allied Amendment
resulted in the following changes to the original terms of the Allied purchase
agreement:
- Approximately $18.9 million of the original $20.0 million placed in escrow
by the Company at the consummation of the Allied acquisition, plus accrued
interest, was repaid to the Company.
- The Company paid certain of the former owners of Allied approximately $4.0
million in settlement of a portion of their potential future contingent
consideration.
- The Company's maximum remaining contingent consideration payable to the
former owners of Allied is approximately $6.1 million, less the
approximate $1.1 million that remains in escrow. The future contingent
payments, if any, will be based upon the operating performance of Allied
for fiscal 1999 through fiscal 2001.
In connection with Merit's acquisition of CMG, the Company, by acquiring
Merit, may be required to make certain future contingent payments in fiscal 1999
to the former shareholders of CMG based upon the performance of three CMG
customer contracts. No contingent consideration will be payable to the former
shareholders of CMG based on the performance of two of the three CMG customer
contracts at September 30, 1998. The Company may still be required to pay
contingent consideration to the former shareholders of CMG depending on the
financial performance of Choice Behavioral Health Partnership ("CHOICE"). CHOICE
is a joint venture with Value Options, Inc. that services a contract with
CHAMPUS. The Company and Value Options, Inc. each own 50% of CHOICE. The payment
of contingent consideration to the former shareholders of CMG depends on the
financial performance of CHOICE from October 1, 1996 to June 30, 1997, which is
subject to a CHAMPUS Adjustment the Company expects to receive in fiscal 1999.
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 September 30, 1998, the
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<PAGE>
Company had approximately $92.5 million of availability under the Revolving
Facility. The Company 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 flows generated from its
operations, together with amounts available for borrowing under the New Credit
Agreement, should be sufficient to fund its debt service requirements,
anticipated capital expenditures, contingent payments, with respect to HAI,
Allied and CMG and other investing and financing activities. The Company's
future operating performance and ability to service or refinance the 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.
The New Credit Agreement imposes restrictions on the Company's ability to
make capital expenditures and both the New Credit Agreement and the Indenture
governing the Notes limit the Company's ability to incur additional
indebtedness. Such restrictions, together with the highly leveraged financial
condition of the Company, may limit the Company's ability to respond to market
opportunities. The covenants contained in the New Credit Agreement also, among
other things, restrict the ability of the Company to dispose of assets, repay
other indebtedness, amend other debt instruments (including the Indenture), pay
dividends, create liens on assets, enter into sale and leaseback transactions,
make investments, loans or advances, redeem or repurchase common stock and make
acquisitions. See "Business-Cautionary Statements-Substantial Leverage and Debt
Service Obligations."
RECENT ACCOUNTING PRONOUNCEMENTS
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants ("AICPA") issued Statement of Position
98-1, "Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use" ("SOP 98-1"). SOP 98-1 establishes accounting guidance for
internal-use software. SOP 98-1 requires the following:
- Computer software costs that are incurred in the preliminary project stage
(as described in SOP 98-1) should be expensed as incurred. Once the
capitalization criteria of SOP 98-1 have been met, external direct costs
of materials and services consumed in developing or obtaining internal-use
computer software; payroll and payroll-related costs for employees who are
directly associated with and who devote time to the internal-use computer
software project (to the extent of the time spent directly on the
project); and interest costs incurred when developing computer software
for internal use should be capitalized. Training costs and data conversion
costs should generally be expensed as incurred.
- Internal costs incurred for upgrades and enhancements should be expensed
or capitalized in accordance with SOP 98-1. Internal costs incurred for
maintenance should be expensed as incurred. Entities that cannot separate
internal costs on a reasonably cost-effective basis between maintenance
and relatively minor upgrades and enhancements should expense such costs
as incurred.
- External costs incurred under agreements related to specified upgrades and
enhancements should be expensed or capitalized in accordance with SOP
98-1. However, external costs related to maintenance, unspecified upgrades
and enhancements, and costs under agreements that combine the costs of
maintenance and unspecified upgrades and enhancements should be recognized
in expense over the contract period on a straight-line basis unless
another systematic and rational basis is more representative of the
services received.
- Impairment should be recognized and measured in accordance with the
provisions of FASB Statement No. 121, ACCOUNTING FOR THE IMPAIRMENT OF
LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF.
51
<PAGE>
- 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 include
internal-use software as defined by SOP 98-1. The care management and claims
processing systems used in the Company's managed care segments are the Company's
most significant internal-use software applications. The Company adopted SOP
98-1, effective October 1, 1997. The Company's adoption of SOP 98-1 had no
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 15, 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 will
adopt SOP 98-5 effective October 1, 1998. The Company's adoption of SOP 98-5
will have no impact on its financial position or results of operations.
Emerging Issues Task Force Issue 96-16, "Investor's Accounting for an
Investee When the Investor Has a Majority of the Voting Interest but a Minority
Shareholder or Shareholders Have Certain Approval or Veto Rights" ("EITF 96-16")
supplements the guidance contained in AICPA Accounting Research Bulletin 51,
"Consolidated Financial Statements", and in Statement of Financial Accounting
Standards No. 94, "Consolidation of All Majority-Owned Subsidiaries" ("ARB
51/FAS 94"), about the conditions under which the Company's consolidated
financial statements should include the financial position, results of
operations and cash flows of subsidiaries which are less than wholly-owned along
with those of the Company and its subsidiaries.
In general, ARB 51/FAS 94 requires consolidation of all majority-owned
subsidiaries except those for which control is temporary or does not rest with
the majority owner. Under the ARB 51/FAS 94 approach, instances of control not
resting with the majority owner were generally regarded to arise from such
events as the legal reorganization or bankruptcy of the majority-owned
subsidiary. EITF 96-16 expands the definition of instances in which control does
not rest with the majority owner to include those where significant approval or
veto rights, other than those which are merely protective of the minority
shareholder's interest, are held by the minority shareholder or shareholders
("Substantive Participating Rights"). Substantive Participating Rights include,
but are not limited to: i) selecting, terminating and setting the compensation
of management responsible for implementing the majority-owned subsidiary's
policies and procedures and ii) establishing operating and capital decisions of
the majority-owned subsidiary, including budgets, in the ordinary course of
business.
The provisions of EITF 96-16 apply to new investment agreements made after
July 24, 1997, and to existing agreements which are modified after such date.
The Company has made no new investments, and has modified no existing
investments, to which the provisions of EITF 96-16 would have applied.
52
<PAGE>
In addition, the transition provisions of EITF 96-16 must be applied to
majority-owned subsidiaries previously consolidated under ARB 51/FAS 94 for
which the underlying agreements have not been modified in financial statements
issued for years ending after December 15, 1998 (fiscal 1999 for the Company).
The adoption of the transition provisions of EITF 96-16 on October 1, 1998 will
have the following effect on the Company's consolidated financial position:
<TABLE>
<CAPTION>
OCTOBER 1,
1998
-----------
<S> <C>
Increase (decrease) in:
Cash and cash equivalents................................................................ $ (21,092)
Other current assets..................................................................... (9,538)
Long-term assets......................................................................... (30,049)
Investment in unconsolidated subsidiaries................................................ 26,498
-----------
Total Assets........................................................................... $ (34,181)
-----------
-----------
Current liabilities...................................................................... $ (10,381)
Minority interest........................................................................ (23,800)
-----------
Total Liablities....................................................................... $ (34,181)
-----------
-----------
</TABLE>
POTENTIAL IMPACT OF YEAR 2000 COMPUTER ISSUES
The year 2000 computer problem is the inability of computer systems, which
store dates by using the last two digits of the year (i.e. "98" for "'1998"), to
reliably recognize that dates after December 31, 1999 are later than, and not
before, 1999. For instance, the date January 1, 2000, may be mistakenly
interpreted as January 1, 1900, in calculations involving dates on systems which
are non-year 2000 compliant.
The Company relies on information technology ("IT") systems and other
systems and facilities such as telephones, building access control systems and
heating and ventilation equipment ("Embedded Systems") to conduct its business.
These systems are potentially vulnerable to year 2000 problems due to their use
of date information.
The Company also has business relationships with customers and health care
providers and other critical vendors who are themselves reliant on IT and
Embedded Systems to conduct their businesses.
STATE OF READINESS
The Company's IT systems are largely decentralized, with each major
operating unit having its own standards for systems which include both purchased
and internally-developed software. The Company's IT hardware infrastructure is
built mainly around mid-range computers and IBM PC-compatible servers and
desktop systems.
The Company's principal means of ensuring year 2000 compliance for purchased
software has been the replacement of non-compliant systems. This replacement
process would have been undertaken for business reasons irrespective of the year
2000 problem; however, it would, more than likely, have been implemented over a
longer period of time. The Company's internally-developed software was either
designed to be year 2000 compliant from inception or is in the process of being
modified to be compliant. Approximately 70% of the Company's mid-range IT
hardware has been certified as year 2000 compliant, with the remainder scheduled
to be certified by the end of the second quarter of fiscal 1999. Most of the
Company's non-compliant IBM PC-compatible servers and desktops have been
replaced, with the remainder expected to be replaced by the end of fiscal 1999.
53
<PAGE>
Additionally, the Company is in the process of integrating recently acquired
businesses and their associated IT systems. A primary focus of the integration
is on standardization of systems where possible, including ensuring the year
2000 compliance of the surviving systems.
Each of the Company's major operating units has a Chief Information Officer
who is responsible for ensuring that all year 2000 issues are addressed and
mitigated before any computational problems related to dates after December 31,
1999, occur.
The Company's plan for IT systems consists of several phases, primarily:
(i) Inventory--identifying all IT systems and the magnitude of year 2000
compliance risk of each according to its potential business impact;
(ii) Date assessment--identifying IT systems that use date functions and
assessing them for year 2000 functionality;
(iii) Remediation--reprogramming, or replacing where necessary, inventoried
items to ensure they are year 2000 ready; and
(iv) Testing and certification--testing the code modifications and new
inventory with other associated systems, including extensive date
testing and performing quality assurance testing to ensure successful
operation in the post-1999 environment. The Company has substantially
completed the inventory and assessment phases for substantially all of
its IT systems. The Company's IT systems are currently in the
remediation and testing and certification phases. The Company plans to
complete the remediation of substantially all of its critical IT
systems by the end of the second quarter of fiscal 1999, the
remediation of its other IT systems by the end of the third quarter of
fiscal 1999 and the testing and certification of all of its IT systems
by the end of fiscal 1999.
The Company leases most of the office space in which its reliance on
Embedded Systems presents a potential problem and is currently working with the
respective lessors to identify and correct any potential year 2000 problems
related to these Embedded Systems.
The Company believes that its year 2000 projects generally are on schedule.
EXTERNAL RELATIONSHIPS
The Company also faces the risk that one or more of its critical suppliers
or customers ("External Relationships") will not be able to interact with the
Company due to the third party's inability to resolve its own year 2000 issues,
including those associated with its own External Relationships. The Company has
completed its inventory of External Relationships and risk rated each External
Relationship based upon the potential business impact, available alternatives
and cost of substitution. The Company is attempting to determine the overall
year 2000 readiness of its External Relationships. In the case of significant
customers and mission critical suppliers such as banks, telecommunications
providers and other utilities and IT vendors, the Company is engaged in
discussions with the third parties and is attempting to obtain detailed
information as to those parties' year 2000 plans and state of readiness. The
Company, however, does not have sufficient information at the current time to
predict whether its External Relationships will be year 2000 ready.
YEAR 2000 COSTS
Total costs incurred solely for remediation of potential year 2000 problems
are currently estimated to be approximately $1.0 million in fiscal 1999. A large
majority of these costs are expected to be incremental expenses that will not
recur in the year 2000 or thereafter. Year 2000 costs incurred were $1.0 million
in fiscal 1998 and were not material in fiscal 1997. The Company expenses these
costs as incurred and
54
<PAGE>
funds these costs through operating cash flows. In addition, the Company
estimates that it will accelerate approximately $5.0 million of capital
expenditures that would have been budgeted for future periods into fiscal 1999
to ensure year 2000 compliance for outdated systems.
Year 2000 compliance is critical to the Company. The Company has redeployed
some resources from non-critical system enhancements to address year 2000
issues. Due to the importance of IT systems to the Company's business,
management has deferred non-critical systems enhancements to become year 2000
ready. The Company does not expect these redeployments and deferrals to have a
material impact on the Company's financial condition or results of operations.
RISKS AND CONTINGENCY/RECOVERY PLANNING
If the Company's year 2000 issues were unresolved, the most reasonably
likely worst case scenario would include, among other possibilities, the
inability to accurately and timely authorize and process benefits and claims,
accurately bill customers, assess claims exposure, determine liquidity
requirements, report accurate data to management, stockholders, customers,
regulators and others, business interruptions or shutdowns, financial losses,
reputational harm, loss of significant customers, increased scrutiny by
regulators and litigation related to year 2000 issues. The Company is attempting
to limit the potential impact of the year 2000 by monitoring the progress of its
own year 2000 project and those of its critical external relationships and by
developing contingency/recovery plans. The Company cannot guarantee that it will
be able to resolve all of its year 2000 issues. Any critical unresolved year
2000 issues at the Company or its external relationships, however, could have a
material adverse effect on the Company's results of operations, liquidity or
financial condition.
The Company has developed contingency/recovery plans aimed at ensuring the
continuity of critical business functions before and after December 31, 1999. As
part of that process, the Company has substantially completed the development of
manual work alternatives to automated processes which will both ensure business
continuity and provide a ready source of input to affected systems when they are
returned to an operational status. These manual alternatives presume, however,
that basic infrastructure such as electrical power and telephone service, as
well as purchased systems which are advertised to be year 2000 compliant by
their manufacturers (primarily personal computers and productivity software)
will remain unaffected by the year 2000 problem.
See "Business-Cautionary Statements--The Company".
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Information with respect to this item is contained in the Company's Consolidated
Financial Statements and financial statement schedule indicated in the Index on
Page F-1 of this Annual Report on Form 10-K and is incorporated herein by
reference.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
55
<PAGE>
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information with respect to the Company's executive officers is contained under
"Item 1. Business-- Executive Officers of the Registrant." Pursuant to General
Instruction G(3) to Form 10-K, the information required by this item with
respect to directors and compliance with Section 16(a) of the Securities
Exchange Act of 1934 has been omitted inasmuch as the Company files with the
Securities and Exchange Commission a definitive proxy statement not later than
120 days subsequent to the end of its fiscal year. Such information is
incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
Pursuant to General Instruction G(3) to Form 10-K, the information required with
respect to this item has been omitted inasmuch as the Company files with the
Securities and Exchange Commission a definitive proxy statement not later than
120 days subsequent to the end of its fiscal year. Such information is
incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Pursuant to General Instruction G(3) to Form 10-K, the information required with
respect to this item has been omitted inasmuch as the Company files with the
Securities and Exchange Commission a definitive proxy statement not later than
120 days subsequent to the end of its fiscal year. Such information is
incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Pursuant to General Instruction G(3) to Form 10-K, the information required with
respect to this item has been omitted inasmuch as the Company files with the
Securities and Exchange Commission a definitive proxy statement not later than
120 days subsequent to the end of its fiscal year. Such information is
incorporated herein by reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(A) DOCUMENTS FILED AS PART OF THE REPORT:
1. FINANCIAL STATEMENTS
Information with respect to this item appears on pages F-2 to F-48 of this
Annual Report on Form 10-K.
2. FINANCIAL STATEMENT SCHEDULES
Information with respect to this item appears on pages S-1 and S-2 of this
Annual Report on Form 10-K.
56
<PAGE>
3. EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- ------------ ------------------------------------------------------------------------------------------------------
<C> <S>
2(a) Stock Purchase Agreement, dated November 14, 1995, among Blue Cross and Blue Shield of New Jersey,
Inc. Health Care Service Corporation, Independence Blue Cross, Medical Service Association of
Pennsylvania, Pierce County Medical Bureau, Inc., Veritus, Inc., Green Spring Health Services, Inc.
and the Company, which was filed as Exhibit 10(e) to the Company's Quarterly Report on Form 10-Q for
the Quarterly period ended December 31, 1995, and is incorporated herein by reference.
2(b) GPA Stock Exchange Agreement, dated November 14, 1995, between Green Spring Health Services, Inc. and
the Company, which was filed as Exhibit 10(f) to the Company's Quarterly Report on Form 10-Q for the
Quarterly period ended December 31, 1995, and is incorporated herein by reference.
2(c) Real Estate Purchase and Sale Agreement, dated January 29, 1997, between the Company and Crescent Real
Estate Equities Limited Partnership, which was filed as Exhibit 2(a) to the Company's current report
on Form 8-K filed on April 23, 1997, and is incorporated herein by reference.
2(d) Amendment No. 1, dated February 28, 1997, to the Real Estate Purchase and Sale Agreement, dated
January 29, 1997, between the Company and Crescent Real Estate Equities Limited Partnership, which was
filed as Exhibit 2(b) to the Company's current report on Form 8-K filed on April 23, 1997, and is
incorporated herein by reference.
2(e) Amendment No. 2, dated May 29, 1997, to the Real Estate Purchase and Sale Agreement, dated January 29,
1997, between the Company and Crescent Real Estate Equities Limited Partnership, which was filed as
Exhibit 2(c) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is
incorporated herein by reference.
2(f) Contribution Agreement, dated June 16, 1997, between the Company and Crescent Operating, Inc., which
was filed as Exhibit 2(d) to the Company's current report on Form 8-K which was filed on June 30,
1997, and is incorporated herein by reference.
2(g) Stock Purchase Agreement, dated August 5, 1997, between the Company and Aetna Insurance Company of
Connecticut, which was filed as Exhibit 2(a) to the Company's current report on Form 8-K, which was
filed on December 17, 1997, and is incorporated herein by reference.
2(h) Master Service Agreement, dated August 5, 1997, between the Company, Aetna U.S. Healthcare, Inc. and
Human Affairs International, Incorporated, which was filed as Exhibit 2(b) to the Company's current
report on Form 8-K, which was filed on December 17, 1997, and is incorporated herein by reference.
2(i) Amendment to Stock Purchase Agreement, dated December 4, 1997, between the Company and Aetna Insurance
Company of Connecticut, which was filed as Exhibit 2(c) to the Company's current report on Form 8-K,
which was filed on December 17, 1997, and is incorporated herein by reference.
2(j) First Amendment to Master Services Agreement, dated December 4, 1997, between the Company, Aetna U.S.
Healthcare, Inc. and Human Affairs International, Incorporated, which was filed as Exhibit 2(d) to the
Company's current report on Form 8-K, which was filed on December 17, 1997, and is incorporated herein
by reference.
</TABLE>
57
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- ------------ ------------------------------------------------------------------------------------------------------
<C> <S>
2(k) Asset Purchase Agreement, dated October 16, 1997, among the Company; Allied Health Group, Inc.; Gut
Management, Inc.; Sky Management Co,; Florida Specialty Network, LTD; Surgical Associates of South
Florida, Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David Russin, M.D. and Lawrence Schimmel, M.D.,
which was filed as Exhibit 2(e) to the Company's Quarterly Report on Form 10-Q for the quarterly
period ended December 31, 1997, and is incorporated herein by reference.
2(l) First Amendment to Asset Purchase Agreement, dated December 5, 1997, among the Company; Allied Health
Group, Inc.; Gut Management, Inc.; Sky Management Co.; Florida Specialty Network, LTD; Surgical
Associates of South Florida, Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David Russin M.D.; and Lawrence
Schimmel, M.D., which was filed as Exhibit 2(f) to the Company's Quarterly Report on Form 10-Q for the
quarterly period ended December 31, 1997, and is incorporated herein by reference.
+2(m) Second Amendment to Asset Purchase Agreement, dated November 18, 1998, among the Company; Allied
Health Group, Inc.; Gut Management, Inc.; Sky Management Co.; Florida Specialty Network, LTD; Surgical
Associates of South Florida, Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David Russin M.D.; and Lawrence
Schimmel, M.D.
2(n) Agreement and Plan of Merger, dated October 24, 1997, among the Company, Merit Behavioral Care
Corporation and MBC Merger Corporation which was filed as Exhibit 2(g) to the Company's Quarterly
Report on Form 10-Q for the quarterly period ended December 31, 1997, and is incorporated herein by
reference.
3(a) Restated Certificate of Incorporation of the Company, as filed in Delaware on October 16, 1992, which
was filed as Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended September 30,
1992, and is incorporated herein by reference.
+3(b) Bylaws of the Company.
3(c) Certificate of Ownership and Merger merging Magellan Health Services, Inc. (a Delaware corporation)
into Charter Medical Corporation (a Delaware corporation), as filed in Delaware on December 21, 1995,
which was filed as Exhibit 3(c) to the Company's Annual Report on Form 10-K for the year ended
September 30, 1995, and is incorporated herein by reference.
4(a) Stockholders' Agreement, dated December 13, 1995, among Green Spring Health Services, Inc., Blue Cross
and Blue Shield of New Jersey, Inc., Health Care Service Corporation, Independence Blue Cross, Pierce
County Medical Bureau, Inc. and the Company, which was filed as Exhibit 4(d) to the Company's
Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1995, and is incorporated
herein by reference.
4(b) First Amendment to Stockholders' Agreement, dated February 28, 1997, among Green Spring Health
Services, Inc, Blue Cross and Blue Shield of New Jersey, Inc., Health Care Service Corporation,
Independence Blue Cross, Pierce County Medical Bureau, Inc. and the Company, which was filed as
Exhibit 4(af) to the Company's Annual Report on Form 10-K for the year ended September 30, 1997, and
is incorporated herein by reference.
4(c) Exchange Agreement, dated December 13, 1995, among Blue Cross and Blue Shield of New Jersey, Inc.,
Health Care Service Corporation, Independence Blue Cross, Pierce County Medical Bureau, Inc. and the
Company, which was filed as Exhibit 4(e) to the Company's Quarterly Report on Form 10-Q for the
quarterly period ended December 31, 1995, and is incorporated herein by reference.
4(d) Stock and Warrant Purchase Agreement, dated December 22, 1995, between the Company and Richard E.
Rainwater, which was filed as Exhibit 4(f) to the Company's Quarterly Report on Form 10-Q for the
quarterly period ended December 31, 1995, and is incorporated herein by reference.
</TABLE>
58
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- ------------ ------------------------------------------------------------------------------------------------------
<C> <S>
4(e) Amendment No. 1 to Stock and Warrant Purchase Agreement, dated January 25, 1996, between the Company
and Rainwater-Magellan Holdings, L.P., which was filed as Exhibit 4.7 to the Company's Registration
Statement on Form S-3 dated February 26, 1996, and is incorporated herein by reference.
4(f) Warrant Purchase Agreement, dated January 29, 1997, between the Company and Crescent Real Estate
Equities Limited Partnership which was filed as Exhibit 4(a) to the Company's current report on Form
8-K, which was filed on April 23, 1997, and is incorporated herein by reference.
4(g) Amendment No. 1, dated June 17, 1997, to the Warrant Purchase Agreement, dated January 29, 1997,
between the Company and Crescent Real Estate Equities Limited Partnership, which was filed as Exhibit
4(b) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is
incorporated herein by reference.
4(h) Indenture, dated as of February 12, 1998, between the Company and Marine Midland Bank, as trustee,
relating to the 9% Senior Subordinated Notes due February 15, 2008 of the Company, which was filed as
Exhibit 4(a) to the Company's Current Report on Form 8-K, which was filed April 3, 1998, and is
incorporated herein by reference.
4(i) Purchase Agreement, dated February 5, 1998, between the Company and Chase Securities Inc., which was
filed as Exhibit 4(b) to the Company's Current Report on Form 8-K, which was filed April 3, 1998, and
is incorporated herein by reference.
4(j) Exchange and Registration Rights Agreement, dated February 12, 1998, between the Company and Chase
Securities Inc., which was filed as Exhibit 4(c) to the Company's Current Report on Form 8-K, which
was filed on April 3, 1998, and is incorporated herein by reference.
4(k) Credit Agreement, dated February 12, 1998, among the Company, certain of the Company's subsidiaries
listed therein and The Chase Manhattan Bank, as administrative agent, which was filed as Exhibit 4(d)
to the Company's Current Report on Form 8-K, which was filed April 3, 1998, and is incorporated herein
by reference.
4(l) Amendment No. 1, dated as of September 30, 1998, to the Credit Agreement, dated as of February 12,
1998, among the Company, certain of the Company's subsidiaries listed therein and The Chase Manhattan
Bank, as administrative agent, which was filed as Exhibit 4(e) to the Company's Registration Statement
Form S-4 (no. 333-49335), which was filed on October 5, 1998, and is incorporated herein by reference.
The Company agrees, pursuant in (b)(4)(iii) of Item 601 of Regulation S-K, to furnish to the
Commission, upon request, a copy of each agreement relating to long-term debt where the total
amount of debt under each such agreement does not exceed 10% of the Company's respective total
on a consolidated basis.
*10(a) 1992 Stock Option Plan of the Company, as amended, which was filed as Exhibit 10(c) to the Company's
Annual Report on Form 10-K for the year ended September 30, 1994, and is incorporated herein by
reference.
*10(b) Directors' Stock Option Plan of the Company, as amended, which was filed as Exhibit 10(d) to the
Company's Annual Report on Form 10-K for the year ended September 30, 1994, and is incorporated herein
by reference.
*10(c) 1994 Stock Option Plan of the Company, as amended, which was filed as Exhibit 10(e) to the Company's
Annual Report on Form 10-K for the year ended September 30, 1994, and is incorporated herein by
reference.
*10(d) Directors' Unit Award Plan of the Company, which was filed as Exhibit 10(i) to the Company's
Registration Statement on Form S-4 (No. 33-53701) filed May 18, 1994, and is incorporated herein by
reference.
</TABLE>
59
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- ------------ ------------------------------------------------------------------------------------------------------
<C> <S>
*10(e) 1996 Stock Option Plan of the Company, which was filed as Exhibit 10(a) to the Company's Quarterly
Report on Form 10-Q for the quarterly period ended March 31, 1996 and is incorporated herein by
reference.
*10(f) 1996 Directors' Stock Option Plan of the Company, which was filed as Exhibit 10(b) to the Company's
Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1996 and is incorporated herein
by reference.
*10(g) 1997 Stock Option Plan of the Company, which was filed as Exhibit 10(i) to the Company's Quarterly
Report on Form 10-Q for the quarterly period ended June 30, 1997, and is incorporated herein by
reference.
*10(h) Employment Agreement, dated February 28, 1995, between the Company and John Cook Barlett, Executive
Vice President--Quality Improvement, which was filed as Exhibit 10(k) to the Company's Annual Report
on Form 10-K for the year ended September 30, 1995, and is incorporated herein by reference.
*10(i) Employment Agreement, dated March 31, 1995, between the Company and Craig L. McKnight, Executive Vice
President and Chief Financial Officer, which was filed as Exhibit 10(l) to the Company's Annual Report
on Form 10-K for the year ended September 30, 1995, and is incorporated herein by reference.
*10(j) Employment Agreement, dated October 1, 1995, between the Company and E. Mac Crawford, Chairman of the
Board of Directors, President and Chief Executive Officer, which was filed as Exhibit 10(m) to the
Company's Annual Report on Form 10-K for the year ended September 30, 1995, and is incorporated herein
by reference.
*10(k) Employment Agreement, dated March 1, 1997, between the Company and E. Mac Crawford, which was filed as
Exhibit 10(g) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30,
1997, and is incorporated herein by reference.
*10(l) Letter Agreement, dated November 9, 1993, between Green Spring Health Services, Inc. and Henry T.
Harbin, M.D., Executive Vice President of the Company and President and Chief Executive Officer of
Green Spring Health Services, Inc., which was filed as Exhibit 10(c) to the Company's Quarterly Report
on Form 10-Q for the quarterly period ended December 31, 1995 and is incorporated herein by reference.
*10(m) Letter Agreement, dated September 19, 1994 between Green Spring Health Services, Inc. and Henry T.
Harbin, M.D., Executive Vice President of the Company and President and Chief Executive Officer of
Green Spring Health Services, Inc., which was filed as Exhibit 10(d) to the Company's Quarterly Report
on Form 10-Q for the quarterly period ended December 31, 1995 and is incorporated herein by reference.
*10(n) Employment Agreement dated May 1, 1996, between the Company and Dr. Danna Mauch, President and Chief
Operating Officer of Magellan Public Solutions, Inc. and Executive Vice President of the Company,
which was filed as Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarterly
period ended June 30, 1996 and is incorporated herein by reference.
*10(o) Employment Agreement dated April 15, 1996, between the Company and John M. DeStefanis, President and
Chief Operating Officer of Charter Behavioral Health Systems, Inc. and Executive Vice President of the
Company, which was filed as Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the
quarterly period ended June 30, 1996 and is incorporated herein by reference.
*10(p) Employment Agreement dated May 7, 1996, between the Company and Steve J. Davis, Executive Vice
President, Administrative Services and General Counsel, which was filed as Exhibit 10(c) to the
Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1996 and is
incorporated herein by reference.
</TABLE>
60
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- ------------ ------------------------------------------------------------------------------------------------------
<C> <S>
*10(q) Employment Agreement dated February 28, 1996, between Green Spring Health Services, Inc. and Henry T.
Harbin, M.D., Executive Vice President of the Company and President and Chief Executive Officer of
Green Spring Health Services, Inc., which was filed as Exhibit 10(t) to the Company's annual report on
Form 10-K for the year ended September 30, 1996, and is incorporated herein by reference.
*10(r) Compensation Agreement dated September 30, 1996, between Magellan Health Services, Inc. and Henry T.
Harbin, M.D., Executive Vice President of the Company and President and Chief Executive Officer of
Green Spring Health Services, Inc., which was filed as Exhibit 10(u) to the Company's annual report on
Form 10-K for the year ended September 30, 1996, and is incorporated herein by reference.
+*10(s) Written description of the Green Spring Health Services, Inc. Annual Incentive Plan for the period
ended September 30, 1998.
*10(t) Written description of the Green Spring Health Services, Inc. Annual Incentive Plan for the year ended
September 30, 1997, which was filed as Exhibit 10(w) to the Company's Annual Report on Form 10-K for
the year ended September 30, 1997, and is incorporated by reference.
10(u) Master Lease Agreement, dated June 16, 1997, between Crescent Real Estate Funding VII, L.P., as
Landlord, and Charter Behavioral Health Systems, LLC, as Tenant, which was filed as Exhibit 99(b) to
the Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein
by reference.
10(v) Master Franchise Agreement, dated June 17, 1997, between the Company and Charter Behavioral Health
Systems, LLC, which was filed as Exhibit 99(c) to the Company's current report on Form 8-K, which was
filed on June 30, 1997, and is incorporated herein by reference.
10(w) Form of Franchise Agreement, dated June 17, 1997, between the Company, as Franchisor, and Franchise
Owners, which was filed as Exhibit 99(d) to the Company's current report on Form 8-K, which was filed
on June 30, 1997, and is incorporated herein by reference.
10(x) Subordination Agreement, dated June 16, 1997, between the Company, Charter Behavioral Health Systems,
LLC and Crescent Real Estate Equities Limited Partnership, which was filed as Exhibit 99(e) to the
Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by
reference.
10(y) Operating Agreement of Charter Behavioral Health Systems, LLC, dated June 16, 1997, between the
Company and Crescent Operating, Inc., which was filed as Exhibit 99(f) to the Company's current report
on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by reference.
10(z) Warrant Purchase Agreement, dated June 16, 1997, between the Company and Crescent Operating, Inc.,
which was filed as Exhibit 99(g) to the Company's current report on Form 8-K, which was filed on June
30, 1997, and is incorporated herein by reference.
*10(aa) 1998 Stock Option Plan of the Company which was filed as Exhibit (ay) to the Company's Registration
Statement on Form S-4, which was filed on April 3, 1998, and is incorporated herein by reference.
*10(ab) Letter Agreement, dated May 7, 1997, between Green Spring Health Services, Inc. and John J. Wider,
Jr., Executive Vice President and Chief Operating Officer of Green Spring Health Services, Inc., which
was filed as Exhibit 10 (az) to the Company's Registration Statement on Form S-4, which was filed on
April 3, 1998, and is incorporated herein by reference.
</TABLE>
61
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT
NO. DESCRIPTION OF EXHIBIT
- ------------ ------------------------------------------------------------------------------------------------------
<C> <S>
*10(ac) Employment Agreement, dated March 12, 1997, between Green Spring Health Services, Inc. and Clarissa C.
Marques, Chief Clinical Officer of Green Spring Health Services, Inc., which was filed as Exhibit 10
(ba) to the Company's Registration Statement on Form S-4, which was filed on April 3, 1998, and is
incorporated herein by reference.
*10(ad) Letter Agreement, dated February 2, 1995, between Green Spring Health Services, Inc. and Clarissa C.
Marques, Senior Vice President of Green Spring Health Services, Inc., which was filed as Exhibit 10
(bb) to the Company's Registration Statement on Form S-4, which was filed on April 3, 1998, and is
incorporated herein by reference.
*10(ae) Employment Agreement, dated June 25, 1998, between the Company and Henry T. Harbin, M.D., President,
Chief Executive Officer of the Company, which was filed as exhibit 10(a) to the Company's quarterly
report on Form 10-Q for the quarterly period ended June 30, 1998 and is incorporated herein by
reference.
10(af) Offer to Purchase and Consent Solicitation Statement, dated January 12, 1998, by the Company for all
of its 11 1/4% Series A Senior Subordinated Notes due 2008, which was filed as Exhibit 10(ad) to the
Company's Registration Statement on Form S-4, which was filed on April 3, 1998, and is incorporated
herein by reference.
10(ag) Offer to Purchase and Consent Solicitation Statement, dated January 12, 1998, by Merit Behavioral Care
Corporation for all of its 11 1/2% Senior Subordinated Notes due 2005, which was filed as Exhibit
10(ad) to the Company's Registration Statement on Form S-4, which was filed on April 3, 1998, and is
incorporated herein by reference.
+10(ah) Agreement and Plan of Merger by and among Merit Behavioral Care Corporation, Merit Merger Corp., and
CMG Health, Inc. dated as of July 14, 1997.
+21 List of subsidiaries of the Company.
+23(a) Consent of Arthur Andersen LLP.
23(b) Consent of Ernst & Young LLP.
27 Financial Data Schedule
</TABLE>
- ------------------------
* Constitutes a management contract or compensatory plan arrangement.
+ Previously filed
(B) REPORTS ON FORM 8-K:
There were no current reports on Form 8-K filed by the Registrant with the
Securities and Exchange Commission during the quarter ended September 30, 1998.
(C) EXHIBITS REQUIRED BY ITEM 601 OF REGULATION S-K:
Exhibits required to be filed by the Company pursuant to Item 601 of Regulation
S-K are contained in a separate volume.
(D) FINANCIAL STATEMENTS AND SCHEDULES REQUIRED BY REGULATION S-X WHICH ARE
EXCLUDED FROM THE COMPANY'S ANNUAL REPORT TO STOCKHOLDERS BY RULE 14A-3(B):
(1) Separate financial statements of subsidiaries not consolidated and fifty
percent or less owned persons appear beginning on pages F-49 (Charter
Behavioral Health Systems, LLC), and F-67 (Choice Behavioral Health
Partnership) of this Annual Report on Form 10-K.
(2) Not applicable.
(3) Financial statement schedule of Charter Behavioral Health Systems, LLC
appears on page S-2 of this Annual Report on Form 10-K.
62
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned thereunto duly authorized.
MAGELLAN HEALTH SERVICES, INC.
(Registrant)
Date: March 30, 1999 /S/ CRAIG L. MCKNIGHT
------------------------------------------
Craig L. McKnight
Executive Vice President and
Chief Financial Officer
Date: March 30, 1999 /S/ JEFFREY T. HUDKINS
------------------------------------------
Jeffrey T. Hudkins
Vice President and Controller
(Chief Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
- ------------------------------ --------------------------- -------------------
/s/ HENRY T. HARBIN President, Chief Executive
- ------------------------------ Officer and Director March 23, 1999
Henry T. Harbin
Director
- ------------------------------
Edwin M. Banks
/s/ G. FRED DIBONA, JR. Director
- ------------------------------ March 23, 1999
G. Fred DiBona, Jr.
Director
- ------------------------------
Andre C. Dimitriadis
/s/ A.D. FRAZIER, JR. Director
- ------------------------------ March 25, 1999
A.D. Frazier, Jr.
Director
- ------------------------------
Raymond H. Kiefer
63
<PAGE>
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
- ------------------------------ --------------------------- -------------------
<C> <S> <C>
/s/ GERALD L. MCMANIS Director
- ------------------------------ March 23, 1999
Gerald L. McManis
/s/ DANIEL S. MESSINA Director
- ------------------------------ March 24, 1999
Daniel S. Messina
/s/ ROBERT W. MILLER Chairman of the Board of
- ------------------------------ Directors March 24, 1999
Robert W. Miller
/s/ DARLA D. MOORE Director
- ------------------------------ March 24, 1999
Darla D. Moore
/s/ JEFFREY A. SONNENFELD Director
- ------------------------------ March 23, 1999
Jeffrey A. Sonnenfeld
</TABLE>
64
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS
The following Consolidated Financial Statements of the Registrant and its
subsidiaries are submitted herewith in response to Item 8 and Item14(a)(1):
<TABLE>
<CAPTION>
PAGE
---------
<S> <C>
MAGELLAN HEALTH SERVICES, INC.
Audited Consolidated Financial Statements
Report of independent public accountants............................................................... F-2
Consolidated balance sheets as of September 30, 1997 and 1998.......................................... F-3
Consolidated statements of operations for the years ended September 30, 1996, 1997 and 1998............ F-4
Consolidated statements of changes in stockholders' equity for the years ended September 30, 1996, 1997
and 1998.............................................................................................. F-5
Consolidated statements of cash flows for the years ended September 30, 1996, 1997 and 1998............ F-6
Notes to consolidated financial statements............................................................. F-7
</TABLE>
The following financial statement schedule of the Registrant and its
subsidiaries is submitted herewith in response to Item 14(a)(2):
<TABLE>
<CAPTION>
PAGE
---------
<S> <C>
Schedule II--Valuation and qualifying accounts......................................................... S-1
The following financial statements of unconsolidated subsidiaries of the Registrant are submitted
herewith in response to Item 14(d)(1):
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC PAGE
---
Audited Consolidated Financial Statements
Report of independent public accountants............................................................... F-49
Consolidated balance sheet as of September 30, 1997 and 1998........................................... F-50
Consolidated statement of operations for the 106 days ended September 30, 1997 and the year ended
September 30, 1998.................................................................................... F-52
Consolidated statement of changes in members' capital for the 106 days ended September 30, 1997 and the
year ended September 30, 1998......................................................................... F-53
Consolidated statement of cash flows for the 106 days ended September 30, 1997 and the year ended
September 30, 1998.................................................................................... F-54
Notes to consolidated financial statements............................................................. F-55
</TABLE>
<TABLE>
<CAPTION>
PAGE
---------
<S> <C>
CHOICE BEHAVIORAL HEALTH PARTNERSHIP
Audited Financial Statements
Report of independent auditors......................................................................... F-67
Balance sheet as of December 31, 1998.................................................................. F-68
Statement of income for the year ended December 31, 1998............................................... F-69
Statement of partners' capital for the year ended December 31, 1998.................................... F-70
Statement of cash flows for the year ended December 31, 1998........................................... F-71
Notes to financial statements.......................................................................... F-72
</TABLE>
The following financial statement schedule for Charter Behavioral Health
Systems, LLC and its subsidiaries is submitted herewith in response to Item
14(d)(3):
<TABLE>
<CAPTION>
PAGE
---------
<S> <C>
Schedule II--Valuation and qualifying accounts............................................................. S-2
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Magellan Health Services, Inc:
We have audited the accompanying consolidated balance sheets of Magellan
Health Services, Inc. (a Delaware corporation) and subsidiaries as of September
30, 1997 and 1998, and the related consolidated statements of operations,
changes in stockholders' equity and cash flows for each of the three years in
the period ended September 30, 1998. These consolidated financial statements and
the schedule referred to below are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Magellan Health Services,
Inc. and subsidiaries as of September 30, 1997 and 1998 and the results of their
operations and their cash flows for each of the three years in the period ended
September 30, 1998 in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedule listed in the index to
financial statements is presented for purposes of complying with the Securities
and Exchange Commission's rules and is not part of the basic financial
statements. This schedule has been subjected to the auditing procedures applied
in the audits of the basic financial statements and, in our opinion, fairly
states, in all material respects, the financial data required to be set forth
therein in relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Atlanta, Georgia
December 3, 1998
F-2
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
SEPTEMBER 30,
---------------------
1997 1998
--------- ----------
<S> <C> <C>
ASSETS
Current Assets:
Cash, including cash equivalents of $319,823 at September 30, 1997 and $14,185 at
September 30, 1998 at cost, which approximates market value.......................... $ 372,878 $ 92,050
Accounts Receivable, less allowance for doubtful accounts of $40,311 at September 30,
1997 and $34,867 at September 30, 1998............................................... 107,998 174,846
Restricted cash and investments....................................................... -- 89,212
Refundable income taxes............................................................... 2,466 4,939
Other current assets.................................................................. 23,696 38,677
--------- ----------
Total Current Assets................................................................ 507,038 399,724
Assets restricted for settlement of unpaid claims and other long-term liabilities......... 87,532 37,910
Property and equipment, net............................................................... 109,214 177,169
Deferred income taxes..................................................................... 1,158 97,386
Investment in CBHS........................................................................ 16,878 --
Other long-term assets.................................................................... 20,893 46,481
Goodwill, net of accumulated amortization of $14,006 at September 30, 1997 and $32,785 at
September 30, 1998...................................................................... 114,234 992,431
Other intangible assets, net of accumulated amortization of $5,855 at September 30, 1997
and $12,343 at September 30, 1998....................................................... 38,673 165,189
--------- ----------
$ 895,620 $1,916,290
--------- ----------
--------- ----------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable........................................................................ $ 45,346 $ 42,873
Accrued liabilities..................................................................... 133,921 193,530
Medical claims payable.................................................................. 36,508 195,330
Current maturities of long-term debt and capital lease obligations...................... 3,601 23,033
--------- ----------
Total Current Liabilities......................................................... 219,376 454,766
Long-term debt and capital lease obligations.............................................. 391,693 1,202,613
Reserve for unpaid claims................................................................. 49,113 30,280
Deferred credits and other long-term liabilities.......................................... 16,110 14,011
Minority interest......................................................................... 61,078 26,985
Commitments and Contingencies
Stockholders' Equity:
Preferred Stock, without par value
Authorized--10,000 shares
Issued and outstanding--none.......................................................... -- --
Common Stock, par value $.25 per share
Authorized--80,000 shares
Issued and outstanding--33,439 shares at September 30, 1997 and 33,898 shares at
September 30, 1998.................................................................... 8,361 8,476
Other Stockholders' Equity:
Additional paid-in capital............................................................ 340,645 349,651
Accumulated deficit................................................................... (129,955) (149,238)
Warrants outstanding.................................................................. 25,050 25,050
Common stock in treasury, 4,424 shares at September 30, 1997 and 2,289 shares at
September 30, 1998................................................................... (82,731) (44,309)
Cumulative foreign currency adjustments............................................... (3,120) (1,995)
--------- ----------
Total Stockholders' Equity........................................................ 158,250 187,635
--------- ----------
$ 895,620 $1,916,290
--------- ----------
--------- ----------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these balance sheets.
F-3
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
------------------------------
<S> <C> <C> <C>
1996 1997 1998
-------- -------- ----------
Net revenue..................................................................................... $1,345,279 $1,210,696 $1,512,454
-------- -------- ----------
Costs and expenses:
Salaries, cost of care and other operating expenses........................................... 1,064,445 978,513 1,294,481
Bad debt expense.............................................................................. 81,470 46,211 4,977
Equity in loss of CBHS........................................................................ -- 8,122 31,878
Depreciation and amortization................................................................. 48,924 44,861 54,885
Interest, net................................................................................. 48,017 45,377 75,375
Stock option expense (credit)................................................................. 914 4,292 (5,623)
Managed Care integration costs................................................................ -- -- 16,962
Loss on Crescent Transactions................................................................. -- 59,868 --
Unusual items, net............................................................................ 37,271 357 458
-------- -------- ----------
1,281,041 1,187,601 1,473,393
-------- -------- ----------
Income before income taxes, minority interest
and extraordinary items....................................................................... 64,238 23,095 39,061
Provision for income taxes...................................................................... 25,695 9,238 20,033
-------- -------- ----------
Income before minority interest and extraordinary items......................................... 38,543 13,857 19,028
Minority interest............................................................................... 6,160 9,102 5,296
-------- -------- ----------
Income before extraordinary items............................................................... 32,383 4,755 13,732
Extraordinary items--net losses on early extinguishments of
debt (net of income tax benefit of $3,503 in 1997 and $22,010 in 1998)........................ -- (5,253) (33,015)
-------- -------- ----------
Net income (loss)............................................................................... $ 32,383 $ (498) $ (19,283)
-------- -------- ----------
-------- -------- ----------
Average number of common shares outstanding--basic.............................................. 31,014 28,781 30,784
-------- -------- ----------
-------- -------- ----------
Average number of common shares outstanding--diluted............................................ 31,596 29,474 31,198
-------- -------- ----------
-------- -------- ----------
Income (loss) per common share--basic:
Income before extraordinary items............................................................. $ 1.04 $ 0.17 $ 0.45
-------- -------- ----------
-------- -------- ----------
Extraordinary losses on early extinguishments of debt......................................... $ -- $ (0.18) $ (1.07)
-------- -------- ----------
-------- -------- ----------
Net income (loss)............................................................................... $ 1.04 $ (0.02) $ (0.63)
-------- -------- ----------
-------- -------- ----------
Income (loss) per common share--diluted:
Income before extraordinary items............................................................. $ 1.02 $ 0.16 $ 0.44
-------- -------- ----------
-------- -------- ----------
Extraordinary losses on early extinguishments of debt......................................... $ -- $ (0.18) $ (1.06)
-------- -------- ----------
-------- -------- ----------
Net income (loss)............................................................................... $ 1.02 $ (0.02) $ (0.62)
-------- -------- ----------
-------- -------- ----------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
F-4
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
-------------------------------
<S> <C> <C> <C>
1996 1997 1998
--------- --------- ---------
<CAPTION>
(IN THOUSANDS)
<S> <C> <C> <C>
Common Stock:
Balance, beginning of period................................................. $ 7,101 $ 8,252 $ 8,361
Exercise of options and warrants............................................. 97 109 115
Green Spring Health Services, Inc. acquisition............................... 54 -- --
Issuance of Common Stock, net of issuance costs.............................. 1,000 -- --
--------- --------- ---------
Balance, end of period....................................................... 8,252 8,361 8,476
--------- --------- ---------
Additional paid-in capital:
Balance, beginning of period................................................. 253,295 327,681 340,645
Stock option expense (credit)................................................ 914 4,292 (5,623)
Green Spring Health Services, Inc. acquisition............................... 4,263 -- --
Exercise of options and warrants............................................. 1,636 8,156 3,867
Issuance of Common Stock, net of issuance costs.............................. 67,573 -- --
Green Spring Minority Stockholder Conversion................................. -- -- 10,722
Other........................................................................ -- 516 40
--------- --------- ---------
Balance, end of period....................................................... 327,681 340,645 349,651
--------- --------- ---------
Accumulated deficit:
Balance, beginning of period................................................. (161,840) (129,457) (129,955)
Net income (loss)............................................................ 32,383 (498) (19,283)
--------- --------- ---------
Balance, end of period....................................................... (129,457) (129,955) (149,238)
--------- --------- ---------
Warrants outstanding:
Balance, beginning of period................................................. 64 54 25,050
Exercise of warrants......................................................... (10) (4) --
Issuance of warrants to Crescent and COI..................................... -- 25,000 --
--------- --------- ---------
Balance, end of period....................................................... 54 25,050 25,050
--------- --------- ---------
Common stock in treasury:
Balance, beginning of period................................................. (9,238) (82,731) (82,731)
Purchases of treasury stock.................................................. (73,493) -- (14,352)
Green Spring Minority Stockholder Conversion................................. -- -- 52,774
--------- --------- ---------
Balance, end of period....................................................... (82,731) (82,731) (44,309)
--------- --------- ---------
Cumulative foreign currency adjustments:
Balance, beginning of period................................................. (822) (1,982) (3,120)
Foreign currency translation gain (loss)..................................... (1,160) (1,138) 1,125
--------- --------- ---------
Balance, end of period....................................................... (1,982) (3,120) (1,995)
--------- --------- ---------
Total Stockholders' Equity..................................................... $ 121,817 $ 158,250 $ 187,635
--------- --------- ---------
--------- --------- ---------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
F-5
<PAGE>
MAGELLAN HEALTH SERVICES, INC. SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
--------------------------------
<S> <C> <C> <C>
1996 1997 1998
--------- --------- ----------
<CAPTION>
(IN THOUSANDS)
<S> <C> <C> <C>
Cash Flows From Operating Activities
Net income (loss)............................................................ $ 32,383 $ (498) $ (19,283)
--------- --------- ----------
Adjustments to reconcile net income (loss) to net cash provided by
(used in) operating activities:
Gain on sale of assets................................................. (2,062) (5,747) (3,001)
Depreciation and amortization.......................................... 48,924 44,861 54,885
Impairment of long-lived assets........................................ -- -- 2,507
Non-cash portion of unusual items...................................... 31,206 -- --
Equity in loss of CBHS................................................. -- 8,122 31,878
Loss on Crescent Transactions.......................................... -- 59,868 --
Stock option expense (credit).......................................... 914 4,292 (5,623)
Non-cash interest expense.............................................. 2,424 1,710 2,935
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................................................. 15,495 60,675 (1,585)
Restricted cash and investments.......................................... -- -- (21,782)
Other current assets..................................................... 129 4,708 (3,010)
Other long-term assets................................................... 6,569 3,156 (7,840)
Accounts payable and accrued liabilities................................. (7,516) (60,659) (43,724)
Income taxes payable and deferred income taxes........................... 14,925 (14,669) (14,489)
Reserve for unpaid claims................................................ (29,985) (26,553) (19,177)
Other liabilities........................................................ (18,968) (23,038) (9,290)
Minority interest, net of dividends paid................................. 6,406 9,633 (929)
Other.................................................................... 1,022 (1,018) (1,701)
--------- --------- ----------
Total adjustments........................................................ 69,483 74,097 15,079
--------- --------- ----------
Net cash provided by (used in) operating activities.................... 101,866 73,599 (4,204)
--------- --------- ----------
Cash Flows From Investing Activities:
Capital expenditures......................................................... (38,801) (33,348) (44,213)
Acquisitions and investments in businesses, net of cash acquired............. (50,918) (50,876) (1,046,436)
Distributions received from unconsolidated subsidiaries...................... -- -- 11,441
Decrease (increase) in assets restricted for settlement of unpaid claims and
other long-term liabilities................................................ (17,732) 17,209 51,006
Proceeds from sale of assets................................................. 5,248 18,270 18,088
Proceeds from sale of property and equipment to Crescent and CBHS,
net of transaction costs................................................... -- 380,425 (6,213)
--------- --------- ----------
Net cash provided by (used in) investing activities.................... (102,203) 331,680 (1,016,327)
--------- --------- ----------
Cash Flows From Financing Activities:
Payments on debt and capital lease obligations............................... (85,835) (390,254) (438,633)
Proceeds from issuance of debt, net of issuance costs........................ 104,800 203,643 1,188,706
Proceeds from issuance of common stock....................................... 68,573 -- --
Proceeds from exercise of stock options and warrants......................... 3,401 8,265 5,739
Proceeds from issuance of warrants........................................... -- 25,000 --
Purchases of treasury stock.................................................. (73,493) -- (14,352)
Income tax payments made on behalf of stock optionee......................... (1,678) -- (1,757)
--------- --------- ----------
Net cash provided by (used in) financing activities.................... 15,768 (153,346) 739,703
--------- --------- ----------
Net increase (decrease) in cash and cash equivalents........................... 15,431 251,933 (280,828)
Cash and cash equivalents at beginning of period............................... 105,514 120,945 372,878
--------- --------- ----------
Cash and cash equivalents at end of period..................................... $ 120,945 $ 372,878 $ 92,050
--------- --------- ----------
--------- --------- ----------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements
F-6
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1998
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements of Magellan Health Services, Inc., a
Delaware corporation, ("Magellan" or the "Company") include the accounts of the
Company and its subsidiaries. All significant intercompany accounts and
transactions have been eliminated in consolidation.
The Company's primary business segment, as of September 30, 1998, was its
behavioral managed healthcare operations. The Company operates in four other
business segments, which are described in further detail in Note 15, "Business
Segment Information."
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and the
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the reporting
period. Actual results could differ from those estimates.
MANAGED CARE REVENUE
Managed care revenue is recognized over the applicable coverage period on a
per member basis for covered members and as earned and estimable for
performance-based revenues. Deferred revenue is recorded when premium payments
are received in advance of the applicable coverage period.
FRANCHISE REVENUE
Continuing annual franchise fees are recognized as the fees are earned and
become receivable from franchisees, subject to an allowance for estimated
uncollectible amounts. Costs relating to continuing franchise fees are expensed
as incurred. Individual franchise sales are recognized when all material
services or conditions relating to the sale have been substantially performed or
satisfied by the Company. Direct costs relating to franchise sales are deferred
until the related revenue is recognized up to the amount of anticipated revenue
less estimated additional related costs.
PROVIDER NET REVENUE
Provider net revenue is based on established billing rates, less estimated
allowances for patients covered by Medicare and other contractual reimbursement
programs, and discounts from established billing rates. Amounts received by the
Company for treatment of patients covered by Medicare and other contractual
reimbursement programs, which may be based on cost of services provided or
predetermined rates, are generally less than the established billing rates of
the Company's hospitals. Final determination of amounts earned under contractual
reimbursement programs is subject to review and audit by the applicable
agencies. The Company recorded net revenue in fiscal 1996, 1997 and 1998 of
$28.3 million, $27.4 million and $7.0 million, respectively, for the settlement
and adjustment of reimbursement issues related to earlier fiscal periods.
Management believes that adequate provision has been made for any adjustments
that may result from such reviews in future periods.
F-7
<PAGE>
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
ADVERTISING COSTS
The production costs of advertising are expensed as incurred. The Company
does not consider any of its advertising costs to be direct-response and,
accordingly, does not capitalize such costs. Advertising costs consist primarily
of radio and television air time, which is amortized as utilized, and printed
media services. Advertising expense was approximately $30.5 million, $19.2
million and $4.7 million for the years ended September 30, 1996, 1997 and 1998,
respectively.
CHARITY CARE
The Company provides healthcare services without charge or at amounts less
than its established rates to patients who meet certain criteria under its
charity care policies. Because the Company does not pursue collection of amounts
determined to be charity care, they are not reported as revenue. For the years
ended September 30, 1996, 1997 and 1998, the Company provided, at its
established billing rates, approximately $37.9 million, $19.5 million and $3.7
million, respectively, of such care.
INTEREST, NET
The Company records interest expense net of interest income. Interest income
for the years ended September 30, 1996, 1997, and 1998 was approximately $10.5
million, $10.1 million and $11.9 million, respectively.
CASH AND CASH EQUIVALENTS
Cash equivalents are short-term, highly liquid interest-bearing investments
with a maturity of three months or less when purchased, consisting primarily of
money market instruments.
RESTRICTED CASH AND INVESTMENTS
Restricted cash and investments at September 30, 1998 include approximately
$89.2 million that is held for the payment of claims under the terms of certain
behavioral managed care contracts and for regulatory purposes related to the
payment of claims in certain jurisdictions.
CONCENTRATION OF CREDIT RISK
Accounts receivable from human services revenue and healthcare provider
revenue subject the Company to a concentration of credit risk with third party
payors that include insurance companies, managed healthcare organizations and
governmental entities. The Company establishes an allowance for doubtful
accounts based upon factors surrounding the credit risk of specific payors,
historical trends and other information. Management believes the allowance for
doubtful accounts is adequate to provide for normal credit losses.
ASSETS RESTRICTED FOR THE SETTLEMENT OF UNPAID CLAIMS AND OTHER LONG-TERM
LIABILITIES
Assets restricted for the settlement of unpaid claims and other long-term
liabilities include investments which are carried at fair market value. Transfer
of such investments from the Company's insurance subsidiaries to Magellan or any
of its other subsidiaries is subject to approval by certain regulatory
authorities.
The investments can be classified into three categories: (i) held to
maturity; (ii) available for sale; and (iii) trading. Unrealized holding gains
or losses are recorded for trading and available for sale
F-8
<PAGE>
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
securities. The Company's investments are classified as available for sale. The
unrealized gain or loss on investments available for sale was not material at
September 30, 1997 and 1998.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost, except for assets that have been
impaired, for which the carrying amount is reduced to estimated fair value.
Expenditures for renewals and improvements are charged to the property accounts.
Replacements and maintenance and repairs that do not improve or extend the life
of the respective assets are expensed as incurred. Internal-use software is
capitalized in accordance with SOP 98-1 (as defined). See "--Recent Accounting
Pronouncements" Amortization of capital lease assets is included in depreciation
expense. Depreciation is provided on a straight-line basis over the estimated
useful lives of the assets, which is generally ten to forty years for buildings
and improvements, three to ten years for equipment and three to five years for
capitalized internal-use software. Depreciation expense was $40.0 million, $34.1
million and $24.0 million for the fiscal years ended September 30, 1996, 1997
and 1998, respectively.
Property and equipment, net, consisted of the following at September 30,
1997 and 1998 (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30,
------------------------
<S> <C> <C>
1997 1998
----------- -----------
Land.......................................................................... $ 11,667 $ 11,607
Buildings and improvements.................................................... 70,174 78,886
Equipment..................................................................... 61,671 112,422
Capitalized internal-use software............................................. 2,048 33,923
----------- -----------
145,560 236,838
Accumulated depreciation...................................................... (37,038) (60,100)
----------- -----------
108,522 176,738
Construction in progress...................................................... 692 431
----------- -----------
Property and equipment, net................................................. $ 109,214 $ 177,169
----------- -----------
----------- -----------
</TABLE>
INTANGIBLE ASSETS
Intangible assets are composed principally of (i) goodwill, (ii) customer
lists, and (iii) deferred financing costs. Goodwill represents the excess of the
cost of businesses acquired over the fair value of the net identifiable assets
at the date of acquisition and is amortized using the straight-line method over
25 to 40 years. Customer lists and other intangible assets are amortized using
the straight-line method over their estimated useful lives of 4 to 30 years.
Deferred financing costs are amortized over the terms of the underlying
agreements.
The Company continually monitors events and changes in circumstances which
could indicate that carrying amounts of intangible assets may not be
recoverable. When events or changes in circumstances are present that indicate
the carrying amount of intangible assets may not be recoverable, the Company
assesses the recoverability of intangible assets by determining whether the
carrying value of such intangible assets will be recovered through the future
cash flows expected from the use of the asset and its eventual disposition. No
impairment losses on intangible assets were recorded by the Company in 1996.
Impairment losses of approximately $14.4 million and $1.9 million were recorded
in fiscal 1997 and fiscal 1998, respectively. (See Notes 3 and 11)
F-9
<PAGE>
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
MEDICAL CLAIMS PAYABLE
Medical claims payable represent the liability for healthcare services
authorized or incurred and not yet paid by the Company's managed care
businesses. Medical claims payable are estimated based upon authorized
healthcare services, past claim payment experience for member groups,
adjudication decisions, patient census data and other factors. While Management
believes the liability for medical claims payable is adequate, actual results
could differ from such estimates.
FOREIGN CURRENCY
Changes in the cumulative translation of foreign currency assets and
liabilities are presented as a separate component of stockholders' equity. Gains
and losses resulting from foreign currency transactions, which were not
material, are included in operations as incurred.
NET INCOME (LOSS) PER COMMON SHARE
Net income (loss) per common share is computed based on the weighted average
number of shares of common stock and common stock equivalents outstanding during
the period.
The Exchange Option, as hereinafter defined (see Note 2), was classified as
a potentially dilutive security for fiscal 1996, 1997 and 1998 for the purpose
of computing diluted income per common share. The Exchange Option was
anti-dilutive for fiscal 1996, 1997 and 1998 and, therefore, was excluded from
the diluted income per common share calculations. The Exchange Option was
exercised in January 1998.
STOCK-BASED COMPENSATION
In October 1995, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation," ("FAS 123") which became effective for fiscal years beginning
after December 15, 1995 (fiscal 1997 for the Company). FAS 123 established new
financial accounting and reporting standards for stock-based compensation plans.
Entities are allowed to measure compensation cost for stock-based compensation
under FAS 123 or APB Opinion No. 25, "Accounting for Stock Issued to Employees."
Entities electing to remain with the accounting in APB Opinion No. 25 are
required to make pro forma disclosures of net income and income per common share
as if the provisions of FAS 123 had been applied. The Company has adopted FAS
123 on a pro forma disclosure basis (see Note 8).
RECENT ACCOUNTING PRONOUNCEMENTS
In February 1997, the FASB issued FAS 128, which applies to entities with
publicly held common stock or potential common stock. FAS 128 replaces APB
Opinion 15, "Earnings per Share" and related interpretations. APB Opinion 15
required that entities with simple capital structures present a single "earnings
per common share" ("EPS") on the face of the income statement, whereas those
with complex capital structures present both "primary" and "fully diluted" EPS.
Primary EPS shows the amount of income attributed to each share of common stock
if every common stock equivalent were converted into common stock. Fully diluted
EPS considers common stock equivalents and all other securities that could be
converted into common stock.
FAS 128 simplifies the computation of EPS by replacing the presentation of
primary EPS with a presentation of basic EPS. The Statement requires dual
presentation of basic and diluted EPS by entities with complex capital
structures. Basic EPS includes no dilution and is computed by dividing income
available to common stockholders by the weighted-average number of common shares
outstanding for
F-10
<PAGE>
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
the period. Diluted EPS reflects the potential dilution of securities that could
share in the earnings of an entity, similar to fully diluted EPS under APB
Opinion 15. The Company adopted FAS 128 during the fiscal year ended September
30, 1998. See Note 8, "Stockholder's Equity".
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 and requires the following:
- Computer software costs that are incurred in the preliminary project stage
(as described in SOP 98-1) should be expensed as incurred. Once the
capitalization criteria of SOP 98-1 have been met, external direct costs
of materials and services consumed in developing or obtaining internal-use
computer software; payroll and payroll-related costs for employees who are
directly associated with and who devote time to the internal-use computer
software project (to the extent of the time spent directly on the project)
and interest costs incurred when developing computer software for internal
use should be capitalized. Training costs and data conversion costs should
generally be expensed as incurred.
- Internal costs incurred for upgrades and enhancements should be expensed
or capitalized in accordance with SOP 98-1. Internal costs incurred for
maintenance should be expensed as incurred. Entities that cannot separate
internal costs on a reasonably cost-effective basis between maintenance
and relatively minor upgrades and enhancements should expense such costs
as incurred.
- External costs incurred under agreements related to specified upgrades and
enhancements should be expensed or capitalized in accordance with SOP
98-1. However, external costs related to maintenance, unspecified upgrades
and enhancements and costs under agreements that combine the costs of
maintenance and unspecified upgrades and enhancements should be recognized
in expense over the contract period on a straight-line basis unless
another systematic and rational basis is more representative of the
services received.
- Impairment should be recognized and measured in accordance with the
provisions of FASB Statement No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of."
- The capitalized costs of computer software developed or obtained for
internal use should be amortized on a straight-line basis unless another
systematic and rational basis is more representative of the software's
use.
SOP 98-1 becomes effective for financial statements for fiscal years
beginning after December 15, 1998. The provisions of SOP 98-1 should be applied
to internal-use software costs incurred in those fiscal years for all projects,
including those projects in progress upon initial application of SOP 98-1. Costs
incurred prior to the initial application of SOP 98-1, whether capitalized or
not, should not be adjusted to the amounts that would have been capitalized had
SOP 98-1 been in effect when those costs were incurred.
The Company adopted SOP 98-1 effective October 1, 1997. Each of the
Company's operating units maintains its own information systems, which include
internal-use software as defined by SOP 98-1. The care management and claims
processing systems used in the Company's managed care businesses are the
Company's most significant internal-use software applications. The adoption of
SOP 98-1 had no impact on the Company's financial position or results of
operations.
F-11
<PAGE>
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
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 cost and organizational costs. SOP 98-5 becomes effective for
financial statements for fiscal years beginning after December 15, 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 will adopt SOP 98-5 on October 1, 1998. The adoption of
SOP 98-5 will have no impact on the Company's financial position or results of
operations.
Emerging Issues Task Force Issue 96-16, "Investor's Accounting for an
Investee When the Investor Has a Majority of the Voting Interest but the
Minority Shareholder or Shareholders Have Certain Approval or Veto Rights"
("EITF 96-16") supplements the guidance contained in AICPA Accounting Research
Bulletin 51, "Consolidated Financial Statements", and in Statement of Financial
Accounting Standards No. 94, "Consolidation of All Majority-Owned Subsidiaries"
("ARB 51/FAS 94"), about the conditions under which the Company's consolidated
financial statements should include the financial position, results of
operations and cash flows of subsidiaries which are less than wholly-owned along
with those of the Company's wholly-owned subsidiaries.
In general, ARB 51/FAS 94 requires consolidation of all majority-owned
subsidiaries except those for which control is temporary or does not rest with
the majority owner. Under the ARB 51/FAS 94 approach, instances of control not
resting with the majority owner were generally regarded to arise from such
events as the legal reorganization or bankruptcy of the majority-owned
subsidiary. EITF 96-16 expands the definition of instances in which control does
not rest with the majority owner to include those where significant approval or
veto rights, other than those which are merely protective of the minority
shareholder's interest, are held by the minority shareholder or shareholders
("Substantive Participating Rights"). Substantive Participating Rights include,
but are not limited to: i) selecting, terminating and setting the compensation
of management responsible for implementing the majority-owned subsidiary's
policies and procedures, and ii) establishing operating and capital decisions of
the majority-owned subsidiary, including budgets, in the ordinary course of
business.
The provisions of EITF 96-16 apply to new investment agreements made after
July 24, 1997, and to existing investment agreements which are modified after
this date. The Company has made no new investments, and has modified no existing
investments, to which the provisions of EITF 96-16 would have applied.
In addition, the provisions of EITF 96-16 must be applied to majority-owned
subsidiaries previously consolidated under ARB 51/FAS 94 for which the
underlying agreements have not been modified in financial statements issued for
years ending after December 15, 1998 (fiscal 1999 for the Company). The
F-12
<PAGE>
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
adoption of the provisions of EITF 96-16 on October 1, 1998, will have the
following effects on the Company's consolidated financial position:
<TABLE>
<CAPTION>
OCTOBER 1,
1998
-----------
<S> <C>
INCREASE (DECREASE) IN:
Cash and cash equivalents....................................................... $ (21,092)
Other current assets........................................................... (9,538)
Long-term assets............................................................... (30,049)
Investment in unconsolidated subsidiaries...................................... 26,498
-----------
Total Assets................................................................. $ (34,181)
-----------
-----------
Current liabilities............................................................ $ (10,381)
Minority interest.............................................................. (23,800)
-----------
Total Liabilities............................................................ $ (34,181)
-----------
-----------
</TABLE>
In June 1997, the FASB issued Statement of Financial Accounting Standards
No. 131, "Disclosures about Segments of an Enterprise and Related Information"
("FAS 131"). FAS 131 redefines how operating segments are determined and
requires disclosure of certain financial and descriptive information about a
company's operating segments. The Company has adopted FAS 131 in fiscal 1998.
Accordingly, segment disclosure for fiscal 1996 and 1997 has been restated to
conform to the fiscal 1998 presentation. See Note 15, "Business Segment
Information."
RECLASSIFICATIONS
Certain reclassifications have been made to fiscal 1996 and 1997 amounts to
conform to fiscal 1998 presentation.
2. ACQUISITIONS AND JOINT VENTURES
ACQUISITIONS
MERIT ACQUISITION. On February 12, 1998, the Company consummated the
acquisition of Merit Behavioral Care Corporation ("Merit") for cash
consideration of approximately $448.9 million plus the repayment of Merit's
debt. Merit manages behavioral healthcare programs 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 governmental agencies and various state Medicaid programs. The Company
accounted for the Merit acquisition using the purchase method of accounting. On
September 12, 1997, Merit completed the acquisition of CMG Health, Inc. ("CMG").
CMG is also a national behavioral managed healthcare. Merit paid approximately
$48.7 million in cash and issued approximately 739,000 shares of Merit common
stock as consideration for CMG. The former owners of CMG may be entitled to
additional consideration, depending on the performance of three CMG customer
contracts. Such contingent payments are subject to an aggregate maximum of $23.5
million. No contingent consideration will be payable to the former shareholders
of CMG based on the performance of two of the three CMG customer contracts at
September 30, 1998. The Company may still be required to pay contingent
consideration to the former shareholders of CMG depending on the financial
performance of CHOICE Behavioral Health Partnership ("Choice"). Choice is a
joint venture with Value Options, Inc. that services a contract with CHAMPUS (as
defined). The Company and Value Options, Inc. each own 50% of Choice. The
payment of contingent consideration, if any, to the former shareholders of CMG,
depends on the financial performance of Choice from October 1, 1996 to June 30,
F-13
<PAGE>
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
1997, which is subject to a CHAMPUS Adjustment (as defined) the Company expects
to receive in fiscal 1999.
In connection with the acquisition of Merit, the Company (i) terminated its
existing 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") providing for a revolving credit facility (the
"Revolving Facility") and a term loan facility (the "Term Loan Facility") of up
to $700 million; and (vi) issued $625 million in 9.0% Senior Subordinated Notes
due 2008 (the "Notes").
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 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 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 determination of final valuation allowances on
deferred tax assets, integration plan matters (see Note 11), CHAMPUS Adjustments
(as defined) and certain other matters. The Company expects the Merit purchase
price allocation to be finalized by February 12, 1999.
HAI ACQUISITION. On December 4, 1997, the Company consummated the purchase
of Human Affairs International, Incorporated ("HAI"), formerly a unit of
Aetna/U.S. Healthcare ("Aetna"), for approximately
F-14
<PAGE>
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
$122.1 million, which the Company funded from cash on hand. The Company
accounted for the HAI acquisition using the purchase method of accounting. HAI
manages behavioral healthcare, primarily through EAPs and other behavioral
managed healthcare plans. 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 amount and timing of the payments will be
contingent upon net increases in the number of HAI's covered lives in specified
products.
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 Contract Years as of the end of
the immediately preceding Contract Year and (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
F-15
<PAGE>
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
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 and (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 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 Company would record contingent consideration payable, if any, as
goodwill and identifiable intangible assets.
ALLIED ACQUISITION. On December 5, 1997, the Company purchased the assets of
Allied Health Group, Inc. and certain affiliates ("Allied"). Allied provides
specialty managed care services, including risk-based products and
administrative services to a variety of insurance companies and other customers.
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 approximately $70.0 million for Allied, with cash on hand, of
which $50.0 million was paid to the seller at closing with the remaining $20.0
million placed in escrow. The Company accounted for the Allied acquisition using
the purchase method of accounting. The escrowed amount was payable in one-third
increments if Allied achieved specified earnings targets during each of the
three years following the closing. Additionally, the purchase price could have
been increased during the three year period by up to $40.0 million if Allied's
performance exceeded specified earnings targets.
On November 25, 1998, the Company and the former owners of Allied amended
the Allied purchase agreement (the "Allied Amendment"). The Allied Amendment
resulted in the following changes to the original terms of the Allied purchase
agreement:
- Approximately $18.9 million of the original $20.0 million placed in escrow
by the Company at the consummation of the Allied acquisition, plus accrued
interest, was repaid to the Company.
F-16
<PAGE>
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
- The Company paid certain of the former owners of Allied approximately $4.0
million in settlement of a portion of their potential future contingent
consideration.
- The Company's maximum remaining contingent consideration payable to the
former owners of Allied is approximately $6.1 million less approximately
$1.1 million that remains in escrow. The future contingent payments, if
any, will be based upon the operating performance of Allied for fiscal
1999 through fiscal 2001.
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 assets. The Company expects the Allied purchase price allocation to
be finalized by December 5, 1998.
The following unaudited pro forma information for the years ended September
30, 1997 and 1998 has been prepared assuming the Crescent Transactions (as
defined), Allied acquisition, HAI acquisition, Merit acquisition, the
Transactions and the Green Spring Minority Shareholder Conversion (as defined)
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 on October 1, 1996 or which may
be attained in future periods (in thousands, except per share data):
<TABLE>
<CAPTION>
PRO FORMA
FOR THE YEAR ENDED
------------------------------
<S> <C> <C>
SEPTEMBER 30, SEPTEMBER 30,
1997 1998
-------------- --------------
Net revenue...................................................................... $ 1,589,776 $ 1,813,768
Income before extraordinary item(1).............................................. 18,910 14,941
Net income(1)(2)................................................................. 13,657 14,941
Income per common share--basic:
Income before extraordinary item............................................... 0.60 0.47
Net income..................................................................... 0.43 0.47
Income per common share--diluted:
Income before extraordinary item............................................... 0.59 0.47
Net income..................................................................... 0.42 0.47
</TABLE>
- ------------------------
(1) Excludes expected unrealized cost savings related to the Integration Plan
(as defined), Managed Care integration costs (See Note 11) and Loss on
Crescent Transactions.
(2) Excludes the extraordinary losses on early extinguishment of debt for the
year ended September 30, 1998, that were directly attributable to the
consummation of the Transactions.
HUMAN SERVICES ACQUISITIONS During fiscal 1998, the Company acquired seven
businesses in its human services segment for an aggregate purchase price of
approximately $57.0 million (collectively, the "Human Services Acquisitions").
The Human Services Acquisitions have been accounted for using the purchase
method of accounting. The Human Services Acquisitions provide various
residential and day services for individuals with acquired brain injuries and
for individuals with mental retardation and developmental disabilities.
GREEN SPRING ACQUISITION. On December 13, 1995, the Company acquired a 51%
ownership interest in Green Spring Health Services, Inc. ("Green Spring") for
approximately $68.9 million in cash, the issuance of 215,458 shares of Magellan
Common Stock valued at approximately $4.3 million and the
F-17
<PAGE>
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
contribution of Group Practice Affiliates, Inc. ("GPA"), a wholly-owned
subsidiary of the Company, which became a wholly-owned subsidiary of Green
Spring. In addition, the minority stockholders of Green Spring were issued an
option agreement whereby they could exchange their interests in Green Spring for
an equivalent of the Company's Common Stock or subordinated notes (the "Exchange
Option"). On December 20, 1995, the Company acquired an additional 10% ownership
interest in Green Spring for approximately $16.7 million in cash as a result of
an exercise by a minority stockholder of its Exchange Option. In January, 1998,
the minority stockholders of Green Spring converted their collective 39%
interest in Green Spring into an aggregate of 2,831,516 shares of the Company's
common stock through exercise of the Exchange Option (the "Green Spring Minority
Stockholder Conversion"). As a result of the Green Spring Minority Stockholder
Conversion, the Company owns 100% of Green Spring. The Company issued shares
from treasury to effect the Green Spring Minority Stockholder Conversion and
accounted for it as a purchase of minority interest at a fair value of
consideration paid of approximately $63.5 million.
The Company recorded the investments in Green Spring using the purchase
method of accounting. Green Spring's results of operations have been included in
the consolidated financial statements since the acquisition date, less minority
interest through January, 1998, at which time the Company became the sole owner
of Green Spring.
At each reporting date through January 1998, the Company assessed the fair
value of the Exchange Option in relation to the redemption price available to
the minority stockholders. In any period that the fair value of the Exchange
Option was determined to be less than the redemption price, the difference would
have been recognized as an adjustment to minority interest. No losses were
recorded in fiscal 1996, 1997 and 1998 as a result of changes in the fair value
of the Exchange Option.
JOINT VENTURES
Through its acquisition of Merit, the Company became a 50% partner with
Value Options, Inc. in Choice, a managed behavioral healthcare company. Choice
derives all of its revenues from a contract with the Civilian Health and Medical
Program of the Uniformed Services ("CHAMPUS"), and with TriCare, the successor
to CHAMPUS. The Company accounts for its investment in Choice using the equity
method.
F-18
<PAGE>
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
A summary of financial information for the Company's investment in Choice is
as follows (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, 1998
--------------------
<S> <C>
Current assets.......................................................... $ 22,974
Property and equipment, net............................................. 345
--------
Total assets.......................................................... $ 23,319
--------
--------
Current liabilities..................................................... $ 16,829
Partners' capital....................................................... 6,490
--------
$ 23,319
--------
--------
Magellan Investment in Choice........................................... $ 3,245
--------
--------
FOR THE 231 DAYS ENDED SEPTEMBER 30, 1998
Net revenue............................................................. $ 38,676
Operating expenses...................................................... 22,914
--------
Net income............................................................ $ 15,762
--------
--------
Magellan equity income.................................................. $ 7,881
--------
--------
</TABLE>
In June 1996, Green Spring became a 33 1/3% member in Premier Behavioral
Systems of Tennessee, LLC ("Premier") with Managed Health Network, Inc. and
Columbia Behavioral Health of Tennessee, LLC equally owning the remaining
membership interests. In July 1996, Green Spring's membership interest increased
to 50% by virtue of Managed Health Network, Inc.'s withdrawal from Premier.
Premier was formed to manage behavioral healthcare benefits for the State of
Tennessee's TennCare program. The Company accounts for its investment in Premier
using the equity method. The Company's investment in Premier at September 30,
1997 and 1998 was $(0.7) million and $5.8 million, respectively. The Company's
equity in income (loss) of Premier for fiscal 1996, 1997 and 1998 was $(2.0)
million, $(5.6) million and $4.7 million, respectively. Equity in income (loss)
of CHOICE and Premier is included in net revenue.
The Company is an owner in six hospital-based joint ventures ("Provider
JV's") at September 30, 1998. Generally, each member of the joint venture leased
and/or contributed certain assets in each respective market to the joint venture
with the Company becoming the managing member.
The Provider JV's results of operations have been included in the
consolidated financial statements since inception, less minority interest. A
summary of the Provider JV's is as follows:
<TABLE>
<CAPTION>
OWNERSHIP
MARKET DATE PERCENTAGE MINORITY OWNER/S
- ----------------------------------- ----------------- ----------------- --------------------------------------------
<S> <C> <C> <C>
Chicago, IL........................ June 1994 75% Naperville Health Ventures
Boston, MA......................... February 1995 95% Westwood/Pembroke Corp.,
Psychiatric Associates of Norfolk County,
Inc.
Albuquerque, NM.................... May 1995 67% Columbia/HCA Healthcare Corporation
Raleigh, NC........................ June 1995 50% Columbia/HCA Healthcare Corporation
Lafayette, LA...................... October 1995 50% Columbia/HCA Healthcare Corporation
Anchorage, AK...................... August 1996 57% Columbia/HCA Healthcare Corporation
</TABLE>
F-19
<PAGE>
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
The Company's ownership interests in the Provider JV's have been managed by
CBHS (as defined) for a fee equivalent to Magellan's portion of the joint
ventures earnings since June 17, 1997.
On October 1, 1998, the Provider JV's, excluding Westwood/Pembroke, were
converted from consolidation to the equity method of accounting due to the
Company's implementation of the transition guidance set forth in EITF 96-16. See
Note 1, "Recent Accounting Pronouncements".
3. CRESCENT TRANSACTIONS
On June 17, 1997, the Company consummated a series of transactions including
the sale of substantially all of its domestic hospital real estate and related
personal property (the "Assets") to Crescent Real Estate Equities Limited
Partnership ("Crescent") and Charter Behavioral Hospital System, LLC ("CBHS").
In addition, CBHS was formed as a joint venture to operate the domestic portion
of the Company's provider business segment. CBHS is owned equally by Magellan
and Crescent Operating, Inc., ("COI") an affiliate of Crescent. The Company
accounts for its 50% investment in CBHS under the equity method of accounting
(See Note 4). The Company received approximately $417.2 million in cash (before
costs estimated to be $16.0 million) and warrants in COI for the purchase of
2.5% of COI's common stock at $18.32, which are exercisable over 12 years. The
Company also issued 1,283,311 warrants each to Crescent and COI (the "Crescent
Warrants") for the purchase of Magellan common stock at an exercise price of $30
per share. (See Note 8.)
In related agreements, (i) Crescent leased the hospital real estate and
related assets to CBHS for initial annual rent beginning at approximately $41.7
million with a 5% annual escalation clause compounded annually (the "Facilities
Lease") and (ii) CBHS will pay Magellan approximately $78.3 million in annual
franchise fees, subject to increase, for the use of assets retained by Magellan
and for support in certain areas. The franchise fees to be paid by CBHS to the
Company are subordinated to the lease obligations in favor of Crescent. The
assets retained by Magellan include, but are not limited to, the "CHARTER" name,
intellectual property, protocols and procedures, clinical quality management,
operating processes and the "1-800-CHARTER" telephone call center. Magellan
provides CBHS ongoing support in areas including advertising and marketing
assistance, risk management services, outcomes monitoring, and consultation on
matters relating to reimbursement, government relations, clinical strategies,
regulatory matters, strategic planning and business development.
The Company initially used approximately $200 million of the proceeds from
the sale of the Assets to reduce its long-term debt, including borrowings under
its then existing credit agreement. In December 1997, the Company used the
remaining proceeds from the sale of the Assets to acquire additional managed
care businesses. See Note 2, "Acquisitions and Joint Ventures."
The Company recorded a loss before income taxes of approximately $59.9
million as a result of the Crescent Transactions, which consisted of the
following (in thousands):
<TABLE>
<S> <C>
Accounts receivable collection fees............................... $ 21,400
Impairment losses on intangible assets............................ 14,408
Exit costs and construction obligation............................ 12,549
Loss on the sale of property and equipment........................ 11,511
---------
$ 59,868
---------
---------
</TABLE>
Accounts receivable collection fees represent the reduction in the net
realizable value of accounts receivable for estimated collection fees on
retained hospital-based receivables for CBHS pursuant to a contractual
obligation with CBHS, whereby CBHS receives a fee equal to 5% of collections for
the first
F-20
<PAGE>
3. CRESCENT TRANSACTIONS (CONTINUED)
120 days after consummation of the Crescent Transaction and estimated bad debt
agency fees of 40% for receivables collected subsequent to 120 days after the
consummation of the Crescent Transactions.
The Company disposed of a significant portion of its provider business
segment as part of the Crescent Transactions. The impairment loss on intangible
assets resulted from reducing the book value of the Company's investment in CBHS
to its approximate fair value at the consummation date. The fair value of CBHS
was determined by the Company's financial advisors using a discounted cash flows
analysis. The impairment losses represent the carrying amount of goodwill and
other intangible assets related to the divested or contributed CBHS operations.
The $5.0 million of exit costs accrued as a result of the Crescent
transactions include incremental staffing, consulting and related costs to
prepare and coordinate audits of terminating Medicare cost reports, prepare and
file income tax, property tax, sales and use tax and other tax returns and
perform accounting functions related to the divested businesses (CBHS). The
Company incurred approximately $0.6 million and $1.8 million of such costs
during the years ended September 30, 1997 and 1998, respectively.
The Company constructed a hospital in Philadelphia as required by the
Crescent Real Estate Purchase Agreement to replace the existing Philadelphia
hospital operated by CBHS. The Company incurred approximately $5.5 million in
construction costs through September 30, 1998.
4. INVESTMENT IN CBHS
The Company owned a 50% interest in CBHS as of September 30, 1997 and 1998.
The Company became a 50% owner of CBHS upon consummation of the Crescent
Transactions. The Company accounts for its investment in CBHS using the equity
method.
A summary of financial information for CBHS is as follows (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, 1997 SEPTEMBER 30, 1998
-------------------- --------------------
<S> <C> <C>
Current assets.................................... $ 148,537 $ 147,119
Property and equipment, net....................... 18,424 21,148
Other noncurrent assets........................... 8,633 8,871
---------- ----------
Total Assets.................................... $ 175,594 $ 177,138
---------- ----------
---------- ----------
Current liabilities............................... $ 68,497 $ 141,379
Long-term debt.................................... 65,860 67,200
Other noncurrent liabilities...................... 7,481 35,437
Members' capital (deficit)........................ 33,756 (66,878)
---------- ----------
Total Liabilities and Members' Capital
(Deficit)..................................... $ 175,594 $ 177,138
---------- ----------
---------- ----------
</TABLE>
F-21
<PAGE>
4. INVESTMENT IN CBHS (CONTINUED)
<TABLE>
<CAPTION>
FOR THE
106 DAYS ENDED FISCAL YEAR ENDED
SEPTEMBER 30, 1997 SEPTEMBER 30, 1998
-------------------- --------------------
<S> <C> <C>
Net revenue....................................... $ 213,730 $ 730,447
---------- ----------
Operating expenses................................ 228,382 822,099
Interest, net..................................... 1,592 5,263
---------- ----------
Net loss........................................ $ (16,244) $ (96,915)
---------- ----------
---------- ----------
Cash used in operating activities................. $ (67,831) $ (788)
---------- ----------
---------- ----------
Magellan equity loss(1),(3)....................... $ (8,122) $ (31,878)
---------- ----------
---------- ----------
</TABLE>
The Company's transactions with CBHS and related balances are as follows (in
thousands):
<TABLE>
<CAPTION>
106 DAYS ENDED FISCAL YEAR ENDED
SEPTEMBER 30, 1997 SEPTEMBER 30, 1998
-------------------- --------------------
<S> <C> <C>
Franchise Fee revenue(1).......................... $ 22,739 $ 55,600
-------- --------
Costs:
Accounts receivable collection fees............. $ 4,993 $ 1,980
Provider JV management fees..................... 2,111 5,329
</TABLE>
<TABLE>
<CAPTION>
SEPTEMBER 30, 1997 SEPTEMBER 30, 1998
-------------------- --------------------
<S> <C> <C>
Due to CBHS, net(2)............................... $ 5,090 $ 1,127
-------- --------
-------- --------
Prepaid Charter call center management fees....... $ -- $ 2,953
-------- --------
-------- --------
Investment in CBHS(1),(3)......................... $ 16,878 $ --
-------- --------
-------- --------
</TABLE>
- ------------------------
(1) The Company's Franchise Fee revenue for the year ended September 30, 1998,
was approximately $55.6 million while CBHS recorded Franchise Fee expense of
approximately $78.6 million for the year ended September 30, 1998.
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 of approximately $11.5 million.
(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 fiscal 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 presented as due to CBHS.
(3) Franchise Fees due from CBHS were approximately $38.0 million as of
September 30, 1998. CBHS's independent public accountants' report on CBHS's
financial statements for the year ended September 30, 1998 makes reference
to uncertainty regarding CBHS's ability to continue as a going concern. The
Company recorded equity in loss in excess of its investment in CBHS until
all Franchise Fees due from CBHS were reduced to $0 at September 30, 1998.
Equity in losses of
F-22
<PAGE>
4. INVESTMENT IN CBHS (CONTINUED)
CBHS in excess of the Company's investment in CBHS of $5.1 million,
excluding the $11.5 million in (1) above, have not been reflected in the
Company's financial statements since the Company has no remaining obligation
or commitment to fund CBHS and has no guarantees outstanding for any CBHS
obligations.
5. UNUSUAL ITEMS
GENERAL
The following table summarizes unusual items recorded during the three years
in the period ended September 30, 1998 (in thousands):
<TABLE>
<CAPTION>
1996 1997 1998
--------- --------- ---------
<S> <C> <C> <C>
Insurance settlements....................................... $ 30,000 $ -- $ --
Facility closures........................................... 4,116 4,201 --
Asset impairments........................................... 1,207 -- --
Gains on the sale of psychiatric hospitals, net............. -- (5,388) (3,000)
Termination of CBHS sale transaction........................ -- -- 3,458
Other....................................................... 1,948 1,544 --
--------- --------- ---------
$ 37,271 $ 357 $ 458
--------- --------- ---------
--------- --------- ---------
</TABLE>
INSURANCE SETTLEMENTS
In August 1996, the Company and a group of insurance carriers resolved a
billing dispute which arose in fiscal 1996 related to matters originating in the
1980's. As part of the settlement of these claims, certain related payer matters
and associated legal fees, the Company recorded a charge of approximately $30.0
million during fiscal 1996. The Company will pay the insurance settlement amount
in twelve installments over a three year period, beginning August 1996. As part
of the settlement, the Company and the insurance carriers agreed that the
dispute and settlement would not negatively impact any present or pending
business relationships nor would it prevent the parties from negotiating in good
faith concerning additional business opportunities available to, and future
relationships between, the parties. The Company will make final payments
totaling $6.0 million in fiscal 1999 for insurance settlements.
FACILITY CLOSURES
During fiscal 1996 and 1997, the Company consolidated, closed or sold nine
and three psychiatric facilities and its one general hospital (the "Closed
Facilities"), respectively, exclusive of the Crescent Transactions. The three
psychiatric facilities closed in 1997 were sold as part of the Crescent
Transactions. The Closed Facilities that are still owned by the Company will be
sold, leased or used for alternative purposes depending on the market conditions
in each geographic area and are reflected as other long-term assets in the
accompanying balance sheets.
The Company recorded charges of approximately $4.1 million and $4.2 million
related to facility closures in fiscal 1996 and 1997, respectively, as follows
(in thousands):
<TABLE>
<CAPTION>
1996 1997
--------- ---------
<S> <C> <C>
Severance and related benefits........................................... $ 2,334 $ 2,976
Contract terminations and other.......................................... 1,782 1,225
--------- ---------
$ 4,116 $ 4,201
--------- ---------
--------- ---------
</TABLE>
F-23
<PAGE>
5. UNUSUAL ITEMS (CONTINUED)
Approximately 620 and 700 employees were terminated at the facilities closed
in fiscal 1996 and 1997, respectively. The recorded amounts have been paid as of
September 30, 1998.
The following table presents net revenue, salaries, cost of care and other
operating expenses and bad debt expenses and depreciation and amortization of
the Closed Facilities (in thousands):
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER
30,
--------------------
<S> <C> <C>
1996 1997
--------- ---------
Net revenue............................................................ $ 82,568 $ 19,582
Salaries, cost of care and other operating expense and bad debt
expenses............................................................. 86,426 23,263
Depreciation and amortization.......................................... 2,015 349
</TABLE>
The Company also recorded a charge of approximately $2.0 million in fiscal
1996 related to severance and related benefits for approximately 275 employees
who were terminated pursuant to planned overhead reductions.
ASSET IMPAIRMENTS
During fiscal 1996, the Company recorded impairment losses on property and
equipment of approximately $1.2 million. Such losses resulted from changes in
the manner that certain of the Company's assets were to be used in future
periods and current period operating losses at certain of the Company's
operating facilities combined with projected future operating losses. Fair
values of the long-lived assets that have been written down were determined
using the best available information in each individual circumstance, which
included quoted market price, comparable sales prices for similar assets or
valuation techniques utilizing present value of estimated expected cash flows.
GAINS ON SALE OF PSYCHIATRIC FACILITIES, NET AND OTHER
During fiscal 1997 and 1998, the Company recorded gains of approximately
$5.4 million and $3.0 million, respectively, related to the sales of psychiatric
hospitals and other real estate. The Company also recorded a charge of
approximately $1.6 million during fiscal 1997 for costs incurred related
primarily to the expiration of its agreement to sell its three European
Hospitals.
TERMINATION OF CBHS SALE TRANSACTION
On March 3, 1998, the Company and certain of its wholly owned subsidiaries
entered into definitive agreements with 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
August 19, 1998, the Company announced that it had terminated discussions with
COI for the sale of its interest in CBHS. Furthermore, the Company exercised, in
the fourth quarter of fiscal 1998, certain limited management rights available
to it under the Master Franchise Agreement and, with CBHS's Board's support,
made operational and management changes at CBHS aimed at improving profitability
and cash flows. The Company has since restored all management rights to the CBHS
Board.
F-24
<PAGE>
5. UNUSUAL ITEMS (CONTINUED)
In connection with the termination of the CBHS sale transaction, the Company
recorded a charge of approximately $3.5 million as follows (in thousands):
<TABLE>
<S> <C>
Severance(1)....................................................... $ 488
Lease termination(1)............................................... 1,067
Impairment of long-lived assets.................................... 153
Transaction costs and other........................................ 1,750
---------
$ 3,458
---------
---------
</TABLE>
- ------------------------
(1) Relates to staffing reductions and lease terminations incurred in the
Company's franchising and outcomes monitoring subsidiaries.
6. BENEFIT PLANS
During fiscal 1992, the Company reinstated a defined contribution plan (the
"Magellan 401-K Plan"). Effective January 1, 1997, the plan was amended to allow
participants to contribute up to 15% of their compensation to the Magellan 401-K
Plan. The Company makes a discretionary contribution of 2% of each employee's
compensation and matches 50% of each employee's contribution up to 3% of their
compensation. During the years ended September 30, 1996, 1997 and 1998, the
Company made contributions of approximately $5.3 million, $5.7 million and $3.2
million respectively, to the Magellan 401-K Plan.
Green Spring maintains a defined contribution plan (the "Green Spring 401-K
Plan"). Employee participants can elect to voluntarily contribute up to 6% or
12% of their compensation, depending upon each employee's compensation level, to
the Green Spring 401-K Plan. Green Spring matches up to 3% of each employee's
compensation. Employees vest in employer contributions over five years. During
the years ended September 30, 1996, 1997 and 1998 Green Spring contributed
approximately $0.8 million, $1.3 million and $1.2 million, respectively, to the
Green Spring 401-K Plan.
Merit maintains a 401(k) savings plan covering substantially all employees
who have completed one year of active employment during which 1,000 hours of
service has been credited. Under the plan, an employee may elect to contribute
on a pre-tax basis to a retirement account up to 15% of the employee's
compensation up to the maximum annual contributions permitted by the Internal
Revenue Code. Merit matches employee contributions at the rate of 50% of the
employee's contributions to the 401(k) savings plan, up to a maximum of 6% of an
employee's annual compensation. Merit's 401(k) savings plan contribution
recognized as expense for the year ended September 30, 1998 was $1.1 million.
F-25
<PAGE>
7. LONG-TERM DEBT, CAPITAL LEASE OBLIGATIONS AND OPERATING LEASES
Information with regard to the Company's long-term debt and capital lease
obligations at September 30, 1997 and 1998 is as follows (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, SEPTEMBER 30,
1997 1998
-------------- --------------
<S> <C> <C>
Credit Agreement:
Revolving Facility (7.84% to 7.88% at September 30, 1998)
due through 2004......................................... $ -- $ 40,000
Term Loan Facility (7.84% to 8.34% at September 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
6.31% to 11.50% Mortgage and other notes payable through
2005....................................................... 7,721 4,198
7.5% Swiss Bonds............................................. 6,443 --
3.8% Capital lease obligations due through 2014.............. 6,438 6,448
-------------- --------------
395,602 1,225,646
Less amounts due within one year........................... 3,601 23,033
Less debt service funds.................................... 308 --
-------------- --------------
$ 391,693 $ 1,202,613
-------------- --------------
-------------- --------------
</TABLE>
The aggregate scheduled maturities of long-term debt and capital lease
obligations during the five years subsequent to September 30, 1998 are as
follows (in thousands): 1999--$23,033; 2000-- $32,429; 2001--$38,929;
2002--$49,429 and 2003--$92,030.
The Notes which are carried at cost, had a fair value of approximately $534
million at September 30, 1998, based on market quotes. The Company's remaining
debt is also carried at cost, which approximates fair market value.
In connection with the acquisition of Merit, 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 the Old Notes; (iv)
completed a tender offer for the Merit Outstanding Notes; (v) entered into the
New Credit Agreement providing for Credit Facilities of up to $700 million; and
(vi) issued the Notes. See Note 2--"Acquisitions and Joint Ventures--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 fiscal 1998, to write off unamortized deferred financing costs
related to terminating the previous 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.
F-26
<PAGE>
7. LONG-TERM DEBT, CAPITAL LEASE OBLIGATIONS AND OPERATING 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.
The Notes are general unsecured senior subordinated obligations of the
Company. The Notes are limited in aggregate principal amount to $625 million and
will mature on February 15, 2008. Interest on the Notes accrues at the rate of
9.0% per annum and is payable semi-annually on each February 15 and
F-27
<PAGE>
7. LONG-TERM DEBT, CAPITAL LEASE OBLIGATIONS AND OPERATING LEASES (CONTINUED)
August 15, commencing on August 15, 1998. The Notes were originally issued as
unregistered securities and later exchanged for securities which were registered
with the Securities and Exchange Commission. Due to a delay in the registration
of the Notes to be exchanged, the Company was required to increase the interest
rate on the Notes by 100 basis points per annum for the period from July 13,
1998 through November 9, 1998, the date of issuance of the Notes to be
exchanged.
The Notes are redeemable at the option of the Company. The Notes may be
redeemed at the option of the Company, 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 the 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 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 Notes limits, among other things: (i) the incurrence
of additional indebtedness by the Company and its restricted subsidiaries; (ii)
the payment of dividends on, and redemption or repurchase of, capital stock of
the Company and its restricted subsidiaries and the redemption of certain
subordinated obligations of the Company; (iii) certain other restricted
payments, including investments; (iv) sales of assets; (v) certain transactions
with affiliates; (vi) the creation of liens; and (vii) consolidations, mergers
and transfers of all or substantially all the Company's assets. The Indenture
for the Notes also prohibits certain restrictions on distributions from
restricted subsidiaries. However, all such limitations and prohibitions are
subject to certain qualifications and exceptions.
The Company recorded extraordinary losses of approximately $5.3 million, net
of tax, during fiscal 1997 to write off unamortized deferred financing costs
related to its previous credit agreement and for costs related to paying off the
variable rate secured notes.
The Company leases certain of its operating facilities, some of which may be
purchased during the lease term or at expiration of the leases. The book value
of the capital leased assets was approximately $3.3 million at September 30,
1998. The leases, which expire at various dates through 2069, generally require
the Company to pay all maintenance, property and tax insurance costs.
At September 30, 1998, aggregate amounts of future minimum payments under
operating leases were as follows: 1999--$31.1 million; 2000--$27.2 million;
2001--$23.2 million; 2002--$19.0 million; 2003--$14.5 million; subsequent to
2003--$65.5 million.
Rent expense for the years ended September 30, 1996, 1997 and 1998 was $18.7
million, $19.2 million and $30.6 million, respectively.
F-28
<PAGE>
8. STOCKHOLDERS' EQUITY
Pursuant to the Company's Restated Certificate of Incorporation, the Company
is authorized to issue 80 million shares of common stock, $.25 par value per
share, and 10 million shares of preferred stock, without par value. No shares of
preferred stock have been issued as of September 30, 1998.
COMMON STOCK
The Company is prohibited from paying dividends on its Common Stock under
the terms of the Indenture and New Credit Agreement except under certain limited
circumstances.
1992 STOCK OPTION PLAN
The 1992 Stock Option Plan provided for the issuance of approximately 3.4
million options to purchase shares of Common Stock. A summary of changes in
options outstanding and other related information is as follows:
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
----------------------------------------------
<S> <C> <C> <C>
1996 1997 1998
---------------- --------------- -----------
Balance, beginning of period................. 715,516 368,990 368,990
Canceled................................... -- -- --
Exercised.................................. (346,526) -- (362,990)
---------------- --------------- -----------
Balance, end of period....................... 368,990 368,990 6,000
---------------- --------------- -----------
---------------- --------------- -----------
Option prices, end of period................. $ 4.36-$22.75 $ 4.36-$22.75 $ 22.75
Price range of exercised options............. $ 4.36-$16.875 -- $ 4.36
Average exercise price....................... $ 4.59 -- $ 4.36
</TABLE>
The exercise price of certain options would have been reduced upon
termination of employment of a certain optionee without cause. The Company
records compensation expense for the difference between the exercise price of
these options and the fair value of the Company's common stock until the
measurement date is known. Such compensation expense was included in stock
option expense (credit) in the Company's statements of operations until such
options were exercised in August 1998.
Options issued pursuant to the 1992 Stock Option Plan are exercisable upon
vesting and expire through October 2000. As of September 30, 1998, 100% of the
options outstanding were vested.
F-29
<PAGE>
1994 STOCK OPTION PLAN
The 1994 Stock Option Plan provided for the issuance of approximately 1.3
million options to purchase shares of Common Stock. Officers and key employees
of the Company are eligible to participate. The options have an exercise price
which approximates fair market value of the Common Stock at the date of grant. A
summary of changes in options outstanding and other related information is as
follows:
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
-------------------------------------------------------------
<S> <C> <C> <C>
1996 1997 1998
------------------- ------------------- -------------------
Balance, beginning of period...... 1,162,331 948,669 1,028,494
Granted......................... 161,000 341,166 --
Canceled........................ (330,162) (87,498) (298,276)
Exercised....................... (44,500) (173,843) (49,001)
------------------- ------------------- -------------------
Balance, end of period............ 948,669 1,028,494 681,217
------------------- ------------------- -------------------
------------------- ------------------- -------------------
Option prices, end of period...... $ 15.687-$27.875 $ 15.687-$27.718 $ 15.687-$27.718
Price range of exercised
options....................... $ 15.687-$27.875 $ 15.687-$27.875 $ 16.125-$22.875
Average exercise price.......... $ 20.70 $ 22.20 $ 19.903
</TABLE>
Options granted under the 1994 Stock Option Plan are exercisable to the
extent vested. An option vests at the rate of 33 1/3% of the shares covered by
the option on each of the first three anniversary dates of the grant of the
option if the optionee is an employee of the Company on such dates. Options must
be exercised no later than ten years after the date of grant. As of September
30, 1998, 88.5% of the options outstanding were vested.
1996 STOCK OPTION PLAN
The 1996 Stock Option Plan (the "1996 Plan") provides for the issuance of
1.75 million options to purchase shares of the Company's Common Stock. Options
must be granted on or before December 31, 1999. Officers and key employees of
the Company are eligible to participate. The options have an exercise price
which approximates fair market value of the Common Stock at the date of grant. A
summary of changes in options outstanding and other related information is as
follows:
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30
----------------------------------------------------------
<S> <C> <C> <C>
1996 1997 1998
---------------- ------------------- -------------------
Balance, beginning of period.... -- 1,298,500 1,411,292
Granted....................... 1,413,000 310,667 50,000
Canceled...................... (114,500) (96,125) (42,000)
Exercised..................... -- (101,750) (178,375)
---------------- ------------------- -------------------
Balance, end of period.......... 1,298,500 1,411,292 1,240,917
---------------- ------------------- -------------------
---------------- ------------------- -------------------
Option prices, end of period.... $ 15.75-$24.00 $ 15.75-$30.875 $ 15.75-$30.875
Price range of exercised
options....................... -- $ 18.125-$18.875 $ 15.75-$25.156
Average exercise price.......... -- $ 18.348 $ 18.568
</TABLE>
Options granted under the 1996 Plan are exercisable to the extent vested. An
option vests at the rate of 25% of the shares covered by the option on each of
the four anniversary dates of the grant of the
F-30
<PAGE>
option if the optionee is an employee of the Company on such dates. Options must
be exercised no later than November 30, 2005.
The 1996 Plan provides that the options granted thereunder, upon the
occurrence of certain events, vest and become fully exercisable upon the "sale,
lease, transfer of other disposition... of all or substantially all" of the
Company's assets. Based upon a review of relevant Delaware case law, the Company
believes that substantial uncertainty existed regarding whether the Crescent
Transactions, which are described in Note 3, constituted a "sale ... of all or
substantially all" of the Company's assets. Accordingly, the Company's Board of
Directors determined it should treat the Crescent Transactions as such an event
in order to eliminate the risk of a dispute. Options outstanding under the 1996
Plan immediately vested upon closing the Crescent Transactions. As of September
30, 1998, 94.5% of the options outstanding under the 1996 Plan were vested.
1997 STOCK OPTION PLAN
The 1997 Stock Option Plan (the "1997 Plan") provides for the issuance of
1.5 million options to purchase shares of the Company's Common Stock. Options
must be granted on or before December 31, 2000. Officers and key employees of
the Company are eligible to participate. The options have an exercise price
which approximates fair market value of the Common Stock at the date of grant. A
summary of changes in options outstanding and other related information is as
follows:
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
---------------------------------------
<S> <C> <C>
1997 1998
------------------ -------------------
Balance, beginning of period......................... -- 988,333
Granted.............................................. 988,333 396,000
Canceled............................................. -- (652,055)
------------------ -------------------
Balance, end of period............................... 988,333 732,278
------------------ -------------------
------------------ -------------------
Option prices, end of period......................... $ 24.375-$31.00 $ 22.328-$31.063
</TABLE>
Options granted under the 1997 Plan are exercisable to the extent vested. An
option vests at the rate of 33 1/3% of the shares covered by the option on each
of the three anniversary dates of the grant of the option if the optionee is an
employee of the Company on such dates. Options must be exercised no later than
February 28, 2007. As of September 30, 1998, 42.9% of the options outstanding
under the 1997 Plan were vested. Certain of the options granted under the 1997
stock option plan were granted prior to the stockholder approval date. The
measurement date for purposes of measuring compensation expense for such grants
under the 1997 Stock Option Plan was the date of stockholder approval, which
resulted in compensation expense of approximately $0.5 million and $0.2 million
in fiscal 1997 and 1998, respectively.
1998 STOCK OPTION PLAN
The 1998 Stock Option Plan (the "1998 Plan") provides for the issuance of
1.0 million options to purchase shares of the Company's Common Stock. Options
must be granted on or before December 31, 2001. Officers and key employees of
the Company are eligible to participate. The options have
F-31
<PAGE>
an exercise price which approximates fair market value of the Common Stock at
the date of grant. A summary of changes in options outstanding and other related
information is as follows:
<TABLE>
<CAPTION>
YEAR ENDED
SEPTEMBER 30,
1998
------------------
<S> <C>
Balance, beginning of period.............................................. --
Granted................................................................... 890,500
Canceled.................................................................. (90,000)
------------------
Balance, end of period.................................................... 800,500
------------------
------------------
Option prices, end of period.............................................. $ 14.56-$22.875
</TABLE>
Options granted under the 1998 Plan are exercisable to the extent vested. An
option vests over the period specified in each stock option grant. Options must
be exercised no later than December 31, 2008. As of September 30, 1998, 8.3% of
the options outstanding under the 1998 Plan were vested.
1994 EMPLOYEE STOCK PURCHASE PLAN
The 1994 Employee Stock Purchase Plan (the "1994 ESPP") covered 600,000
shares of Common Stock that could be purchased by eligible employees of the
Company.
The initial offering period began on April 1, 1994 and expired on March 31,
1995. The second offering period began on April 1, 1995 and ended March 31,
1996. On the first date of these offering periods, each participant was granted
an option to purchase shares of Common Stock at a purchase price equal to 85% of
the fair value of a share of Common Stock on such date. Total options granted on
April 1, 1994 and April 1, 1995 were 85,115 and 41,565, respectively, with
option prices of $21.144 and $15.831, respectively. A total of 4,872 and 22,065
options were exercised at the end of the first and second offering periods,
respectively.
Effective August 1, 1995, the Company amended the 1994 ESPP to change the
option price in subsequent offering periods to the lesser of (i) 85% of the fair
value of a share of Common Stock on the first day of the offering period or (ii)
85% of the fair value of a share of Common Stock on the last day of the offering
period. Holders of the options from the second offering period as of July 31,
1995 were given the choice of (i) canceling their options to purchase shares of
Common Stock, (ii) exercising the option to purchase shares of Common Stock at a
purchase price of $15.831 or (iii) keeping their options. A total of 11,870
options were exercised on July 31, 1995. The third offering period began August
1, 1995 and ended December 31, 1995. A total of 29,217 options were exercised at
a purchase price of $16.681 at the end of the third offering period.
The fourth offering period began January 1, 1996 and ended on June 30, 1996.
A total of 68,146 options were exercised at a purchase price of $18.275 at the
end of the fourth offering period. The fifth offering period began July 1, 1996
and ended on December 31, 1996. A total of 80,018 options were exercised at a
purchase price of $17.85 at the end of the fifth and final offering period.
1997 EMPLOYEE STOCK PURCHASE PLAN
The 1997 Employee Stock Purchase Plan (the "1997 ESPP") covers 600,000
shares of Common Stock that can be purchased by eligible employees of the
Company. The 1997 ESPP offering periods will have a term not less than three
months and not more than 12 months. The first offering period under the 1997
ESPP began January 1, 1997 and the last offering period will end on or before
December 31, 1999. The option price of each offering period will be the lesser
of (i) 85% of the fair value of a share of Common Stock on the first day of the
offering period or (ii) 85% of the fair value of a share of Common Stock on the
last day of the offering period.
F-32
<PAGE>
A summary of the 1997 ESPP is as follows:
<TABLE>
<CAPTION>
OFFERING OPTIONS EXERCISE
PERIOD BEGAN ENDED EXERCISED PRICE
- --------------- ------------------- ----------------------- ----------- -----------
<C> <S> <C> <C> <C>
1 January 2, 1997 June 30, 1997 73,410 $ 19.125
2 August 1, 1997 December 31, 1997 26,774 $ 19.125
3 January 1, 1998 June 30, 1998 43,800 $ 18.4875
4 July 1, 1998 December 31, 1998 -- --
</TABLE>
The number of options granted and the option price for the fourth offering
period will be determined on December 31, 1998 when the option price is known.
1992 DIRECTORS' STOCK OPTION PLAN AND DIRECTORS' UNIT AWARD PLAN
The 1992 Directors' Stock Option Plan provides for the grant of options to
non-employee members of the Company's Board of Directors to purchase up to
175,000 shares of the Company's Common Stock, subject to adjustments to reflect
certain changes in capitalization. The options have an exercise price which
approximates the fair market value of the Common Stock on the date of grant.
During fiscal 1996, 1997 and 1998, no options were granted. As of September 30,
1998, 125,000 options were outstanding at exercise prices ranging from $14.56 to
$22.875. No options were exercised during fiscal 1996, 1997 and 1998.
Options granted can be exercised from the date of vesting until February 1,
2003. No options can be granted after December 31, 1995. Options vest 20% when
granted and an additional 20% on each successive February 1 for a period of four
years, if the optionee continues to serve as a non-employee director on the
applicable February 1. Unvested options vest in full in certain instances of
termination. As of September 30, 1998, 96.0% of the options outstanding were
vested.
In addition, during fiscal 1994, the Company approved the Directors' Unit
Award Plan (the "Unit Plan") which provides for the award of a maximum of 15,000
units (the "Units") that, upon vesting under the terms of the Unit Plan, would
result in the issuance of an aggregate of 15,000 shares of Common Stock in
settlement of Units.
The Unit Plan provides for the award to each director who is not an employee
of the Company of 2,500 Units. Upon vesting of the Units awarded to a director,
the Company will settle the Units by issuing to the director, with no exercise
price, a number of shares of the Company's Common Stock equal to the number of
vested Units.
1996 DIRECTORS' STOCK OPTION PLAN
The 1996 Directors' Stock Option Plan provides for the grant of options to
non-employee members of the Company's Board of Directors to purchase up to
250,000 shares of the Company's Common Stock, subject to adjustments to reflect
certain changes in capitalization. The options have an exercise price which
approximates the fair market value of a share of the Common Stock on the date of
grant. During fiscal 1996, 175,000 options were granted at exercise prices
ranging from $18.25 to $23.375. During fiscal 1997, 25,000 options were granted
at an exercise price of $30.812. During fiscal 1998, 50,000 options were granted
at an exercise prices ranging from $20.25 to $22.4375. As of September 30, 1998,
250,000 options were outstanding at exercise prices ranging from $18.25 to
$30.812. No options were exercised during fiscal 1996, 1997 or 1998.
Options granted can be exercised from the date of vesting until November 30,
2005. No options can be granted after December 31, 1999. Options vest at the
rate of 25% of the shares covered on each of the four anniversary dates of the
grant of the option if the optionee continues to serve as a non-employee
director on such dates. Options vest in full in certain instances of
termination. As of September 30, 1998, 41.7% of the options outstanding were
vested.
F-33
<PAGE>
RIGHTS PLAN
The Company adopted a Share Purchase Rights Plan in fiscal 1992 (the "Rights
Plan"). Pursuant to the Rights Plan, each share of Common Stock also represents
one Share Purchase Right (collectively, the "Rights"). The Rights trade
automatically with the underlying shares of Common Stock. Upon becoming
exercisable, but prior to the occurrence of certain events, each Right initially
entitles its holder to buy one share of Common Stock from the Company at an
exercise price of $60.00. The Rights will be distributed and become exercisable
only if a person or group acquires, or announces its intention to acquire,
Common Stock exceeding certain levels, as specified in the Rights Plan. Upon the
occurrence of such events, the exercise price of each Right reduces to one-half
of the then current market price. The Rights also give the holder certain rights
in an acquiring company's common stock. The Company is entitled to redeem the
Rights at a price of $.01 per Right at any time prior to the distribution of the
Rights. The Rights have no voting power until exercised.
COMMON STOCK WARRANTS
The Company issued 114,690 warrants in fiscal 1992 which expire on June 30,
2002 (the "2002 Warrants") to purchase one share each of the Company's Common
Stock. The 2002 Warrants have an exercise price of $5.24 per share. During
fiscal 1996, 1997 and 1998, 4,320, 1,397 and 1,553 shares were issued,
respectively, upon the exercise of 2002 Warrants. At September 30, 1998, 18,920
of the 2002 Warrants were outstanding.
The 2006 Warrants, which expire on September 1, 2006, were subject to
certain adjustments, and accordingly, 146,791 of such warrants are currently
outstanding with an exercise price of $38.70 per share.
Crescent and COI each have the right to purchase 1,283,311 shares of Common
Stock (2,566,622 shares in aggregate) at a warrant exercise price of $30 per
share (subject to adjustment pursuant to antidilution provisions). The Crescent
Warrants will be exercisable at the following times and in the following
amounts:
<TABLE>
<CAPTION>
NUMBER OF SHARES OF
DATE FIRST COMMON STOCK END OF
EXERCISABLE ISSUABLE UPON EXERCISE EXERCISE PERIOD
JUNE 17, OF WARRANTS JUNE 17,
- ------------------------------ ------------------------------ ------------------------------
<S> <C> <C>
1998 30,000 2001
1999 62,325 2002
2000 97,114 2003
2001 134,513 2004
2002 174,678 2005
2003 217,770 2006
2004 263,961 2007
2005 313,433 2008
2006 366,376 2009
2007 422,961 2009
2008 483,491 2009
</TABLE>
Crescent's and COI's rights with respect to the Crescent Warrants are not
contingent on or subject to the satisfaction or completion of any obligation
that Crescent or COI may have to CBHS, or that CBHS may have to the Company, or
by any subordination of fees otherwise payable to the Company by CBHS.
The Crescent Warrants contain provisions relating to adjustments in the
number of shares covered by the Crescent Warrants and the warrant exercise price
in the event of stock splits, stock dividends, mergers, reorganizations and
similar transactions.
F-34
<PAGE>
The Crescent Warrants were recorded at $25 million upon issuance, or their
approximate fair value upon execution of the Warrant Purchase Agreement in
January 1997.
PRIVATE PLACEMENT TRANSACTION
On January 25, 1996, the Company issued 4 million shares of Common Stock
(the "Shares") along with a warrant to purchase an additional 2 million shares
of Common Stock (the "Warrant") pursuant to a Stock and Warrant Purchase
Agreement. The Warrant entitles the holders to purchase such additional shares
of Common Stock at a per share price of $26.15, subject to adjustment for
certain dilutive events, and provides registration rights for the shares of
Common Stock underlying the Warrant. The aggregate purchase price for the Shares
and the Warrant was approximately $69.73 million. The Warrant became exercisable
on January 25, 1997 and expires on January 25, 2000.
Approximately $68.0 million of the proceeds were used to repay outstanding
borrowings under the then existing credit agreement.
TREASURY STOCK TRANSACTIONS
On August 15, 1996, the Company commenced a "Dutch Auction" self-tender
offer to stockholders for the repurchase of 1,891,891 shares of its own Common
Stock. On September 5, 1996, the Company increased the self-tender offer to
3,300,000 shares. Under the terms of the offer, stockholders were invited to
tender their shares by September 18, 1996 at prices ranging from $16.50 to
$18.50 per share as specified by each stockholder.
At the conclusion of the offer, the Company repurchased 3,961,505 shares on
September 27, 1996 at $18.375 per share for a total cost of approximately $73.5
million, including transaction costs. The total shares repurchased represent
approximately 12.0% of the outstanding Common Stock at such date. The
transaction was financed through cash on hand and borrowings under the then
existing credit agreement.
During fiscal 1998, the Company repurchased an aggregate of 696,600 shares
of its common stock in the open market for approximately $14.4 million. Those
transactions were funded with cash on hand.
In January 1998, the Company issued an aggregate of 2,831,516 shares of
treasury stock to the then existing minority stockholders of Green Spring to
effect the Green Spring Minority Stockholder Conversion. See Note 2,
"Acquisitions."
INCOME (LOSS) 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 fiscal 1996 and 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:
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
-------------------------------
<S> <C> <C> <C>
1996 1997 1998
--------- --------- ---------
Weighted average common shares outstanding--basic.................................. 31,014 28,781 30,784
Common stock equivalents--stock options............................................ 563 676 399
Common stock equivalents--warrants................................................. 19 17 15
--------- --------- ---------
Weighted average common shares outstanding--diluted................................ 31,596 29,474 31,198
--------- --------- ---------
--------- --------- ---------
</TABLE>
Options to purchase approximately 2,051,000 shares of common stock at
$23.00-$31.0625 per share were outstanding during fiscal 1998 but were not
included in the computation of diluted EPS
F-35
<PAGE>
because the options exercise price was greater than the average market price of
the common shares. Approximately 1,341,000 of these options, which expire
between fiscal 2001 and 2009, were still outstanding at September 30, 1998.
Warrants to purchase approximately 4,713,000 shares of common stock at
$26.15 to $38.70 per share were outstanding during fiscal 1998 but were not
included in the computation of diluted EPS because the warrants exercise price
was greater than the average market price of the common shares. The warrants,
which expire between fiscal 2000 and 2009, were still outstanding at September
30, 1998.
The Company owned a 61% equity interest in Green Spring Health Services,
Inc. ("Green Spring") during the periods presented above. The four minority
stockholders of Green Spring had the options to exchange their ownership
interests in Green Spring for 2,831,516 shares of the Company's common stock or
$65.1 million of subordinated notes (the "Exchange Option"). The Exchange Option
was considered a potentially dilutive security since the Company acquired Green
Spring in December 1995 for the purpose of computing diluted income per common
share. The Exchange Option was anti-dilutive for all periods presented and,
therefore, was excluded from the respective diluted income per common share
calculations.
Each of the minority stockholders of Green Spring exercised the Exchange
Option in January 1998, which resulted in the issuance of 2,831,516 shares of
the Company's common stock. See Note 2-- "Acquisitions and Joint Ventures--Green
Spring."
On November 17, 1998, the Company's Board of Directors approved the
repricing of stock options outstanding under the Company's existing stock option
plans (the "Stock Option Repricing"). Each holder of 10,000 or more stock
options that was eligible to participate in the Stock Option Repricing was
required to forfeit a percentage of outstanding stock options as follows:
<TABLE>
<S> <C> <C>
Directors, including the Chief Executive 40%
- - Officer....................................
- - Named Executive Officers................... 30%
- - Holders of 50,000 or more stock options.... 25%
- - Holders of 10,000-49,999 stock options..... 15%
</TABLE>
The Stock Option Repricing was consummated on December 8, 1998 based on the
fair value of the Company's Common Stock on such date. Approximately 1.7 million
outstanding stock options were repriced to $8.41 and approximately 0.5 million
outstanding stock options were forfeited as a result of the Stock Option
Repricing. Each participant in the Stock Option Repricing is precluded from
exercising repriced stock options until June 8, 1999.
STOCK-BASED COMPENSATION
Effective October 1, 1996, the Company adopted the disclosure requirements
of FAS 123. FAS 123 requires disclosure of pro forma net income and pro forma
net income per share as if the fair value-based method of accounting for stock
options had been applied in measuring compensation cost for stock-based awards
granted in fiscal 1996, 1997 and 1998. Pro forma amounts are not representative
of the effects of stock-based awards on future pro forma net income and pro
forma net income per share because those pro forma amounts exclude the pro forma
compensation expense related to unvested stock options granted before fiscal
1996.
F-36
<PAGE>
Reported and pro forma net income and net income per share amounts are set
forth below (in thousands, except per share data):
<TABLE>
<CAPTION>
1996 1997 1998
--------- --------- ----------
<S> <C> <C> <C>
Reported:
Income before extraordinary items....................... $ 32,383 $ 4,755 $ 13,732
Net income (loss)....................................... 32,383 (498) (19,283)
Income (loss) per common share--basic:
Income before extraordinary items....................... 1.04 0.17 0.45
Net income (loss)....................................... 1.04 (0.02) (0.63)
Income (loss) per common share--diluted:
Income before extraordinary items....................... 1.02 0.16 0.44
Net income (loss)....................................... 1.02 (0.02) (0.62)
Pro Forma:
Income (loss) before extraordinary items................ 28,835 (3,721) 9,787
Net income (loss)....................................... 28,835 (8,974) (23,228)
Income (loss) per common share--basic:
Income (loss) before extraordinary items................ 0.93 (0.13) 0.32
Net income (loss)....................................... 0.93 (0.31) (0.76)
Income (loss) per common share--diluted:
Income (loss) before extraordinary items................ 0.91 (0.13) 0.31
Net income (loss)....................................... 0.91 (0.31) (0.75)
</TABLE>
The fair values of the stock options and ESPP options granted were estimated
on the date of their grant using the Black-Scholes option pricing model based on
the following weighted average assumptions:
<TABLE>
<CAPTION>
1996 1997 1998
--------- ----------- -----------
<S> <C> <C> <C>
Risk-free interest rate................................. 6% 6% 4.5%
Expected life........................................... 5 years 5.5 years 4 years
Expected volatility..................................... 35% 30% 50%
Expected dividend yield................................. 0% 0% 0%
</TABLE>
The weighted average fair value of options granted during fiscal 1996, 1997
and 1998 was $6.85, $9.67 and $9.53, respectively.
Stock option activity for all plans for 1996, 1997 and 1998 was as follows:
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
-----------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
1996 1997 1998
------------------------ ------------------------ -------------------------
<CAPTION>
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE
----------- ----------- ----------- ----------- ------------ -----------
<S> <C> <C> <C> <C> <C> <C>
Balance, beginning of period........ 2,002,847 $ 15.32 2,916,159 $ 17.92 4,122,109 $ 20.13
Granted............................. 1,749,000 19.05 1,665,166 24.24 1,386,500 24.22
Canceled............................ (444,662) 21.20 (183,623) 20.84 (1,082,331) 23.66
Exercised........................... (391,026) 6.37 (275,593) 20.26 (590,366) 9.90
----------- ----------- ------------
Balance, end of period.............. 2,916,159 17.92 4,122,109 20.13 3,835,912 22.23
----------- ----------- ------------
----------- ----------- ------------
Exercisable, end of period.......... 926,195 14.75 2,419,711 17.65 2,375,919 20.89
----------- ----------- ------------
----------- ----------- ------------
</TABLE>
F-37
<PAGE>
8. STOCKHOLDERS' EQUITY (CONTINUED)
Stock options outstanding on September 30, 1998:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
- ---------------------------------------------------------------------------- ------------------------
<S> <C> <C> <C> <C> <C>
WEIGHTED
AVERAGE WEIGHTED WEIGHTED
RANGE OF REMAINING AVERAGE AVERAGE
EXERCISE CONTRACTUAL EXERCISE EXERCISE
PRICE OPTIONS LIFE PRICE OPTIONS PRICE
- --------------------------------- ----------- --------------- ----------- ----------- -----------
$14.56-$20.44 1,288,579 6.70 $ 18.21 1,181,081 $ 18.15
$20.50-$23.00 1,265,722 7.61 22.32 635,557 22.34
$23.06-$31.06 1,281,611 8.51 26.24 559,281 25.04
----------- -----------
$14.56-$31.06 3,835,912 7.60 22.23 2,375,919 20.89
----------- -----------
----------- -----------
</TABLE>
9. INCOME TAXES
The provision for income taxes consisted of the following (in thousands):
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
--------------------------------
<S> <C> <C> <C>
1996 1997 1998
---------- --------- ---------
Income taxes currently payable:
Federal................................................. $ 6,900 $ 11,148 $ 3,462
State................................................... (1,139) 3,959 1,794
Foreign................................................. 3,779 3,678 2,340
Deferred income taxes:
Federal................................................. 15,313 (6,670) 11,117
State................................................... 807 (2,569) 1,320
Foreign................................................. 35 (308) --
---------- --------- ---------
$ 25,695 $ 9,238 $ 20,033
---------- --------- ---------
---------- --------- ---------
</TABLE>
A reconciliation of the Company's income tax provision to that computed by
applying the statutory federal income tax rate is as follows (in thousands):
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
-------------------------------
<S> <C> <C> <C>
1996 1997 1998
--------- --------- ---------
Income tax provision at federal statutory income tax
rate..................................................... $ 22,483 $ 8,083 $ 13,671
State income taxes, net of federal income tax benefit...... (216) 904 2,024
Foreign income taxes, net of federal income tax benefit.... 2,479 2,190 1,521
Merit goodwill amortization................................ -- -- 4,410
Other--net................................................. 949 (1,939) (1,593)
--------- --------- ---------
Income tax provision....................................... $ 25,695 $ 9,238 $ 20,033
--------- --------- ---------
--------- --------- ---------
</TABLE>
As of September 30, 1998, the Company has estimated tax net operating loss
("NOL") carryforwards of approximately $476 million available to reduce future
federal taxable income. These NOL carryforwards expire in 2006 through 2018 and
are subject to examination by the Internal Revenue Service. In addition, the
Company also has estimated tax NOL carryforwards of approximately $151
F-38
<PAGE>
million available to reduce the federal taxable income of Merit and its
subsidiaries. These NOL carryforwards expire in 2010 through 2018 and are
subject to examination by the Internal Revenue Service. Further, these NOL
carryforwards are subject to limitations on the taxable income of Merit and its
subsidiaries. The Company has recorded a valuation allowance against the portion
of the total NOL deferred tax asset and certain other deferred tax assets, that
in management's opinion, are not likely to be recovered.
Components of the net deferred income tax (assets) liabilities at September
30, 1997 and 1998 are as follows (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30,
--------------------------
<S> <C> <C>
1997 1998
------------ ------------
Deferred tax liabilities:
Insurance settlements........................................... $ 8,460 $ --
Property and depreciation....................................... -- 8,670
Long-term debt and interest..................................... 54,820 20,388
ESOP............................................................ 11,112 12,777
Other........................................................... 17,449 9,556
------------ ------------
Total deferred tax liabilities................................ 91,841 51,391
------------ ------------
Deferred tax assets:
Property and depreciation....................................... (7,123) --
Intangible Assets............................................... (6,785) (8,992)
Operating loss carryforwards.................................... (111,251) (250,512)
Self-insurance reserves......................................... (30,918) (9,534)
Restructuring costs............................................. (22,990) (4,071)
Other........................................................... (38,924) (39,561)
------------ ------------
Total deferred tax assets....................................... (217,991) (312,670)
------------ ------------
Valuation allowance............................................. 124,992 163,893
------------ ------------
Deferred tax assets after valuation allowance................... (92,999) (148,777)
------------ ------------
Net deferred tax assets......................................... $ (1,158) $ 97,386
------------ ------------
------------ ------------
</TABLE>
The Internal Revenue Service is currently examining the Company's income tax
returns for fiscal 1992 and 1993 and expects a report to be issued during fiscal
1999. In management's opinion, adequate provisions have been made for any
adjustments which may result from these examinations, including a potential
reduction in the amount of NOL carryforwards. The Company believes the
examinations could result in a reduction in NOL carryforwards available to
offset future taxable income.
F-39
<PAGE>
10. ACCRUED LIABILITIES
Accrued liabilities consist of the following (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30,
------------------------
1997 1998
----------- -----------
<S> <C> <C>
Salaries, wages and other benefits...................................................... $ 21,647 $ 23,893
Amounts due health insurance programs................................................... 14,126 9,392
Interest................................................................................ 19,739 9,271
Crescent Transactions................................................................... 14,648 3,972
CHAMPUS Adjustments..................................................................... -- 25,484
Other................................................................................... 63,761 121,518
----------- -----------
$ 133,921 $ 193,530
----------- -----------
----------- -----------
</TABLE>
11. 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
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 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 Integration Plan will result in the elimination of approximately 1,000
positions during fiscal 1998 and fiscal 1999. Approximately 350 employees had
been involuntarily terminated pursuant to the Integration Plan as of September
30, 1998, and approximately 280 positions had been eliminated by normal
attrition through September 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 March 31, 1999 and will
complete its involuntary terminations by the end of fiscal 1999.
The Integration Plan has resulted in the closure and identified closure of
approximately 20 leased facilities at the BMCOs, Allied and CMR during fiscal
1998 and 1999. The Company expects the remaining office closures, if any, to be
insignificant.
The Company has recorded approximately $21.3 million of liabilities related
to the Integration Plan, of which $12.4 million was recorded as part of the
Merit purchase price allocation and $8.9 million was recorded in the statement
of operations under "Managed Care integration costs". The Company may record
additional liabilities as a result of the Integration Plan in fiscal 1999 as
final decisions regarding office closures and other contractual obligation
terminations are made.
F-40
<PAGE>
11. MANAGED CARE INTEGRATION PLAN AND COSTS (CONTINUED)
The following table provides a rollforward of liabilities resulting from the
Integration Plan (in thousands):
<TABLE>
<CAPTION>
BALANCE BALANCE
SEPTEMBER 30, SEPTEMBER 30,
TYPE OF COST 1997 ADDITIONS PAYMENTS 1998
- ------------------------------------------- ----------------- ----------- ------------- --------------
<S> <C> <C> <C> <C>
Employee termination benefits.............. $ -- $ 13,009 $ (6,819) $ 6,190
Facility closing costs..................... -- 8,008 (533) 7,475
Other...................................... -- 244 (75) 169
----- ----------- ------------- --------------
$ -- $ 21,261 $ (7,427) $ 13,834
----- ----------- ------------- --------------
----- ----------- ------------- --------------
</TABLE>
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 year ended September 30, 1998, the Company incurred approximately
$8.1 million, in other integration costs, including long-lived asset impairments
of approximately $2.4 million, and outside consulting costs of approximately
$4.1 million. The asset impairments relate primarily to identifiable intangible
assets and leasehold improvements that no longer have value and have been
written off as a result of the Integration Plan.
12. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental cash flow information is as follows (in thousands):
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
----------------------------------
1996 1997 1998
--------- --------- ------------
<S> <C> <C> <C>
(UNAUDITED)
Income taxes paid, net of refunds received.................................. $ 9,299 $ 18,406 $ 11,116
Interest paid, net of amounts capitalized................................... 56,248 54,378 95,153
Long-term debt assumed in connection with acquisitions...................... 12,100 -- --
Non-cash Transactions:
Initial capital contribution to CBHS, primarily property and equipment, less
assumed liabilities....................................................... -- 5,281 --
Common Stock in Treasury issued in connection with the purchase of the
remaining 39% interest in Green Spring Health Services, Inc............... -- -- 63,496
</TABLE>
13. COMMITMENTS AND 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 included
in reserve for unpaid claims in the Company's balance sheet and are based on
actuarial estimates that are discounted at an average rate of 6% to their
present value based on the
F-41
<PAGE>
13. COMMITMENTS AND CONTINGENCIES (CONTINUED)
Company's historical claims experience adjusted for current industry trends. The
undiscounted amount of the reserve for unpaid claims at September 30, 1997 and
1998 was approximately $56.1 million and $34.6 million, respectively. The
carrying amount of accrued medical malpractice claims was $47.7 million and
$26.2 million at September 30, 1997 and 1998, respectively. The reserve for
unpaid claims is adjusted periodically as such claims mature, to reflect changes
in actuarial estimates based on actual experience. During fiscal 1996, 1997 and
1998, the Company recorded reductions in malpractice claim reserves of
approximately $15.3 million, $7.5 million and $4.1 million, 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 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.
The healthcare industry is subject to numerous laws and regulations. The
subjects of such laws and regulations include but are not limited to, matters
such as licensure, accreditation, government healthcare program participation
requirements, reimbursement for patient services, and Medicare and Medicaid
fraud and abuse. Recently, government activity has increased with respect to
investigations and/or allegations concerning possible violations of fraud and
abuse and false claims statutes and/or regulations by healthcare providers.
Entities that are found to have violated these laws and regulations may be
excluded from participating in government healthcare programs, subjected to
fines or penalties or required to repay amounts received from the government for
previously billed patient services. The Office of the Inspector General of the
Department of Health and Human Services and the United States Department of
Justice and certain other governmental agencies are currently conducting
inquiries and/ or investigations regarding the compliance by the Company and
certain of its subsidiaries and the compliance by CBHS and certain of its
subsidiaries with such laws and regulations. Certain of the inquiries relate to
the operations and business practices of the Psychiatric Hospital Facilities
prior to the consummation of the Crescent Transactions. In addition, the Company
is also subject to or party to litigation, claims and civil suits relating to
its operations and business practices. In the opinion of management, the Company
has recorded reserves that are adequate to cover litigation, claims or
assessments that have been or may be asserted against the Company arising out of
such litigation, civil suits and governmental inquiries. Furthermore, management
believes that the resolution of such litigation, civil suits and governmental
inquiries will not have a material adverse effect on the Company's financial
position or results of operations; however, there can be no assurance in this
regard.
In January 1996, the Company settled an ongoing dispute with the Resolution
Trust Corporation ("RTC"), for itself or in its capacity as conservator or
receiver for 12 financial institutions, which formerly held certain debt
securities that were issued by the Company in 1988. In connection with the
settlement, the Company, denying any liability or fault, paid $2.7 million to
the RTC in exchange for a release of all claims.
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 was based on disputed clinical and
factual issues which the Company believes do not constitute a violation
F-42
<PAGE>
13. COMMITMENTS AND CONTINGENCIES (CONTINUED)
of the Act. On the Company's motion, the Court ordered the parties to
participate in mediation of the matter. As a result of the mediation, the
parties reached a settlement. Pursuant to the settlement, the Company paid
approximately $4.8 million in August 1998. Furthermore, Charter Orlando (now
operated by CBHS) 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 liability of approximately $2.3 million
as of September 30, 1998 for this reimbursement.
In October 1996, a group of eight plaintiffs purporting to represent an
uncertified class of psychiatrists, psychologists and 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 "Stephens Case") alleges that the Defendants
violated Section I 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. On November 16, 1998,
the Second Circuit court issued a Summary Order affirming the District Court's
decision. The plaintiffs have not filed a petition for rehearing, and the time
allotted for doing so has expired. The plaintiffs have 90 days from the date of
judgment to file a petition for certiorari with the United States Supreme Court.
The plaintiffs have not indicated whether they will file such a petition. If no
petition is filed, or if a filed petition is denied, this matter will have been
concluded. 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 Stephens
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 behavorial healthcare organizations that
are the defendants in the Stephens Case. The Defendants believe the factual and
legal issues involved in this case are substantially similar to those involved
in the Stephens Case. The Defendants intend to vigorously defend themselves in
this litigation. On August 28, 1998, the defendants filed a joint motion
requesting that the case be: (1) transferred to the Southern District of New
York; (2) alternatively, that all proceedings be stayed pending the Second
Circuit's determination of the Stephens Case appeal, given the RES JUDICATA
effect of the Stephens Case dismissal; and (3) if the Court proceeds with the
case, that the complaint be dismissed for failure to state a claim for
substantially the same reasons as in the Stephens Case. The plaintiffs have
opposed this motion, which was argued on November 23, 1998. At the conclusion of
the November 23 hearing, the Court ruled that the case should be transferred to
the Southern District of New York. The Defendants' motion to dismiss was deemed
withdrawn without prejudice to its resubmission in the Southern District. The
plaintiffs have stated that they intend to appeal the Court's transfer order to
the United States District
F-43
<PAGE>
13. COMMITMENTS AND CONTINGENCIES (CONTINUED)
Court for the District of New Jersey. The Company does not believe this matter
will have a material adverse effect on its financial position or results of
operations.
The Company provides mental health and substance abuse services, as a
subcontractor, to beneficiaries of CHAMPUS. The fixed monthly amounts that the
Company receives for medical costs under CHAMPUS contracts are subject to
retroactive adjustment ("CHAMPUS Adjustments") based upon actual healthcare
utilization during the period known as the "data collection period". The Company
has recorded reserves of approximately $25.5 million as of September 30, 1998
for CHAMPUS Adjustments. While management believes that the present reserve for
CHAMPUS Adjustments is reasonable, ultimate settlement resulting from the
adjustment and available appeal process may vary from the amount provided.
14. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Gerald L. McManis, a director of the Company, is the President of McManis
Associates, Inc. ("MAI"), a healthcare development and management consulting
firm. During fiscal 1996, 1997 and 1998, MAI provided consulting services to the
Company with respect to the development of strategic plans and a review of the
Company's business processes. The Company incurred approximately $287,000,
$865,000 and $85,000 in fees for such services and related expenses during
fiscal 1996, 1997 and 1998, respectively.
G. Fred DiBona, Jr., a director of the Company, is a Director and the
President and Chief Executive Officer of Independence Blue Cross ("IBC"), a
health insurance company.
IBC owned 16.67% of Green Spring prior to December 13, 1995. On December 13,
1995, IBC sold 4.42% of its ownership interest in Green Spring to the Company
for $5,376,000 in cash. IBC had a cost basis of $3,288,000 in the 4.42%
ownership interest sold to the Company. The Exchange Option described previously
gave IBC the right to exchange its ownership interest in Green Spring for a
maximum of 889,456 shares of Common Stock or $20,460,000 in subordinated notes
through December 13, 1998. IBC exercised its Exchange Option in January 29, 1998
for Magellan Common Stock valued at approximately $17.9 million.
IBC and its affiliated entities contract with Green Spring for provider
network, care management and medical review services pursuant to contractual
relationships entered into on July 7, 1994 with terms of up to five years.
During the period from December 14, 1995 through September 30, 1996, fiscal 1997
and fiscal 1998, IBC and its affiliated entities made payments to Green Spring
of approximately $29.2 million, $48.0 million and $54.7 million and owed Green
Spring approximately $13.6 million and $13.5 million at September 30, 1997 and
1998, respectively. Green Spring recorded revenue of approximately $32.8
million, $47.4 million and $54.6 million from IBC during fiscal 1996, 1997 and
1998, respectively.
On July 7, 1994, IBC sold a subsidiary to Green Spring in exchange for a $15
million promissory note. As of September 30, 1998, $3 million remained
outstanding under such promissory note and is due and payable on July 7, 1999.
Darla D. Moore, a director of the Company since February 1996, is the spouse
of Richard E. Rainwater, Chairman of the Board of Crescent and the largest
stockholder of the Company (13.1% beneficial ownership as of September 30,
1998). Because of her relationship to Mr. Rainwater, Ms. Moore did not
participate in any Board action taken with respect to the Crescent Transactions.
F-44
<PAGE>
14. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (CONTINUED)
Daniel S. Messina, a director of the Company, is the Chief Financial Officer
of Aetna. Mr. Messina became a director of the Company in December 1997. On
December 4, 1997, the Company consummated the purchase of HAI, formerly a unit
of Aetna, for approximately $122.1 million.
The Company may be required to make additional contingent payment of up to
$60.0 million annually to Aetna over the five-year period subsequent to closing.
The amount and timing of the payments will be contingent upon net increases in
the HAI's covered lives in specified products. The consideration paid for HAI
was determined through arm's length negotiations that considered, among other
factors, the historical and projected income of HAI. The consideration paid by
the Company was determined by the Board with the advice of management and the
Company's investment bankers.
Aetna and its affiliated entities contract with the Company for various
behavioral managed care services pursuant to contractual relationships, the most
material of which is the Master Service Agreement, which was entered into on
December 4, 1997. During fiscal 1998, Aetna and its affiliated entities paid the
Company approximately $72.3 million for such services. As of September 30, 1998.
Aetna and its affiliated entities owed the Company approximately $0.8 million.
The Company recorded revenue of approximately $69.2 million from Aetna during
fiscal 1998.
15. BUSINESS SEGMENT INFORMATION
The Company operates through five reportable segments engaging in (i) the
behavioral managed healthcare business, (ii) the human services business, (iii)
the specialty managed healthcare business, (iv) the healthcare franchising
business and (v) the healthcare provider business. The behavorial managed
healthcare segment provides behavioral managed care services to health plans,
insurance companies, corporations, labor unions and various governmental
agencies. The human services segment provides therapeutic foster care services
and residential and day services to individuals with acquired brain injuries and
for individuals with mental retardation and developmental disabilities. The
speciality managed healthcare segment provides managed care services to health
plans and insurance companies for chronic medical conditions. The healthcare
franchising segment "franchises" the CHARTER system of behavioral healthcare,
which includes call center management, clinical outcomes monitoring and
advertising and marketing services. The healthcare provider segment provides
behavioral healthcare services to people in the U.S., United Kingdom and
Switzerland.
The accounting policies of the segments are the same as those described in
the summary of significant accounting policies. The Company evaluates
performance of its segments based on profit or loss from operations before
depreciation, amortization, interest, stock option expense (credit), managed
care integration costs, gain or loss on asset sales, other unusual items, income
taxes and minority interest ("Segment Profit"). Intersegment sales and transfers
are not significant.
The Company's reportable segments are strategic business units that offer
different services. They are managed separately because each business has (i)
different marketing strategies due to differences in types of customers and (ii)
different capital resource needs.
F-45
<PAGE>
15. BUSINESS SEGMENT INFORMATION (CONTINUED)
The following tables summarize, for the periods indicated, operating results
and other financial information, by business segment (in thousands):
<TABLE>
<CAPTION>
BEHAVIORAL SPECIALTY
MANAGED HUMAN MANAGED HEALTHCARE HEALTHCARE CORPORATE
HEALTHCARE SERVICES HEALTHCARE FRANCHISING PROVIDER OVERHEAD CONSOLIDATED
----------- ----------- ----------- ------------ ------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
1996
Net revenue................ $ 230,755 $ 69,813 $ -- $ -- $ 1,044,711 $ -- $ 1,345,279
Segment profit (loss)...... 25,589 9,910 -- -- 198,651 (34,786) 199,364
Equity in loss of
unconsolidated
subsidiary................ (2,005) -- -- -- -- -- (2,005)
Capital expenditures....... 6,018 1,964 -- -- 21,737 9,082 38,801
</TABLE>
<TABLE>
<CAPTION>
BEHAVIORAL SPECIALTY
MANAGED HUMAN MANAGED HEALTHCARE HEALTHCARE CORPORATE
HEALTHCARE SERVICES HEALTHCARE FRANCHISING PROVIDER OVERHEAD CONSOLIDATED
----------- --------- ----------- ------------ ----------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
1997
Net revenue................... $ 369,974 $ 88,331 $ -- $ 22,739 $ 729,652 $ -- $ 1,210,696
Segment profit (loss)......... 37,019 10,695 (2,303) 10,964 147,053 (25,578) 177,850
Equity in loss of
unconsolidated
subsidiaries................ (5,567) -- -- (8,122) -- -- (13,689)
Total assets.................. 231,543 39,454 2,366 19,134 271,555 331,568 895,620
Investment in unconsolidated
subsidiaries................ (658) -- -- 16,878 -- -- 16,220
Capital expenditures.......... 9,548 1,880 567 195 18,172 2,986 33,348
</TABLE>
<TABLE>
<CAPTION>
BEHAVIORAL SPECIALTY
MANAGED HUMAN MANAGED HEALTHCARE HEALTHCARE CORPORATE
HEALTHCARE SERVICES HEALTHCARE FRANCHISING PROVIDER OVERHEAD CONSOLIDATED
------------- ----------- ----------- ------------ ----------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
1998
Net revenue................ $ 1,039,038 $ 141,032 $ 143,503 $ 55,625 $ 133,256 $ -- $ 1,512,454
Segment profit (loss)...... 137,192 15,493 3,128 14,676 26,379 (15,750) 181,118
Equity in income (loss) of
unconsolidated
subsidiaries.............. 12,859 -- -- (31,878) -- -- (19,019)
Total assets............... 1,356,259 119,356 78,062 1,941 178,217 182,455 1,916,290
Investment in
unconsolidated
subsidiaries.............. 10,125 -- -- -- -- -- 10,125
Capital expenditures....... 27,535 8,391 3,937 1,483 2,219 648 44,213
</TABLE>
F-46
<PAGE>
15. BUSINESS SEGMENT INFORMATION (CONTINUED)
The following tables reconcile segment profit to consolidated income before
provision for income taxes, minority interest and extraordinary items:
<TABLE>
<S> <C>
1996
Segment profit................................................................... $ 199,364
Depreciation and amortization.................................................... (48,924)
Interest, net.................................................................... (48,017)
Stock option expense............................................................. (914)
Unusual items.................................................................... (37,271)
---------
Income before provision for income taxes,
minority interest and extraordinary items.................................... $ 64,238
---------
---------
</TABLE>
<TABLE>
<S> <C>
1997
Segment profit................................................................... $ 177,850
Depreciation and amortization.................................................... (44,861)
Interest, net.................................................................... (45,377)
Stock option expense............................................................. (4,292)
Loss on Crescent Transactions.................................................... (59,868)
Unusual items.................................................................... (357)
---------
Income before provision for income taxes, minority interest and extraordinary
items........................................................................ $ 23,095
---------
---------
</TABLE>
<TABLE>
<S> <C>
1998
Segment profit................................................................... $ 181,118
Depreciation and amortization.................................................... (54,885)
Interest, net.................................................................... (75,375)
Stock option credit.............................................................. 5,623
Managed care integration costs................................................... (16,962)
Unusual items.................................................................... (458)
---------
Income before provision for income taxes, minority interest and extraordinary
items........................................................................ $ 39,061
---------
---------
</TABLE>
Revenue generated and long-lived assets located in foreign countries are not
material. Revenues from one customer of the Company's behavioral managed
healthcare segment represented 10.1% of the Company's consolidated revenues for
fiscal 1998.
16. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of the quarterly results of operations for the
years ended September 30, 1997 and 1998. The second quarter and third quarter of
fiscal 1997 include unusual items of approximately $1.4 million and ($1.0)
million, respectively. The third quarter of fiscal 1997 also includes a $59.9
million loss on the Crescent Transactions. See Notes 3 and 5 for an explanation
of these items. The fourth quarter of 1997 includes increases to income before
income taxes and minority interest for revenue and bad debt expense adjustments
of approximately $6.4 million relating to a change in estimate for contractual
allowances and allowance for doubtful accounts in the Company's provider
business. The third and fourth quarters of fiscal 1998 include unusual items of
$(3.0) million and $3.5 million, respectively. See Note 5 for an explanation of
these items. The second, third, and fourth quarters of fiscal 1998 included
managed care integrations cost of $11.0 million, $1.3 million and $4.7 million,
respectively. See Note 11 for an explanation of these costs. Net revenue and
cost of care were both reduced from amounts previously reported in the first,
second and third quarters of fiscal 1998 by $4.4 million, $0.1 million and $4.1
million, respectively.
F-47
<PAGE>
16. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (CONTINUED)
<TABLE>
<CAPTION>
FISCAL QUARTERS
--------------------------------------------------
<S> <C> <C> <C> <C>
FIRST SECOND THIRD FOURTH
----------- ----------- ----------- -----------
<CAPTION>
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
1997
Net revenue.................................................. $ 346,819 $ 349,922 $ 324,921 $ 189,034
Income (loss) before extraordinary items..................... 7,141 11,892 (24,441) 10,163
Net income (loss)............................................ 4,191 11,892 (26,744) 10,163
Income (loss) per common share--basic:
Income (loss) before extraordinary items................... 0.25 0.41 (0.85) 0.35
Net income (loss).......................................... 0.15 0.41 (0.93) 0.35
Income (loss) per common share--diluted:
Income (loss) before extraordinary items................... 0.25 0.41 (0.85) 0.33
Net income (loss).......................................... 0.14 0.41 (0.93) 0.33
1998
Net revenue.................................................. $ 211,737 $ 372,153 $ 470,679 $ 457,885
Income (loss) before extraordinary items..................... 7,628 (2,292) 7,410 986
Net income (loss)............................................ 7,628 (35,307) 7,410 986
Income (loss) per common share--basic:
Income (loss) before extraordinary items................... 0.26 (0.07) 0.24 0.03
Net income (loss).......................................... 0.26 (1.14) 0.24 0.03
Income (loss) per common share--diluted:
Income (loss) before extraordinary items................... 0.26 (0.07) 0.23 0.03
Net Income (loss).......................................... 0.26 (1.14) 0.23 0.03
</TABLE>
F-48
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
TO THE MEMBERS OF
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC:
We have audited the accompanying consolidated balance sheets of Charter
Behavioral Health Systems, LLC (a Delaware limited liability corporation) and
subsidiaries as of September 30, 1997 and 1998, and the related consolidated
statements of operations, changes in members' capital (deficit) and cash flows
for the period June 17, 1997 to September 30, 1997 and for the year ended
September 30, 1998. These consolidated financial statements and the schedule
referred to below are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Charter Behavioral Health
Systems, LLC and subsidiaries as of September 30, 1997 and 1998, and the results
of their operations and their cash flows for the period June 17, 1997 to
September 30, 1997 and for the year ended September 30, 1998, in conformity with
generally accepted accounting principles.
The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern. As discussed in Note
1 to the financial statements, the Company has incurred recurring losses from
operations and has a net capital deficiency that raises substantial doubt about
its ability to continue as a going concern. Management's plans in regard to
these matters are also described in Note 1. The financial statements do not
include any adjustments that might result from the outcome of this uncertainty.
Our audit was made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedule listed in the index to the
consolidated financial statements is presented for purposes of complying with
the Securities and Exchange Commission's rules and is not a required part of the
basic financial statements. The schedule has been subjected to the auditing
procedures applied in the audit of the basic financial statements and, in our
opinion, fairly states, in all material respects, the financial data required to
be set forth therein in relation to the basic financial statements taken as a
whole.
ARTHUR ANDERSEN LLP
ATLANTA, GEORGIA
DECEMBER 3, 1998
F-49
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
<TABLE>
<CAPTION>
SEPTEMBER 30,
------------------------
<S> <C> <C>
1997 1998
----------- -----------
ASSETS
Current Assets:
Cash, including cash equivalents of $15,477 in 1997 and $9,117 in 1998,
at cost, which approximates market value............................................ $ 23,443 $ 13,493
Accounts receivable, less allowance for doubtful accounts of $17,605
in 1997 and $33,548 in 1998......................................................... 107,961 120,187
Accounts receivable from Magellan..................................................... 5,090 --
Supplies.............................................................................. 2,313 2,665
Prepaid expenses...................................................................... 9,385 10,538
Other current assets.................................................................. 345 236
----------- -----------
Total Current Assets.............................................................. 148,537 147,119
Property and Equipment:
Buildings and improvements............................................................ 11,879 9,616
Equipment............................................................................. 7,121 11,924
----------- -----------
19,000 21,540
Accumulated depreciation.............................................................. (662) (2,916)
----------- -----------
18,338 18,624
Construction in progress.............................................................. 86 2,524
----------- -----------
Total Property and Equipment...................................................... 18,424 21,148
Other Long-Term Assets.................................................................. 6,471 6,699
Goodwill, net of accumulated amortization of $3 in 1997 and $17 in 1998................. 286 294
Deferred Financing Fees, net of accumulated amortization of $115 in 1997 and $513 in
1998.................................................................................. 1,876 1,878
----------- -----------
$ 175,594 $ 177,138
----------- -----------
----------- -----------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these consolidated balance sheets.
F-50
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
<TABLE>
<CAPTION>
SEPTEMBER 30,
-------------------------
<S> <C> <C>
1997 1998
----------- ------------
LIABILITIES AND MEMBERS' CAPITAL (DEFICIT)
Current Liabilities:
Accounts payable..................................................................... $ 34,864 $ 54,443
Accounts payable to Magellan......................................................... -- 36,857
Accrued liabilities.................................................................. 33,578 47,279
Current maturities of long-term debt and capital lease obligations................... 55 2,800
----------- ------------
Total Current Liabilities.......................................................... 68,497 141,379
Long-Term Debt and Capital Lease Obligations........................................... 65,860 67,200
Reserve for Unpaid Claims.............................................................. 2,686 10,812
Deferred Rent.......................................................................... 3,956 17,054
Long-Term Obligations to Lessor........................................................ 803 3,803
Minority Interest and Other Long-Term Liabilities...................................... 36 3,768
Members' Capital (Deficit):
Preferred interests.................................................................. 35,000 35,000
Common interests..................................................................... 15,000 15,000
Accumulated deficit.................................................................. (16,244) (116,878)
----------- ------------
Total Members' Capital (Deficit)................................................... 33,756 (66,878)
----------- ------------
$ 175,594 $ 177,138
----------- ------------
----------- ------------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these consolidated balance sheets.
F-51
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS)
<TABLE>
<CAPTION>
106 DAYS ENDED YEAR ENDED
SEPTEMBER 30, SEPTEMBER 30,
1997 1998
---------------- --------------
<S> <C> <C>
Net revenue.................................................................... $ 213,730 $ 730,447
---------------- --------------
Costs and expenses:
Salaries, supplies and other operating expenses.............................. 170,619 606,628
Franchise fees--Magellan..................................................... 22,739 78,584
Crescent Lease expense....................................................... 16,919 56,133
Bad debt expense............................................................. 17,437 63,895
Depreciation and amortization................................................ 668 5,693
Interest, net................................................................ 1,592 5,263
Unusual items................................................................ -- 11,125
---------------- --------------
229,974 827,321
---------------- --------------
Loss before minority interest.................................................. (16,244) (96,874)
Minority interest.............................................................. -- 41
---------------- --------------
Net loss....................................................................... (16,244) (96,915)
Preferred dividend requirement................................................. -- 3,719
---------------- --------------
Net loss applicable to common members.......................................... $ (16,244) $ (100,634)
---------------- --------------
---------------- --------------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these consolidated statements.
F-52
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
CONSOLIDATED STATEMENTS OF CHANGES IN MEMBERS' CAPITAL (DEFICIT)
(IN THOUSANDS)
<TABLE>
<CAPTION>
106 DAYS ENDED YEAR ENDED
SEPTEMBER 30, SEPTEMBER 30,
1997 1998
---------------- --------------
<S> <C> <C>
Preferred Interests:
Balance, beginning of period................................................. $ -- $ 35,000
Issuance of cumulative redeemable preferred
interests--Magellan........................................................ 17,500 --
Issuance of cumulative redeemable preferred
interests--COI............................................................. 17,500 --
-------- --------------
Balance, end of period....................................................... 35,000 35,000
-------- --------------
Common Interests:
Balance, beginning of period................................................. -- 15,000
Capital contribution--Magellan............................................... 7,500 --
Capital contribution--COI.................................................... 7,500 --
-------- --------------
Balance, end of period....................................................... 15,000 15,000
-------- --------------
Accumulated Deficit:
Balance, beginning of period................................................. -- (16,244)
Net loss applicable to common members........................................ (16,244) (100,634)
-------- --------------
Balance, end of period....................................................... (16,244) (116,878)
-------- --------------
Total Members' Capital (Deficit)............................................... $ 33,756 $ (66,878)
-------- --------------
-------- --------------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these consolidated statements.
F-53
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
106 DAYS ENDED YEAR ENDED
SEPTEMBER 30, SEPTEMBER 30,
1997 1998
---------------- --------------
<S> <C> <C>
Cash Flows From Operating Activities
Net loss..................................................................... $ (16,244) $ (96,915)
-------- --------------
Adjustments to reconcile net loss to net cash used in operating activities:
(Gain) loss on sale of businesses.......................................... (355) 2,688
Depreciation and amortization.............................................. 668 5,693
Non-cash interest expense.................................................. 115 398
Cash flows from changes in assets and liabilities, net of effects from
sales and acquisitions of businesses:
Accounts receivable, net................................................. (98,504) (5,318)
Accounts receivable/payable to Magellan.................................. (5,090) 41,947
Other current assets..................................................... (5,089) (1,096)
Other long-term assets................................................... (4,565) (275)
Accounts payable and accrued liabilities................................. 53,791 30,848
Reserve for unpaid claims................................................ 2,686 8,126
Deferred rent............................................................ 3,956 13,098
Minority interest, net of dividends paid................................. -- (25)
Other liabilities........................................................ 800 43
-------- --------------
Total adjustments........................................................ (51,587) 96,127
-------- --------------
Net cash used in operating activities.................................. (67,831) (788)
-------- --------------
Cash Flows From Investing Activities
Capital expenditures......................................................... (149) (9,549)
Purchase of information systems equipment from Magellan...................... (5,000) --
Purchase of net assets from Magellan......................................... (11,288) --
Proceeds from sale of businesses, net of transaction costs................... -- 1,160
Acquisition of businesses, net of cash acquired.............................. -- (5,327)
-------- --------------
Net cash used in investing activities.................................. (16,437) (13,716)
-------- --------------
Cash Flows From Financing Activities
Payments on debt and capital lease obligations............................... (16) (46)
Proceeds from issuance of debt, net of issuance costs........................ 98,009 4,600
Proceeds from capital contributions--Magellan................................ 2,218 --
Proceeds from capital contributions--COI..................................... 7,500 --
-------- --------------
Net cash provided by financing activities.............................. 107,711 4,554
-------- --------------
Net increase(decrease) in cash and cash equivalents............................ 23,443 (9,950)
Cash and cash equivalents at beginning of period............................... -- 23,443
-------- --------------
Cash and cash equivalents at end of period..................................... $ 23,443 $ 13,493
-------- --------------
-------- --------------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these consolidated statements.
F-54
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1997 AND 1998
1. ORGANIZATION AND BASIS OF PRESENTATION
The consolidated financial statements of Charter Behavioral Health Systems,
LLC ("CBHS" or the "Company"), a Delaware limited liability corporation, include
the accounts of the Company and its subsidiaries. All significant intercompany
accounts and transactions have been eliminated in consolidation.
The Company provides behavioral healthcare services in the United States.
The Company's principal services include group and individual inpatient
treatment, day and partial hospitalization services, group and individual
outpatient treatment and residential services.
On June 17, 1997 the Company began operations pursuant to a series of
transactions (the "Crescent Transactions") between Magellan Health Services,
Inc. ("Magellan"), Crescent Real Estate Equities Limited Partnership
("Crescent") and Crescent Operating, Inc. ("COI"). The Crescent Transactions
provided for the following:
- -- Magellan sold to Crescent 80 behavioral healthcare facilities (76 operating
and four held for sale) ("Purchased Facilities") and related medical office
buildings formerly operated by Magellan.
- -- The Company operates the Purchased Facilities and the Contributed Facilities
(defined below) (together the "Facilities"). The Company is owned equally by
Magellan and COI.
- -- Magellan contributed to the Company certain property and intangible rights
used in connection with the Facilities with a net book value of
approximately $5.0 million in exchange for its equity interest in CBHS. The
property that was contributed by Magellan included five acute care
psychiatric hospitals and other ancillary facilities that Magellan leased
from third parties (together the "Contributed Facilities"). The Company also
purchased certain assets from Magellan relating to Magellan's information
systems subsidiary for $5.0 million.
- -- COI contributed $5.0 million of cash as its initial equity investment in the
Company.
- -- CBHS entered into a service agreement with Magellan pursuant to which the
Company manages Magellan's interest in certain joint ventures with
unaffiliated third parties, including joint ventures that operate or manage
ten behavioral healthcare facilities. Magellan is the general partner or
managing entity of such joint ventures.
- -- CBHS leased the Purchased Facilities from Crescent under an initial 12-year
lease term with four renewal terms of five years each ("Crescent Lease").
CBHS pays annual base rent to Crescent, which was initially $41.7 million
and increases at 5% compounded annually (See Note 5).
- -- CBHS and certain of its subsidiaries entered into franchise agreements with
Magellan (the "Franchise Agreements") pursuant to which CBHS and such
subsidiaries operate using the "CHARTER" name, services and protocols and
pay Magellan annual franchise fees, subject to increase, of approximately
$78.3 million (See Note 6). The franchise fees due Magellan are subordinate
to the payment of rent due Crescent.
- -- Both Magellan and COI contributed an additional $2.5 million in cash to the
capital of CBHS. In addition, each made a commitment to loan CBHS up to
$17.5 million each, for a period of five years. Such loans were made to CBHS
by each for $17.5 million ("Member Loans") and, effective September 30,
1997, were converted to cumulative redeemable preferred interests (See Note
8).
F-55
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997 AND 1998
1. ORGANIZATION AND BASIS OF PRESENTATION (CONTINUED)
The Company's financial statements have been prepared assuming that the
Company will continue as a going concern. As shown in the financial statements
during the 106 days ended September 30, 1997 and the year ended September 30,
1998, the Company has incurred losses from operations, and therefore, the
Company has a significant accumulated deficit at September 30, 1998. The
financial statements do not include any adjustments relating to the
recoverability and classification of liabilities that might be necessary should
the Company be unable to continue as a going concern.
The Company's continuation as a going concern is dependent upon its ability
to generate sufficient cash flows to meet its obligations on a timely basis. The
Company believes its cash flows and profitability are influenced by the cyclical
nature of the behavioral healthcare provider business, with a reduced demand for
certain services generally occurring during the first fiscal quarter around
major holidays and during the summer months comprising the fourth fiscal
quarter. Management has formulated and implemented a business plan to reduce
overhead and add new lines of business to improve the cash flows and the
profitability of the Company. Additionally, the Company is actively pursuing
additional sources of capital and/or borrowings.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenue and expenses during the reporting period. Actual
results could differ from those estimates.
NET REVENUE
Net revenue is based on established billing rates, less estimated allowances for
patients covered by Medicare and other contractual reimbursement programs, and
discounts from established billing rates. Amounts received by the Company for
treatment of patients covered by Medicare and other contractual reimbursement
programs, which may be based on cost of services provided or predetermined
rates, are generally less than the established billing rates of the Company's
hospitals. Final determination of amounts earned under contractual reimbursement
programs is subject to review and audit by the applicable agencies. Net revenue
in fiscal 1998 included a charge of $0.7 million for the settlement and
adjustment of reimbursement issues related to the previous fiscal period.
Management believes that adequate provision has been made for any adjustments
that may result from such reviews.
ADVERTISING COSTS
The production costs of advertising are expensed as incurred. The Company does
not consider any of its advertising costs to be direct-response and,
accordingly, does not capitalize such costs. Advertising costs consist primarily
of radio and television air time, which is amortized as utilized, and printed
media services. Advertising expense was approximately $6.4 million and $20.3
million for the 106 days ended September 30,1997 and for the year ended
September 30, 1998, respectively.
F-56
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997 AND 1998
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
CHARITY CARE
The Company provides healthcare services without charge or at amounts less than
its established rates to patients who meet certain criteria under its charity
care policies. Because the Company does not pursue collection of amounts
determined to be charity care, they are not reported as revenue. For the 106
days ended September 30, 1997 and for the year ended September 30, 1998, the
Company provided, at its established billing rates, approximately $5.3 million
and $28.4 million, respectively, of such care.
INTEREST, NET
The Company records interest expense net of interest income. Interest income for
the 106 days ended September 30, 1997 and for the year ended September 30, 1998
was approximately $0.2 million and $0.3 million, respectively.
CASH AND CASH EQUIVALENTS
Cash equivalents are short-term, highly liquid interest-bearing investments with
a maturity of three months or less when purchased, consisting primarily of money
market instruments.
CONCENTRATION OF CREDIT RISK
Accounts receivable from patient revenue subject the Company to a concentration
of credit risk with third-party payors that include insurance companies, managed
healthcare organizations and governmental entities. The Company establishes an
allowance for doubtful accounts based upon factors surrounding the credit risk
of specific payors, historical trends and other information. Management believes
the allowance for doubtful accounts is adequate to provide for normal credit
losses.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Expenditures for renewals and
improvements are charged to the property accounts. Replacements and maintenance
and repairs that do not improve or extend the lives of the respective assets are
expensed as incurred. Amortization of capital lease assets is included in
depreciation expense. Depreciation is provided on a straight-line basis over the
estimated useful lives of the assets, which is generally three to ten years for
equipment. Leasehold improvements are amortized over the useful lives of the
related assets or the terms of the leases, whichever is shorter. Depreciation
and amortization expense was $0.7 million and $5.7 million for the 106 days
ended September 30, 1997 and for the year ended September 30, 1998,
respectively.
INTANGIBLE ASSETS
Intangible assets are composed principally of goodwill and deferred financing
costs. Goodwill represents the excess of the cost of businesses acquired over
the fair value of the net identifiable assets at the date of acquisition and is
amortized using the straight-line method over 25 years. Deferred financing costs
are the costs incurred by the Company to obtain and amend its credit agreement
(See Note 5) and are amortized over the term of the related agreement (five
years).
F-57
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997 AND 1998
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The Company continually monitors events and changes in circumstances which
could indicate that carrying amounts of intangible assets may not be
recoverable. When events or changes in circumstances are present that indicate
that the carrying amount of intangible assets may not be recoverable, the
Company assesses the recoverability of intangible assets by determining whether
the carrying value of such intangible assets will be recovered through the
future cash flows expected from the use of the asset and its eventual
disposition. No impairment losses on intangible assets were recorded by the
Company for the 106 days ended September 30, 1997 or for the year ended
September 30, 1998.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company estimates that the carrying amounts of financial instruments
including cash and cash equivalents, accounts receivable and accounts payable
approximated their fair values as of the date of the balance sheets due to the
relatively short maturity of these instruments.
3. ACQUISITIONS, JOINT VENTURES AND DIVESTITURES
ACQUISITIONS
On September 28, 1998, the Company acquired four inpatient behavioral healthcare
facilities, two related transitional care businesses and a behavioral healthcare
contract management business (collectively "Acquired Hospitals") from Ramsay
Health Care, Inc. The purchase price for the Acquired Hospitals was
approximately $5.3 million. The Company accounted for the acquisition using the
purchase method of accounting. The operating results of the Acquired Hospitals
are included in the Company's Consolidated Statements of Operations since the
date of acquisition.
JOINT VENTURES
Effective September 2, 1998, the Company entered into a hospital-based
behavioral healthcare joint venture ("Brentwood JV") with Brentwood Behavioral
Healthcare, LLC. The Company contributed certain assets from an existing
behavioral healthcare facility in Shreveport, Louisiana, to the joint venture in
exchange for its 50% interest in the Brentwood JV. The Company subsequently
closed its Shreveport, Louisiana, facility. The Company accounts for its
investment in the Brentwood JV using the equity method.
DIVESTITURES
On September 30, 1997, the Company sold the operations of a 60-bed behavioral
healthcare hospital in Sioux Falls, South Dakota, for $422,000. Proceeds from
the sale were not received until October 2, 1997. The transaction resulted in a
gain of $355,000.
F-58
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997 AND 1998
4. UNUSUAL ITEMS
The following table summarizes the unusual items recorded during the year
ended September 30, 1998 (in thousands):
<TABLE>
<CAPTION>
YEAR ENDED
SEPTEMBER 30,
1998
--------------
<S> <C>
Purchase Terminations......................................................... $ 4,450
Severance..................................................................... 3,002
Divestitures.................................................................. 2,688
Other......................................................................... 985
--------------
$ 11,125
--------------
--------------
</TABLE>
PURCHASE TERMINATIONS
In the first quarter of fiscal 1998, the Company recorded a charge of
approximately $2.1 million related to expenses incurred in connection with a
terminated acquisition of an unrelated entity. In the fourth quarter of fiscal
1998, the Company recorded a charge of approximately $2.3 million related to
expenses incurred in connection with terminated transactions with Magellan and
COI that included (i) the purchase of Magellan's franchise operations relating
to the "CHARTER" system and certain other assets, (ii) termination of the
Franchise Agreements, (iii) the sale of Magellan's equity interest in CBHS to
COI and (iv) review of the potential to obtain new capital for the Company
(collectively the "Magellan Buyout"). See Note 12.
SEVERANCE
The Company recorded charges of approximately $3.0 million during fiscal 1998
related to severance and related benefits for employees who were terminated
during fiscal 1998 pursuant to planned overhead reductions.
DIVESTITURES
In June 1998, the Company sold a 77-bed behavioral healthcare facility in
Virginia for approximately $0.8 million which resulted in a loss of
approximately $2.7 million.
OTHER
In the fourth quarter of fiscal 1998, the Company accrued approximately $0.8
million for estimated expenses incurred in connection with the settlement of
various litigation matters. Also in the fourth quarter of fiscal 1998, the
Company closed and consolidated one behavioral health care operation in Texas
and recorded charges of approximately $0.2 million related to severance and
related benefits and closure costs.
F-59
<PAGE>
CHARTER BEHAVORIAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997 AND 1998
5. LONG-TERM DEBT AND LEASE OBLIGATIONS
Information with regard to the Company's long-term debt and capital lease
obligations at September 30, 1997 and 1998 is as follows (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30,
--------------------
<S> <C> <C>
1997 1998
--------- ---------
Revolving Credit Agreement due through 2002 (6.90234% to 7.59375%)......................... $ 65,000 $ 70,000
10.5% Capital lease obligations............................................................ 915 --
--------- ---------
65,915 70,000
Less amounts due within one year......................................................... 55 2,800
--------- ---------
$ 65,860 $ 67,200
--------- ---------
--------- ---------
</TABLE>
The aggregate scheduled maturities of long-term debt during the five years
subsequent to September 30, 1998 are as follows (in thousands): 1999--$2,800;
2000--$0; 2001--$0, 2002--$67,200; 2003--$0.
The Company's debt is carried at cost which approximates fair market value.
REVOLVING CREDIT AGREEMENTS
On June 17, 1997, the Company entered into a credit agreement (the "Revolving
Credit Agreement") with certain financial institutions for a five-year senior
secured revolving credit facility in an aggregate committed amount of $100
million. Effective September 30, 1998, the Revolving Credit Agreement was
amended to provide for, among other things, modification of financial covenant
levels and increases in interest rates.
The maximum amount allowed to be borrowed under the Revolving Credit
Agreement is based on a working capital calculation. At September 30, 1998, the
Company did not have any amounts available for borrowing under the Revolving
Credit Agreement. The Revolving Credit Agreement is secured by the tangible and
intangible personal property, including accounts receivable, owned by the
Company.
The loans outstanding under the Revolving Credit Agreement bear interest
(subject to certain potential adjustments) at a rate per annum equal to one,
two, three or six-month LIBOR plus 2.75% or the Alternative Base Rate ("ABR"),
as defined, plus 1.75%. Interest on ABR loans is payable at the end of each
fiscal quarter. Interest on LIBOR-based loans is payable at the end of their
respective terms, but at a minimum of every three months.
COVENANTS
The Revolving Credit Agreement contains a number of restrictive covenants which,
among other things, limit the ability of the Company and certain of its
subsidiaries to incur other indebtedness, engage in transactions with
affiliates, incur liens, make certain restricted payments, and enter into
certain business combinations. The Revolving Credit Agreement also requires the
Company to maintain certain specified financial ratios. The Company was in
compliance with all debt covenants under the Revolving Credit Agreement, as
amended, at September 30, 1998. Budget projections prepared by management for
the fiscal year ending September 30, 1999 estimate that the Company will be in
compliance with all debt
F-60
<PAGE>
CHARTER BEHAVORIAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997 AND 1998
5. LONG-TERM DEBT AND LEASE OBLIGATIONS (CONTINUED)
covenants under the Revolving Credit Agreement, as amended, during fiscal 1999.
Management believes that its budget projections for fiscal 1999 are reasonable
and achievable, however, there can be no assurances that such projections will
be achieved. If the Company were to fail to achieve such budget projections
during fiscal 1999, the Company could become in noncompliance with certain debt
covenants resulting in an event of default under the Revolving Credit Agreement.
CRESCENT LEASE
Effective June 17, 1997, the Company entered into an agreement to lease the
Purchased Facilities from Crescent under an initial 12-year lease term with four
renewal terms of five years each. The Crescent Lease requires the Company to pay
all maintenance, property tax and insurance costs.
The base rent for the first year of the initial term was $41.7 million and
increases at 5% compounded annually. The Company accounts for the Crescent Lease
as an operating lease and accordingly, records base rent expense on a
straight-line basis over the lease term. Effective December 1, 1997, Crescent
and the Company amended the Crescent Lease to delete the requirement for the
Company to pay an additional annual rent of $20.0 million. This amendment has no
impact on future commitments for the Company as it remains directly liable for
the capital expenditures and other obligations under the Crescent Lease which
were to be funded by the additional annual rent.
OTHER LEASES
The Company also leases certain of its operating facilities other than the
Purchased Facilities. The leases, which expire at various dates through 2027,
generally require the Company to pay all maintenance, property tax and insurance
costs.
In connection with the purchase of the Acquired Hospitals, CBHS entered into
an agreement to lease a behavioral healthcare facility under an initial
eight-year lease term with two renewal terms of four years each. The lease
requires the Company to pay all maintenance, property tax and insurance costs.
The base rent is $270,000, subject to increases for inflation. The Company
accounts for the lease as an operating lease.
At September 30, 1998, aggregate amounts of future minimum payments under
operating leases were as follows (in thousands): 1999--$49,225; 2000--$49,719;
2001--$50,562; 2002--$52,597; 2003--$54,972; subsequent to 2003--$367,948.
Rent expense for the 106 days ended September 30, 1997 and for the year
ended September 30, 1998 was $20.0 million and $67.4 million, respectively.
6. FRANCHISE FEES--MAGELLAN
Effective June 17, 1997, the Company and certain of its subsidiaries entered
into franchise agreements with Magellan, pursuant to which CBHS and such
subsidiaries operate using the "CHARTER" name, services and protocols. The
franchise agreements provide, among other things, that:
- Magellan agrees to use its commercially reasonable best efforts, subject
to applicable law, to cause CBHS and such subsidiaries to have "preferred
provider" status in connection with
F-61
<PAGE>
CHARTER BEHAVORIAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997 AND 1998
6. FRANCHISE FEES--MAGELLAN (CONTINUED)
Magellan's managed behavioral healthcare business on a basis
substantially consistent with existing agreements for such business.
- Magellan agrees to operate or provide a toll free "800" telephone number
and call center as a means of assisting customers to locate the places of
business of franchisees.
- Franchisees were granted a right to a defined territory to engage in the
business of providing behavioral healthcare business, as defined.
- Magellan will provide franchisees with the following assistance: (i)
advertising and marketing assistance including consultation, access to
media buying programs and access to broadcast and other advertising
materials produced by Magellan from time to time for franchisees; (ii)
risk management services, including risk financial planning, loss control
and claims management; (iii) outcomes monitoring; (iv) national and
regional contracting services; and (v) consultation by telephone or at
the Magellan offices with respect to matters relating to the franchisee's
business in which Magellan has expertise, including reimbursement,
government relations, clinical strategies, regulatory matters, strategic
planning and business development.
Franchise fees payable by the Company are the greater of (i) $78.3 million,
subject to increases for inflation; or (ii) $78.3 million, plus 3% of gross
revenues over $1 billion and not exceeding $1.2 billion and 5% of gross revenues
over $1.2 billion. Pursuant to a subordination agreement, franchise fees
generally are subordinated to base rent under the Crescent lease and the 5%
annual increase.
The initial term of the franchise agreements is 12 years with four renewal
terms of five years each.
Pursuant to the provisions of the franchise agreement, the Company must pay
additional franchise fees to Magellan on management contract agreements entered
into during the term of the Franchise Agreement ("Managed Business"). Managed
Business franchise fees payable by the Company are 15% or 30% of the Managed
Business total fees less total direct costs for contract locations within or
outside of the Company's existing franchise territories, respectively. Managed
Business franchise fees expense was $0 and $0.3 million for the 106 days ended
September 30, 1997 and for the year ended September 30, 1998, respectively.
On December 22, 1997, Magellan and the Company entered into a management
agreement relating to the operation of the "call centers" formerly operated by
Magellan. The Company received $5.9 million as consideration for performing the
various obligations relating to the "call centers" for the 18-month period ended
June 21, 1999.
The Company has not made total monthly franchise fee payments to Magellan
since February 1998, and, as a result, is in default under the franchise
agreements. Franchise fee arrearages are approximately $38.0 million at
September 30, 1998. In addition to other remedies, whenever franchise fees are
past due for any reason in the amount of $6.0 million or more, Magellan has the
right to prohibit any incentive compensation to CBHS management and prohibit any
vesting of CBHS management equity. Whenever fees are past due in the amount of
$18.0 million or more, Magellan has the right to prohibit any salary increases
for key personnel of CBHS, prohibit any additional hiring by CBHS, and prohibit
any new direct or indirect hospital acquisitions or joint ventures
participation. If franchise fees are past due in an amount greater than $24.0
million, Magellan has the right to require a 5% cutback on budgeted
F-62
<PAGE>
CHARTER BEHAVORIAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997 AND 1998
6. FRANCHISE FEES--MAGELLAN (CONTINUED)
expenses under the then-current approved CBHS annual budget, require monthly
approval of expenditures of CBHS, including capital and operating expenditures,
and require the transfer of control and management of CBHS and CBHS franchisees
to Magellan.
During the fourth quarter of fiscal 1998, due to the franchise fee
arrearages, Magellan exercised its limited management rights under the franchise
agreements and, with CBHS's board of directors' support, made operational and
management changes at CBHS. Subsequent to September 30, 1998, Magellan notified
the CBHS board of directors that it was relinquishing its exercise of limited
management rights of CBHS.
7. BENEFIT PLAN
The Company has a defined contribution retirement plan (the "401(k) Plan").
Employee participants can elect to voluntarily contribute up to 15% of their
compensation to the 401(k) Plan. The Company makes contributions to the 401(k)
Plan based on employee compensation and contributions. The Company makes a
discretionary contribution of 2% of each employee's compensation and matches 50%
of each employee's contribution up to 3% of their compensation.
During the year ended September 30, 1998, the Company made contributions of
approximately $2.7 million to the 401(k) Plan.
8. CUMULATIVE REDEEMABLE PREFERRED INTERESTS
Effective September 30, 1997, Magellan and COI each agreed to exchange their
respective Member Loans for cumulative redeemable preferred interest ("Preferred
Interests") in the Company. The Preferred Interests are callable in whole at the
Company's option on or after April 1, 1998, at an amount equal to the initial
amount plus all accrued dividends thereon. Each holder of Preferred Interests
receives preferential allocation of the Company's profits computed at 10% per
annum on a cumulative basis, compounded monthly. In addition, each Preferred
Interests has a similar preferred position in the event of dissolution of the
Company. The Company recorded approximately $3.7 million in fiscal 1998 relating
to this dividend requirement, which is all unpaid and included in Other
Long-Term Liabilities at September 30, 1998.
9. ACCRUED LIABILITIES
Accrued liabilities consist of the following (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30,
--------------------
1997 1998
--------- ---------
<S> <C> <C>
Salaries and wages..................................................... $ 18,220 $ 20,334
Property taxes......................................................... 4,874 5,157
Interest............................................................... 333 105
Other.................................................................. 10,151 21,683
--------- ---------
$ 33,578 $ 47,279
--------- ---------
--------- ---------
</TABLE>
F-63
<PAGE>
CHARTER BEHAVORIAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997 AND 1998
10. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental cash flow information for the 106 days ended September 30, 1997
and for the year ended September 30, 1998 is as follows (in thousands):
<TABLE>
<CAPTION>
106 DAYS ENDED YEAR ENDED
SEPTEMBER 30, SEPTEMBER 30,
1997 1998
---------------- --------------
<S> <C> <C>
Interest paid.................................................................. $ 1,291 $ 5,561
Exchange of debt for cumulative preferred interest--COI........................ 17,500 --
Exchange of debt for cumulative preferred interest--Magellan................... 17,500 --
Initial capital contribution from Magellan, primarily property and equipment
less assumed liabilities..................................................... 5,282 --
Account receivable for the sale of facility.................................... 386 --
Accrued dividend requirement on cummulative redeemable preferred interests..... -- 3,719
Capital lease obligation assigned with sale of facility........................ -- 874
</TABLE>
11. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
As part of the Crescent Transactions, (i) certain items of working capital
were purchased from Magellan, (ii) the Company agreed to collect Magellan's
patient accounts receivable outstanding as of the closing date for a fee of 5%
of cash collections and (iii) the Company agreed to manage Magellan's interest
in certain joint ventures for a management fee. Included in net revenues for the
106 days ended September 30, 1997 and for the year ended September 30, 1998 are
approximately $5.0 million and $2.0 million, respectively, of these collection
fee revenues and approximately $2.1 million and $5.5 million, respectively, of
these joint venture management fees.
The Company had a net receivable from Magellan as of September 30, 1997 of
approximately $5.1 million and a net payable to Magellan as of September 30,
1998 of approximately $36.9 million. This receivable/payable results from (i)
amounts due for the management of Magellan's joint ventures as of September 30,
1997 and 1998, (ii) amounts due for the collection fees on Magellan's patient
accounts receivable as of September 30, 1997 and 1998, (iii) receivable for the
settlement of working capital related matters as of September 30, 1997 and 1998,
(iv) receivable for the reimbursement effect associated with the collection fees
as of September 30, 1997 and 1998 and (v) payable for the franchise fees as of
September 30, 1998.
Effective April 1, 1998, the Company entered into an agreement with Green
Spring Health Services, Inc. ("Green Spring"), a wholly-owned subsidiary of
Magellan, for managed mental health, substance abuse and employee assistance
plan services for the Company's employees. During fiscal 1998, the Company paid
approximately $0.1 million to Green Spring for these services.
John C. Goff was the Chairman of CBHS and the Vice Chairman of both Crescent
and COI. During fiscal 1998, the Company paid approximately $0.4 million to John
Goff for salary and related benefits. In November 1998, Mr. Goff resigned his
position on the CBHS board. Richard P. Knight, the Chief Financial Officer of
COI, was appointed to fill the vacancy on the CBHS board left by Mr. Goff's
resignation. Jeffrey L. Stevens of COI was subsequently elected Chairman of
CBHS.
F-64
<PAGE>
CHARTER BEHAVORIAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997 AND 1998
12. COMMITMENTS AND CONTINGENCIES
The Company carries general and professional liability insurance from an
unrelated commercial insurance carrier with a self insured retention of $1.5
million per occurrence and $8.0 million in the aggregate, on a claim made basis.
In addition, the Company has an umbrella policy with coverage up to $75.0
million per occurrence and in the aggregate.
Magellan and the predecessor to the Company's Orlando, Florida facility (the
"Orlando Facility") were named as defendants in a complaint entitled United
States of America ex rel. Francine M. Mettevis and Rhea Rowan v. Charter
Hospital of St. Louis, Inc. et al. The action was filed on November 6, 1994 as a
qui tam action in the United States District court for the Middle District of
Florida. Magellan, the Department of Justice, and the Company entered into a
settlement of the action in August 1998. Pursuant to the settlement agreement,
Magellan paid the government $4.75 million and the Company entered into a
Corporate Integrity Agreement for the Orlando Facility whereby the Orlando
Facility will be monitored for five years by the Department of Health and Human
Services ("HHS) and the Office of the Inspector General ("OIG") as well as a
concurrent reviewer. In the settlement agreement, the Company also agreed that
the Orlando Facility would not bill Medicare for the treatment of Medicare
patients for a period of 12 to 15 months beginning August 1, 1998 (the
"Non-Billing Period"). The Company intends to seek indemnification from Magellan
under the Crescent Transactions for all of the fees, costs, expenses and losses
it incurs in connection with the settlement agreement and the Corporate
Integrity Agreement. The Company has been reimbursed by Magellan for losses and
costs it has incurred through October 1998 which relate to the services provided
by the Orlando Facility to Medicare beneficiaries.
In connection with the Magellan Buyout, Magellan and COI entered into a
Support Agreement pursuant to which COI agreed, under certain conditions, to
assist the Company in obtaining the funds required to consummate the
contemplated transactions and to pay expenses incurred in obtaining such funds.
On August 19, 1998, Magellan and COI each announced the termination of
negotiations regarding the Magellan Buyout. On November 5, 1998, Magellan
notified COI that Magellan believes COI owes CBHS $2.3 million for the
reimbursement of expenses incurred by the Company in connection with attempts to
obtain financing for the contemplated transactions. COI disputes this matter
which will be sent to arbitration. See Note 4.
In April 1998, following the death of a patient at the Company's Greensboro,
North Carolina facility ("Greensboro Facility"), the North Carolina Department
of Health and Human Services ("NC HHS") conducted a survey of that facility. On
April 14, 1998, the Greensboro Facility received notice that as a result of the
survey, NC HHS was recommending to the Health Care Financing Administration
("HCFA") that the Greensboro Facility be excluded from participation in Medicare
within 23 days. Similarly, on April 14, 1998, the Greensboro Facility received
notice that as a result of the survey, NC HHS intended to revoke the Greensboro
Facility's state license. In response to such notices, the Company submitted a
plan of correction and refutation of deficiencies with HCFA and NC HHS, and NC
HHS conducted a subsequent visit on May 4 through May 6, 1998. On May 7, 1998,
the Greensboro Facility received notice from HCFA that based on the findings in
the second visit, the date scheduled for involuntary termination was extended to
July 7, 1998. On June 5, 1998, the Greensboro Facility entered into a settlement
agreement with NCHHS which resolved all outstanding regulatory and operational
issues with NCHHS and HCFA arising from the patient's death. The local District
Attorney's office and the North Carolina Board of Nursing ("NCBN") have
continued their separate investigations into this incident. An indictment
F-65
<PAGE>
CHARTER BEHAVORIAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997 AND 1998
12. COMMITMENTS AND CONTINGENCIES (CONTINUED)
of one of the Greensboro Facility's employees has been returned while the NCBN
continues its investigation. At this stage, it is not possible to predict
whether any future action will be taken against the Greensboro Facility or any
of its other employees involved in the patient's death, the likelihood of an
unfavorable outcome, or the amount of any potential loss associated with any
such action.
The healthcare industry is subject to numerous laws and regulations. The
subjects of such laws and regulations include, but are not limited to, matters
such as licensure, accreditation, government healthcare program participation
requirements, reimbursement for patient services, and Medicare and Medicaid
fraud and abuse. Recently, government activity has increased with respect to
investigations and/or allegations concerning possible violations of fraud and
abuse and false claims statutes and regulations by healthcare providers.
Entities that are found to have violated these laws and regulations may be
excluded from participating in government healthcare programs, subjected to
fines or penalties or required to repay amounts received from the government for
previously billed patient services. The Office of the Inspector General of the
Department of Health and Human Services and the United States Department of
Justice and certain other governmental agencies are currently conducting
inquiries and/ or investigations regarding the compliance by the Company and
certain of its subsidiaries with such laws and regulations. In addition, the
Company is also subject to or party to litigation, claims and civil suits
relating to its operations and business practices. In the opinion of management,
the Company has recorded reserves that are adequate to cover litigation, claims
or assessments that have been or may be asserted against the Company arising out
of such litigation, civil suits and governmental inquiries. Furthermore,
management believes that the resolution of such litigation, civil suits and
governmental inquiries will not have a material adverse effect on the Company's
financial position or results of operations; however, there can be no assurance
in this regard.
F-66
<PAGE>
Report of Independent Auditors
Executive Board
Choice Behavioral Health Partnership
We have audited the accompanying balance sheet of Choice Behavioral Health
Partnership (Choice) as of December 31, 1998, and the related statements of
income, partners' capital, and cash flows for the year then ended. These
financial statements are the responsibility of Choice's management. Our
responsibility is to express an opinion on these financial statements based on
our audit.
We conducted our audit in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Choice Behavioral Health
Partnership at December 31, 1998, and the results of its operations, changes in
its partners' capital, and its cash flows for the year then ended in conformity
with generally accepted accounting principles.
ERNST & YOUNG LLP
Jacksonville, Florida
February 11, 1999
F-67
<PAGE>
CHOICE BEHAVIORAL HEALTH PARTNERSHIP
BALANCE SHEET
DECEMBER 31, 1998
<TABLE>
<S> <C>
ASSETS
Current assets:
Cash and cash equivalents................................................... $ 3,995,107
Restricted cash and investments............................................. 11,591,085
Receivable from Humana...................................................... 4,883,700
Other current assets........................................................ 477,944
-----------
Total current assets.......................................................... 20,947,836
Property and equipment, net................................................... 310,225
-----------
Total assets.................................................................. $21,258,061
-----------
-----------
LIABILITIES AND PARTNERS' CAPITAL
Current liabilities:
Medical claims payable...................................................... $11,591,085
Accounts payable and accrued expenses....................................... 910,062
Due to related parties...................................................... 61,475
Contract settlement reserve................................................. 1,942,561
-----------
Total current liabilities..................................................... 14,505,183
Partners' capital:
CMG Health, Inc............................................................. 3,376,439
FHC Options, Inc............................................................ 3,376,439
-----------
Total partners' capital....................................................... 6,752,878
-----------
Total liabilities and partners' capital....................................... $21,258,061
-----------
-----------
</TABLE>
The accompanying notes to financial statements are an integral part of this
balance sheet.
F-68
<PAGE>
CHOICE BEHAVIORAL HEALTH PARTNERSHIP
STATEMENT OF INCOME
YEAR ENDED DECEMBER 31, 1998
<TABLE>
<S> <C>
Provider contract revenue..................................................... $70,351,009
Clinical expenses............................................................. 29,169,252
-----------
Gross margin.................................................................. 41,181,757
Administrative expenses....................................................... 5,362,452
-----------
Income from operations........................................................ 35,819,305
Other income:
Investment income........................................................... 1,037,021
-----------
Net income.................................................................... $36,856,326
-----------
-----------
</TABLE>
The accompanying notes to financial statements are an integral part of this
statement.
F-69
<PAGE>
CHOICE BEHAVIORAL HEALTH PARTNERSHIP
STATEMENT OF PARTNERS' CAPITAL
YEAR ENDED DECEMBER 31, 1998
<TABLE>
<CAPTION>
CMG HEALTH, INC. FHC OPTIONS, INC. TOTAL
----------------- ------------------ --------------
<S> <C> <C> <C>
Balance at December 31, 1997............................... $ 1,454,361 $ 1,454,361 $ 2,908,722
Partner distributions.................................... (16,506,085) (16,506,085) (33,012,170)
Net income............................................... 18,428,163 18,428,163 36,856,326
----------------- ------------------ --------------
Balance at December 31, 1998............................... $ 3,376,439 $ 3,376,439 $ 6,752,878
----------------- ------------------ --------------
----------------- ------------------ --------------
</TABLE>
The accompanying notes to financial statements are an integral part of this
statement.
F-70
<PAGE>
CHOICE BEHAVIORAL HEALTH PARTNERSHIP
STATEMENT OF CASH FLOWS
YEAR ENDED DECEMBER 31, 1998
<TABLE>
<S> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net income.................................................................... $36,856,326
Adjustments to reconcile net income to net cash provided by operating
activities
Depreciation................................................................ 188,904
Loss on disposal of equipment............................................... 7,460
Changes in operating assets and liabilities:
Decrease in restricted cash and investments............................... 5,134,237
Increase in accounts receivable........................................... (4,883,700)
Increase in other current assets.......................................... (147,459)
Increase in accounts payable and accrued expenses......................... 188,000
Decrease in medical claims payable........................................ (5,134,237)
Decrease in contract settlement reserve................................... (4,040,844)
Decrease in due to related parties........................................ (88,356)
-----------
Net cash provided by operating activities..................................... 28,080,331
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property and equipment........................................... (91,327)
CASH FLOWS FROM FINANCING ACTIVITIES
Distributions to partners..................................................... (33,012,170)
-----------
Decrease in cash and cash equivalents......................................... (5,023,166)
Cash and cash equivalents, beginning of year.................................. 9,018,273
-----------
Cash and cash equivalents, end of year........................................ $ 3,995,107
-----------
-----------
</TABLE>
The accompanying notes to financial statements are an integral part of this
statement.
F-71
<PAGE>
CHOICE BEHAVIORAL HEALTH PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1998
1. BUSINESS AND BASIS OF PRESENTATION
Choice Behavioral Health Partnership (Choice) is engaged in the business of
managing mental health and substance abuse services under a subcontract (the
Subcontract) with Humana Military Healthcare Services (Humana), a subsidiary of
Humana, Inc. Humana is the prime contractor awarded the managed care support
contract for Civilian Health and Medical Program of the Uniformed Services
(CHAMPUS) beneficiaries in the Department of Defense Regions 3 and 4 (the
Contract). Under the Subcontract, Choice is responsible for the management of
mental health and substance abuse services for these regions which are comprised
of Florida, Alabama, Georgia, South Carolina, Mississippi, Tennessee, and
portions of Louisiana and Arkansas. Choice receives a fixed fee for the
management of mental health and substance abuse services provided under the
Subcontract and assumes full risk for both inpatient and outpatient services
(subject to certain limitations) for all beneficiaries in the defined service
area.
Choice was formed as a general partnership on January 1, 1996, organized under
the laws of the Commonwealth of Virginia, between CMG Health, Inc. (CMG), a
Maryland corporation and FHC Options, Inc. (Options), a Virginia corporation.
CMG became a wholly owned subsidiary of Magellan Health Services, Inc.
(Magellan), a Delaware corporation, by virtue of Magellan's acquisition of Merit
Behavioral Care Corporation, CMG's parent company, on February 12, 1998.
The original term of the Contract was for the twelve month option period ended
June 30, 1997 with four additional twelve month option periods available for
contract extensions at the discretion of CHAMPUS. The third option period was
extended through June 30, 1999; however, there can be no guarantee that the
remaining option periods will be extended.
If the Contract is extended for an option period, the Subcontract is
automatically extended as well. Choice's management of mental health services
under the Subcontract commenced on July 1, 1996.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the amounts reported in the financial statements and accompanying notes.
Actual results could differ from those estimates.
CASH AND CASH EQUIVALENTS
Cash equivalents are short-term, highly liquid, interest bearing investments
with an original maturity of three months or less.
RESTRICTED CASH AND INVESTMENTS
The Subcontract requires that Choice maintain cash balances sufficient to pay
claims payable.
CONCENTRATIONS OF CREDIT RISK
Choice was formed to provide, and currently exclusively provides, services under
the Subcontract. The reliance on Humana, which is Choice's sole customer and the
holder of the Contract, and on CHAMPUS, which has sole discretion in extending
the Contract under which the Subcontract automatically renews,
F-72
<PAGE>
CHOICE BEHAVIORAL HEALTH PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
subjects Choice to a concentration of credit risk with respect to the
Subcontract. Receivable from Humana represents amounts owed to Choice for
services provided under the Subcontract for the month of December 1998.
PROPERTY AND EQUIPMENT
Property and equipment is carried at cost and is depreciated over the shorter of
the estimated useful life of the asset or the maximum remaining life of the
Subcontract using the straight-line method. Leasehold improvements are amortized
on the straight-line method over the shorter of the estimated useful life or the
remaining lease term. Amortization of leasehold improvements is included in
depreciation expense, which was approximately $189,000.
Property and equipment is comprised of the following:
<TABLE>
<S> <C>
Leasehold improvements........................................... $ 3,986
Furniture and fixtures........................................... 354,155
Computer equipment............................................... 372,733
Computer software................................................ 15,420
---------
746,294
Less accumulated depreciation.................................... 436,069
---------
$ 310,225
---------
---------
</TABLE>
CLINICAL EXPENSES AND MEDICAL CLAIMS PAYABLE
Choice contracts with various mental health providers for the provision of
mental health services to its beneficiaries. Licensed psychiatrists, licensed
psychologists and licensed masters-level clinicians generally are compensated on
a discounted fee for service basis. Institutional providers generally are
compensated on a per diem basis for acute, partial hospitalization, and
residential treatment center services.
Medical claims payable includes the cost of services for which providers have
submitted claims as well as management's estimate of the cost of claims that
have been incurred, but not yet reported. The cost of claims that have been
incurred but not yet reported has been estimated by management based on relevant
industry data and historical trends adjusted for management's estimate of the
cost efficiencies to be derived from the management of care. Management believes
that methodologies employed to estimate the claim liability are reasonable and
the claim liability recorded at December 31, 1998 of approximately $11,591,000
is appropriate. Adjustments to estimates of claims payable to reflect actual
experience are reflected in the statement of income in the period in which such
adjustments become known to management. During 1998, clinical expenses were
decreased by approximately $5,576,000, due to revisions to claims payable to
reflect more accurate claims data which became available as a result of several
factors, including more timely access to authorization and claims payment
information and increased experience in managing care related to the
Subcontract. Due to uncertainties inherent in the claims estimation process, it
is reasonably possible that the claims paid in the near term could differ
materially from estimated amounts.
F-73
<PAGE>
CHOICE BEHAVIORAL HEALTH PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
PROVIDER CONTRACT REVENUE
All revenue recorded by Choice is attributable to the Subcontract.
INCOME TAXES
As a partnership, Choice's income is included in the income tax returns of its
partners. Accordingly, no provision for income taxes has been made in the
accompanying financial statements.
3. FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amount of current assets and current liabilities in the
accompanying balance sheet approximates their fair value.
4. RELATED PARTY TRANSACTIONS
CMG, Options and Humana provide certain services to Choice and pay certain
expenses on behalf of Choice. Choice is billed for the actual cost of all
services provided and expenses paid on its behalf. Choice paid the following
amounts to these related parties:
<TABLE>
<S> <C>
SERVICES PROVIDED BY CMG
Salaries, benefits and payroll taxes of CMG employees providing
services to Choice............................................. $ 24,393
Employee business expenses....................................... 45,617
Supplies and utilities........................................... 5,658
---------
$ 75,668
---------
---------
SERVICES PROVIDED BY OPTIONS
Salaries, benefits and payroll taxes of Options employees
providing services to Choice................................... $ 24,393
Employee business expenses....................................... 36,693
Supplies and utilities........................................... 5,101
---------
$ 66,189
---------
---------
SERVICES PROVIDED BY HUMANA
Telephone services............................................... $ 250,703
Field office facility space...................................... 44,697
Miscellaneous.................................................... 22,732
---------
$ 318,132
---------
---------
</TABLE>
F-74
<PAGE>
CHOICE BEHAVIORAL HEALTH PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
4. RELATED PARTY TRANSACTIONS (CONTINUED)
The amounts due to related parties is comprised of the following:
<TABLE>
<S> <C>
Options........................................................... $ 2,666
Humana............................................................ 58,809
---------
$ 61,475
---------
---------
</TABLE>
5. EMPLOYEE BENEFIT PLANS
Choice has a 401(k) savings plan covering all of its employees who meet certain
eligibility requirements. Under this plan, employees are allowed to contribute
up to 15% of their pre-tax compensation subject to aggregate maximum limits
under current tax law. Choice has the right to make a discretionary contribution
as determined by the Board of Directors. A discretionary contribution of
approximately $250,000 was made during the year. Choice paid approximately
$4,500 in administration costs for the plan during the year.
6. COMMITMENTS AND CONTINGENCIES
Choice is subject to potential claims arising from the conduct of its business
and maintains a general and professional liability insurance policy with per
claim and aggregate limits of $1,000,000 each with excess liability coverage of
$5,000,000 per occurrence and $15,000,000 in aggregate. Management is unaware of
any significant claims which may have been asserted against Choice. In the
opinion of management, Choice maintains adequate insurance coverage to contain
any claims which may eventually be asserted.
Choice receives payments in fixed monthly amounts for the management of mental
health and substance abuse care. These amounts are subject to retroactive
CHAMPUS adjustments, referred to as bid-price adjustments (BPA). There are seven
scheduled BPAs which occur over the course of the five-year contract and which
measure a variety of factors, including changes in covered lives; estimates of
actual costs for the data collection period (DCP); shifts in workload between
military-provided services and contractor-provided services; changes in the
acuity of services; and CHAMPUS inflation relative to projections. The DCP is
the 12-month period ended June 30, 1996 (12-month period immediately preceding
healthcare delivery). BPA1 was determined in 1997 based on estimates of actual
covered lives for the option period and actual utilization for the DCP. BPA2 was
determined during 1998 based on remeasurement of covered lives, estimated DCP
utilization and consideration of changes in workload. Future BPAs will measure
the factors noted for each of the option periods. The BPAs are estimated and
reflected as an adjustment to provider contract revenue during the applicable
period. Estimated amounts payable to Humana, if any, are included in contract
settlement reserve.
During 1998, Humana received additional information from CHAMPUS in conjunction
with the BPA2 calculations, including revised counts of covered lives, updated
estimates of actual DCP utilization and preliminary estimates of military
workload. Humana calculated BPA2 to be approximately 29% and 20% of total
clinical revenue specified in the final bid for option periods one and two,
respectively. During
F-75
<PAGE>
CHOICE BEHAVIORAL HEALTH PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
6. COMMITMENTS AND CONTINGENCIES (CONTINUED)
1998, management increased provider contract revenue by approximately
$14,366,000 due to the settlement of BPA2.
While management believes that the contract settlement reserve of approximately
$1,943,000 is reasonable, because of the inherent uncertainty surrounding the
factors included in the determination of the final BPA for each option period,
it is reasonably possible that the estimated amounts may differ materially from
the amounts that would have been recorded had the actual factors been known.
F-76
<PAGE>
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS--MAGELLAN
(IN THOUSANDS)
<TABLE>
<CAPTION>
CHARGED TO
BALANCE AT CHARGED TO OTHER BALANCE AT
BEGINNING COSTS AND ACCOUNTS-- DEDUCTIONS-- END OF
CLASSIFICATION OF PERIOD EXPENSES DESCRIBE DESCRIBE PERIOD
- ---------------------------------------------------- ----------- ------------ ------------ ------------- -----------
<S> <C> <C> <C> <C> <C>
Year ended September30, 1996:
Allowance for doubtful accounts................... $ 48,741 $ 81,470(D) $ 22,761(A) $ 103,236(B) $ 50,548
812(C)
----------- ------------ ------------ ------------- -----------
$ 48,741 $ 81,470 $ 23,573 $ 103,236 $ 50,548
----------- ------------ ------------ ------------- -----------
----------- ------------ ------------ ------------- -----------
Year ended September30, 1997:
Allowance for doubtful accounts................... $ 50,548 $ 46,211(D) $ 19,373(A) $ 89,114(B) $ 40,311
$ 21,400(E) 5,164(F)
2,943(G)
----------- ------------ ------------ ------------- -----------
$ 50,548 $ 67,611 $ 19,373 $ 97,221 $ 40,311
----------- ------------ ------------ ------------- -----------
----------- ------------ ------------ ------------- -----------
Year ended September30, 1998:
Allowance for doubtful accounts................... $ 40,311 $ 4,977(D) $ 15,031(A) $ 24,440(B) $ 34,867
4,376(C) 5,388(F)
----------- ------------ ------------ ------------- -----------
$ 40,311 $ 4,977 $ 19,407 $ 29,828 $ 34,867
----------- ------------ ------------ ------------- -----------
----------- ------------ ------------ ------------- -----------
</TABLE>
- ------------------------
(A) Recoveries of accounts receivable previously written off.
(B) Accounts written off.
(C) Allowance for doubtful accounts assumed in acquisitions.
(D) Bad debt expense.
(E) Accounts receivable collection fees included in loss on Crescent
Transactions.
(F) Accounts receivable collection fees payable to CBHS and outside vendors.
(G) Amounts reclassified to contractual allowances.
S-1
<PAGE>
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS-CBHS
(IN THOUSANDS)
<TABLE>
<CAPTION>
ADDITIONS
------------------------
<S> <C> <C> <C> <C> <C>
CHARGED TO
BALANCE AT CHARGED TO OTHER BALANCE AT
BEGINNING COSTS AND ACCOUNTS- DEDUCTIONS- END
CLASSIFICATION OF PERIOD EXPENSE DESCRIBE DESCRIBE OF PERIOD
- ------------------------------------------------------ ----------- ----------- ----------- ------------ -----------
106 days ended September 30, 1997:
Allowance for doubtful accounts..................... $ -- $ 17,437 $ 39(A) $ 843(B) $ 17,605
972(C)
----------- ----------- ----------- ------------ -----------
$ -- $ 17,437 $ 1,011 $ 843 $ 17,605
----------- ----------- ----------- ------------ -----------
----------- ----------- ----------- ------------ -----------
Year ended September 30, 1998:
Allowance for doubtful accounts..................... $ 17,605 $ 63,895 $ 4,035(A) $ 51,987(B) $ 33,548
----------- ----------- ----------- ------------ -----------
$ 17,605 $ 63,895 $ 4,035 $ 51,987 $ 33,548
----------- ----------- ----------- ------------ -----------
----------- ----------- ----------- ------------ -----------
</TABLE>
- ------------------------
(A) Recoveries of amounts previously charged to income.
(B) Accounts written off.
(C) Allowance for doubtful accounts assumed in purchase of net assets from
Magellan.
S-2
<PAGE>
EXHIBIT 23(b)
CONSENT OF INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statements
(Form S-3 Amendment 1 No. 333-53353, Form S-3 No. 333-20371, Form S-3 Amendment
3 No. 333-01217 and Form S-3 No. 333-50423) of Magellan Health Services, Inc. of
our report dated February 11, 1999, with respect to the financial statements of
Choice Behavioral Health Partnership for the year ended December 31, 1998,
included in this Annual Report (Form 10-K/A).
ERNST & YOUNG LLP
Jacksonville, Florida
March 25, 1999
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED BALANCE SHEETS AND CONSOLIDATED STATEMENTS OF OPERATIONS FOUND ON
PAGES F-3 AND F-4 OF THE COMPANY'S FORM 10-K FOR THE YEAR-TO-DATE, AND IS
QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> SEP-30-1998
<PERIOD-END> SEP-30-1998
<CASH> 92,050,000
<SECURITIES> 0
<RECEIVABLES> 174,846,000
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 399,724,000
<PP&E> 237,269,000
<DEPRECIATION> 60,100,000
<TOTAL-ASSETS> 1,916,290,000
<CURRENT-LIABILITIES> 454,766,000
<BONDS> 1,202,613,000
0
0
<COMMON> 8,476,000
<OTHER-SE> 179,159,000
<TOTAL-LIABILITY-AND-EQUITY> 1,916,290,000
<SALES> 1,512,454,000
<TOTAL-REVENUES> 1,512,454,000
<CGS> 0
<TOTAL-COSTS> 1,294,481,000
<OTHER-EXPENSES> 98,560,000
<LOSS-PROVISION> 4,977,000
<INTEREST-EXPENSE> 75,375,000
<INCOME-PRETAX> 39,061,000
<INCOME-TAX> 20,033,000
<INCOME-CONTINUING> 13,732,000
<DISCONTINUED> 0
<EXTRAORDINARY> (33,015,000)
<CHANGES> 0
<NET-INCOME> (19,283,000)
<EPS-PRIMARY> (0.63)
<EPS-DILUTED> (0.62)
</TABLE>
