MAGELLAN HEALTH SERVICES INC, 10-Q, 2000-05-11

MAGELLAN HEALTH SERVICES INC
10-Q, 2000-05-11
HOSPITALS

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

/x/	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended March 31, 2000
or

/ /	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)

Delaware		58-1076937
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
6950 Columbia Gateway Drive Columbia, Maryland		21046
(Address of principal executive offices)		(Zip Code)

(410) 953-1000
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /x/ No / /

The number of shares of the registrant's common stock outstanding as of April 30, 2000 was 32,165,203.

FORM 10-Q
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
INDEX

		Page No.
PART I—Financial Information:
Condensed Consolidated Balance Sheets— September 30, 1999 and March 31, 2000		1
Condensed Consolidated Statements of Operations— For the Three Months and the Six Months ended March 31, 1999 and 2000		2
Condensed Consolidated Statements of Cash Flows— For the Six Months ended March 31, 1999 and 2000		3
Notes to Condensed Consolidated Financial Statements		4
Management's Discussion and Analysis of Financial Condition and Results of Operations
PART II—Other Information:
Item 6.—Exhibits and Reports on Form 8-K		31
Signatures		32

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)
(In thousands, except per share amounts)

	September 30, 1999			March 31, 2000
ASSETS
Current assets:
Cash and cash equivalents	$	37,440		$	36,357
Accounts receivable, net		198,646			168,254
Restricted cash and investments		116,824			109,457
Refundable income taxes		3,452			4,982
Other current assets		18,565			18,862

Total current assets		374,927			337,912
Property and equipment, net of accumulated depreciation of $66,692 at September 30, 1999 and $77,516 at March 31, 2000		120,667			117,222
Deferred income taxes		91,657			112,087
Investments in unconsolidated subsidiaries		18,396			18,578
Other long-term assets		9,599			9,579
Goodwill, net		1,108,086			1,060,003
Other intangible assets, net		158,283			149,851

	$	1,881,615		$	1,805,232

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable	$	44,425		$	35,844
Accrued liabilities		209,796			153,711
Medical claims payable		189,928			227,429
Current maturities of long-term debt and capital lease obligations		30,119			31,544

Total current liabilities		474,268			448,528
Long-term debt and capital lease obligations		1,114,189			1,107,394
Deferred credits and other long-term liabilities		92,948			36,746
Minority interest		3,514			3,763
Commitments and contingencies
Redeemable preferred stock		—			55,321
Stockholders' equity:
Preferred stock, without par value
Authorized—10,000 shares at September 30, 1999 and 9,793 shares at March 31, 2000
Issued and outstanding—none		—			—
Common stock, par value $0.25 per share
Authorized—80,000 shares
Issued and outstanding—34,268 shares and 34,455 shares at September 30, 1999 and March 31, 2000, respectively		8,566			8,613
Other stockholders' equity
Additional paid-in capital		352,030			351,662
Accumulated deficit		(144,550	)		(187,420	)
Warrants outstanding		25,050			25,050
Common stock in treasury, 2,289 shares at September 30, 1999 and March 31, 2000		(44,309	)		(44,309	)
Cumulative foreign currency adjustments included in comprehensive income		(91	)		(116	)

Total stockholders' equity		196,696			153,480

	$	1,881,615		$	1,805,232

The accompanying notes to Condensed Consolidated Financial Statements
are an integral part of these balance sheets.

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)
(In thousands, except per share amounts)

	For the Three Months Ended March 31,						For the Six Months Ended March 31,
	1999			2000			1999			2000
Net Revenue	$	479,703		$	502,156		$	923,034		$	983,981

Cost and expenses:
Salaries, cost of care and other operating expenses		429,602			473,604			821,915			907,875
Equity in earnings of unconsolidated subsidiaries		(6,262	)		(2,908	)		(10,045	)		(6,382	)
Depreciation and amortization		18,129			19,779			35,642			39,143
Interest, net		24,229			24,254			48,351			48,245
Managed care integration costs		2,119			—			3,869			—
Special charges		2,258			58,173			3,354			58,173

		470,075			572,902			903,086			1,047,054

Income (loss) from continuing operations before provision for (benefit from) income taxes and minority interest		9,628			(70,746	)		19,948			(63,073	)
Provision for (benefit from) income taxes		5,658			(25,099	)		11,573			(20,234	)

Income (loss) from continuing operations before minority interest		3,970			(45,647	)		8,375			(42,839	)
Minority interest		(34	)		(111	)		376			31

Income (loss) from continuing operations		4,004			(45,536	)		7,999			(42,870	)
Income (loss) from discontinued operations (net of income tax provision (benefit) of $(31) and $93)		(47	)		—			139			—

Net income (loss)		3,957			(45,536	)		8,138			(42,870	)
Preferred dividend requirement and amortization of redeemable preferred stock issuance costs		—			1,088			—			1,289

Income (loss) available to common stockholders		3,957			(46,624	)		8,138			(44,159	)
Unrealized foreign currency translation gain (loss)		(706	)		12			(1,797	)		(42	)
Provision for (benefit from) income taxes related to unrealized foreign currency translation gain (loss)		(283	)		5			(719	)		(17	)

		(423	)		7			(1,078	)		(25	)

Comprehensive income (loss)	$	3,534			(46,617	)	$	7,060			(44,184	)

Average number of common shares outstanding—basic		31,741			32,058			31,676			32,019

Average number of common shares outstanding—diluted		31,751			32,058			31,697			32,019

Income (loss) per common share—basic:
Income (loss) from continuing operations	$	0.13		$	(1.45	)	$	0.25		$	(1.38	)

Income (loss) from discontinued operations	$	—		$	—		$	—		$	—

Net income (loss)	$	0.12		$	(1.45	)	$	0.26		$	(1.38	)

Income per common share—diluted:
Income (loss) from continuing operations	$	0.13		$	(1.45	)	$	0.25		$	(1.38	)

Income (loss) from discontinued operations	$	—		$	—		$	—		$	—

Net income (loss)	$	0.12		$	(1.45	)	$	0.26		$	(1.38	)

The accompanying notes to Condensed Consolidated Financial Statements
are an integral part of these statements

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

	For the Six Months Ended March 31,
	1999			2000
Cash flows from operating activities:
Net income (loss)	$	8,138		$	(42,870	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		35,642			39,143
Impairment of long-lived assets		—			58,783
Equity in earnings of unconsolidated subsidiaries		(10,045	)		(6,382	)
Non-cash interest expense		1,885			2,194
Loss (gain) on sale of assets		289			(610	)
Non-cash portion of discontinued operations income		(652	)		—
Cash flows from changes in assets and liabilities, net of effects from sales and acquisitions of businesses:
Accounts receivable, net		(4,056	)		20,603
Other assets		6,785			(4,455	)
Restricted cash and investments		(26,910	)		7,367
Accounts payable and other accrued liabilities		8,780			(53,740	)
Medical claims payable		3,685			27,821
Reserve for unpaid claims		(4,653	)		(78	)
Income taxes payable and deferred income taxes		12,595			(21,943	)
Other liabilities		5			(292	)
Minority interest, net of dividends paid		1,145			239
Other		(1,202	)		(42	)

Total adjustments		23,293			68,608

Net cash provided by operating activities		31,431			25,738

Cash flows from investing activities:
Capital expenditures		(26,131	)		(15,303	)
Acquisitions and investments in businesses, net of cash acquired and return of escrowed funds		(55,596	)		(63,464	)
Conversion of joint ventures from consolidation to equity method		(21,092	)		—
Distributions received from unconsolidated subsidiaries		15,150			6,200
Decrease in assets restricted for settlement of unpaid claims		8,844			469
Proceeds from sale of assets, net of transaction costs		6,897			(777	)

Net cash used in investing activities		(71,928	)		(72,875	)

Cash flows from financing activities:
Proceeds from issuance of debt, net of issuance costs		49,624			59,643
Payments on debt and capital lease obligations		(47,498	)		(69,370	)
Proceeds from issuance of redeemable preferred stock, net of issuance costs		—			54,813
Proceeds from exercise of stock options and warrants		1,145			968

Net cash provided by financing activities		3,271			46,054

Net decrease in cash and cash equivalents		(37,226	)		(1,083	)
Cash and cash equivalents at beginning of period		92,050			37,440

Cash and cash equivalents at end of period	$	54,824		$	36,357

The accompanying notes to Condensed Consolidated Financial Statements
are an integral part of these statements.

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2000
(Unaudited)

NOTE A—Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments considered necessary for a fair presentation, have been included.

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.

On September 2, 1999, the Company's Board of Directors approved a formal plan to dispose of the businesses and interests that comprised the Company's healthcare provider and healthcare franchising business segments. Accordingly, the results of operations of such business segments have been reported in the condensed consolidated financial statements of which these notes are a component as discontinued operations for all periods presented. Additionally, the Company recorded a $58.2 million impairment charge related to goodwill and other long-lived assets related to its specialty managed healthcare segment during the quarter and the six months ended March 31, 2000. See Note K—"Impairment of Long-Lived Assets."

All references to fiscal years contained herein refer to periods of twelve consecutive months ending on September 30. Certain reclassifications have been made to fiscal 1999 amounts to conform to fiscal 2000 presentation.

These financial statements should be read in conjunction with the audited consolidated financial statements of Magellan Health Services, Inc. and Subsidiaries ("Magellan" or the "Company") for the fiscal year ended September 30, 1999, included in the Company's Annual Report on Form 10-K/A.

NOTE B—Supplemental Cash Flow Information

Below is supplemental cash flow information related to the six months ended March 31, 1999 and 2000 (in thousands):

	Six Months Ended March 31,
	1999			2000
Income taxes paid, net of refunds received	$	(2,043	)	$	1,689

Interest paid	$	53,226		$	49,528

NOTE C—Long-Term Debt and Leases

Information with regard to the Company's long-term debt and capital lease obligations at September 30, 1999 and March 31, 2000 is as follows (in thousands):

	September 30, 1999		March 31, 2000
Credit Agreement:
Revolving Facility due through 2004 (8.0% at March 31, 2000)	$	20,000	$	55,000
Term Loan Facility (8.188% to 8.938% at March 31, 2000) due through 2006		492,873		452,503
9.0% Senior Subordinated Notes due 2008		625,000		625,000
11.5% notes payable through 2005		35		35
3.75% capital lease obligations due through 2014		6,400		6,400

		1,144,308		1,138,938
Less amounts due within one year		30,119		31,544

	$	1,114,189	$	1,107,394

NOTE D—Accrued Liabilities

Accrued liabilities consist of the following (in thousands):

	September 30, 1999		March 31, 2000
Salaries, wages and other benefits	$	22,318	$	13,210
CHAMPUS Adjustments		51,784		19,389
Due to providers		35,918		10,515
Other		99,776		110,597

	$	209,796	$	153,711

NOTE E—Income per Common Share

The following tables reconcile income (loss) (numerator) and shares (denominator) used in the Company's computations of income (loss) from continuing operations per common share (in thousands):

	Three Months Ended March 31,					Six Months Ended March 31,
	1999		2000			1999		2000
Numerator:
Income (loss) from continuing operations	$	4,004	$	(45,536	)	$	7,999	$	(42,870	)
Less: preferred dividend requirement and amortization of redeemable preferred stock issuance costs		—		(1,088	)		—		(1,289	)

Income (loss) from continuing operations—basic		4,004		(46,624	)		7,999		(44,159	)
Add: presumed conversion of redeemable preferred stock(1)		—		—			—		—

Income (loss) from continuing operations—diluted	$	4,004	$	(46,624	)	$	7,999	$	(44,159	)

Denominator:
Average number of common shares outstanding—basic		31,741		32,058			31,676		32,019
Common stock equivalents—stock options		4		—			14		—
Common stock equivalents—warrants		6		—			7		—
Common stock equivalents—redeemable preferred stock		—		—			—		—

Average number of common shares outstanding—diluted		31,751		32,058			31,697		32,019

Income (loss) from continuing operations per common share:
Basic (basic numerator/basic denominator)	$	0.13	$	(1.45	)	$	0.25	$	(1.38	)

Diluted (diluted numerator/diluted denominator)	$	0.13	$	(1.45	)	$	0.25	$	(1.38	)

(1): Conversion of redeemable preferred stock not presumed for the three months and the six months ended March 31, 2000, due to the anti-dilutive effect of such presumed conversion.

The following potentially dilutive equity instruments were anti-dilutive as a result of the Company's loss from continuing operations for the three months and the six months ended March 31, 2000, and were excluded from the Company's computation of average number of common shares outstanding—diluted for such periods. Their inclusion would have resulted in an increase to average number of common shares

outstanding—diluted of approximately 6,530,000 and 3,924,000 for the three months and the six months ended March 31, 2000, respectively.

	Maximum number of shares issuable During the six months Ended March 31, 2000	Amount Outstanding At March 31, 2000	Range of Exercise Prices	Fiscal Years of Expiration
Stock options	1,949,591	1,938,241	$4.19-$6.16	2004-2010
Warrants	18,920	18,920	$5.24	2002
Redeemable preferred stock	6,300,000	6,300,000	N/A	2010

	8,268,511	8,257,161

The following potentially dilutive equity instruments were anti-dilutive due to the fact that their exercise prices were greater than the average market price of the Company's common stock during the three months and the six months ended March 31, 2000, and were excluded from the Company's computation of average number of shares outstanding—diluted for such periods.

	Maximum number of shares issuable During the six months Ended March 31, 2000	Amount Outstanding At March 31, 2000	Range of Exercise Prices	Fiscal Years of Expiration
Stock options	3,568,929	2,529,091	$6.72-$24.38	2004-2010
Warrants	4,713,413	2,713,413	$26.15-$38.70	2001-2009
TPG Series A Option	2,240,000	2,240,000	$9.375	2002

	10,522,342	7,482,504

Totals for all anti-dilutive equity instruments outstanding during the period were as follows:

	Maximum number of shares issuable During the six months Ended March 31, 2000	Amount Outstanding At March 31, 2000	Range of Exercise Prices	Fiscal Years of Expiration
Stock options	5,518,520	4,467,332	$4.19-$24.38	2004-2010
Warrants	4,732,333	2,732,333	$5.24-$38.70	2001-2009
Redeemable preferred stock	6,300,000	6,300,000	N/A	2010
TPG Series A Option	2,240,000	2,240,000	$9.375	2002

	18,790,853	15,739,665

On November 17, 1998, the Company's Board of Directors (the "Board") approved the repricing of stock options outstanding under the Company's existing stock option plans and held by current directors and full-time employees (the "Stock Option Repricing"). Each holder of 10,000 or more stock options who chose to participate in the Stock Option Repricing was required to forfeit a percentage of outstanding stock options depending upon such factors as level of employment and number of options held.

In order to participate in the Stock Option Repricing: (i) members of the Board, including the Chief Executive Officer ("CEO"), were required to forfeit 40% of their outstanding options; (ii) Named Executive Officers (as defined by Securities and Exchange Commission Regulations) other than the CEO were required to forfeit 30% of their outstanding options; (iii) all other holders of 50,000 or more options were required to forfeit 25% of their outstanding options; and (iv) all other holders of 10,000 to 49,999 options were required to forfeit 15% of their outstanding options.

The Stock Option Repricing was consummated on December 8, 1998, based on the fair market value of the Company's common stock on such date. Approximately 2.0 million outstanding stock options were repriced to $8.406 and approximately 0.7 million outstanding stock options were canceled as a result of the Stock Option Repricing. Each participant in the Stock Option Repricing was precluded from exercising repriced stock options until June 8, 1999.

NOTE F—Acquisitions of Businesses and Investments in Unconsolidated Subsidiaries

Vivra acquisition. As of February 29, 2000, the Company consummated the purchase of the outstanding stock of Vivra, Inc. ("Vivra"), a specialty managed healthcare company. The Company paid $5.0 million to the former owners of Vivra at closing and will make an additional payment of $5.25 million in September 2000, for a total initial purchase price of $10.25 million, excluding transaction costs. The Company may also be required to pay the former owners of Vivra up to $10.0 million of additional consideration which is contingent upon the Company's specialty managed healthcare business segment's achieving certain operating targets.

The Company accounted for the Vivra acquisition using the purchase method of accounting, and, accordingly, Vivra's results of operations subsequent to the purchase date are included in the results of operations of the Company and of its specialty managed healthcare business segment. The deferred purchase price amount of $5.25 million is included in "Deferred credits and other long-term liabilities" in the Company's condensed consolidated balance sheet at March 31, 2000. The Company initially recorded approximately $1.2 million of identifiable intangible assets and approximately $9.1 million of goodwill associated with the Vivra acquisition and will amortize the identifiable intangible assets using the straight-line method over a weighted-average estimated useful life of ten years. The Company believes the life of the goodwill associated with Vivra to be indeterminate and, therefore, will amortize this goodwill using the straight-line method over a period of forty years. Any contingent payments which may be made with respect to Vivra would be recorded as an addition to goodwill and amortized using the straight-line method over the remaining portion of the original forty year life.

Approximately 30% of the voting interest in Vivra was owned by the investment firm Texas Pacific Group ("TPG") at the time of the Company's acquisition. Three of the Company's twelve board members are affiliated with TPG; however, these three Board members did not participate in the Board's approval of the Vivra acquisition. TPG is the holder of 59,063 shares of the Company's redeemable preferred stock, representing approximately 16% of the outstanding voting securities of Company at March 31, 2000. See Note L—"Redeemable Preferred Stock."

2000 Human Services acquisitions. During the six months ended March 31, 2000, the Company acquired five businesses, in aggregate, in its human services segment for an initial aggregate purchase price

of approximately $5.0 million (collectively, the "2000 Human Services Acquisitions"), excluding transaction costs. The 2000 Human Services Acquisitions were accounted for using the purchase method of accounting. The 2000 Human Services Acquisitions provide various residential day services for individuals with acquired brain injuries and for individuals with mental retardation and developmental disabilities.

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2000
(Unaudited)

NOTE F—Acquisitions of Businesses and Investments in Unconsolidated Subsidiaries (Continued)

Choice Behavioral Health Partnership. The Company is a 50% partner with Value Options, Inc. in Choice Behavioral Health Partnership ("Choice"), a general partnership. Choice is a managed behavioral healthcare company which 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.

A summary of financial information for the Company's investment in Choice is as follows (in thousands):

	September 30, 1999		March 31, 2000
Current assets	$	19,572	$	21,314
Property and equipment, net		228		184

Total assets	$	19,800	$	21,498

Current liabilities	$	12,673	$	14,337
Partners' capital		7,127		7,161

Total liabilities and partners' capital	$	19,800	$	21,498

Company investment	$	3,563	$	3,581

	Three Months Ended March 31,				Six Months Ended March 31,
	1999		2000		1999		2000
Net revenue	$	13,166	$	14,027	$	27,746	$	28,074
Operating expenses		4,241		8,219		12,589		15,641

Net income	$	8,925	$	5,808	$	15,157	$	12,433

Company equity income	$	4,463	$	2,904	$	7,579	$	6,217

Premier Behavioral Systems, LLC. The Company owns a 50% interest in Premier Behavioral Systems, LLC ("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, 1999 and March 31, 2000 was $12.2 million and $12.0 million, respectively. The Company's equity in earnings (losses) of Premier for the three months ended March 31, 1999 and 2000 was $1.9 million and $(0.1) million, respectively, and for the six months ended March 31, 1999 and 2000 was $2.6 million and $(0.2) million, respectively.

NOTE G—Discontinued Operations

General

On September 10, 1999, the Company consummated the transfer of assets and other interests pursuant to a Letter Agreement dated August 10, 1999 with Crescent Real Estate Equities ("Crescent"), Crescent Operating, Inc. ("COI") and Charter Behavioral Health Systems, LLC ("CBHS") that effected

the Company's exit from its healthcare provider and healthcare franchising businesses (the "CBHS Transactions"). Significant terms of the CBHS Transactions are summarized as follows:

Healthcare Provider Interests

•: The Company disposed of the majority of its interests in CBHS and was left with only a 10% non-voting common interest in CBHS at September 30, 1999 and March 31, 2000. The Company's interest in CBHS was valued at $0 as of September 30, 1999 and March 31, 2000.
•: The Company agreed to transfer to CBHS its interests in five of its six hospital-based joint ventures and certain other provider real estate and interests as soon as practicable. These joint ventures had previously been managed by CBHS for a fee equivalent to the Company's portion of their earnings.
•: The Company transferred to CBHS the right to receive approximately $7.1 million from Crescent for the sale of two psychiatric hospitals that were acquired by the Company (and leased to CBHS) in connection with CBHS' acquisition of certain businesses from Ramsay Healthcare, Inc. in fiscal 1998.
•: The Company forgave receivables due from CBHS of approximately $3.3 million for payments received by CBHS for patient services prior to the formation of CBHS on June 17, 1997. The receivables related primarily to patient stays that "straddled" the formation date of CBHS.
•: The Company will pay $2.0 million to CBHS in 12 equal monthly installments beginning on the first anniversary of the closing date.
•: CBHS will indemnify the Company for 20% of up to the first $50 million ($10 million in total) for expenses, liabilities and settlements related to government investigations for events that occurred prior to June 17, 1997 (the "CBHS Indemnification"). CBHS will be required to pay the Company a maximum of $500,000 per year under the CBHS Indemnification.
•: Crescent, COI, CBHS and Magellan have provided each other with mutual releases of claims among all of the parties with respect to the original transactions that effected the formation of CBHS and the operation of CBHS since June 17, 1997 with certain specified exceptions.

Healthcare Franchising Interests

•: The Company transferred all of its healthcare franchising interests to CBHS and was released from performing any further franchise services or incurring future franchising expenses.
•: The Company forgave unpaid franchise fees of approximately $115 million.

The CBHS Transactions, together with the formal plan of disposal authorized by the Company's Board of Directors on September 2, 1999, represent the disposal of the Company's healthcare provider and healthcare franchising business segments under Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB 30"). APB 30 requires that the results of continuing operations be reported separately from those of discontinued operations for all periods presented and that any gain or loss from disposal of a segment of a business be reported in

conjunction with the related results of discontinued operations. Accordingly, the Company has restated its results of operations for all prior periods. The Company recorded an after-tax loss on disposal of its healthcare provider and healthcare franchising business segments of approximately $47.4 million, (primarily non-cash) in the fourth quarter of fiscal 1999. The Company expects to transfer the Provider JVs and related real estate to CBHS and to sell its remaining joint venture interest and related real estate by no later than August 31, 2000.

Substantially all of the Company's healthcare provider and healthcare franchising operations were either sold or assigned to CBHS during September 1999 and no income or expense related to these operations was recorded for the three months or the six months ended March 31, 2000. Accordingly, the following summary of discontinued operations income is for the three months and the six months ended March 31, 1999 only (in thousands):

	Three Months Ended March 31, 1999			Six Months Ended March 31, 1999
Net revenue (1)	$	17,612		$	37,424

Salaries, cost of care and other operating expenses		18,041			38,944
Equity in earnings of unconsolidated subsidiaries		(1,165	)		(2,364	)
Depreciation and amortization		834			1,712
Interest income (2)		(20	)		(33	)
Other income, net		—			(1,062	)
Other expenses (3)		(31	)		88

Net income (loss)	$	(47	)	$	139

(1): Amounts for the six months ended March 31, 1999, include $1.3 million related to the settlement and adjustment of reimbursement issues related to prior periods ("Cost Report Settlements").
(2): Interest expense has not been allocated to discontinued operations.
(3): Includes income taxes and minority interest.

Remaining assets and liabilities of the healthcare provider business at March 31, 2000 include, among other things, (i) hospital-based real estate of $6.5 million, (ii) long-term debt of $6.4 million related to the hospital-based real estate and (iii) liabilities resulting from the CBHS Transactions of approximately $8.2 million. The Company is also subject to inquiries and investigations from governmental agencies related to its operating and business practices prior to consummation of the Crescent Transactions (as defined) on June 17, 1997. See Note H—"Contingencies."

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2000
(Unaudited)

NOTE G—Discontinued Operations (Continued)

The following table provides a rollforward of liabilities resulting from the CBHS Transactions (in thousands):

Type of Cost	Balance September 30, 1999		Additions		(Receipts) Payments			Balance March 31, 2000
Transaction costs and legal fees	$	7,553	$	—	$	3,345		$	4,208
Provider JV working capital		3,116		—		—			3,116
Other		755		—		(150	)		905

	$	11,424	$	—	$	3,195		$	8,229

On February 16, 2000, CBHS filed a voluntary petition for relief of indebtedness under Chapter 11 of the United States Bankruptcy Code. The Company has no material receivables from CBHS apart from any amount which may be owed in the future for indemnification claims under the previously described provisions of the CBHS Transactions. The Company does not believe that CBHS' bankruptcy will have a material impact on its financial position, results of operations or cash flows.

NOTE H—Contingencies

The management and administration of the delivery of behavorial managed healthcare services is subject to laws and regulations and entails significant risk of liability. Such laws and regulations relate to matters including, without limitation, licensure; Medicaid fraud and abuse and administration of employee health benefit plans. 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, including malpractice professional negligence and other related actions and claims.

Until July 2, 1999, the Company was self-insured for a portion of its general and professional liability risks. The reserves for self-insured general and professional liability losses, including loss adjustment expenses, were included in reserve for unpaid claims in the Company's balance sheet and were based on actuarial estimates that were discounted at an average rate of 6% to their present value based on the Company's historical claims experience adjusted for current industry trends. These reserves related primarily to the professional liability risks of the Company's healthcare provider segment prior to June 1997. On July 2, 1999, the Company transferred its remaining medical malpractice claims portfolio (the "Loss Portfolio Transfer") to a third-party insurer for approximately $22.3 million. The Loss Portfolio Transfer was funded from assets restricted for settlement of unpaid claims. The insurance limit obtained through the Loss Portfolio Transfer for future medical malpractice claims is $26.3 million, and the Company believes that all claims will be settled within this limit.

Providers of healthcare services are subject to numerous laws and regulations. While it disposed of its healthcare provider segment in June 1997, the Company remains subject to these laws and regulations for operations of that business prior to June 1997 as well as with respect to certain outpatient clinics the Company continues to operate and the operations of its human services business segment. 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 subjected to fines or penalties, required to repay amounts received from the government for previously billed patient services and/or excluded from participating in government healthcare programs. The Office of the Inspector General of the Department of Health and Human Services and the United States Department of Justice ("Department of Justice") and certain other governmental agencies are currently conducting inquiries and/or investigations regarding the operations and business practices of the Company's psychiatric provider operations prior to the disposition of such operations in June 1997. The Department of Justice has indicated that its inquiries are based on its belief that the Federal government has certain civil and administrative causes of action under the Civil False Claims Act, the Civil Monetary Penalties Law, other federal statutes and the common law arising from the participation in federal health benefit programs by these psychiatric facilities nationwide. The Department of Justice inquiries could relate to the following matters: (i) Medicare cost reports, (ii) Medicaid cost statements, (iii) supplemental applications to CHAMPUS/TriCare based on Medicare cost reports, (iv) medical necessity of services to patients and admissions, (v) failure to provide medically necessary treatment or admissions and (vi) submission of claims to government payors for inpatient and outpatient psychiatric services. No claims have been asserted, and the Company cannot reasonably estimate the liability, if any, associated with the Department of Justice inquiries. Accordingly, no reserve has been recorded related to this matter.

On May 26, 1998, a group of eleven plaintiffs purporting to represent an uncertified class of psychiatrists, psychologists and social workers brought an action (the "Holstein Case") under the federal antitrust laws in the United States District Court for the District of New Jersey against nine behavioral health managed care organizations, including Merit, CMG, Green Spring and HAI (collectively, the "Defendants"). The complaint alleges that the Defendants violated Section 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. Upon joint motion by the Defendants, the case was transferred to the United States District Court for the Southern District of New York, the same court where a previous similar case (the "Stephens Case") was dismissed for failure to state a claim upon which relief can be granted. On June 16, 1999, the court denied a joint motion filed by Defendants to dismiss the case for substantially the same reasons as in the Stephens Case. On October 14, 1999, the Plaintiffs filed a motion seeking class certification for a class of approximately 200,000 providers. Before the court heard argument on that motion, the parties reached an agreement on the terms of a resolution of the litigation, and that potential resolution is pending before the court. The Company does not believe this matter will have a material adverse effect on its financial position, results of operations or cash flows.

The Company is also subject to or party to other litigation, claims, and civil suits, relating to its operations and business practices. Certain of the Company's managed care litigation matters involve class action lawsuits, including the Holstein Case, in which the Company has been named as a defendant. Besides the Holstein Case, the Company has been named in a class action lawsuit alleging that a provider affiliated with the Company violated the privacy rights of certain patients and in other class action lawsuits which allege that the Company inappropriately denied and/or failed to authorize benefits for mental health treatment under benefit plans administered by the Company. In the opinion of management, the Company has recorded reserves which are adequate to cover litigation, claims or assessments that have been or may be asserted against the Company, and for which the outcome is probable and reasonably estimable, arising out of such other litigation, claims and civil suits. Furthermore, management believes that the resolution of such litigation, claims and civil suits will not have a material adverse effect on the Company's financial position, results of operations or cash flows; however, there can be no assurance in this regard.

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 $51.8 million and $19.4 million as of September 30, 1999 and March 31, 2000, respectively for CHAMPUS Adjustments. During the quarter ended December 31, 1999, the Company reached a settlement agreement with a contractor under one of its CHAMPUS contracts whereby the Company paid approximately $38.1 million to the contractor during such quarter. The Company and the contractor under this CHAMPUS contract are in the process of appealing the Department of Defense's retroactive adjustment. 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.

NOTE I—Managed Care Integration Plan and Costs

Integration Plan

The Company integrated 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 integrated two specialty managed care organizations, Allied and Care Management Resources, Inc. ("CMR"). During fiscal 1998, management committed the Company to a plan to combine and integrate the operations of its BMCOs and specialty managed care organizations (the "Integration Plan") that resulted in the elimination of duplicative functions and standardized business practices and information technology platforms. The Integration Plan was completed on September 30, 1999.

The Integration Plan resulted in the elimination of approximately 1,000 positions during fiscal 1998 and fiscal 1999. Approximately 510 employees were involuntarily terminated pursuant to the Integration Plan.

The employee groups of the BMCOs that were 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 Integration Plan resulted in the closure of approximately 20 leased facilities at the BMCOs, Allied and CMR during fiscal 1998 and 1999.

The Company recorded approximately $21.0 million of liabilities related to the Integration Plan, of which $11.6 million was recorded as part of the Merit purchase price allocation and $9.4 million ($8.9 million in fiscal 1998 and $0.5 million in fiscal 1999) was recorded in the statement of operations under "Managed care integration costs."

The following table provides a rollforward of liabilities resulting from the Integration Plan (in thousands):

Type of Cost	Balance September 30, 1999		Adjustments			Payments		Balance March 31, 2000
Employee termination benefits	$	769	$	150		$	677	$	242
Facility closing costs		3,094		(150	)		834		2,110

	$	3,863	$	—		$	1,511	$	2,352

Other Integration Costs

The Integration Plan resulted in additional incremental costs that were expensed as incurred in accordance with Emerging Issues Task Force Consensus 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)" that are not described above and certain other charges. Other integration costs include, but are not limited to, outside consultants, costs to relocate closed office contents and long-lived asset impairments. Other integration costs are reflected in the statement of operations under "Managed care integration costs".

During the quarter and the six months ended March 31, 1999, the Company incurred approximately $1.0 million and $2.8 million in other integration costs, respectively, including outside consulting costs of approximately $0.7 million and $1.5 million and employee and office relocation costs of approximately $0.1 million and $0.5 million, respectively.

The Company discontinued its practice of classifying other integration costs separately in its consolidated statements of operations for fiscal periods ending after September 30, 1999, on which date the Integration Plan was completed. The Company will continue to incur costs for activities which are similar in nature to those which would have been reported as integration costs prior to the completion of the Integration Plan. The Company does not expect such costs to materially impact its financial position, results of operations or cash flows.

NOTE J—Business Segment Information

The Company operates through three reportable segments which are engaged in various aspects of the healthcare industry. The Company evaluates performance of its segments based on profit or loss from

continuing operations before depreciation and amortization; interest, net; managed care integration costs; special charges, income taxes and minority interest ("Segment Profit"). Intersegment sales and transfers are not significant.

The following tables summarize, for the periods indicated, net revenue and Segment Profit by continuing business segment (in thousands):

	Behavioral Managed Healthcare		Human Services		Specialty Managed Healthcare			Corporate Overhead and other			Consolidated
Three Months ended March 31, 1999
Net revenue	$	382,360	$	46,982	$	50,361		$	—		$	479,703

Segment Profit	$	53,516	$	5,527	$	967		$	(3,647	)	$	56,363

Three Months ended March 31, 2000
Net revenue	$	411,801	$	54,399	$	35,956		$	—		$	502,156

Segment Profit(1)	$	52,939	$	6,124	$	(24,037	)	$	(3,566	)	$	31,460

Six Months ended March 31, 1999
Net revenue	$	738,911	$	92,721	$	91,402		$	—		$	923,034

Segment Profit	$	106,136	$	10,814	$	1,383		$	(7,169	)	$	111,164

Six Months ended March 31, 2000
Net revenue	$	797,506	$	105,663	$	80,812		$	—		$	983,981

Segment Profit(1)	$	107,860	$	11,362	$	(29,728	)	$	(7,006	)	$	82,488

Total assets, September 30, 1999	$	1,472,539	$	127,348	$	88,535		$	193,193		$	1,881,615

Total assets, March 31, 2000	$	1,442,925	$	134,931	$	42,924		$	184,452		$	1,805,232

(1): The Company also recorded a $58.2 million impairment of long-lived assets during the quarter and the six months ended March 31, 2000, related to its specialty managed healthcare segment (see Note K—"Impairment of Long-Lived Assets").

The following tables reconcile Segment Profit to consolidated income from continuing operations before provision for income taxes and minority interest (in thousands):

	Three Months Ended March 31,						Six Months Ended March 31,
	1999			2000			1999			2000
Segment Profit	$	56,363		$	31,460		$	111,164		$	82,488
Depreciation and amortization		(18,129	)		(19,779	)		(35,642	)		(39,143	)
Interest, net		(24,229	)		(24,254	)		(48,351	)		(48,245	)
Managed care integration costs		(2,119	)		—			(3,869	)		—
Special charges		(2,258	)		(58,173	)		(3,354	)		(58,173	)

Income (loss) from continuing operations before provision for income taxes and minority interest	$	9,628		$	(70,746	)	$	19,948		$	(63,073	)

NOTE K—Impairment of Long-Lived Assets

The Company recorded a charge of approximately $58.2 million during the quarter and the six months ended March 31, 2000, related to the impairment of certain long-lived assets in accordance with Statement of Financial Accounting Standards No. 121 "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("FAS 121"). This amount is included in "Special charges" in the Company's condensed consolidated statements of operations for such periods and is related to the goodwill, property and equipment and identifiable intangible assets (collectively, the "Allied Assets") of Allied Specialty Care Services, Inc. ("Allied"), which, prior to the Vivra acquisition, was the principal component of the Company's specialty managed healthcare business segment.

During the quarter ended March 31, 2000, Allied recorded significant losses associated primarily with the termination or restructuring of various customer contracts. These events and the resulting expectation of lower future earnings and cash flows from Allied represent a change in circumstances with respect to the business of Allied. The Company estimates that the future undiscounted cash flows expected to be generated by Allied are insufficient to fully recover the recorded cost of the Allied Assets.

Accordingly, the Company adjusted the Allied Assets to their estimated fair value as of March 31, 2000. Based upon the circumstances described above, the Company estimates that the fair value of the Allied Assets was approximately $6.3 million at March 31, 2000. This value reflects the Company's estimate of the recoverable fair value of Allied's property and equipment through sale or continued use.

The Company will continually monitor events and changes in circumstances regarding the recoverability of the remaining value of the Allied Assets.

NOTE L—Redeemable Preferred Stock

On July 19, 1999, the Company entered into a definitive agreement to issue approximately $75.4 million of cumulative convertible preferred stock to TPG Magellan, LLC, an affiliate of TPG (the "TPG

Investment"). On December 15, 1999, the Company and TPG amended and restated the definitive agreement and consummated the TPG Investment.

Pursuant to the amended and restated definitive agreement, TPG purchased approximately $59.1 million of the Company's Series A Cumulative Convertible Preferred Stock (the "Series A Preferred Stock") and an Option (the "Option") to purchase approximately $21.0 million of additional Series A Preferred Stock. Net proceeds from issuance of Series A Preferred Stock were $54.0 million. Approximately 50% of such net proceeds were used to reduce debt outstanding under the Term Loan Facility, with the remaining 50% being used for general corporate purposes. The Series A Preferred Stock carries a dividend of 6.5% per annum, payable in quarterly installments in cash or common stock, subject to certain conditions. Dividends not paid in cash or common stock will accumulate. The Series A Preferred Stock is convertible at any time by the holder into approximately 6.3 million shares of the Company's common stock at a conversion price of $9.375 per share and carries "as converted" voting rights. The Company may, under certain circumstances, require the holders of the Series A Preferred Stock to convert such stock into common stock. The Series A Preferred Stock, plus accrued and unpaid dividends thereon, must be redeemed by the Company on December 15, 2009. The Option will expire unless exercised by August 19, 2002. TPG may exercise the Option in whole or in part. The Company may, under certain circumstances, require TPG to exercise the Option. The terms of the shares of Series A Preferred Stock issuable pursuant to the Option are identical to the terms of the shares of Series A Preferred Stock issued to TPG at the closing of the TPG Investment.

TPG has three representatives on the Company's twelve-member Board of Directors.

The TPG Investment is reflected under the caption "Redeemable preferred stock" in the Company's condensed consolidated balance sheet as follows (in thousands):

	March 31, 2000
Redeemable convertible preferred stock:
Series A - stated value $1, 87 shares authorized, 59 shares issued and outstanding	$	59,063
Series B - stated value $1, 60 shares authorized, none issued and outstanding		—
Series C - stated value $1, 60 shares authorized, none issued and outstanding		—

		59,063
Less: Unamortized fair value of Series A Option		(2,992	)

Total redeemable convertible preferred stock		56,071
Accumulated unpaid dividends on Series A Preferred Stock		1,140
Unamortized fair value of Series A Option		2,992
Issuance costs, net of amortization of $149		(4,882	)

	$	55,321

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
March 31, 2000

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

This quarterly report on Form 10-Q includes "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended. Although the Company believes that its plans, intentions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such plans, intentions or expectations will be achieved. Important factors that could cause actual results to differ materially from the Company's forward-looking statements are set forth in the Company's Annual Report on Form 10-K/A for the fiscal year ended September 30, 1999. All forward-looking statements attributable to the Company or persons acting on behalf of the Company are expressly qualified in their entirety by the cautionary statements set forth in the Company's Annual Report on Form 10-K/A for the fiscal year ended September 30, 1999.

Overview

The Company currently operates through three principal business segments which are engaged in:

•: The behavioral managed healthcare business. The Company's Magellan Behavioral Health division coordinates and manages the delivery of behavioral healthcare treatment services through its network of providers, which includes psychiatrists, psychologists and other medical professionals. The treatment services provided through these provider networks include outpatient programs (such as counseling or therapy), intermediate care programs (such as intensive outpatient programs and partial hospitalization services), inpatient treatment and alternative care services (such as residential treatment and home or community-based programs). The Company provides these services primarily through: (i) risk-based products, where the Company assumes all or a portion of the responsibility for the cost of providing treatment services in exchange for a fixed per member per month fee, (ii) administrative services only ("ASO") products, where the Company provides services such as utilization review, claims administration or provider network management, (iii) employee assistance programs ("EAP") and (iv) products which combine features of some or all of the Company's risk-based, ASO, or EAP products. At March 31, 2000, the Magellan Behavioral Health division managed the behavioral healthcare benefits of approximately 68.6 million individuals.
•: The human services business. The Company provides various human services through its National MENTOR, Inc. ("Mentor") subsidiary. These human services include specialty home-based healthcare services provided through "mentor" homes as well as residential and day treatment services for individuals with acquired brain injuries and for individuals with mental retardation and developmental disabilities. The Company acquired five businesses in its human services business segment for an aggregate purchase price of approximately $5.0 million during the quarter ended March 31, 2000. At March 31, 2000, Mentor provided community-based services to approximately 7,400 individuals.
•: The specialty managed healthcare business. The Company's Magellan Specialty Health division provides specialty risk-based and ASO services to a variety of health insurance companies and other customers. As of February 29, 2000, the Company acquired Vivra, Inc. for an initial purchase price of approximately $10.25 million. See Note F—"Acquisitions of Businesses and Investments in Unconsolidated Subsidiaries" to the Company's condensed consolidated financial statements set forth elsewhere herein.

On September 10, 1999, the Company consummated a series of related transactions which are more fully described as the CBHS Transactions in Note G—"Discontinued Operations" to the Company's condensed consolidated financial statements set forth elsewhere herein. The CBHS Transactions, together with the formal plan of disposal authorized by the Company's Board of Directors on September 2, 1999, represented the disposal of the Company's healthcare provider and healthcare franchising business segments under Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB 30"). APB 30 requires that the results of continuing operations be reported separately from those of discontinued operations for all periods presented and that any gain or loss from disposal of a segment of a business be reported in conjunction with the related results of discontinued operations. Accordingly, the Company has restated its results of operations for all periods prior to the fourth quarter of fiscal 1999. The Company recorded an after-tax loss on the disposal of its healthcare provider and healthcare franchising business segments of approximately $47.4 million (primarily non-cash) in the fourth quarter of fiscal 1999.

The CBHS Transactions represented the final step in the Company's transformation from being a provider of behavioral healthcare services to patients in primarily an inpatient setting to being primarily a manager of specialty healthcare services. The Company undertook the initial steps of this transformation with the belief that becoming a fully integrated manager/provider of specialty healthcare services would simultaneously position it to take advantage of opportunities in the growing managed care industry while enhancing its ability to effectively treat patients in its inpatient psychiatric hospitals. As the Company's managed care business grew; however, it became apparent that the opportunities available to the Company through consolidating the then-fractured managed specialty healthcare industry were superior to those available to a fully integrated manager/provider company; therefore, it decided to sell its provider interests and invest the proceeds in expansion of its managed specialty healthcare business.

A brief timeline of the significant steps in this transformation is as follows:

•: December 1995. The Company acquired a 61% ownership interest in Green Spring Health Services, Inc. ("Green Spring"). At this time, the Company was the largest operator of freestanding psychiatric hospitals in the United States and was not significantly engaged in the managed specialty healthcare business.
•: February 1997. The Company acquired an 85% interest in Care Management Resources, Inc. ("CMR"), signaling the Company's first significant involvement in a component of the managed healthcare industry not related to behavioral care.
•: June 1997. The Company sold substantially all of the real estate and other property used in its domestic psychiatric hospital business and contributed the operations of the hospitals to Charter Behavioral Health Systems, LLC ("CBHS"). The Company retained a 50% ownership interest in CBHS, which continued to operate the Company's former hospital-based provider business. The Company also retained certain intellectual property which it licensed to CBHS under a franchise agreement.
•: December 1997. The Company used the net proceeds from the sale of the psychiatric hospital real estate to finance the acquisitions of Human Affairs International, Incorporated ("HAI") and Allied Specialty Care Services, Inc. ("Allied").
•: January 1998. The former owners of Green Spring exchanged their collective 39% ownership interest in Green Spring to the Company for 2,831,516 shares of the Company's common stock.
•: February 1998. The Company acquired Merit Behavioral Care Corporation, Inc. ("Merit"), for approximately $750 million, which was provided primarily through issuance of long-term debt. The Company implemented the Integration Plan, which is more fully described in Note I—"Managed Care Integration Plan and Costs" to the Company's condensed consolidated financial statements

set forth elsewhere herein, and organized operations around a divisional structure. The Magellan Behavioral Health division was formed from Green Spring, HAI and Merit, and the Magellan Specialty Health division was formed from CMR and Allied.

•: April 1999. The Company sold its European psychiatric hospitals.
•: September 1999. The Company sold its healthcare franchising operations and 80% of its remaining interest in CBHS. The Company completed the Integration Plan.
•: February 2000. The Company acquired Vivra, Inc. under the Magellan Specialty Health division.

Results of Operations

The following tables summarize, for the periods indicated, operating results by continuing business segment (in thousands).

	Behavioral Managed Healthcare			Human Services		Specialty Managed Healthcare			Corporate Overhead and other			Consolidated
Three Months Ended March 31, 1999
Net revenue	$	382,360		$	46,982	$	50,361		$	—		$	479,703

Salaries, cost of care and other operating expenses		335,106			41,455		49,394			3,647			429,602
Equity in earnings of unconsolidated subsidiaries		(6,262	)		—		—			—			(6,262	)

		328,844			41,455		49,394			3,647			423,340

Segment Profit (1)	$	53,516		$	5,527	$	967		$	(3,647	)	$	56,363

Three Months Ended March 31, 2000
Net revenue	$	411,801		$	54,399	$	35,956		$	—		$	502,156

Salaries, cost of care and other operating expenses		361,770			48,275		59,993			3,566			473,604
Equity in earnings of unconsolidated subsidiaries		(2,908	)		—		—			—			(2,908	)

		358,862			48,275		59,993			3,566			470,696

Segment Profit (1)	$	52,939		$	6,124	$	(24,037	)	$	(3,566	)	$	31,460

Six Months Ended March 31, 1999
Net revenue	$	738,911		$	92,721	$	91,402		$	—		$	923,034

Salaries, cost of care and other operating expenses		642,820			81,907		90,019			7,169			821,915
Equity in earnings of unconsolidated subsidiaries		(10,045	)		—		—			—			(10,045	)

		632,775			81,907		90,019			7,169			811,870

Segment Profit(1)	$	106,136		$	10,814	$	1,383		$	(7,169	)	$	111,164

Six Months Ended March 31, 2000
Net revenue	$	797,506		$	105,663	$	80,812		$	—		$	983,981

Salaries, cost of care and other operating expenses		696,028			94,301		110,540			7,006			907,875
Equity in earnings of unconsolidated subsidiaries		(6,382	)		—		—			—			(6,382	)

		689,646			94,301		110,540			7,006			901,493

Segment Profit(1)	$	107,860		$	11,362	$	(29,728	)	$	(7,006	)	$	82,488

(1): Segment Profit is the measure of profitability used by management to assess the operating performance of each business segment. See Note J—"Business Segment Information" to the Company's condensed consolidated financial statements set forth elsewhere herein.

Quarter ended March 31, 2000 ("Current Year Quarter"), compared to the same period in fiscal 1999 ("Prior Year Quarter")

Behavioral Managed Healthcare. Revenue increased 7.7% or $29.4 million, to $411.8 million for the Current Year Quarter. Salaries, cost of care and other operating expenses increased 8.0% or $26.7 million, to $361.8 million for the Current Year Quarter. Equity in earnings of unconsolidated subsidiaries decreased approximately $3.4 million, or 54.0% to $2.9 million for the Current Year Quarter due primarily to fluctuations in the profitability of Choice and increased care cost at Premier. The increases in revenue and salaries, cost of care and other operating expenses resulted primarily from (i) increased enrollment related to existing health plan customers, (ii) expanded services and lives under management with certain public sector customers, and (iii) new business development. Total covered lives increased 7.3% to approximately 68.6 million at March 31, 2000 from 64.3 million at March 31, 1999.

Human Services. Revenue increased 15.8% or $7.4 million, to $54.4 million for the Current Year Quarter. Salaries, cost of care and other operating expenses increased 16.4% or $6.8 million, to $48.3 million for the Current Year Quarter. The increases in revenue and salaries, cost of care and other operating expenses resulted primarily from (i) growth in placements, (ii) acquisition of businesses, (iii) increased spending related to new business starts and (iv) to a lesser extent continued pricing pressures.

Specialty Managed Healthcare Revenue decreased 28.6% or $14.4 million, to $36.0 million for the Current Year Quarter, primarily related to changes in contractual relationships. Salaries, cost of care and other operating expenses increased 21.5% or $10.6 million, to $60.0 million for the Current Year Quarter. During the three months ended March 31, 2000, the segment recorded a Segment Profit loss of approximately $24.0 million. A significant portion of this loss relates to certain risk-based contracts that have been terminated as of March 31, 2000 and is comprised primarily of provisions for uncollectible receivables and estimated contractual expenses under such contracts. The Company also incurred segment administrative expenses which were not otherwise covered by contractual gross margins. Further, the Company recorded approximately $1.0 million of severance liabilities related to individuals severed during the quarter. The Company also recorded a $58.2 million impairment of long-lived assets in the quarter ended March 31, 2000 related to its specialty managed healthcare segment. See Note K—"Impairment of Long-lived Assets" to the Company's condensed consolidated financial statements set forth elsewhere herein.

Depreciation and Amortization. Depreciation and amortization increased 9.1%, or $1.7 million, to $19.8 million for the Current Year Quarter from $18.1 million in the Prior Year Quarter. The increase is primarily attibutable to amortization of contingent consideration paid to Aetna for the purchase of HAI and depreciation of capital expenditures made during fiscal 1999.

Interest, net. Interest expense, net was nearly identical for the quarters ended March 31, 2000 and 1999. This is primarily attributable to lower average outstanding debt during the Current Year Quarter, offset by increased interest rates and lower amounts of interest income due to lower average balances of cash and cash equivalents and restricted cash and investments.

Other Items. The Company recorded managed care integration costs of $2.1 million during the Prior Year Quarter and recorded no such cost during the Current Year Quarter due to the completion of the Integration Plan. For a more complete discussion of managed care integration costs, see Note I—"Managed Care Integation Plan and Costs" to the Company's condensed consolidated financial statements set forth elsewhere herein.

Special charges. The Company recorded special charges of $58.2 million in the Current Year Quarter related to the impairment of Allied's long-lived assets, compared to a $2.3 million special charge recorded in the Prior Year Quarter which was primarily related to the loss on sale of the Company's former corporate headquarters. For a more complete discussion of the special charge in the Current Year Quarter,

see Note K—"Impairment of Long-Lived Assets" to the Company's condensed consolidated financial statements set forth elsewhere herein.

The Company's effective income tax rate decreased to 35.5% for the Current Year Quarter, from 58.8% for Prior Year Quarter. The decrease is primarily attributable to the Company's loss from continuing operations in the Current Year Quarter relative to the amount of non-deductible goodwill amortization expense associated with the Merit acquisition.

Six Months ended March 31, 2000 ("Current Year To Date"), compared to the same period in fiscal 1999 ("Prior Year To Date")

Behavioral Managed Healthcare. Revenue increased 7.9% or $58.6 million, to $797.5 million for the Current Year To Date. Salaries, cost of care and other operating expenses increased 8.3% or $53.2 million, to $696.0 million for the Current Year To Date. Equity in earnings of unconsolidated subsidiaries decreased approximately $3.6 million, or 36% to $6.4 million for the Current Year To Date due primarily to fluctuations in the profitability of Choice and increased care cost at Premier. The increases in revenue and salaries, cost of care and other operating expenses resulted primarily from (i) increased enrollment related to existing health plan customers, (ii) expanded services and lives under management with certain public sector customers, and (iii) new business development.

Human Services. Revenue increased 14.0% or $13.0 million, to $105.7 million for the Current Year To Date. Salaries, cost of care and other operating expenses increased 15.1% or $12.4 million, to $94.3 million for the Current Year To Date. The increases in revenue and salaries, cost of care and other operating expenses resulted primarily from (i) growth in placements, (ii) acquisition of businesses, (iii) increased spending related to new business starts and (iv) to a lessor extent continued pricing pressures.

Specialty Managed Healthcare Revenue decreased 11.6% or $10.6 million, to $80.8 million for the Current Year To Date, primarily due to changes in contractual relationships. Salaries, cost of care and other operating expenses increased 22.8% or $20.5 million, to $110.5 million for the Current Year To Date. During the six months ended March 31, 2000, the segment had Segment Profit losses of $29.7 million. This loss is due to the factors mentioned above in the comparison of the Current Year Quarter to the Prior Year Quarter. The Company also recorded a $58.2 million impairment of long-lived assets, including certain intangible assets, in the quarter ended March 31, 2000 related to its specialty managed healthcare segment. See Note K—"Impairment of Long-lived Assets" to the Company's condensed consolidated financial statements set forth elsewhere herein.

Depreciation and Amortization. Depreciation and amortization increased 9.8%, or $3.5 million, to $39.1 million for the Current Year To Date from $35.6 million in the Prior Year To Date. The increase is primarily attibutable to the factors mentioned in the comparison of the Current Year Quarter to the Prior Year Quarter.

Interest, net. Interest expense, net was $48.2 million and $48.4 million for the six months ended March 31, 2000 and 1999 respectively. This is primarily attributable to the factors mentioned in the comparison of the Current Year Quarter to the Prior Year Quarter.

Other Items. The Company recorded managed care integration costs of $3.9 million during the Prior Year To Date and recorded no such cost during the Current Year To Date due to the completion of the Integration Plan. For a more complete discussion of managed care integration costs, see Note I—"Managed Care Integration Plan and Costs" to the Company's condensed consolidated financial statements set forth elsewhere herein.

Special charges. The Company recorded special charges of $58.2 million in the Current Year to Date period related to the impairment of Allied's long-lived assets, including certain intangible assets, compared to a $3.4 million special charge recorded in the Prior Year Quarter which was primarily related to the loss

on sale of the Company's former corporate headquarters and to non-capitalizable acquisition-related expenditures in the Company's specialty managed healthcare business segment. For a more complete discussion of the special charge in the Current Year To Date, see Note K—"Impairment of Long-Lived Assets" to the Company's condensed consolidated financial statements set forth elsewhere herein.

The Company's effective income tax rate decreased to 32.1% for the Current Year To Date, from 58.0% for Prior Year To Date. The decrease is primarily attributable to the Company's loss from continuing operations in the Current Year To Date relative to the amount of non-deductible goodwill amortization expense associated with the Merit acquisition.

Discontinued Operations. The Company recorded income from discontinued operations of $0.2 million, net of tax, during the Prior Year To Date. During September 1999 the Company exited its healthcare provider and healthcare franchising operations, see Note G—"Discontinued Operations" to the Company's condensed consolidated financial statements set forth elsewhere herein.

Historical Liquidity and Capital Resources

Operating Activities The Company's net cash provided by operating activities was $25.7 million and $31.4 million for the six months ended March 31, 2000 and 1999, respectively. The decrease in cash provided by operating activities in fiscal 2000 compared to fiscal 1999 was primarily the result of (i) timing of working capital receipts and payments and (ii) payments of managed care integration costs in the fiscal 1999 period. During the fiscal 2000 period, non-recurring cash inflows of approximately $24.0 million related to cost report settlements and non-recurring cash payments totaling $38.1 million related to CHAMPUS Adjustments were incurred.

Investing Activities Capital expenditures decreased 41.4%, or $10.8 million, to $15.3 million for the Current Year to Date, compared to $26.1 million in the Prior Year to Date. The decrease was primarily a result of (i) increased capital requirements in the fiscal 1999 period related to integration activities, (ii) reduction of expenditures related to year 2000 preparedness and (iii) deferral of capital projects in the fiscal 2000 period.

The Company acquired businesses in its specialty managed healthcare and human services segments and paid contingent purchase consideration related to previously acquired businesses during the fiscal 2000 period. During the fiscal 1999 period, the cash paid for acquisition of businesses was offset by the return of approximately $20.0 million of escrowed amounts related to the acquisition of Allied.

The Company's cash flow for the fiscal 1999 period reflects a reduction of cash and cash equivalents of $21.1 million which is related to the conversion of eight joint ventures from consolidation to the equity method. See "—Recent Accounting Pronouncements—EITF 96-16". This reduction does not represent an actual reduction of cash and cash equivalents at the affected subsidiaries.

Financing Activities The Company repaid $40.4 million of indebtedness outstanding under the Term Loan Facility during the six months ended March 31, 2000, including a payment of $27.0 million from the proceeds from issuance of redeemable preferred stock to TPG. Borrowings outstanding under the Revolving Facility increased by $35.0 million over the same period. As of March 31, 2000 the Company had $65.4 million of availability under the Revolving Facility, excluding $29.6 million of availability reserved for certain letters of credit. During the fiscal 2000 period the Company reduced amounts outstanding under its Credit Agreement and other obligations by an aggregate amount of $5.4 million.

The Company completed the sale of 59,063 shares of Series A Redeemable Preferred Stock to TPG during the quarter ended December 31, 1999, for a total price of approximately $54.0 million, net of issuance costs. Approximately 50% of the net proceeds were used to reduce debt outstanding under the Term Loan Facility with the remaining 50% being used for general corporate purposes. See Note L—

"Redeemable Preferred Stock" to the Company's condensed consolidated financial statements set forth elsewhere herein.

Outlook-Liquidity and Capital Resources

Debt Service Obligations. The interest payments on the Company's $625.0 million 9% Series A Senior Subordinated Notes due 2008 (the "Notes") and interest and principal payments on indebtedness outstanding pursuant to the Company's $700.0 million senior secured bank credit agreement (the "Credit Agreement") represent significant liquidity requirements for the Company. Borrowings under the Credit Agreement bear interest at floating rates and require interest payments on varying dates depending on the interest rate option selected by the Company. Borrowings pursuant to the Credit Agreement include $452.5 million, as of March 31, 2000, under a term loan facility (the "Term Loan Facility") and up to $150.0 million under a revolving facility (the "Revolving Facility"). The Company is required to repay the principal amount of borrowings outstanding under the Term Loan Facility and the principal amount of the Notes in the years and amounts set forth in the following table (in millions):

Fiscal Year	Remaining Principal Amount
2000	$	15.1
2001		34.2
2002		43.4
2003		80.8
2004		137.6
2005		115.8
2006		25.6
2007		—
2008		625.0

In addition, any amounts outstanding under the Revolving Facility mature in February 2004. The Company had $55.0 million of borrowings outstanding under the Revolving Facility as of May 11, 2000.

Potential Purchase Price Adjustments. In December 1997, the Company purchased HAI from Aetna for approximately $122.1 million, excluding transaction costs. In addition, the Company incurred the obligation to make contingent payments to Aetna which may total up to $60.0 million annually 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 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 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 $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 Company paid $60.0 million to Aetna during March, 1999 for both the full Tranche 1 Payment and the full Tranche 2 Payment for the Contract Year ended December 31, 1998. This payment was recorded as an additional $60.0 million of goodwill and other intangible assets related to the purchase of HAI.

Also, based upon the membership enrollment data related to the Contract Year ended December 31, 1999 ("Contract Year 2"), the Company, prior to the issuance of its September 30, 1999, financial statements, believed beyond a reasonable doubt that it would be required to make both the full Tranche 1 Payment and the full Tranche 2 Payment ($60.0 million in aggregate) related to Contract Year 2.

Accordingly, the Company recorded an additional $60.0 million of goodwill and other intangible assets related to the purchase of HAI, for a total increase of $120.0 million during fiscal 1999. The Contract Year 2 liability of $60.0 million is included in "Deferred credits and other long-term liabilities" in the Company's condensed consolidated balance sheets as of September 30, 1999. The Company paid $60.0 million to Aetna during February, 2000 for both the full Tranche 1 Payment and the full Tranche 2 Payment for Contract Year 2.

By virtue of acquiring Merit, the Company may be required to make certain payments to the former shareholders of CMG Health, Inc. ("CMG") a managed behavioral healthcare company that was acquired by Merit in September, 1997. Such contingent payments are subject to an aggregate maximum of $23.5 million. The Company has initiated legal proceedings against certain former owners of CMG with respect to representations made by such former owners in conjunction with Merit's acquisition of CMG. Whether any contingent payments will be made to the former shareholders of CMG and the amount and timing of contingent payments, if any, may be subject to the outcome of these proceedings.

Revolving Facility and Liquidity. The Revolving Facility provides the Company with revolving loans and letters of credit in an aggregate principal amount at any time not to exceed $150.0 million. At May 11, 2000, the Company had approximately $65.4 million of availability under the Revolving Facility. The Company estimates that it will spend less than the approximately $29.2 million originally budgeted for capital expenditures over the remainder of fiscal 2000, in addition to the $15.3 million spent to-date. 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 Revolving Facility, should be sufficient to fund its debt service requirements; anticipated capital expenditures; contingent payments, if any, with respect to HAI and CMG and other investing and financing activities for the foreseeable future. The Company has borrowed under the Revolving Facility to help meet significant commitments during the second quarter of fiscal 2000 including, but not limited to, the semi-annual interest payment on the Notes of $28.1 million and contingent consideration for the Company's purchase of HAI of $60.0 million, which were paid in February, 2000. The Company expects its borrowing capacity under the Revolving Facility to decline to approximately $30.0 million to $55.0 million by September 30, 2000 depending primarily on (i) the timing and amount of contingent consideration paid related to CMG (if any), (ii) the operating and cash flow performance of the Company, (iii) capital resources needed to pursue certain new risk-based managed care business and (iv) the timing and amount of acquisition-related spending. Management intends to delay or forego certain investing activities, including capital expenditures and acquisitions, and possibly forego certain new business opportunities in order to improve liquidity. 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 Credit Agreement will be subject to future economic conditions and to financial, business, regulatory and other factors, many of which are beyond the Company's control.

Restrictive Financing Covenants. The Credit Agreement imposes restrictions on the Company's ability to make capital expenditures, and both the Credit Agreement and the indenture governing the Notes (the "Indenture") 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 and conditions. The covenants contained in the 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. On September 30, 2000, the Company's financial covenants become more restrictive, and the ability to comply with such covenants is less assured as a result of the approximately $29.7 million Segment Profit loss incurred in the specialty managed healthcare segment during fiscal 2000. These more restrictive covenants may not be met at September 30, 2000, if the Company's budgeted results

are not achieved for the remainder of fiscal 2000 or if the Company's specific action steps to improve liquidity and cash flows and to reduce debt are not successfully implemented.

Strategic Alternatives to Reduce Long-Term Debt and Improve Liquidity. The Company is currently evaluating the potential to divest certain assets and businesses and is currently involved in discussions with various parties. There can be no assurance that the Company will be able to divest any asset or businesses or that such divestiture would result in significant reductions of long-term debt or improvements in liquidity. The Company is also reviewing additional strategic alternatives to improve its capital structure and liquidity. There can be no assurance that the Company will be able to consummate any transaction that will improve its capital structure or liquidity.

Net Operating Loss Carryforwards. During June 1999, the Company received an assessment from the Internal Revenue Service (the "IRS Assessment") related to its federal income tax returns for the fiscal years ended September 30, 1992 and 1993. The IRS Assessment disallowed approximately $162 million of deductions that relate primarily to interest expense in fiscal 1992. The Company filed an appeal of the IRS Assessment during September 1999. The Company had previously recorded a valuation allowance for the full amount of the $162 million of deductions disallowed in the IRS Assessment. The IRS Assessment is not expected to result in a material cash payment for income taxes related to prior years; however, the Company's federal income tax net operating loss carryforwards would be reduced if the Company's appeal is unsuccessful.

Speciality Managed Healthcare Segment Impact

The $29.7 million in Segment Profit losses incurred in the specialty managed healthcare segment during the six months ended March 31, 2000, had the impact of reducing the Company's working capital by the same amount. Although not assured, management anticipates that the acquisition of Vivra will serve to improve the results of operations of the specialty managed healthcare segment. Based upon the operations of Vivra, management's objectives are to reduce additional Segment Profit losses for the specialty managed healthcare segment for the remainder of fiscal 2000. Management's objectives are to achieve at least a break-even Segment Profit for the specialty managed healthcare segment, inclusive of Vivra, by the first quarter of fiscal 2001. Management will continue to monitor the results of operations of the specialty managed healthcare segment against these objectives. In addition the Company expects to report certain restructuring and integration costs, most of which is expected to be incurred in the third quarter of fiscal 2000.

Recent Accounting Pronouncements

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 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 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.

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 had the following effect on the Company's consolidated financial position (in thousands):

	October 1, 1998
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	)

Year 2000 Computer Issues

Overview. 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 the date information.

The Company also has business relationships with customers and healthcare providers and other critical vendors who are themselves reliant on IT and Embedded Systems to conduct their businesses.

State of Readiness. The Company completed its year 2000 remediation efforts prior to December 31, 1999, including the implementation of a company-wide year-end transition strategy. Corporate offices and regional service center teams worked diligently before,during and after the rollover to see that systems and processes were ready and that our members were able to access the quality of care they needed. The Company organized three command centers in different regions of the country, overseeing the millennium rollover of centrally and locally supported mission-critical systems. In addition, key vendors (e.g. utilities, banks, telecommunications providers, hardware and software vendors, etc.), providers and business partners were monitored for status and performance. The Company did not encounter any year 2000 related issues resulting in any disruption of service to its customers, nor did it implement any year 2000 contingency plans to continue operation of mission critical systems.

External Relationships. The Company completed its risk assessment of all External Relationships and developed contingency plans to mitigate risk. Action plans were implemented to monitor key vendors for status and performance during the millenium rollover period. The Company did not encounter any disruption of service and did not implement any of its contingency plans.

Year 2000 Costs. Total costs incurred solely for remediation of potential year 2000 problems were approximately $4.3 million in fiscal 1999. The Company incurred no significant year 2000-related costs subsequent to September 30, 1999. A large majority of these costs were incremental expenses that will not recur in calendar 2000 or thereafter. The Company expenses these costs as incurred and funds these costs through operating cash flows. In addition, the Company estimates that it accelerated approximately $5.5 million of capital expenditures that would have been budgeted for future periods into fiscal 1999 to ensure year 2000 readiness for outdated systems.

PART II—OTHER INFORMATION

Item 6.—Exhibits and Reports on Form 8-K

(a): Exhibits

Exhibit No.		Description of Exhibit
2		Stock Purchase Agreement, dated as of January 28, 2000, by and among Magellan Health Services, Inc.; Allied Specialty Cone Services, Inc. and Vivra Holdings, Inc.
*10(a)		Magellan Corporate Short-Term Incentive Plan for the fiscal year ended September 30, 2000.
*10(b)		Magellan Behavorial Health Short-Term Incentive Plan for the fiscal year ended September 30, 2000.
27		Financial Data Schedule.

(b): Reports on Form 8-K
None.

*: Constitutes a management contract or compensatory plan arrangement.

FORM 10-Q
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

		MAGELLAN HEALTH SERVICES, INC. (Registrant)
Date: May 11, 2000		/s/ CLIFFORD W. DONNELLY Clifford W. Donnelly Executive Vice President and Chief Financial Officer
Date: May 11, 2000		/s/ THOMAS C. HOFMEISTER Thomas C. Hofmeister Senior Vice President and Chief Accounting Officer

QuickLinks

FORM 10-Q MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES INDEX
CONDENSED CONSOLIDATED BALANCE SHEETS
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
PART II—OTHER INFORMATION
FORM 10-Q MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES