<PAGE>
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q/A
Amendment No. 1*
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
Commission file number 1-10968
MARINER POST-ACUTE NETWORK, INC.
(formerly "Paragon Health Network, Inc.")
(Exact name of registrant as specified in its charter)
Delaware 74-2012902
(State or other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
One Ravinia Drive, Suite 1500
Atlanta, Georgia 30346
(Address of principal executive offices) (Zip Code)
(678) 443-7000
(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
------- -------
There were 41,146,662 shares outstanding of the issuer's only class of
common stock as of January 31, 1998.
* The purpose of this amendment is to revise the allocation methodology of the
Company's recapitalization, indirect merger and other expenses.
<PAGE>
PARAGON HEALTH NETWORK, INC.
AND SUBSIDIARIES
FORM 10-Q
TABLE OF CONTENTS
December 31, 1997
PAGE
----
Part I - FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements and Notes 3
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 15
SIGNATURE PAGE 26
2
<PAGE>
PART 1 FINANCIAL INFORMATION
Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
(unaudited)
<TABLE>
<CAPTION>
Three Months
Ended December 31,
---------------------------------
1997 1996
-------------- --------------
<S> <C> <C>
Net Revenues
Nursing home revenue:
Net patient services $305,709 $182,684
Other 1,583 1,337
Non-nursing home revenue:
Pharmacy services 51,586 46,603
Therapy services 40,888 47,670
Home health, hospital services, and other 21,840 1,908
-------------- --------------
421,606 280,202
Costs and Expenses:
Salaries and wages 160,021 111,435
Employee benefits 35,634 24,276
Nursing, dietary and other supplies 20,178 13,479
Ancillary services 93,783 54,215
General and administrative 60,758 39,703
Depreciation and amortization 15,363 9,903
Provision for bad debts 8,705 5,509
Recapitalization, indirect merger and other expenses 40,985 -
-------------- --------------
435,427 258,520
-------------- --------------
Income (loss) from operations (13,821) 21,682
Other Income and Expense:
Interest expense 21,612 5,124
Interest and dividend income (2,284) (1,070)
-------------- --------------
19,328 4,054
-------------- --------------
Income (loss) before income taxes,
equity earnings/minority interest,
and extraordinary loss (33,149) 17,628
Provision (Benefit) for Income Taxes (3,803) 7,240
-------------- --------------
Income (loss) before equity earnings/
minority interest and extraordinary loss (29,346) 10,388
Equity Earnings/Minority Interest (172) (63)
-------------- --------------
Income (loss) before extraordinary loss (29,518) 10,325
Extraordinary Loss on Early Extinguishment
of Debt, net of $6,034 Income Tax Benefit (11,275) -
-------------- --------------
Net Income (Loss) ($40,793) $10,325
============== ==============
Earnings (Loss) Per Share:
Basic and diluted ($0.86) $0.18
============== ==============
Weighted Average Common
Shares Outstanding:
Basic 47,590 58,507
============== ==============
Diluted 47,590 58,957
============== ==============
</TABLE>
The accompanying notes are an integral part of these financial statements.
3
<PAGE>
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share amounts)
<TABLE>
<CAPTION>
December 31, September 30,
ASSETS 1997 1997
------------ -------------
(unaudited)
<S> <C> <C>
Current Assets:
Cash and cash equivalents $66,593 $14,355
Receivables, less allowances of $71,193 and $33,138 400,448 211,989
Supplies 21,221 21,237
Deferred income taxes 71,126 24,294
Prepaid expenses and other current assets 19,476 15,354
------------ -------------
Total current assets 578,864 287,229
Property and Equipment:
Land, buildings and improvements 543,161 378,251
Furniture, fixtures and equipment 161,520 121,698
Leased property under capital leases 12,551 12,551
------------ -------------
717,232 512,500
Less accumulated depreciation 217,174 210,117
------------ -------------
500,058 302,383
Goodwill, net 467,699 196,120
Restricted Investments 103,805 51,976
Notes Receivable, net 31,696 11,200
Other Assets 91,022 25,459
------------ -------------
$1,773,144 $874,367
============ =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Notes payable and current maturities of long-term debt $4,768 $43,196
Accounts payable 127,342 46,872
Accrued payroll and related expenses 88,740 66,866
Accrued interest 19,017 2,355
Other accrued expenses 49,730 25,836
------------ -------------
Total current liabilities 289,597 185,125
Long-Term Debt, net of current maturities 1,286,876 252,763
Long-Term Insurance Reserves 43,680 27,555
Deferred Income Taxes and Other Noncurrent Liabilities 71,842 33,641
Commitments and Contingencies
Stockholders' Equity:
Preferred stock, par value $0.01; 5,000,000 and 4,650,000
shares authorized; none issued - -
Series A - Junior participating preferred stock, par
value $0.01; none and 350,000 shares authorized and
reserved; none issued - -
Common stock, par value $0.01; 75,000,000 shares
authorized; 41,075,718 and 60,803,760 shares issued 411 608
Capital surplus 494,358 226,972
Retained earnings (deficit) (414,252) 164,650
Unrealized gain on securities available-for-sale 632 244
Treasury stock at cost - none and 2,004,444 shares - (17,191)
------------ -------------
Total stockholders' equity 81,149 375,283
------------ -------------
$1,773,144 $874,367
============ =============
</TABLE>
The accompanying notes are an integral part of these financial statements.
4
<PAGE>
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(dollars and shares in thousands)
(unaudited)
<TABLE>
<CAPTION>
Common Stock Retained Unrealized Treasury Stock
------------------ Capital Earnings Gain on ---------------------
Shares Amount Surplus (Deficit) Securities Shares Amount Total
-------- -------- ---------- ---------- ---------- --------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance, September 30, 1997 60,804 $608 $226,972 $164,650 $244 2,004 ($17,191) $375,283
Net (loss) (40,793) (40,793)
Issuance of shares to Apollo
Management, L.P. and affiliates 17,778 178 232,572 232,750
Repurchase of shares in connection
with the Recapitalization Merger 54,461 (735,223) (735,223)
Retirement of treasury stock (55,082) (551) (202,060) (538,109) (55,082) 740,720 -
Issuance of shares and options
in exchange for GranCare
common stock and options 17,440 175 238,814 238,989
Funding of options exercised or
canceled under 1992 Employee
Stock Option Plan, net of tax (3,886) (1,350) 11,410 7,524
Funding of employee benefit plans 92 (32) 275 367
Issuance of treasury stock in
exchange for warrants (9) (1) 9 -
Issuance of stock under
various stock option plans,
net of tax 136 1 1,863 1,864
Unrealized gain on
securities available-for-sale 388 388
-------- -------- ---------- ---------- -------- ---------- ---------- ----------
Balance, December 31, 1997 41,076 $411 $494,358 ($414,252) $632 - - $ 81,149
======== ======== ========== ========== ======== ========== ========== ==========
</TABLE>
The accompanying notes are an integral part of these financial statements.
5
<PAGE>
PARAGON HEALTH NETWORK, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
(unaudited)
<TABLE>
<CAPTION>
Three Months
Ended December 31,
--------------------------
1997 1996
----------- ------------
<S> <C> <C>
Cash Flows From Operating Activities:
Net income (loss) $(40,793) $10,325
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization 15,363 9,903
Income taxes deferred (370) (392)
Equity earnings/minority interest 172 63
Provision for bad debts 8,705 5,509
Changes in noncash working capital:
Receivables (8,586) (30,885)
Supplies 1,823 590
Prepayments and other current assets 2,510 2,207
Accounts payable (21,783) (238)
Accrued expenses and other current liabilities 14,469 (497)
Changes in long-term insurance reserves 6,091 4,556
Other 2,835 (199)
----------- ------------
Net Cash Provided By (Used In) Operating Activities (19,564) 942
Cash Flows Used In Investing Activities:
Acquisitions and investments - (11,629)
Purchases of property and equipment (6,993) (11,298)
Disposals of property, equipment and
other assets 2,252 935
Restricted investments (10,454) (3,552)
Net collections on notes receivable 593 282
Deposits and other (7,463) 23
----------- ------------
Net Cash Used In Investing Activities (22,065) (25,239)
Cash Flows From Financing Activities:
Issuance of shares to Apollo Management, L.P.
and affiliates 232,750 -
Proceeds from Senior Credit Facility 740,000 -
Proceeds from Senior Subordinated Notes and
Senior Subordinated Discount Notes 448,871 -
Repurchase of shares in connection
with the Recapitalization Merger (735,223) -
Net draws under credit line - 24,972
Repayment of long-term debt (563,337) (830)
Deferred financing fees (31,678) -
Funding of options under 1992 employee stock
purchase plan, employee benefit plans, and other 2,484 83
----------- ------------
Net Cash Provided By Financing Activities 93,867 24,225
Increase (Decrease) in Cash and Cash Equivalents 52,238 (72)
Cash and Cash Equivalents, beginning of period 14,355 21,394
----------- ------------
Cash and Cash Equivalents, end of period $66,593 $21,322
=========== ============
</TABLE>
The accompanying notes are an integral part of these financial statements.
6
<PAGE>
PARAGON HEALTH NETWORK, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Note 1. Organization and Basis of Presentation
Organization
Paragon Health Network, Inc. ("Paragon" or the "Company"), formerly known
as Living Centers of America, Inc. ("LCA"), was formed in November 1997 through
the recapitalization by merger of LCA with a newly-formed entity owned by
certain affiliates of Apollo Management, L.P. and certain other investors (the
"Recapitalization Merger"), and the subsequent merger of GranCare, Inc.
("GranCare") with a wholly-owned subsidiary of LCA (the "GranCare Merger" and
collectively with the Recapitalization Merger, the "Mergers"). See Notes 2 and
3. At the time of the GranCare Merger, GranCare operated long-term health care
facilities that provided skilled nursing and residential care services in 15
states, a specialty hospital geriatric services company, and home health
operations. The accompanying condensed consolidated financial statements include
the accounts of Paragon and its subsidiaries and all significant intercompany
accounts and transactions have been eliminated.
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements of
the Company have been prepared in accordance with generally accepted accounting
principles for interim financial information and pursuant to the rules and
regulations of the Securities and Exchange Commission. Accordingly, they do not
include all of the information and notes required by generally accepted
accounting principles for annual financial statements. In the opinion of
management, all adjustments (which include normal recurring adjustments)
considered necessary for a fair presentation have been included. Operating
results for the three months ended December 31, 1997 are not necessarily
indicative of the results that may be expected for the year ended September 30,
1998. These financial statements should be read in conjunction with the audited
consolidated financial statements and notes thereto for the year ended September
30, 1997 included in the Company's Annual Report filed with the Securities and
Exchange Commission on Form 10-K, file No. 1-10968.
Certain prior year amounts have been reclassified to conform with the 1997
presentation.
Note 2. Recapitalization Merger
During 1997 the Company entered into a Recapitalization Merger Agreement
with Apollo Management, L.P. ("Apollo") and one of its affiliates which was
completed effective November 1, 1997. In connection with the Recapitalization
Merger, certain affiliates of Apollo and certain other investors (the "Apollo
Investors") invested $240 million to purchase approximately 17.8 million shares
(adjusted for the three-for-one stock split, see Note 7), of newly issued common
stock of LCA. Concurrent with the Recapitalization Merger, LCA changed its name
to Paragon Health Network, Inc.
Also effective November 1, 1997, Paragon sold $275 million of its 9.5%
Senior Subordinated Notes due 2007, at a price of 99.5% of face value and $294
million of its 10.5% Senior Subordinated Discount Notes due 2007, at a price of
59.6% of face value (collectively the "Notes"), in a private offering to
institutional investors. Concurrent with the private Notes offering, Paragon
entered into a new Senior Credit Facility which is composed of $740 million in
Term Loans and a Revolving Credit Facility which provides for borrowings of up
to an additional $150 million. See Note 6.
Paragon used the $240 million less, $7.2 million in related costs, invested
by Apollo Investors and the $1.189 billion of net proceeds provided by the Notes
offering and the Term Loans to (i) purchase approximately 90.5% of the issued
and outstanding common stock of the Company for a per share price of $13.50
(adjusted for the three-for-one stock split, see Note 7), (ii) to repay
substantially all amounts outstanding under the Company's and under GranCare's
(see below for description of the GranCare Merger) previous credit facilities
and (iii) pay for certain costs associated with the Mergers.
7
<PAGE>
PARAGON HEALTH NETWORK, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Note 3. GranCare Merger
Effective November 1, 1997, and subsequent to the Company's
recapitalization, Paragon completed the merger acquisition of GranCare pursuant
to the terms of the previously announced GranCare Merger Agreement. In the
merger acquisition, approximately 17.4 million shares (adjusted for the three-
for-one stock split, see Note 7) of Paragon common stock were exchanged for
GranCare common stock and approximately 1.3 million options (adjusted for the
three-for-one stock split, see Note 7) to purchase shares of Paragon common
stock were exchanged for options to purchase GranCare common stock. The
Company's total purchase price of the acquisition was approximately $250.6
million including legal, consulting and other direct costs. The acquisition was
accounted for under the purchase method of accounting and, accordingly, the
results of GranCare's operations are included in the Company's consolidated
financial statements since the date of acquisition. The assets and liabilities
of GranCare have been recorded at fair market value based on a preliminary
purchase price allocation. The total purchase price has been allocated as
follows (in thousands):
Current assets............................................ $ 260,313
Property and equipment.................................... 203,075
Goodwill.................................................. 263,690
Restricted investments.................................... 40,987
Other long-term assets.................................... 46,721
Current liabilities....................................... ( 126,601)
Long-term debt............................................ ( 369,871)
Other non-current liabilities............................. ( 67,755)
--------------
Total purchase price...................................... $ 250,559
==============
At December 31, 1997, no adjustment had been made to record GranCare's
property and equipment at fair value, assign a purchase price to unfavorable
operating leases for property and equipment, or to assign a value to
identifiable intangible assets, if any. The Company is in the process of
revaluing these items. Goodwill is amortized on a straight-line basis over 30
years. The Omega Note (see Note 6) assumed by Paragon in the GranCare Merger has
been recorded at its fair value with the excess of fair value over the principle
amortized over the remaining life of the mortgage notes. Such amount is being
amortized using the effective interest method over the expected life of the
note. Amortization, which was approximately $0.7 million for the three months
ended December 31, 1997, was recorded as a reduction to interest expense.
Note 4. Recapitalization, Indirect Merger and Other Expenses
Recapitalization, indirect merger and other expenses of $41.0 million
primarily related to costs associated with the Apollo/LCA/GranCare Mergers, $2.8
million of which was unpaid and included in other accrued expenses at December
31, 1997.
8
<PAGE>
PARAGON HEALTH NETWORK, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Note 5. Pro Forma Financial Information
The following unaudited pro forma financial information (in thousands,
except per share data) presents the consolidated results of operations of LCA
and GranCare as if the Mergers had occurred effective October 1, 1997 and 1996,
respectively, after giving effect to certain adjustments, including amortization
of goodwill, increased interest expense on debt related to the Mergers, and
related income tax effects. Such adjustments also exclude a $12.0 million
charge, net of a $7.0 million income tax benefit, for termination fees paid by
GranCare to Vitalink Pharmacy Services, Inc. and Minor Care, Inc. in conjunction
with the GranCare Merger. The pro forma financial information is not necessarily
indicative of the results of operations that would have been achieved had the
Mergers been consummated as of those dates, nor are they necessarily indicative
of future operating results.
<TABLE>
<CAPTION>
Three Months Ended December 31,
1997 1996
----------------- -----------------
<S> <C> <C>
Net revenues................................................ $ 489,898 $ 476,983
================= =================
Net income (loss) before extraordinary item................. $ (34,429) $ 3,836
Extraordinary item.......................................... (11,275) --
----------------- -----------------
Net income (loss)........................................... $ (45,704) $ 3,836
================= =================
Earnings (loss) per share:
Basic:
Net income (loss) before extraordinary item............ $ (0.84) $ 0.10
Extraordinary item..................................... (0.28) --
----------------- -----------------
Net income (loss)...................................... $ (1.12) $ 0.10
================= =================
Diluted:
Net income (loss) before extraordinary item............ $ (0.84) $ 0.09
Extraordinary item..................................... (0.28) --
----------------- -----------------
Net income (loss)...................................... $ (1.12) $ 0.09
================= =================
</TABLE>
Note 6. Long-Term Debt
A summary of total debt as of December 31, 1997 is as follows (in
thousands):
Senior Debt:
------------
Senior Credit Facility:
Revolving Credit Facility...................... $ --
Term Loans..................................... 740,000
Mortgage notes..................................... 93,413
Obligations under capital leases................... 6,103
Other notes payable................................ 3,223
Subordinated Debt:
------------------
Senior Subordinated Notes due 2007................. 273,794
Senior Subordinated Discount Notes due 2007........ 175,111
---------------
1,291,644
Less short-term notes payable and
current maturities................................. ( 4,768)
---------------
Total long-term debt................................. $ 1,286,876
===============
9
<PAGE>
PARAGON HEALTH NETWORK, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Senior Credit Facility. The Senior Credit Facility consists of four
components: a 6 1/2 year term loan facility in an aggregate principal amount of
$240 million (the "Tranche A Term Loan Facility"); a 7 1/2 year term loan
facility in an aggregate principal amount of $250 million (the "Tranche B Term
Loan Facility"); an 8 1/2 year term loan facility in an aggregate principal
amount of $250 million (the "Tranche C Term Loan Facility"); and a 6 1/2 year
revolving credit facility in the maximum amount of $150 million (the "Revolving
Credit Facility"). Loans made under the Tranche A Term Loan Facility ("Tranche A
Term Loans"), the Tranche B Term Loan Facility ("Tranche B Term Loans") and the
Tranche C Term Loan Facility ("Tranche C Term Loans") are collectively referred
to herein as "Term Loans." Advances under the Revolving Credit Facility are
sometimes referred to as "Revolving Loans." The proceeds from borrowings under
the Term Loans were used, along with the proceeds of the Senior Subordinated
Notes offering, to fund a portion of the Recapitalization Merger, refinance a
significant portion of LCA's and GranCare's pre-merger indebtedness and to pay
costs and expenses associated with the Mergers.
The Term Loans will be amortized in quarterly installments totaling $0,
$26.5 million, $49.0 million, $51.5 million, $51.5 million, $56.5 million,
$186.0 million, $239.0 million and $80.0 million in the fiscal years 1998, 1999,
2000, 2001, 2002, 2003, 2004, 2005 and 2006, respectively. Principal amounts
outstanding under the Revolving Credit Facility will be due and payable in April
2005. With the exception of approximately $13.7 million letter of credit
issuances, as of December 31, 1997, there were no amounts borrowed under the
Revolving Credit Facility.
Interest on outstanding borrowings accrue, at the option of the Company, at
the customary Alternate Base Rate (the "ABR") of The Chase Manhattan Bank
("Chase") or at a reserve adjusted Eurodollar Rate (the "Eurodollar Rate") plus,
in each case, an Applicable Margin. The term "Applicable Margin" means a
percentage that will vary in accordance with a pricing matrix based upon the
respective term loan tenor and the Company's leverage ratio. Through April 1998,
the Applicable Margin for Revolving Loans and Tranche A Term Loans will equal
1.25% for loans based on ABR ("ABR Loans") and 2.25% for loans based on the
Eurodollar Rate ("Eurodollar Loans"); for Tranche B Term Loans, 1.50% in the
case of ABR Loans and 2.50% in the case of Eurodollar Loans; and for Tranche C
Term Loans, 1.75% in the case of ABR Loans and 2.75% in the case of Eurodollar
Loans. The covenants contained in the Senior Credit Facility also, among other
things, restrict the ability of the Company to dispose of assets, repay other
indebtedness or amend other debt instruments, pay dividends, and make
acquisitions.
Subject in each case to certain exceptions, the following amounts are
required to be applied, as mandatory prepayments, to prepay the Term Loans: (i)
75% of the net cash proceeds of the sale or issuance of equity by the Company;
(ii) 100% of the net cash proceeds of the incurrence of certain indebtedness;
(iii) 75% of the net cash proceeds of any sale or other disposition by the
Company or any of its subsidiaries of any assets (excluding the sale of
inventory and obsolete or worn-out property, and subject to a limited exception
for reinvestment of such proceeds within 12 months); and (iv) 75% of excess cash
flow for each fiscal year, which percentage will be reduced to 50% in the event
the Company's leverage ratio as of the last day of such fiscal year is not
greater than 4.50 to 1.00. Mandatory prepayments will be applied pro rata to the
unmatured installments of the Tranche A Term Loans, the Tranche B Term Loans and
the Tranche C Term Loans; provided, however, that as long as any Tranche A Term
Loan remains outstanding, each holder of a Tranche B Term Loan or a Tranche C
Term Loan will have the right to refuse any such mandatory prepayment otherwise
allocable to it, in which case the amount so refused will be applied as an
additional prepayment of the Tranche A Term Loans. The Company will also have
the right to prepay the Senior Credit Facility, in whole or in part, at its
option. Partial prepayments must be in minimum amounts of $1 million and in
increments of $100,000 in excess thereof.
Amounts applied as prepayments of the Revolving Credit Facility may be
reborrowed; amounts prepaid under the Term Loans may not be reborrowed.
10
<PAGE>
PARAGON HEALTH NETWORK, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Senior Subordinated Notes. Also in connection with the Mergers, on November
4, 1997 the Company completed a private offering to institutional investors of
$275 million of its 9.5% Senior Subordinated Notes due 2007, at a price of 99.5%
of face value and $294 million of its 10.5% Senior Subordinated Discount Notes
due 2007, at a price of 59.6% of face value (collectively, the "Notes").
Interest on the Senior Subordinated Notes is payable semi-annually commencing
May 1, 1998. Interest on the Senior Subordinated Discount Notes will accrete
until November 1, 2002 at a rate of 10.57% per annum, compounded semi-annually,
and will be cash pay at a rate of 10.5% per annum thereafter. The Notes will
mature on November 1, 2007. The net proceeds from this offering, along with
proceeds from the Senior Credit Facility, were used to fund a portion of the
Recapitalization Merger, refinance a significant portion of LCA's and GranCare's
pre-merger indebtedness and to pay costs and expenses associated with the
Mergers.
Other Significant Indebtedness. In connection with the GranCare Merger, the
Company became a party to various agreements between GranCare and Health and
Retirement Properties Trust ("HRPT") and Omega Healthcare Investors, Inc.
("Omega"). HRPT is the holder of a mortgage loan to AMS Properties, Inc. ("AMS
Properties"), a wholly-owned subsidiary of the Company, dated October 1, 1994,
in the aggregate principal amount of $11.5 million (the "HRPT Loan"). The HRPT
Loan is secured, in part, by mortgage and security agreements dated as of March
31, 1995 (collectively, the "HRPT Mortgage") in favor of HRPT and encumbering
two nursing facilities in Wisconsin owned by AMS Properties.
A wholly-owned subsidiary of the Company, Professional Health Care
Management, Inc. ("PHCMI"), is the borrower under a $58.8 million mortgage note
executed on August 14, 1992 (the "Omega Note") in favor of Omega, and under the
related Michigan loan agreement dated as of June 7, 1992 as amended (the "Omega
Loan Agreement"). All $58.8 million was outstanding as of December 31, 1997.
The Omega Note bears interest at a rate which is adjusted annually based on
either (i) changes in the Consumer Price Index or (ii) a percentage of the
change in gross revenues of PHCMI and its subsidiaries from year to year,
divided by 58.8 million, whichever is higher, but in any event subject to a
maximum rate not to exceed 105% of the interest rate in effect for the Omega
Note for the prior calendar year. The current interest rate is 15.0% per annum
which is paid monthly. Additional interest accrues on the outstanding principal
of the Omega Note at the rate of 1% per annum. Such interest is compounded
annually and is due and payable on a pro rata basis at the time of each
principal payment or prepayment. Beginning October 1, 2002, quarterly amortizing
installments of principal in the amount of $1.5 million will also become due and
payable on the first day of each calendar quarter. The entire outstanding
principal amount of the Omega Note is due and payable on August 13, 2007. The
Omega Note may be prepaid without penalty during the first 100 days following
August 14, 2002. Payment of the Omega Note after acceleration upon the
occurrence of an event of default will result in a prepayment penalty in the
nature of a "make whole" premium.
As substitute collateral for certain divested PHCMI facilities, and as
consideration for granting its consent to such divestiture, Omega required
GranCare to cause a letter of credit in favor of Omega to be issued in the
amount of $9.0 million (the "Omega Letter of Credit"). The Omega Letter of
Credit can be drawn upon following the occurrence of: (i) any event of default
under the Omega Loan documents; (ii) if the Omega Letter of Credit is not
renewed or extended at least 30 days prior to its scheduled expiration date
(currently March 31, 1998); or (iii) if certain representations, warranties or
covenants of PHCMI under the Omega Loan documents are breached and such breaches
are not cured within the prescribed time after notice. Following the Mergers,
the Company caused the Omega Letter of Credit to be replaced with a new standby
letter of credit issued under the Senior Credit Facility.
The Omega Loan Agreement obligates PHCMI, among other things, to maintain a
minimum tangible net worth of at least $10 million, which may be increased or
decreased under certain circumstances but may not be less than $10 million. The
Company must contribute additional equity to PHCMI, if and when necessary, to
assure that such minimum tangible net worth test is met. PHCMI has satisfied
this test in the past without the contribution of additional equity, and
management believes that it will continue to do so in the future.
11
<PAGE>
PARAGON HEALTH NETWORK, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Note 7. Stock Split
On November 24, 1997, the Board of Directors of the Company declared a
three-for-one stock split to stockholders of record as of December 15, 1997 that
was paid on December 30, 1997. In all instances throughout the financial
statements and footnotes, common stock and additional paid-in capital have been
restated to reflect this split.
Note 8. Earnings per Share
In February 1997 the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 128, "Earnings per Share" ("SFAS 128").
SFAS 128 was designed to simplify the standards for computing earnings per share
and increase the comparability of earnings per share data on an international
basis. SFAS 128 replaces the presentation of primary earnings per share with a
presentation of basic earnings per share and requires dual presentation of basic
and diluted earnings per share on the face of the statement of income of all
entities with complex capital structures. The Company adopted SFAS 128 in the
three months ended December 31, 1997 and, accordingly, earnings per share for
all prior periods presented have been restated to conform to the requirements of
this new standard. The following table sets forth the computation of basic and
diluted earnings per share (in thousands, except per share data):
<TABLE>
<CAPTION>
Three Months Ended December 31,
1997 1996
----------------- ----------------
<S> <C> <C>
Numerator for Basic and Diluted Earnings Per Share:
Net income (loss) before extraordinary item...................... (29,518) $ 10,325
Extraordinary item............................................... (11,275) --
----------------- ----------------
Net income (loss)................................................ (40,793) $ 10,325
================= ================
Denominator:
Denominator for basic earnings per share-weighted
average shares........................................... 47,590 58,507
Effect of dilutive securities - Stock options.................... -- 450
----------------- ----------------
Denominator for diluted earnings per share-adjusted
weighted-average shares and assumed conversions.......... 47,590 58,957
================= ================
Basic and Diluted Earnings Per Share:
Net income (loss) before extraordinary item...................... (0.62) $ 0.18
Extraordinary item............................................... (0.24) --
----------------- ----------------
Net income (loss) per common share............................... (0.86) $ 0.18
================= ================
</TABLE>
The effect of dilutive securities for the three months ended December 31,
1997 has been excluded because the effect is antidilutive.
Note 9. Income Taxes
For the three months ended December 31, 1997, the provision for income
taxes was affected by recapitalization and indirect merger costs that are not
deductible for income tax purposes as well as non-deductible amortization of
goodwill associated with the GranCare Merger. Excluding the effect of these non-
deductible items, the effective income tax rate for the three months ended
December 31, 1997 was approximately 49.1% compared to 41.2% for the same period
in 1996. The effective income tax rate reflected the continuation of previously
existing non-deductible items and the lower pre-tax book income.
Deferred income taxes reflected in current assets in the accompanying
balance sheets have increased from $24.3 million at September 30, 1997 to $71.1
million at December 31, 1997. This increase is primarily attributable to
deferred taxes recorded in the GranCare Merger.
12
<PAGE>
PARAGON HEALTH NETWORK, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Note 10. Commitments and Contingencies
In October 1996 the Company entered into a leasing program, initially
totaling $70.0 million and subsequently increased to $100.0 million, to be used
as a funding mechanism for future assisted living and skilled nursing facility
construction, lease conversions, and other facility acquisitions. The lease is
an unconditional "triple net" lease for a period of seven years with the annual
lease obligation a function of the amount spent by the lessor to acquire or
construct the project, a variable interest rate, and commitment and other fees.
The Company guarantees a minimum of approximately 83% of the residual value of
the leased property and also has an option to purchase the properties at any
time prior to the maturity date at a price sufficient to pay the entire amount
financed, accrued interest, and certain expenses. At December 31, 1997,
approximately $37.4 million of this leasing arrangement was utilized. The
leasing program is accounted for as an operating lease.
As is typical in the healthcare industry, the Company is and will be
subject to claims that its services have resulted in resident injury or other
adverse effects, the risks of which will be greater for higher acuity residents
receiving services from the Company than for other long-term care residents. The
Company is, from time to time, subject to such negligence claims and other
litigation. In addition, resident, visitor, and employee injuries will also
subject the Company to the risk of litigation. From time to time, the Company
and its subsidiaries have been parties to various legal proceedings in the
ordinary course of their respective businesses. In the opinion of management,
except as described below, there are currently no proceedings which,
individually or in the aggregate, if determined adversely to the Company and
after taking into account the insurance coverage maintained by the Company,
would have a material adverse effect on the Company's financial position or
results of operations.
The Company received a letter dated September 5, 1997 from an Assistant
United States Attorney ("AUSA") in the United States Attorney's Office for the
Eastern District of Texas (Beaumont) advising that the office is involved in an
investigation of allegations that services provided at some of the Company's
facilities may violate the Civil False Claims Act. The AUSA informed the Company
that the investigation is the result of a qui tam complaint (which involves a
private citizen requesting the federal government to intervene in an action
because of an alleged violation of a federal statute) filed under seal against
the Company, and the AUSA is investigating the allegations in order to determine
if the United States will intervene in the proceedings. The AUSA has requested
that the Company voluntarily produce a substantial amount of documents,
including medical records of former residents. Counsel for the Company has met
with the AUSA, and the parties are currently engaged in discussions on whether
the voluntary production of former residents' medical records can be
accomplished without violating the residents' rights to privacy and
confidentiality. Based upon the information currently known about the complaint,
the Company believes that given an opportunity to address the allegations, the
AUSA will find intervention by the United States is without merit. The Company
will vigorously contest the alleged claims if the complaint is pursued.
The Department of Justice ("DOJ") has advised the Company that the United
States has declined to intervene in the qui tam complaint filed against The
Brian Center Corporation ("BCC") and one of its subsidiaries, Med-Therapy
Rehabilitation Services, Inc. ("Med-Therapy"), both wholly-owned subsidiaries of
the Company (and of LCA before the Mergers) in the federal district court for
the Western District of North Carolina. The individual plaintiff is continuing
to pursue the alleged claims that BCC and Med-Therapy caused certain therapists
to make improper therapy record entries with respect to screening services, and
that any claims filed with Medicare for payments based upon such improper record
entries should be viewed as false claims under the Civil False Claims Act. The
Company continues to vigorously contest these claims. No assurance can be given
that, if the plaintiff were to prevail in his claim, the resulting judgment
would not have a material adverse effect on the Company. Moreover, in connection
with the Company's acquisition of BCC, the primary stockholder (Donald C.
Beaver) agreed to indemnify and hold harmless the Company from and against any
and all loss, expense, damage, penalty and liability which could result from
this claim, subject to further adjustment. Mr. Beaver's indemnity requires any
payment to the Company to be in the form of shares of the Company common stock
held by him.
13
<PAGE>
PARAGON HEALTH NETWORK, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
The Company was served with a Petition, Cause No. 97-1500-G, Community
Healthcare Services of America, Inc., v. Rehability Health Services, Inc. and
Living Centers of America, Inc., in the 319th Judicial District Court of Nueces
County, Texas, seeking $5.0 million in damages, filed by Community Health
Services, Inc. ("Community"), in connection with a home health agency management
agreement entered into between Community and a subsidiary of the Company. Such
subsidiary operated a Texas home health agency which Community managed. The
Company is vigorously defending the allegations of Community that the Company
breached the agreement by terminating Community's management services and has
filed a lawsuit against Community for breach of the agreement, Cause No.
97-03569; Rehability Health Services, Inc. v. Community Healthcare Services,
Inc., in the 353rd Judicial District Court of Travis County, Texas. The Nueces
County action was transferred to Travis County and the two cases have been
consolidated into Cause No. 97-03569.
14
<PAGE>
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Overview
Effective November 1, 1997 the Company completed two merger transactions.
First, pursuant to an agreement and plan of merger among Apollo Management, L.P.
("Apollo Management," and together with certain of its affiliates, "Apollo"),
Apollo LCA Acquisition Corp. (a corporation owned by certain Apollo affiliates
and other investors, "Apollo Sub") and Living Centers of America, Inc. ("LCA"),
Apollo Sub was capitalized with $240 million in cash and was merged with and
into LCA (the "Recapitalization Merger"). In the Recapitalization Merger, LCA
was the surviving corporation and was renamed Paragon Health Network, Inc.
("Paragon" or the "Company"). Second, pursuant to an agreement and plan of
merger among LCA, GranCare, Inc. ("GranCare"), Apollo Management and LCA
Acquisition Sub, Inc., a wholly-owned subsidiary of Paragon ("LCA Sub"),
GranCare merged with LCA Sub with GranCare surviving as a wholly-owned
subsidiary of Paragon (the "GranCare Merger," and collectively with the
Recapitalization Merger, the "Mergers"). The GranCare Merger was accounted for
under the purchase method of accounting and, accordingly, the results of
GranCare's operations have been included in the Company's consolidated financial
statements since the date of acquisition.
The Company provides a diverse range of services in the health care
continuum including: (i) post-acute care; (ii) pharmacy, therapy, subacute and
other specialty medical services; and (iii) contract management of specialty
medical programs for acute care hospitals. Post-acute care refers to any care
that a patient receives after discharge from an acute care hospital setting,
including subacute, long-term and specialty medical care. Subacute care refers
to complex medical care and intensive nursing care provided to patients with
high acuity disorders. Long-term care refers to care, typically conducted over
an extended period of time, at a skilled nursing or assisted living facility as
well as care rendered in a patient's home, regardless of whether such care is
rendered following discharge from an acute care hospital. Specialty medical
services refer to any service provided by the Company other than routine skilled
nursing care.
Results of Operations
Nursing home revenues are derived from two basic sources: routine services
($224.8 million or 73.2% in the first quarter of fiscal 1998) and ancillary
services ($82.5 million or 26.8% in the first quarter of fiscal 1998) and are a
function of occupancy rates in the long-term care facilities and the payor mix.
Weighted average occupancy, as identified in the following table, increased by
0.7% which included a 0.3% improvement as a result of the GranCare Merger.
<TABLE>
<CAPTION>
Three Months
Ended December 31,
------------------
1997 1996
---- ----
<S> <C> <C>
Weighted average licensed bed count 32,503 23,322
Weighted average number of residents 27,347 19,442
Weighted average occupancy 84.1% 83.4%
</TABLE>
Payor mix is the source of payment for the services provided and consists
of private pay, Medicare and Medicaid. Private pay includes revenue from
individuals who pay directly for services without government assistance through
the Medicare and Medicaid programs. Additional sources of private pay include
managed care companies, commercial insurers, health maintenance organizations,
and Veteran's Administration contractual payments.
15
<PAGE>
Reimbursement rates from government sponsored programs, such as Medicare
and Medicaid, are strictly regulated and subject to funding appropriations from
federal and state governments. To the extent unfavorable changes in economic
conditions impact payments under governmental or third-party payor programs, the
Company would be adversely affected. Revenues derived from the Company's
pharmacy and therapy groups are also influenced by payor mix. The table below
presents the approximate percentage of the Company's net patient revenues
derived from the various sources of payment for the periods indicated:
<TABLE>
<CAPTION>
Three Months
Ended December 31,
------------------
1997 1996
---- ----
<S> <C> <C>
Private pay 27.8% 34.1%
Medicare 32.7% 24.3%
Medicaid 39.5% 41.6%
</TABLE>
The percentage of revenue derived from private pay sources declined in the
three months ended December 31, 1997 primarily as a result of the GranCare
Merger. GranCare has historically had a lower percentage of private pay revenue
than LCA. Excluding GranCare, the percentage of revenues derived from private
pay and Medicare sources increased to 59.1% for the three months ended December
31, 1997 from 58.4% for the three months ended December 31, 1996, which was
primarily attributable to the growth in the Company's non-nursing home
operations and an increase in Medicare residents. The revenues from the
non-nursing home operations, which are primarily generated from private pay and
Medicare sources, result in a reduction of the percentage of net revenues
derived from the Medicaid program. In addition, average reimbursement rates for
Medicare patients have increased more rapidly than for Medicaid residents
primarily due to the higher reimbursement rates associated with the increase in
acuity levels. Although cost reimbursement for Medicare residents generates a
higher level of revenue per patient day, profitability is not proportionally
increased due to the additional costs associated with the required higher level
of care and other services for such residents. For cost reporting periods
beginning on or after July 1, 1998, the Medicare program will change its method
of payment to a flat per diem rate. See Capital Resources and Liquidity-Changes
in Healthcare Legislation.
First Quarter of Fiscal 1998 Compared to First Quarter of Fiscal 1997. Net
revenues comprising nursing home and non-nursing home operations totaled $421.6
million for the quarter ended December 31, 1997 an increase of $141.4 million or
50.5 %, as compared to the same period for fiscal 1997. Nursing home operations
contributed $123.3 million of the increase, which included the acquisition of
GranCare effective November 1, 1997 of $115.8 million, and at the former LCA
facilities, rate increases of $7.1 million, higher ancillary service billings
resulting from the improvement in mix, primarily Medicare, of $3.9 million., and
a $1.2 million reduction due to a lower average number of residents. Non-nursing
home operations contributed $18.1 million of the increase, consisting of an
increase of $5.0 million for pharmacy services, a decrease of $6.8 million for
therapy services, and an increase of $19.9 million from home health, hospital
services, and other. Home health, hospital services and other revenue increased
by $15.2 million as a result of the GranCare acquisition and $4.6 million from
the purchase of two home health agencies during fiscal year 1997.
Pre-tax recapitalization, indirect merger and other expenses primarily
related to the Apollo/LCA/GranCare Mergers totaled $41.0 million for the quarter
ended December 31, 1997.
Costs and expenses, excluding recapitalization, indirect merger, and
other expenses, totaled $394.4 million for the quarter ended December 31, 1997,
an increase of $135.9 million or 52.6%, as compared to the same period for
fiscal 1997. The acquisition of GranCare contributed $123.8 million to the
increase in costs. Excluding GranCare, payroll, ancillary, and general and
administrative costs increased $0.9, $2.9, and $2.4 million, respectively. The
increase in ancillary services is primarily the result of higher pharmaceutical
costs related to the increase in pharmacy services revenue. Excluding GranCare,
bad debt expense increased $2.5 million primarily due to average days
outstanding for accounts receivable at therapy operations remaining at a high
level.
16
<PAGE>
Interest expense totaled $21.6 million for the quarter ended December 31,
1997, an increase of $16.5 million as compared to the same period for fiscal
1997, which was primarily a result of the additional debt incurred in
conjunction with the Mergers.
For the three months ended December 31, 1997, the provision for income
taxes was affected by recapitalization and indirect merger costs that are not
deductible for income tax purposes as well as non-deductible amortization of
goodwill associated with the GranCare Merger. Excluding the effect of these non-
deductible items, the effective income tax rate for the three months ended
December 31, 1997 was approximately 49.1% compared to 41.2% for the same period
in 1996. The effective income tax rate reflected the continuation of previously
existing non-deductible items and the lower pre-tax book income.
The Company recognized an extraordinary loss of $11.3 million (net of a
$6.0 million income tax benefit) associated with prepayment penalties on the
early extinguishment of debt and the write-off of certain deferred financing
fees.
Seasonality
The Company's revenues and operating income generally fluctuate from
quarter to quarter. This seasonality is related to a combination of factors
which include the timing of Medicaid rate increases, the number of work days in
the period, and seasonal census cycles.
Capital Resources and Liquidity
Cash and cash equivalents were $66.6 million at December 31, 1997, and
working capital was $289.3 million, an increase of $187.2 million during the
first quarter of fiscal 1998 which included an increase of $133.7 million as a
result of the GranCare Merger. Cash used in operations was $19.6 million which
included approximately $38.2 million in payments for recapitalization, indirect
merger, and other expenses. Excluding accrued expenses acquired in the GranCare
Merger, accrued expenses and other current liabilities increased by $14.5
million primarily as a result of an increase in accrued interest of $12.0
million, and a reduction in income taxes payable of $7.7 million. The Company
expects to incur additional recapitalization, indirect merger and other expenses
during the remainder of fiscal 1998. Excluding accounts payable acquired in the
GranCare Merger, accounts payable decreased by $21.8 million primarily as a
result of the $19.0 million termination fees paid to Vitalink Pharmacy Services,
Inc. and Manor Care, Inc. in consideration of the termination of a non-
competition agreement in conjunction with the GranCare Merger.
Excluding the accounts receivable acquired in the GranCare Merger, accounts
receivable increased by $8.6 million for the three months ended December 31,
1997. Management is continuing to monitor trends in the Company's accounts
receivable and is reviewing the Company's collection procedures, including the
timing of filing claims for reimbursement. The Company receives payment for
nursing facility services based on rates set by individual state Medicaid
programs. Although payment cycles for these programs vary, payments generally
are made within 30 to 60 days of services provided. The Federal Medicare
program, currently a cost-based reimbursement program (See Capital Resources and
Liquidity-Changes in Healthcare Legislation), pays interim rates, based on
estimated costs of services, on a 30 to 45-day basis. Final cost settlements,
based on the difference between audited costs and interim rates, are paid
following final cost report audits by Medicare fiscal intermediaries. Because of
the cost report and audit process, final settlement may not occur until up to 24
months after each facility's Medicare year end. Specialty medical services
generally increase the amount of payments received on a delayed basis. The
Company is also moving to a single operating platform for the post-acute care
division accounts receivable. At December 31, 1997, approximately 50% of the
former GranCare facilities had been converted to LCA's field-based accounts
receivable system.
Cash used in investing activities was $22.1 million in the first quarter of
fiscal 1998, as compared to $25.2 million in the first quarter of fiscal 1997.
Restricted investments increased by $10.5 million as a result of normal
quarterly funding to the Company's insurance company subsidiaries which was in
excess of actual disbursements for claim payments. Deposits and other primarily
included a deposit to HRPT of $15 million (see Capital Resources and
Liquidity-Other Significant Indebtedness) reduced by the cash received in the
GranCare Merger. Other investing activities for the three months ended December
31, 1997 included $7.0 million for routine capital expenditures. Capital
expenditures are expected to be funded by cash from operations or the Revolving
Credit Facility.
17
<PAGE>
Financing activities provided $93.9 million during the first fiscal quarter
of 1998. Cash provided by financing activities included $232.8 million, net of
$7.2 million of associated costs, from the issuance of 17.8 million shares of
stock to Apollo and certain other investors, $740.0 million in proceeds from the
Senior Credit Facility, and $448.9 million in proceeds from the Senior
Subordinated Notes and Senior Subordinated Discount Notes. Cash of $735.2
million was used to purchase approximately 90.5% of the issued and outstanding
stock of the Company in conjunction with the Recapitalization Merger, $563.3
million to repay substantially all amounts outstanding under the Company's and
GranCare's previous credit facilities, and $31.7 million to pay financing fees
associated with the Senior Credit Facility and Senior Subordinated Notes.
Senior Credit Facility. The Senior Credit Facility consists of four
components: a 6 1/2 year term loan facility in an aggregate principal amount of
$240 million (the "Tranche A Term Loan Facility"); a 7 1/2 year term loan
facility in an aggregate principal amount of $250 million (the "Tranche B Term
Loan Facility"); an 8 1/2 year term loan facility in an aggregate principal
amount of $250 million (the "Tranche C Term Loan Facility"); and a 6 1/2 year
revolving credit facility in the maximum amount of $150 million (the "Revolving
Credit Facility"). Loans made under the Tranche A Term Loan Facility ("Tranche A
Term Loans"), the Tranche B Term Loan Facility ("Tranche B Term Loans") and the
Tranche C Term Loan Facility ("Tranche C Term Loans") are collectively referred
to herein as "Term Loans." Advances under the Revolving Credit Facility are
sometimes referred to as "Revolving Loans." The proceeds from borrowings under
the Term Loans were used, along with the proceeds of the Senior Subordinated
Notes offering, to fund a portion of the Recapitalization Merger, refinance a
significant portion of LCA's and GranCare's pre-merger indebtedness and to pay
costs and expenses associated with the Mergers.
The Term Loans will be amortized in quarterly installments totaling $0,
$26.5 million, $49.0 million, $51.5 million, $51.5 million, $56.5 million,
$186.0 million, $239.0 million and $80 million in the fiscal years 1998, 1999,
2000, 2001, 2002, 2003, 2004, 2005 and 2006, respectively. Principal amounts
outstanding under the Revolving Credit Facility will be due and payable in April
2005. With the exception of approximately $13.7 million of letter of credit
issuances, as of December 31, 1997, there were no amounts borrowed under the
Revolving Credit Facility.
Interest on outstanding borrowings accrue, at the option of the Company, at
the customary Alternate Base Rate (the "ABR") of The Chase Manhattan Bank
("Chase") or at a reserve adjusted Eurodollar Rate (the "Eurodollar Rate") plus,
in each case, an Applicable Margin. The term "Applicable Margin" means a
percentage that will vary in accordance with a pricing matrix based upon the
respective term loan tenor and the Company's leverage ratio. Through April 1998,
the Applicable Margin for Revolving Loans and Tranche A Term Loans will equal
1.25% for loans based on ABR ("ABR Loans") and 2.25% for loans based on the
Eurodollar Rate ("Eurodollar Loans"); for Tranche B Term Loans, 1.50% in the
case of ABR Loans and 2.50% in the case of Eurodollar Loans; and for Tranche C
Term Loans, 1.75% in the case of ABR Loans and 2.75% in the case of Eurodollar
Loans. The covenants contained in the Senior Credit Facility also, among other
things, restrict the ability of the Company to dispose of assets, repay other
indebtedness or amend other debt instruments, pay dividends, and make
acquisitions.
Subject in each case to certain exceptions, the following amounts are
required to be applied, as mandatory prepayments, to prepay the Term Loans: (i)
75% of the net cash proceeds of the sale or issuance of equity by the Company;
(ii) 100% of the net cash proceeds of the incurrence of certain indebtedness;
(iii) 75% of the net cash proceeds of any sale or other disposition by the
Company or any of its subsidiaries of any assets (excluding the sale of
inventory and obsolete or worn-out property, and subject to a limited exception
for reinvestment of such proceeds within 12 months); and (iv) 75% of excess cash
flow for each fiscal year, which percentage will be reduced to 50% in the event
the Company's leverage ratio as of the last day of such fiscal year is not
greater than 4.50 to 1.00. Mandatory prepayments will be applied pro rata to the
unmatured installments of the Tranche A Term Loans, the Tranche B Term Loans and
the Tranche C Term Loans; provided, however, that as long as any Tranche A Term
Loans remain outstanding, each holder of a Tranche B Term Loan or a Tranche C
Term Loan will have the right to refuse any such mandatory prepayment otherwise
allocable to it, in which case the amount so refused will be applied as an
additional prepayment of the Tranche A Term Loans. The Company will also have
the right to prepay the Senior Credit Facility, in whole or in part, at its
option. Partial prepayments must be in minimum amounts of $1 million and in
increments of $100,000 in excess thereof.
Amounts applied as prepayments of the Revolving Credit Facility may be
reborrowed; amounts prepaid under the Term Loans may not be reborrowed.
18
<PAGE>
Senior Subordinated Notes. Also in connection with the Mergers, on November
4, 1997 the Company completed a private offering to institutional investors of
$275 million of its 9.5% Senior Subordinated Notes due 2007, at a price of 99.5%
of face value and $294 million of its 10.5% Senior Subordinated Discount Notes
due 2007, at a price of 59.6% of face value (collectively, the "Notes").
Interest on the Senior Subordinated Notes is payable semi-annually commencing
May 1, 1998. Interest on the Senior Subordinated Discount Notes will accrete
until November 1, 2002 at a rate of 10.57% per annum, compounded semi-annually,
and will be cash pay at a rate of 10.5% per annum thereafter. The Notes will
mature on November 1, 2007. The net proceeds from this offering, along with
proceeds from the Senior Credit Facility, were used to fund a portion of the
Recapitalization Merger, refinance a significant portion of LCA's and GranCare's
pre-merger indebtedness and to pay costs and expenses associated with the
Mergers.
Other Significant Indebtedness. In connection with the Mergers, the Company
became a party to various agreements between GranCare and Health and Retirement
Properties Trust ("HRPT") and Omega Healthcare Investors, Inc. ("Omega"). HRPT
is the holder of a mortgage loan to AMS Properties, Inc. ("AMS Properties"), a
wholly- owned subsidiary of the Company, dated October 1, 1994, in the aggregate
principal amount of $11.5 million (the "HRPT Loan"). The HRPT Loan is secured,
in part, by mortgage and security agreements dated as of March 31, 1995
(collectively, the "HRPT Mortgage") in favor of HRPT and encumbering two nursing
facilities in Wisconsin owned by AMS Properties.
In connection with certain transactions effected in February 1997 by
GranCare's predecessor with Vitalink Pharmacy Services, Inc. ("Vitalink"),
Vitalink (a) paid a consent fee to HRPT in the amount of $10 million, which was
promptly reimbursed by GranCare immediately following the consummation of the
transactions with Vitalink and (b) entered into a limited guaranty (not to
exceed $15 million in the aggregate) of the obligations by GranCare, AMS
Properties and GCIHCC under the HRPT Mortgages, the GCIHCC Lease and the HRPT
Loan (collectively, the "HRPT Obligations") for so long as such obligations
remained outstanding. To support Vitalink's limited guaranty of the foregoing
obligations, GranCare caused an irrevocable letter of credit to be issued to
Vitalink in the event Vitalink made any payments under the limited guaranty (the
"HRPT Letter of Credit").
In connection with obtaining HRPT's consent to the Mergers, GranCare and
HRPT executed a Restructure and Asset Exchange Agreement dated October 31, 1997
pursuant to which HRPT and GranCare are in the process of restructuring their
relationship (the "HRPT/GranCare Restructuring"). As a part of the HRPT/GranCare
Restructuring, HRPT consented to the consummation of the Mergers and the
transactions related thereto. In addition, Vitalink's guaranty of the HRPT
Obligations was released and the HRPT Letter of Credit was terminated and
replaced with an unlimited guaranty by the Company and all subsidiaries of the
Company having an ownership interest in AMS and/or GCIHCC (individually, a
"Tenant Entity" and collectively, the "Tenant Entities") which guaranty is
secured by a cash collateral deposit of $15 million, the earned interest on
which is retained by HRPT. The performance by the Tenant Entities of their
respective obligations to HRPT continues to be secured by a pledge of one
million shares of HRPT common stock beneficially owned by GranCare and, as part
of the HRPT/GranCare Restructuring, GranCare agreed to waive the ability to
request a release of such collateral upon the attainment of certain financial
conditions. Accordingly, the Company does not have the ability to sell these
shares to meet any capital requirements. The terms of the leases between HRPT
and the Tenant Entities were extended to January 31, 2013, constituting lease
extensions ranging from 3 to 7 years and the aggregate base rental for all
facilities leased from HRPT (excluding the Exchange Facilities (as defined
below)) increased by $500,000 per year. AMS Properties will also prepay the
$11.5 million HRPT Loan and HRPT will release the HRPT Mortgage. In addition, by
April 29, 1998 the Tenant Entities will exchange, in a transaction structured as
a like-kind exchange transaction (the "Exchange Transaction"), five nursing
facilities (the two nursing facilities previously subject to the HRPT Mortgage
and three nursing facilities currently owned by the Company (collectively the
"Exchange Facilities")) for four nursing facilities owned by HRPT. Following
completion of the Exchange Transaction, the Tenant Entities will lease back the
Exchange Facilities for an aggregate annual rent amount equal to the aggregate
rent on the four HRPT facilities.
In consideration of the HRPT/GranCare Restructuring, the Company paid HRPT
a one time restructuring payment of $10 million. The overall impact of the
HRPT/GranCare Restructuring is not expected to have any material effect on the
Company's operations or cash flows. The Company also paid an aggregate amount of
$19.0 million to Vitalink Pharmacy Services, Inc. ("Vitalink") and Manor Care,
Inc. ("Manor Care") in connection with the settlement of certain litigation
initiated by Vitalink and Manor Care seeking to enjoin the consummation of the
GranCare Merger.
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A wholly-owned subsidiary of the Company, Professional Health Care
Management, Inc. ("PHCMI"), is the borrower under a $58.8 million mortgage note
executed on August 14, 1997 (the "Omega Note") in favor of Omega, and under the
related Michigan loan agreement dated as of June 7, 1992 as amended (the "Omega
Loan Agreement"). All $58.8 million was outstanding as of December 31, 1997.
The Omega Note bears interest at a rate which is adjusted annually based on
either (i) changes in the Consumer Price Index or (ii) a percentage of the
change in gross revenues of PHCMI and its subsidiaries from year to year,
divided by 58.8 million, whichever is higher, but in any event subject to a
maximum rate not to exceed 105% of the interest rate in effect for the Omega
Note for the prior calendar year. The current interest rate is 15.0% per annum
which is paid monthly. Additional interest accrues on the outstanding principal
of the Omega Note at the rate of 1% per annum. Such interest is compounded
annually and is due and payable on a pro rata basis at the time of each
principal payment or prepayment. Beginning October 1, 2002, quarterly amortizing
installments of principal in the amount of $1.5 million will also become due and
payable on the first day of each calendar quarter. The entire outstanding
principal amount of the Omega Note is due and payable on August 13, 2007. The
Omega Note may be prepaid without penalty during the first 100 days following
August 14, 2002. Payment of the Omega Note after acceleration upon the
occurrence of an event of default will result in a prepayment penalty in the
nature of a "make whole" premium.
In addition to the interest on the Omega Note described in the preceding
paragraph, and as a condition to obtaining Omega's consent to the transaction
between Vitalink and GranCare, PHCMI agreed to pay additional interest to Omega
in the amount of $20,500 per month, through and including July 1, 2002. If the
principal balance of the Omega Note for any reason becomes due and payable prior
to that date, there will be added to the indebtedness owed by PHCMI: (i) the sum
of $1.0 million, plus; (ii) interest thereon at 11% per annum to the prepayment
date; less (iii) the amount of such additional interest paid to Omega prior to
the prepayment date.
As substitute collateral for certain divested PHCMI facilities, and as
consideration for granting its consent to such divestiture, Omega required
GranCare to cause a letter of credit in favor of Omega to be issued in the
amount of $9.0 million (the "Omega Letter of Credit"). The Omega Letter of
Credit can be drawn upon following the occurrence of: (i) any event of default
under the Omega Note documents; (ii) if the Omega Letter of Credit is not
renewed or extended at least 30 days prior to its scheduled expiration date
(currently March 31, 1998); or (iii) if certain representations, warranties or
covenants of PHCMI under the Omega Note documents are breached and such breaches
are not cured within the prescribed time after notice. Following the Mergers,
the Company caused the Omega Letter of Credit to be replaced with a new standby
letter of credit issued under the Senior Credit Facility.
The Omega Loan Agreement obligates PHCMI, among other things, to maintain a
minimum tangible net worth of at least $10 million, which may be increased or
decreased under certain circumstances but may not be less than $10 million. The
Company must contribute additional equity to PHCMI, if and when necessary, to
assure that such minimum tangible net worth test is met. PHCMI has satisfied
this test in the past without the contribution of additional equity, and
management believes that it will continue to do so in the future.
Changes in Healthcare Legislation. The Balanced Budget Act enacted in
August 1997 (the "Balanced Budget Act"), contains numerous changes to the
Medicare and Medicaid programs with the intent of reducing payments under these
programs by $115 billion and $13 billion, respectively, over the next five
years. While part of the reduction will be achieved through slowing the annual
growth rate of Medicare payments, a large portion of the reductions will also
come from changes to the Medicare and Medicaid programs.
The Balanced Budget Act amended the Medicare program by revising the
payment system. Currently, nursing homes are reimbursed under the Medicare
program based on the actual costs of services provided. However, the Balanced
Budget Act requires the establishment of a prospective payment system ("PPS")
for nursing homes for cost reporting periods beginning on or after July 1, 1998.
Under PPS, nursing homes will receive a per diem rate for each of their patients
which, during the first three years, will be based on a blend of facility
specific costs and Federal acuity adjusted rates. Thereafter, the per diem rates
will be based solely on Federal acuity adjusted rates. Subsumed in this per diem
rate will be ancillary services, such as pharmacy and rehabilitation services,
which historically have been provided to many of the Company's nursing
facilities by the Company's pharmacy and therapy subsidiaries.
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The Balanced Budget Act also requires the establishment of an interim
payment system for home health services for cost reporting periods beginning on
or after October 1, 1997. The interim system established per visit limits and
per beneficiary annual limits. A permanent prospective payment system for home
health services will be established by October 1, 1999. The PPS rates for
patients in the Company's nursing homes have not yet been set.
The Company is not able to predict at this time what effect the PPS system
will have on its nursing home, home health, pharmacy, rehabilitation and
hospital services businesses. The Company is evaluating the new regulations and
believes that while PPS may initially result in more intense price competition
and lower margins among ancillary service providers (including the Company's
pharmacy, therapy, and hospital services subsidiaries), opportunities will be
available to efficiently operated low cost providers who can achieve economies
of scale.
The Balanced Budget Act also repealed the Boren Amendment, which
had required state Medicaid programs to reimburse nursing facilities for the
costs that are incurred by efficiently and economically operated providers in
order to meet quality and safety standards. Because of the repeal of Boren,
states now have considerable flexibility in establishing Medicaid payment rates.
In addition, Boren provided a dispute resolution mechanism whereby providers
could challenge Medicaid rates set by the various states, the repeal of which
will now make it more difficult to challenge these rates in the future. The
Company is not able to predict whether any states will adopt changes in their
Medicaid reimbursement programs, or, if adopted and implemented, what effect
such initiatives would have on the Company.
On January 30, 1998, the Health Care Financing Administration issued
its new salary equivalency guidelines which change Medicare reimbursement rates
for therapy services. Under salary equivalency, the Company is reimbursed for
therapy services based on the time spent on the premises times a fixed rate,
depending on the service provided. While the new rates for physical therapy
represent an increase over what the Company previously received for such
services, the new rates for occupational therapy and speech language pathology
represent decreases from what the Company was previously able to bill. The
salary equivalency guidelines will remain in effect until the facility at which
such services are provided, including the Company's facilities and other
facilities serviced by the Company's therapy subsidiaries, start billing under
PPS. The Company believes that while salary equivalency will have a slight
adverse effect on its therapy revenue, the Company does not believe that salary
equivalency will have a material adverse effect on the Company's consolidated
revenues.
Other Factors Affecting Liquidity and Capital Resources. In addition to
principal and interest payments on its long-term indebtedness, the Company has
significant rent obligations relating to its leased facilities. The Company's
estimated principal payments, cash interest payments, and rent obligations for
fiscal year 1998 are approximately $187 million.
The Company's operations require capital expenditures for renovations of
existing facilities in order to continue to meet regulatory requirements, to
upgrade facilities for the treatment of subacute patients and to accommodate the
addition of specialty medical services, and to improve the physical appearance
of its facilities for marketing purposes. The Company estimates that total
capital expenditures for the year ending September 30, 1998 will be
approximately $60 million of which $30 million represents maintenance capital
expenditures.
In addition to the Senior Credit Facility, the Company has a lease
arrangement providing for up to $100.0 million to be used as a funding mechanism
for future assisted living and skilled nursing facility construction, lease
conversions, and other facility acquisitions (the "Synthetic Lease"). This
leasing program allows the Company to complete these projects without committing
significant financing resources. The lease is an unconditional "triple net"
lease for a period of seven years with the annual lease obligation a function of
the amount spent by the lessor to acquire or construct the project, a variable
interest rate, and commitment and other fees. The Company guarantees a minimum
of approximately 83% of the residual value of the leased property and also has
an option to purchase the properties at any time prior to the maturity date at a
price sufficient to pay the entire amount financed, accrued interest, and
certain expenses. At December 31, 1997 approximately $37.4 million of this
leasing arrangement was utilized. The leasing program is accounted for as an
operating lease.
The Company currently maintains two captive insurance subsidiaries to
provide for reinsurance obligations under workers' compensation, general and
professional liability, and automobile liability. These obligations are funded
with long-term, fixed income investments which are not available to satisfy
other obligations of the Company.
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The Company believes that the cash flow generated from its operations, the
Company's cash and cash equivalents, together with amounts available under the
Senior Credit Facility, should be sufficient to fund its debt service
requirements, working capital needs, anticipated capital expenditures and other
operating expenses. The Revolving Credit Facility will provide the Company with
revolving loans in an aggregate principal amount at any time not to exceed $150
million, of which $136.3 million is expected to be available after considering
$13.7 million in outstanding letters of credit. The Company's future operating
performance and ability to service or refinance the Notes and to extend or
refinance the Senior Credit Facility will be subject to future economic
conditions and to financial, business and other factors, many of which are
beyond the Company's control.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this amendment to be signed
on its behalf by the undersigned, thereunto duly authorized.
January 25, 1999
MARINER POST-ACUTE NETWORK, INC.
(Registrant)
By: /s/ Ronald W. Fleming
----------------------------
Ronald W. Fleming
Vice President, Controller,
and Chief Accounting Officer
(Duly Authorized Officer and
Chief Accounting Officer)
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