<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 MARCH 31, 1998
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 41,442,068 shares outstanding of the issuer's only class of common
stock as of April 30, 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/A
TABLE OF CONTENTS
MARCH 31, 1998
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 17
SIGNATURE PAGE 32
<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 Six Months
Ended March 31, Ended March 31,
------------------------ ------------------------
1998 1997 1998 1997
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Net Revenues
Nursing home revenue:
Net patient services $362,670 $185,323 $668,379 $368,007
Other 3,579 1,363 5,162 2,700
Non-nursing home revenue:
Pharmacy services 55,263 48,656 106,849 95,259
Therapy services 39,371 45,899 80,259 93,569
Home health, hospital services, and other 26,278 4,077 48,118 5,985
-------- -------- -------- --------
487,161 285,318 908,767 565,520
Costs and Expenses:
Salaries and wages 178,655 108,962 338,676 220,397
Employee benefits 43,793 25,974 79,427 50,250
Nursing, dietary and other supplies 23,861 13,314 44,039 26,793
Ancillary services 107,867 56,715 201,650 110,930
General and administrative 74,101 39,880 134,859 79,583
Depreciation and amortization 17,963 10,163 33,326 20,066
Provision for bad debts 4,694 4,466 13,399 9,975
Recapitalization, indirect merger and other expenses 13,636 - 54,621 -
-------- -------- -------- --------
464,570 259,474 899,997 517,994
-------- -------- -------- --------
Income (loss) from operations 22,591 25,844 8,770 47,526
Other Income and Expense:
Interest expense 30,422 5,501 52,034 10,625
Interest and dividend income (2,460) (1,119) (4,744) (2,189)
-------- -------- -------- --------
27,962 4,382 47,290 8,436
-------- -------- -------- --------
Income (loss) before income taxes,
equity earnings/minority interest,
and extraordinary loss (5,371) 21,462 (38,520) 39,090
Provision (Benefit) for Income Taxes (1,025) 9,129 (4,828) 16,369
-------- -------- -------- --------
Income (loss) before equity earnings/
minority interest and extraordinary loss (4,346) 12,333 (33,692) 22,721
Equity Earnings/Minority Interest (127) (119) (299) (182)
-------- -------- -------- --------
Income (loss) before extraordinary loss (4,473) 12,214 (33,991) 22,539
Extraordinary Loss on Early Extinguishment
of Debt, net of $6,034 Income Tax Benefit - - (11,275) -
-------- -------- -------- --------
Net Income (Loss) $ (4,473) $ 12,214 $(45,266) $ 22,539
======== ======== ======== ========
Earnings (Loss) Per Share:
Basic $ (0.11) $ 0.21 $ (1.02) $ 0.38
======== ======== ======== ========
Diluted $ (0.11) $ 0.21 $ (1.02) $ 0.38
======== ======== ======== ========
Weighted Average Common
Shares Outstanding:
Basic 41,208 58,616 44,434 58,561
======== ======== ======== ========
Diluted 41,208 59,478 44,434 59,423
======== ======== ======== ========
</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>
March 31, September 30,
ASSETS 1998 1997
----------- ------------
(unaudited)
<S> <C> <C>
Current Assets:
Cash and cash equivalents $ 19,464 $ 14,355
Receivables, less allowances of $71,984 and $33,138 427,910 211,989
Supplies 21,505 21,237
Deferred income taxes 74,298 24,294
Prepaid expenses and other current assets 31,687 15,354
---------- --------
Total current assets 574,864 287,229
Property and Equipment:
Land, buildings and improvements 550,031 378,251
Furniture, fixtures and equipment 169,171 121,698
Leased property under capital leases 12,551 12,551
---------- --------
731,753 512,500
Less accumulated depreciation 229,063 210,117
---------- --------
502,690 302,383
Goodwill, net 474,303 196,120
Restricted Investments 96,241 51,976
Notes Receivable, net 31,482 11,200
Other Assets 88,608 25,459
---------- --------
$1,768,188 $874,367
========== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Notes payable and current maturities of long-term debt $ 17,330 $ 43,196
Accounts payable 128,814 46,872
Accrued payroll and related expenses 88,181 66,866
Accrued interest 30,282 2,355
Other accrued expenses 31,469 25,836
---------- --------
Total current liabilities 296,076 185,125
Long-Term Debt, net of current maturities 1,278,488 252,763
Long-Term Insurance Reserves 42,583 27,555
Deferred Income Taxes and Other Noncurrent Liabilities 70,170 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; 41,389,954 and 60,803,760 shares issued 414 608
Capital surplus 497,835 226,972
Retained earnings (deficit) (418,725) 164,650
Unrealized gain on securities available-for-sale 1,347 244
Treasury stock at cost - none and 2,004,444 shares - (17,191)
---------- --------
Total stockholders' equity 80,871 375,283
---------- --------
$1,768,188 $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) (45,266) (45,266)
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 450 4 5,340 5,344
Unrealized gain on
securities available-for-sale 1,103 1,103
------- ----- --------- --------- ------ ------ -------- ---------
BALANCE, MARCH 31, 1998 41,390 $ 414 $ 497,835 $(418,725) $1,347 - - $ 80,871
======= ===== ========= ========= ====== ====== ======== =========
</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>
Six Months
Ended March 31,
-------------------------
1998 1997
--------- ---------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $(45,266) $22,539
Adjustments to reconcile net income (loss) to net cash
used in operating activities:
Depreciation and amortization 33,326 20,066
Provision for bad debts 13,399 9,975
Interest accretion on Senior Subordinated
Discount Notes 7,640 -
Income taxes deferred 2,137 (603)
Equity earnings/minority interest 299 182
Changes in noncash working capital:
Receivables (42,201) (43,826)
Supplies 1,872 122
Prepayments and other current assets (8,268) 2,007
Accounts payable (28,676) (9,799)
Accrued expenses and other current liabilities 2,003 (12,497)
Changes in long-term insurance reserves 4,994 7,360
Other 1,898 (334)
------- -------
NET CASH USED IN OPERATING ACTIVITIES (56,843) (4,808)
CASH FLOWS USED IN INVESTING ACTIVITIES:
Acquisitions and investments (10,831) (15,536)
Purchases of property and equipment (21,934) (21,181)
Disposals of property, equipment and
other assets 2,252 4,928
Restricted investments (2,175) (19,251)
Net collections on notes receivable 1,529 96
Deposits and other (9,238) (1,433)
------- -------
NET CASH USED IN INVESTING ACTIVITIES (40,397) (52,377)
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) -
Proceeds from long-term debt - 806
Net draws under credit line 5,500 48,814
Repayment of long-term debt (564,468) (3,560)
Deferred financing fees (30,178) -
Funding of options under 1992 employee stock
purchase plan, employee benefit plans, and other 5,097 82
------- -------
NET CASH PROVIDED BY FINANCING ACTIVITIES 102,349 46,142
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 5,109 (11,043)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 14,355 21,394
------- -------
CASH AND CASH EQUIVALENTS, END OF PERIOD $19,464 $10,351
======= =======
</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 and six months ended March 31, 1998 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 1998
presentation.
Recent Accounting Pronouncements
In June 1997 the Financial Accounting Standards Board adopted Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS
130"). SFAS 130 establishes standards for reporting and display of
comprehensive income and its components in a full set of general-purpose
financial statements and is effective for fiscal years beginning after December
15, 1997. Reclassification of financial statements for earlier periods provided
for comparative purposes is required.
In June 1997 the Financial Accounting Standards Board adopted Statement of
Financial Accounting Standards No. 131, "Disclosures about Segments of an
Enterprise and Related Information" ("SFAS 131"). SFAS 131 requires public
business enterprises to report information about operating segments and related
disclosures about products and services, geographic areas, and major customers.
SFAS 131 is effective for fiscal years beginning after December 15, 1997 and is
applicable to interim periods in the second year of application. Comparative
information for earlier years is required to be restated in the initial year of
application.
In February 1998 the Financial Accounting Standards Board adopted Statement of
Financial Accounting Standards No. 132, "Employers' Disclosures about Pensions
and Other Postretirement Benefits--an amendment of FASB Statements No. 87, 88,
and 106" ("SFAS 132"). SFAS 132 standardizes disclosure requirements for
pensions and other postretirement benefits, requires additional information on
changes in the benefit obligations and fair values of plan assets, and
eliminates certain existing disclosure requirements. SFAS 132 is effective for
fiscal years beginning after December 15, 1997.
SFAS Nos. 130, 131, and 132 become effective in the Company's fiscal year
ending September 30, 1999. The adoption of these statements is not expected to
have a material impact on the Company's financial statements.
7
<PAGE>
PARAGON HEALTH NETWORK, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
In March 1998 the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued Statement of Position 98-1,
"Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use" ("SOP"). This SOP provides guidance as to whether certain costs
for internal-use software should be capitalized or expensed when incurred. This
SOP is effective for fiscal years beginning after December 31, 1998, but earlier
application is encouraged. The Company does not expect the adoption of this SOP
to have a material impact on its financial statements.
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 (the "Recapitalization Merger"). 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.
On November 4, 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
the 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 Note 3 for description of the GranCare Merger) previous credit facilities
and (iii) pay for certain costs associated with the Mergers.
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):
<TABLE>
<S> <C>
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
========
</TABLE>
8
<PAGE>
PARAGON HEALTH NETWORK, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
At March 31, 1998, 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, nor 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 $1.1 million and $1.8 million for the three and six
months ended March 31, 1998, respectively, was recorded as a reduction to
interest expense.
NOTE 4. RECAPITALIZATION, INDIRECT MERGER AND OTHER EXPENSES
Recapitalization, indirect merger, and other expenses of $54.6 million
primarily related to costs associated with the Apollo/LCA/GranCare Mergers,
significantly all of which were paid by March 31, 1998.
9
<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 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 Manor Care, Inc. in conjunction with the
GranCare Merger. The results of operations for the three and six months ended
March 31, 1997 include a $30.0 million charge, net of a $6.0 million income tax
benefit, recorded by GranCare in February 1997 in connection with the spin-off
of its institutional pharmacy business. 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 Six Months
Ended March 31, Ended March 31,
-------------------------- ------------------------
1998 1997 1998 1997
-------- -------- --------- ---------
<S> <C> <C> <C> <C>
Net revenues......................................... $487,161 $487,527 $977,059 $964,510
======== ======== ======== ========
Net income (loss) before extraordinary item.......... $ (4,473) $(21,941) $(38,902) $(18,105)
Extraordinary item................................... -- (4,831) (11,275) (4,831)
-------- -------- -------- --------
Net income(loss)..................................... $ (4,473) $(26,772) $(50,177) $(22,936)
======== ======== ======== ========
Basic Earnings (Loss) Per Share:
Net income (loss) before extraordinary item........ $ (0.11) $ (0.55) $ (0.95) $ (0.45)
Extraordinary item................................. -- (0.12) (0.27) (0.12)
-------- -------- -------- --------
Net income (loss)................................... $ (0.11) $ (0.67) $ (1.22) $ (0.57)
======== ======== ======== ========
Diluted Earnings (Loss) Per Share:
Net income (loss) before extraordinary item........ $ (0.11) $ (0.55) $ (0.95) $ (0.45)
Extraordinary item................................. -- $ (0.12) (0.27) (0.12)
-------- -------- -------- --------
Net income (loss).................................. $ (0.11) $ (0.67) $ (1.22) $ (0.57)
======== ======== ======== ========
</TABLE>
NOTE 6. LONG-TERM DEBT
A summary of total debt as of March 31, 1998 is as follows (in thousands):
<TABLE>
<CAPTION>
Senior Debt:
- ------------
<S> <C>
Senior Credit Facility:
Revolving Credit Facility.................................. $ 5,500
Term Loans................................................. 740,000
Mortgage notes................................................. 93,185
Obligations under capital leases............................... 5,474
Other notes payable............................................ 2,704
Subordinated Debt:
- ------------------
Senior Subordinated Notes due 2007............................. 273,825
Senior Subordinated Discount Notes due 2007.................... 175,130
----------
1,295,818
Less short-term notes payable and current maturities... (17,330)
----------
Total long-term debt............................................. $1,278,488
==========
</TABLE>
10
<PAGE>
PARAGON HEALTH NETWORK, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Senior Credit Facility. The Senior Credit Facility consists of four
components: a 61/2 year term loan facility in an aggregate principal amount of
$240 million (the "Tranche A Term Loan Facility"); a 71/2 year term loan
facility in an aggregate principal amount of $250 million (the "Tranche B Term
Loan Facility"); an 81/2 year term loan facility in an aggregate principal
amount of $250 million (the "Tranche C Term Loan Facility"); and a 61/2 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. As of March 31, 1998, there was $5.5 million borrowed under the Revolving
Credit Facility in addition to approximately $13.7 million letter of credit
issuances.
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 restrict, among
other things, 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.
11
<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 March 31, 1998.
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 July 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.
12
<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 in the form of a stock dividend 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 Six Months
Ended March 31, Ended March 31,
--------------------------- --------------------------
1998 1997 1998 1997
------------ ------------ ----------- ------------
<S> <C> <C> <C> <C>
Numerator for Basic and Diluted Earnings Per Share:
Net income (loss) before extraordinary item..... $(4,473) $12,214 $(33,991) $22,539
Extraordinary item ............................ -- -- (11,275) --
------- ------- -------- -------
Net income (loss)............................... $(4,473) $12,214 $(45,266) $22,539
======= ======= ======== =======
Denominator:
Denominator for basic earnings per share-
weighted average shares.................... 41,208 58,616 44,434 58,561
Effect of dilutive securities -- Stock
options.................................... 618 862 -- 862
------- ------- -------- -------
Denominator for diluted earnings per share-
adjusted weighted-average shares and assumed
conversions.................................... 41,826 59,478 44,434 59,423
======= ======= ======== =======
Basic Earnings (Loss) Per Share:
Net income (loss) before extraordinary item.... $ (0.11) $ 0.21 $ (0.77) $ 0.38
Extraordinary item............................. -- -- (0.25) --
------- ------- -------- -------
Net income (loss) per common share............. $ (0.11) $ 0.21 $ (1.02) $ 0.38
======= ======= ======== =======
Diluted Earnings (Loss) Per Share:
Net income (loss) before extraordinary item.... $ (0.11) $ 0.21 $ (0.77) $ 0.38
Extraordinary item............................. -- -- (0.25) --
------- ------- -------- -------
Net income (loss) per common share............. $ (0.11) $ 0.21 $ (1.02) $ 0.38
======= ======= ======== =======
</TABLE>
The effect of dilutive securities for the six months ended March 31, 1998 has
been excluded because the effect is antidilutive as a result of the net loss for
the period.
13
<PAGE>
PARAGON HEALTH NETWORK, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 9. INCOME TAXES
For the three and six months ended March 31, 1998, 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 and six months
ended March 31, 1998 was approximately 45.3% and 47.2%, respectively, compared
to 42.5% and 41.9%, respectively, for the same periods in fiscal 1997.
Deferred income taxes reflected in current assets in the accompanying balance
sheets have increased from $24.3 million at September 30, 1997 to $74.3 million
at March 31, 1998. This increase is primarily attributable to deferred taxes
recorded as a result of the GranCare Merger.
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 March 31, 1998,
approximately $40.4 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. In November 1997, counsel for
the Company met with the AUSA and the parties 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. In December
1997, the Company advised the AUSA that absent the United States agreeing to
protect the confidentiality of the residents' medical records, and to prevent
unauthorized disclosure of the information requested to non-government
personnel, the Company would not agree to a voluntary production. The Company
has heard nothing further from the AUSA. The Company will vigorously contest
the alleged claims if the complaint is pursued.
14
<PAGE>
PARAGON HEALTH NETWORK, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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. The plaintiff recently
filed an amended complaint in response to a court order on defendants' motion to
dismiss which gave plaintiff 20 days to file an amended complaint or have the
original complaint dismissed. The defendants intend to file a motion to dismiss
the amended complaint, which does not raise any new or different allegations.
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.
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's
common stock.
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. This matter is currently in the discovery phase.
On June 10, 1997, a GranCare stockholder filed a civil action in state
district court in Harris County, Texas: Howard Gunty, Inc. Profit Sharing Plan
v. Gene E. Burleson, Charles M. Blalack, Antoinette Hubenette, Joel S. Kanter,
Ronald G. Kenny, Robert L. Parker, William G. Petty, Jr., Edward V. Regan, Gary
U. Rolle and GranCare, Inc., No. 97-30762. This complaint alleged, generally,
that the defendants breached their fiduciary duties owed to GranCare's
stockholders by failing to take all reasonable steps necessary to ensure that
GranCare's stockholders receive maximum value for their shares of GranCare
common stock in connection with the GranCare Merger. The plaintiffs sought (i)
an injunction prohibiting the consummation of the GranCare Merger or (ii)
alternatively, if the GranCare Merger were consummated, to have such transaction
rescinded and set aside. In addition, the plaintiffs sought unspecified
compensatory damages, costs and to have the action certified as a class action.
On October 28, 1997, the parties to the aforementioned litigation entered into
an Agreement and Stipulation of Settlement (the "Settlement Agreement") pursuant
to which the plaintiffs agreed to dismiss, with prejudice, all claims against
GranCare in consideration of, among other things, (i) certain additional
disclosure included in the disclosure documents sent to GranCare stockholders in
connection with their approval of the GranCare Merger and (ii) the payment by
GranCare of the fees and expenses of plaintiffs' counsel in an aggregate amount
of no more than $350,000. The effectiveness of the Settlement Agreement is
subject to a number of conditions, including, among others, the entry by the
court of a final judgment approving the terms of the settlement. GranCare
entered into the Settlement Agreement based upon its belief that a speedy
resolution of this dispute was in the best interest of the GranCare stockholders
and in so doing did not in any way admit any wrongdoing or liability in
connection with this matter. On April 6, 1998, the court preliminarily accepted
the Settlement Agreement and ordered that notice of the Settlement Agreement be
mailed to all class members. The court has set July 10, 1998 as the hearing
date on which to finally approve the Settlement Agreement.
15
<PAGE>
PARAGON HEALTH NETWORK, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
On August 26, 1996, a class action complaint was asserted against GranCare in
the Denver, Colorado District Court, Salas, et al. v. GranCare, Inc., and AMS
Properties, Inc., d/b/a Cedars Health Care Center, Inc. Case No. 96 CV 4449,
asserting five claims for relief, including third-party beneficiary, tortious
interference and negligence per se causes of action arising out of quality of
care issues at a healthcare facility formerly owned by GranCare. On January 20,
1998, plaintiffs requested leave to amend their complaint by adding an
additional class claim for fraud and three new named plaintiffs. The complaint
was amended a second time on February 2, 1998 by adding an additional plaintiff.
At the class certification hearing held on February 20, 1998, plaintiffs again
amended their complaint to clarify that damages for all of the class claims
would be limited to restitution and emotional distress. Pursuant to the Third
Amended Complaint, the class claims were identified as third-party beneficiary
of contract; breach of contract; tortious interference with contract; fraud; and
negligence per se. In addition to the class claims, the named plaintiffs each
asserted claims for promissory estoppel and violation of the Colorado Consumer
Protection Act.
On March 15, 1998, the court entered an order in which it certified a class
action in the matter. The court certified three classes consisting of one
primary class ("Class I") and two subclasses ("Class II" and "Class III").
Class I consists of all people who were residents of Cedars at any time from
September 21, 1993 through February 20, 1998, and is asserting tortious
interference, fraud and negligence per se claims. Class II is comprised of
those members of Class I who were private pay residents and therefore were
individually parties to a contract with Cedars and only asserts the breach of
contract claim. Class III consists of those members of Class I who were either
Medicaid or Medicare residents at Cedars and seeks to recover for breach of the
Medicare or Medicaid provider agreements to which they assert they were third
party beneficiaries.
Although the Cedars plaintiffs agreed to limit the class damages to
restitution and emotional distress, the court has only certified the Classes
with respect to the issue of liability and the various Classes' rights to
restitution. The court determined that emotional distress damages are of such
an individualized and personal nature that the class-wide request for emotional
distress damages was not appropriate for class treatment. Therefore, the class
action will proceed only for purposes of proving liability under the claims and
any corresponding rights to restitution. Upon a finding of liability, if any,
emotional distress damages for any Class member other than the Class
representatives, will be determined in separate trials.
At a status conference on May 7, 1998, the court set the matter for trial for
six weeks commencing January 4, 1999. At the time of this conference,
plaintiff's counsel orally dismissed her promissory estoppel claims on behalf of
the named plaintiffs. The Company intends to vigorously contest the remaining
alleged claims and the certification of the various Classes.
NOTE 11. SUBSEQUENT EVENTS
As previously reported, the Company entered into a definitive merger agreement
on April 13, 1998 with Mariner Health Group, Inc. ("Mariner"). Under the terms
of the agreement, Mariner shareholders will receive one share of Paragon common
stock for each Mariner share held. Each company has also been granted an option
to acquire 19.9% of the other company's common stock under certain events. The
merger is anticipated to close during the third calendar quarter of 1998.
On May 1, 1998 the Company completed the acquisition of Professional
Rehabilitation, Inc. and certain affiliated entities for $27.4 million in cash
and $22.6 million in common stock of the Company (1,147,225 shares). South
Carolina-based Professional Rehabilitation, Inc. provides contract physical,
occupational, and speech therapy primarily to skilled nursing facilities in
South Carolina, North Carolina, Georgia, Tennessee, and Alabama. The
transaction will be recorded using the purchase method of accounting.
16
<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
($259.1 million or 70.7% in the second quarter of fiscal 1998 and $483.9 million
or 71.8% year-to-date in fiscal 1998) and ancillary services ($107.1 million or
29.3% in the second quarter of fiscal 1998 and $189.6 million or 28.2% year-to-
date in 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 0.8% over the prior year period for both the three
and six months ended March 31, 1998, which included a 0.3% improvement for both
periods as a result of the GranCare Merger.
<TABLE>
<CAPTION>
Three Months Six Months
Ended March 31, Ended March 31,
--------------------------- ---------------------------
1998 1997 1998 1997
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Weighted average licensed bed count 37,526 23,098 34,987 23,211
Weighted average number of residents 31,343 19,093 29,323 19,270
Weighted average occupancy 83.5% 82.7% 83.8% 83.0%
</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,
Veteran's Administration contractual payments, and payments for services
provided under contract management programs.
17
<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 reduce payments under governmental or third-party payor programs, the
Company would be adversely affected. Revenues derived from the Company's non-
nursing home groups are also influenced by payor mix. The table below presents
the approximate percentage of the Company's net revenues derived from the
various sources of payment for the periods indicated:
<TABLE>
<CAPTION>
Three Months Six Months
Ended March 31, Ended March 31,
--------------------------- ---------------------------
1998 1997 1998 1997
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Private 27.9% 33.4% 28.3% 33.7%
Medicare 33.9% 26.2% 33.1% 25.3%
Medicaid 38.2% 40.4% 38.6% 41.0%
</TABLE>
The percentage of net revenues derived from private pay sources declined in
the three and six months ended March 31, 1998 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 net revenues derived
from private pay and Medicare sources increased to 59.3% for the six months
ended March 31, 1998 from 59.0% for the six months ended March 31, 1997, which
was primarily attributable to the growth in the Company's non-nursing home
operations and an increase in Medicare residents. The net 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 net 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 fixed per diem rate. See Capital Resources and Liquidity-Changes
in Healthcare Legislation.
SECOND QUARTER OF FISCAL 1998 COMPARED TO SECOND QUARTER OF FISCAL 1997. Net
revenues comprising nursing home and non-nursing home operations totaled $487.2
million for the quarter ended March 31, 1998, an increase of $201.9 million or
70.7 %, as compared to the same period for fiscal 1997. Nursing home operations
contributed $179.6 million of the increase, which included the acquisition of
GranCare effective November 1, 1997 of $173.2 million, and at the former LCA
facilities, rate increases of $4.6 million, higher ancillary service billings
resulting from the improvement in mix, primarily Medicare, of $4.1 million, and
a $1.6 million reduction due to divested facilities. Non-nursing home operations
contributed $22.3 million of the increase, consisting of an increase of $6.6
million for pharmacy services, a decrease of $6.5 million for therapy services,
and an increase of $22.2 million from home health, hospital services, and other.
Home health, hospital services and other revenue increased by $21.7 million as a
result of the GranCare acquisition.
Pre-tax recapitalization, indirect merger and other expenses primarily related
to the Apollo/LCA/GranCare Mergers totaled $13.6 million for the three months
ended March 31, 1998.
Costs and expenses, excluding recapitalization, indirect merger, and other
expenses, totaled $450.9 million for the quarter ended March 31, 1998, an
increase of $191.5 million or 73.8%, as compared to the same period for fiscal
1997. The acquisition of GranCare contributed $185.5 million to the increase in
costs. Excluding GranCare, ancillary costs increased by $4.6 million as a result
of the increase in ancillary service billings in the nursing home operations and
higher pharmaceutical costs related to the increase in pharmacy services
revenue. Excluding GranCare, bad debt expense decreased by $0.7 million
primarily due to a $2.5 million reduction for therapy operations which was
partially offset by bad debt expense in the prior year period being reduced by
$1.1 million as a result of the collection of a note receivable that was
substantially reserved. The reduction in bad debt expense at therapy operations
over the prior year period was a result of a reduction in average days
outstanding.
Interest expense totaled $30.4 million for the quarter ended March 31, 1998,
an increase of $24.9 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 March 31, 1998, the provision for income taxes was
affected by the recapitalization and indirect merger costs that are not
deductible for income tax purposes as well as non-deductible amortization of
goodwill associated with the Mergers. Excluding the effect of these non-
deductible items, the effective income tax rate for the three months ended March
31, 1998 was approximately 45.3% compared to 42.5% for the same period in 1997.
The higher effective income tax rate reflected the amortization of non-
deductible goodwill associated with the GranCare Merger and the lower pre-tax
book income.
18
<PAGE>
FISCAL 1998 YEAR TO DATE COMPARED TO FISCAL 1997 YEAR TO DATE. Net revenues
comprising nursing home and non-nursing home operations totaled $908.8 million
for the six months ended March 31, 1998, an increase of $343.2 million or 60.7%,
as compared to the same period for fiscal 1997. Nursing home operations
contributed $302.8 million of the increase, which included the acquisition of
GranCare effective November 1, 1997 of $288.9 million, and at the former LCA
facilities, rate increases of $11.7 million, higher ancillary service billings
resulting from the improvement in mix, primarily Medicare, of $8.0 million, a
$2.0 million reduction due to a lower average number of residents, and a $4.3
million reduction due to divested facilities. Non-nursing home operations
contributed $40.4 million of the increase, consisting of an increase of $11.6
million for pharmacy services, a decrease of $13.3 million for therapy services,
and an increase of $42.1 million from home health, hospital services, and other.
Home health, hospital services and other revenue increased by $36.9 million as a
result of the GranCare acquisition and $5.2 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 $54.6 million for the six months
ended March 31, 1998.
Costs and expenses excluding recapitalization, indirect merger, and other
expenses totaled $845.4 million for the six months ended March 31, 1998, an
increase of $327.4 million or 63.2%, as compared to the same period for fiscal
1997. The acquisition of GranCare contributed $309.3 million to the increase in
costs. Excluding GranCare, ancillary and general and administrative costs
increased $7.5 and $5.5 million, respectively. The increase in ancillary costs
is the result of higher ancillary service billings in the nursing home
operations and higher pharmaceutical costs related to the increase in pharmacy
services revenue. Excluding GranCare, bad debt expense increased by $1.8 million
primarily due to bad debt expense in the prior year period being reduced by $1.1
million as a result of the collection of a note receivable that was
substantially reserved.
Interest expense totaled $52.0 million for the six months ended March 31,
1998, an increase of $41.4 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 six months ended March 31, 1998, 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 six months ended March
31, 1998 was approximately 47.2% compared to 41.9% for the same period in 1997.
The effective income tax rate reflected the continuation of previously existing
non-deductible items and the lower pre-tax book income.
For the six months ended March 31, 1998, 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.
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IMPACT OF YEAR 2000 ISSUE
The Company completed an assessment of issues related to the Year 2000 and
determined that certain programs would need to be modified or replaced in order
for its financial and human resource information systems to function properly
with respect to dates in the year 2000 and after. The Company determined that
it would replace these systems with new systems that have a total estimated cost
of approximately $8.0 million, primarily for new hardware and software that will
be capitalized. Through March 31, 1998, the Company has capitalized
approximately $3.1 million related to these replacement systems. This project
is expected to be fully implemented by June 1999 which is prior to any
anticipated date-related impact on its operating systems. However, if such
replacement systems are not completed in a timely manner, the Year 2000 Issue
could have a material impact on the operations of the Company.
In addition to its financial and human resource systems, the Company has
developed an inventory of critical computer systems and is in the process of
developing and implementing solutions for those systems that are found to have
date-related problems. The Company does not expect the resolution of the Year
2000 Issue to have a material impact on the Company's business or financial
condition. However, the Company could be adversely impacted by the Year 2000
Issue if its key suppliers and third parties, including governmental agencies
and other third party payors, do not address the issue successfully.
CAPITAL RESOURCES AND LIQUIDITY
Cash and cash equivalents were $19.5 million at March 31, 1998, and working
capital was $278.8 million, an increase of $176.7 million during the six months
ended March 31, 1998 which included an increase of $133.7 million as a result of
the GranCare Merger. Cash used in operations was $56.8 million which included
approximately $54.6 million in payments for recapitalization, indirect merger
and other expenses. The Company expects to incur additional recapitalization,
indirect merger and other expenses during the remainder of fiscal 1998.
Excluding the acquisition of accrued expenses in the GranCare Merger, accrued
expenses and other current liabilities increased by $2.0 million. Excluding the
acquisition of accounts payable in the GranCare Merger, accounts payable
decreased by $28.7 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 acquisition of accounts receivable in the GranCare Merger,
accounts receivable increased by $42.2 million for the six months ended March
31, 1998. The increase in receivables was primarily attributable to the timing
of collections on Medicare cost reports and rate adjustments ($14.9 million),
revenue increases ($15.6 million) and an increase in average days outstanding
($6.4 million). The increase in receivables related to the timing of collection
on Medicare cost reports and rate adjustments is related to fiscal intermediary
delays in responding to requests for interim rate increases and the Company
continuing to file Medicare routine cost limit exception requests. Review by the
fiscal intermediary, approval by the Health Care Financing Administration, and
processing for payment by the intermediaries of a filed routine cost limit
exception request generally takes 12 to 18 months. Management is continuing to
monitor trends in the Company's accounts receivable and is reviewing the
Company's collection procedures.
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. Additionally, the federal government recently announced that, in order
to stay within Medicare's 1998 budget and performance requirements, it will
reduce the frequency of payment of Medicare claims. 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 March 31, 1998, approximately 52% of the former
GranCare facilities had been converted to LCA's field-based accounts receivable
system.
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Cash used in investing activities was $40.4 million in the six months ended
March 31, 1998, as compared to $52.4 million for the same period in fiscal 1997.
Investing activities for the six months ended March 31, 1998 included $3.4
million to purchase a previously leased facility and $7.4 million related to
various pharmacy acquisitions. 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 six months ended March 31, 1998 included $21.9
million for routine capital expenditures. Capital expenditures are expected to
be funded by cash from operations or the Revolving Credit Facility.
Financing activities provided $102.3 million during the six months ended March
31, 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 $30.2 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 61/2 year term loan facility in an aggregate principal amount of
$240 million (the "Tranche A Term Loan Facility"); a 71/2 year term loan
facility in an aggregate principal amount of $250 million (the "Tranche B Term
Loan Facility"); an 81/2 year term loan facility in an aggregate principal
amount of $250 million (the "Tranche C Term Loan Facility"); and a 61/2 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. As of March 31, 1998, there was $5.5 million borrowed under the Revolving
Credit Facility in addition to approximately $13.7 million letter of credit
issuances.
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. The Company is currently seeking, and expects to receive, a
waiver of certain covenants in the Senior Credit Facility with respect to the
announced merger between the Company and Mariner Health Group, Inc. (see
"Merger").
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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.
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").
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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 upon completion
of a like-kind exchange transaction whereby the Tenant Entities will exchange
(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. The Company anticipates that the Exchange Transaction
will be completed by June 1998. 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.
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 March 31, 1998.
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.
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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 July 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 slowing the growth of payments under these
programs by $115 billion and $13 billion, respectively, over the next five
years. Approximately 50% of the savings will be achieved through a reduction
in the growth of payments to providers and physicians.
The Balanced Budget Act amended the Medicare program by revising the payment
system for skilled nursing services. Currently, nursing homes are reimbursed by
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 fixed per diem rate
for each of their patients which, during the first three years, will be based on
a blend of facility specific rates 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.
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 payment system continues per visit limits and
establishes new per beneficiary annual cost limits. A permanent prospective
payment system for home health services will be established by October 1, 1999.
On May 5, 1998, the Health Care Financing Administration released the nursing
home PPS rates that will be in effect from July 1, 1998 through September 30,
1999. 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), PPS will also provide
opportunities 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.
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On January 30, 1998, the Health Care Financing Administration issued its new
salary equivalency guidelines which change Medicare reimbursement rates for
contracted therapy services. Under salary equivalency, the Company is
reimbursed for contracted therapy services based on the time spent on the
premises by the contract therapist 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 previously received. 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 March 31, 1998 approximately $40.4 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.
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 $130.8 million was available after considering $13.7 million
in outstanding letters of credit and the $5.5 million borrowed at March 31,
1998. 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.
MERGER
As previously reported, the Company entered into a definitive merger agreement
on April 13, 1998 with Mariner Health Group, Inc. ("Mariner"). Under the terms
of the agreement, Mariner shareholders will receive one share of Paragon common
stock for each Mariner share held. Each company has also been granted an option
to acquire 19.9% of the other company's common stock under certain events. The
merger is anticipated to close during the third calendar quarter of 1998.
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CAUTIONARY STATEMENTS
Information provided herein by the Company contains, and from time to time the
Company may disseminate materials and make statements which may contain
"forward-looking" information, as that term is defined by the Private Securities
Litigation Reform Act of 1995 (the "Act"). In particular, "Management's
Discussion and Analysis of Financial Condition and Results of Operation Capital
Resources and Liquidity" contains information concerning the ability of the
Company to service its debt obligations and other financial commitments as they
come due and the effect of changes in healthcare legislation and regulation. The
aforementioned forward looking statements, as well as other forward looking
statements made herein, are qualified in their entirety by these cautionary
statements, which are being made pursuant to the provisions of the Act and with
the intention of obtaining the benefits of the "safe harbor" provisions of the
Act.
The Company cautions investors that any forward-looking statements made by the
Company are not guarantees of future performance and that actual results may
differ materially from those in the forward-looking statements as a result of
various factors, including, but not limited to, the following:
(i) In recent years, an increasing number of legislative proposals have
been introduced, proposed, and in some cases adopted, by Congress and
in some state legislatures which would effect major changes in the
healthcare system. However, the Company cannot predict the form of
future healthcare reform legislation which may be proposed or adopted
by Congress or by state legislatures. Accordingly, the Company is
unable to assess the effect of any such legislation on its business.
There can be no assurance that any such legislation will not have a
material adverse impact on the future growth, revenues and net income
of the Company.
(ii) The Company derives substantial portions of its revenues from third-
party payors, including government reimbursement programs such as
Medicare and Medicaid, and some portions of its revenues from non-
governmental sources, such as commercial insurance companies, health
maintenance organizations and other charge-based contracted payment
sources. Both government and non government payors have undertaken
cost-containment measures designed to limit payments to healthcare
providers, such as PPS. There can be no assurance that payments under
governmental and non-governmental payor programs will be sufficient
to cover the costs allocable to patients eligible for reimbursement.
The Company cannot predict whether or what proposals or cost-
containment measures will be adopted or, if adopted and implemented,
what effect, if any, such proposals might have on the operations of
the Company. As stated above, the Company is currently evaluating the
effect of the recently announced PPS rates on its business.
(iii) The Company is subject to extensive federal, state and local
regulations governing licensure, conduct of operations at existing
facilities, construction of new facilities, purchase or lease of
existing facilities, addition of new services, certain capital
expenditures, cost-containment and reimbursement for services
rendered. The failure to obtain or renew required regulatory
approvals or licenses, the delicensing of facilities owned, leased or
operated by the Company or the disqualification of the Company from
participation in certain federal and state reimbursement programs
could have a material adverse effect upon the operations of the
Company.
(iv) There can be no assurance that the Company will be able to continue
its substantial growth or be able to fully implement its business
strategies for its post-acute care, pharmaceutical services,
rehabilitation services, or hospital services divisions or that
management will be able to successfully integrate the operations of
GranCare and LCA.
26
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
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)
27
