<PAGE>
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q/A-2
/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: 1-12040
SUN HEALTHCARE GROUP, INC.
(Exact name of Registrant as specified in its charter)
Delaware 85-0410612
(State of Incorporation) (I.R.S. Employer Identification No.)
101 Sun Avenue, NE
Albuquerque, New Mexico 87109
(505) 821-3355
(Address and telephone number of Registrant)
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 twelve 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 ninety days.
Yes X No
------- --------
As of May 6, 1998, there were 49,607,942 shares of the Registrant's $.01
par value Common Stock outstanding, net of treasury shares.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE>
SUN HEALTHCARE GROUP, INC.
INDEX
FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 1998
- --------------------------------------------------------------------------------
PART I. FINANCIAL INFORMATION
<TABLE>
<CAPTION>
Page Numbers
<C> <S> <C>
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets
March 31, 1998 and December 31, 1997 3-4
Consolidated Statement of Earnings
For the three months ended March 31, 1998 and 1997 5
Consolidated Statements of Comprehensive Income
For the three months ended March 31, 1998 and 1997 6
Consolidated Statements of Cash Flows
For the three months ended March 31, 1998 and 1997 7-8
Notes to the Consolidated Financial Statements 9-16
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 17-33
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 34
Item 6. Exhibits and Reports on Form 8-K 34
Signatures 35
</TABLE>
<PAGE>
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
<TABLE>
<CAPTION>
As of March 31, As of December 31,
-------------- ------------------
ASSETS 1998 1997
-------------- ------------------
(In thousands, except share data)
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 1,113 $ 21,020
Accounts receivable, net of allowance for doubtful accounts
of $36,620 and $34,433 as of March 31, 1998 and 601,120 523,161
December 31, 1997, respectively
Other receivables 53,710 33,550
Prepaids and other assets 50,941 38,440
Deferred tax assets 8,621 16,546
-------------- ------------------
Total current assets 715,505 632,717
-------------- ------------------
Property and equipment, net 654,971 631,102
Goodwill, net 1,035,181 1,030,893
Notes receivable 97,919 91,062
Other assets 179,692 171,898
Deferred tax assets 4,718 21,564
-------------- ------------------
Total assets $2,687,986 $2,579,236
-------------- ------------------
-------------- ------------------
</TABLE>
(Continued on next page)
3
<PAGE>
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (CONTINUED)
(UNAUDITED)
<TABLE>
<CAPTION>
As of March 31, As of December 31,
--------------- ------------------
LIABILITIES AND STOCKHOLDERS' EQUITY 1998 1997
--------------- ------------------
(In thousands, except share data)
<S> <C> <C>
Current liabilities:
Current portion of long-term debt $ 54,013 $ 56,817
Current portion of obligations under capital leases 2,260 2,054
Accounts payable 59,389 61,873
Accrued compensation and benefits 101,148 78,960
Accrued interest 14,306 20,451
Accrued self-insurance obligations 35,907 34,354
Other accrued liabilities 74,597 71,183
Income taxes payable -- --
--------------- ------------------
Total current liabilities 341,620 325,692
--------------- ------------------
Long-term debt, net of current portion 1,558,343 1,488,861
Obligations under capital leases, net of current portion 80,022 79,110
Other long-term liabilities 41,915 42,428
Deferred tax liabilities 9,963 9,807
--------------- ------------------
Total liabilities 2,031,863 1,945,898
--------------- ------------------
Minority interest 16,573 16,285
Commitments and contingencies -- --
Stockholders' equity:
Preferred stock of $.01 par value, authorized 5,000,000 shares,
none issued -- --
Common stock of $.01 par value, authorized 100,000,000 shares,
51,716,655 and 51,697,914 shares issued and outstanding
as of March 31, 1998 and December 31, 1997, respectively 517 517
Additional paid-in capital 638,324 639,637
Retained earnings 75,501 57,114
Accumulated other comprehensive income 5,391 1,766
--------------- ------------------
719,733 699,034
--------------- ------------------
Less:
Unearned compensation 12,952 14,203
Common stock held in treasury, at cost, 2,122,701 and
2,053,207 shares as of March 31, 1998 and December 31,
1997, respectively 26,931 25,574
Grantor stock trust, at market, 2,163,747 and 2,178,315
shares as of March 31, 1998 and December 31, 1997,
respectively 40,300 42,204
--------------- ------------------
Total stockholders' equity 639,550 617,053
--------------- ------------------
Total liabilities and stockholders' equity $2,687,986 $2,579,236
--------------- ------------------
--------------- ------------------
</TABLE>
The accompanying notes are an integral part of these consolidated
balance sheets.
4
<PAGE>
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS
(UNAUDITED)
<TABLE>
<CAPTION>
For the Three Months Ended March 31,
------------------------------------
1998 1997
-------- --------
(In thousands, except per share data)
<S> <C> <C>
Total net revenues $741,490 $398,636
-------- --------
Costs and expenses:
Operating 608,585 327,903
Corporate general and administrative 39,301 18,447
Provision for losses on accounts receivable 6,013 3,194
Depreciation and amortization 20,474 11,641
Interest, net 35,140 11,324
-------- --------
Total costs and expenses 709,513 372,509
-------- --------
Earnings before income taxes 31,977 26,127
Income taxes 13,590 10,190
-------- --------
Net earnings $ 18,387 $ 15,937
-------- --------
-------- --------
Net earnings per common and common equivalent share:
Net earnings:
Basic $ 0.39 $ 0.35
-------- --------
-------- --------
Diluted $ 0.37 $ 0.33
-------- --------
-------- --------
Weighted average number of common and common equivalent
shares outstanding:
Basic 46,905 46,119
-------- --------
-------- --------
Diluted 52,381 51,352
-------- --------
-------- --------
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
5
<PAGE>
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(UNAUDITED)
<TABLE>
<CAPTION>
For the Three Months Ended March 31,
1998 1997
------- -------
(In thousands)
<S> <C> <C>
Net earnings $18,387 $15,937
Foreign currency translation
adjustments, net of tax 3,625 ($3,291)
------- -------
Comprehensive income $18,387 $15,937
------- -------
------- -------
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
6
<PAGE>
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
For the Three Months Ended March 31,
------------------------------------
1998 1997
-------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES: (In thousands)
<S> <C> <C>
Net earnings $ 18,387 $ 15,937
Adjustments to reconcile net earnings to net cash
provided by (used for) operating activities -
Depreciation and amortization 20,474 11,641
Provision for losses on accounts receivable 6,013 3,194
Other, net 2,086 (272)
Changes in operating assets and liabilities:
Accounts receivable (85,499) (25,105)
Other current assets (21,638) 6,730
Other current liabilities 12,252 18,924
Income taxes payable 12,175 9,988
-------- ---------
Net cash provided by (used for) operating activities (35,750) 41,037
-------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures, net (24,829) (13,113)
Acquisitions, net of cash acquired (7,339) (166,832)
Proceeds from sale and leaseback of property and equipment -- 32,138
Increase in long-term note receivables (6,857) (17,197)
Other assets expenditures (9,909) (11,678)
-------- ---------
Net cash used for investing activities (48,934) (176,682)
-------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Long-term debt borrowings 88,318 148,420
Long-term debt repayments (22,070) (1,630)
Net proceeds from issuance of common stock 543 342
Purchases of treasury stock (1,357) -
Financing fees paid (255) (120)
-------- ---------
Net cash provided by financing activities 65,179 147,012
-------- ---------
Effect of exchange rate on cash and cash equivalents (402) (1,381)
-------- ---------
Net increase (decrease) in cash and cash equivalents (19,907) 9,986
Cash and cash equivalents at beginning of year 21,020 14,880
-------- ---------
Cash and cash equivalents at end of period $ 1,113 $ 24,866
-------- ---------
-------- ---------
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
7
<PAGE>
SUN HEALTHCARE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended March 31,
----------------------------
1998 1997
---- ----
(In Thousands)
<S> <C> <C>
Supplemental disclosure of cash flow information:
Cash paid during period for:
Interest net of $573 and $535 capitalized during the three months
ended March 31, 1998 and 1997, respectively $43,897 $ 13,492
------- ---------
------- ---------
Income taxes $505 $202
------- ---------
------- ---------
Supplementary schedule of non-cash investing and financing activities:
The Company's acquisitions during the three months ended March 31,
1998 and 1997, involved the following:
Fair value of assets acquired $ 7,438 $ 253,572
Liabilities assumed (99) (105,742)
Cash payments made to former APTA shareholders -- 19,192
Fair value of stock and warrants issued -- (190)
------- ---------
Cash payments made, net of cash received from others $ 7,339 $ 166,832
------- ---------
------- ---------
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
8
<PAGE>
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
In the opinion of management of Sun Healthcare Group, Inc. (the
"Company" or "Sun"), the accompanying interim consolidated financial
statements present fairly the Company's financial position at March 31, 1998
and December 31, 1997, the consolidated results of its operations for the
three month periods ended March 31, 1998 and 1997, and the consolidated
statements of cash flows for the three month periods ended March 31, 1998 and
1997. All adjustments are of a normal and recurring nature. These
statements are presented in accordance with the rules and regulations of the
United States Securities and Exchange Commission ("SEC"). Accordingly, they
are unaudited, and certain information and footnote disclosures normally
included in the Company's annual consolidated financial statements have been
condensed or omitted, as permitted under the applicable rules and
regulations. Readers of these statements should refer to the Company's
audited consolidated financial statements and notes thereto for the year
ended December 31, 1997, which are included in the Company's Annual Report on
Form 10-K as amended on Form 10-K/A for the year ended December 31, 1997.
The results of operations presented in the accompanying financial statements
are not necessarily representative of operations for an entire year.
Certain amounts in the 1997 consolidated financial statements and notes
have been reclassified to conform to the 1998 presentation.
ADOPTION OF NEW ACCOUNTING PRONOUNCEMENT
In the first quarter of 1998, the Company adopted Statement of Financial
Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income."
Comprehensive income is defined as the change in equity of a business during
a period from transactions and other events and circumstances from non-owner
sources. Under SFAS 130, the term "comprehensive income" is used to describe
the total of net earnings plus other comprehensive income which, for the
Company, includes foreign currency translation adjustments.
The adoption of SFAS 130 did not impact the calculations of net earnings
or earnings per share, nor did it impact reported assets, liabilities or
total stockholders' equity. It did impact the presentation of stockholders'
equity within the balance sheet and will result in the presentation of
comprehensive income within the annual financial statements, which must be
displayed with the same prominence as other financial statements. Within the
annual financial statements, the Company will report comprehensive income in
the statement of stockholders' equity.
9
<PAGE>
2. ACQUISITIONS
The Company agreed in February 1997 to acquire Retirement Care
Associates, Inc. ("Retirement Care"), an operator of skilled nursing
facilities and assisted living centers in seven states in the southeastern
United States. Retirement Care also owns (and the Company would acquire)
approximately 65% of Contour Medical, Inc. ("Contour"), a national provider
of medical/surgical supplies. The amended terms of the RCA Merger provide for
a purchase price of approximately $144.7 million in Sun Common Stock (based
upon the closing price of Sun Common Stock as of May 11, 1998), approximately
$2.8 million of Sun Preferred Stock and the assumption of approximately
$173.1 million of indebtedness, excluding approximately $19.8 million of
indebtedness which will be eliminated in consolidation (based on Retirement
Care's December 31, 1997 balance sheet). Specifically, the agreement, as
amended, calls for the Company to issue shares of Sun Common Stock having a
value equal to $10.00 in exchange for each outstanding share of Retirement
Care's common stock (subject to a 10% collar centered on a $22.00 share price
for Sun Common Stock). The Company expects that the RCA Merger will be
accounted for as a pooling of interests. The Company has also agreed to
acquire the remaining 35% of Contour not presently owned by Retirement Care
for approximately $35 million, payable in Sun Common Stock or cash, at the
option of the Company. The Contour Merger will be accounted for as a
purchase. While there can be no assurance that either the RCA Merger or the
Contour Merger will be consummated, these mergers are expected to close
during the second quarter of 1998.
Costs to be incurred in connection with the mergers of Retirement Care
and Contour are expected to be significant and will be charged against
earnings of the combined company. The charge is currently estimated to be
approximately $30 million for transaction costs and integration expenses,
including elimination of redundant corporate functions, severance costs
related to headcount reductions, the write-off of certain intangibles and
property and equipment and the settlement of certain class action lawsuits
(described below). Approximately $25 million of these estimated charges are
expected to be charged to operations in the fiscal quarter in which the RCA
Merger is consummated. Approximately $5 million of the estimated charges
relating to the integration expenses are expected to be expensed as incurred
as these costs will benefit future combined operations. These amounts are
preliminary estimates only and are, therefore, subject to change. In
addition, there can be no assurance that the Company will not incur
additional charges in subsequent quarters to reflect costs associated with
the RCA Merger and the Contour Merger. As of March 31, 1998, the Company has
incurred approximately $2.6 million in transaction costs (as described above).
On January 10, 1997, the Company loaned Retirement Care $9.8 million in
order to enable Retirement Care to cause the repayment of certain
indebtedness incurred by Contour in connection with Contour's acquisition of
Atlantic Medical Supply Company, Inc. ("Atlantic") on August 6, 1996. On July
10, 1997, the Company and Retirement Care amended the terms of the loan to:
(i) increase the applicable interest rate by 2.0%; (ii) extend the maturity
date to 120 days after the termination of the agreement; and (iii) replace
the collateral securing the loan with a second lien on all of Retirement
Care's accounts receivable. Consistent with Retirement Care's bank line of
credit, the loan is unconditionally and irrevocably guaranteed by certain
officers of Retirement Care. On July 10, 1997, the Company also agreed to
loan Retirement Care an additional $5.0 million which is also secured by a
second lien on all of Retirement Care's accounts receivable and is
unconditionally and irrevocably guaranteed by certain officers
10
<PAGE>
of Retirement Care. The interest receivable related to the promissory notes
was $1.3 million and $1.0 million as of March 31, 1998 and December 31, 1997,
respectively. In addition, Retirement Care owed the Company an additional
$22.9 million and $12.4 million in the form of unsecured trade receivables in
respect to ancillary and management services provided by the Company as of
March 31, 1998 and December 31, 1997, respectively.
On November 25, 1997, the Company, Retirement Care and representatives
of the plaintiffs in certain pending class actions against Retirement Care
and its management reached an agreement in principle to settle these class
actions for $9.0 million. In connection with the agreement in principle, the
Company has escrowed on behalf of the defendants the settlement amount into
an escrow fund which is included in other long-term assets as of March 31,
1998. The settlement is contingent upon the closing of the RCA Merger and is
subject to, among other things, confirmatory discovery, the execution of
definitive documentation and court approval.
In October 1997, the Company acquired the capital stock of Regency
Health Services, Inc. ("Regency"), an operator of skilled nursing facilities
and a provider of related specialty healthcare services, including
rehabilitation therapy, pharmacy and home health services in the United
States. Total consideration for the shares acquired was approximately $367.2
million. The total fair value of Regency's assets acquired, including
goodwill of approximately $412.2 million, was approximately $736.6 million,
and liabilities assumed totaled approximately $354.7 million. Recorded
purchase liabilities included approximately $11.2 million for severance and
related costs and $2.0 million for costs associated with the shut down of
certain acquired pharmacies and home health service agencies that will be
consolidated with the Company's existing facilities. At March 31, 1998,
liabilities for approximately $2.5 million in severance costs and $2.0
million for facility related costs remained on the balance sheet. The
Company expects to complete its termination of pharmacy, home health service
agency and corporate employees and consolidation of pharmacies and home
health service agencies by mid-1998.
The acquisition of Regency was accounted for as a purchase and the
operating results of Regency have been included in the consolidated
statements of earnings from the date of acquisition. The following unaudited
proforma results for the three months ended March 31, 1997 assume that the
acquisition occurred as of January 1, 1997 (in thousands, except for share
data):
<TABLE>
<CAPTION>
<S> <C>
Net revenues $558,083
Net earnings 12,323
Net earnings per share:
Basic $ 0.27
Diluted 0.26
</TABLE>
In addition, during the three months ended March 31, 1998, the Company
acquired from various third parties the net ownership of, leasehold rights to
or the management contracts of 15 long-term care facilities in the United
Kingdom. Also during the three months ended March 31, 1998, the Company
acquired four pharmacies in the United States. The pro forma impact of these
acquisitions is immaterial.
3. COMMITMENTS
11
<PAGE>
(A) CONSTRUCTION COMMITMENTS
As of March 31, 1998, the Company had capital commitments of
approximately $22.7 million, including a corporate office building and a
long-term care facility, and various contracts related to improvements to
existing facilities in the United States, and capital commitments of
approximately L0.6 million ($1.0 million as of March 31, 1998).
(B) FINANCING COMMITMENTS
The Company has advanced $41.4 million and has agreed to advance up to a
total of $47.0 million under a revolving subordinated credit agreement
("Financing Facility") to a developer of assisted living facilities for the
development, construction and operation of assisted living facilities. Any
advances under the Financing Facility have been and are expected to be funded
by borrowings under the Company's Senior Credit Facility and will be subject
to certain conditions, including the approval of each project by the Company.
The developer has obtained a commitment for mortgage financing to fund 50%
of the cost of each project. The Company's advances under the Financing
Facility are subordinate to the mortgage financing. The Financing Facility
with respect to each facility bears interest at 9% or 13% depending on the
percentage of completion of the facility under construction. All amounts
advanced are due in full on November 1, 2001. The advances to the developer
totaled $41.4 million and $32.8 million at March 31, 1998 and December 31,
1997, respectively. As of March 31, 1998, four assisted living facilities
were under development. Construction was completed on two facilities during
the three months ended March 31, 1998. In addition, the Company has entered
into a purchase option agreement with the developer whereby the Company will
pay the developer $50,000 for each option to purchase any of the facilities.
The option will grant the Company the right to purchase the facilities, after
a specified time period, at the greater of the estimated fair market value of
the property or the total amount invested by the developer.
4. NET EARNINGS PER SHARE
Basic net earnings is based upon the weighted average number of common
shares outstanding during the period.
Diluted net earnings per share in periods of earnings is based upon the
weighted average number of common shares outstanding during the period plus
the number of incremental shares of common stock contingently issuable upon
exercise of stock options and, if dilutive, including the assumption that the
Company's convertible debentures were converted as of the beginning of the
period. Net earnings, if conversion of the debentures is assumed, is
adjusted for the interest on the debentures, net of interest related to
additional assumed borrowings to fund the cash consideration on conversion of
certain convertible debentures and the related income tax benefits.
Earnings per share is calculated as follows for the three months ended
March 31, (in thousands, except per share data):
<TABLE>
<CAPTION>
1998 1997
---- ----
<S> <C> <C>
BASIC:
Net earnings $18,387 $15,937
</TABLE>
12
<PAGE>
<TABLE>
<CAPTION>
1998 1997
---- ----
<S> <C> <C>
Weighted average shares outstanding 46,905 46,119
Earnings per share:
Net earnings $ 0.39 $ 0.35
------- -------
------- -------
DILUTED:
Net earnings used in basic calculation $18,387 $15,937
Income impact of assumed conversion 811 855
------- -------
Adjusted net earnings $19,198 $16,792
------- -------
------- -------
Weighted average shares used in basic calculation 46,905 46,119
Effect of dilutive securities:
Stock options and warrants 831 520
Assumed conversion of convertible debt 4,645 4,713
------- -------
Weighted average common and common equivalent
shares outstanding 52,381 51,352
------- -------
------- -------
Earnings per share:
Net earnings $ 0.37 $ 0.33
------- -------
------- -------
</TABLE>
On May 4, 1998, the Company issued $345 million of 7% convertible trust
issued preferred securities. These securities are convertible into the
Company's common stock at a conversion rate of 1.2419 shares of Sun Common
Stock for each convertible trust issued preferred security (equivalent to an
initial conversion price of $20.13 per share of Sun Common Stock).
5. OTHER EVENTS
(a) GOVERNMENT INVESTIGATION
In January 1995, the Company learned that it was the subject of a
pending Federal investigation. The investigating agencies are the United
States Department of Health and Human Services' Office of the Inspector
General ("OIG") and the United States Department of Justice. At this time,
the Company does not know the full scope of the investigation. However, the
Company currently believes that the investigation is focused principally on
whether the Company provided and billed for unnecessary or unordered therapy
services to residents of skilled nursing facilities and whether the Company
adequately documented the therapy services which it provided.
In July 1997, the Criminal Division of the U.S. Department of Justice
informed the Company that it had completed its investigation of the Company,
and that it would not initiate any actions against the Company or any
individuals. The investigation by the Civil Division of the Department of
Justice and the OIG is still proceeding. The government continues to collect
information, and the Company continues to cooperate with the investigators.
The Company and the government have had preliminary discussions, and the
Company expects to have continuing discussions, regarding a possible
settlement of the investigation.
13
<PAGE>
The Company is unable to determine at this time when the investigation
will be concluded, how large a monetary settlement the government may seek,
the nature of any other remedies that may be sought by the government,
whether or when a settlement will in fact occur or whether any such
settlement or any other outcome of the investigation will have a material
adverse effect on the Company's financial condition or results of operations.
From time to time the negative publicity surrounding the investigation has in
the past adversely affected the private pay enrollment in certain inpatient
facilities and slowed the Company's success in obtaining additional outside
contracts in the rehabilitation therapy business, which resulted in higher
than required therapist staffing levels. Negative publicity in the future
could have a similar effect.
(b) LITIGATION
On or about January 23, 1996, two former stockholders of SunCare, John
Brennan and Susan Bird, filed a lawsuit (the "SunCare Litigation") against
the Company and certain of its officers and directors in the United States
District Court for the Southern District of Indiana. Plaintiffs allege, among
other things, that the Company did not disclose material facts concerning the
investigation by the OIG and that the Company's financial results were
misstated. The complaints purport to state claims, INTER ALIA, under Federal
and state securities laws and for breach of contract, including a breach of a
registration rights agreement pursuant to which the Company agreed to
register the shares of the Company's common stock issued to such former
stockholders of SunCare in the acquisition. On May 21, 1998, the Company and
the plaintiffs reached an agreement in principle to settle the action for
$7.4 million. The settlement is subject to the execution of definitive
documentation. The settlement of $7.4 million will be recorded by the Company
as a pretax charge during the second quarter of 1998.
On September 8, 1995, a derivative action was filed by Brickell Partners
against certain of the Company's current and former directors and officers in
the United States District Court for the District of New Mexico, captioned
BRICKELL PARTNERS V. TURNER, ET AL. The complaint was not served on any
defendant. On June 19, 1996, an amended complaint alleging breach of
fiduciary duty by certain of the Company's current and former directors and
officers was filed and subsequently served on the defendants. On August 5,
1996, the District Court dismissed this action without prejudice for failure
to serve the defendants within the required time period. The plaintiffs filed
a new complaint, alleging the same claims, on August 19, 1996. In December
1997, the Company and the plaintiffs reached an agreement in principle to
settle the action for an immaterial amount. The settlement is subject to
definitive documentation and court approval.
(c) OTHER INQUIRIES
From time to time, fiscal intermediaries and Medicaid agencies examine
cost reports filed by predecessor operators. The Company is currently the
subject of several such examinations. If, as a result of any such
examination, it is concluded that overpayments to a predecessor operator were
made, the Company, as the current operator of such facilities, may be held
financially responsible for such overpayments. At this time, the Company is
unable to predict the outcome of any existing or future examinations.
14
<PAGE>
The Company was notified in 1997 by a law firm representing several
national insurance companies that these companies believed that the Company
had engaged in improper billing and other practices in connection with the
Company's delivery of therapy and related services. In response, the Company
began discussions directly with these insurers and hopes to resolve these
matters without litigation; however, the Company is unable at this time to
predict whether it will be able to do so, what the eventual outcome may be or
the extent of its liability, if any, to these insurers.
6. SUMMARIZED FINANCIAL INFORMATION
The Company acquired The Mediplex Group, Inc. ("Mediplex") on June 23,
1994 and became a co-obligor with Mediplex with respect to the 6 1/2%
Convertible Subordinated Debentures and the 11 3/4% Senior Subordinated Notes
subsequent to the acquisition. Summarized financial information of Mediplex
is provided below (in thousands):
<TABLE>
<CAPTION>
AS OF AS OF
MARCH 31, DECEMBER 31,
1998 1997
--------- ------------
<S> <C> <C>
Current assets $112,764 $108,232
Noncurrent assets 388,869 391,048
Current liabilities 27,386 26,016
Noncurrent liabilities 71,716 72,373
Due to parent 175,825 165,207
</TABLE>
<TABLE>
<CAPTION>
FOR THE
THREE MONTHS ENDED
MARCH 31,
------------------
1998 1997
---- ----
<S> <C> <C>
Net revenues $144,631 $121,359
Costs and expenses 136,106 116,128
-------- --------
Earnings before intercompany
charges and income taxes 8,525 5,231
Intercompany charges (1) 24,265 16,355
-------- --------
Earnings (loss) before income
taxes (15,740) (11,124)
Income taxes (benefit) (6,763) (4,407)
-------- --------
Net earnings (loss) $ (8,977) $ (6,717)
-------- --------
-------- --------
</TABLE>
- -----------------
(1) Through various intercompany agreements entered into by Sun and
Mediplex, Sun provides management services, licenses the use of its
trademarks and acts on behalf of Mediplex to make financing available for its
operations. Sun charged Mediplex for management services totaling $11.4
million and $7.6 million for the three months ended March 31, 1998 and 1997,
respectively. Royalty fees charged to
15
<PAGE>
Mediplex for the three months ended March 31, 1998 and 1997 for the use of
Sun trademarks were $2.6 million and $1.7 million, respectively. Intercompany
interest charged to Mediplex for the three months ended March 31, 1998 and
1997 for advances from Sun was $10.2 million and $7.0 million, respectively.
7. SUBSEQUENT EVENTS
On May 4, 1998, the Company issued $345 million of 7% convertible trust
issued preferred securities and $125 million of 9 3/8% Senior Subordinated
Notes due 2008 (yield of 9.425%) (collectively, the "Offerings"). Each
convertible preferred security is convertible into shares of Common Stock,
par value $0.01 per share, of Sun, at an equivalent rate of 1.2419 shares of
Sun common stock for each convertible preferred security (equivalent to an
initial conversion price of $20.13 per share of Sun Common Stock). $300
million of the net proceeds from the Offerings were used by the Company to
permanently repay certain outstanding borrowings under the term loan portion
of the Senior Credit Facility and the remainder of the net proceeds from the
Offerings were used to reduce certain outstanding borrowings under the
revolving credit portion of the Senior Credit Facility (which amounts may be
subsequently reborrowed).
On May 5, 1998 the Company entered into certain interest rate
transactions with an aggregate notional value of $850 million to minimize the
risks and/or costs associated with certain long-term debt of the Company. The
Company does not otherwise utilize financial instruments for trading or other
speculative purposes. The counterparty to these contractual arrangements is a
major international financial institution with which the Company has other
financial relationships. The Company will be exposed to credit loss in the
event of non-performance by the counterparty. However, the Company does not
anticipate non-performance.
The interest rate swap transactions have been designated as hedges for
accounting purposes. The Company will continue to evaluate this designation
on a periodic basis. The amounts to be paid or received are accrued and are
recognized as an adjustment to interest expense.
Under the interest rate swap transactions, the Company will be a
variable rate payor, effectively converting $550 million of fixed rate debt
and $300 million of variable rate Senior Credit Facility debt, which is based
on U.S. LIBOR, into variable rate debt based on an index of foreign interest
rates. The index of foreign interest rates is based on an equally weighted
average of the LIBOR rates of Germany and Switzerland and the Bank Bill rate
of Australia except that on May 1, 2001 the LIBOR of the United Kingdom will
replace the LIBOR of Switzerland with respect to the $300 million swap having
a maturity date of May 2008. All payments will be denominated in U.S.
dollars. Each interest rate swap includes cap protection limiting the
Company's exposure to interest rate fluctuations. The following summarizes
the terms of the various interest rate swap transactions at May 5, 1998:
<TABLE>
<CAPTION>
NOTIONAL MATURITY INTEREST RATE MAXIMUM INTEREST
AMOUNT DATE RECEIVE PAY(1) RATE PAID
-------- -------- ------- -------- --------------------
<S> <C> <C> <C> <C>
$300,000,000 5/2003 5.69%(2) 5.53% 7.0%
$300,000,000 5/2008 7.00%(3) 6.35% 7.0% (5/1998-5/2001)
8.5% (5/2001-5/2008)
$250,000,000 7/2002 9.50%(3) 8.95% 9.5% (5/1998-4/2000)
10.5% (4/2000-7/2002)
</TABLE>
(1) An index of foreign short term rates, reset quarterly (see above
description).
(2) U.S. LIBOR, reset quarterly.
(3) Fixed.
16
<PAGE>
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
The Company, through its direct and indirect subsidiaries (hereinafter
collectively referred to as the "Company"), is a provider of long-term,
subacute and related specialty healthcare services, including rehabilitation
and respiratory therapy services and pharmaceutical services. Long-term care
and subacute care services and outpatient therapy services are provided
through affiliated facilities. Therapy services and pharmaceutical services
are provided by the Company in both affiliated and nonaffiliated facilities
located in the United States. The Company also provides long-term care
services in the United Kingdom, Spain and Germany and acute care services in
Australia and pharmaceutical services in the United Kingdom, Germany and
Spain.
The Company's earnings growth has historically resulted from the
acquisition of long-term and subacute care facilities, use of its long-term
and subacute care operations as a base for expansion of its ancillary
services, provision of ancillary services to nonaffiliated facilities and
expansion of ancillary services through acquisitions. Under the current
Medicare reimbursement system, ancillary services, such as rehabilitation and
respiratory therapy services and pharmaceutical services, have significantly
higher operating margins than the margins associated with the provision of
routine services to patients at long-term and subacute care facilities and
accordingly have provided more than half of the Company's operating profits.
The higher operating margins from the provision of ancillary services are
primarily attributable to more favorable reimbursement rates. In addition, a
substantial portion of the Company's consolidated interest expense was
attributable to the Company's long-term and sub-acute services and its
foreign operations due to the capital intensive nature of these businesses
and to related acquisitions. The Company believes that when Medicare
implements the Prospective Payment System ("PPS") for long-term and subacute
care services it may be better able than some of its competitors to respond
to the new PPS environment because it provides more types of ancillary
services in-house and to nonaffiliated facilities than many of its
competitors. There can be no assurance that the Company will be able to
maintain its margins or that its margins will not decrease and that PPS will
not have a material adverse effect on the Company's financial condition or
results of operations. See "-- Effects from Changes in Reimbursement."
The Company's results of operations for the three months ended March 31,
1998 and 1997 reflect the acquisition of facilities, the growth of the
Company's existing facility operations, the expansion of the Company's
therapy service operations and temporary therapy staffing services, and the
growth of the Company's pharmaceutical service operations.
In October 1997, the Company acquired Regency, an operator of skilled
nursing facilities and a diversified provider of rehabilitation therapy,
pharmacy and home health services. At the date of acquisition, Regency
operated 111 long-term care facilities (including one managed facility) in
the United States and provided rehabilitation therapy and pharmacy services
to both affiliated and nonaffiliated facilities.
In February 1997, the Company agreed to acquire Retirement Care, an
operator of approximately 106 skilled nursing facilities and assisted living
centers, in seven states in the southeastern United States.
17
<PAGE>
Retirement Care also owns (and Sun would acquire) approximately 65% of
Contour, a national provider of medical/surgical supplies. The amended terms
of the RCA Merger provide for a purchase price of approximately $144.7
million in Sun Common Stock (based upon the closing price of Sun Common Stock
as of May 11, 1998), approximately $2.8 million of Sun Preferred Stock and
the assumption of approximately $173.1 million of indebtedness, excluding
approximately $19.8 million of long-term indebtedness which will be
eliminated in consolidation (based on Retirement Care's December 31, 1997
balance sheet.) The acquisition of Retirement Care is expected to be
accounted for as a pooling of interests and the acquisition of the minority
interest of Contour is expected to be accounted for as a purchase. While
there can be no assurance that either the RCA Merger or the Contour Merger
will be consummated, these mergers are expected to close during the second
quarter of 1998.
At March 31, 1998, the Company operated 318 facilities with 36,488
licensed beds in the United States, 177 facilities with 11,132 licensed beds
in the United Kingdom, eight facilities with 1,328 licensed beds in Spain, 11
facilities with 934 licensed beds in Germany and six facilities with 353
licensed beds in Australia. During the three months ended March 31, 1998,
the Company acquired one facility with 134 licensed beds in the United States
and 12 facilities with 616 licensed beds in the United Kingdom. Also, during
the three months ended March 31, 1998, the Company developed and opened one
facility in the United Kingdom with a total of 64 licensed beds.
At December 31, 1997, the Company operated 321 facilities with 36,655
licensed beds in the United States and 137 facilities with 7,837 licensed
beds in the United Kingdom, 8 facilities with 1,328 licensed beds in Spain,
11 facilities with 930 licensed beds in Germany and 6 facilities with 353
licensed beds in Australia. In addition to Regency and Ashbourne, during
1997, the Company acquired 54 facilities in the United States and 9
facilities in the United Kingdom, resulting in a total increase of 6,399 and
476 licensed beds in the United States and United Kingdom, respectively.
Also, in 1997 the Company developed and opened one facility in the United
States and 9 facilities in the United Kingdom with a total of 154 and 604
licensed beds in the United States and United Kingdom, respectively. The
Company also acquired 38% of the equity of Alpha, an operator of ten acute
care facilities in Australia.
The Company's therapy service operations include the provision of
physical, occupational and speech therapy, the provision of respiratory care,
the provision of additional ancillary healthcare services, such as dentistry,
and the distribution of related equipment and supplies. As of March 31, 1998,
the Company provided its therapy services to 1,389 nonaffiliated facilities,
an increase of 131 facilities from the 1,258 nonaffiliated facilities
serviced at March 31, 1997.
The Company's temporary therapy service operations which provide
temporary therapists, had 29 and 27 division offices at March 31, 1998 and
December 31, 1997, respectively. During the three months ended March 31,
1998, the Company provided a total of 672,000 temporary therapy staffing
hours to nonaffiliates, an increase of 1,000 hours from the 671,000
nonaffiliated temporary therapy staffing hours provided during the three
months ended March 31, 1997.
The Company's pharmaceutical service operations include the provision of
pharmaceuticals, the distribution of related supplies and home care. As of
March 31, 1998, the Company operated 38 regional pharmacies, four in-house
long-term care pharmacies, 14 home health service agencies, and a
pharmaceutical billing and consulting center.
The Company's foreign operations, in addition to the nursing home
facilities in the United Kingdom, Spain and Germany and acute care facilities
in Australia, include the provision of pharmaceutical services in the United
Kingdom, Germany and Spain and outpatient therapy services in Canada. During
1997, the Company announced its intention to sell and divest itself of its
outpatient therapy service
18
<PAGE>
operations in Canada, as well as in the United States. As of March 31, 1998,
the Company operated 19 pharmacies and one supply distribution center in the
United Kingdom and one pharmacy in Spain.
The following table sets forth certain operating data for the Company as
of the dates indicated:
<TABLE>
<CAPTION>
MARCH 31, DECEMBER 31, 1997
--------- -----------------
1998 1997
---- ----
<S> <C> <C> <C>
Long-term and Subacute Care Facility Operations:
Long-term and subacute care facilities
(including managed facilities):
Domestic operations 318 173 321
Foreign operations 177 131 162
----- ----- -----
Total 495 304 483
----- ----- -----
----- ----- -----
Licensed beds (including managed facilities):
Domestic operations 36,488 20,707 36,655
Foreign operations 11,132 7,531 10,448
----- ----- -----
Total 47,620 28,238 47,103
----- ----- -----
----- ----- -----
Therapy Service Operations:
Nonaffiliated facilities served 1,389 789 1,278
Affiliated facilities served 287 163 287
----- ----- -----
Total 1,676 952 1,565
----- ----- -----
----- ----- -----
Temporary Therapy Staffing Service Operations:
Hours billed to nonaffiliates (in thousands)
Three months ended March 31 672 671 --
Twelve months ended December 31 -- -- 2,817
Pharmaceutical Operations:
Nonaffiliated facilities served 576 364 546
Affiliated facilities served 264 118 255
----- ----- -----
Total 840 482 801
----- ----- -----
----- ----- -----
</TABLE>
RESULTS OF OPERATIONS
The following table sets forth the amount and percentages of certain
elements of total net revenues for the periods presented (dollars in
thousands):
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
---------
1998 1997
---- ----
<S> <C> <C> <C> <C>
Long-term and subacute
care services $480,008 65% $239,289 60%
</TABLE>
19
<PAGE>
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
---------
1998 1997
---- ----
<S> <C> <C> <C> <C>
Therapy services to
nonaffiliates 102,042 13 65,424 16
Foreign operations 66,306 9 37,773 10
Temporary therapy staffing
services to nonaffiliates 35,526 5 32,945 8
Pharmaceutical services to
nonaffiliates 52,842 7 20,721 5
Management fees and other 4,766 1 2,484 1
-------- --- -------- ---
Total net revenues $741,490 100% $398,636 100%
-------- --- -------- ---
-------- --- -------- ---
</TABLE>
Revenues for long-term and subacute care services include revenues
billed to patients for therapy and pharmaceutical services provided by the
Company's affiliated operations. Revenues for therapy services provided to
domestic affiliated facilities were $79.5 million and $34.0 million for the
three months ended March 31, 1998 and 1997, respectively. Revenues provided
to domestic affiliated facilities for pharmaceutical services were $15.2
million and $6.0 million for the three months ended March 31, 1998 and 1997,
respectively.
The following table presents the percentage of total net revenues
represented by certain items for the Company for the periods presented:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
---------
1998 1997
---- ----
<S> <C> <C>
Total net revenues 100.0% 100.0%
----- -----
Costs and expenses:
Operating 82.1 82.3
Corporate general and administrative 5.3 4.6
Provision for losses on accounts receivable 0.8 0.8
Depreciation and amortization 2.8 2.9
Interest, net 4.7 2.8
----- -----
Total costs and expenses 95.7 93.4
----- -----
Earnings before income taxes 4.3 6.6
Income taxes 1.8 2.6
----- -----
Net earnings 2.5% 4.0%
----- -----
----- -----
</TABLE>
THREE MONTHS ENDED MARCH 31, 1998 COMPARED TO THREE MONTHS ENDED MARCH 31, 1997
Total net revenues for the three months ended March 31, 1998 increased
86% from approximately $398.6 million for the three months ended March 31,
1997 to approximately $741.5 million.
20
<PAGE>
Net revenues from long-term and subacute care services, which includes
revenues generated from therapy and pharmaceutical services provided at the
Company's facilities, increased from $239.3 million for the three months
ended March 31, 1997 to approximately $480.0 million for the three months
ended March 31, 1998, a 101% increase. Approximately $137.4 million or 57%
of this increase results from the 110 leased or owned facilities acquired
from Regency in October 1997 and approximately $78.8 million or 33% of this
increase resulted from an additional 67 leased or owned facilities acquired
or opened since December 31, 1996. The acquisition of Regency occurred in
October 1997 and net revenues include the results of operations since the
date of acquisition. The remaining net revenues increase of $29.6 million,
after giving effect to a decrease in net revenues of approximately $5.1
million relating to four facilities sold during 1997 and six facilities sold
during 1998, is primarily attributable to an increase in revenue per patient
day on a same facility basis for the 141 leased or owned facilities in
operation for all of 1997 and 1998. The increase in revenue per patient day
was a result of payor rate increases and the expansion of the Company's
subacute services.
Net revenues from therapy services to nonaffiliated facilities increased
56% from $65.4 million for the three months ended March 31, 1997 to $102.0
million for the three months ended March 31, 1998, primarily as a result of
an increase in the number of nonaffiliated facilities served from 789
facilities at March 31, 1997 to 1,389 facilities at March 31, 1998. This
increase includes 72 nonaffiliated facilities and approximately $9.3 million
in net revenues from therapy services provided to Retirement Care facilities
during the three months ended March 31, 1998.
Net revenues from foreign operations increased 75% from $37.8 million
for the three months ended March 31, 1997 to $66.3 million for the three
months ended March 31, 1998. Approximately $12.8 million or 45% of this
increase was the result of increased net revenues from the nursing home
operations in the United Kingdom. The increase relating to the nursing home
operations in the United Kingdom was primarily the result of the Company's
acquisition of Ashbourne on January 30, 1997 which added approximately $6.4
million or 50% of the increase in net revenues from the nursing home
operations in the United Kingdom during the three months ended March 31,
1998. Approximately $13.2 million or 46% of this total increase is the
result of the Company's acquisitions of nursing homes in Germany, Australia
and Spain during 1997. Approximately $3.9 million or 14% of the total
increase was the result of increased net revenues from the pharmacy
operations which was primarily the result of 13 pharmacies and a supply
distribution center acquired or opened since December 31, 1996 in the United
Kingdom.
Net revenues from pharmaceutical services to nonaffiliated facilities
increased 155% from $20.7 million for the three months ended March 31, 1997
to $52.8 million for the three months ended March 31, 1998. Approximately
$21.6 million or 85% of the increase in net revenues was the result of the
addition of 10 pharmacies and 14 home health agencies acquired from Regency.
In addition, the remaining net revenues increase was primarily the result of
the increase in nonaffiliated facilities served as a result of additional
acquisitions during 1997.
Operating expenses, which includes rent expense of $55.2 million and
$27.6 million for the three months ended March 31, 1998 and 1997,
respectively, increased 86% from approximately $327.9 million
21
<PAGE>
for the three months ended March 31, 1997 to approximately $608.6 million for
the three months ended March 31, 1998. The increase resulted primarily from
the net increase of 257 leased or owned facilities during various times
during the year ended December 31, 1997 and 12 leased or owned facilities
during the three months ended March 31, 1998 and the growth in therapy and
pharmaceutical services. Operating expenses as a percentage of net revenues
decreased from 82.3% for the three months ended March 31, 1997 to 82.1% for
the three months ended March 31, 1998. The decrease in operating expenses as
a percentage of net revenues was primarily due to the acquisition of
Ashbourne on January 30, 1997 whose facility leases are primarily capital
leases and therefore include interest and depreciation expense instead of
rent expense. The decrease is offset by lower operating margins in the United
Kingdom as occupancy rates in the United Kingdom have been negatively
impacted by an excess number of available beds in the United Kingdom. In
addition, since December 31, 1996, the Company has opened 21 long-term care
facilities in the United Kingdom which has also negatively impacted occupancy
as well as operating margins.
Corporate general and administrative expenses, which include regional
costs related to the supervision of operations, increased 114% from $18.4
million for the three months ended March 31, 1997 to $39.3 million for the
three months ended March 31, 1998. As a percentage of net revenues, corporate
general and administrative expenses increased from 4.6% for the three months
ended March 31, 1997 to 5.3% for the three months ended March 31, 1998. The
increase was primarily due to an increase in costs relating to the expansion
of the Company's corporate infrastructure to support newly acquired domestic
operations including the acquisition of Regency and the pending merger with
Retirement Care, and implementation of new business strategies.
The provision for losses on accounts receivable increased 88% from $3.2
million for the three months ended March 31, 1997 to $6.0 million for the
three months ended March 31, 1998. As a percentage of net revenues, provision
for losses on accounts receivable remained relatively constant at 0.8% for
the three months ended March 31, 1997 and 1998.
Depreciation and amortization increased 77% from $11.6 million for the
three months ended March 31, 1997 to $20.5 million for the three months ended
March 31, 1998. As a percentage of net revenues, depreciation and
amortization expense remained relatively constant at 2.9% for the three
months ended March 31, 1997 as compared to 2.8% for the three months ended
March 31, 1998.
Net interest expense increased 211% from $11.3 million for the three
months ended March 31, 1997 to $35.1 million for the three months ended March
31, 1998. As a percentage of net revenues, interest expense increased from
2.8% for the three months ended March 31, 1997 to 4.7% for the three months
ended March 31, 1998. The increase was related to (i) an increase in the
Company's weighted average interest rate resulting from the Company's
issuance of $250 million of 9 1/2% Notes in July 1997, (ii) higher interest
rates and borrowing costs under the Company's Senior Credit Facility as
compared to the old credit facility that was retired in October 1997 and
(iii) an increase in borrowings including under the Company's Senior Credit
Facility associated with various acquisitions during 1997 and 1998 including
Regency and Ashbourne and various acquisitions in Spain, Germany and
Australia. The increase was also due to interest expense related to capital
leases assumed by the Company as part of the Company's acquisition of
Ashbourne.
The Company's effective tax rate was 42.5% for the three months ended
March 31, 1998 and was 39.0% for the three months ended March 31, 1997. The
increase in the effective tax rate was primarily due
22
<PAGE>
to a less favorable mix of state income in the United States and the
increased amount of nondeductible goodwill amortization expense resulting
primarily from the acquisition of Regency.
Net earnings increased 16% from $15.9 million for the three months ended
March 31, 1997 to $18.4 million for the three months ended March 31, 1998.
As a percentage of net revenues, net earnings before income taxes decreased
from 6.6% for the three months ended March 31, 1997 to 4.3% for the three
months ended March 31, 1998. The margin decrease was primarily due to
increased borrowings and borrowing costs, increased corporate and general
administrative expenses and the increased costs and lower margins from the
Company's nursing home operations in the United Kingdom (discussed above).
LIQUIDITY AND CAPITAL RESOURCES
At March 31, 1998, the Company had working capital of $373.9 million,
including cash and cash equivalents of $1.1 million, as compared to working
capital of $307.0 million, including cash and cash equivalents of $21.0
million at December 31, 1997. For the three months ended March 31, 1998, net
cash used for operations was $35.8 million compared to net cash used for
operations for the three months ended March 31, 1997 of $41.0 million. The
net cash used for operations for the three months ended March 31, 1998
reflects an increase in the net cash used to fund an increase in accounts
receivable. This was offset by the Company's growth in net earnings and
timing of payment of certain obligations of the Company.
The Company's accounts receivable have increased since December 31,
1997. Accounts receivable increased in part because of the growth in the
Company's inpatient, therapy and pharmaceutical services businesses since
December 31, 1997. The growth in accounts receivable is also attributable to
the fact that when long-term care facilities are acquired by the Company, the
fiscal intermediaries are changed to the Company's fiscal intermediary
resulting in temporary delays in timing of third-party payments. The Company
is currently in the process of changing fiscal intermediaries related to
facilities acquired from Regency and other acquisitions which occurred during
the latter half of 1997. This process has resulted in temporary delays in
receiving reimbursement from third-party payors.
Accounts receivable for therapy services have also increased in part
because the ability of nonaffiliated facilities to provide timely payments
has been impacted by their receipt of payments from fiscal intermediaries
which, in some instances, have been delayed due to the fiscal intermediaries
conducting reviews of facilities' therapy claims.
Other significant operating uses of cash for the three months ended
March 31, 1998 were payments of $44.5 million for interest and net payments
totaling $0.5 million for income taxes.
The Company incurred approximately $24.8 million in capital expenditures
during the three months ended March 31, 1998. Substantially all such
expenditures during the three months ended March 31, 1998 related to the
Company's long-term and subacute care facility operations and were for the
continued development and construction of one facility in the United States,
two new facilities in the United Kingdom, and routine capital expenditures.
These routine capital expenditures include expenditures to refurbish existing
and recently acquired facilities. These capital expenditures were financed
through borrowings under the Company's Senior Credit Facility. The Company
had capital expenditure commitments, as of March 31, 1998, under various
contracts, including approximately $22.7 million in the United States and
L0.6 million ($1.0 million as of March 31, 1998) in the United Kingdom. These
include contractual commitments to
23
<PAGE>
improve existing facilities and to develop, construct and complete a
corporate office building and a long-term care facility in the United States.
The Company paid approximately a net of $7.3 million in cash for
acquisitions during the three months ended March 31, 1998. These
acquisitions were funded by borrowings under the Company's Senior Credit
Facility.
In total, during the three months ended March 31, 1998, the Company
acquired a total net ownership of, the leasehold rights to, or the management
of 15 long-term care facilities in the United Kingdom. The Company also
acquired or opened a total net four pharmacies in the United States and a
supply distribution center in Germany.
The Company agreed in February 1997 to acquire Retirement Care, an
operator of skilled nursing facilities and assisted living centers in seven
states in the southeastern United States. Retirement Care also owns (and the
Company would acquire) approximately 65% of Contour, a national provider of
medical/surgical supplies. The amended terms of the RCA Merger provide for a
purchase price of approximately $144.7 million in Sun Common Stock (based
upon the closing price of Sun Common Stock as of May 11, 1998), approximately
$2.8 million of Sun Preferred Stock and the assumption of approximately
$173.1 million of indebtedness, excluding approximately $19.8 million of
indebtedness which will be eliminated in consolidation (based on Retirement
Care's December 31, 1997 balance sheet). Specifically, the agreement, as
amended, calls for the Company to issue shares of Sun Common Stock having a
value equal to $10.00 in exchange for each outstanding share of Retirement
Care's common stock (subject to a 10% collar centered on a $22.00 share price
for Sun Common Stock). The Company expects that the RCA Merger will be
accounted for as a pooling of interests. The Company has also agreed to
acquire the remaining 35% of Contour not presently owned by Retirement Care
for approximately $35 million, payable in Sun Common Stock or cash, at the
option of the Company. The Contour Merger will be accounted for as a
purchase. While there can be no assurance that either the RCA Merger or the
Contour Merger will be consummated, these mergers are expected to close during
the second quarter of 1998.
Based upon a review of Retirement Care's, Contour's and the Company's
publicly available historical financial statements, the RCA and Contour
Mergers would have had a dilutive impact on the Company's reported earnings
per share for the twelve months ended December 31, 1997. There can be no
assurance that the future combined results will not continue to be dilutive.
Costs to be incurred in connection with the mergers of Retirement Care
and Contour are expected to be significant and will be charged against
earnings of the combined company. The charge is currently estimated to be
approximately $30 million for transaction costs and integration expenses,
including elimination of redundant corporate functions, severance costs
related to headcount reductions, the write-off of certain intangibles and
property and equipment and the settlement of certain class action lawsuits
(described below). Approximately $25 million of these estimated charges are
expected to be charged to operations in the fiscal quarter in which the RCA
Merger is consummated. Approximately $5 million of the estimated charges
relating to the integration expenses are expected to be expensed as incurred
as these costs will benefit future combined operations. These amounts are
preliminary estimates only and are, therefore, subject to change. In
addition, there can be no assurance that the Company will not incur
additional charges in subsequent quarters to reflect costs associated with
the RCA Merger and the Contour Merger. As of March 31, 1998, the Company has
incurred approximately $2.6 million in transaction costs (as described above).
On January 10, 1997, the Company loaned Retirement Care $9.8 million in
order to enable Retirement Care to cause the repayment of certain
indebtedness incurred by Contour in connection with
24
<PAGE>
Contour's acquisition of Atlantic Medical Supply Company, Inc. ("Atlantic")
on August 6, 1996. On July 10, 1997, the Company and Retirement Care amended
the terms of the loan to: (i) increase the applicable interest rate by 2.0%;
(ii) extend the maturity date to 120 days after the termination of the
agreement; and (iii) replace the collateral securing the loan with a second
lien on all of Retirement Care's accounts receivable. Consistent with
Retirement Care's bank line of credit, the loan is unconditionally and
irrevocably guaranteed by certain officers of Retirement Care. On July 10,
1997, the Company also agreed to loan Retirement Care an additional $5.0
million which is also secured by a second lien on all of Retirement Care's
accounts receivable and is unconditionally and irrevocably guaranteed by
certain officers of Retirement Care. The interest receivable related to the
promissory notes was $1.3 million and $1.0 million as of March 31, 1998 and
December 31, 1997, respectively. In addition, Retirement Care owed the
Company an additional $22.9 million and $12.4 million in the form of
unsecured trade receivables in respect to ancillary and management services
provided by the Company as of March 31, 1998 and December 31, 1997,
respectively.
On November 25, 1997, the Company, Retirement Care and representatives
of the plaintiffs in certain pending class actions against Retirement Care
and its management reached an agreement in principle to settle these class
actions for $9.0 million. In connection with the agreement in principle, the
Company has escrowed on behalf of the defendants the settlement amount into
an escrow fund which is included in other long-term assets as of March 31,
1998. The settlement is contingent upon the closing of the RCA Merger and is
subject to, among other things, confirmatory discovery, the execution of
definitive documentation and court approval.
The Company conducts business outside of the United States, in the
United Kingdom, Spain, Australia, Germany and Canada. The foreign operations
accounted for 9% and 10% of the Company's total net revenues during the three
months ended March 31, 1998 and 1997, respectively, and 24% of the Company's
consolidated total assets as of March 31, 1998. The Company's financial
condition and results of operations are subject to foreign exchange risk.
Because of the Company's foreign growth strategies, the Company does not
expect to repatriate funds invested overseas and, therefore, foreign currency
transaction exposure is not normally hedged. Exceptional planned foreign
currency cash flow requirements, such as acquisitions overseas, are hedged
selectively to prevent fluctuations in the anticipated foreign currency
value. Changes in the net worth of the Company's foreign subsidiaries arising
from currency fluctuations are accumulated in the translation adjustments
component of stockholders' equity.
The Company has advanced $41.4 million and has agreed to advance up to a
total of $47.0 million under a revolving subordinated credit agreement
("Financing Facility") to a developer of assisted living facilities for the
development, construction and operation of assisted living facilities. Any
advances under the Financing Facility have been and are expected to be funded
by borrowings under the Company's Senior Credit Facility and will be subject
to certain conditions, including the approval of each project by the Company.
The developer has obtained a commitment for mortgage financing to fund 50% of
the cost of each project. The Company's advances under the Financing Facility
are subordinate to the mortgage financing. The Financing Facility with
respect to each facility bears interest at 9% or 13% depending on the
percentage of completion of the facility under construction. All amounts
advanced are due in full on November 1, 2001. The advances to the developer
totaled approximately $41.4 million and $32.8 million at March 31, 1998 and
December 31, 1997. As of March 31, 1998, four assisted living facilities were
under development. Construction was completed on two facilities during the
three months ended March 31, 1998. In addition, the Company has entered into
a purchase option agreement with the developer whereby the Company will pay
the developer $50,000 for each option to purchase any
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<PAGE>
of the facilities. The option will grant the Company the right to purchase
any of the facilities, after a specified time period, at the greater of the
estimated fair market value of the property or the total amount invested by
the developer.
At March 31, 1998, the Company had, on a consolidated basis,
approximately $1.7 billion of outstanding indebtedness including capital
lease obligations, including approximately $1.1 billion of indebtedness under
its $1.2 billion Senior Credit Facility. The Company also had $51.0 million
of outstanding standby letters of credit under its Senior Credit Facility as
of March 31, 1998.
On May 4, 1998, the Company issued $345 million of 7% convertible trust
issued preferred securities and $125 million of 9 3/8% Senior Subordinated
Notes due 2008 (yield of 9.425%) (collectively the "Offerings"). Each
convertible preferred security is convertible into shares of common stock,
par value $0.01 per share, of Sun, at an equivalent rate of 1.2419 shares of
Sun common stock for each convertible preferred security (equivalent to an
initial conversion price of $20.13 per share of Sun common stock). $300
million of the net proceeds from the Offerings were used by the Company to
permanently repay certain outstanding borrowings under the term loan portion
of the Senior Credit Facility and the remainder of the net proceeds from the
Offerings were used to reduce certain outstanding borrowings under the
revolving credit portion of the Senior Credit Facility (which amounts may be
subsequently reborrowed).
On May 5, 1998 the Company entered into certain interest rate swap
transactions with an aggregate notional value of $850 million to minimize the
risks and/or costs associated with certain long-term debt of the Company. The
Company does not otherwise utilize financial instruments for trading or other
speculative purposes.
The interest rate swaps have been designated as hedges for accounting
purposes. The Company will continue to evaluate this designation on a
periodic basis. The amounts to be paid or received are accrued and are
recognized as an adjustment to interest expense.
Under the interest rate swap transactions, the Company is a variable
rate payor, effectively converting $550 million of fixed rate debt and $300
million of variable rate Senior Credit Facility debt, which is based on U.S.
LIBOR, into variable rate debt based on an index of foreign interest rates.
The index of foreign interest rates is based on an equally weighted average
of the LIBOR rates of Germany and Switzerland and the Bank Bill rate of
Australia except that on May 1, 2001 the LIBOR of the United Kingdom will
replace the LIBOR of Switzerland with respect to the $300 million swap having
a maturity date of May 2008. All payments are denominated in U.S. dollars.
Each interest rate swap includes cap protection limiting the Company's
exposure to interest rate fluctuations. The following summarizes the terms of
the various interest rate swap transactions at May 5, 1998:
<TABLE>
<CAPTION>
NOTIONAL MATURITY INTEREST RATE MAXIMUM INTEREST
AMOUNT DATE RECEIVE PAY(1) RATE PAID
-------- -------- ------- -------- --------------------
<S> <C> <C> <C> <C>
$300,000,000 5/2003 5.69%(2) 5.53% 7.0%
$300,000,000 5/2008 7.00%(3) 6.35% 7.0% (5/1998-5/2001)
8.5% (5/2001-5/2008)
$250,000,000 7/2002 9.50%(3) 8.95% 9.5% (5/1998-4/2000)
10.5% (4/2000-7/2002)
</TABLE>
(1) An index of foreign short term rates, reset quarterly (see above
description).
(2) U.S. LIBOR, reset quarterly.
(3) Fixed.
The Company's hedging strategy in entering into the interest rate swap
transactions is to obtain the benefit of less costly variable rate debt while
capping its overall exposure to interest rate fluctuations. The Company
believes that an index of foreign interest rates lessens the volatility of
interest rate fluctuations. However, no assurance can be given that such a
strategy will lower the volatility of interest rate fluctuations or reduce
the cost of capital.
The Company's ongoing capital requirements relate to, among other
things, the costs associated with its facilities under construction, routine
capital expenditures, advances under the Financing Facility, potential
acquisitions and implementation of growth strategies.
The Company believes that its current borrowing capacity under its
Senior Credit Facility, the net proceeds from the Offerings and cash from
operations will be sufficient to satisfy its working capital needs, capital
commitments related to its facilities under construction, routine capital
expenditures, advances under the Financing Facility, current debt service
obligations and to fund potential conversions of 6 1/2% Convertible
Debentures. The Company anticipates that it will fund its construction
commitments as well as its requirements relating to future growth through (i)
the available borrowing capacity under its Senior Credit Facility, (ii) the
use of operating leases and debt or equity related securities in the future
as a means of acquiring facilities and new operations, (iii) the availability
of sale and leaseback financing through real estate investment trusts and
other financing sources and (iv) the sale of debt or equity securities in the
public or private capital markets. There can be no assurance that the Company
will seek or obtain additional sources of financing in the next twelve
months. In addition, such additional financing, if any, may be subject to
certain restrictions including mandatory prepayment provisions in the Senior
Credit Facility or otherwise require approval of various lenders under the
Company's Senior Credit Facility. The Company has on file with the Securities
and Exchange Commission a shelf registration statement on Form S-3 which,
among other things, provides for the sale of up to $1.0 billion of securities
which sales are subject to the registration statement being declared
effective by the Securities and Exchange Commission. If such additional
sources of financing are not available, the Company may not be able to pursue
growth opportunities as actively as it has in the past, and may be required
to alter certain of its operating strategies.
EFFECTS FROM CHANGES IN REIMBURSEMENT
The Company derives a substantial percentage of its total revenues from
Medicare, Medicaid and private insurance. The Company's financial condition
and results of operations may be affected by the revenue reimbursement
process, which is complex and can involve lengthy delays between the
recognition of revenue and the time reimbursement amounts are settled. Net
revenues realizable under third-party payor agreements are subject to change
due to examination and retroactive adjustment by payors during the settlement
process. Payors may disallow in whole or in part requests for reimbursement
based on determinations that certain costs are not reimbursable or reasonable
or because additional supporting documentation is necessary. The Company
recognizes revenues from third-party payors and accrues estimated settlement
amounts in the period in which the related services are provided. The Company
estimates these settlement balances by making determinations based on its
prior settlement experience and its understanding of the applicable
reimbursement rules and regulations. The majority of third-party payor
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<PAGE>
balances are settled two to three years following the provision of services.
The Company has experienced differences between the net amounts accrued and
subsequent settlements, which differences are recorded in operations at the
time of settlement. For example, in the fourth quarter of 1997, the Company
recorded negative revenue adjustments totaling approximately $15.0 million
resulting from changes in accounting estimates of amounts realizable from
third-party payors. These changes in accounting estimates primarily arose out
of the settlement in late 1997 of certain facility cost reports for 1994 and
1995 and also include estimated charges for projected settlements in 1996.
Accounts receivable have also increased in part because the ability of
nonaffiliated facilities to provide timely payments has been impacted by
their receipt of payments from fiscal intermediaries which, in some
instances, have been delayed due to the fiscal intermediaries conducting
reviews of facilities' therapy claims.
The Company's financial condition and results of operations would be
materially and adversely affected if the amounts actually received from
third-party payors in any reporting period differed materially from the
amounts accrued in prior periods. The Company's financial condition and
results of operations may also be affected by the timing of reimbursement
payments and rate adjustments from third-party payors. The Company has from
time to time experienced delays in receiving final settlement and
reimbursement from government agencies.
Various cost containment measures adopted by governmental and private
pay sources have begun to restrict the scope and amount of reimbursable
healthcare expenses and limit increases in reimbursement rates for medical
services. Any reductions in reimbursement levels under Medicaid, Medicare or
private payor programs and any changes in applicable government regulations
or interpretations of existing regulations could significantly affect the
Company's profitability. Furthermore, government programs are subject to
statutory and regulatory changes, retroactive rate adjustments,
administrative rulings and government funding restrictions, all of which may
materially affect the rate of payment to the Company's facilities and its
therapy and pharmaceutical businesses. There can be no assurance that
payments under governmental or private payor programs will remain at levels
comparable to present levels or will be adequate to cover the costs of
providing services to patients eligible for assistance under such programs.
Significant decreases in utilization, changes in reimbursement, including
salary equivalency and PPS, could have a material adverse effect on the
Company's financial condition and results of operations, including the
possible impairment of certain assets.
In the Balanced Budget Act of 1997 (the "BBA"), Congress passed numerous
changes to the reimbursement policies applicable to exempt hospital services,
skilled nursing, therapy and other ancillary services. The BBA generally
provides for a phase-in of a prospective payment system for skilled nursing
facilities over a four year period, effective for the Company's facilities on
January 1, 1999. Under PPS, Medicare will pay skilled nursing facilities a
fixed fee per patient day based on the acuity level of the patient to cover
all post-hospital extended care routine service costs (i.e. Medicare Part A
patients), including ancillary and capital related costs for beneficiaries
receiving skilled services. The per diem rate will also cover substantially
all items and services furnished during a covered stay for which
reimbursement is currently made separately under Medicare. Such services are
currently reimbursed on a "pass through" basis. During the phase-in, payments
will be based on a blend of the facility's historical costs and a federally
established per diem rate. Interim final regulations, including the federal
per diem rate, were published on May 12, 1998. It is unclear what impact PPS
will have on the Company. There can be no assurance that PPS will not have a
material adverse effect on the results of operations and financial condition
of the Company.
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<PAGE>
The Company's revenues from its inpatient facilities will be
significantly affected by the size of the federally established per diem
rate. There can be no assurance that the per diem rate will not be less than
the amount the Company's inpatient facilities currently receive for treating
the patients currently in its care. Moreover, since the Company treats a
greater percentage of higher acuity patient than many nursing homes, the
Company may also be adversely impacted if the federal per diem rates for
higher acuity patients does not adequately compensate the Company for the
additional expenses and risks for caring for such patients. As a result,
there can be no assurance that the Company's financial condition and results
of operations will not be materially and adversely affected.
The Company is responding to the implementation of PPS by establishing
SunSolution. SunSolution will offer to provide ancillary services for a fixed
fee to nonaffiliated facilities. There can be no assurance that there will be
a market for the SunSolution products and services or whether a change in the
demand for the Company's services following the imposition of PPS will not
adversely affect the Company's revenues. Even if SunSolution is successful,
no assurance can be given that the costs of providing the contracted for
services will be less than the fixed fee received by the Company for such
services. Given the relative profitability of Sun's ancillary services, there
can be no assurance that the Company's margins and ultimately the Company's
results of operations and financial condition will not be materially and
adversely affected.
In addition, for all Medicare patients not receiving post-hospital
extended care services (i.e., Medicare Part B patients), effective July 1,
1998, reimbursement for ancillary services, including rehabilitation therapy,
medical supplies, pharmacy, temporary staffing for rehabilitation therapy,
and other ancillary services, will be made pursuant to yet-to-be developed
fee schedules. In addition, effective January 1, 1999, there will be an
annual per beneficiary cap of $1,500 on reimbursement for outpatient physical
therapy and speech therapy and an annual per beneficiary cap of $1,500 on
reimbursement for occupational therapy. Facilities will be permitted to bill
patients directly for services rendered in excess of these caps; however,
there can be no assurance that the Company will receive any payments in
excess of these caps. There also can be no assurance that such yet-to-be
developed fee schedules or caps will not have a material adverse effect on
the Company.
The Company's growth strategy relies heavily on the acquisition of
long-term and subacute care facilities. Regardless of the legal form of the
acquisition, the Medicare and Medicaid Programs often require that the
Company assume certain obligations relating to the reimbursement paid to the
former operators of the facilities acquired by the Company. From time to
time, fiscal intermediaries and Medicaid agencies examine cost reports filed
by such predecessor operators. The Company is currently the subject of
several such examinations. If, as a result of any such examinations, it is
concluded that overpayments to a predecessor operator were made, the Company,
as the current operator of such facilities, may be held financially
responsible for such overpayments. At this time the Company is unable to
predict the outcome of any existing or future examinations.
Reimbursement for therapy services is currently evaluated under
Medicare's reasonable cost principles. Under current law, the reasonable
costs for physical therapy and respiratory services may not exceed an amount
equal to the salary that would reasonably have been paid to a therapist for
providing the services (together with certain additional costs) within each
geographical area. Salary equivalency guidelines are the amounts published by
HCFA which reflect the prevailing salary, fringe benefit and expense factors
as determined by HCFA. HCFA then uses the salary equivalency guidelines to
determine the reimbursement rates for physical therapy and respiratory
therapy costs. Although salary equivalency
28
<PAGE>
guidelines will no longer be effective following the implementation of PPS
and fee schedule reimbursement, HCFA has published new salary equivalency
guidelines.
On January 30, 1998, HCFA revised salary equivalency guidelines for
respiratory therapy and physical therapy, and for the first time published
new salary equivalency guidelines for speech therapy and occupational
therapy. HCFA has applied the new salary equivalency guidelines to all
services rendered on or after April 10, 1998. Implementation of these
guidelines has increased reimbursement rates for respiratory therapy and
physical therapy, but reduced reimbursement rates for speech therapy and
occupational therapy. The effect of the changes could have a material adverse
impact on the Company's results of operations. The salary equivalency
guidelines rates will have no continuing impact on reimbursement for therapy
services rendered to a Medicare patient receiving post-hospital extended care
services following the commencement of PPS, because under PPS, therapy
services will be bundled into each facility's per diem reimbursement from
Medicare. In addition, the salary equivalency guidelines will have no
continuing impact on therapy services rendered to all other Medicare patients
after the institution of fee schedule reimbursement for therapy services,
which may be effective as early as July 1, 1998.
Additionally, if the proposed guidelines are adopted, it could have an
adverse effect on the cash flow of the facilities to whom the Company
provides services, thereby potentially adversely affecting the collectibility
of amounts owed to the Company.
In 1995, and periodically since then, HCFA has provided information to
intermediaries for use in determining reasonable costs for occupational and
speech therapy. This information, although not intended to impose limits on
such costs, suggests that fiscal intermediaries should carefully review costs
which appear to be in excess of what a "prudent buyer" would pay for those
services. While the effect of these directives is still uncertain, they are a
factor considered by such intermediaries in evaluating the reasonableness of
amounts paid by providers for the services of the Company's rehabilitation
therapy subsidiary. When salary equivalency guidelines, PPS and fee schedules
are implemented, reimbursement for these services will no longer be on a
"pass through" basis and the HCFA directives and reasonable cost guidelines
discussed in this paragraph will become moot as to services rendered after
their effectiveness. In addition, some intermediaries require facilities to
justify the cost of contract therapists versus employed therapists as an
aspect of the "prudent buyer" analysis. With respect to rehabilitation
therapy services provided to affiliated facilities, a retroactive adjustment
of Medicare reimbursement could be made for some prior periods. With respect
to nonaffiliated facilities, an adjustment of reimbursement rates for therapy
services could result in indemnity claims against the Company, based on the
terms of substantially all of the Company's existing contracts with such
facilities, for payments previously made by such facilities to the Company
that are reduced by Medicare in the audit process. Any change in
reimbursement rates resulting from implementation of the HCFA directives or a
reduction in reimbursement as a result of a change in application of
reasonable cost guidelines could have a material adverse effect on the
Company's financial condition and results of operations (depending on the
rates adopted) and customers' ability to pay for prior and continuing
services. When PPS with respect to Medicare Part A (effective for the
Company's facilities on January 1, 1999) and fee schedules with respect to
Medicare Part B (which may be effective as early as July 1, 1998) are
implemented, the Company's facilities' reimbursement will no longer be
affected by salary equivalency guidelines and the cost reporting settlement
process for services rendered after their effectiveness.
29
<PAGE>
Current Medicare regulations that apply to transactions between related
parties, such as the Company's subsidiaries, are relevant to the amount of
Medicare reimbursement that the Company is entitled to receive for the
rehabilitation and respiratory therapy and pharmaceutical services that it
provides to Company-operated facilities. These related party regulations
require that, among other things, a substantial part of the rehabilitation
and respiratory therapy services or pharmaceutical services, as the case may
be, of the relevant subsidiary be transacted with nonaffiliated entities in
order for the Company to receive reimbursement for services provided to
Company-operated facilities at the rates applicable to services provided to
nonaffiliated entities. The related party regulations do not indicate a
specific level of services that must be provided to nonaffiliated entities in
order to satisfy the "substantial part" requirement of such regulations. In
instances where this issue has been litigated by others, no consistent
standard has emerged as to the appropriate threshold necessary to satisfy the
"substantial part" requirement.
The Company's net revenues from rehabilitation therapy services,
including net revenues from temporary therapy staffing services, provided to
nonaffiliated facilities represented 63%, 70% and 74% of total
rehabilitation and temporary therapy staffing services net revenues for the
three months ended March 31, 1998 and the years ended December 31, 1997 and
1996, respectively. Respiratory therapy services provided to nonaffiliated
facilities represented 56%, 63% and 55% of total respiratory therapy services
net revenues for the three months ended March 31, 1998 and the years ended
December 31, 1997 and 1996, respectively. Net revenues from pharmaceutical
services billed to nonaffiliated facilities represented 78%, 79% and 78% of
total pharmaceutical services revenues for the three months ended March 31,
1998 and the years ended December 31, 1997 and 1996, respectively. The
Company believes that it satisfies the requirements of these regulations
regarding nonaffiliated business. Consequently, it has claimed and received
reimbursement under Medicare for rehabilitation and respiratory therapy and
pharmaceutical services provided to patients in its own facilities at a
higher rate than if it did not satisfy these requirements. If the Company
were deemed to not have satisfied these regulations, the reimbursement that
the Company receives for rehabilitation and respiratory therapy and
pharmaceutical services provided to its own facilities would be significantly
reduced, as a result of which the Company's financial condition and results
of operations would be materially and adversely affected. If, upon audit by
Federal or state reimbursement agencies, such agencies find that these
regulations have not been satisfied, and if, after appeal, such findings are
sustained, the Company could be required to refund some or all of the
difference between its cost of providing these services to any entity found
to be subject to the related party regulations and the higher amount actually
received. While the Company believes that it has satisfied and will continue
to satisfy these regulations, there can be no assurance that its position
would prevail if contested by relevant reimbursement agencies. The foregoing
statements with respect to the Company's ability to satisfy these regulations
are forward looking and could be affected by a number of factors, including
the interpretation of Medicare regulations by Federal or state reimbursement
agencies and the Company's ability to provide services to nonaffiliated
facilities. When the salary equivalency guidelines, PPS and the fee schedules
are implemented, the Medicare impact of the related party rule will be
significantly reduced.
In addition, the OIG recently published a report, based on a limited
review of patient records in six unidentified long-term care facilities in
California, that found that between 4% and 80% of therapy services were
medically unnecessary in such facilities. The OIG announced that it will
conduct a full national study to quantify the extent of medically unnecessary
services and to develop baseline data to compare therapy utilization before
and after the BBA.
REGULATION
The Company's subsidiaries, including those which provide subacute and
long-term care, rehabilitation and respiratory therapy and pharmaceutical
services, are engaged in industries which are extensively regulated. As such,
in the ordinary course of business, the operations of these subsidiaries are
continuously subject to state and Federal regulatory scrutiny, supervision
and control. Such regulatory scrutiny often includes inquiries,
investigations, examinations, audits, site visits and surveys, some of which
may be non-routine. The Company is currently the subject of several such
investigations.
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<PAGE>
In addition to being subject to the direct regulatory oversight of state
and Federal regulatory agencies, these industries are frequently subject to
the regulatory supervision of fiscal intermediaries. Fiscal intermediaries
are agents of HCFA who interpret and implement applicable laws and
regulations and make decisions about the appropriate reimbursement to be paid
under Medicare and Medicaid. The Company's subsidiaries are subject to the
oversight of several different intermediaries. Those different intermediaries
have taken varying interpretations of the applicable laws and regulations.
The lack of uniformity in the interpretation and implementation of such laws
and regulations reflects in part the fact that the statutory standards are
subject to interpretation and the manuals which are published and utilized by
HCFA and the intermediaries in performing their regulatory functions are
often not sufficiently specific to provide clear guidance in the areas which
are the subject of regulatory scrutiny.
It is the policy of the Company to comply with all applicable laws and
regulations, and the Company believes that its subsidiaries are in
substantial compliance with all material laws and regulations which are
applicable to their businesses. However, given the extent to which the
interpretation and implementation of applicable laws and regulations vary and
the lack of clear guidance in many of the areas which are the subject of
regulatory scrutiny, there can be no assurance that the business activities
of the Company's subsidiaries will not from time to time become the subject
of regulatory scrutiny, or that such scrutiny will not result in
interpretations of applicable laws or regulations by government regulators or
intermediaries which differ materially from those taken by the Company's
subsidiaries. In addition, if a provider is ever found to have engaged in
improper practices, it could be subject to civil, administrative or criminal
fines, penalties or restitutionary relief, and reimbursement authorities
could also seek the suspension or exclusion of the provider or individuals
from participation in their programs.
In January 1995, the Company learned that it was the subject of a
pending Federal investigation. The investigating agencies are the OIG and the
United States Department of Justice. At this time, the Company does not know
the full scope of the investigation. However, the Company currently believes
that the investigation is focused principally on whether the Company provided
and billed for unnecessary or unordered therapy services to residents of
skilled nursing facilities and whether the Company adequately documented the
therapy services which it provided.
In July 1997, the Criminal Division of the U.S. Department of Justice
informed the Company that it had completed its investigation of the Company,
and that it would not initiate any actions against the Company or any
individuals. The investigation by the Civil Division of the Department of
Justice and the OIG is still proceeding. The government continues to collect
information, and the Company continues to cooperate with the investigators.
The Company and the government have had preliminary discussions, and the
Company expects to have continuing discussions, regarding a possible
settlement of the investigation.
The Company is unable to determine at this time when the investigation
will be concluded, how large a monetary settlement the government may seek,
the nature of any other remedies that may be sought by the government,
whether or when a settlement will in fact occur or whether any such
settlement or any other outcome of the investigation will have a material
adverse effect on the Company's financial condition or results of operations.
The foregoing statements with respect to the outcome of the investigation are
forward-looking and could be affected by a number of factors, including the
actual scope of the investigation, the government's factual findings and the
interpretation of Federal statutes and regulations by the government and
federal courts and whether any such factual findings could serve as a basis
for proceedings by other governmental authorities. From time to time the
negative publicity surrounding the investigation has in the past adversely
affected the private pay enrollment in certain inpatient facilities and
slowed the Company's success in obtaining additional outside contracts in the
rehabilitation therapy
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<PAGE>
business, which resulted in higher than required therapist staffing levels.
Negative publicity in the future could have a similar effect.
In 1996, the Connecticut Attorney General's office and the Connecticut
Department of Social Services ("DSS") began an investigation and initiated a
hearing in order to determine whether the Company's long-term care subsidiary
submitted false and misleading fiscal information on its 1993 and 1994
Medicaid cost reports. Since 1997, the investigation has also covered
information for the 1995 cost year as well as cost reporting periods prior to
1993. The information under review includes submissions and representations
by the long-term care subsidiary and the Company's chief executive officer.
The evidentiary phase of the hearing has concluded. The Company has submitted
a settlement offer to the DSS in February 1998 and the DSS responded with a
counter-offer in late May 1998. Based on the Company's current understanding
of the investigation and the terms of the DSS counter-offer, the Company does
not believe the terms of a settlement, if any, would have a material adverse
effect on the Company's business, financial condition or results of
operations. However, the Company is unable to determine at this time when the
proceedings will be concluded or, if no settlement is reached, whether the
DSS will seek further administrative action or Medicaid reimbursement
sanctions. No assurance may be given that a settlement will in fact occur or
whether any such settlement or other outcome of the investigation will not
have a material adverse effect on the Company's business, financial condition
or results of operations. The foregoing statement with regard to the outcome
of this investigation is forward looking and could be affected by a number of
factors, including factual findings and the interpretation of applicable laws
and regulations by the Attorney General and the DSS and whether any such
factual findings could serve as a basis for proceedings by other governmental
authorities in Connecticut or elsewhere.
Pursuant to the Health Insurance Portability and Accountability Act of
1996, Congress has provided additional funding to Medicare and Medicaid
enforcement units to investigate potential cases of reimbursement abuse in
the health care services industry. The Act also sets guidelines to encourage
federal, state, and local law enforcement agencies to share general
information and to coordinate specific law enforcement activities including
conducting investigations, audits, evaluations, and inspections relating to
the delivery of and payment for health care. From time to time enforcement
agencies conduct audits, inspections and investigations with respect to the
reimbursement activities of the subsidiaries of the Company. The Company is
currently the subject of several such investigations. It is the Company's
practice to cooperate fully in such matters.
LITIGATION
On or about January 23, 1996, two former stockholders of SunCare, John
Brennan and Susan Bird, filed a lawsuit (the "SunCare Litigation") against
the Company and certain of its officers and directors in the United States
District Court for the Southern District of Indiana. Plaintiffs allege, among
other things, that the Company did not disclose material facts concerning the
investigation by the OIG and that the Company's financial results were
misstated. The complaints purport to state claims, INTER ALIA, under Federal
and state securities laws and for breach of contract, including a breach of a
registration rights agreement pursuant to which the Company agreed to
register the shares of the Company's common stock issued to such former
stockholders of SunCare in the acquisition. On May 21, 1998, the Company and
the plaintiffs reached an agreement in principle to settle the action for
$7.4 million. The settlement is subject to the execution of definitive
documentation.
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The Company believes the SunCare Litigation will not have a material
adverse impact on its financial condition or results of operations, although
the unfavorable resolution of this action in any reporting period could have
a material adverse impact on the Company's results of operations for that
period. The foregoing statements with respect to the possible outcome of the
SunCare Litigation are forward-looking and could be affected by a number of
factors, including judicial interpretations of applicable law, the
uncertainties and risk inherent in any litigation, particularly a jury trial,
the existence and scope of any subsequently filed complaints, the scope of
insurance coverage, and the outcome of the OIG investigation and all factors
that could affect that outcome.
On September 8, 1995, a derivative action was filed by Brickell Partners
against certain of the Company's current and former directors and officers in
the United States District Court for the District of New Mexico, captioned
BRICKELL PARTNERS V. TURNER, ET AL. The complaint was not served on any
defendant. On June 19, 1996, an amended complaint alleging breach of
fiduciary duty by certain of the Company's current and former directors and
officers was filed and subsequently served on the defendants. On August 5,
1996, the District Court dismissed this action without prejudice for failure
to serve the defendants within the required time period. The plaintiffs filed
a new complaint, alleging the same claims, on August 19, 1996. In December
1997, the Company and the plaintiffs reached an agreement in principle to
settle the action for an immaterial amount. The settlement is subject to
court approval.
The Company was notified in 1997 by a law firm representing several
national insurance companies that these companies believed that the Company
had engaged in improper billing and other practices in connection with the
Company's delivery of therapy and related services. In response, the Company
began discussions directly with these insurers and hopes to resolve these
matters without litigation; however, the Company is unable at this time to
predict whether it will be able to do so, what the eventual outcome may be or
the extent of its liability, if any, to these insurers.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Information with respect to this item is found in Management's
Discussion and Analysis of Financial Condition and Results of Operations and
is hereby incorporated herein by reference.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
(10.1) Second Amendment to Credit Agreement among Sun, certain lenders,
certain co-agents, and NationsBank of Texas, as Administrative
Lender, dated as of March 27, 1998.
(10.2) Indenture among the Company, U.S. Bank Trust National
Association, as trustee, and certain guarantors, dated as of
May 4, 1998.
(10.3) Amended and Restated Declaration of Trust of Sun Financing I
among the Company, as sponsor, Robert F. Murphy, as trustee,
Robert D. Woltil, as trustee, William C. Warrick, as trustee,
The Bank of New York (Delaware), as trustee, and The Bank of
New York, dated as of May 4, 1998.
(10.4) Indenture among the Company and The Bank of New York, as
trustee, dated as of May 4, 1998.
(10.5) Preferred Securities Guarantee among the Company and The Bank
of New York, as trustee, dated as of May 4, 1998.
(10.6) Registration Rights Agreement among the Company, certain
guarantors and Bear, Stearns & Co. Inc., Donaldson, Lufkin &
Jenrette Securities Corporation, J.P. Morgan Securities Inc.,
NationsBanc Montgomery Securities LLC and Schroder & Co. Inc.,
dated as of May 4, 1998.
(10.7) Registration Rights Agreement among Sun Financing I, the
Company and Bear, Stearns & Co. Inc., Donaldson, Lufkin &
Jenrette Securities Corporation, J.P. Morgan Securities Inc.,
NationsBanc Montgomery Securities LLC and Schroder & Co. Inc.,
dated as of May 4, 1998.
(27.1) Financial Data Schedule
(b) Reports on Form 8-K
Report dated February 26, 1998 and filed March 20, 1998 reporting the
earnings of the Company for the fourth quarter and the twelve months ended
December 31, 1997.
Report dated April 3, 1998 and filed April 10, 1998 reporting an Amendment
to the Agreement and Plan of Merger and Reorganization, dated as of
February 17, 1997, as amended by Amendment No. 1 thereto dated as of May
27, 1997, by Amendment No. 2 thereto dated as of August 21, 1997 and by
Amendment No. 3 thereto dated as of November 27, 1997, by and among Sun,
Retirement Care Associates, Inc. and Peach Acquisition Corporation.
Report dated April 14, 1998 and filed April 16, 1998 reporting that Sun has
commenced marketing two private placements of its securities. Sun and Sun
Financing, a Delaware statutory business trust and subsidiary of Sun, will
offer $300 million ($345 million if the initial purchasers' overallotment
is exercised in full) of convertible trust issued preferred securities and
Sun will offer $125 million of Senior Subordinated Notes due 2008.
Report dated October 8, 1997 and filed April 16, 1998 reporting the
financial statements of Regency Health Services, Inc.
Report dated April 29, 1998 and filed April 29, 1998 reporting the pricing
of two private placements of $150 million of Senior Subordinated Notes due
2008 and $345 million of convertible trust issued preferred securities.
34
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SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
SUN HEALTHCARE GROUP, INC.
Date: May 21, 1998 By: /s/ Robert D. Woltil*
----------------------------
Robert D. Woltil
Chief Financial Officer
*Signing on the behalf of the Registrant and as principal financial officer.
35
