-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, DLz6NBWNzvpn252ksA3mh7cpYDBPIFK/Gs5nGfakRZa+cM04EzBoURAYvArCKU9h pSBQaMM/9HY6Lio+VTc0UQ== 0000912057-00-014553.txt : 20000331 0000912057-00-014553.hdr.sgml : 20000331 ACCESSION NUMBER: 0000912057-00-014553 CONFORMED SUBMISSION TYPE: 10-K/A PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990930 FILED AS OF DATE: 20000330 FILER: COMPANY DATA: COMPANY CONFORMED NAME: MAGELLAN HEALTH SERVICES INC CENTRAL INDEX KEY: 0000019411 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-HOSPITALS [8060] IRS NUMBER: 581076937 STATE OF INCORPORATION: DE FISCAL YEAR END: 0930 FILING VALUES: FORM TYPE: 10-K/A SEC ACT: SEC FILE NUMBER: 001-06639 FILM NUMBER: 584207 BUSINESS ADDRESS: STREET 1: 6950 COLUMBIA GATEWAY STREET 2: STE 400 CITY: COLUMBIA STATE: MD ZIP: 21046 BUSINESS PHONE: 4109531000 FORMER COMPANY: FORMER CONFORMED NAME: CHARTER MEDICAL CORP DATE OF NAME CHANGE: 19920703 10-K/A 1 10-K/A - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-K/A AMENDMENT NO. 1 TO /X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1999 / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ______________ TO ______________ COMMISSION FILE NO. 1-6639 MAGELLAN HEALTH SERVICES, INC. (Exact name of registrant as specified in its charter) DELAWARE 58-1076937 - --------------------------------------- ------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 6950 COLUMBIA GATEWAY DRIVE SUITE 400 COLUMBIA, MARYLAND 21046 - --------------------------------------- ------------------- (Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (410) 953-1000 -------------------------- Securities registered pursuant to Section 12(b) of the Act:
NAME OF EACH EXCHANGE ON TITLE OF EACH CLASS WHICH REGISTERED - ------------------- ------------------------ Common Stock ($0.25 par value) New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /X/ No / / Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. / / The aggregate market value of the voting stock held by non-affiliates of the registrant at November 30, 1999 was approximately $178 million. Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes / / No / / The number of shares of the registrant's common stock outstanding as of November 30, 1999 was 31,979,324. DOCUMENTS INCORPORATED BY REFERENCE: The registrant's definitive proxy materials on Schedule 14A relating to its annual meeting of stockholders on February 17, 2000 are incorporated by reference into Part III as set forth herein. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- MAGELLAN HEALTH SERVICES, INC. ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1999 TABLE OF CONTENTS
PAGE PART I -------- ITEM 1. Business.................................................... 2 ITEM 2. Properties.................................................. 27 ITEM 3. Legal Proceedings........................................... 27 ITEM 4. Submission of Matters to a Vote of Security Holders......... 29 PART II ITEM 5. Market Price for Registrant's Common Equity and Related Stockholder Matters......................................... 30 ITEM 6. Selected Financial Data..................................... 30 ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 32 ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk........................................................ 46 ITEM 8. Financial Statements and Supplementary Data................. 46 ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.................................... 46 PART III ITEM 10. Directors and Executive Officers of the Registrant.......... 47 ITEM 11. Executive Compensation...................................... 47 ITEM 12. Security Ownership of Certain Beneficial Owners and Management.................................................. 47 ITEM 13. Certain Relationships and Related Transactions.............. 47 PART IV ITEM 14. Exhibits, Financial Statement Schedule and Reports on Form 8-K......................................................... 47
The undersigned Registrant hereby amends Items 8 and 14 of its Annual Report on Form 10-K for the fiscal year ended September 30, 1999, to include the audited financial statements of Choice Behavioral Health partnership for the year ended December 31, 1999. PART I ITEM 1. BUSINESS Magellan Health Services, Inc. (the "Company"), which was incorporated in 1969 under the laws of the State of Delaware, is a national healthcare company. The Company operates through three principal segments engaging in (i) the behavioral managed healthcare business, (ii) the human services business and (iii) the specialty managed healthcare business. The Company's executive offices are located at Suite 400, 6950 Columbia Gateway Drive, Columbia, Maryland 21046, and its telephone number at that location is (410) 953-1000. RECENT DEVELOPMENTS SALE OF EUROPEAN PROVIDER OPERATIONS. On April 9, 1999, the Company sold its European psychiatric provider operations to Investment AB Bure of Sweden for approximately $57.0 million (before transaction costs of approximately $2.5 million) which resulted in a non-recurring gain of approximately $23.9 million before provision for income taxes. The Company used approximately $38.2 million of the net proceeds to make a mandatory unscheduled principal payment on indebtedness outstanding under the Term Loan Facility (as defined). The remaining proceeds were used to reduce borrowings outstanding under the Revolving Facility (as defined). TPG INVESTMENT. On July 19, 1999, the Company entered into a definitive agreement to issue approximately $75.4 million of cumulative convertible preferred stock to TPG Magellan, LLC, an affiliate of the investment firm Texas Pacific Group ("TPG") (the "TPG Investment"). On December 15, 1999, the Company and TPG amended and restated the definitive agreement and consummated the TPG Investment. Pursuant to the amended and restated definitive agreement, TPG purchased approximately $59.1 million of the Company's Series A Cumulative Convertible Preferred Stock (the "Series A Preferred Stock") and an Option (the "Option") to purchase an additional approximately $21.0 million of Series A Preferred Stock. Net proceeds from issuance of the Series A Preferred Stock were $54.0 million. Approximately 50% of the net proceeds received from the issuance of the Series A Preferred Stock was used to reduce debt outstanding under the Term Loan Facility (as defined) with the remaining 50% of the proceeds being used for general corporate purposes. The Series A Preferred Stock carries a dividend of 6.5% per annum, payable in quarterly installments in cash or common stock, subject to certain conditions. Dividends not paid in cash or common stock will accumulate. The Series A Preferred Stock is convertible at any time into approximately 6.3 million shares of the Company's common stock at a conversion price of $9.375 per share and carries "as converted" voting rights. The Company may, under certain circumstances, require the holders of the Series A Preferred Stock to convert such stock into common stock. The Series A Preferred Stock, plus accrued and unpaid dividends thereon, must be redeemed by the Company on December 15, 2009. The Options will expire unless exercised by June 15, 2002. TPG may exercise the Options in whole or in part. The Company may, under certain circumstances, require TPG to exercise the Options. The terms of the shares of Series A Preferred Stock issuable pursuant to the Options are identical to the terms of the shares of Series A Preferred Stock issued to TPG at the closing of the TPG Investment. TPG has three representatives on the Company's twelve-member Board of Directors. The issuance of common stock in respect of accrued and unpaid dividend obligations on the Series A Preferred Stock and the issuance of common stock underlying the Options are subject to approval by the 2 Company's stockholders. The Company intends to seek such approval no later than the next annual meeting of its stockholders, which is expected to be held on February 17, 2000. DISPOSITION OF HEALTHCARE PROVIDER AND FRANCHISING BUSINESSES. On September 10, 1999, the Company consummated the transfer of certain assets and other interests pursuant to a Letter Agreement dated August 10, 1999 with Crescent Real Estate Equities ("Crescent"), Crescent Operating, Inc. ("COI") and Charter Behavioral Health Systems, LLC ("CBHS"). The transfer effected the Company's exit from its healthcare provider and healthcare franchising businesses (the "CBHS Transactions"). The terms of the CBHS Transactions are summarized as follows: - CBHS redeemed 80% of the Company's CBHS common interest and all of its CBHS preferred interest, leaving the Company with a 10% non-voting common interest in CBHS. - The Company agreed to transfer to CBHS its interests in five of its six hospital-based joint ventures ("Provider JVs") and related real estate as soon as practicable. - The Company transferred to CBHS the right to receive approximately $7.1 million from Crescent for the sale of two psychiatric hospitals that were acquired by the Company (and leased to CBHS) in connection with CBHS' acquisition of certain businesses from Ramsay Healthcare, Inc. in fiscal 1998. - The Company forgave receivables due from CBHS of approximately $3.3 million for payments received by CBHS for patient services prior to the formation of CBHS on June 17, 1997. The receivables related primarily to patient stays that "straddled" the formation date of CBHS. - The Company agreed to pay $2.0 million to CBHS in 12 equal monthly installments beginning on the first anniversary of the closing date. - CBHS agreed to indemnify the Company for 20% of up to the first $50 million (i.e., $10 million) for expenses, liabilities and settlements related to government investigations for events that occurred prior to June 17, 1997 (the "CBHS Indemnification"). CBHS will be required to pay the Company a maximum of $500,000 per year under the CBHS Indemnification. - Crescent, COI, CBHS and Magellan provided each other with mutual releases of claims among all of the parties with respect to the original transactions that effected the formation of CBHS and the operation of CBHS since June 17, 1997 with certain specified exceptions. - The Company transferred certain other real estate and interests related to the healthcare provider business to CBHS. - The Company transferred its healthcare franchising interests, which included Charter Advantage, LLC, the Charter call center operation, the Charter name and related intellectual property to CBHS. The Company has been released from performing any further franchise services or incurring future franchising expenses. - The Company forgave prepaid call center management fees of approximately $2.7 million. - The Company forgave unpaid franchise fees of approximately $115 million. The CBHS Transactions, together with the formal plan of disposal authorized by the Company's Board of Directors on September 2, 1999, represents the disposal of the Company's healthcare provider and healthcare franchising business segments under Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB 30"). APB 30 requires that the results of continuing operations be reported separately from those of discontinued operations for all periods presented and that any gain or loss from disposal of a segment of a business be reported in conjunction with the related results of discontinued operations. Accordingly, the Company has restated its results of operations for all prior periods. The Company recorded an after-tax loss on disposal of its healthcare provider and healthcare franchising business segments of approximately $47.4 million (primarily non-cash), in the fourth quarter of fiscal 1999. 3 HISTORY OVERVIEW Prior to June 1997, the Company derived the majority of its revenue and earnings from providing behavioral healthcare services in an inpatient setting. Payments from third-party payors are the principal source of revenue for most healthcare providers. In the early 1990's, many third-party payors sought to control the cost of providing care to their patients by instituting managed care programs or seeking the assistance of managed care companies. Providers participating in managed care programs agree to provide services to patients for a discount from established rates, which generally results in pricing concessions by the providers and lower margins. Additionally, managed care programs generally encourage alternatives to inpatient treatment settings and reduce utilization of inpatient services. As a result, third-party payors established managed care programs or engaged managed care companies in many areas of healthcare, including behavioral healthcare. The Company, which, until June 1997, was the largest operator of psychiatric hospitals in the United States, was adversely affected by the adoption of managed care programs as the principal cost control measure of third party payors. Prior to the first quarter of fiscal 1996, the Company was not engaged in the behavioral managed healthcare business. During the first quarter of fiscal 1996, the Company acquired a 61% ownership interest in Green Spring Health Services, Inc. ("Green Spring"), a managed care company specializing in mental health and substance abuse/dependence services. At that time, the Company intended to become a fully integrated behavioral healthcare provider by combining the behavioral managed healthcare products offered by Green Spring with the direct treatment services offered by the Company's psychiatric hospitals. The Company believed that an entity that participated in both the managed care and provider segments of the behavioral healthcare industry could more efficiently provide and manage behavioral healthcare for insured populations than an entity that was solely a managed care company. The Company also believed that earnings from its behavorial managed care business would offset, in part, the negative impact on the financial performance of its psychiatric hospitals caused by managed care. Subsequent to the Company's acquisition of Green Spring, the growth of the behavioral managed healthcare industry accelerated. Under the Company's majority ownership, Green Spring increased its base of covered lives from 12.0 million at the end of calendar 1995 to 21.1 million at the end of calendar 1997, a compound annual growth rate of over 32%. While growth in the industry was accelerating, the behavioral managed healthcare industry also began to consolidate. The Company concluded that this consolidation presented an opportunity for it to increase its participation in the behavioral managed healthcare industry, which the Company believed offered growth and earnings prospects superior to those of the psychiatric hospital industry. Therefore, the Company decided to sell its domestic psychiatric facilities to obtain capital for expansion of its behavioral managed healthcare business. The Company took a significant step toward implementing this strategy during fiscal 1997, when it sold substantially all of its domestic acute-care psychiatric hospitals and residential treatment facilities (collectively, the "Psychiatric Hospital Facilities") to Crescent for $417.2 million in cash (before costs of approximately $16.0 million) and certain other consideration (the "Crescent Transactions"). Simultaneously with the sale of the Psychiatric Hospital Facilities, the Company and COI, an affiliate of Crescent, formed CBHS to conduct the operations of the Psychiatric Hospital Facilities and certain other facilities transfered to CBHS by the Company. The Company retained a 50% ownership of CBHS; the other 50% of the equity of CBHS was owned by COI. The Cresent Transactions provided the Company with approximately $200 million of net cash proceeds, after debt repayment, for use in implementing its business strategy of expanding its managed care operations. The Company used the proceeds to finance the acquisitions of HAI (as defined) and Allied (as defined) in December 1997 and further implemented its business strategy through the Merit (as defined) acquisition (collectively, the "Managed Care Acquisitions"). A summary of the Managed Care Acquisitions and related transactions are as follows: HUMAN AFFAIRS INTERNATIONAL, INCORPORATED ACQUISITION. On December 4, 1997, the Company consummated the purchase of Human Affairs International, Incorporated ("HAI"), formerly a unit of Aetna/U.S. 4 Healthcare ("Aetna"), for approximately $122.1 million, which the Company funded from cash on hand. HAI managed behavioral healthcare programs primarily through employee assistance programs ("EAPs") and other behavioral managed healthcare plans. The Company may be required to make additional contingent payments of up to $60.0 million annually to Aetna over the five year period subsequent to closing. The amount and timing of the payments will be contingent upon net increases in the number of HAI's covered lives in specified products. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Outlook--Liquidity and Capital Resources." ALLIED HEALTH GROUP, INC. ACQUISITION. On December 5, 1997, the Company purchased the assets of Allied Health Group, Inc. and certain of its affiliates ("Allied"). Allied provides specialty managed care products, including risk-based products and administrative services to a variety of insurance companies and other customers, including Prudential and Cigna. The Company paid approximately $54.5 million for Allied. The Company may be required to make additional contingent payments to the former owners of Allied depending on Allied's future performance. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Outlook--Liquidity and Capital Resources." MERIT ACQUISITION. On February 12, 1998, the Company consummated the acquisition of Merit Behavioral Care Corporation ("Merit") for cash consideration of approximately $448.9 million plus the repayment of Merit's debt. Merit managed behavioral healthcare programs across all segments of the healthcare industry, including health maintenance organizations ("HMO's"), Blue Cross/Blue Shield organizations and other insurance companies, corporations and labor unions, federal, state and local governmental agencies and various state Medicaid programs. In connection with the consummation of the Merit acquisition, the Company consummated certain related transactions (together with the Merit acquisition, collectively, the "Transactions"), as follows: (i) the Company terminated its existing credit agreement (the "Magellan Existing Credit Agreement"); (ii) the Company repaid all loans outstanding pursuant to and terminated Merit's existing credit agreement (the "Merit Existing Credit Agreement") (the Magellan Existing Credit Agreement and the Merit Existing Credit Agreement are hereinafter referred to as the "Existing Credit Agreements"); (iii) the Company consummated a tender offer for its 11 1/4% Series A Senior Subordinated Notes due 2004 (the "Magellan Outstanding Notes"); (iv) Merit consummated a tender offer for its 11 1/2% Senior Subordinated Notes due 2005 (the "Merit Outstanding Notes") (the Magellan Outstanding Notes and the Merit Outstanding Notes are hereinafter referred to collectively as the "Outstanding Notes" and such tender offers are hereinafter referred to collectively as the "Debt Tender Offers"); (v) the Company entered into a new senior secured bank credit agreement (the "Credit Agreement"), providing for a revolving credit facility (the "Revolving Facility") and a term loan facility (the "Term Loan Facility") which provides for borrowings of up to $700 million; and (vi) the Company issued the 9% Series A Senior Subordinated Notes due 2008 (the "Notes") pursuant to an indenture which governs the Notes ("Indenture"). 5 The following table sets forth the sources and uses of funds for the Transactions (in millions): SOURCES: Cash and cash equivalents................................... $ 59.3 Credit Agreement: Revolving Facility(1)..................................... 20.0 Term Loan Facility........................................ 550.0 The Notes................................................... 625.0 -------- Total sources........................................... $1,254.3 ======== USES: Direct Cash Merger Consideration............................ $ 448.9 Repayment of Merit Existing Credit Agreement(2)............. 196.4 Purchase of Magellan Outstanding Notes(3)................... 432.1 Purchase of Merit Outstanding Notes(4)...................... 121.6 Transaction costs(5)........................................ 55.3 -------- Total uses.............................................. $1,254.3 ========
------------------------------- (1) The Revolving Facility provides for borrowings of up to $150.0 million. (2) Includes principal amount of $193.7 million and accrued interest of $2.7 million. (3) Includes principal amount of $375.0 million, tender premium of $43.4 million and accrued interest of $13.7 million. (4) Includes principal amount of $100.0 million, tender premium of $18.8 million and accrued interest of $2.8 million. (5) Transaction costs include, among other things, costs paid at closing associated with the debt tender offers, the Notes offering, the Merit acquisition and the Credit Agreement. DISPOSITION OF PROVIDER AND FRANCHISE OPERATIONS. The Company completed its exit from the healthcare provider and franchising businesses during fiscal 1999. In April 1999, the Company sold its European psychiatric provider operations to Investment AB Bure of Sweden for approximately $57.0 million and, in September 1999, the Company consummated the CBHS Transactions. INDUSTRY OVERVIEW Behavioral healthcare costs have increased significantly in the United States in recent years. According to industry sources, direct medical costs of behavioral health problems, combined with certain indirect costs, were conservatively estimated at more than $160.0 billion in 1990, the latest year for which statistics are available. In addition, according to industry sources, in 1994 (the most recent year for which such information was available), direct behavioral healthcare services treatment costs amounted to approximately $82.0 billion, or approximately 8% of total healthcare industry spending. These direct costs have grown, in part, as society has begun to recognize and address behavioral health concerns and employers have realized that rehabilitation of employees suffering from substance abuse and relatively mild mental health problems can reduce losses due to absenteeism and decreased productivity. In response to these escalating costs, behavioral managed healthcare companies such as Green Spring, HAI and Merit were formed. Behavorial managed healthcare companies focus on care management techniques with the goal of arranging for the provision of an appropriate level of care in a cost-efficient and effective manner by improving early access to care and assuring an effective match between the patient and the behavioral healthcare provider's specialty. As the growth of behavioral managed healthcare has 6 increased, there has been a significant decrease in occupancy rates and average lengths of stay for inpatient psychiatric facilities and an increase in outpatient treatment and alternative care services. According to an industry trade publication entitled "Open Minds Year Book of Managed Behavioral Health Market Share in the United States 1999-2000" published by Open Minds, Gettysburg, Pennsylvania (hereinafter referred to as "OPEN MINDS"), as of January 1999, approximately 176.8 million beneficiaries were covered by some form of behavioral managed healthcare plan and an additional 18.8 million beneficiaries were enrolled in internally-managed behavioral healthcare programs within HMOs. The number of covered beneficiaries has grown from approximately 86.3 million beneficiaries in 1993 to approximately 176.8 million as of January 1999, representing an approximate 13% compound annual growth rate since 1993. In addition, according to OPEN MINDS, beneficiaries covered under risk-based programs are growing even more rapidly, from approximately 13.6 million as of January 1993 to approximately 49.0 million as of January 1999, representing a compound annual growth rate of over 25%. OPEN MINDS estimates that the revenues of behavioral managed healthcare companies totaled approximately $4.4 billion in 1999. OPEN MINDS divides the managed behavioral healthcare industry as of January 1999 into the following categories of care, based on services provided, extent of care management and level of risk assumption:
BENEFICIARIES PERCENT CATEGORY OF CARE (IN MILLIONS) OF TOTAL - ---------------- ------------- -------- Utilization Review/Care Management Programs.............. 35.1 19.9% Risk-Based Network Products.............................. 49.0 27.7 Non-Risk-Based Network Products.......................... 36.7 20.8 EAPs..................................................... 41.8 23.6 Integrated Programs...................................... 14.2 8.0 ----- ----- Total............................................ 176.8 100.0% ===== =====
Management believes the current trends in the behavioral healthcare industry include increased utilization of risk-based network managed care products and the integration of EAPs with such managed care products. Management believes that these trends have developed in response to the attempt by payors to reduce rapidly escalating behavioral healthcare costs and to limit their risk associated with such costs while continuing to provide access to high quality care. According to OPEN MINDS, risk-based network products, integrated programs and EAPs are the most rapidly growing segments of the behavioral managed healthcare industry. UTILIZATION REVIEW/CARE MANAGEMENT PRODUCTS. Under utilization review/care management products, a managed behavioral healthcare company manages and often arranges for treatment, but does not maintain a network of providers or assume any of the responsibility for the cost of providing treatment services. The Company categorizes its products within this segment of the managed behavioral healthcare industry (as it is defined by OPEN MINDS) as administrative services only ("ASO") products. The Company does not expect this segment of the industry to experience significant growth. NON-RISK-BASED NETWORK PRODUCTS. Under non-risk-based network products, the behavioral managed healthcare company provides a full array of managed care services, including selecting, credentialing and managing a network of providers (such as psychiatrists, psychologists, social workers and hospitals), and performs utilization review, claims administration and care management functions. The third-party payor remains responsible for the cost of providing the treatment services rendered. The Company categorizes its products within this segment of the behavioral managed healthcare industry (as it is defined by OPEN MINDS) as ASO products. RISK-BASED NETWORK PRODUCTS. Under risk-based network products, the behavioral managed healthcare company assumes all or a portion of the responsibility for the cost of providing a full or specified range of behavioral healthcare treatment services. Most of these programs have payment arrangements in which the managed care company agrees to arrange for services in exchange for a fixed fee per member per month that varies depending on the profile of the beneficiary population or otherwise shares the 7 responsibility for arranging for all or some portion of the treatment services at a specific cost per person. Under these products, the behavioral managed healthcare company not only reviews and monitors a course of treatment, but also arranges and pays for the provision of patient care. Therefore, the behavioral managed healthcare company must contract with, credential and manage a network of specialized providers and facilities that covers the complete continuum of care. The behavioral managed healthcare company must also see that the appropriate level of care is delivered in the appropriate setting. Given the ability of payors of behavioral healthcare benefits to reduce their risk with respect to the cost of treatment services through risk-based network products while continuing to provide access to high quality care, this market segment has grown rapidly in recent years. In addition to the expected growth in total beneficiaries covered under behavioral managed healthcare products, this shift of beneficiaries into risk-based network products should further contribute to revenue growth for the behavioral managed healthcare industry because such contracts generate significantly higher revenue than ASO contracts. The higher revenue is intended to compensate the behavioral managed healthcare company for bearing the financial responsibility for the cost of delivering care. The Company's risk-based products are risk-based network products as defined by OPEN MINDS. EMPLOYEE ASSISTANCE PROGRAMS. An EAP is a worksite-based program designed to assist in the early identification and resolution of productivity problems associated with behavioral conditions or other personal concerns of employees and their dependants. Under an EAP, staff or network providers or other affiliated clinicians provide assessment and referral services to employee beneficiaries and their dependants. These services consist of evaluating a patient's needs and, if indicated, providing limited counseling and/or identifying an appropriate provider, treatment facility or other resource for more intensive treatment services. The EAP industry developed largely out of employers' efforts to combat alcoholism and substance abuse problems afflicting workers. A 1990 industry survey estimated the total costs of this dependency at approximately $98.6 billion per year. Many businesses have implemented alcoholism and drug abuse treatment programs in the workplace, and in some cases have expanded those services to cover a wider spectrum of personal problems experienced by workers and their families. As a result, EAP products now typically include consultation services, evaluation and referral services, employee education and outreach services. The Company believes that federal and state "drug-free workplace" measures and Federal Occupational Health and Safety Act requirements, taken together with the growing public perception of increased violence in the workplace, have prompted many companies to implement EAPs. Although EAPs originated as a support tool to assist managers in dealing with troubled employees, payors increasingly regard EAPs as an important component in the continuum of behavioral healthcare services. INTEGRATED EAP/MANAGED BEHAVIORAL HEALTHCARE PRODUCTS. EAPs are utilized in a preventive role and in facilitating early intervention and brief treatment of behavioral healthcare problems before more extensive treatment is required. Consequently, EAPs often are marketed and sold in tandem with managed behavioral healthcare programs through "integrated" product offerings. Integrated products offer employers comprehensive management and treatment of all aspects of behavioral healthcare. In an effort to both reduce costs and increase accessibility and ease of treatment, employers are increasingly attempting to consolidate EAP and behavioral managed healthcare services into a single product. Although integrated EAP/managed behavioral healthcare products are currently only a small component of the overall industry, the Company expects this market segment to grow. AREAS OF GROWTH Management believes that the growth of the behavioral managed healthcare industry will continue, as payors of behavioral healthcare benefits attempt to reduce the costs of behavioral healthcare while maintaining high quality care. Management also believes that a number of opportunities exist in the behavioral managed healthcare industry for continued growth, primarily for risk-based products. The following paragraphs discuss factors contributing to the growth of risk-based products and the increase in the number of covered lives in certain markets. 8 RISK-BASED PRODUCTS. According to OPEN MINDS, industry enrollment in risk-based products has grown from approximately 13.6 million covered lives in 1993 to approximately 49.0 million covered lives in 1999, a compound annual growth rate of over 25%. Despite this growth, only approximately 27.7% of total managed behavioral healthcare covered lives were enrolled in risk-based products as of January 1999. The Company believes that the market for risk-based products has grown and will continue to grow as payors attempt to reduce their responsibility for the cost of providing behavioral healthcare while ensuring an appropriate level of access to care. Risk-based products can generate significantly greater revenue per covered life than other non-risk product types. According to the OPEN MINDS survey, risk-based products account for approximately one-half of total managed behavioral healthcare industry revenue, but, as stated above, accounted for only approximately 27.7% of total covered lives as of January 1999. During fiscal 1999, risk-based products accounted for approximately 75.2% of the Company's behavorial managed healthcare revenue and represented approximately 28.9% of covered lives as of September 30, 1999. See "Cautionary Statements--Risk-Based Products." MEDICAID. Medicaid is a joint state and federal program to provide healthcare benefits to low income individuals, including welfare recipients. According to the Health Care Financing Administration of the United States Department of Health and Human Services ("HCFA"), federal and state Medicaid spending increased from $75.4 billion in 1990 to an estimated $159.9 billion in 1997, at an average annual rate almost twice as fast as the annual increase in overall healthcare spending. Furthermore, according to HCFA, from 1991 to 1996 the number of Medicaid beneficiaries covered under full managed contracts grew at a compound annual rate of approximately 40% per year. The Company expects that the Balanced Budget Act of 1997 (the "Budget Act") will slow the growth of Medicaid spending by accelerating the trend of state Medicaid programs toward shifting beneficiaries into managed care programs in order to control rising costs. Despite the recent increase in managed care enrollment of Medicaid beneficiaries, Medicaid managed care enrollment as a percentage of all Medicaid beneficiaries remains small. As of June 1996, according to the National Institute for Health Care Management, only approximately 35% of all Medicaid beneficiaries were enrolled in some form of managed care program, and less than 7% were enrolled in risk-based programs. The Company expects the number of Medicaid recipients enrolled in managed behavioral healthcare programs to increase through two avenues: (i) subcontracts with HMOs and (ii) direct contracts with state agencies. As HMOs increase their penetration of the Medicaid market, the Company expects that many HMOs will continue to (or begin to) subcontract with behavioral managed healthcare companies to provide services for Medicaid beneficiaries. State agencies have also begun to contract directly with behavioral managed healthcare companies to provide behavioral healthcare services to their Medicaid beneficiaries. Iowa, Massachusetts, Nebraska, Maryland, Pennsylvania, Tennessee and Montana are examples of states that have decided to "carve out" behavioral healthcare from their overall Medicaid managed care programs and have contracted or are expected to contract directly with behavioral managed healthcare companies to provide such services. The Company expects that the Budget Act will accelerate the trend of states contracting directly with behavioral managed healthcare companies. During fiscal 1999, Medicaid programs accounted for approximately 27.3% of the Company's behavorial managed healthcare revenue and represented approximately 4.4% of covered lives as of September 30, 1999. A majority of the Company's Medicaid contracts are risk-based. See "Cautionary Statements--Dependence on Government Spending for Managed Healthcare; Possible Impact of Healthcare Reform" and "--Risk-Based Products" and "Business--Regulation--Budget Act." 9 COMPANY OVERVIEW GENERAL According to enrollment data reported in OPEN MINDS, the Company is the nation's largest provider of behavioral managed healthcare services. As of September 30, 1999, the Company had approximately 66.4 million covered lives under behavioral managed healthcare contracts and managed behavioral healthcare programs for approximately 3,500 customers. Through its current network of over 40,000 providers and 5,000 treatment facilities, the Company manages behavioral healthcare programs for HMOs, Blue Cross/Blue Shield organizations and other insurance companies, corporations, federal, state and local governmental agencies, labor unions and various state Medicaid programs. The Company believes it has the largest and most comprehensive behavioral healthcare provider network in the United States. In addition to the Company's behavioral managed healthcare segment, the Company offers specialty managed care products related to the management of certain chronic medical conditions. The Company also offers a broad continuum of human services to 6,444 individuals who receive healthcare benefits funded by state and local governmental agencies through National Mentor, Inc. ("Mentor"), its wholly-owned human services provider. The Company's professional care managers coordinate and manage the delivery of behavioral healthcare treatment services through the Company's network of providers, which includes psychiatrists, psychologists, licensed clinical social workers, marriage and family therapists and licensed clinical professional counselors. The treatment services provided by the Company's behavioral provider network include outpatient programs (such as counseling and therapy), intermediate care programs (such as sub-acute emergency care, intensive outpatient programs and partial hospitalization services), inpatient treatment services and alternative care services (such as residential treatment, home and community-based programs and rehabilitative and support services). The Company provides these services through: (i) risk-based products, (ii) EAPs, (iii) ASO products and (iv) products that combine features of some or all of these products. Under risk-based products, the Company arranges for the provision of a full range of behavioral healthcare services for beneficiaries of its customers' healthcare benefit plans through fee arrangements under which the Company assumes all or a portion of the responsibility for the cost of providing such services in exchange for a fixed per member per month fee. Under EAPs, the Company provides assessment services to employees and dependents of its customers, and if required, referral services to the appropriate behavioral healthcare service provider. Under ASO products, the Company provides services such as utilization review, claims administration and provider network management. The Company does not assume the responsibility for the cost of providing healthcare services pursuant to its ASO products. The Company conducts operations in three business segments: (i) behavioral managed healthcare, (ii) human services and (iii) specialty managed healthcare. The following describes the Company's three business segments: BEHAVIORAL MANAGED HEALTHCARE. The behavioral managed healthcare segment is the Company's primary operating segment. The Company's behavioral managed healthcare operations are organized around three customer segments: (i) the Health Plan Division, focusing on the needs of health insurance plans and HMO's and their members; (ii) the Workplace Division, focusing on self-insured employers and labor unions and their employees and dependants; and (iii) the Public Sector Division, focusing on the needs of public purchasers of behavioral healthcare services and their constituents. HUMAN SERVICES. The Company's human services business provided specialty home-based behavioral healthcare services through Mentor, to approximately 6,444 individuals in 181 programs in 22 states as of September 30, 1999. Mentor was founded in 1983 and was acquired by the Company in January 1995. Mentor's services include specialty home-based behavioral healthcare services, which feature individualized home and community-based health and human services delivered in highly structured and professionally monitored family environments or "mentor" homes. The mentor homes serve clients with 10 chronic behavioral disorders and disabilities requiring long-term care, including children and adolescents with behavioral problems, individuals with mental retardation or developmental disabilities, and individuals with neurological impairment or other medical and behavioral frailties. Mentor also provides various residential and day services for individuals with acquired brain injuries and for individuals with mental retardation and developmental disabilities. SPECIALTY MANAGED HEALTHCARE. The Company's specialty managed healthcare business provides specialty risk-based products and administrative services to a variety of health insurance companies and other customers, including Prudential, Cigna and HIP of New York and Florida. The specialty managed healthcare operations focus on the needs of health plans to manage their specialty care networks and disease management programs in areas such as diabetes, asthma, oncology and cardiology. BUSINESS STRATEGY INCREASE ENROLLMENT IN BEHAVIORAL MANAGED HEALTHCARE PRODUCTS. The Company believes it has an opportunity to increase covered lives in all its behavioral managed healthcare products. The Company believes it will increase ASO and EAP covered lives with further penetration of large corporate, HMO and insurance customers. The Company also believes that it has an opportunity to increase revenues, earnings and cash flows from operations by increasing lives covered by its risk-based products in all customer segments. The Company is the industry's leading provider of risk-based products, according to data reported by OPEN MINDS, and believes that it may benefit from the continuing shift to risk-based products. According to OPEN MINDS, industry enrollment in risk-based products has grown from approximately 13.6 million in 1993 to approximately 49.0 million as of January 1999, representing a compound annual growth rate of over 25%. Despite this growth, only approximately 27.7% of total behavioral managed healthcare enrollees were in risk-based products as of January 1999. The Company believes that the market for risk-based products has grown and will continue to grow as payors attempt to reduce their cost of providing behavioral healthcare while ensuring a high quality of care and an appropriate level of access to care. The Company believes enrollment in its risk-based products will increase through growth in new covered lives and through the transition of covered lives in ASO and EAP products to higher revenue risk-based products. There are certain risks associated with increased enrollment in risk-based products. See "Cautionary Statements--Risk-Based Products." PURSUE ADDITIONAL SPECIALTY MANAGED HEALTHCARE OPPORTUNITIES. The Company believes that significant demand exists for specialty managed healthcare products related to the management of certain chronic conditions. The Company believes its large number of covered lives, information systems infrastructure and experience in managing behavioral healthcare programs position the Company to provide customers with specialty managed healthcare products. In addition, the Company may attempt to expand its specialty managed care product offerings by pursuing strategic acquisitions. The Company may be unable to fully execute its acquisition strategy due to possible financial and liquidity concerns. See "Cautionary Statements--Leverage and Debt Service Obligations" and "Management's Discussion and Analysis of Financial Condition and Results of Operations--Outlook--Liquidity and Capital Resources." EXPANSION OF HUMAN SERVICES GEOGRAPHIC COVERAGE AND PRODUCT MIX. The human services industry is a very fragmented, $100 billion industry that continues to be consolidated by a few competitors. The Company believes continued growth will result from its ability to increase its geographic coverage through strategic acquisitions as well as leveraging its human services product offerings on a nationwide basis. The Company may be unable to fully execute its acquisition strategy due to possible financial and liquidity concerns. See "Cautionary Statements--Leverage and Debt Service Obligations" and "Management's Discussion and Analysis of Financial Condition and Results of Operations--Outlook--Liquidity and Capital Resources." 11 BEHAVIORAL MANAGED HEALTHCARE PRODUCTS AND SERVICES GENERAL. The following table sets forth the approximate number of covered lives as of September 30, 1998 and 1999 and revenue for fiscal 1998 and 1999 for the types of behavioral managed healthcare programs offered by the Company:
PROGRAMS COVERED LIVES PERCENT REVENUE PERCENT - -------- ------------- -------- -------- -------- (IN MILLIONS, EXCEPT PERCENTAGES) 1998 Risk-Based Products.................................... 18.6 30.2% $ 773.3 75.4% EAP, ASO and other products............................ 43.0 69.8 252.9 24.6 ---- ----- -------- ----- Total.............................................. 61.6 100.0% $1,026.2 100.0% ==== ===== ======== ===== 1999 Risk-Based Products.................................... 19.2 28.9% $1,115.3 75.2% EAP, ASO and other products............................ 47.2 71.1 367.9 24.8 ---- ----- -------- ----- Total.............................................. 66.4 100.0% $1,483.2 100.0% ==== ===== ======== =====
The number of the Company's covered lives fluctuates based on the number of the Company's customer contracts and as employee, HMO and insurance company subscriber and government program enrollee populations change from time to time. RISK-BASED PRODUCTS. Under the Company's risk-based products, the Company typically arranges for the provision of a full range of outpatient, intermediate and inpatient treatment services to beneficiaries of its customers' healthcare benefit plans, primarily through arrangements in which the Company assumes all of the responsibility for the cost of providing such services in exchange for a per member per month fee. The Company's experience with risk-based contracts covering a large number of lives has given it a broad base of data from which to analyze utilization rates. The Company believes that this broad database permits it to estimate utilization trends and costs more accurately than many of its competitors, which allows it to bid effectively. The Company believes that its experience has also allowed it to develop effective measures for managing the cost of providing a unit of care to its covered lives. The Company has developed or acquired clinical protocols, which permit it to assist its network providers to administer effective treatment in a cost efficient manner, and claims management technology, which permits the Company to reduce the cost of processing claims. The Company's care managers are an essential element in its provision of cost-effective care. Care managers, in consultation with treating professionals, and using the Company's clinical protocols, authorize an appropriate level and intensity of services that can be delivered in a cost-efficient manner. EMPLOYEE ASSISTANCE PROGRAMS. The Company's EAP products typically provide assessment and referral services to employees and dependents of the Company's customers in an effort to assist in the early identification and resolution of productivity problems associated with the employees who are impaired by behavioral conditions or other personal concerns. For many EAP customers, the Company also provides limited outpatient therapy (typically limited to eight or fewer sessions) to patients requiring such services. For these services, the Company typically is paid a fixed fee per member per month; however, the Company is usually not responsible for the cost of providing care beyond these services. If further services are necessary beyond limited outpatient therapy, the Company will refer the beneficiary to an appropriate provider or treatment facility. INTEGRATED PRODUCTS. Under its integrated products, the Company typically establishes an EAP to function as the "front end" of a managed care program that provides a full range of services, including more intensive treatment services not covered by the EAP. The Company typically manages the EAP and accepts all or some of the responsibility for the cost of any additional treatment required upon referral out 12 of the EAP, thus integrating the two products and using both the Company's care management and clinical care techniques to manage the provision of care. ASO PRODUCTS. Under its ASO products, the Company provides services ranging from utilization review and claims administration to the arrangement for and management of a full range of patient treatment services, but does not assume any of the responsibility for the cost of providing treatment services. Services include member assistance, management reporting and claims processing in addition to utilization review and care management. BEHAVIORAL MANAGED HEALTHCARE CUSTOMERS GENERAL. The following table sets forth the approximate number of covered lives as of September 30, 1998 and 1999 and revenue for fiscal 1998 and 1999 in each of the Company's market segments described below:
MARKET COVERED LIVES PERCENT REVENUE PERCENT - ------ ------------- -------- -------- -------- (IN MILLIONS, EXCEPT PERCENTAGES) 1998 Workplace (Corporations and Labor Unions).............. 22.8 37.0% $ 165.3 16.1% Health Plans........................................... 35.4 57.5 625.3 60.9 Public Sector (Primarily Medicaid)..................... 3.4 5.5 235.6 23.0 ---- ----- -------- ----- Total.............................................. 61.6 100.0% $1,026.2 100.0% ==== ===== ======== ===== 1999 Workplace (Corporations and Labor Unions).............. 27.0 40.7% $ 252.8 17.1% Health Plans........................................... 36.5 54.9 824.9 55.6 Public Sector (Primarily Medicaid)..................... 2.9 4.4 405.5 27.3 ---- ----- -------- ----- Total.............................................. 66.4 100.0% $1,483.2 100.0% ==== ===== ======== =====
CORPORATIONS AND LABOR UNIONS. Corporations and, to a lesser extent, labor unions, account for a large number of the Company's contracts to provide behavioral managed healthcare services and, in particular, EAP and integrated EAP/managed care services. The Company has structured a variety of fee arrangements with corporate customers to cover all or a portion of the responsibility of the cost of providing treatment services. In addition, the Company operates a number of programs for corporate customers on an ASO basis. Management believes the corporate market is an area of potential growth for the Company, as corporations are anticipated to increase their utilization of behavioral managed healthcare services. In an effort to increase penetration of the corporate market, the Company intends to build upon its experience in managing programs for large corporate customers (such as IBM, Federal Express and AT&T) and to market integrated programs to existing EAP customers and other prospective corporate clients. HEALTH PLANS. The Company is a leader in the HMO market, providing behavioral managed healthcare services to HMO beneficiaries. HMO contracts are full, limited or shared risk contracts in which the Company generally accepts a fixed fee per member per month from the HMO in exchange for arranging for a full or specified range of behavioral healthcare services for a specific portion of the HMO's beneficiaries. Although certain large HMOs provide their own behavioral managed healthcare services, many HMOs "carve out" behavioral healthcare from their general healthcare services and subcontract such services to behavioral managed healthcare companies such as the Company. The Company anticipates that its business with HMOs will continue to grow. The Company is also the nation's leading provider of behavioral managed healthcare services to Blue Cross/Blue Shield organizations, serving 35 such organizations as of September 30, 1999. 13 PUBLIC SECTOR. The Company provides behavioral managed healthcare services to Medicaid recipients through both direct contracts with state and local governmental agencies and through subcontracts with HMOs focused on Medicaid beneficiary populations. In addition to the Medicaid population, other public entitlement programs, such as Medicare and state insurance programs for the uninsured, offer the Company areas of potential future growth. The Company expects that governmental agencies will continue to implement a significant number of managed care Medicaid programs through contracts with HMOs and that many HMOs will subcontract with behavioral managed healthcare organizations, such as the Company, for behavioral healthcare services. The Company also expects that other states will continue the trend of "carving-out" behavioral healthcare services from their general healthcare benefit plans and contracting directly with behavioral managed healthcare companies such as the Company. See "Industry--Areas of Growth," "Cautionary Statements--Dependence on Government Spending for Managed Healthcare; Possible Impact of Healthcare Reform" and "Cautionary Statements--Regulation--Other Proposed Legislation." BEHAVIORAL MANAGED HEALTHCARE CONTRACTS The Company's contracts with customers typically have terms of one to three years, and in certain cases contain renewal provisions (at the customer's option) for successive terms of between one and two years (unless terminated earlier). Substantially all of these contracts are immediately terminable with cause and many are terminable without cause by the customer or the Company either upon the giving of requisite notice and the passage of a specified period of time (typically between 60 and 180 days) or upon the occurrence of other specified events. In addition, the Company's contracts with federal, state and local governmental agencies, under both direct contract and subcontract arrangements with HMOs, generally are conditioned on legislative appropriations. These contracts, notwithstanding terms to the contrary, generally can be terminated or modified by the customer if such appropriations are not made. See "Cautionary Statements--Risk Based Programs" and "Cautionary Statements--Reliance on Customer Contracts." The specific terms of the Company's contracts are determined by whether the contracts are for risk-based, EAP, integrated or ASO products. Risk-based, EAP and ASO contracts provide for payment of a per member per month fee to the Company. The Company's billing arrangements for integrated products vary on a case by case basis. BEHAVIORAL MANAGED HEALTHCARE NETWORK The Company's behavioral managed healthcare and EAP treatment services are provided by a network of third-party providers. The number and type of providers in a particular area depend upon customer preference, site, geographic concentration and demographic make-up of the beneficiary population in that area. Network providers include a variety of specialized behavioral healthcare personnel, such as psychiatrists, psychologists, licensed clinical social workers, substance abuse counselors and other professionals. As of September 30, 1999, the Company had contractual arrangements covering over 40,000 individual third-party network providers. The Company's network providers are independent contractors located throughout the local areas in which the Company's customers' beneficiary populations reside. Network providers work out of their own offices, although the Company's personnel are available to assist them with consultation and other needs. Network providers include both individual practitioners, as well as individuals who are members of group practices or other licensed centers or programs. Network providers typically execute standard contracts with the Company for which they are typically paid by the Company on a fee-for-service basis. In some cases, network providers are paid on a "case rate" basis, whereby the provider is paid a set rate for an entire course of treatment, or through other risk sharing arrangements. 14 As of September 30, 1999, the Company's behavorial managed healthcare network included contractual arrangements with approximately 5,000 third-party treatment facilities, including inpatient psychiatric and substance abuse hospitals, intensive outpatient facilities, partial hospitalization facilities, community health centers and other community-based facilities, rehabilitative and support facilities, and other intermediate care and alternative care facilities or programs. This variety of facilities enables the Company to offer patients a full continuum of care and to refer patients to the most appropriate facility or program within that continuum. Typically, the Company contracts with facilities on a per diem or fee-for-service basis and, in some cases, on a "case rate" or capitated basis. The contracts between the Company and inpatient and other facilities typically are for one year terms and, in some cases, are automatically renewable at the Company's option. Facility contracts are usually terminable by the Company or the facility owner upon 30 to 120 days notice. COMPETITION Each segment of the Company's business is highly competitive. With respect to its managed care businesses, the Company competes with large insurance companies, HMOs, PPOs, third-party administrators ("TPAs"), independent practitioner associations ("IPAs"), multi-disciplinary medical groups and other managed care companies. Many of the Company's competitors are significantly larger and have greater financial, marketing and other resources than the Company, and some of the Company's competitors provide a broader range of services. The Company may also encounter substantial competition in the future from new market entrants. Many of the Company's customers that are managed care companies may, in the future, seek to provide behavioral managed healthcare and EAP services to their employees or subscribers directly, rather than by contracting with the Company for such services. Because of competition, the Company does not expect to be able to rely on price increases to achieve revenue growth and expects to continue experiencing pressure on direct operating margins. See "Cautionary Statements--Highly Competitive Industry." The Company's human services operations compete with various for profit and not-for-profit entities, including, but not limited to: (i) behavioral managed healthcare companies that have started managing human services for governmental agencies; (ii) home health care organizations; (iii) proprietary nursing home companies; and (iv) proprietary human services companies. The Company believes that the most significant factors in a customer's selection of services include price, quality of services and outcomes. The pricing aspect of such services is especially important to attract public sector agencies looking to outsource public services to the private sector as demand for quality services escalates while budgeted dollars for healthcare services are reduced. The Company's management believes that it competes effectively with respect to these factors. The Company believes it benefits from the competitive strengths described below: INDUSTRY LEADERSHIP. The Company is the largest provider of behavioral managed healthcare services in the United States, according to enrollment data reported in OPEN MINDS. The Company believes, based on data reported in OPEN MINDS, that it also now has the number one market position in each of the major product markets in which it competes. The Company believes its position will enhance its ability to: (i) provide a consistent level of high quality service on a nationwide basis; (ii) enter into agreements with behavioral healthcare providers that allow it to control healthcare costs for its customers; and (iii) market its behavioral managed care products to large corporate, HMO and health insurance customers, which, the Company believes, increasingly prefer to be serviced by a single-source provider on a national basis. See "Cautionary Statements--Highly Competitive Industry and --Reliance on Customer Contracts" for a discussion of the risks associated with the highly competitive nature of the behavioral managed healthcare industry and the Company's reliance on contracts with payors of behavioral healthcare benefits, respectively. 15 BROAD PRODUCT OFFERING AND NATIONWIDE PROVIDER NETWORK. The Company offers behavioral managed care products that can be designed to meet specific customer needs, including risk-based and partial risk-based products, integrated EAPs, stand-alone EAPs and ASO products. The Company's provider network encompasses over 40,000 providers and nearly 5,000 treatment facilities in all 50 states. The Company believes that the combination of its product offerings and its provider network allows the Company to meet its customers needs for behavioral managed healthcare on a nationwide basis, and positions the Company to capture incremental revenue opportunities resulting from the continued growth of the behavioral managed healthcare industry and the continued migration of its customers from ASO and EAP products to higher revenue risk-based products. See "Cautionary Statements--Risk-Based Products" for a discussion of the risks associated with risk-based products, which are the Company's primary source of revenue. BROAD BASE OF CUSTOMER RELATIONSHIPS. The Company believes that the breadth of its customer relationships are attributable to the Company's broad product offerings, nationwide provider network, commitment to quality care and ability to manage behavioral healthcare costs effectively. The Company's customers include: (i) Blue Cross/Blue Shield organizations; (ii) national HMOs and other large insurers, such as Aetna and Humana; (iii) large corporations, such as IBM, Federal Express and AT&T; (iv) state and local governmental agencies through commercial, Medicaid and other programs; and (v) the federal government through contracts with CHAMPUS and the U.S. Postal Service. This broad base of customer relationships provides the Company with stable and diverse sources of revenue, earnings and cash flows and an established base from which to continue to increase covered lives and revenue. See "Cautionary Statements--Reliance on Customer Contracts" for a discussion of the risks associated with the Company's reliance on certain contracts with payors of behavioral healthcare benefits. PROVEN RISK MANAGEMENT EXPERIENCE. The Company had approximately 19.2 million covered lives under risk-based contracts at September 30, 1999, making it the nation's industry leader in at-risk behavioral managed healthcare products, based on data reported in OPEN MINDS. The Company's experience with risk-based products covering a large number of lives has given it a broad base of data from which to analyze utilization rates. The Company believes that this broad database permits it to estimate utilization trends and costs more accurately than many of its competitors, which allows it to bid effectively. The Company believes that its experience has also allowed it to develop effective measures for controlling the cost of providing a unit of care to its covered lives. Among other cost control measures, the Company has developed or acquired clinical protocols, which permit the Company to assist its network providers to administer effective treatment in a cost efficient manner, and claims management technology, which permits the Company to reduce the cost of processing claims. INSURANCE The Company maintains a general and professional liability insurance policy with an unaffiliated insurer. The policy is written on an "occurrence" basis, subject to a $250,000 per claim and $1.0 million annual aggregate self-insured retention, for a three-year policy period ending June 2001. 16 REGULATION GENERAL. The behavioral managed healthcare industry and the provision of behavioral healthcare services are subject to extensive and evolving state and federal regulation. The Company is subject to certain state laws and regulations, including those governing: (i) the licensing of insurance companies, HMOs, PPOs, TPAs and companies engaged in utilization review and (ii) the licensing of healthcare professionals, including restrictions on business corporations from practicing, controlling or exercising excessive influence over behavioral healthcare services through the direct employment of psychiatrists or, in a few states, psychologists and other behavioral healthcare professionals. These laws and regulations vary considerably among states and the Company may be subject to different types of laws and regulations depending on the specific regulatory approach adopted by each state to regulate the managed care business and the provision of behavioral healthcare treatment services. In addition, the Company is subject to certain federal laws as a result of the role the Company assumes in connection with managing its customers' employee benefit plans. The regulatory scheme generally applicable to the Company's managed care operations is described in this section. The Company believes its operations are structured to comply with applicable laws and regulations in all material respects and that it has received all licenses and approvals that are material to the operation of its business. However, regulation of the managed healthcare industry is evolving, with new legislative enactments and regulatory initiatives at the state and federal levels being implemented on a regular basis. Consequently, it is possible that a court or regulatory agency may take a position under existing or future laws or regulations, or as a result of a change in the interpretation thereof, that such laws or regulations apply to the Company in a different manner than the Company believes such laws or regulations apply. Moreover, any such position may require significant alterations to the Company's business operations in order to comply with such laws or regulations, or interpretations thereof. Expansion of the Company's business to cover additional geographic areas, to serve different types of customers, to provide new services or to commence new operations could also subject the Company to additional licensure requirements and/ or regulation. LICENSURE. Certain regulatory agencies having jurisdiction over the Company possess discretionary powers when issuing or renewing licenses or granting approval of proposed actions such as mergers, a change in ownership, transfer or assignment of licenses and certain intracorporate transactions. One or multiple agencies may require as a condition of such licensure or approval that the Company cease or modify certain of its operations in order to comply with applicable regulatory requirements or policies. In addition, the time necessary to obtain licensure or approval varies from state to state, and difficulties in obtaining a necessary license or approval may result in delays in the Company's plans to expand operations in a particular state and, in some cases, lost business opportunities. Compliance activities, mandated changes in the Company's operations, delays in the expansion of the Company's business or lost business opportunities as a result of regulatory requirements or policies could have a material adverse effect on the Company. INSURANCE, HMO AND PPO ACTIVITIES. To the extent that the Company operates or is deemed to operate in one or more states as an insurance company, HMO, PPO or similar entity, it may be required to comply with certain laws and regulations that, among other things, may require the Company to maintain certain types of assets and minimum levels of deposits, capital, surplus, reserves or net worth. In many states, entities that assume risk under contracts with licensed insurance companies or HMOs have not been considered by state regulators to be conducting an insurance or HMO business. As a result, the Company has not sought licensure as either an insurer or HMO in certain states. The National Association of Insurance Commissioners (the "NAIC") has undertaken a comprehensive review of the regulatory status of entities arranging for the provision of healthcare services through a network of providers that, like the Company, may assume risk for the cost and quality of healthcare services, but that are not currently licensed as an HMO or similar entity. As a result of this review, the NAIC developed a "health organizations risk-based capital" formula, designed specifically for managed care organizations, that 17 establishes a minimum amount of capital necessary for a managed care organization to support its overall operations, allowing consideration for the organization's size and risk profile. The NAIC initiative also may result in the adoption of a model NAIC regulation in the area of health plan standards, which could be adopted by individual states in whole or in part, and could result in the Company being required to meet additional or new standards in connection with its existing operations. Individual states have also recently adopted their own regulatory initiatives that subject entities such as the Company to regulation under state insurance laws. This includes, but is not limited to, requiring licensure as an insurance company or HMO and requiring adherence to specific financial solvency standards. State insurance laws and regulations may limit the ability of the Company to pay dividends, make certain investments and repay certain indebtedness. Licensure as an insurance company, HMO or similar entity could also subject the Company to regulations governing reporting and disclosure, mandated benefits, and other traditional insurance regulatory requirements. PPO regulations to which the Company may be subject may require the Company to register with a state authority and provide information concerning its operations, particularly relating to provider and payor contracting. The imposition of such requirements could increase the Company's cost of doing business and could delay the Company's conduct or expansion of its business in some areas. The licensure process under state insurance laws can be lengthy and, unless the applicable state regulatory agency allows the Company to continue to operate while the licensure process is ongoing, the Company could experience a material adverse effect on its operating results and financial condition while its licensure application is pending. In addition, failure by the Company to obtain and maintain required licenses typically also constitutes an event of default under the Company's contracts with its customers. The loss of business from one or more of the Company's major customers as a result of such an event of default or otherwise could have a material adverse effect on the Company. UTILIZATION REVIEW AND THIRD-PARTY ADMINISTRATOR ACTIVITIES. Numerous states in which the Company does business have adopted, or are expected to adopt, regulations governing entities engaging in utilization review and TPA activities. Utilization review regulations typically impose requirements with respect to the qualifications of personnel reviewing proposed treatment, timeliness and notice of the review of proposed treatment, and other matters. TPA regulations typically impose requirements regarding claims processing and payments and the handling of customer funds. Utilization review and TPA regulations may increase the Company's cost of doing business in the event that compliance requires the Company to retain additional personnel to meet the regulatory requirements and to take other required actions and make necessary filings. Although compliance with utilization review regulations has not had a material adverse effect on the Company, there can be no assurance that specific regulations adopted in the future would not have such a result, particularly since the nature, scope and specific requirements of such provisions vary considerably among states that have adopted regulations of this type. There is a trend among states to require licensure or certification of entities performing utilization review or TPA activities; however, certain federal courts have held that such licensure requirements are preempted by the Employee Retirement Income Security Act of 1974, as amended, ("ERISA"). ERISA preempts state laws that mandate employee benefit structures or their administration, as well as those that provide alternative enforcement mechanisms. The Company believes that its TPA activities performed for its self-insured employee benefit plan customers are exempt from otherwise applicable state licensing or registration requirements based upon federal preemption under ERISA and has relied on this general principle in determining not to seek licensure for certain of its activities in many states. Existing case law is not uniform on the applicability of ERISA preemption with respect to state regulation of utilization review or TPA activities. There can be no assurance that additional licensure will not be required with respect to utilization review or TPA activities in certain states. "ANY WILLING PROVIDER" LAWS. Several states in which the Company does business have adopted, or are expected to adopt, "any willing provider" laws. Such laws typically impose upon insurance companies, PPOs, HMOs or other types of third-party payors an obligation to contract with, or pay for the services of, any healthcare provider willing to meet the terms of the payor's contracts with similar providers. 18 Compliance with any willing provider laws could increase the Company's costs of assembling and administering provider networks and could, therefore, have a material adverse effect on its operations. LICENSING OF HEALTHCARE PROFESSIONALS. The provision of behavioral healthcare treatment services by psychiatrists, psychologists and other providers is subject to state regulation with respect to the licensing of healthcare professionals. The Company believes that the healthcare professionals who provide behavioral healthcare treatment on behalf of or under contracts with the Company are in compliance with the applicable state licensing requirements and current interpretations thereof; however, there can be no assurance that changes in such state licensing requirements or interpretations thereof will not adversely affect the Company's existing operations or limit expansion. With respect to the Company's crisis intervention program, additional licensure of clinicians who provide telephonic assessment or stabilization services to individuals who are calling from out-of-state may be required if such assessment or stabilization services are deemed by regulatory agencies to be treatment provided in the state of such individual's residence. The Company believes that any such additional licensure could be obtained; however, there can be no assurance that such licensing requirements will not adversely affect the Company's existing operations or limit expansion. PROHIBITION ON FEE SPLITTING AND CORPORATE PRACTICE OF PROFESSIONS. The laws of some states limit the ability of a business corporation to directly provide, control or exercise excessive influence over behavioral healthcare services through the direct employment of psychiatrists, psychologists, or other behavioral healthcare professionals. In addition, the laws of some states prohibit psychiatrists, psychologists, or other healthcare professionals from splitting fees with other persons or entities. These laws and their interpretations vary from state to state and enforcement by the courts and regulatory authorities may vary from state to state and may change over time. The Company believes that its operations as currently conducted are in material compliance with the applicable laws, however, there can be no assurance that the Company's existing operations and its contractual arrangements with psychiatrists, psychologists and other healthcare professionals will not be successfully challenged under state laws prohibiting fee splitting or the practice of a profession by an unlicensed entity, or that the enforceability of such contractual arrangements will not be limited. The Company believes that it could, if necessary, restructure its operations to comply with changes in the interpretation or enforcement of such laws and regulations, and that such restructuring would not have a material adverse effect on its operations. DIRECT CONTRACTING WITH LICENSED INSURERS. Regulators in several states in which the Company does business have adopted policies that require HMOs or, in some instances, insurance companies, to contract directly with licensed healthcare providers, entities or provider groups, such as IPAs, for the provision of treatment services, rather than with unlicensed intermediary companies. In such states, the Company's customary model of contracting directly with its customers may need to be modified so that, for example, the IPAs (rather than the Company) contract directly with the HMO or insurance company, as appropriate, for the provision of treatment services. The Company intends to work with a number of these HMO customers to restructure existing contractual arrangements, upon contract renewal or in renegotiations, so that the entity which contracts with the HMO directly is an IPA. The Company does not expect this method of contracting to have a material adverse effect on its operations. OTHER REGULATION OF HEALTHCARE PROVIDERS. The Company's business is affected indirectly by regulations imposed upon healthcare providers. Regulations imposed upon healthcare providers include provisions relating to the conduct of, and ethical considerations involved in, the practice of psychiatry, psychology, social work and related behavioral healthcare professions and, in certain cases, the common law duty to warn others of danger or to prevent patient self-injury. Confidentiality and patient privacy requirements are particularly strict in the field of behavioral healthcare services, and additional legislative initiatives relating to confidentiality are expected. The Health Insurance Portability and Accountability Act of 1996 ("HIPAA") included a provision that prohibits the wrongful disclosure of certain "individually identifiable health information." HIPAA requires the Secretary of the Department to adopt standards 19 relating to the transmission of such health information by healthcare providers and healthcare plans. Although the Company believes that such regulations do not at present materially impair the Company's operations, there can be no assurance that such indirect regulation will not have a material adverse effect on the Company in the future. REGULATION OF CUSTOMERS. Regulations imposed upon the Company's customers include, among other things, benefits mandated by statute, exclusions from coverages prohibited by statute, procedures governing the payment and processing of claims, record keeping and reporting requirements, requirements for and payment rates applicable to coverage of Medicaid and Medicare beneficiaries, provider contracting and enrollee rights, and confidentiality requirements. Although the Company believes that such regulations do not at present materially impair the Company's operations, there can be no assurance that such indirect regulation will not have a material adverse effect on the Company in the future. ERISA. Certain of the Company's services are subject to the provisions of ERISA. ERISA governs certain aspects of the relationship between employer-sponsored healthcare benefit plans and certain providers of services to such plans through a series of complex laws and regulations that are subject to periodic interpretation by the Internal Revenue Service and the Department of Labor. In some circumstances, and under certain customer contracts, the Company may be expressly named as a "fiduciary" under ERISA, or be deemed to have assumed duties that make it an ERISA fiduciary, and thus be required to carry out its operations in a manner that complies with ERISA requirements in all material respects. Although the Company believes that it is in material compliance with the applicable ERISA requirements and that such compliance does not currently have a material adverse effect on the Company's operations, there can be no assurance that continuing ERISA compliance efforts or any future changes to the applicable ERISA requirements will not have a material adverse effect on the Company. OTHER PROPOSED LEGISLATION. In the last five years, legislation has periodically been introduced at the state and federal level providing for new healthcare regulatory programs and materially revising existing healthcare regulatory programs. Any such legislation, if enacted, could materially adversely affect the Company's business, financial condition or results of operations. Such legislation could include both federal and state bills affecting the Medicaid programs which may be pending in or recently passed by state legislatures and which are not yet available for review and analysis. Such legislation could also include proposals for national health insurance and other forms of federal regulation of health insurance and healthcare delivery. It is not possible at this time to predict whether any such legislation will be adopted at the federal or state level, or the nature, scope or applicability to the Company's business of any such legislation, or when any particular legislation might be implemented. No assurance can be given that any such federal or state legislation will not have a material adverse effect on the Company. CAUTIONARY STATEMENTS This Form 10-K includes "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act") Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Although the Company believes that its plans, intentions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such plans, intentions or expectations will be achieved. Important factors that could cause actual results to differ materially from the Company's forward-looking statements are set forth below and elsewhere in this Form 10-K. All forward-looking statements attributable to the Company or persons acting on behalf of the Company are expressly qualified in their entirety by the cautionary statements set forth below. LEVERAGE AND DEBT SERVICE OBLIGATIONS The Company is currently highly leveraged, with indebtedness that is substantial in relation to its stockholders' equity. As of September 30, 1999, the Company's aggregate outstanding indebtedness was approximately $1.14 billion and the Company's stockholders' equity was approximately $196.7 million. The Credit Agreement and the Indenture permit the Company to incur or guarantee certain additional indebtedness, subject to certain limitations. 20 The Company's high degree of leverage could have important consequences to the Company, including, but not limited to, the following: (i) the Company's ability to obtain additional financing for working capital, capital expenditures, acquisitions, general corporate purposes or other purposes may be impaired in the future; (ii) a substantial portion of the Company's cash flows from operations must be dedicated to the payment of principal and interest on its indebtedness; (iii) the Company is substantially more leveraged than certain of its competitors, which might place the Company at a competitive disadvantage; (iv) the Company may be hindered in its ability to adjust rapidly to changing market conditions and (v) the Company's high degree of leverage could make it more vulnerable in the event of a downturn in general economic conditions or its business or in the event of adverse changes in the regulatory environment or other adverse circumstances applicable to the Company. The Company's ability to repay or to refinance its indebtedness and to pay interest on its indebtedness will depend on its financial and operating performance, which, in turn, is subject to prevailing economic and competitive conditions and to certain financial, business and other factors, many of which are beyond the Company's control. These factors could include operating difficulties, increased operating costs, the actions of competitors, regulatory developments and delays in implementing strategic projects. The Company's ability to meet its debt service and other obligations may depend in significant part on the extent to which the Company can successfully implement its business strategy. There can be no assurance that the Company will be able to implement its strategy fully or that the anticipated results of its strategy will be realized. See "Business--Business Strategy." If the Company's cash flows and capital resources are insufficient to fund its debt service obligations, the Company may be forced to reduce or delay capital expenditures, sell assets or seek to obtain additional equity capital or to restructure its debt. There can be no assurance that the Company's cash flows and capital resources will be sufficient for payment of principal of and interest on its indebtedness in the future, or that any such alternative measures would be successful or would permit the Company to meet its scheduled debt service obligations. In addition, because the Company's obligations under the Credit Agreement bear interest at floating rates, an increase in interest rates could adversely affect, among other things, the Company's ability to meet its debt service obligations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Outlook--Results of Operations." RESTRICTIVE FINANCING COVENANTS The Credit Agreement and the Indenture contain a number of covenants that restrict the operations of the Company and its subsidiaries. In addition, the Credit Agreement requires the Company to comply with specified financial ratios and tests, including a minimum interest coverage ratio, a maximum leverage ratio, a minimum net worth test, a maximum senior debt ratio and a minimum "EBITDA" test (as defined in the Credit Agreement, as amended). There can be no assurance that the Company will be able to comply with such covenants, ratios and tests in the future. The Company's ability to comply with such covenants, ratios and tests may be affected by events beyond its control, including prevailing economic, financial and industry conditions. The breach of any such covenants, ratios or tests could result in a default under the Credit Agreement that would permit the lenders thereunder to declare all amounts outstanding thereunder to be immediately due and payable, together with accrued and unpaid interest, and to prevent the Company from paying principal, premium, interest or other amounts due on any or all of the Notes until the default is cured or all senior indebtedness is paid or satisfied in full. Furthermore, the commitments of the lenders under the Credit Agreement to make further extensions of credit thereunder could be terminated. If the Company were unable to repay all amounts accelerated, the lenders could proceed against the subsidiary guarantors and the collateral securing the Company's and the subsidiary guarantors' obligations pursuant to the Credit Agreement. If the indebtedness outstanding pursuant to the Credit Agreement were to be accelerated, there can be no assurance that the assets of the Company would be sufficient to repay such indebtedness and the other indebtedness of the Company. The value of the Company's common stock would be adversely affected if the Company were unable to repay such indebtedness. 21 RISK-BASED PRODUCTS Revenues under risk-based contracts are the primary source of the Company's revenue from its behavioral managed healthcare business. Such revenues accounted for approximately 59.6% of the Company's total revenue and approximately 75.2% of its behavioral managed healthcare revenue in fiscal 1999. Under a risk-based contract, the Company assumes all or a portion of the responsibility for the cost of providing a full or specified range of behavioral healthcare treatment services to a specified beneficiary population in exchange, generally, for a fixed fee per member per month. In order for such contracts to be profitable, the Company must accurately estimate the rate of service utilization by beneficiaries enrolled in programs managed by the Company and control the unit cost of such services. If the aggregate cost of behavioral healthcare treatment services provided to a given beneficiary population in a given period exceeds the aggregate of the per member per month fees received by the Company with respect to the beneficiary population in such period, the Company will incur a loss with respect to such beneficiary population during such period. Furthermore, the Company may be required to pay during any period amounts with respect to behavioral healthcare treatment services provided to a given beneficiary population that exceed per member per month fees received with respect to such beneficiary population during the same period. There can be no assurance that the Company's assumptions as to service utilization rates and costs will accurately and adequately reflect actual utilization rates and costs, nor can there be any assurance that increases in behavioral healthcare costs or higher-than-anticipated utilization rates, significant aspects of which are outside the Company's control, will not cause expenses associated with such contracts to exceed the Company's revenue for such contracts. In addition, there can be no assurance that adjustments will not be required to the estimates, particularly those regarding cost of care, made in reporting historical financial results. See Note 1 to the audited consolidated financial statements of the Company included elsewhere herein. The Company expects to attempt to increase membership in its risk-based products. If the Company is successful in this regard, the Company's exposure to potential losses from its risk-based products will also be increased. Furthermore, certain of such contracts and certain state regulations limit the profits that may be earned by the Company on risk-based business and may require refunds if the loss experience is more favorable than that originally anticipated. Such contracts and regulations may also require the Company or certain of its subsidiaries to reserve a specified amount of cash as financial assurance that it can meet its obligations under such contracts. As of September 30, 1999, the Company had restricted cash and investments of $116.8 million pursuant to such contracts and regulations. Such amounts will not be available to the Company for general corporate purposes. Furthermore, certain state regulations restrict the ability of subsidiaries that offer risk-based products to pay dividends to the Company. Certain state regulations relating to the licensing of insurance companies may also adversely affect the Company's risk-based business. See "--Regulation." Although experience varies on a contract-by-contract basis, historically, the Company's risk-based contracts have been profitable. However, the degree of profitability varies significantly from contract to contract. For example, the Company's Medicaid contracts with governmental entities generally tend to have direct profit margins that are lower than the Company's other contracts. The most significant factor affecting the profitability of risk-based contracts is the ability to control direct service costs in relation to contract pricing. RELIANCE ON CUSTOMER CONTRACTS Approximately 79.2% of the Company's revenue in fiscal 1999 was derived from contracts with payors of behavioral healthcare benefits. The Company's behavioral managed healthcare contracts typically have terms of one to three years, and in certain cases contain renewal provisions providing for successive terms of between one and two years (unless terminated earlier). Substantially all of these contracts are immediately terminable with cause and many, including some of the Company's most significant contracts, are terminable without cause by the customer upon the provision of requisite notice and the passage of a specified period of time (typically between 60 and 180 days), or upon the occurrence of certain other specified events. The Company's ten largest behavioral managed healthcare customers accounted for approximately 57.5% of the Company's behavioral managed healthcare revenue for fiscal 1999. The Company's contract with the State of Tennessee to manage the behavioral healthcare benefits for the State's TennCare program represented approximately 14.4% of the Company's 22 behavioral managed healthcare revenue and approximately 11.4% of the Company's consolidated revenue in fiscal 1999. The Company's managed behavioral contracts and specialty managed care contracts with Aetna, including Nylcare and Prudential, which were acquired by Aetna in July 1998 and August 1999, respectively, represented approximately 15.9% and 29.3% of the Company's behavioral managed healthcare revenue and specialty managed healthcare revenue, respectively, and approximately 15.7% of the Company's consolidated revenue in fiscal 1999. There can be no assurance that such contracts will be extended or successfully renegotiated or that the terms of any new contracts will be comparable to those of existing contracts. Loss of all of these contracts or customers would, and loss of any one of these customers could, have a material adverse effect on the Company. In addition, price competition in bidding for contracts can significantly affect the financial terms of any new or renegotiated contract. DEPENDENCE ON GOVERNMENT SPENDING FOR MANAGED HEALTHCARE; POSSIBLE IMPACT OF HEALTHCARE REFORM A significant portion of the Company's managed care revenue is derived, directly or indirectly, from federal, state and local governmental agencies, including state Medicaid programs. Reimbursement rates vary from state to state, are subject to periodic negotiation and may limit the Company's ability to maintain or increase rates. The Company is unable to predict the impact on the Company's operations of future regulations or legislation affecting Medicaid or Medicare programs, or the healthcare industry in general, and there can be no assurance that future regulations or legislation will not have a material adverse effect on the Company. Moreover, any reduction in government spending for such programs could also have a material adverse effect on the Company. In addition, the Company's contracts with federal, state and local governmental agencies, under both direct contract and subcontract arrangements, generally are conditioned upon financial appropriations by one or more governmental agencies, especially with respect to state Medicaid programs. These contracts generally can be terminated or modified by the customer if such appropriations are not made. Finally, some of the Company's contracts with federal, state and local governmental agencies, under both direct contract and subcontract arrangements, require the Company to perform additional services if federal, state or local laws or regulations imposed after the contract is signed so require, in exchange for additional compensation to be negotiated by the parties in good faith. Government and other third-party payors are generally seeking to impose lower reimbursement rates and to renegotiate reduced contract rates with service providers in a trend toward cost control. See "Industry-- Areas of Growth" and "Business--Business Strategy." The House of Representatives of the U.S. Congress recently passed the Norwood-Dingell bill which would (if it or similar legislation became law), among other things, place limits on health care plans methods of operations, limit employers' and health care plans' ability to define medical necessity and permit employers and health care plans to be sued in state courts for coverage determinations. It is uncertain whether the Company could recoup, through higher premiums or other measures, the increased costs of federally mandated benefits or other increased costs caused by such legislation or similar legislation. The Company cannot predict the effect of this legislation, or other legislation that may be adopted by Congress, and no assurance can be given that such legislation will not have an adverse effect on the Company. REGULATION The managed healthcare industry and the provision of behavioral healthcare services are subject to extensive and evolving state and federal regulation. The Company is subject to certain state laws and regulations, including those governing: (i) the licensing of insurance companies, HMOs, PPOs, TPAs and companies engaged in utilization review and (ii) the licensing of healthcare professionals, including restrictions on business corporations from practicing, controlling or exercising excessive influence over behavioral healthcare services through the direct employment of psychiatrists or, in a few states, psychologists and other behavioral healthcare professionals. In addition, the Company is subject to certain federal laws as a result of the role the Company assumes in connection with managing its customers' employee benefit plans. The Company's managed care operations are also indirectly affected by regulations applicable to the establishment and operation of behavioral healthcare clinics and facilities. 23 In many states, entities that assume risk under contracts with licensed insurance companies or HMOs have not been considered by state regulators to be conducting an insurance or HMO business. As a result, the Company has not sought licensure as either an insurer or HMO in certain states. Regulators in some states, however, have determined that risk assuming activity by entities that are not themselves providers of care is an activity that requires some form of licensure. There can be no assurance that other states in which the Company operates will not adopt a similar view, thus requiring the Company to obtain additional licenses. Such additional licensure might require the Company to maintain minimum levels of deposits, net worth, capital, surplus or reserves, or limit the Company's ability to pay dividends, make investments or repay indebtedness. The imposition of these additional licensure requirements could increase the Company's cost of doing business or delay the Company's conduct or expansion of its business. Regulators may impose operational restrictions on entities granted licenses to operate as insurance companies or HMOs. For example, the California Department of Corporations ("DOC") imposed certain restrictions on the Company in connection with its issuance of an approval of the Company's acquisitions of HAI and Merit, including restrictions on the ability of the California subsidiaries of HAI and Merit to fund the Company's operations in other states and on the ability of the Company to make certain operational changes with respect to HAI and Merit California subsidiaries. In addition, utilization review and TPA activities conducted by the Company are regulated by many states, which states impose requirements upon the Company that increase its business costs. The Company believes that its TPA activities performed for its self-insured employee benefit plan customers are exempt from otherwise applicable state licensing or registration requirements based upon federal preemption under ERISA, and has relied on this general principle in determining not to seek licensure for certain of its activities in many states. Existing case law is not uniform on the applicability of ERISA preemption with respect to state regulation of utilization review or TPA activities. There can be no assurance that additional licensure will not be required with respect to utilization review or TPA activities in certain states. See "Business--Regulation--Insurance, HMO, and PPO Activities" and "--Utilization Review and Third-Party Administrator Activities." State regulatory agencies responsible for the administration and enforcement of the laws and regulations to which the Company's operations are subject have broad discretionary powers. A regulatory agency or a court in a state in which the Company operates could take a position under existing or future laws or regulations, or change its interpretation or enforcement practices with respect thereto, that such laws or regulations apply to the Company differently than the Company believes such laws and regulations apply or should be enforced. The resultant compliance with, or revocation of, or failure to obtain, required licenses and governmental approvals could result in significant alteration to the Company's business operations, delays in the expansion of the Company's business and lost business opportunities, any of which, under certain circumstances, could have a material adverse effect on the Company. See "Business--Regulation--General," "--Licensure," "--Insurance, HMO and PPO Activities" and "--Utilization Review and Third-Party Administrator Activities." The laws of some states limit the ability of a business corporation to directly provide, control or exercise excessive influence over behavioral healthcare services through the direct employment of psychiatrists, psychologists, or other behavioral healthcare professionals. In addition, the laws of some states prohibit psychiatrists, psychologists, or other healthcare professionals from splitting fees with other persons or entities. These laws and their interpretations vary from state to state and enforcement by the courts and regulatory authorities may vary from state to state and may change over time. The Company believes that its operations as currently conducted are in material compliance with the applicable laws, however there can be no assurance that the Company's existing operations and its contractual arrangements with psychiatrists, psychologists and other healthcare professionals will not be successfully challenged under state laws prohibiting fee splitting or the practice of a profession by an unlicensed entity, or that the enforceability of such contractual arrangements will not be limited. The Company believes that it 24 could, if necessary, restructure its operations to comply with changes in the interpretation or enforcement of such laws and regulations, and that such restructuring would not have a material adverse effect on its operations. Several states in which the Company does business have adopted, or are expected to adopt, "any willing provider" laws. Such laws typically impose upon insurance companies, PPOs, HMOs or other types of third-party payors an obligation to contract with, or pay for the services of, any healthcare provider willing to meet the terms of the payor's contracts with similar providers. Compliance with any willing provider laws could increase the Company's costs of assembling and administering provider networks and could, therefore, have a material adverse effect on its operations. HIGHLY COMPETITIVE INDUSTRY The industry in which the Company conducts its managed care businesses is highly competitive. The Company competes with large insurance companies, HMOs, PPOs, TPAs, provider groups and other managed care companies. Many of the Company's competitors are significantly larger and have greater financial, marketing and other resources than the Company, and some of the Company's competitors provide a broader range of services. The Company may also encounter substantial competition in the future from new market entrants. Many of the Company's customers that are managed care companies may, in the future, seek to provide behavioral managed healthcare services to their employees or subscribers directly, rather than contracting with the Company for such services. See "Business--Competition." RISKS RELATED TO AMORTIZATION OF INTANGIBLE ASSETS The Company's total assets at September 30, 1999 reflect intangible assets of approximately $1.27 billion. At September 30, 1999, net intangible assets were 67.3% of total assets and 643.8% of total stockholders' equity. Intangible assets include goodwill of approximately $1.11 billion, which is amortized over 25 to 40 years, and other identifiable intangible assets (primarily customer lists, provider networks and treatment protocols) of approximately $158.3 million that are amortized over 4 to 30 years. The amortization periods used by the Company may differ from those used by other entities. In addition, the Company may be required to shorten the amortization period for intangible assets in future periods based on the prospects of acquired companies. There can be no assurance that the value of such assets will ever be realized by the Company. The Company evaluates, on a regular basis, whether events and circumstances have occurred that indicate that all or a portion of the carrying value of intangible assets may no longer be recoverable, in which case a charge to earnings for impairment losses could become necessary. Any determination requiring the write-off of a significant portion of unamortized intangible assets would adversely affect the Company's results of operations. A write-off of intangible assets could become necessary if the anticipated undiscounted cash flows of an acquired company do not support the carrying value of long-lived assets, including intangible assets. At present, no evidence exists that would indicate impairment losses may be necessary in future periods. PROFESSIONAL LIABILITY; INSURANCE The management and administration of the delivery of behavioral and specialty managed healthcare services, like other healthcare services, entail significant risks of liability. The Company is regularly subject to lawsuits alleging malpractice and related legal theories, some of which involve situations in which participants in the Company's behavioral programs have committed suicide. The Company is also subject to claims of professional liability for alleged negligence in performing utilization review activities, as well as for acts and omissions of independent contractors participating in the Company's third-party provider networks. The Company is subject to claims for the costs of services for which payment was denied. There can be no assurance that the Company's procedures for limiting liability have been or will be effective, or that one or more lawsuits will not have a material adverse effect on the Company in the future. Recently, certain managed healthcare companies have been targeted as defendants in several national class action lawsuits regarding their business practices. These class action complaints include (i) inadequate disclosure of provider compensation arrangements to members, (ii) misrepresentation and omissions in advertising and health plan materials and (iii) concealment of information from health plan 25 members used to determine what claims will be paid, procedures to determine medical necessity and procedures to determine the extent and type of coverage. The Company believes that these national class action lawsuits are part of a trend targeting the healthcare industry, particularly managed care companies. While the Company has received suits of a similar nature in the past, it has not been named as a defendant in any of these new trend of national class action lawsuits. However, there can be no assurance that the Company won't be named in such class action lawsuits or that such lawsuits won't have a material adverse effect on the Company. The Company carries professional liability insurance, subject to certain deductibles. There can be no assurance that such insurance will be sufficient to cover any judgments, settlements or costs relating to present or future claims, suits or complaints or that, upon expiration thereof, sufficient insurance will be available on favorable terms, if at all. If the Company is unable to secure adequate insurance in the future, or if the insurance carried by the Company is not sufficient to cover any judgments, settlements or costs relating to any present or future actions or claims, there can be no assurance that the Company will not be subject to a liability that could have a material adverse effect on the Company. See "Business-Insurance" and "Legal Proceedings." The Company has certain potential liabilities relating to the self-insurance program it maintained with respect to its provider business prior to the Crescent Transactions. In addition, the Company continues to be subject to governmental investigations and inquiries, civil suits and other claims and assessments with respect to the provider business. See "Legal Proceedings" and Note 11 to the Company's audited historical consolidated financial statements included elsewhere herein. EXECUTIVE OFFICERS OF THE REGISTRANT
NAME AGE POSITION - ---- -------- -------- Henry T. Harbin M.D.................... 52 President, Chief Executive Officer and Director Mark S. Demilio........................ 44 Executive Vice President and General Counsel Clifford W. Donnelly................... 46 Executive Vice President and Chief Financial Officer Clarissa C. Marques, Ph.D.............. 47 Executive Vice President of Clinical and Quality Management John J. Wider, Jr...................... 52 President and Chief Operating Officer of Magellan Behavorial Health
HENRY T. HARBIN, M.D. became President, Chief Executive Officer and a Director of the Company on March 18, 1998. Dr. Harbin served as President and Chief Executive Officer of Green Spring from 1994 to 1998. Dr. Harbin served as Executive Vice President of the Company from 1995 until becoming President and Chief Executive Officer of the Company. MARK S. DEMILIO became Executive Vice President and General Counsel of the Company in July 1999. Prior thereto, Mr. Demilio was with Youth Services International, Inc., a publicly traded company that managed facilities for adjudicated youth, serving as Executive Vice President Business Development and General Counsel from March 1997 and Acting Chief Financial Officer from June 1998. Mr. Demilio was a partner with Miles & Stockbridge, a Baltimore, Maryland-based law firm, from 1994 to March 1997 and served as an associate with that firm from 1989. CLIFFORD W. DONNELLY became Executive Vice President and Chief Financial Officer of the Company in March 1999. Mr. Donnelly was Chief Financial Officer for Physicians Corporation of America ("PCA") from 1988 to September 1997 when PCA was acquired by Humana, Inc. PCA was a publicly-held company specializing in managed healthcare through HMO products and workers compensation products. CLARISSA C. MARQUES, PH.D. has served as Executive Vice President of Clinical and Quality Management since March 1998. Dr. Marques served as Executive Vice President and Chief Clinical Officer of 26 Green Spring during 1997 and 1998. Dr. Marques served as Senior Vice President of Green Spring from 1992 to 1997. JOHN J. WIDER, JR. has served as President and Chief Operating Officer of Magellan Behavorial Health ("MBH") since March 1998. Mr. Wider served as Executive Vice President and Chief Operating Officer of Green Spring from 1997 to 1998. Mr. Wider was President and General Manager for Cigna Healthcare Corporation's ("Cigna") Mid-Atlantic region from 1996 to 1997. Mr. Wider served as Area Operations Officer for Cigna during 1995 and 1996 and as Vice President of Sales of Cigna's Midwest region from 1993 to 1995. EMPLOYEES OF THE REGISTRANT At September 30, 1999, the Company had approximately 12,500 full-time and part-time employees. The Company believes it has satisfactory relations with its employees. ITEM 2. PROPERTIES GENERAL. The Company's principal executive offices are located in Columbia, Maryland; the lease for the Company's headquarters expires in 2003. BEHAVORIAL MANAGED CARE BUSINESS. Magellan Behavioral Health ("MBH") leases its 172 offices with terms expiring between 1999 and 2008. MBH's headquarters are leased and are co-located with the principal executive offices in Columbia, Maryland. HUMAN SERVICES BUSINESS. Mentor leases its 134 offices with terms expiring between 1999 and 2005. Mentor's headquarters are leased and are located in Boston, Massachusetts with the lease expiring in 2002. SPECIALITY MANAGED CARE BUSINESS. Allied and Care Management Resources, Inc. lease their 5 offices with terms expiring between 1999 and 2004. ITEM 3. LEGAL PROCEEDINGS The management and administration of the delivery of behavioral managed healthcare services, and the direct provision of behavioral healthcare treatment services, entail significant risks of liability. From time to time, the Company is subject to various actions and claims arising from the acts or omissions of its employees, network providers or other parties. In the normal course of business, the Company receives reports relating to suicides and other serious incidents involving patients enrolled in its programs. Such incidents occasionally give rise to malpractice, professional negligence and other related actions and claims against the Company or its network providers. As the number of lives covered by the Company grows and the number of providers under contract increases, actions and claims against the Company (and, in turn, possible legal liability) predicated on malpractice, professional negligence or other related legal theories can be expected to increase. See "Cautionary Statements--Professional Liability; Insurance." Many of these actions and claims received by the Company seek substantial damages and therefore require the defendant to incur significant fees and costs related to their defense. To date, claims and actions against the Company alleging professional negligence have not resulted in material liabilities and the Company does not believe that any pending action against it will have a material adverse effect on the Company. There can be no assurance that pending or future actions or claims for professional liability (including any judgments, settlements or costs associated therewith) will not have a material adverse effect on the Company. See "--Insurance" and "Cautionary Statements--Professional Liability; Insurance." From time to time, the Company receives notifications from and engages in discussions with various governmental agencies concerning its respective managed care businesses and operations. As a result of these contacts with regulators, the Company in many instances implements changes to its operations, revises its filings with such agencies and/or seeks additional licenses to conduct its business. In recent years, 27 in response to governmental agency inquiries or discussions with regulators, the Company has determined to seek licensure as a single service HMO, TPA or utilization review agent in one or more jurisdictions. On May 26, 1998, a group of eleven plaintiffs purporting to represent an uncertified class of psychiatrists, psychologists and social workers brought an action under the federal antitrust laws in the United States District Court for the District of New Jersey against nine behavioral health managed care organizations, including Merit, CMG, Green Spring and HAI (collectively, the "Defendants"). The complaint alleges that the Defendants violated Section I of the Sherman Act by engaging in a conspiracy to fix the prices at which the Defendants purchase services from mental healthcare providers such as the plaintiffs. The complaint further alleges that the Defendants engaged in a group boycott to exclude mental healthcare providers from the Defendants' networks in order to further the goals of the alleged conspiracy. The complaint also challenges the propriety of the Defendants' capitation arrangements with their respective customers, although it is unclear from the complaint whether the plaintiffs allege that the Defendants unlawfully conspired to enter into capitation arrangements with their respective customers. The complaint seeks treble damages against the Defendants in an unspecified amount and a permanent injunction prohibiting the Defendants from engaging in the alleged conduct which forms the basis of the complaint, plus costs and attorneys' fees. Upon joint motion by the Defendants, the case was transferred to the United States District Court for the Southern District of New York, the same court where a previous similar case (the "Stephens Case") was dismissed for failure to state a claim upon which relief can be granted. On March 15, 1999, the Defendants filed a joint motion to dismiss the case for substantially the same reasons as in the Stephens Case. On June 16, 1999, the court denied the motion to dismiss. The case currently is in discovery. On October 14, 1999, the Plaintiffs filed a motion seeking class certification for a class that would include approximately 200,000 providers. The court has not yet heard argument on that motion. The Company does not believe this matter will have a material adverse effect on its financial position or results of operations. The healthcare industry is subject to numerous laws and regulations. The subjects of such laws and regulations include, but are not limited to, matters such as licensure, accreditation, government healthcare program participation requirements, reimbursement for patient services, and Medicare and Medicaid fraud and abuse. Recently, government activity has increased with respect to investigations and/or allegations concerning possible violations of fraud and abuse and false claims statutes and/or regulations by healthcare providers. Entities that are found to have violated these laws and regulations may be excluded from participating in government healthcare programs, subjected to fines or penalties or required to repay amounts received from the government for previously billed patient services. The Office of the Inspector General of the Department of Health and Human Services and the United States Department of Justice ("Department of Justice") and certain other governmental agencies are currently conducting inquiries and/ or investigations regarding the compliance by the Company and certain of its subsidiaries and the compliance by CBHS and certain of its subsidiaries with such laws and regulations. Certain of the inquiries relate to the operations and business practices of the Psychiatric Hospital Facilities prior to the consummation of the Crescent Transactions in June 1997. The Department of Justice has indicated that its inquiries are based on its belief that the federal government has certain civil and administrative causes of action under the Civil False Claims Act, the Civil Monetary Penalties Law, other federal statutes and the common law arising from the participation in federal health benefit programs of CBHS psychiatric facilities nationwide. The Department of Justice inquiries relate to the following matters: (i) Medicare cost reports, (ii) Medicaid cost statements, (iii) supplemental applications to CHAMPUS/TRICARE based on Medicare cost reports, (iv) medical necessity of services to patients and admissions, (v) failure to provide medically necessary treatment or admissions and (vi) submission of claims to government payors for inpatient and outpatient psychiatric services. No amounts related to such proposed causes of action have yet been specified. The Company cannot reasonably estimate the settlement amount, if any, associated with the Department of Justice inquiries. Accordingly, no reserve has been recorded related to this matter. 28 The Company is also subject to or party to other litigation, claims, and civil suits, relating to its operations and business practices. In the opinion of management, the Company has recorded reserves that are adequate to cover litigation, claims or assessments that have been or may be asserted against the Company, and for which the outcome is probable and reasonably estimable, arising out of such other litigation, claims and civil suits. Furthermore, management believes that the resolution of such litigation, claims and civil suits will not have a material adverse effect on the Company's financial position or results of operations; however, there can be no assurance in this regard. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 29 PART II ITEM 5. MARKET PRICE FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company has one class of common stock, $0.25 par value per share, which is listed for trading on the New York Stock Exchange (ticker symbol "MGL"). As of November 30, 1999, there were 9,354 holders of record of the Company's common stock. The following table sets forth the high and low sales prices of the Company's common stock from October 1, 1997 through the fiscal year ended September 30, 1999 as reported by the New York Stock Exchange:
COMMON STOCK SALES PRICES ------------------------- CALENDAR YEAR HIGH LOW - ------------------------------------------------------------ ------------ ---------- 1997 Fourth Quarter.......................................... 31 3/4 20 9/16 1998 First Quarter........................................... 26 18 5/8 Second Quarter.......................................... 28 7/16 24 Third Quarter........................................... 26 9 5/8 Fourth Quarter.......................................... 10 3/4 6 3/8 1999 First Quarter........................................... 11 1/8 4 3/16 Second Quarter.......................................... 10 3 9/16 Third Quarter........................................... 10 1/2 6 7/8
The Company did not declare any cash dividends during fiscal 1998 or 1999. As of November 30, 1999, the Company was prohibited from paying dividends on its common stock under the terms of the Credit Agreement, except in very limited circumstances. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth selected historical consolidated financial information of the Company for each of the five years in the period ended September 30, 1999. On September 2, 1999, the Company's Board of Directors approved a formal plan to dispose of the businesses included in the Company's healthcare provider and healthcare franchising segments. On September 10, 1999, the Company consummated the CBHS Transactions. Accordingly, the statement of operations data has been restated to reflect the healthcare provider and healthcare franchising segments as discontinued operations. Selected consolidated financial information for the three years ended September 30, 1999 and as of September 30, 1998 and 1999, presented below, have been derived from, and should be read in conjunction with, the Company's audited consolidated financial statements and the notes thereto. Selected consolidated financial information for the two years ended September 30, 1995 and 1996 and as of September 30, 1995, 1996 and 1997 has been derived from the Company's unaudited consolidated financial statements. The selected financial data set forth below should be read in conjunction with the Company's audited consolidated financial statements and the notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing elsewhere herein. 30
FISCAL YEAR ENDED SEPTEMBER 30, -------------------------------------------------------------- 1995 1996 1997 1998 1999 ---------- ---------- ---------- ---------- ---------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) STATEMENT OF OPERATIONS DATA: Net revenue.................................. $ 56,077 $ 302,573 $ 463,872 $1,310,778 $1,871,636 Salaries, cost of care and other operating expenses................................... 77,499 299,855 438,472 1,183,626 1,663,626 Equity in (earnings) loss of unconsolidated subsidiaries............................... -- 2,005 5,567 (12,795) (20,442) Depreciation and amortization................ 3,664 14,290 19,683 49,264 73,531 Interest, net................................ 55,405 48,584 46,438 76,505 93,752 ESOP expense................................. 17,960 -- -- -- -- Stock option expense (credit)................ (467) 914 4,292 (5,623) 18 Managed care integration costs............... -- -- -- 16,962 6,238 Special charges, net......................... -- 1,221 -- -- 4,441 Income (loss) from continuing operations before income taxes, minority interest and extraordinary items........................ (97,984) (64,296) (50,580) 2,839 50,472 Provision for (benefit from) income taxes.... (39,194) (25,719) (20,232) 5,544 27,376 Income (loss) from continuing operations before minority interest and extraordinary items...................................... (58,790) (38,577) (30,348) (2,705) 23,096 Minority interest............................ -- 4,531 6,856 4,094 630 Income (loss) from continuing operations before extraordinary items................. (58,790) (43,108) (37,204) (6,799) 22,466 Discontinued operations: Income from discontinued operations........ 15,827 75,491 41,959 20,531 29,645 Loss on disposal of discontinued operations............................... -- -- -- -- (47,423) Income (loss) before extraordinary items..... (42,963) 32,383 4,755 13,732 4,688 Extraordinary items-losses on early extinguishments of debt.................... -- -- (5,253) (33,015) -- Net income (loss)............................ $ (42,963) $ 32,383 $ (498) $ (19,283) $ 4,688 INCOME (LOSS) PER COMMON SHARE--BASIC: Income (loss) from continuing operations before extraordinary items................. $ (2.11) $ (1.39) $ (1.29) $ (0.22) $ 0.71 Income (loss) from discontinued operations... 0.57 2.43 1.46 0.67 (0.56) Loss from extraordinary items................ -- -- (0.18) (1.07) -- Net income (loss)............................ $ (1.54) $ 1.04 $ (0.02) $ (0.63) $ 0.15 INCOME (LOSS) PER COMMON SHARE--DILUTED: Income (loss) from continuing operations before extraordinary items................. $ (2.11) $ (1.39) $ (1.29) $ (0.22) $ 0.70 Income (loss) from discontinued operations... 0.57 2.43 1.46 0.67 (0.56) Loss from extraordinary items................ -- -- (0.18) (1.07) -- Net income (loss)............................ $ (1.54) $ 1.04 $ (0.02) $ (0.63) $ 0.15 BALANCE SHEET DATA (END OF PERIOD): Current assets............................... $ 305,575 $ 338,150 $ 507,038 $ 399,724 $ 374,927 Current liabilities.......................... 214,162 274,316 219,376 454,766 474,268 Property and equipment, net.................. 488,767 495,390 109,214 177,169 120,667 Total assets................................. 983,558 1,140,137 896,868 1,917,088 1,881,615 Total debt and capital lease obligations..... 541,569 572,058 395,294 1,225,646 1,144,308 Stockholders' equity......................... 88,560 121,817 159,498 188,433 196,696
31 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES SEPTEMBER 30, 1999 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Prior to June 1997, the Company derived the majority of its revenue from providing behavioral healthcare services in an inpatient setting. Payments from third-party payors are the principal source of revenue for most behavioral healthcare providers. In the early 1990's, many third party payors sought to control the cost of providing care to their patients by instituting managed care programs or seeking the assistance of managed care companies. Providers participating in managed care programs agree to provide services to patients for a discount from established rates, which generally results in pricing concessions by the providers and lower margins. Additionally, managed care programs generally encourage alternatives to inpatient treatment settings and reduce utilization of inpatient services. As a result, third-party payors established managed care programs or engaged managed care companies in many areas of healthcare, including behavioral healthcare. The Company, which until June 1997, was the largest operator of psychiatric hospitals in the United States, was adversely affected by the adoption of managed care programs as the principal cost control measure of third-party payors. Prior to the first quarter of fiscal 1996, the Company was not engaged in the behavioral managed healthcare business. During the first quarter of fiscal 1996, the Company acquired a 61% ownership interest in Green Spring Health Services, Inc. ("Green Spring"). At that time, the Company intended to become a fully integrated behavioral healthcare provider by combining the behavorial managed healthcare products offered by Green Spring with the direct treatment services offered by the Company's psychiatric hospitals. The Company believed that an entity that participated in both the managed care and the provider segments of the behavioral healthcare industry could more efficiently provide and manage behavioral healthcare for insured populations than an entity that was solely a managed care company. The Company also believed that earnings from its behavioral managed care business would offset, in part, the negative impact on the financial performance of its psychiatric hospitals caused by managed care. Green Spring was the Company's first significant involvement in behavioral managed healthcare. During the second quarter of fiscal 1998, the minority stockholders of Green Spring converted their 39% ownership interest in Green Spring into an aggregate of 2,831,516 shares of Magellan common stock. Subsequent to the Company's acquisition of Green Spring, the growth of the behavioral managed healthcare industry accelerated. Under the Company's majority ownership, Green Spring increased its base of covered lives from 12.0 million at of the end of calendar year 1995 to 21.1 million at the end of calendar year 1997, a compound annual growth rate of over 32%. While growth in the industry was accelerating, the behavioral managed healthcare industry also began to consolidate. The Company concluded that this consolidation presented an opportunity for it to increase its participation in the behavioral managed healthcare industry, which the Company believed offered growth and earnings prospects superior to those of the psychiatric hospital industry. Therefore, the Company decided to sell its domestic psychiatric facilities to obtain capital for expansion of its behavioral managed healthcare business. On June 17, 1997, the Company consummated the Crescent Transactions which provided the Company with approximately $200 million of net cash proceeds, after debt repayment, for use in implementing its business strategy to increase its participation in the managed healthcare industry. The Company used the net cash proceeds of approximately $200 million, after debt repayment, to finance the acquisitions of HAI and Allied in December 1997. The Company further implemented its business strategy through the acquisition of Merit in February 1998. 32 On September 10, 1999, the Company consummated the CBHS Transactions. The CBHS Transactions, together with the formal plan of disposal authorized by the Company's Board of Directors on September 2, 1999, represents the disposal of the Company's healthcare provider and healthcare franchising business segments under APB 30. APB 30 requires that the results of continuing operations be reported separately from those of discontinued operations for all periods presented and that any gain or loss from disposal of a segment of a business be reported in conjunction with the related results of discontinued operations. Accordingly, the Company has restated its results of operations for all prior periods. The Company recorded an after-tax loss on disposal of its healthcare provider and healthcare franchising business segments of approximately $47.4 million (primarily non-cash), in fiscal 1999. The Company currently operates through three principal business segments which are engaged in: - THE BEHAVIORAL MANAGED HEALTHCARE BUSINESS. The Company's MAGELLAN BEHAVIORAL HEALTH division coordinates and manages the delivery of behavioral healthcare treatment services through its network of providers, which includes psychiatrists, psychologists and other medical professionals. The treatment services provided through these provider networks include outpatient programs (such as counseling or therapy), intermediate care programs (such as intensive outpatient programs and partial hospitalization services), inpatient treatment and alternative care services (such as residential treatment and home or community-based programs). The Company provides these services primarily through: (i) risk-based products, where the Company assumes all or a portion of the responsibility for the cost of providing treatment services in exchange for a fixed per member per month fee, (ii) ASO products, where the Company provides services such as utilization review, claims administration or provider network management, (iii) EAPs and (iv) products which combine features of some or all of the Company's risk-based, ASO, or EAP products. - THE HUMAN SERVICES BUSINESS. The Company provides various human services through Mentor. These human services include specialty home-based healthcare services provided through "mentor" homes as well as residential and day treatment services for individuals with acquired brain injuries and for individuals with mental retardation and developmental disabilities. - THE SPECIALTY MANAGED HEALTHCARE BUSINESS. The Company's MAGELLAN SPECIALTY HEALTH division provides specialty risk-based and ASO services to a variety of health insurance companies and other customers. At September 30, 1999, the Company's MAGELLAN BEHAVIORAL HEALTH division, managed the behavioral healthcare benefits of approximately 66.4 million individuals; Mentor, which provided community-based services to 6,444 individuals; and the Company's MAGELLAN SPECIALTY HEALTH division, which was formed primarily through acquisitions completed in fiscal 1997 (Care Management Resources, Inc.) and fiscal 1998 (Allied) managed specialty benefits for approximately 3.5 million members of health plans. 33 RESULTS OF OPERATIONS The following tables summarize, for the periods indicated, operating results by continuing business segment (in thousands).
BEHAVIORAL SPECIALTY CORPORATE MANAGED HUMAN MANAGED OVERHEAD FISCAL 1997 HEALTHCARE SERVICES HEALTHCARE AND OTHER CONSOLIDATED - ----------- ---------- -------- ---------- --------- ------------ Net revenue............................ $375,541 $88,331 $ -- $ -- $ 463,872 -------- ------- ------- -------- ---------- Salaries, cost of care and other operating expenses................... 332,955 77,636 2,303 25,578 438,472 Equity in loss of unconsolidated subsidiaries......................... 5,567 -- -- -- 5,567 -------- ------- ------- -------- ---------- 338,522 77,636 2,303 25,578 444,039 -------- ------- ------- -------- ---------- Segment Profit(1).................... $ 37,019 $10,695 $(2,303) $(25,578) $ 19,833 ======== ======= ======= ======== ==========
BEHAVIORAL SPECIALTY CORPORATE MANAGED HUMAN MANAGED OVERHEAD FISCAL 1998 HEALTHCARE SERVICES HEALTHCARE AND OTHER CONSOLIDATED - ----------- ---------- -------- ---------- --------- ------------ Net revenue............................ $1,026,243 $141,032 $143,503 $ -- $1,310,778 ---------- -------- -------- -------- ---------- Salaries, cost of care and other operating expenses................... 901,846 125,539 140,375 15,866 1,183,626 Equity in earnings of unconsolidated subsidiaries......................... (12,795) -- -- -- (12,795) ---------- -------- -------- -------- ---------- 889,051 125,539 140,375 15,866 1,170,831 ---------- -------- -------- -------- ---------- Segment Profit(1).................... $ 137,192 $ 15,493 $ 3,128 $(15,866) $ 139,947 ========== ======== ======== ======== ==========
BEHAVIORAL SPECIALTY CORPORATE MANAGED HUMAN MANAGED OVERHEAD FISCAL 1999 HEALTHCARE SERVICES HEALTHCARE AND OTHER CONSOLIDATED - ----------- ---------- -------- ---------- --------- ------------ Net revenue............................ $1,483,202 $191,277 $197,157 $ -- $1,871,636 ---------- -------- -------- -------- ---------- Salaries, cost of care and other operating expenses................... 1,285,391 169,549 194,747 13,939 1,663,626 Equity in earnings of unconsolidated subsidiaries......................... (20,442) -- -- -- (20,442) ---------- -------- -------- -------- ---------- 1,264,949 169,549 194,747 13,939 1,643,184 ---------- -------- -------- -------- ---------- Segment Profit(1)...................... $ 218,253 $ 21,728 $ 2,410 $(13,939) $ 228,452 ========== ======== ======== ======== ==========
(1) Segment Profit is the measure of profitability used by management to assess the operating performance of each business segment. See Note 13, "Business Segment Information", to the Company's audited consolidated financial statements appearing elsewhere herein. FISCAL 1998 COMPARED TO FISCAL 1999 BEHAVIORAL MANAGED HEALTHCARE. Revenue increased 44.5% or $457.0 million, to $1.48 billion for fiscal 1999, from $1.03 billion in fiscal 1998. Salaries, cost of care and other operating expenses increased 42.5%, or $383.5 million, to $1.29 billion for fiscal 1999, from $901.8 million in fiscal 1998. Equity in earnings of unconsolidated subsidiaries increased $7.6 million, to $20.4 million for fiscal 1999, from $12.8 million for fiscal 1998. The increases resulted primarily from (i) the HAI and Merit acquisitions in fiscal 1998, (ii) increased enrollment related to existing customers, (iii) expanded services and lives under 34 management with certain public sector customers, (iv) new business development and (v) increases in retroactive customer settlements, offset by reductions in general and administrative costs as a result of the integration of Green Spring, HAI and Merit and the termination of one public sector contract (Montana Medicaid) in fiscal 1999. Total covered lives increased 7.8% or 4.8 million to 66.4 million at September 30, 1999 from 61.6 million at September 30, 1998. The Company frequently records retroactive customer settlements, which may be favorable or unfavorable, under its commercial behavioral managed healthcare contracts. Revenue and Segment Profit for fiscal 1999 reflect approximately $9.8 million of such favorable settlements compared to favorable settlements of $1.8 million during fiscal 1998. The Company recorded $3.7 million of favorable retroactive customer settlements in the fourth quarter of fiscal 1999. HUMAN SERVICES. Revenue increased 35.7%, or $50.3 million, to $191.3 million for fiscal 1999, from $141.0 million in fiscal 1998. Salaries, cost of care and other operating expenses increased 35.1%, or $44.0 million, to $169.5 million for fiscal 1999 from $125.5 million in fiscal 1998. The increases were attributable to acquisitions consummated in fiscal 1998 and fiscal 1999 and internal growth, offset by reductions in revenue and Segment Profit at one acquired business in fiscal 1999 as a result of rate and placement reductions from a state agency. Total placements increased 9.5% to 6,444 at September 30, 1999, compared to 5,883 at September 30, 1998. SPECIALTY MANAGED HEALTHCARE. Revenue increased 37.4%, or $53.7 million, to $197.2 million for fiscal 1999, compared to $143.5 million in the same period in fiscal 1998. Salaries, cost of care and other operating expenses increased 38.7%, or $54.3 million, to $194.7 million for fiscal 1999, compared to $140.4 million in fiscal 1998. The increase in revenue and salaries, cost of care and other operating expenses was primarily related to the Allied acquisition in fiscal 1998 and a shift toward more risk-based business in fiscal 1999 offset by the loss of a significant customer at the end of fiscal 1998 and increased administrative spending in fiscal 1999 to support future internal growth. CORPORATE OVERHEAD AND OTHER. Salaries and other operating expenses decreased 12.1%, or $1.9 million, primarily as a result of ongoing integration of corporate administrative functions with business unit administrative functions. DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased 49.1%, or $24.2 million, to $73.5 million for fiscal 1999, from $49.3 million in fiscal 1998. The increase was primarily attributed to (i) the acquisition of HAI, Allied and Merit in fiscal 1998, (ii) depreciation related to recent capital expenditures and (iii) amortization related to the Aetna Payment (as defined) made in fiscal 1999. INTEREST, NET. Interest expense, net, increased 22.6%, or $17.3 million, to $93.8 million for fiscal 1999, from $76.5 million in fiscal 1998. The increase was primarily the result of interest expense incurred on borrowings used to fund the Merit acquisition and related transactions in fiscal 1998. OTHER ITEMS. Stock option expense for fiscal 1999 was not material compared to a credit of $5.6 million in fiscal 1998 primarily due to fluctuations in the market price of the Company's stock in fiscal 1998. The Company recorded managed care integration costs of $6.2 million for fiscal 1999, compared to $17.0 million in fiscal 1998. For a more complete discussion of managed care integration costs, see Note 9, "Managed Care Integration Plan and Costs and Special Charges" to the Company's audited consolidated financial statements set forth elsewhere herein. The Company recorded special charges of $4.4 million during fiscal 1999 related primarily to the loss on disposal of an office building, executive severance and costs associated with moving the Company's corporate headquarters from Atlanta, Georgia to Columbia, Maryland. The Company's effective income tax rate was 54.2% for fiscal 1999. The effective income tax rate exceeds statutory rates due primarily to non-deductible goodwill amortization resulting from the Merit acquisition of $18.0 million for fiscal 1999. 35 Minority interest decreased $3.5 million, to $0.6 million during fiscal 1999 primarily as a result of the Green Spring minority stockholder conversion in fiscal 1998. Income from discontinued operations, net of tax, increased 44.4% or $9.1 million to $29.6 million for fiscal 1999 compared to $20.5 million for fiscal 1998. Income from the healthcare provider segment increased 171.1%, or $20.7 million to $32.8 million for fiscal 1999 compared to $12.1 million for fiscal 1998. The increase is primarily attributable to (i) the net effect of the Company's sale of its three European Hospitals in April 1999, which included a gain on sale of $14.4 million, net of tax, (ii) increases in income of $8.8 million, net of tax, from cost report settlements related primarily to the resolution of Medicare cost report matters in the fourth quarter of fiscal 1999 associated with the Company's sale of the Psychiatric Hospital Facilities, and (iii) increases in income of $4.8 million, net of tax, related to adjustments to accounts receivable collection fee reserves recorded in connection with the Crescent Transactions, offset by reductions in adjustments to income of $2.5 million, net of tax, related to updated actuarial estimates of malpractice claims. Income from the healthcare franchising segment decreased $11.6 million, net of tax, to a loss of $3.2 million, net of tax, for fiscal 1999 compared to income of $8.4 million, net of tax, for the same period in 1998. The decrease was primarily attributable to the declining operating performance of CBHS, which resulted in the Company recording and collecting no franchise fees from CBHS in fiscal 1999. The Company recorded a loss on disposal of discontinued operations of approximately $47.4 million, net of tax, during fiscal 1999 as a result of the CBHS Transactions. See Note 3, "Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein. The Company recorded an extraordinary loss on early extinguishment of debt of approximately $33.0 million, net of tax, during fiscal 1998, related primarily to refinancing the Company's long-term debt in connection with the Merit acquisition. FISCAL 1997 COMPARED TO FISCAL 1998 BEHAVIORAL MANAGED HEALTHCARE. Revenue increased 173.3%, or $650.7 million, to $1,026.2 million for fiscal 1998 from $375.5 million in fiscal 1997. Salaries, cost of care and other operating expenses increased 170.8%, or $568.8 million, to $901.8 million for fiscal 1998 from $333.0 million in fiscal 1997. Equity in earnings of unconsolidated subsidiaries increased $18.4 million to $12.8 million in fiscal 1998 compared to a loss of $5.6 million in fiscal 1997. The increases resulted primarily from the acquisitions of HAI and Merit in fiscal 1998 and internal growth at Green Spring. Revenue and Segment Profit increased as a result of acquisitions, the award of several new contracts in fiscal 1997 and 1998 and significant improvements in negotiated rates and terms of the TennCare contract in fiscal 1998. HUMAN SERVICES. Revenue increased 59.7%, or $52.7 million, to $141.0 million for fiscal 1998 from $88.3 million in fiscal 1997. Salaries, cost of care and other operating expenses increased 61.7%, or $47.9 million, to $125.5 million in fiscal 1998 from $77.6 million in fiscal 1997. The increases were attributable to seven acquisitions consummated in fiscal 1998 and internal growth. Placements in Mentor homes increased 19.6% in fiscal 1998. SPECIALTY MANAGED HEALTHCARE. Revenue was $143.5 million in fiscal 1998 compared to $0 in fiscal 1997. Salaries, cost of care and other operating expenses were $140.4 million in fiscal 1998 compared to $2.3 million in fiscal 1997. The increase in revenues and salaries, cost of care and other operating expenses were primarily related to the Allied acquisition. Fiscal 1997 salaries, cost of care and other operating expenses represent start-up costs related to the Company's initial involvement in the specialty managed care business. CORPORATE OVERHEAD AND OTHER. Salaries and other operating expenses decreased 38.0%, or $9.7 million, due primarily to the transfer of personnel and overhead to CBHS and the healthcare franchising segment in fiscal 1997 as a result of the Crescent Transactions. 36 DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased 150.3%, or $29.6 million, to $49.3 million in fiscal 1998 from $19.7 million fiscal 1997. The increase was primarily attributable to increases in depreciation and amortization resulting from the HAI, Allied and Merit acquisitions. INTEREST, NET. Interest expense, net, increased 64.9% or $30.1 million to $76.5 million in fiscal 1998 from $46.4 million in fiscal 1997. The increase was primarily the result of interest expense incurred on borrowings used to fund the Merit acquisition and related transactions offset by lower interest expense due to lower average borrowings and higher interest income from cash received in the Crescent Transactions through December 5, 1997. OTHER ITEMS. Stock option expense for fiscal 1998 decreased $9.9 million compared to fiscal 1997 primarily due to fluctuations in the market price of the Company's common stock. The Company recorded managed care integration costs of $17.0 million for fiscal 1998. See Note 9, "Managed Care Integration Plan and Costs, and Special Charges" to the Company's audited consolidated financial statements set forth elsewhere herein. The Company's effective income tax rate was 195.3% for fiscal 1998 primarily due to non-deductible goodwill amortization of approximately $11.0 million resulting from the Merit acquisition in fiscal 1998. Minority interest decreased $2.8 million during fiscal 1998, compared to fiscal 1997. The decrease was primarily attributable to the Green Spring minority stockholder conversion in January 1998 offset by Green Spring's net income growth in fiscal 1998 through January 1998. Income from discontinued operations, net of tax, decreased 51.2%, or $21.5 million to $20.5 million in fiscal 1998 from $42.0 million in fiscal 1997. Income from the healthcare provider segment decreased 65.9% or $23.4 million to $12.1 million in fiscal 1998 from $35.5 million in fiscal 1997. The decrease resulted primarily from (i) the effect of the Crescent Transactions which included a $35.9 million loss in 1997, net of tax, (ii) decreases in income of $12.3 million from settlements and adjustments related to reimbursement issues ("Cost Report Settlements"), net of tax, (iii) favorable adjustments to fiscal 1997 income of $3.8 million related to accounts receivable retained by the Company that were generated by the hospitals operated by CBHS, net of tax, and (iv) decreases in adjustments to income of $2.0 million related to updated actuarial estimates of malpractice claim reserves, net of tax. Income from the healthcare franchising segment increased 29.2%, or $1.9 million, to $8.4 million in fiscal 1998 compared to $6.5 million in fiscal 1997. The increase resulted primarily from the effect of the Crescent Transactions offset by declining operating performance of CBHS in fiscal 1998. See Note 3, "Discontinued Operations", to the Company's audited consolidated financial statements included elsewhere herein. The Company recorded extraordinary losses on early extinguishments of debt, net of tax, of $5.3 million and $33.0 million during fiscal 1997 and 1998, respectively, related primarily to the termination of its then existing credit agreements in fiscal 1997 and 1998 and the extinguishment of the long-term debt related to the Merit acquisition in fiscal 1998. See Note 5, "Long-Term Debt, Capital Lease Obligations and Operating Leases," to the Company's audited consolidated financial statements set forth elsewhere herein. OUTLOOK--RESULTS OF OPERATIONS BEHAVIORAL MANAGED HEALTHCARE RESULTS OF OPERATIONS. The Company's behavioral managed healthcare Segment Profit is subject to significant fluctuations on a quarterly basis. These fluctuations may result from: (i) changes in utilization levels by enrolled members of the Company's risk-based contracts, including seasonal utilization patterns; (ii) performance-based contractual adjustments to revenue, reflecting utilization results or other performance measures; (iii) retroactive contractual adjustments under commercial contracts and CHAMPUS contracts; (iv) retrospective membership adjustments; (v) timing of implementation of new contracts and enrollment changes, (vi) pricing adjustments upon long-term 37 contract renewals and (vii) changes in estimates regarding medical costs and incurred but not yet reported medical claims. The Company's contract with the State of Tennessee to manage the behavioral healthcare benefits for the State's TennCare program ("TennCare Contract") represented approximately 14.4% of the Company's behavioral managed healthcare revenue and approximately 11.4% of the Company's consolidated revenue in fiscal 1999. The TennCare Contract contains provisions that limit the Company's profit, subject to the carryforward of losses incurred in prior periods. The Company's profit under the TennCare Contract benefited from the carryforward of losses incurred in prior periods during fiscal 1999. The Company's Segment Profit under the TennCare Contract is expected to be up to $10 million lower in fiscal 2000 than fiscal 1999 as result of these contract provisions. The Company performs provider network, care management and medical review services for Independence Blue Cross ("IBC"), a health insurance company, under a contract that was entered into on July 7, 1994, with terms of up to five years. The Company is in the process of renegotiating the terms of its contract with IBC. Based on preliminary discussions with IBC, the Company expects to renew the IBC contract on a long-term basis. However, there can be no assurance that the Company will be able to renew the IBC contract at existing pricing levels. INTEREST RATE RISK. The Company had $512.9 million of total debt outstanding under the Credit Agreement at September 30, 1999. Debt under the Credit Agreement bears interest at variable rates. Historically, the Company's has elected the interest rate option under the Credit Agreement that is an adjusted London inter-bank offer rate ("LIBOR") plus a borrowing margin. See Note 5, "Long-Term Debt, Capital Lease Obligations and Operating Leases", to the Company's audited consolidated financial statements appearing elsewhere herein. Based on September 30, 1999 borrowing levels, a 25 basis point increase in interest rates would cost the Company approximately $1.3 million per year in additional interest expense. LIBOR-based Eurodollar borrowing rates have increased since January 1999. One month and six month LIBOR-based Eurodollar rates increased by approximately 45 basis points and 100 basis points, respectively, between January 1999 and September 1999 and may continue to increase during fiscal 2000. The Company's earnings could be adversely affected by further increases in interest rates. TPG INVESTMENT. On December 15, 1999, the Company consummated the TPG Investment. See Note 15, "Subsequent Event" to the Company's audited consolidated financial statements set forth elsewhere herein. The TPG Investment will reduce fiscal 2000 diluted income from continuing operations per common share. HISTORICAL LIQUIDITY AND CAPITAL RESOURCES--FISCAL 1997-1999 OPERATING ACTIVITIES. The Company's net cash provided by (used in) operating activities was $73.6 million, $(4.2) million and $41.9 million for fiscal 1997, 1998 and 1999, respectively. The increase in cash provided by operating activities in fiscal 1999 compared to fiscal 1998 was primarily the result of reduction in income taxes paid, net of refunds received, of $10.8 million, and increases in cash flows from operations as a result of the HAI and Merit acquisitions, offset by reductions in franchise fees collected from CBHS of $40.6 million, changes in reserve for unpaid claims of $11.0 million and increases in interest paid of $6.9 million. The decrease in cash provided by operating activities in fiscal 1998 compared to fiscal 1997 was primarily the result of: (i) higher interest payments ($54.4 million and $95.2 million in fiscal 1997 and 1998, respectively,) as a result of the Merit acquisition; (ii) reduced cash flows from the provider business, net of franchise fees received and (iii) the funding of liabilities related to the Merit acquisition. INVESTING ACTIVITIES. The Company utilized $33.3 million, $44.2 million and $48.1 million in funds during fiscal 1997, 1998 and 1999, respectively, for capital expenditures. The increases were the result of the Company's transition to the managed care business from the provider business. The Company used $50.9 million, $1.05 billion and $69.5 million in funds during fiscal 1997, 1998 and 1999, respectively, net of cash acquired, for acquisitions and investments in businesses. This included 38 primarily equity investments in CBHS and Premier (as defined) and hospital acquisitions in fiscal 1997, managed care acquisitions and human services acquisitions in fiscal 1998 and contingent consideration paid related to managed care acquisitions in fiscal 1999. The Company received distributions from unconsolidated subsidiaries of $11.4 million and $21.2 million in fiscal 1998 and 1999, respectively. Distributions received from Choice (as defined) were $11.4 million and $13.0 million in fiscal 1998 and 1999, respectively, with the remaining distributions being received from the Provider JVs in fiscal 1999. The Company received proceeds from the sale of assets of $398.7 million, $11.9 million and $54.2 million in fiscal 1997, 1998 and 1999, respectively. The sales proceeds were generated primarily from (i) the Crescent Transactions in fiscal 1997, (ii) the sale of hospital real estate related to closed hospitals retained by the Company and (iii) the sale of the European Hospitals in fiscal 1999. FINANCING ACTIVITIES. The Company borrowed approximately $203.6 million, $1.2 billion and $76.8 million during fiscal 1997, 1998 and 1999, respectively. The fiscal 1997 borrowings primarily funded the repayment of variable rate secured notes and other long-term debt (including the refinancing of a previous revolving credit agreement), acquisitions and working capital needs. The fiscal 1998 borrowings primarily funded the Merit acquisition and related long-term debt refinancing with the remaining amounts representing borrowings under the Revolving Facility for short-term capital needs. The fiscal 1999 borrowings were primarily draws under the Revolving Facility for short-term capital needs. The Company repaid approximately $390.3 million, $438.6 million and $156.0 million of debt and capital lease obligations during fiscal 1997, 1998 and 1999, respectively. The fiscal 1997 repayments related primarily to a previous revolving credit agreement and repaying variable rate secured notes as a result of the Crescent Transactions. The fiscal 1998 repayments related primarily to the extinguishment of the Magellan Outstanding Notes as part of the Merit acquisition. The fiscal 1999 payments were for Term Loan Facility principal amortization, required Term Loan Facility principal payments related to the sale of the European Hospitals and payments on balances outstanding under the Revolving Facility. The Company issued approximately 2.6 million warrants, in aggregate, to Crescent and COI for $25.0 million in cash as part of the Crescent Transactions during fiscal 1997. On November 1, 1996, the Company announced that its board of directors had approved the repurchase of an additional 3.0 million shares of common stock from time to time subject to the terms of the Company's then current credit agreements. During fiscal 1998, the Company repurchased approximately 0.7 million shares of its common stock for approximately $14.4 million. As of September 30, 1999, the Company had approximately $112.4 million of availability under the Revolving Facility, excluding approximately $17.6 million of availability reserved for certain letters of credit. The Company was in compliance with all debt covenants as of September 30, 1999. OUTLOOK--LIQUIDITY AND CAPITAL RESOURCES DEBT SERVICE OBLIGATIONS. The interest payments on the Company's $625.0 million 9% Series A Senior Subordinated Notes due 2008 and interest and principal payments on indebtedness outstanding pursuant to the Company's $700.0 million Credit Agreement represent significant liquidity requirements for the Company. Borrowings under the Credit Agreement bear interest at floating rates and require interest payments on varying dates depending on the interest rate option selected by the Company. As of September 30, 1999, borrowings pursuant to the Credit Agreement included $492.9 million under the Term Loan Facility and up to $150.0 million under the Revolving Facility. The Company had $20.0 million of borrowings and $17.6 million of letters of credit outstanding under the Revolving Facility at September 30, 1999. As of September 30, 1999, the Company is required to repay the principal amount of borrowings 39 outstanding under the Term Loan Facility and the principal amount of the Notes in the years and amounts set forth in the following table (in millions):
REMAINING FISCAL YEAR PRINCIPAL AMOUNT - ----------- ---------------- 2000 $ 30.1 2001 36.2 2002 45.9 2003 85.5 2004 145.6 2005 122.5 2006 27.1 2007 -- 2008 625.0
In addition, any amounts outstanding under the Revolving Facility mature in February 2004. POTENTIAL PURCHASE PRICE ADJUSTMENTS. In December 1997, the Company purchased HAI from Aetna for approximately $122.1 million, excluding transaction costs. In addition, the Company incurred the obligation to make contingent payments to Aetna which may total up to $60.0 million annually over the five-year period subsequent to closing. The Company is obligated to make contingent payments under two separate calculations as follows: In respect of each Contract Year (as defined), the Company may be required to pay to Aetna the "Tranche 1 Payments" (as defined) and the "Tranche 2 Payments" (as defined). "Contract Year" means each of the twelve-month periods ending on the last day of December in 1998, 1999, 2000, 2001, and 2002. Upon the expiration of each Contract Year, the Tranche 1 Payment shall vest with respect to such Contract Year in an amount equal to the product of (i) the Tranche 1 Cumulative Incremental Members (as defined) for such Contract Year and (ii) the Tranche 1 Multiplier (as defined) for such Contract Year. The vested amount of Tranche 1 Payment shall be zero with respect to any Contract Year in which the Tranche 1 Cumulative Incremental Members is a negative number. Furthermore, in the event that the number of Tranche 1 Cumulative Incremental Members with respect to any Contract Year is a negative number due to a decrease in the number of Tranche 1 Cumulative Incremental Members for such Contract Year (as compared to the immediately preceding Contract Year), Aetna will forfeit the right to receive a certain portion (which may be none or all) of the vested and unpaid amounts of the Tranche 1 Payment relating to preceding Contract Years. "Tranche 1 Cumulative Incremental Members" means, with respect to any Contract Year, (i) the number of Equivalent Members (as defined) serviced by the Company during such Contract Year for Tranche 1 Members, minus (ii)(A) for each Contract Year other than the initial Contract Year, the number of Equivalent Members serviced by the Company for Tranche 1 Members during the immediately preceding Contract Year or (B) for the initial Contract Year, the number of Tranche 1 Members as of September 30, 1997, subject to certain upward adjustments. There were 3,761,253 Tranche 1 Members for the initial Contract Year, prior to such upward adjustments. "Tranche 1 Members" are members of managed behavioral healthcare plans for whom the Company provides services in any of specified categories of products or services. "Equivalent Members" for any Contract Year equals the aggregate Member Months for which the Company provides services to a designated category or categories of members during the applicable Contract Year divided by 12. "Member Months" means, for each member, the number of months for which the Company provides services and is compensated. The "Tranche 1 Multiplier" is $80, $50, $40, $25, and $20 for the Contract Years 1998, 1999, 2000, 2001, and 2002, respectively. 40 For each Contract Year, the Company is obligated to pay to Aetna the lesser of (i) the vested portion of the Tranche 1 Payment for such Contract Year and the vested and unpaid amount relating to prior Contract Years as of the end of the immediately preceding Contract Year and (ii) $25.0 million. To the extent that the vested and unpaid portion of the Tranche 1 Payment exceeds $25.0 million, the Tranche 1 Payment remitted to Aetna shall be deemed to have been paid first from any vested but unpaid amounts from previous Contract Years in order from the earliest Contract Year for which vested amounts remain unpaid to the most recent Contract Year at the time of such calculation. Except with respect to the Contract Year ending in 2002, any vested but unpaid portion of the Tranche 1 Payment shall be available for payment to Aetna in future Contract Years, subject to certain exceptions. All vested but unpaid amounts of Tranche 1 Payments shall expire following the payment of the Tranche 1 Payment in respect to the Contract Year ending in 2002, subject to certain exceptions. In no event shall the aggregate Tranche 1 Payments to Aetna exceed $125.0 million. Upon the expiration of each Contract Year, the Tranche 2 payment shall be an amount equal to the lesser of: (a) (i) the product of (A) the Tranche 2 Cumulative Members (as defined) for such Contract Year and (B) the Tranche 2 Multiplier (as defined) applicable to such number of Tranche 2 Cumulative Members, minus (ii) the aggregate of the Tranche 2 Payments paid to Aetna for all previous Contract Years and (b) $35.0 million. The amount shall be zero with respect to any Contract Year in which the Tranche 2 Cumulative Members is a negative number. "Tranche 2 Cumulative Members" means, with respect to any Contract Year, (i) the Equivalent Members serviced by the Company during such Contract Year for Tranche 2 Members, minus (ii) the Tranche 2 Members as of September 30, 1997, subject to certain upward adjustments. There were 936,391 Tranche 2 Members prior to such upward adjustments. "Tranche 2 Members" means Members for whom the Company provides products or services in the HMO category. The "Tranche 2 Multiplier" with respect to each Contract Year is $65 in the event that the Tranche 2 Cumulative Members are less than 2,100,000 and $70 if more than or equal to 2,100,000. For each Contract Year, the Company shall pay to Aetna the amount of Tranche 2 Payment payable for such Contract Year. All rights to receive Tranche 2 Payment shall expire following the payment of the Tranche 2 Payment in respect to the Contract Year ending in 2002, subject to certain exceptions. Notwithstanding anything herein to the contrary, in no event shall the aggregate Tranche 2 Payment to Aetna exceed $175.0 million, subject to certain exceptions. The Company paid $60.0 million to Aetna on March 26, 1999 for both the full Tranche 1 Payment and the full Tranche 2 Payment for the Contract Year ended December 31, 1998. Also, based upon the most recent membership enrollment data related to the Contract Year to end December 31, 1999 ("Contract Year 2"), the Company believes beyond a reasonable doubt that it will be required to make both the full Tranche 1 Payment and the full Tranche 2 Payment ($60.0 million in aggregate) related to Contract Year 2. Accordingly, the Company recorded $120.0 million of goodwill and other intangible assets related to the purchase of HAI during fiscal 1999. The Contract Year 2 liability of $60.0 million is included in "Deferred credits and other long-term liabilities" in the Company's consolidated balance sheet as of September 30, 1999. The Company intends to borrow under the Revolving Facility to meet this obligation, which is expected to be paid during the second quarter of fiscal 2000. In December, 1997 the Company purchased Allied for $70.0 million, excluding transaction costs. The purchase price the Company originally paid for Allied consisted of a $50.0 million payment to the former owners of Allied and a $20.0 million deposit into an interest-bearing escrow account and was subject to increase or decrease based on the operating performance of Allied during the three years following the closing. The Company was required to pay up to $60.0 million, of which $20.0 million would have been distributed from the escrow account, during the three years following the closing of the Allied acquisition if Allied's performance exceeded certain earnings targets. 41 During the quarter ended December 31, 1998, the Company and the former owners of Allied amended the Allied purchase agreement (the "Allied Amendments"). The Allied Amendments resulted in the following changes to the original terms of the Allied purchase agreement: - The original $20.0 million placed in escrow by the Company at the consummation of the Allied acquisition, plus accrued interest, was repaid to the Company. - The Company paid the former owners of Allied $4.5 million of additional consideration, which was recorded as goodwill. - The Company capped future obligations with respect to additional contingent payments for the purchase of Allied at $3.0 million. The earnings targets which must be met by Allied for this amount to be paid were increased. By virtue of acquiring Merit, the Company may be required to make certain payments to the former shareholders of CMG Health, Inc. ("CMG") a managed behavioral healthcare company that was acquired by Merit in September, 1997. Such contingent payments are subject to an aggregate maximum of $23.5 million. The Company has initiated legal proceedings against certain former owners of CMG with respect to representations made by such former owners in conjunction with Merit's acquisition of CMG. Whether any contingent payments will be made to the former shareholders of CMG and the amount and timing of contingent payments, if any, may be subject to the outcome of these proceedings. REVOLVING FACILITY AND LIQUIDITY. The Revolving Facility provides the Company with revolving loans and letters of credit in an aggregate principal amount at any time not to exceed $150.0 million. At September 30, 1999, the Company had approximately $112.4 million of availability under the Revolving Facility. The Company estimates that it will spend approximately $45.0 million for capital expenditures in fiscal 2000. The majority of the Company's anticipated capital expenditures relate to management information systems and related equipment. The Company believes that the cash flows generated from its operations, together with amounts available for borrowing under the Revolving Facility, should be sufficient to fund its debt service requirements, anticipated capital expenditures, contingent payments, if any, with respect to HAI and CMG, and other investing and financing activities for the foreseeable future. The Company expects to have significant liquidity needs during the first and second fiscal quarters of fiscal 2000 including, but not limited to, (i) CHAMPUS settlement payments of $38.1 million (first fiscal quarter), (ii) 1999 short-term incentive plan payments of approximately $12.0 million (second fiscal quarter), (iii) semi-annual interest payments on the Notes of $28.1 million (second fiscal quarter) and (iv) contingent consideration payable to Aetna of to $60.0 million (second fiscal quarter). The Company expects its borrowing capacity under the Revolving Facility to decline to approximately $30.0 million to $40.0 million by March 31, 2000 depending primarily on (i) the timing and amount of contingent consideration paid related to HAI and CMG (if any), (ii) operating and cash flow performance of the Company in fiscal 2000, (iii) capital resources needed to pursue certain new risk-based managed care business and (iv) the timing and amount of acquisition-related spending. If the Company's borrowing capacity under the Revolving Facility is expected to fall below the levels described above, management intends to delay or forego certain investing activities, including capital expenditures and acquisitions, and possibly forego certain new business opportunities. The Company's future operating performance and ability to service or refinance the Notes or to extend or refinance the indebtedness outstanding pursuant to the Credit Agreement will be subject to future economic conditions and to financial, business, regulatory and other factors, many of which are beyond the Company's control. RESTRICTIVE FINANCING COVENANTS. The Credit Agreement imposes restrictions on the Company's ability to make capital expenditures, and both the Credit Agreement and the Indenture limit the Company's ability to incur additional indebtedness. Such restrictions, together with the highly leveraged financial condition of the Company, may limit the Company's ability to respond to market opportunities. The covenants contained in the Credit Agreement also, among other things, restrict the ability of the Company to dispose of assets; repay other indebtedness; amend other debt instruments (including the 42 Indenture); pay dividends; create liens on assets; enter into sale and leaseback transactions; make investments, loans or advances; redeem or repurchase common stock and make acquisitions. STRATEGIC ALTERNATIVES TO REDUCE LONG-TERM DEBT AND IMPROVE LIQUIDITY. The Company's sale of the European Hospitals in April 1999 was one of the steps in the Company's exit from the healthcare provider and healthcare franchising businesses in order to reduce long-term debt and improve liquidity. The Company is currently involved in discussions with various parties to divest certain other non-core businesses. There can be no assurance that the Company will be able to divest any businesses or that the divestiture of such businesses would result in significant reductions of long-term debt or improvements in liquidity. On December 15, 1999, the Company received approximately $54.0 million of net proceeds (after transaction costs) upon issuance of Series A Preferred Stock to TPG. Approximately 50% of the net proceeds received from the issuance of the Series A Preferred Stock was used to reduce debt outstanding under the Term Loan Facility with the remaining 50% of the proceeds being used for general corporate purposes. The Company is also reviewing additional strategic alternatives to improve its capital structure and liquidity. There can be no assurance that the Company will be able to consummate any transaction that will improve its capital structure and/or liquidity. NET OPERATING LOSS CARRYFORWARDS. During June 1999, the Company received an assessment from the Internal Revenue Service (the "IRS Assessment") related to its federal income tax returns for the fiscal years ended September 30, 1992 and 1993. The IRS Assessment disallowed approximately $162 million of deductions that relate primarily to interest expense in fiscal 1992. The Company filed an appeal of the IRS Assessment during September 1999. The Company had previously recorded a valuation allowance for the full amount of the $162 million of deductions disallowed in the IRS Assessment. The IRS Assessment is not expected to result in a material cash payment for income taxes related to prior years; however, the Company's federal income tax net operating loss carryforwards would be reduced if the Company's appeal is unsuccessful. RECENT ACCOUNTING PRONOUNCEMENTS In April 1998, the AICPA issued Statement of Position 98-5, "Reporting on the Costs of Start-up Activities" ("SOP 98-5"). SOP 98-5 requires all nongovernmental entities to expense costs of start-up activities as those costs are incurred. Start-up costs, as defined by SOP 98-5, include pre-operating costs, pre-opening costs and organization costs. SOP 98-5 becomes effective for financial statements for fiscal years beginning after December 15, 1998. At adoption, a company must record a cumulative effect of a change in accounting principle to write off any unamortized start-up costs remaining on the balance sheet when SOP 98-5 is adopted. Prior year financial statements cannot be restated. The Company adopted SOP 98-5 effective October 1, 1998. The Company's adoption of SOP 98-5 had no impact on its financial position or results of operations. Emerging Issues Task Force Issue 96-16, "Investor's Accounting for an Investee When the Investor Has a Majority of the Voting Interest but a Minority Shareholder or Shareholders Have Certain Approval or Veto Rights" ("EITF 96-16") supplements the guidance contained in AICPA Accounting Research Bulletin 51, "Consolidated Financial Statements", and in Statement of Financial Accounting Standards No. 94, "Consolidation of All Majority-Owned Subsidiaries" ("ARB 51/FAS 94"), about the conditions under which the Company's consolidated financial statements should include the financial position, results of operations and cash flows of subsidiaries which are less than wholly-owned along with those of the Company and its subsidiaries. In general, ARB 51/FAS 94 requires consolidation of all majority-owned subsidiaries except those for which control is temporary or does not rest with the majority owner. Under the ARB 51/FAS 94 approach, instances of control not resting with the majority owner were generally regarded to arise from such events 43 as the legal reorganization or bankruptcy of the majority-owned subsidiary. EITF 96-16 expands the definition of instances in which control does not rest with the majority owner to include those where significant approval or veto rights, other than those which are merely protective of the minority shareholder's interest, are held by the minority shareholder or shareholders ("Substantive Participating Rights"). Substantive Participating Rights include, but are not limited to: (i) selecting, terminating and setting the compensation of management responsible for implementing the majority-owned subsidiary's policies and procedures and (ii) establishing operating and capital decisions of the majority-owned subsidiary, including budgets, in the ordinary course of business. The provisions of EITF 96-16 apply to new investment agreements made after July 24, 1997, and to existing agreements which are modified after such date. The Company has made no new investments, and has modified no existing investments, to which the provisions of EITF 96-16 would have applied. In addition, the transition provisions of EITF 96-16 must be applied to majority-owned subsidiaries previously consolidated under ARB 51/FAS 94 for which the underlying agreements have not been modified in financial statements issued for years ending after December 15, 1998 (fiscal 1999 for the Company). The adoption of the transition provisions of EITF 96-16 on October 1, 1998 had the following effect on the Company's consolidated financial position:
OCTOBER 1, 1998 ---------- Increase (decrease) in: Cash and cash equivalents................................. $(21,092) Other current assets...................................... (9,538) Long-term assets.......................................... (30,049) Investment in unconsolidated subsidiaries................. 26,498 -------- Total Assets............................................ $(34,181) ======== Current liabilities....................................... $(10,381) Minority interest......................................... (23,800) -------- Total Liablities........................................ $(34,181) ========
POTENTIAL IMPACT OF YEAR 2000 COMPUTER ISSUES OVERVIEW. The year 2000 computer problem is the inability of computer systems which store dates by using the last two digits of the year (i.e. "98" for "1998") to reliably recognize that dates after December 31, 1999 are later than, and not before, 1999. For instance, the date January 1, 2000, may be mistakenly interpreted as January 1, 1900, in calculations involving dates on systems which are non-year 2000 compliant. The Company relies on information technology ("IT") systems and other systems and facilities such as telephones, building access control systems and heating and ventilation equipment ("Embedded Systems") to conduct its business. These systems are potentially vulnerable to year 2000 problems due to their use of the date information. The Company also has business relationships with customers and healthcare providers and other critical vendors who are themselves reliant on IT and Embedded Systems to conduct their businesses. STATE OF READINESS. The Company's IT systems are largely decentralized, with each major operating unit having its own standards for systems which include both purchased and internally-developed software. The Company's IT hardware infrastructure is built mainly around mid-range computers and IBM PC- compatible servers and desktop systems. The Company's principal means of ensuring year 2000 readiness for purchased software has been the replacement, upgrade or repair of non-compliant systems. This replacement process would have been 44 undertaken for business reasons irrespective of the year 2000 problem; however, it would, more than likely, have been implemented over a longer period of time. The Company's internally-developed software was either designed to be year 2000 ready from inception or have been modified to be year 2000 ready and has gone through an independent verification and validation process. The Company believes its mission critical systems have been remediated to a state of year 2000 readiness. To successfully prepare for the Year 2000, a Program Management Office "(PMO)" was established by the Company. The PMO's responsibility is to provide oversight to the year 2000 project, develop plans, policies and procedures, manage risk, as well as perform independent verification and validation for the Company's year 2000 readiness. Each of the Company's major operating units has a Chief Information Officer who is responsible for ensuring that all year 2000 issues are addressed and mitigated before any computational problems related to dates after December 31, 1999, occur. The Company's plan for IT systems consists of several phases, primarily: (i) Inventory--identifying all IT systems and the magnitude of year 2000 readiness risk of each according to its potential business impact; (ii) Date assessment--identifying IT systems that use date functions and assessing them for year 2000 functionality; (iii) Remediation--reprogramming, replacing or upgrading where necessary, inventoried items to ensure they are year 2000 ready; and (iv) Testing and certification--testing the code modifications and new inventory with other associated systems, including extensive date testing and performing quality assurance testing to ensure successful operation in the post-1999 environment. The Company has completed the inventory and assessment phases for substantially all of its IT systems. The Company has completed the remediation, testing and certification of substantially all of its IT systems. The Company leases most of the office space in which its reliance on Embedded Systems presents a potential problem and has been working with the respective lessors to identify any potential year 2000 problems related to these Embedded Systems. Responses concerning year 2000 readiness have been received and assessed from all facilities considered mission critical. Risk has been determined for each facility and follow-up activities continue to ensure that facilities remain a low risk for year 2000. The Company believes that its year 2000 projects have been substantially completed. EXTERNAL RELATIONSHIPS. The Company also faces the risk that one or more of its critical suppliers or customers ("External Relationships") will not be able to interact with the Company due to the third party's inability to resolve its own year 2000 issues, including those associated with its own External Relationships. The Company has completed its inventory of External Relationships and risk rated each External Relationship based upon the potential business impact, available alternatives and cost of substitution. The Company determined the overall year 2000 readiness of its External Relationships. In the case of significant customers and mission critical suppliers such as banks, telecommunications providers and other utilities and IT vendors, the Company has been engaged in discussions with the third parties and has, in many cases, obtainined detailed information as to those parties' year 2000 plans and state of readiness. YEAR 2000 COSTS. Total costs incurred solely for remediation of potential year 2000 problems were approximately $4.3 million in fiscal 1999. A large majority of these costs were incremental expenses that will not recur in calendar 2000 or thereafter. The Company expenses these costs as incurred and funds these costs through operating cash flows. In addition, the Company estimates that it has accelerated 45 approximately $5.5 million of capital expenditures that would have been budgeted for future periods into fiscal 1999 to ensure year 2000 readiness for outdated systems. Year 2000 readiness is critical to the Company. The Company has redeployed some resources from non-critical system enhancements to address year 2000 issues. Due to the importance of IT systems to the Company's business, management has deferred non-critical systems enhancements to become year 2000 ready. The Company does not expect these redeployments and deferrals to have a material impact on the Company's financial condition or results of operations. RISKS AND CONTINGENCY/RECOVERY PLANNING. If the Company's year 2000 issues were unresolved, the most reasonably likely worst case scenario would include, among other possibilities, the inability to accurately and timely authorize and process benefits and claims, accurately bill customers, assess claims exposure, determine liquidity requirements, report accurate data to management, stockholders, customers, regulators and others, cause business interruptions or shutdowns, financial losses, reputational harm, loss of significant customers, increased scrutiny by regulators and litigation related to year 2000 issues. The Company is attempting to limit the potential impact of the year 2000 by monitoring the progress of its own year 2000 project and those of its critical External Relationships and by developing contingency/recovery plans. The Company cannot guarantee that it will be able to resolve all of its year 2000 issues. Any critical unresolved year 2000 issues at the Company or its External Relationships, however, could have a material adverse effect on the Company's results of operations, liquidity or financial condition. The Company has developed, or is developing, contingency/recovery plans aimed at ensuring the continuity of critical business functions before and after December 31, 1999. As part of that process, the Company has substantially completed the development of manual work alternatives to automated processes which should both ensure business continuity and provide a ready source of input to affected systems when they are returned to an operational status. These manual alternatives presume, however, that basic infrastructure such as electrical power and telephone service, as well as purchased systems which are advertised to be year 2000 ready by their manufacturers (primarily personal computers and productivity software) will remain unaffected by the year 2000 problem. Contingency planning activities will continue through calendar year-end. Activities consist of, but are not limited to, plan verification of all key corporate functions, establishment of response teams and associated "war rooms", testing of call centers telephone re-routing strategy and rehearsal for year-end transition. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company has significant interest rate risk related to its variable rate debt outstanding under the Credit Agreement. See "Cautionary Statements--Leverage and Debt Service Obligations," "Management's Discussion and Analysis of Financial Condition and Results of Operations--Outlook--Results of Operations and Outlook--Liquidity and Capital Resources" and Note 5, "Long-Term Debt, Capital Lease Obligations and Operating Leases" to the Company's audited consolidated financial statements set forth elsewhere herein. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Information with respect to this item is contained in the Company's audited consolidated financial statements and financial statement schedule indicated in the Index on Page F-1 of this Annual Report on Form 10-K and is incorporated herein by reference. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 46 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information with respect to the Company's executive officers is contained under "Item 1. Business--Executive Officers of the Registrant." Pursuant to General Instruction G(3) to Form 10-K, the information required by this item with respect to directors and compliance with Section 16(a) of the Exchange Act has been omitted inasmuch as the Company files with the Securities and Exchange Commission a definitive proxy statement not later than 120 days subsequent to the end of its fiscal year. Such information is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION Pursuant to General Instruction G(3) to Form 10-K, the information required with respect to this item has been omitted inasmuch as the Company files with the Securities and Exchange Commission a definitive proxy statement not later than 120 days subsequent to the end of its fiscal year. Such information is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pursuant to General Instruction G(3) to Form 10-K, the information required with respect to this item has been omitted inasmuch as the Company files with the Securities and Exchange Commission a definitive proxy statement not later than 120 days subsequent to the end of its fiscal year. Such information is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pursuant to General Instruction G(3) to Form 10-K, the information required with respect to this item has been omitted inasmuch as the Company files with the Securities and Exchange Commission a definitive proxy statement not later than 120 days subsequent to the end of its fiscal year. Such information is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A) DOCUMENTS FILED AS PART OF THE REPORT: 1. FINANCIAL STATEMENTS Information with respect to this item is contained on Pages F-1 to F-51 of this Annual Report on Form 10-K. 2. FINANCIAL STATEMENT SCHEDULE Information with respect to this item is contained on page S-1 of this Annual Report on Form 10-K. 47 3. EXHIBITS
EXHIBIT NO. DESCRIPTION OF EXHIBIT - --------------------- ---------------------- 2(a) Stock Purchase Agreement, dated November 14, 1995, among Blue Cross and Blue Shield of New Jersey, Inc. Health Care Service Corporation, Independence Blue Cross, Medical Service Association of Pennsylvania, Pierce County Medical Bureau, Inc., Veritus, Inc., Green Spring Health Services, Inc. and the Company, which was filed as Exhibit 10(e) to the Company's Quarterly Report on Form 10-Q for the Quarterly period ended December 31, 1995, and is incorporated herein by reference. 2(b) GPA Stock Exchange Agreement, dated November 14, 1995, between Green Spring Health Services, Inc. and the Company, which was filed as Exhibit 10(f) to the Company's Quarterly Report on Form 10-Q for the Quarterly period ended December 31, 1995, and is incorporated herein by reference. 2(c) Real Estate Purchase and Sale Agreement, dated January 29, 1997, between the Company and Crescent Real Estate Equities Limited Partnership, which was filed as Exhibit 2(a) to the Company's current report on Form 8-K filed on April 23, 1997, and is incorporated herein by reference. 2(d) Amendment No. 1, dated February 28, 1997, to the Real Estate Purchase and Sale Agreement, dated January 29, 1997, between the Company and Crescent Real Estate Equities Limited Partnership, which was filed as Exhibit 2(b) to the Company's current report on Form 8-K filed on April 23, 1997, and is incorporated herein by reference. 2(e) Amendment No. 2, dated May 29, 1997, to the Real Estate Purchase and Sale Agreement, dated January 29, 1997, between the Company and Crescent Real Estate Equities Limited Partnership, which was filed as Exhibit 2(c) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by reference. 2(f) Contribution Agreement, dated June 16, 1997, between the Company and Crescent Operating, Inc., which was filed as Exhibit 2(d) to the Company's current report on Form 8-K which was filed on June 30, 1997, and is incorporated herein by reference. 2(g) Stock Purchase Agreement, dated August 5, 1997, between the Company and Aetna Insurance Company of Connecticut, which was filed as Exhibit 2(a) to the Company's current report on Form 8-K, which was filed on December 17, 1997, and is incorporated herein by reference. 2(h) Master Service Agreement, dated August 5, 1997, between the Company, Aetna U.S. Healthcare, Inc. and Human Affairs International, Incorporated, which was filed as Exhibit 2(b) to the Company's current report on Form 8-K, which was filed on December 17, 1997, and is incorporated herein by reference. 2(i) First Amendment to Stock Purchase Agreement, dated December 4, 1997, between the Company and Aetna Insurance Company of Connecticut, which was filed as Exhibit 2(c) to the Company's current report on Form 8-K, which was filed on December 17, 1997, and is incorporated herein by reference. 2(j) First Amendment to Master Services Agreement, dated December 4, 1997, between the Company, Aetna U.S. Healthcare, Inc. and Human Affairs International, Incorporated, which was filed as Exhibit 2(d) to the Company's current report on Form 8-K, which was filed on December 17, 1997, and is incorporated herein by reference. 2(k) Asset Purchase Agreement, dated October 16, 1997, among the Company; Allied Health Group, Inc.; Gut Management, Inc.; Sky Management Co,; Florida Specialty Network, LTD; Surgical Associates of South Florida, Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David Russin, M.D. and Lawrence Schimmel, M.D., which was filed as Exhibit 2(e) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1997, and is incorporated herein by reference.
48
EXHIBIT NO. DESCRIPTION OF EXHIBIT - --------------------- ---------------------- 2(l) First Amendment to Asset Purchase Agreement, dated December 5, 1997, among the Company; Allied Health Group, Inc.; Gut Management, Inc.; Sky Management Co.; Florida Specialty Network, LTD; Surgical Associates of South Florida, Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David Russin M.D.; and Lawrence Schimmel, M.D., which was filed as Exhibit 2(f) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1997, and is incorporated herein by reference. 2(m) Second Amendment to Asset Purchase Agreement, dated November 18, 1998, among the Company; Allied Health Group, Inc.; Gut Management, Inc.; Sky Management Co.; Florida Specialty Network, LTD; Surgical Associates of South Florida, Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David Russin M.D.; and Lawrence Schimmel, M.D., which was filed as Exhibit 2(m) to the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 1998 and is incorporated herein by reference. 2(n) Third Amendment to Asset Purchase agreement, dated December 31, 1998, among the Company; Allied Health Group, Inc.; Gut Management, Inc.; Sky Management Co.; Florida Specialty Network, LTD; Surgical Associates of South Florida, Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David Russin, M.D.; and Lawrence Schimmel, M.D., which was filed as Exhibit 2(b) to the Company's Quarterly on Form 10-Q for the quarterly period ended December 31, 1998 and is incorporated herein by reference. 2(o) Agreement and Plan of Merger, dated October 24, 1997, among the Company, Merit Behavioral Care Corporation and MBC Merger Corporation which was filed as Exhibit 2(g) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1997, and is incorporated herein by reference. 2(p) Share Purchase Agreement, dated April 2, 1999, by and among the Company, Charter Medical International, S.A., Inc. (a wholly owned subsidiary of the Company), Investment AB Bure, and CMEL Holding Limited (a wholly owned subsidiary of Investment AB Bure), filed as Exhibit 2(a) to the Company's current report on Form 8-K, which was filed on April 12, 1999, and is incorporated herein by reference. 2(q) Stock Purchase Agreement, dated April 2, 1999, by and among the Company, Charter Medical International S.A., Inc. (a wholly owned subsidiary of the Company), Investment AB Bure and Grodrunden 515 AB (a wholly owned subsidiary of Investment AB Bure), filed as Exhibit 2(b) to the Company's current report on Form 8-K, which was filed on April 12, 1999, and is incorporated herein by reference. 2(r) First Amendment to Share Purchase Agreement, dated April 8, 1999, by and among the Company, Charter Medical International S.A., Inc. (a wholly owned subsidiary of the Company), Investment AB Bure, and CMEL Holding Limited (a wholly owned subsidiary of Investment AB Bure), filed as Exhibit 2(c) to the Company's current report on Form 8-K, which was filed on April 12, 1999, and is incorporated herein by reference. 2(s) First Amendment to Stock Purchase Agreement, dated April 8, 1999, among the Company, Charter Medical International S.A., Inc. (a wholly owned subsidiary of the Company), Investment AB Bure, and CMEL Holding Limited (a wholly owned subsidiary of Investment AB Bure), filed as Exhibit 2(d) to the Company's current report on Form 8-K, which was filed on April 12, 1999, and is incorporated herein by reference. 2(t) Letter Agreement dated August 10, 1999 by and among the Company, Charter Behavioral Health Systems, LLC, Crescent Real Estate Equities Limited Partnership and Crescent Operating, Inc., which was filed as Exhibit 2(a) to the Company's current report on Form 8-K , which was filed on September 24, 1999 and is incorporated herein by reference. 3(a) Restated Certificate of Incorporation of the Company, as filed in Delaware on October 16, 1992, which was filed as Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended September 30, 1992, and is incorporated herein by reference.
49
EXHIBIT NO. DESCRIPTION OF EXHIBIT - --------------------- ---------------------- 3(b) Bylaws of the Company. 3(c) Certificate of Ownership and Merger merging Magellan Health Services, Inc. (a Delaware corporation) into Charter Medical Corporation (a Delaware corporation), as filed in Delaware on December 21, 1995, which was filed as Exhibit 3(c) to the Company's Annual Report on Form 10-K for the year ended September 30, 1995, and is incorporated herein by reference. 4(a) Stockholders' Agreement, dated December 13, 1995, among Green Spring Health Services, Inc., Blue Cross and Blue Shield of New Jersey, Inc., Health Care Service Corporation, Independence Blue Cross, Pierce County Medical Bureau, Inc. and the Company, which was filed as Exhibit 4(d) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1995, and is incorporated herein by reference. 4(b) First Amendment to Stockholders' Agreement, dated February 28, 1997, among Green Spring Health Services, Inc, Blue Cross and Blue Shield of New Jersey, Inc., Health Care Service Corporation, Independence Blue Cross, Pierce County Medical Bureau, Inc. and the Company, which was filed as Exhibit 4(af) to the Company's Annual Report on Form 10-K for the year ended September 30, 1997, and is incorporated herein by reference. 4(c) Exchange Agreement, dated December 13, 1995, among Blue Cross and Blue Shield of New Jersey, Inc., Health Care Service Corporation, Independence Blue Cross, Pierce County Medical Bureau, Inc. and the Company, which was filed as Exhibit 4(e) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1995, and is incorporated herein by reference. 4(d) Stock and Warrant Purchase Agreement, dated December 22, 1995, between the Company and Richard E. Rainwater, which was filed as Exhibit 4(f) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1995, and is incorporated herein by reference. 4(e) Amendment No. 1 to Stock and Warrant Purchase Agreement, dated January 25, 1996, between the Company and Rainwater-Magellan Holdings, L.P., which was filed as Exhibit 4.7 to the Company's Registration Statement on Form S-3 dated February 26, 1996, and is incorporated herein by reference. 4(f) Warrant Purchase Agreement, dated January 29, 1997, between the Company and Crescent Real Estate Equities Limited Partnership which was filed as Exhibit 4(a) to the Company's current report on Form 8-K, which was filed on April 23, 1997, and is incorporated herein by reference. 4(g) Amendment No. 1, dated June 17, 1997, to the Warrant Purchase Agreement, dated January 29, 1997, between the Company and Crescent Real Estate Equities Limited Partnership, which was filed as Exhibit 4(b) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by reference. 4(h) Indenture, dated as of February 12, 1998, between the Company and Marine Midland Bank, as trustee, relating to the 9% Senior Subordinated Notes due February 15, 2008 of the Company, which was filed as Exhibit 4(a) to the Company's Current Report on Form 8-K, which was filed April 3, 1998, and is incorporated herein by reference. 4(i) Purchase Agreement, dated February 5, 1998, between the Company and Chase Securities Inc., which was filed as Exhibit 4(b) to the Company's Current Report on Form 8-K, which was filed April 3, 1998, and is incorporated herein by reference. 4(j) Exchange and Registration Rights Agreement, dated February 12, 1998, between the Company and Chase Securities Inc., which was filed as Exhibit 4(c) to the Company's Current Report on Form 8-K, which was filed on April 3, 1998, and is incorporated herein by reference.
50
EXHIBIT NO. DESCRIPTION OF EXHIBIT - --------------------- ---------------------- 4(k) Credit Agreement, dated February 12, 1998, among the Company, certain of the Company's subsidiaries listed therein and The Chase Manhattan Bank, as administrative agent, which was filed as Exhibit 4(d) to the Company's Current Report on Form 8-K, which was filed April 3, 1998, and is incorporated herein by reference. 4(l) Amendment No. 1, dated as of September 30, 1998, to the Credit Agreement, dated as of February 12, 1998, among the Company, certain of the Company's subsidiaries listed therein and The Chase Manhattan Bank, as administrative agent, which was filed as Exhibit 4(e) to the Company's Registration Statement Form S-4 (no. 333-49335), which was filed on October 5, 1998, and is incorporated herein by reference. 4(m) Amendment No. 2, dated as of April 30, 1999, to the Credit Agreement dated as of February 12, 1998, among the Company certain of the Company's subsidiaries listed therein and the Chase Manhattan Bank, as administrative agent which was filed as Exhibit 4(a) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1999 and is incorporated herein by reference. +4(n) Amendment No. 3, dated as of July 29, 1999, to the Credit Agreement dated as of February 12, 1998, among the Company's subsidiaries listed therein and the Chase Manhattan Bank, as administrative agent. +4(o) Amendment No. 4, dated as of September 8, 1999, to the Credit Agreement dated as of February 12, 1998, among the Company's subsidiaries listed therein and the Chase Manhattan Bank, as administrative agent. 4(p) Investment Agreement dated as of July 19, 1999, between the Company and TPG Magellan LLC together with the following exhibits: (i) form of Certificate of Designations of Series A Cumulative Convertible Preferred Stock; (ii) form of Certificate of Designation of Series B Cumulative Convertible Preferred Stock; (iii) form of Certificate of Designations of Series C Junior Participating Preferred Stock; and (iv) form of Escrow Agreement by and among The Company, TPG Magellan LLC and SunTrust Bank, Atlanta, as escrow agent, filed as Exhibit 4.1 to the Company's current report on Form 8-K, which was filed on July 21, 1999, and is incorporated herein by reference. 4(q) Registration Rights Agreement, dated as of July 19, 1999, between the Company and TPG Magellan LLC, filed as Exhibit 4.2 to the Company's current report on Form 8-K, which was filed on July 21, 1999, and is incorporated herein by reference. +4(r) Amended and Restated Investment Agreement, dated December 14, 1999, between the Company and TPG Magellan LLC together with the following exhibits: (i) form of Certificate of Designations of Series A Cumulative Convertible Preferred Stock; (ii) form of Certificate of Designation of Series B Cumulative Convertible Preferred Stock; (iii) form of Certificate of Designations of Series C Junior Participating Preferred Stock. *10(a) 1992 Stock Option Plan of the Company, as amended, which was filed as Exhibit 10(c) to the Company's Annual Report on Form 10-K for the year ended September 30, 1994, and is incorporated herein by reference. *10(b) 1992 Directors' Stock Option Plan of the Company, as amended, which was filed as Exhibit 10(d) to the Company's Annual Report on Form 10-K for the year ended September 30, 1994, and is incorporated herein by reference. *10(c) 1994 Stock Option Plan of the Company, as amended, which was filed as Exhibit 10(e) to the Company's Annual Report on Form 10-K for the year ended September 30, 1994, and is incorporated herein by reference. *10(d) Directors' Unit Award Plan of the Company, which was filed as Exhibit 10(i) to the Company's Registration Statement on Form S-4 (No. 33-53701) filed May 18, 1994, and is incorporated herein by reference.
51
EXHIBIT NO. DESCRIPTION OF EXHIBIT - --------------------- ---------------------- *10(e) 1996 Stock Option Plan of the Company, which was filed as Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1996 and is incorporated herein by reference. *10(f) 1996 Directors' Stock Option Plan of the Company, which was filed as Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1996 and is incorporated herein by reference. *10(g) 1997 Stock Option Plan of the Company, which was filed as Exhibit 10(i) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1997, and is incorporated herein by reference. *10(h) Amendment to the Company's 1992 Directors' Stock Option Plan, which was filed as Exhibit 10(d) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999 and is incorporated herein by reference. *10(i) Amendment to the Company's Directors' 1996 Directors Stock Option Plan, which was filed as Exhibit 10(e) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999 and is incorporated herein by reference. *10(j) Amendment to the Company's 1994 Stock Option Plan, which was filed as Exhibit 10(f) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999 and is incorporated herein by reference. *10(k) Amendment to the Company's 1996 Stock Option Plan, which was filed as Exhibit 10(g) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999 and is incorporated herein by reference. *10(l) Amendment to the Company's 1997 Stock Option Plan, which was filed as Exhibit 10(h) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999 and is incorporated herein by reference. *10(m) Amended 1998 Stock Option Plan of the Company, which was filed as Exhibit 10(i) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999 and is incorporated herein by reference. *10(n) Third Amendment to the Company's 1998 Stock Option Plan, which was filed as Exhibit 10(j) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999 and is incorporated herein by reference. *10(o) Employment Agreement, dated March 31, 1995, between the Company and Craig L. McKnight, Executive Vice President and Chief Financial Officer, which was filed as Exhibit 10(l) to the Company's Annual Report on Form 10-K for the year ended September 30, 1995, and is incorporated herein by reference. *10(p) Letter Agreement, dated November 9, 1993, between Green Spring Health Services, Inc. and Henry T. Harbin, M.D., Executive Vice President of the Company and President and Chief Executive Officer of Green Spring Health Services, Inc., which was filed as Exhibit 10(c) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1995 and is incorporated herein by reference. *10(q) Letter Agreement, dated September 19, 1994 between Green Spring Health Services, Inc. and Henry T. Harbin, M.D., Executive Vice President of the Company and President and Chief Executive Officer of Green Spring Health Services, Inc., which was filed as Exhibit 10(d) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1995 and is incorporated herein by reference. *10(r) Employment Agreement dated February 28, 1996, between Green Spring Health Services, Inc. and Henry T. Harbin, M.D., Executive Vice President of the Company and President and Chief Executive Officer of Green Spring Health Services, Inc., which was filed as Exhibit 10(t) to the Company's Annual Report on Form 10-K for the year ended September 30, 1996, and is incorporated herein by reference.
52
EXHIBIT NO. DESCRIPTION OF EXHIBIT - --------------------- ---------------------- *10(s) Compensation Agreement dated September 30, 1996, between Magellan Health Services, Inc. and Henry T. Harbin, M.D., Executive Vice President of the Company and President and Chief Executive Officer of Green Spring Health Services, Inc., which was filed as Exhibit 10(u) to the Company's Annual Report on Form 10-K for the year ended September 30, 1996, and is incorporated herein by reference. *10(t) Written description of the Green Spring Health Services, Inc. Annual Incentive Plan for the period ended September 30, 1998, which was filed as Exhibit 10(s) to the Company's Annual Report on Form 10-K for the year ended September 30, 1998 and is incorporated herein by reference. *10(u) Magellan Corporate Short-Term Incentive Plan for the fiscal year ended September 30, 1999, which was filed as Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999 and is incorporated herein by reference. *10(v) Magellan Behavioral Health Short-Term Incentive Plan for the fiscal year ended September 30, 1999, which was filed as Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999 and is incorporated herein by reference. +*10(w) Letter Agreement, dated March 2, 1999, between the Company and Clifford W. Donnelly, Executive Vice President of the Company. +*10(x) Letter Agreement, dated June 4, 1999, between the Company and Mark S. Demilio, Executive Vice President of the Company. 10(y) Master Lease Agreement, dated June 16, 1997, between Crescent Real Estate Funding VII, L.P., as Landlord, and Charter Behavioral Health Systems, LLC, as Tenant, which was filed as Exhibit 99(b) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by reference. 10(z) Master Franchise Agreement, dated June 17, 1997, between the Company and Charter Behavioral Health Systems, LLC, which was filed as Exhibit 99(c) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by reference. 10(aa) Form of Franchise Agreement, dated June 17, 1997, between the Company, as Franchisor, and Franchise Owners, which was filed as Exhibit 99(d) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by reference. 10(ab) Subordination Agreement, dated June 16, 1997, between the Company, Charter Behavioral Health Systems, LLC and Crescent Real Estate Equities Limited Partnership, which was filed as Exhibit 99(e) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by reference. 10(ac) Operating Agreement of Charter Behavioral Health Systems, LLC, dated June 16, 1997, between the Company and Crescent Operating, Inc., which was filed as Exhibit 99(f) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by reference. 10(ad) Warrant Purchase Agreement, dated June 16, 1997, between the Company and Crescent Operating, Inc., which was filed as Exhibit 99(g) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by reference. *10(ae) 1998 Stock Option Plan of the Company which was filed as Exhibit (ay) to the Company's Registration Statement on Form S-4, which was filed on April 3, 1998, and is incorporated herein by reference.
53
EXHIBIT NO. DESCRIPTION OF EXHIBIT - --------------------- ---------------------- *10(af) Letter Agreement, dated May 7, 1997, between Green Spring Health Services, Inc. and John J. Wider, Jr., Executive Vice President and Chief Operating Officer of Green Spring Health Services, Inc., which was filed as Exhibit 10 (az) to the Company's Registration Statement on Form S-4, which was filed on April 3, 1998, and is incorporated herein by reference. *10(ag) Employment Agreement, dated December 9, 1998, between Magellan Behavioral Health, Inc. and John Wider, President and Chief Operating Officer of Magellan Behavioral Health, Inc., which was filed as Exhibit 10 to the Company's Form 10-Q for the quarterly period ended December 31, 1998 and is incorporated herein by reference. *10(ah) Employment Agreement, dated March 12, 1997, between Green Spring Health Services, Inc. and Clarissa C. Marques, Chief Clinical Officer of Green Spring Health Services, Inc., which was filed as Exhibit 10 (ba) to the Company's Registration Statement on Form S-4, which was filed on April 3, 1998, and is incorporated herein by reference. *10(ai) Letter Agreement, dated February 2, 1995, between Green Spring Health Services, Inc. and Clarissa C. Marques, Senior Vice President of Green Spring Health Services, Inc., which was filed as Exhibit 10 (bb) to the Company's Registration Statement on Form S-4, which was filed on April 3, 1998, and is incorporated herein by reference. *10(aj) Employment Agreement, dated February 11, 1999, between the Company and Clarissa C. Marques, Ph.D., Executive Vice President of the Company, which was filed as Exhibit 10(c) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999 and is incorporated herein by reference. *10(ak) Employment Agreement, dated June 25, 1998, between the Company and Henry T. Harbin, M.D., President, Chief Executive Officer of the Company, which was filed as exhibit 10(a) to the Company's quarterly report on Form 10-Q for the quarterly period ended June 30, 1998 and is incorporated herein by reference. 10(al) Offer to Purchase and Consent Solicitation Statement, dated January 12, 1998, by the Company for all of its 11 1/4% Series A Senior Subordinated Notes due 2008, which was filed as Exhibit 10(ad) to the Company's Registration Statement on Form S-4, which was filed on April 3, 1998, and is incorporated herein by reference. 10(am) Offer to Purchase and Consent Solicitation Statement, dated January 12, 1998, by Merit Behavioral Care Corporation for all of its 11 1/2% Senior Subordinated Notes due 2005, which was filed as Exhibit 10(ad) to the Company's Registration Statement on Form S-4, which was filed on April 3, 1998, and is incorporated herein by reference. 10(an) Agreement and Plan of Merger by and among Merit Behavioral Care Corporation, Merit Merger Corp., and CMG Health, Inc. dated as of July 14, 1997, which was filed as Exhibit 10(ah) to the Company's Annual Report on Form 10-K for the year ended September 30, 1998 and is incorporated herein by reference. +21 List of subsidiaries of the Company. +23 Consent of Arthur Andersen LLP. 23(b) Consent of Ernst & Young LLP. +27 Financial Data Schedule
- ------------------------ * Constitutes a management contract or compensatory plan arrangement. + Previously filed. 54 (B) REPORTS ON FORM 8-K: The Company filed the following current reports on Form 8-K with the Securities and Exchange Commission during the quarter ended September 30, 1999.
FINANCIAL STATEMENT DATE OF REPORT ITEM REPORTED AND DESCRIPTION FILED --------------------- ----------------------------------------------------------- --------- July 19, 1999 Item 5. Other Events--TPG Investment No September 24, 1999 Item 2. Disposition of Assets--CBHS Transactions Yes(1)
- ------------------------ (1) Unaudited Pro Forma Consolidated Balance Sheet at June 30, 1999; Unaudited Pro Forma Consolidated Statement of Operations for fiscal 1996, 1997 and 1998 and for the nine months ended June 30, 1998 and 1999. (C) EXHIBITS REQUIRED BY ITEM 601 OF REGULATION S-K: Exhibits required to be filed by the Company pursuant to Item 601 of Regulation S-K are contained in a separate volume. (D) FINANCIAL STATEMENTS AND SCHEDULES REQUIRED BY REGULATION S-X WHICH ARE EXCLUDED FROM THE COMPANY'S ANNUAL REPORT TO STOCKHOLDERS BY RULE 14A-3(B): (1) Separate financial statements of subsidiaries not consolidated and fifty percent or less owned persons appear beginning on page F-52 of this Annual Report on Form 10-K. (2) Not applicable. 55 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized. MAGELLAN HEALTH SERVICES, INC. (Registrant) Date: March 30, 2000 /S/ CLIFFORD W. DONNELLY ------------------------------------------------ Clifford W. Donnelly Executive Vice President and Chief Financial Officer Date: December 23, 1999 * ------------------------------------------------ Thomas C. Hofmeister Senior Vice President and Chief Accounting Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE --------- ----- ---- * President, Chief Executive ------------------------------------------- Officer and Director December 23, 1999 Henry T. Harbin * Director ------------------------------------------- December 23, 1999 David Bonderman * Director ------------------------------------------- December 23, 1999 Jonathan J. Coslet * Director ------------------------------------------- December 23, 1999 G. Fred DiBona, Jr. * Director ------------------------------------------- December 23, 1999 Andre C. Dimitriadis * Director ------------------------------------------- December 23, 1999 A.D. Frazier, Jr. * Director ------------------------------------------- December 23, 1999 Gerald L. McManis
56
SIGNATURE TITLE DATE --------- ----- ---- * Director ------------------------------------------- December 23, 1999 Daniel S. Messina * Chairman of the Board of ------------------------------------------- Directors December 23, 1999 Robert W. Miller * Director ------------------------------------------- December 23, 1999 Darla D. Moore * Director ------------------------------------------- December 23, 1999 Jeffrey A. Sonnenfeld * Director ------------------------------------------- December 23, 1999 James B. Williams
- ------------------------ * Individual signed the Company's Annual Report on Form 10-K which was filed with the Securities and Exchange Commission on December 27, 1999, and is not required to sign this Amendment No. 1 to the Company's Annual Report on Form 10-K/A pursuant to Rule 12(b)-15 of the Securities Exchange Act of 1934, as amended. 57 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENTS The following consolidated financial statements of the registrant and its subsidiaries are submitted herewith in response to Item 8 and Item 14(a)1:
PAGE -------- MAGELLAN HEALTH SERVICES, INC. Audited Consolidated Financial Statements Report of independent public accountants................ F-2 Consolidated balance sheets as of September 30, 1998 and 1999................................................... F-3 Consolidated statements of operations for the fiscal years ended September 30, 1997, 1998 and 1999.......... F-4 Consolidated statements of changes in stockholders' equity for the fiscal years ended September 30, 1997, 1998 and 1999.......................................... F-5 Consolidated statements of cash flows for the fiscal years ended September 30, 1997, 1998 and 1999.......... F-6 Notes to consolidated financial statements.............. F-7
The following financial statement schedule of the registrant and its subsidiaries is submitted herewith in response to Item 14(a)2:
PAGE -------- Schedule II--Valuation and qualifying accounts.......... S-1
The following financial statements of unconsolidated subsidiaries of the registrant are submitted herewith in response to Item 14(d)(1):
PAGE -------- CHOICE BEHAVIORAL HEALTH PARTNERSHIP Audited Financial Statements Report of independent auditors.......................... F-52 Balance sheets as of December 31, 1998 and December 31, 1999................................................... F-53 Statements of income for the years ended December 31, 1998 and December 31, 1999............................. F-54 Statements of partners' capital for the years ended December 31, 1998 and December 31, 1999................ F-55 Statements of cash flows for the years ended December 31, 1998 and December 31, 1999................ F-56 Notes to financial statements........................... F-57
F-1 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of Magellan Health Services, Inc: We have audited the accompanying consolidated balance sheets of Magellan Health Services, Inc. (a Delaware corporation) and subsidiaries as of September 30, 1998 and 1999, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for each of the three years in the period ended September 30, 1999. These consolidated financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Magellan Health Services, Inc. and subsidiaries as of September 30, 1998 and 1999 and the results of their operations and their cash flows for each of the three years in the period ended September 30, 1999 in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index to financial statements is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly states, in all material respects, the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN LLP Baltimore, Maryland November 30, 1999 (except with respect to the matter discussed in Note 15, as to which the date is December 15, 1999) F-2 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
SEPTEMBER 30, ----------------------- 1998 1999 ---------- ---------- ASSETS Current Assets: Cash, including cash equivalents of $14,185 at September 30, 1998 and $10,147 at September 30, 1999 at cost, which approximates market value.................. $ 92,050 $ 37,440 Accounts receivable, less allowance for doubtful accounts of $34,867 at September 30, 1998 and $28,437 at September 30, 1999.................................. 174,846 198,646 Restricted cash and investments......................... 89,212 116,824 Refundable income taxes................................. 4,939 3,452 Other current assets.................................... 38,677 18,565 ---------- ---------- Total Current Assets.................................. 399,724 374,927 Assets restricted for settlement of unpaid claims and other long-term liabilities..................................... 37,910 -- Property and equipment, net................................. 177,169 120,667 Deferred income taxes....................................... 98,184 91,657 Investments in unconsolidated subsidiaries.................. 11,066 18,396 Other long-term assets...................................... 35,415 9,599 Goodwill, net of accumulated amortization of $32,785 at September 30, 1998 and $60,869 at September 30, 1999............................. 992,431 1,108,086 Other intangible assets, net of accumulated amortization of $12,343 at September 30, 1998 and $26,457 at September 30, 1999........................................ 165,189 158,283 ---------- ---------- $1,917,088 $1,881,615 ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable.......................................... $ 42,873 $ 44,425 Accrued liabilities....................................... 193,530 209,796 Medical claims payable.................................... 195,330 189,928 Current maturities of long-term debt and capital lease obligations............................................. 23,033 30,119 ---------- ---------- Total Current Liabilities........................... 454,766 474,268 Long-term debt and capital lease obligations................ 1,202,613 1,114,189 Reserve for unpaid claims................................... 30,280 -- Deferred credits and other long-term liabilities............ 14,011 92,948 Minority interest........................................... 26,985 3,514 Commitments and Contingencies Stockholders' Equity: Preferred stock, without par value Authorized--10,000 shares Issued and outstanding--none............................ -- -- Common stock, par value $.25 per share Authorized--80,000 shares Issued and outstanding--33,898 shares at September 30, 1998 and 34,268 shares at September 30, 1999............ 8,476 8,566 Other Stockholders' Equity: Additional paid-in capital.............................. 349,651 352,030 Accumulated deficit..................................... (149,238) (144,550) Warrants outstanding.................................... 25,050 25,050 Common stock in treasury, 2,289 shares at September 30, 1998 and September 30, 1999............................ (44,309) (44,309) Cumulative foreign currency adjustments included in other comprehensive income............................. (1,197) (91) ---------- ---------- Total Stockholders' Equity.......................... 188,433 196,696 ---------- ---------- $1,917,088 $1,881,615 ========== ==========
The accompanying Notes to Consolidated Financial Statements are an integral part of these balance sheets. F-3 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
FISCAL YEAR ENDED SEPTEMBER 30, ---------------------------------- 1997 1998 1999 -------- ---------- ---------- Net revenue................................................. $463,872 $1,310,778 $1,871,636 -------- ---------- ---------- Costs and expenses: Salaries, cost of care and other operating expenses....... 438,472 1,183,626 1,663,626 Equity in (earnings) losses of unconsolidated subsidiaries.............................................. 5,567 (12,795) (20,442) Depreciation and amortization............................. 19,683 49,264 73,531 Interest, net............................................. 46,438 76,505 93,752 Stock option expense (credit)............................. 4,292 (5,623) 18 Managed care integration costs............................ -- 16,962 6,238 Special charges........................................... -- -- 4,441 -------- ---------- ---------- 514,452 1,307,939 1,821,164 -------- ---------- ---------- Income (loss) from continuing operations before income taxes, minority interest and extraordinary items.......... (50,580) 2,839 50,472 Provision for (benefit from) income taxes................... (20,232) 5,544 27,376 -------- ---------- ---------- Income (loss) from continuing operations before minority interest and extraordinary items.......................... (30,348) (2,705) 23,096 Minority interest........................................... 6,856 4,094 630 -------- ---------- ---------- Income (loss) from continuing operations before extraordinary items....................................... (37,204) (6,799) 22,466 Discontinued operations: Income from discontinued operations(1).................... 41,959 20,531 29,645 Loss on disposal of discontinued operations, net of income tax benefit of $31,616.................................. -- -- (47,423) -------- ---------- ---------- 41,959 20,531 (17,778) -------- ---------- ---------- Income before extraordinary items........................... 4,755 13,732 4,688 Extraordinary items--net losses on early extinguishments of debt (net of income tax benefit of $3,503 in 1997 and $22,010 in 1998).......................................... (5,253) (33,015) -- -------- ---------- ---------- Net income (loss)........................................... $ (498) $ (19,283) $ 4,688 Other comprehensive income (loss)........................... (683) 675 1,106 -------- ---------- ---------- Comprehensive income (loss)................................. $ (1,181) $ (18,608) $ 5,794 ======== ========== ========== Weighted average number of common shares outstanding--basic........................................ 28,781 30,784 31,758 ======== ========== ========== Weighted average number of common shares outstanding--diluted...................................... 28,781 30,784 31,916 ======== ========== ========== Income (loss) per common share--basic: Income (loss) from continuing operations before extraordinary items....................................... $ (1.29) $ (0.22) $ 0.71 ======== ========== ========== Income (loss) from discontinued operations................ $ 1.46 $ 0.67 $ (0.56) ======== ========== ========== Extraordinary losses on early extinguishments of debt..... $ (0.18) $ (1.07) $ -- ======== ========== ========== Net income (loss)........................................... $ (0.02) $ (0.63) $ 0.15 ======== ========== ========== Income (loss) per common share--diluted: Income (loss) from continuing operations before extraordinary items....................................... $ (1.29) $ (0.22) $ 0.70 ======== ========== ========== Income (loss) from discontinued operations................ $ 1.46 $ 0.67 $ (0.56) ======== ========== ========== Extraordinary losses on early extinguishments of debt..... $ (0.18) $ (1.07) $ -- ======== ========== ========== Net income (loss)........................................... $ (0.02) $ (0.63) $ 0.15 ======== ========== ==========
- ------------------------------ (1) Net of income tax provision of $27,973, $13,687 and $19,763, for fiscal 1997, 1998 and 1999, respectively. The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. F-4 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (IN THOUSANDS)
FISCAL YEAR ENDED SEPTEMBER 30, --------------------------------- 1997 1998 1999 --------- --------- --------- Common Stock: Balance, beginning of period.............................. $ 8,252 $ 8,361 $ 8,476 Exercise of options and warrants.......................... 109 115 90 --------- --------- --------- Balance, end of period.................................... 8,361 8,476 8,566 --------- --------- --------- Additional paid-in capital: Balance, beginning of period.............................. 327,681 340,645 349,651 Stock option expense (credit)............................. 4,292 (5,623) 18 Exercise of options and warrants.......................... 8,156 3,867 2,542 Green Spring Minority Stockholder Conversion.............. -- 10,722 -- Other..................................................... 516 40 (181) --------- --------- --------- Balance, end of period.................................... 340,645 349,651 352,030 --------- --------- --------- Accumulated deficit: Balance, beginning of period.............................. (129,457) (129,955) (149,238) Net income (loss)......................................... (498) (19,283) 4,688 --------- --------- --------- Balance, end of period.................................... (129,955) (149,238) (144,550) --------- --------- --------- Warrants outstanding: Balance, beginning of period.............................. 54 25,050 25,050 Exercise of warrants...................................... (4) -- -- Issuance of warrants to Crescent and COI.................. 25,000 -- -- --------- --------- --------- Balance, end of period.................................... 25,050 25,050 25,050 --------- --------- --------- Common stock in treasury: Balance, beginning of period.............................. (82,731) (82,731) (44,309) Purchases of treasury stock............................... -- (14,352) -- Green Spring Minority Stockholder Conversion.............. -- 52,774 -- --------- --------- --------- Balance, end of period.................................... (82,731) (44,309) (44,309) --------- --------- --------- Cumulative foreign currency adjustments included in other comprehensive income: Balance, beginning of period.............................. (1,189) (1,872) (1,197) Components of other comprehensive income (loss): Unrealized foreign currency translation gain (loss) (net of reclassification adjustment related to sale of European Hospitals of $1,678 in 1999)................... (1,138) 1,125 (230) Sale of European Hospitals................................ -- -- 2,074 --------- --------- --------- (1,138) 1,125 1,844 Provision for (benefit from) income taxes................. (455) 450 738 --------- --------- --------- Other comprehensive income (loss)......................... (683) 675 1,106 --------- --------- --------- Balance, end of period.................................... (1,872) (1,197) (91) --------- --------- --------- Total Stockholders' Equity.................................. $ 159,498 $ 188,433 $ 196,696 ========= ========= =========
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. F-5 MAGELLAN HEALTH SERVICES, INC. SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
FISCAL YEAR ENDED SEPTEMBER 30, --------------------------------------------- 1997 1998 1999 ---- ---- ---- Cash Flows From Operating Activities Net income (loss)......................................... $ (498) $ (19,283) $ 4,688 --------- ----------- ---------- Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Loss (gain) on sale of assets....................... 54,121 (3,001) (23,623) Loss on CBHS Transactions........................... -- -- 79,039 Depreciation and amortization....................... 19,683 49,264 73,531 Impairment of long-lived assets..................... -- 2,507 -- Other non-cash portion of special charges and discontinued operations............................. 33,300 37,499 (422) Equity in (earnings) losses of unconsolidated subsidiaries........................................ 5,567 (12,795) (20,442) Stock option expense (credit)....................... 4,292 (5,623) 18 Non-cash interest expense........................... 1,710 2,935 3,843 Extraordinary losses on early extinguishments of debt................................................ 8,756 55,025 -- Cash flows from changes in assets and liabilities, net of effects from sales and acquisitions of businesses: Accounts receivable, net.............................. 60,675 (1,585) (21,321) Restricted cash and investments....................... -- (21,782) (22,130) Other current assets.................................. 4,708 (3,010) 6,182 Other long-term assets................................ (2,411) 4,955 2,577 Accounts payable and accrued liabilities.............. (68,715) (50,082) (20,842) Medical claims payable................................ 8,056 6,358 (22,202) Income taxes payable and deferred income taxes........ (14,669) (14,489) 14,143 Reserve for unpaid claims............................. (26,553) (19,177) (30,196) Other liabilities..................................... (23,038) (9,290) 17,224 Minority interest, net of dividends paid.............. 9,633 (929) 3,142 Other................................................. (1,018) (1,701) (1,333) --------- ----------- ---------- Total adjustments..................................... 74,097 15,079 37,188 --------- ----------- ---------- Net cash provided by (used in) operating activities.......................................... 73,599 (4,204) 41,876 --------- ----------- ---------- Cash Flows From Investing Activities: Capital expenditures...................................... (33,348) (44,213) (48,119) Acquisitions and investments in businesses, net of cash acquired................................................ (50,876) (1,046,436) (69,457) Conversion of joint ventures from consolidation to equity method.................................................. -- -- (21,092) Distributions received from unconsolidated subsidiaries... -- 11,441 21,970 Decrease in assets restricted for settlement of unpaid claims and other long-term liabilities.................. 17,209 51,006 42,570 Proceeds from sale of assets.............................. 398,695 11,875 54,196 --------- ----------- ---------- Net cash provided by (used in) investing activities.......................................... 331,680 (1,016,327) (19,932) --------- ----------- ---------- Cash Flows From Financing Activities: Payments on debt and capital lease obligations............ (390,254) (438,633) (156,004) Proceeds from issuance of debt, net of issuance costs..... 203,643 1,188,706 76,818 Proceeds from exercise of stock options and warrants...... 8,265 3,982 2,632 Proceeds from issuance of warrants........................ 25,000 -- -- Purchases of treasury stock............................... -- (14,352) -- --------- ----------- ---------- Net cash provided by (used in) financing activities.......................................... (153,346) 739,703 (76,554) --------- ----------- ---------- Net increase (decrease) in cash and cash equivalents........ 251,933 (280,828) (54,610) Cash and cash equivalents at beginning of period............ 120,945 372,878 92,050 --------- ----------- ---------- Cash and cash equivalents at end of period.................. $ 372,878 $ 92,050 $ 37,440 ========= =========== ==========
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements F-6 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1999 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The consolidated financial statements of Magellan Health Services, Inc., a Delaware corporation, ("Magellan" or the "Company") include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. The Company's primary business segment, as of September 30, 1999, was its behavioral managed healthcare business. The Company operates in two other business segments, which are described in further detail in Note 13, "Business Segment Information." On September 2, 1999, the Company's Board of Directors approved a formal plan to dispose of the businesses and interests that comprise the Company's healthcare provider and healthcare franchising business segments (the "Disposal Plan"). The results of operations of the healthcare provider and healthcare franchising business segments have been reported in the accompanying financial statements as discontinued operations for all periods presented. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. MANAGED CARE REVENUE Managed care revenue is recognized over the applicable coverage period on a per member basis for covered members and as earned and estimable for performance-based revenues. Deferred revenue is recorded when premium payments are received in advance of the applicable coverage period. ADVERTISING COSTS The production costs of advertising are expensed as incurred. The Company does not consider any of its advertising costs to be direct-response and, accordingly, does not capitalize such costs. Advertising costs consist primarily of radio and television air time, which is amortized as utilized, and printed media services. Advertising expense for continuing operations was approximately $0.7 million, $2.4 million and $2.4 million for the fiscal years ended September 30, 1997, 1998 and 1999, respectively. Advertising expense for discontinued operations was approximately $18.5 million, $2.3 million and $0.2 million for the years ended September 30, 1997, 1998, and 1999, respectively. INTEREST, NET The Company records interest expense net of interest income. Interest income for the fiscal years ended September 30, 1997, 1998, and 1999 was approximately $9.0 million, $10.8 million and $10.4 million, respectively. CASH AND CASH EQUIVALENTS Cash equivalents are short-term, highly liquid interest-bearing investments with a maturity of three months or less when purchased, consisting primarily of money market instruments. F-7 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) RESTRICTED CASH AND INVESTMENTS Restricted cash and investments at September 30, 1998 and 1999 include approximately $89.2 million and $116.8 million, respectively that is held for the payment of claims under the terms of certain behavioral managed care contracts and for regulatory purposes related to the payment of claims in certain jurisdictions. CONCENTRATION OF CREDIT RISK Accounts receivable subject the Company to a concentration of credit risk with third party payors that include health insurance companies, managed healthcare organizations, healthcare providers and governmental entities. The Company establishes an allowance for doubtful accounts based upon factors surrounding the credit risk of specific payors, historical trends and other information. Management believes the allowance for doubtful accounts is adequate to provide for normal credit losses. ASSETS RESTRICTED FOR THE SETTLEMENT OF UNPAID CLAIMS AND OTHER LONG-TERM LIABILITIES Assets restricted for the settlement of unpaid claims and other long-term liabilities include investments which are carried at fair market value. Transfer of such investments from the Company's insurance subsidiaries to Magellan or any of its other subsidiaries is subject to approval by certain regulatory authorities. As of September 30, 1998 and 1999, assets restricted for settlement of unpaid claims and other long-term liabilities were approximately $37.9 million and $0, respectively. On July 2, 1999, the Company transferred its remaining unpaid claims portfolio to a third party insurer for approximately $22.3 million. This transfer was funded from assets restricted for the settlement of unpaid claims. The investments can be classified into three categories: (i) held to maturity; (ii) available for sale; and (iii) trading. Unrealized holding gains or losses are recorded for trading and available for sale securities. The Company's investments are classified as available for sale. The unrealized gain or loss on investments available for sale was not material at September 30, 1997, 1998 and 1999. PROPERTY AND EQUIPMENT Property and equipment are stated at cost, except for assets that have been impaired, for which the carrying amount is reduced to estimated fair value. Expenditures for renewals and improvements are charged to the property accounts. Replacements and maintenance and repairs that do not improve or extend the life of the respective assets are expensed as incurred. Internal-use software is capitalized in accordance with AICPA Statement of Position 98-1. Amortization of capital lease assets is included in depreciation expense. Depreciation is provided on a straight-line basis over the estimated useful lives of the assets, which is generally ten to forty years for buildings and improvements, three to ten years for equipment and three to five years for capitalized internal-use software. Depreciation expense for continuing operations was $9.6 million, $18.6 million and $30.0 million for the fiscal years ended September 30, 1997, 1998 and 1999, respectively. Depreciation expense for discontinued operations was $24.5 million, $5.4 million and $2.3 million for the fiscal years ended September 30, 1997, 1998 and 1999, respectively. F-8 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Property and equipment, net, consisted of the following at September 30, 1998 and 1999 (in thousands):
SEPTEMBER 30, ------------------- 1998 1999 -------- -------- Land........................................................ $ 11,607 $ 114 Buildings and improvements.................................. 78,886 12,079 Equipment................................................... 112,422 119,518 Capitalized internal-use software........................... 33,923 55,648 -------- -------- 236,838 187,359 Accumulated depreciation.................................... (60,100) (66,692) -------- -------- 176,738 120,667 Construction in progress.................................... 431 -- -------- -------- Property and equipment, net............................... $177,169 $120,667 ======== ========
INTANGIBLE ASSETS Intangible assets are composed principally of (i) goodwill, (ii) customer lists and relationships and (iii) deferred financing costs. Goodwill represents the excess of the cost of businesses acquired over the fair value of the net identifiable assets at the date of acquisition and is amortized using the straight-line method over 25 to 40 years. Customer lists and relationships and other intangible assets are amortized using the straight-line method over their estimated useful lives of 4 to 30 years. Deferred financing costs are amortized over the terms of the underlying agreements. The Company continually monitors events and changes in circumstances which could indicate that carrying amounts of intangible assets may not be recoverable. When events or changes in circumstances are present that indicate the carrying amount of intangible assets may not be recoverable, the Company assesses the recoverability of intangible assets by determining whether the carrying value of such intangible assets will be recovered through the future cash flows expected from the use of the asset and its eventual disposition. Impairment losses from continuing operations of approximately $2.4 million were recorded in fiscal 1998 as a result of the Integration Plan (see Note 9), including property and equipment. MEDICAL CLAIMS PAYABLE Medical claims payable represent the liability for healthcare claims reported but not yet paid and claims incurred but not yet reported ("IBNR") related to the Company's managed healthcare businesses. The IBNR portion of medical claims payable is estimated based upon authorized healthcare services, past claim payment experience for member groups, adjudication decisions, enrollment data, utilization statistics and other factors. Although considerable variability is inherent in such estimates, management believes the liability for medical claims payable is adequate. Medical claims payable balances are continually monitored and reviewed. Changes in assumptions for care costs caused by changes in actual experience could cause these estimates to change in the near term. F-9 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) FOREIGN CURRENCY Changes in the cumulative translation of foreign currency assets and liabilities are presented as a separate component of stockholders' equity. Gains and losses resulting from foreign currency transactions, which were not material, are included in operations as incurred. NET INCOME (LOSS) PER COMMON SHARE Net income (loss) per common share is computed based on the weighted average number of shares of common stock and common stock equivalents outstanding during the period. The Exchange Option (as defined), was classified as a potentially dilutive security for fiscal 1997 and 1998 for the purpose of computing diluted income per common share. The Exchange Option (as defined) was anti-dilutive for fiscal 1997 and 1998 and, therefore, was excluded from the diluted income per common share calculations. The Exchange Option (as defined) was exercised in January 1998. STOCK-BASED COMPENSATION In October 1995, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," ("FAS 123") which became effective for fiscal years beginning after December 15, 1995 (fiscal 1997 for the Company). FAS 123 established new financial accounting and reporting standards for stock-based compensation plans. Entities are allowed to measure compensation cost for stock-based compensation under FAS 123 or APB Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). Entities electing to remain with the accounting in APB 25 are required to make pro forma disclosures of net income and income per common share as if the provisions of FAS 123 had been applied. The Company has adopted FAS 123 on a pro forma disclosure basis. The Company continues to account for stock-based compensation under APB 25. See Note 6, "Stockholders' Equity". RECENT ACCOUNTING PRONOUNCEMENTS In April 1998, the AICPA issued Statement of Position 98-5, "Reporting on the Costs of Start-up Activities" ("SOP 98-5"). SOP 98-5 requires all nongovernmental entities to expense costs of start-up activities as those costs are incurred. Start-up costs, as defined by SOP 98-5, include pre-operating costs, pre-opening costs and organizational costs. SOP 98-5 became effective for financial statements for fiscal years beginning after December 15, 1998. At adoption, a company must record a cumulative effect of a change in accounting principle to write off any unamortized start-up costs remaining on the balance sheet when SOP 98-5 is adopted. Prior year financial statements cannot be restated. The Company adopted SOP 98-5 on October 1, 1998. The adoption of SOP 98-5 did not have any impact on the Company's financial position or results of operations. Emerging Issues Task Force Issue 96-16, "Investor's Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights" ("EITF 96-16") supplements the guidance contained in AICPA Accounting Research Bulletin 51, "Consolidated Financial Statements", and in Statement of Financial Accounting Standards No. 94, "Consolidation of All Majority-Owned Subsidiaries" ("ARB 51/FAS 94"), about the conditions under which the Company's consolidated financial statements should include the financial F-10 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) position, results of operations and cash flows of subsidiaries which are less than wholly-owned along with those of the Company's wholly-owned subsidiaries. In general, ARB 51/FAS 94 requires consolidation of all majority-owned subsidiaries except those for which control is temporary or does not rest with the majority owner. Under the ARB 51/FAS 94 approach, instances of control not resting with the majority owner were generally regarded to arise from such events as the legal reorganization or bankruptcy of the majority-owned subsidiary. EITF 96-16 expands the definition of instances in which control does not rest with the majority owner to include those where significant approval or veto rights, other than those which are merely protective of the minority shareholder's interest, are held by the minority shareholder or shareholders ("Substantive Participating Rights"). Substantive Participating Rights include, but are not limited to: i) selecting, terminating and setting the compensation of management responsible for implementing the majority-owned subsidiary's policies and procedures, and ii) establishing operating and capital decisions of the majority-owned subsidiary, including budgets, in the ordinary course of business. The provisions of EITF 96-16 apply to new investment agreements made after July 24, 1997, and to existing investment agreements which are modified after this date. The Company has made no new investments, and has modified no existing investments, to which the provisions of EITF 96-16 would have applied. In addition, the provisions of EITF 96-16 must be applied to majority-owned subsidiaries previously consolidated under ARB 51/FAS 94 for which the underlying agreements have not been modified in financial statements issued for years ending after December 15, 1998 (fiscal 1999 for the Company). The adoption of the provisions of EITF 96-16 on October 1, 1998, had the following effects on the Company's consolidated financial position:
OCTOBER 1, 1998 ---------- INCREASE (DECREASE) IN: Cash and cash equivalents.................................. $(21,092) Other current assets...................................... (9,538) Long-term assets.......................................... (30,049) Investment in unconsolidated subsidiaries................. 26,498 -------- Total Assets............................................ $(34,181) ======== Current liabilities....................................... $(10,381) Minority interest......................................... (23,800) -------- Total Liabilities....................................... $(34,181) ========
RECLASSIFICATIONS Certain reclassifications have been made to fiscal 1997 and 1998 amounts to conform to fiscal 1999 presentation. F-11 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 2. ACQUISITIONS AND JOINT VENTURES ACQUISITIONS MERIT ACQUISITION. On February 12, 1998, the Company consummated the acquisition of Merit Behavioral Care Corporation ("Merit") for cash consideration of approximately $448.9 million plus the repayment of Merit's debt. Merit manages behavioral healthcare programs across all segments of the healthcare industry, including HMOs, Blue Cross/Blue Shield organizations and other insurance companies, corporations and labor unions, federal, state and local governmental agencies and various state Medicaid programs. The Company accounted for the Merit acquisition using the purchase method of accounting. On September 12, 1997, Merit completed the acquisition of CMG Health, Inc. ("CMG"). CMG was also a national behavioral managed healthcare company. Merit paid approximately $48.7 million in cash and issued approximately 739,000 shares of Merit common stock as consideration for CMG. The former owners of CMG may be entitled to additional consideration, depending on the performance of three CMG customer contracts. Such contingent payments are subject to an aggregate maximum of $23.5 million. No contingent consideration will be payable to the former shareholders of CMG based on the performance of two of the three CMG customer contracts at September 30, 1999. The Company may still be required to pay contingent consideration to the former shareholders of CMG depending on the financial performance of CHOICE Behavioral Health Partnership ("Choice"). Choice is a joint venture with Value Options, Inc. that services a contract with CHAMPUS (as defined). The Company and Value Options, Inc. each own 50% of Choice. The payment of contingent consideration, if any, to the former shareholders of CMG, depends on the financial performance of Choice from October 1, 1996 to June 30, 1997, which is subject to a CHAMPUS Adjustment (as defined) the Company expects to receive in fiscal 2000. The Company has initiated legal proceedings against certain former owners of CMG with respect to representations made by such former owners in conjunction with Merit's acquisition of CMG. Whether any contingent payments will be made to the former shareholders of CMG and the amount and timing of contingent payments, if any, may be subject to the outcome of these proceedings. In connection with the acquisition of Merit, the Company (i) terminated its existing credit agreement; (ii) repaid all loans outstanding pursuant to Merit's existing credit agreement; (iii) completed a tender offer for its 11.25% Series A Senior Subordinated Notes due 2004 (the "Old Notes"); (iv) completed a tender offer for Merit's 11.50% Senior Subordinated notes due 2005 (the "Merit Outstanding Notes"); (v) entered into a new senior secured bank credit agreement (the "Credit Agreement") providing for a revolving credit facility (the "Revolving Facility") and a term loan facility (the "Term Loan Facility") of up to $700 million; and (vi) issued $625 million in 9.0% Senior Subordinated Notes due 2008 (the "Notes"). F-12 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 2. ACQUISITIONS AND JOINT VENTURES (CONTINUED) The following table sets forth the sources and uses of funds for the Merit acquisition and related transactions (the "Transactions") at closing (in thousands): SOURCES: Cash and cash equivalents................................... $ 59,290 Credit Agreement: Revolving Facility (1).................................... 20,000 Term Loan Facility........................................ 550,000 The Notes................................................... 625,000 ---------- Total sources........................................... $1,254,290 ========== USES: Cash paid to Merit Shareholders............................. $ 448,867 Repayment of Merit existing credit agreement (2)............ 196,357 Purchase of the Old Notes (3)............................... 432,102 Purchase of Merit Outstanding Notes (4)..................... 121,651 Transaction costs (5)....................................... 55,313 ---------- Total uses.............................................. $1,254,290 ==========
- ------------------------ (1) The Revolving Facility provides for borrowings of up to $150.0 million. (2) Includes principal amount of $193.7 million and accrued interest of $2.7 million. (3) Includes principal amount of $375.0 million, tender premium of $43.4 million and accrued interest of $13.7 million. (4) Includes principal amount of $100.0 million, tender premium of $18.8 million and accrued interest of $2.8 million. (5) Transaction costs include, among other things, expenses associated with the debt tender offers, the Notes offering, the Merit acquisition and the Credit Agreement. HAI ACQUISITION. On December 4, 1997, the Company consummated the purchase of Human Affairs International, Incorporated ("HAI"), formerly a unit of Aetna, Inc. ("Aetna"), for approximately $122.1 million, which the Company funded from cash on hand. HAI manages behavioral healthcare programs, primarily through EAPs and other behavioral managed healthcare plans. The Company may be required to make additional contingent payments of up to $60.0 million annually to Aetna over the five year period subsequent to closing. The amount and timing of the payments will be contingent upon net increases in the number of HAI's covered lives in specified products. The Company accounted for the HAI acquisition using the purchase method of accounting. The Company may be required to make additional contingent payments of up to $300 million to Aetna (the "Contingent Payments") over the five-year period (each year a "Contract Year") subsequent to closing. The amount and timing of the Contingent Payments will depend upon HAI's receipt of additional covered lives as computed, under two separate calculations. Under the first calculation, the Company may be required to pay up to $25.0 million per year for each of five years following the acquisition based on the net annual growth in the number of lives covered in specified HAI products. Under the second calculation, F-13 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 2. ACQUISITIONS AND JOINT VENTURES (CONTINUED) the Company may be required to pay up to $35.0 million per Contract Year, based on the net cumulative increase in lives covered by certain other HAI products. The Company is obligated to make contingent payments under two separate calculations (as previously described) as follows: In respect of each Contract Year, the Company may be required to pay to Aetna the "Tranche 1 Payments" (as defined) and the "Tranche 2 Payments" (as defined). Upon the expiration of each Contract Year, the Tranche 1 Payment shall vest with respect to such Contract Year in an amount equal to the product of (i) the Tranche 1 Cumulative Incremental Members (as defined) for such Contract Year and (ii) the Tranche 1 Multiplier (as defined) for such Contract Year. The vested amount of Tranche 1 Payment shall be zero with respect to any Contract Year in which the Tranche 1 Cumulative Incremental Members is a negative number. Furthermore, in the event that the number of Tranche 1 Cumulative Incremental Members with respect to any Contract Year is a negative number due to a decrease in the number of Tranche 1 Cumulative Incremental Members for such Contract Year (as compared to the immediately preceding Contract Year), Aetna will forfeit the right to receive a certain portion (which may be none or all) of the vested and unpaid amounts of the Tranche 1 Payment relating to preceding Contract Years. "Tranche 1 Cumulative Incremental Members" means, with respect to any Contract Year, (i) the number of Equivalent Members (as defined) serviced by the Company during such Contract Year for Tranche 1 Members, minus (ii)(A) for each Contract Year other than the Initial Contract Year, the number of Equivalent Members serviced by the Company for Tranche 1 Members during the immediately preceding Contract Year or (B) for the Initial Contract Year, the number of Tranche 1 Members as of September 30, 1997, subject to certain upward adjustments. There were 3,761,253 Tranche 1 Members for the initial Contract Year, prior to such upward adjustments. "Tranche 1 Members" are members of managed behavioral healthcare plans for whom the Company provides services in any of specified categories of products or services. "Equivalent Members" for any Contract Year equals the aggregate Member Months for which the Company provides services to a designated category or categories of members during the applicable Contract Year divided by 12. "Member Months" means, for each member, the number of months for which the Company provides services and is compensated. The "Tranche 1 Multiplier" is $80, $50, $40, $25, and $20 for the Contract Years 1998, 1999, 2000, 2001, and 2002, respectively. For each Contract Year, the Company is obligated to pay to Aetna the lesser of (i) the vested portion of the Tranche 1 Payment for such Contract Year and the vested and unpaid amount relating to prior Contract Years as of the end of the immediately preceding Contract Year and (ii) $25.0 million. To the extent that the vested and unpaid portion of the Tranche 1 Payment exceeds $25.0 million, the Tranche 1 Payment remitted to Aetna shall be deemed to have been paid first from any vested but unpaid amounts from previous Contract Years in order from the earliest Contract Year for which vested amounts remain unpaid to the most recent Contract Year at the time of such calculation. Except with respect to the Contract Year ending in 2002, any vested but unpaid portion of the Tranche 1 Payment shall be available for payment to Aetna in future Contract Years, subject to certain exceptions. All vested but unpaid amounts of Tranche 1 Payments shall expire following the payment of the Tranche 1 Payment in respect to the Contract Year ending in 2002, subject to certain exceptions. In no event shall the aggregate Tranche 1 Payments to Aetna exceed $125.0 million. F-14 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 2. ACQUISITIONS AND JOINT VENTURES (CONTINUED) Upon the expiration of each Contract Year, the Tranche 2 Payment shall be an amount equal to the lesser of: (a)(i) the product of (A) the Tranche 2 Cumulative Members (as defined) for such Contract Year and (B) the Tranche 2 Multiplier (as defined) applicable to such number of Tranche 2 Cumulative Members, minus (ii) the aggregate of the Tranche 2 Payments paid to Aetna for all previous Contract Years and (b) $35.0 million. The amount shall be zero with respect to any Contract Year in which the Tranche 2 Cumulative Members is a negative number. "Tranche 2 Cumulative Members" means, with respect to any Contract Year; (i) the Equivalent Members serviced by the Company during such Contract Year for Tranche 2 Members, minus (ii) the Tranche 2 Members as of September 30, 1997, subject to certain upward adjustments. There were 936,391 Tranche 2 Members prior to such upward adjustments. "Tranche 2 Members" means Members for whom the Company provides products or services in the HMO category. The "Tranche 2 Multiplier" with respect to each Contract Year is $85 in the event that the Tranche 2 Cumulative Members are less than 2,100,000, and $70 if more than or equal to 2,100,000. For each Contract Year, the Company shall pay to Aetna the amount of Tranche 2 Payment payable for such Contract Year. All rights to receive Tranche 2 Payment shall expire following the payment of the Tranche 2 Payment in respect to the Contract Year ending in 2002, subject to certain exceptions. Notwithstanding anything herein to the contrary, in no event shall the aggregate Tranche 2 payment to Aetna exceed $175.0 million, subject to certain exceptions. The Company paid $60.0 million to Aetna on March 26, 1999 for both the full Tranche 1 Payment and the full Tranche 2 Payment for the Contract Year ended December 31, 1998. Also, based upon the most recent membership enrollment data related to the Contract Year to end December 31, 1999 ("Contract Year 2"), the Company believes beyond a reasonable doubt that it will be required to make both the full Tranche 1 Payment and the full Tranche 2 Payment ($60.0 million in aggregate) related to Contract Year 2. Accordingly, the Company recorded $120.0 million of goodwill and other intangible assets related to the purchase of HAI during fiscal 1999. The Contract Year 2 liability of $60.0 million is included in "Deferred credits and other long-term liabilities" in the Company's consolidated balance sheet as of September 30, 1999. The Company intends to borrow under the Revolving Facility to meet this obligation, which is expected to be paid during the second quarter of fiscal 2000. The Company would record additional contingent consideration payable, if any, as goodwill and identifiable intangible assets. ALLIED ACQUISITION. On December 5, 1997, the Company purchased the assets of Allied Health Group, Inc. and certain affiliates ("Allied"). Allied provides specialty managed care services, including risk-based products and administrative services to a variety of insurance companies and other customers. Allied has over 80 physician networks across the eastern United States. Allied's networks include physicians specializing in cardiology, oncology and diabetes. The Company paid approximately $70.0 million for Allied, with cash on hand, of which $50.0 million was paid to the seller at closing with the remaining $20.0 million placed in escrow. The Company accounted for the Allied acquisition using the purchase method of accounting. The escrowed amount was payable in one-third increments if Allied achieved specified earnings targets during each of the three years following the closing. Additionally, the purchase price could have been increased during the three year period by up to $40.0 million if Allied's performance exceeded specified earnings targets. F-15 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 2. ACQUISITIONS AND JOINT VENTURES (CONTINUED) During the quarter ended December 31, 1998, the Company and the former owners of Allied amended the Allied purchase agreement (the "Allied Amendments"). The Allied Amendments resulted in the following changes to the original terms of the Allied purchase agreement: - The original $20.0 million placed in escrow by the Company at the consummation of the Allied acquisition, plus accrued interest, was repaid to the Company. This $20.0 million was included in the $70.0 million originally paid for Allied. - The Company paid the former owners of Allied $4.5 million additional consideration which was recorded as goodwill. - The Company capped future obligations with respect to additional contingent payments for the purchase of Allied at $3.0 million. The earnings targets which must be met by Allied for this amount to be paid were increased. The Company would record contingent consideration payable, if any, as additional goodwill. The following unaudited pro forma information for the fiscal years ended September 30, 1998 and 1999 has been prepared assuming the Allied acquisition, HAI acquisition, Merit acquisition, the Transactions, the Green Spring Minority Stockholder Conversion (as defined), the Europe Sale (as defined) and the CBHS Transactions (as defined), were consummated on October 1, 1997. The unaudited pro forma information does not purport to be indicative of the results that would have actually been obtained had such transactions been consummated on October 1, 1997 or which may be attained in future periods (in thousands, except per share data):
PRO FORMA FOR THE FISCAL YEAR ENDED ----------------------------- SEPTEMBER 30, SEPTEMBER 30, 1998 1999 ------------- ------------- Net revenue................................................. $1,609,770 $1,871,636 Income (loss) from continuing operations before extraordinary item(1)(2)................................... (1,152) 28,924 Income (loss) per common share--basic: Income (loss) from continuing operations before extraordinary item...................................... (0.04) 0.91 Income (loss) per common share--diluted: Income (loss) from continuing operations before extraordinary item...................................... (0.04) 0.91
- ------------------------ (1) Excludes expected unrealized cost savings related to the Integration Plan (as defined) and managed care integration costs (See Note 9). (2) Excludes the extraordinary losses on early extinguishment of debt for the year ended September 30, 1998, that were directly attributable to the consummation of the Transactions. HUMAN SERVICES ACQUISITIONS During fiscal 1998 and 1999, the Company acquired eight businesses, in aggregate, in its human services segment for an initial aggregate purchase price of approximately $60 million (collectively, the "Human Services Acquisitions"). The Human Services Acquisitions were accounted for using the purchase method of accounting. The Human Services Acquisitions provide various residential and day services for individuals with acquired brain injuries and for individuals with mental retardation and developmental disabilities. F-16 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 2. ACQUISITIONS AND JOINT VENTURES (CONTINUED) GREEN SPRING ACQUISITION. On December 13, 1995, the Company acquired a 51% ownership interest in Green Spring Health Services, Inc. ("Green Spring") for approximately $68.9 million in cash, the issuance of 215,458 shares of common stock valued at approximately $4.3 million and the contribution of Group Practice Affiliates, Inc. ("GPA"), a wholly-owned subsidiary of the Company, which became a wholly-owned subsidiary of Green Spring. In addition, the minority stockholders of Green Spring were issued an option agreement whereby they could exchange their interests in Green Spring for an equivalent of the Company's common stock or subordinated notes (the "Exchange Option"). On December 20, 1995, the Company acquired an additional 10% ownership interest in Green Spring for approximately $16.7 million in cash as a result of an exercise by a minority stockholder of its Exchange Option. In January 1998, the minority stockholders of Green Spring converted their collective 39% interest in Green Spring into an aggregate of 2,831,516 shares of the Company's common stock through exercise of the Exchange Option (the "Green Spring Minority Stockholder Conversion"). As a result of the Green Spring Minority Stockholder Conversion, the Company owns 100% of Green Spring. The Company issued shares from treasury to effect the Green Spring Minority Stockholder Conversion and accounted for it as a purchase of minority interest at a fair value of consideration paid of approximately $63.5 million. The Company recorded the investments in Green Spring using the purchase method of accounting. Green Spring's results of operations have been included in the Company's consolidated financial statements since the acquisition date, less minority interest through January, 1998, at which time the Company became the sole owner of Green Spring. At each reporting date through January 1998, the Company assessed the fair value of the Exchange Option in relation to the redemption price available to the minority stockholders. In any period that the fair value of the Exchange Option was determined to be less than the redemption price, the difference would have been recognized as an adjustment to minority interest. No losses were recorded in fiscal 1997 and 1998 as a result of changes in the fair value of the Exchange Option. JOINT VENTURES Through its acquisition of Merit, the Company became a 50% partner with Value Options, Inc. in Choice, a managed behavioral healthcare company. Choice derives all of its revenues from a contract with the Civilian Health and Medical Program of the Uniformed Services ("CHAMPUS"), and with TriCare, the successor to CHAMPUS. The Company accounts for its investment in Choice using the equity method. F-17 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 2. ACQUISITIONS AND JOINT VENTURES (CONTINUED) A summary of unaudited financial information for the Company's investment in Choice is as follows (in thousands):
SEPTEMBER 30, 1998 SEPTEMBER 30, 1999 ------------------ ------------------ Current assets.............................. $22,974 $19,572 Property and equipment, net................. 345 228 ------- ------- Total assets.............................. $23,319 $19,800 ======= ======= Current liabilities......................... $16,829 $12,673 Partners' capital........................... 6,490 7,127 ------- ------- Total liabilities and partners' capital..... $23,319 $19,800 ======= ======= Magellan investment in Choice............... $ 3,245 $ 3,563 ======= =======
FOR THE 231 DAYS ENDED FISCAL YEAR ENDED SEPTEMBER 30, 1998 SEPTEMBER 30, 1999 ------------------- ------------------- Net revenue................................. $38,676 $54,880 Operating expenses.......................... 22,914 28,124 ------- ------- Net income................................ $15,762 $26,756 ======= ======= Magellan equity income...................... $ 7,881 $13,378 ======= =======
The Company owns a 50% interest in Premier Behavioral Systems of Tennessee, LLC ("Premier"). Premier was formed to manage behavioral healthcare benefits for the State of Tennessee's TennCare program. The Company accounts for its investment in Premier using the equity method. The Company's investment in Premier at September 30, 1998 and 1999 was $5.8 million and $12.2 million, respectively. The Company's equity in income (loss) of Premier for fiscal 1997, 1998 and 1999 was $(5.6) million, $4.7 million and $6.3 million, respectively. 3. DISCONTINUED OPERATIONS GENERAL On September 10, 1999, the Company consummated the transfer of assets and other interests pursuant to a Letter Agreement dated August 10, 1999 with Crescent Real Estate Equities ("Crescent"), Crescent Operating, Inc. ("COI") and Charter Behavioral Health Systems, LLC ("CBHS") that effects the Company's exit from its healthcare provider and healthcare franchising businesses (the "CBHS Transactions"). The terms of the CBHS Transactions are summarized as follows: HEALTHCARE PROVIDER INTERESTS - The Company redeemed 80% of its CBHS common interest and all of its CBHS preferred interest, leaving it with a 10% non-voting common interest in CBHS. - The Company agreed to transfer to CBHS its interests in five of its six hospital-based joint ventures ("Provider JVs") and related real estate as soon as practicable. F-18 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 3. DISCONTINUED OPERATIONS (CONTINUED) - The Company transferred to CBHS the right to receive approximately $7.1 million from Crescent for the sale of two psychiatric hospitals that were acquired by the Company (and leased to CBHS) in connection with CBHS' acquisition of certain businesses from Ramsay Healthcare, Inc. in fiscal 1998. - The Company forgave receivables due from CBHS of approximately $3.3 million for payments received by CBHS for patient services prior to the formation of CBHS on June 17, 1997. The receivables related primarily to patient stays that "straddled" the formation date of CBHS. - The Company will pay $2.0 million to CBHS in 12 equal monthly installments beginning on the first anniversary of the closing date. - CBHS will indemnify the Company for 20% of up to the first $50 million (i.e., $10 million) for expenses, liabilities and settlements related to government investigations for events that occurred prior to June 17, 1997 (the "CBHS Indemnification"). CBHS will be required to pay the Company a maximum of $500,000 per year under the CBHS Indemnification. - Crescent, COI, CBHS and Magellan have provided each other with mutual releases of claims among all of the parties with respect to the original transactions that effected the formation of CBHS and the operation of CBHS since June 17, 1997 with certain specified exceptions. - The Company transfered certain other real estate and interests related to the healthcare provider business to CBHS. HEALTHCARE FRANCHISING INTERESTS - The Company transferred its healthcare franchising interests to CBHS, which included Charter Advantage, LLC, the Charter call center operation, the Charter name and related intellectual property. The Company has been released from performing any further franchise services or incurring future franchising expenses. - The Company forgave prepaid call center management fees of approximately $2.7 million. - The Company forgave unpaid franchise fees of approximately $115 million. The CBHS Transactions, together with the formal plan of disposal authorized by the Company's Board of Directors on September 2, 1999, represents the disposal of the Company's healthcare provider and healthcare franchising business segments under Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB 30"). APB 30 requires that the results of continuing operations be reported separately from those of discontinued operations for all periods presented and that any gain or loss from disposal of a segment of a business be reported in conjunction with the related results of discontinued operations. Accordingly, the Company has restated its results of operations for all prior periods. The Company recorded an after-tax loss on disposal of its healthcare provider and healthcare franchising business segments of approximately $47.4 million, (primarily non-cash) in the fourth quarter of fiscal 1999. The Company expects to transfer the Provider JVs and related real estate to CBHS and to sell its remaining joint venture interest and related real estate by no later than August 31, 2000. F-19 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 3. DISCONTINUED OPERATIONS (CONTINUED) The summarized results of the operations of the healthcare provider and healthcare franchising segments are as follows (in thousands):
FISCAL YEARS ENDED SEPTEMBER 30 --------------------------------- HEALTHCARE PROVIDER 1997 1998 1999 - ------------------------------------------------------------ -------- -------- -------- Net revenue(1).............................................. $729,652 $133,256 $ 74,860 -------- -------- -------- Salaries, cost of care and other operating expenses......... 582,609 106,760 53,952 Equity in earnings of unconsolidated subsidiaries........... -- -- (2,901) Depreciation and amortization............................... 25,018 5,266 2,141 Interest income(2).......................................... (1,060) (1,130) (76) Special charges(income), net................................ 60,225 135 (33,046) Other expenses(3)........................................... 27,390 10,093 21,907 -------- -------- -------- Net income.................................................. $ 35,470 $ 12,132 $ 32,883 ======== ======== ======== HEALTHCARE FRANCHISING - ------------------------------------------------------------ Net revenue................................................. $ 22,739 $ 55,625 $ 563 -------- -------- -------- Salaries, cost of care and other operating expenses......... 3,643 9,072 5,623 Equity in loss of CBHS...................................... 8,122 31,878 -- Depreciation and amortization............................... 160 355 337 Special charges............................................. -- 323 -- Other expenses(3)........................................... 4,325 5,598 (2,159) -------- -------- -------- Net income (loss)........................................... $ 6,489 $ 8,399 $ (3,238) ======== ======== ======== DISCONTINUED OPERATIONS--COMBINED - ------------------------------------------------------------ Net revenue(1).............................................. $752,391 $188,881 $ 75,423 -------- -------- -------- Salaries, cost of care and other operating expenses......... 586,252 115,832 59,575 Equity in (earnings) losses of unconsolidated subsidiaries.............................................. 8,122 31,878 (2,901) Depreciation and amortization............................... 25,178 5,621 2,478 Interest income(2).......................................... (1,060) (1,130) (76) Special charges (income), net............................... 60,225 458 (33,046) Other expenses(3)........................................... 31,715 15,691 19,748 -------- -------- -------- Net income.................................................. $ 41,959 $ 20,531 $ 29,645 ======== ======== ========
- ------------------------ (1) Includes $27.4 million, $7.0 million and $21.6 million in fiscal 1997, 1998 and 1999, respectively, related to the settlement and adjustment of reimbursement issues related to prior periods ("Cost Report Settlements"). (2) Interest expense has not been allocated to discontinued operations. (3) Includes income taxes and minority interest. F-20 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 3. DISCONTINUED OPERATIONS (CONTINUED) The summary of the loss on disposal of discontinued operations is as follows (in thousands): Basis in Provider JV's.................................. $ 44,598 Basis in Real Estate transferred to CBHS................ 13,969 Basis in Franchise and other operations................. 7,285 Working capital forgiveness............................. 5,565 Transaction costs and legal fees........................ 7,622 -------- Loss before income taxes................................ 79,039 Income tax benefit...................................... 31,616 -------- $ 47,423 ========
Remaining assets and liabilities of the provider business at September 30, 1999 include, among other things, (i) net amounts receivable for Cost Report Settlements of $16.2 million, (ii) hospital-based real estate of $7.0 million, (iii) long-term debt of $6.4 million related to the hospital-based real estate and (iv) reserve for discontinued operations of $11.4 million. The Company is also subject to inquiries and investigations from governmental agencies related to its operating and business practices prior to consummation of the Crescent Transactions (as defined) on June 17, 1997. See Note 11. The following table provides a rollforward of liabilities resulting from the CBHS Transactions (in thousands):
BALANCE BALANCE SEPTEMBER 30, SEPTEMBER 30, TYPE OF COST 1998 ADDITIONS PAYMENTS OTHER 1999 - ------------ ------------- --------- -------- -------- ------------- Transaction costs and legal fees.......... $ -- $ 7,622 $(69) $ -- $ 7,553 Provider JV working capital............... -- 2,931 -- 185 3,116 Other..................................... -- 755 -- -- 755 ---- ------- ---- ---- ------- $ -- $11,308 $(69) $185 $11,424 ==== ======= ==== ==== =======
CRESCENT TRANSACTIONS On June 17, 1997, the Company consummated a series of transactions including the sale of substantially all of its domestic hospital real estate and related personal property (the "Psychiatric Hospital Facilities") to Crescent and the sale of certain related assets to CBHS. In addition, CBHS was formed as a joint venture to operate the domestic portion of the Company's provider business segment. CBHS was initially owned equally by Magellan and COI. The Company accounted for its 50% investment in CBHS under the equity method of accounting. The Company received approximately $417.2 million in cash (before costs estimated to be $16.0 million) and warrants in COI for the purchase of 2.5% of COI's common stock at $18.32, which are exercisable over 12 years. The Company also issued 1,283,311 warrants each to Crescent and COI (the "Crescent Warrants") for the purchase of Magellan common stock at an exercise price of $30 per share. F-21 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 3. DISCONTINUED OPERATIONS (CONTINUED) In related agreements, (i) Crescent leased the hospital real estate and related assets to CBHS for initial annual rent beginning at approximately $41.7 million with a 5% annual escalation clause compounded annually (the "Facilities Lease") and (ii) CBHS was to pay Magellan approximately $78.3 million in annual franchise fees, subject to increase, for the use of assets retained by Magellan and for support in certain areas. The franchise fees to be paid by CBHS to the Company were subordinated to the lease obligations in favor of Crescent. The assets retained by Magellan included, but were not limited to, the "CHARTER" name, intellectual property, protocols and procedures, clinical quality management, operating processes and the "1-800-CHARTER" telephone call center. Magellan provided CBHS ongoing support in areas including advertising and marketing assistance, risk management services, outcomes monitoring, and consultation on matters relating to reimbursement, government relations, clinical strategies, regulatory matters, strategic planning and business development. The Company initially used approximately $200 million of the proceeds from the Crescent Transactions to reduce its long-term debt, including borrowings under its then existing credit agreement. In December 1997, the Company used the remaining proceeds from the Crescent Transactions to acquire additional managed healthcare businesses. See Note 2, "Acquisitions and Joint Ventures." The Company recorded a loss before income taxes of approximately $59.9 million in fiscal 1997 as a result of the Crescent Transactions, which consisted of the following (in thousands): Accounts receivable collection fees......................... $21,400 Impairment losses on intangible assets...................... 14,408 Exit costs and construction obligation...................... 12,549 Loss on the sale of property and equipment.................. 11,511 ------- $59,868 =======
Accounts receivable collection fees represent the reduction in the net realizable value of accounts receivable for estimated collection fees on retained hospital-based receivables for CBHS pursuant to a contractual obligation with CBHS, whereby CBHS received a fee equal to 5% of collections for the first 120 days after consummation of the Crescent Transactions and estimated bad debt agency fees of 40% for receivables collected subsequent to 120 days after the consummation of the Crescent Transactions. The Company reduced the accounts receivable collection fees reserve by $8.1 million during the fourth quarter of fiscal 1999 as substantially all hospital-based receivables subject to the collection fees had been collected at September 30, 1999. INVESTMENT IN CBHS The Company owned a 50% voting interest and 10% non-voting interest in CBHS as of September 30, 1998 and 1999 respectively. The Company became a 50% owner of CBHS upon consummation of the Crescent Transactions and reduced its ownership interest to 10% as a result of the CBHS Transactions. The Company accounted for its investment in CBHS using the equity method through September 10, 1999. The Company's 10% investment in CBHS is valued at $0 at September 30, 1999. HOSPITAL-BASED JOINT VENTURES. The Company was an owner in six and five hospital-based joint ventures at September 30, 1998 and 1999, respectively. The Company sold its interest in the Chicago, IL F-22 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 3. DISCONTINUED OPERATIONS (CONTINUED) joint venture to the minority owner in September 1999. Generally, each member of the joint venture leased and/or contributed certain assets in each respective market to the joint venture with the Company becoming the managing member. On October 1, 1998, the Provider JVs, excluding Westwood/Pembroke, were converted from consolidation to the equity method of accounting due to the Company's implementation of the transition guidance set forth in EITF 96-16. See Note 1, "Recent Accounting Pronouncements". A summary of the Provider JVs is as follows:
OWNERSHIP MARKET DATE PERCENTAGE MINORITY OWNER/S ------ ---- ---------- ----------------------------------- Chicago, IL (sold September June 1994 75% Naperville Health Ventures 1999)....................... Boston, MA.................... February 1995 97.5% Westwood/Pembroke Corp., Psychiatric Associates of Norfolk County, Inc. Albuquerque, NM............... May 1995 67% Columbia/HCA Healthcare Corporation Raleigh, NC................... June 1995 50% Columbia/HCA Healthcare Corporation Lafayette, LA................. October 1995 50% Columbia/HCA Healthcare Corporation Anchorage, AK................. August 1996 57% Columbia/HCA Healthcare Corporation
The Provider JVs have been managed by CBHS for a fee equivalent to the Company's portion of their earnings since June 17, 1997. The net proceeds from the sale of the Chicago, IL joint venture were transferred to CBHS in September 1999. SPECIAL CHARGES (INCOME) GENERAL The following table summarizes special charges (income) recorded during the three years in the period ended September 30, 1999 in the Company's healthcare provider and healthcare franchising businesses (in thousands):
FISCAL YEAR ENDED SEPTEMBER 30, ------------------------------ 1997 1998 1999 -------- -------- -------- Facility closures............................... $ 4,201 $ -- $ -- Gains on the sale of psychiatric hospitals, net........................................... (5,388) (3,000) (24,974) Loss on Crescent Transactions................... 59,868 -- (8,072) Termination of CBHS sale transaction............ -- 3,458 -- Other........................................... 1,544 -- -- ------- ------- -------- $60,225 $ 458 $(33,046) ======= ======= ========
F-23 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 3. DISCONTINUED OPERATIONS (CONTINUED) FACILITY CLOSURES During fiscal 1997, the Company consolidated, closed or sold three psychiatric facilities and its one general hospital (the "Closed Facilities"), respectively, exclusive of the Crescent Transactions. The three psychiatric facilities closed in fiscal 1997 were sold as part of the Crescent Transactions. The Company recorded charges of approximately $4.2 million related to facility closures in fiscal 1997:
1997 -------- Severance and related benefits.............................. $2,976 Contract terminations and other............................. 1,225 ------ $4,201 ======
Approximately 700 employees were terminated at the facilities closed in 1997. The recorded amounts have been paid as of September 30, 1998. GAINS ON SALE OF PSYCHIATRIC FACILITIES, NET AND OTHER During fiscal 1997, 1998 and 1999, the Company recorded gains of approximately $5.4 million, $3.0 million and $1.1 million, respectively, related to the sales of psychiatric hospitals and other real estate. The Company also recorded a charge of approximately $1.5 million during fiscal 1997 for costs incurred related primarily to the expiration of its agreement to sell its three European Hospitals. EUROPEAN PSYCHIATRIC HOSPITALS. On April 9, 1999, the Company sold its European psychiatric provider operations to Investment AB Bure of Sweden for approximately $57.0 million (before transaction costs of approximately $2.5 million) (the "Europe Sale"). The Europe Sale resulted in a non-recurring gain of approximately $23.9 million before provision for income taxes which is included in gain of sale of psychiatric hospitals. The Company used approximately $38.2 million of the net proceeds from the Europe Sale to make mandatory unscheduled principal payments on indebtedness outstanding under the Term Loan Facility (as defined). The remaining proceeds were used to reduce borrowings outstanding under the Revolving Facility (as defined). TERMINATION OF CBHS SALE TRANSACTION On March 3, 1998, the Company and certain of its wholly owned subsidiaries entered into definitive agreements with COI and CBHS pursuant to which the Company would have, among other things, sold the Company's franchise operations, certain domestic provider operations and certain other assets and operations. On August 19, 1998, the Company announced that it had terminated discussions with COI for the sale of its interest in CBHS. F-24 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 3. DISCONTINUED OPERATIONS (CONTINUED) In connection with the termination of the CBHS sale transaction, the Company recorded a charge of approximately $3.5 million as follows (in thousands): Severance(1)................................................ $ 488 Lease termination(1)........................................ 1,067 Impairment of long-lived assets............................. 153 Transaction costs and other................................. 1,750 ------ $3,458 ======
- ------------------------ (1) Relates to staffing reductions and lease terminations incurred in the Company's franchising and outcomes monitoring subsidiaries. 4. BENEFIT PLANS The Company currently has a defined contribution retirement plan (the "401(k) Plan"), which is in the form of an amendment and restatement of the Green Spring 401(k) Plan. Certain other 401(k) plans and assets, including the Magellan 401(k) Plan, were merged into the Green Spring Plan effective January 1, 1999. Employee participants can elect to voluntarily contribute up to 15% of their compensation to the 401(k) Plan. The Company makes contributions to the 401(k) Plan based on employee compensation and contributions. Additionally, the Company makes a discretionary contribution of 2% of each eligible employee's compensation. The Company matches 50% of each employee's contribution up to 3% of their compensation. The Company recognized $3.0 million of expense for the year ended September 30, 1999 for the matching contribution to the 401(k) Plan. The Company maintained a defined contribution plan (the "Magellan 401-K Plan"). Participants could contribute up to 15% of their compensation to the Magellan 401-K Plan. The Company made discretionary contributions of 2% of each employee's compensation and matched 50% of each employee's contribution up to 3% of their compensation. During the fiscal years ended September 30, 1997, 1998 and 1999, the Company made contributions of approximately $5.7 million, $3.2 million and $1.2 million respectively, to the Magellan 401-K Plan. Green Spring maintained a defined contribution plan (the "Green Spring 401-K Plan"). Employee participants could elect to voluntarily contribute up to 6% or 12% of their compensation, depending upon each employee's compensation level, to the Green Spring 401-K Plan. Green Spring matched up to 3% of each employee's compensation. Employees vested in employer contributions over five years. During the fiscal years ended September 30, 1997, 1998 and 1999 the Company contributed approximately $1.3 million, $1.2 million and $2.9 million, respectively, to the Green Spring 401-K Plan. F-25 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 5. LONG-TERM DEBT, CAPITAL LEASE OBLIGATIONS AND OPERATING LEASES Information with regard to the Company's long-term debt and capital lease obligations at September 30, 1998 and 1999 is as follows (in thousands):
SEPTEMBER 30, SEPTEMBER 30, 1998 1999 ------------- ------------- Credit Agreement: Revolving Facility (7.63% at September 30, 1999) due through 2004............................... $ 40,000 $ 20,000 Term Loan Facility (7.75% to 8.25% at September 30, 1999) due through 2006........... 550,000 492,873 9.0% Senior Subordinated Notes due 2008............ 625,000 625,000 11.5% other notes payable through 2005............. 4,198 35 3.8% capital lease obligations due through 2014.... 6,448 6,400 ---------- ---------- 1,225,646 1,144,308 Less amounts due within one year................. 23,033 30,119 ---------- ---------- $1,202,613 $1,114,189 ========== ==========
The aggregate scheduled maturities of long-term debt and capital lease obligations during the five fiscal years subsequent to September 30, 1999 are as follows (in thousands): 2000--$30,119; 2001--$36,161; 2002--$45,922; 2003--$85,523 and 2004--$145,560. The Notes, which are carried at cost, had a fair value of approximately $534 million at both September 30, 1998 and 1999, based on market quotes. The Company's remaining debt is also carried at cost, which approximates fair market value. The Company recognized a net extraordinary loss from the early extinguishment of debt of approximately $33.0 million, net of income tax benefit, during fiscal 1998, to write off unamortized deferred financing costs related to terminating the previous credit agreement and extinguishing the Old Notes, to record the tender premium and related costs of extinguishing the Old Notes and to record the gain on extinguishment of the Company's 7.5% Swiss bonds. The Credit Agreement provides for a Term Loan Facility in an original aggregate principal amount of $550 million, consisting of an approximately $183.3 million Tranche A Term Loan (the "Tranche A Term Loan"), an approximately $183.3 million Tranche B Term Loan (the "Tranche B Term Loan") and an approximately $183.3 million Tranche C Term Loan (the "Tranche C Term Loan"), and a Revolving Facility providing for revolving loans to the Company and the "Subsidiary Borrowers" (as defined therein) and the issuance of letters of credit for the account of the Company and the Subsidiary Borrowers in an aggregate principal amount (including the aggregate stated amount of letters of credit) of $150.0 million. Letters of credit outstanding were $17.6 million at September 30, 1999. The Tranche A Term Loan and the Revolving Facility mature on February 12, 2004. The Tranche B Term Loan matures on February 12, 2005 and the Tranche C Term Loan matures on February 12, 2006. The Tranche A Term Loan amortizes in installments in each fiscal year in amounts equal to $26.0 million in 2000, $32.1 million in 2001, $41.8 million in 2002, $44.6 million in 2003 and $10.5 million in 2004. The Tranche B Term Loan amortizes in installments in amounts equal to $2.0 million in each of 2000 through 2002, $38.9 million in 2003, $96.2 million in 2004 and $27.7 million in 2005. The Tranche C Term Loan F-26 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 5. LONG-TERM DEBT, CAPITAL LEASE OBLIGATIONS AND OPERATING LEASES (CONTINUED) amortizes in installments in each fiscal year in amounts equal to $2.0 million in each of 2000 through 2003, $38.9 million in 2004, $94.8 million in 2005 and $27.1 million in 2006. In addition, the Credit Facilities are subject to mandatory prepayment and reductions (to be applied first to the Term Loan Facility) in an amount equal to (a) 75% of the net proceeds of certain offerings of equity securities by the Company or any of its subsidiaries, (b) 100% of the net proceeds of certain debt issues of the Company or any of its subsidiaries, (c) 75% of the Company's excess cash flow, as defined, and (d) 100% of the net proceeds of certain asset sales or other dispositions of property of the Company and its subsidiaries, in each case subject to certain limited exceptions. The Credit Agreement contains a number of covenants that, among other things restrict the ability of the Company and its subsidiaries to dispose of assets, incur additional indebtedness, incur or guarantee obligations, prepay other indebtedness or amend other debt instruments (including the indenture for the Notes (the "Indenture")), pay dividends, create liens on assets, make investments, make loans or advances, redeem or repurchase common stock, make acquisitions, engage in mergers or consolidations, change the business conducted by the Company and its subsidiaries and make capital expenditures. In addition, the Credit Agreement requires the Company to comply with specified financial ratios and tests, including minimum coverage ratios, maximum leverage ratios, maximum senior debt ratios and minimum "EBITDA" (as defined in the Credit Agreement) and minimum net worth tests. As of September 30, 1999, the Company was in compliance with its debt covenants. At the Company's election, the interest rates per annum applicable to the loans under the Credit Agreement are a fluctuating rate of interest measured by reference to either (a) an adjusted London inter-bank offer rate ("LIBOR") plus a borrowing margin or (b) an alternate base rate ("ABR") (equal to the higher of the Chase Manhattan Bank's published prime rate or the Federal Funds effective rate plus 1/2 of 1%) plus a borrowing margin. The borrowing margins applicable to the Tranche A Term Loan and loans under the Revolving Facility are currently 1.25% for ABR loans and 2.25% for LIBOR loans, and are subject to reduction if the Company's financial results satisfy certain leverage tests. The borrowing margins applicable to the Tranche B Term Loan and the Tranche C Term Loan are 1.50% and 1.75%, respectively, for ABR loans and 2.50% and 2.75%, respectively, for LIBOR loans, and are not subject to reduction. Amounts outstanding under the credit facilities not paid when due bear interest at a default rate equal to 2.00% above the rates otherwise applicable to each of the loans under the Term Loan Facility and the Revolving Facility. The obligations of the Company and the Subsidiary Borrowers under the Credit Agreement are unconditionally and irrevocably guaranteed by, subject to certain exceptions, each wholly owned domestic subsidiary and, subject to certain exceptions, each foreign subsidiary of the Company. In addition, the Revolving Facility, the Term Loan Facility and the guarantees are secured by security interests in and pledges of or liens on substantially all the material tangible and intangible assets of the guarantors, subject to certain exceptions. The Notes are general unsecured senior subordinated obligations of the Company. The Notes are limited in aggregate principal amount to $625.0 million and will mature on February 15, 2008. Interest on the Notes accrues at the rate of 9.0% per annum and is payable semi-annually on each February 15 and August 15, commencing on August 15, 1998. The Notes were originally issued as unregistered securities and later exchanged for securities which were registered with the Securities and Exchange Commission. Due to a delay in the registration of the Notes to be exchanged, the Company was required to increase the F-27 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 5. LONG-TERM DEBT, CAPITAL LEASE OBLIGATIONS AND OPERATING LEASES (CONTINUED) interest rate on the Notes by 100 basis points per annum for the period from July 13, 1998 through November 9, 1998, the date of issuance of the Notes to be exchanged. The Notes are redeemable at the option of the Company. The Notes may be redeemed at the option of the Company, in whole or in part, at the redemption prices (expressed as a percentage of the principal amount) set forth below, plus accrued and unpaid interest, during the twelve-month period beginning on February 15 of the years indicated below:
REDEMPTION YEAR PRICES ---- ---------- 2003............................................. 104.5% 2004............................................. 103.0% 2005............................................. 101.5% 2006 and thereafter.............................. 100.0%
In addition, at any time and from time to time prior to February 15, 2001, the Company may, at its option, redeem up to 35% of the original aggregate principal amount of the Notes at a redemption price (expressed as a percentage of the principal amount) of 109%, plus accrued and unpaid interest with the net cash proceeds of one or more equity offerings; provided that at least 65% of the original aggregate principal amount of Notes remains outstanding immediately after the occurrence of such redemption and that such redemption occurs within 60 days of the date of the closing of any such equity offering. The Indenture limits, among other things: (i) the incurrence of additional indebtedness by the Company and its restricted subsidiaries; (ii) the payment of dividends on, and redemption or repurchase of, capital stock of the Company and its restricted subsidiaries and the redemption of certain subordinated obligations of the Company; (iii) certain other restricted payments, including investments; (iv) sales of assets; (v) certain transactions with affiliates; (vi) the creation of liens; and (vii) consolidations, mergers and transfers of all or substantially all the Company's assets. The Indenture also prohibits certain restrictions on distributions from restricted subsidiaries. However, all such limitations and prohibitions are subject to certain qualifications and exceptions. The Company recorded extraordinary losses of approximately $5.3 million, net of tax, during fiscal 1997 to write off unamortized deferred financing costs related to its previous credit agreement and for costs related to paying off its then existing variable rate secured notes. F-28 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 The Company leases certain of its operating facilities. The leases, which expire at various dates through 2008, generally require the Company to pay all maintenance, property and tax insurance costs. At September 30, 1999, aggregate amounts of future minimum payments under operating leases were as follows: 2000--$34.5 million; 2001--$30.8 million; 2002--$26.7 million; 2003--$19.7 million; 2004--$11.1 million; subsequent to 2004--$15.2 million. Rent expense for continuing operations was $10.3 million, $27.8 million and $39.9 million, respectively for the years ended September 30, 1997, 1998 and 1999. Rent expense for discontinued operations was $8.9 million, $2.8 million and $1.7 million, respectively for the fiscal years ended September 30, 1997, 1998 and 1999. 6. STOCKHOLDERS' EQUITY Pursuant to the Company's Restated Certificate of Incorporation, the Company is authorized to issue 80 million shares of common stock, $.25 par value per share, and 10 million shares of preferred stock, without par value. No shares of preferred stock have been issued as of September 30, 1999. COMMON STOCK The Company is prohibited from paying dividends on its common stock under the terms of the Indenture and the Credit Agreement except under very limited circumstances. 1992 STOCK OPTION PLAN The 1992 Stock Option Plan provided for the issuance of approximately 3.4 million options to purchase shares of common stock. A summary of changes in options outstanding and other related information is as follows:
FISCAL YEAR ENDED SEPTEMBER 30, ----------------------------------- 1997 1998 1999 ------------ --------- -------- Balance, beginning of period............... 368,990 368,990 6,000 Canceled................................. -- -- (6,000) Exercised................................ -- (362,990) -- ------------ --------- ------- Balance, end of period..................... 368,990 6,000 -- ============ ========= ======= Option prices, end of period............... $4.36-$22.75 $ 22.75 $ -- Price range of exercised options........... -- $ 4.36 $ -- Average exercise price..................... -- $ 4.36 $ --
The exercise price of certain options would have been reduced upon termination of employment of a certain optionee without cause. The Company recorded compensation expense for the difference between the exercise price of these options and the fair value of the Company's common stock until the measurement date was known. Such compensation expense was included in stock option expense (credit) in the Company's statements of operations until such options were exercised in August 1998. F-29 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 6. STOCKHOLDERS' EQUITY (CONTINUED) 1994 STOCK OPTION PLAN The 1994 Stock Option Plan (the "1994 Plan") provided for the issuance of approximately 1.3 million options to purchase shares of common stock. Officers and key employees of the Company are eligible to participate. The options have an exercise price which approximates fair market value of the Common Stock at the date of grant. A summary of changes in options outstanding and other related information is as follows:
FISCAL YEAR ENDED SEPTEMBER 30, -------------------------------------------------- 1997 1998 1999 --------------- --------------- -------------- Balance, beginning of period.... 948,669 1,028,494 681,217 Granted....................... 341,166 -- -- Canceled...................... (87,498) (298,276) (152,057) Exercised..................... (173,843) (49,001) (46,266) --------------- --------------- -------------- Balance, end of period.......... 1,028,494 681,217 482,894 =============== =============== ============== Option prices, end of period.... $15.687-$27.718 $15.687-$27.718 $8.406-$22.875 Price range of exercised options..................... $15.687-$27.875 $16.125-$22.875 $ 8.406 Average exercise price........ $ 22.20 $ 19.903 $ 8.406
Options granted under the 1994 Plan are exercisable to the extent vested. An option vests at the rate of 33 1/3% of the shares covered by the option on each of the first three anniversary dates of the grant of the option if the optionee is an employee of the Company on such dates. Options must be exercised no later than ten years after the date of grant. As of September 30, 1999, 94.3% of the options outstanding were vested. 1996 STOCK OPTION PLAN The 1996 Stock Option Plan (the "1996 Plan") provides for the issuance of 1.75 million options to purchase shares of the Company's common stock. Options must be granted on or before December 31, 1999. Officers and key employees of the Company are eligible to participate. The options have an exercise price which approximates fair market value of the common stock at the date of grant. A summary of changes in options outstanding and other related information is as follows:
FISCAL YEAR ENDED SEPTEMBER 30 -------------------------------------------------- 1997 1998 1999 --------------- --------------- -------------- Balance, beginning of period..................... 1,298,500 1,411,292 1,240,917 Granted.................... 310,667 50,000 548,803 Canceled................... (96,125) (42,000) (335,055) Exercised.................. (101,750) (178,375) (2,000) --------------- --------------- -------------- Balance, end of period....... 1,411,292 1,240,917 1,452,665 =============== =============== ============== Option prices, end of period..................... $ 15.75-$30.875 $ 15.75-$30.875 $4.188-$23.438 Price range of exercised options.................... $18.125-$18.875 $ 15.75-$25.156 $ 8.406 Average exercise price....... $ 18.348 $ 18.568 $ 8.406
F-30 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 6. STOCKHOLDERS' EQUITY (CONTINUED) Options granted under the 1996 Plan are exercisable to the extent vested. An option vests at the rate of 25% of the shares covered by the option on each of the four anniversary dates of the grant of the option if the optionee is an employee of the Company on such dates. Options must be exercised no later than November 30, 2005. The 1996 Plan provides that the options granted thereunder, upon the occurrence of certain events, vest and become fully exercisable upon the "sale, lease, transfer of other disposition... of all or substantially all" of the Company's assets. Based upon a review of relevant Delaware case law, the Company believes that substantial uncertainty existed regarding whether the Crescent Transactions, which are described in Note 3, constituted a "sale ... of all or substantially all" of the Company's assets. Accordingly, the Company's Board of Directors determined it should treat the Crescent Transactions as such an event in order to eliminate the risk of a dispute. Options outstanding under the 1996 Plan immediately vested upon closing the Crescent Transactions. As of September 30, 1999, 62.5% of the options outstanding under the 1996 Plan were vested. 1997 STOCK OPTION PLAN The 1997 Stock Option Plan (the "1997 Plan") provides for the issuance of 1.5 million options to purchase shares of the Company's common stock. Options must be granted on or before December 31, 2000. Officers and key employees of the Company are eligible to participate. The options have an exercise price which approximates fair market value of the common stock at the date of grant. A summary of changes in options outstanding and other related information is as follows:
FISCAL YEAR ENDED SEPTEMBER 30, ------------------------------------------------- 1997 1998 1999 -------------- --------------- -------------- Balance, beginning of period...................... -- 988,333 732,278 Granted....................... 988,333 396,000 801,500 Canceled...................... -- (652,055) (167,873) -------------- --------------- -------------- Balance, end of period........ 988,333 732,278 $ 1,365,905 ============== =============== ============== Option prices, end of period...................... $24.375-$31.00 $22.328-$31.063 $4.188-$24.375
Options granted under the 1997 Plan are exercisable to the extent vested. An option vests at the rate of 33 1/3% of the shares covered by the option on each of the three anniversary dates of the grant of the option if the optionee is an employee of the Company on such dates. Options must be exercised no later than February 28, 2007. As of September 30, 1999, 34.3% of the options outstanding under the 1997 Plan were vested. Certain of the options granted under the 1997 stock option plan were granted prior to the stockholder approval date. The measurement date for purposes of measuring compensation expense for such grants under the 1997 Plan was the date of stockholder approval, which resulted in compensation expense of approximately $0.5 million and $0.2 million in fiscal 1997 and 1998, respectively. 1998 STOCK OPTION PLAN The 1998 Stock Option Plan (the "1998 Plan") provides for the issuance of 1.0 million options to purchase shares of the Company's common stock. Options must be granted on or before December 31, F-31 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 6. STOCKHOLDERS' EQUITY (CONTINUED) 2001. Officers and key employees of the Company are eligible to participate. The options have an exercise price which approximates fair market value of the common stock at the date of grant. A summary of changes in options outstanding and other related information is as follows:
FISCAL YEAR ENDED SEPTEMBER 30, ------------------------------ 1998 1999 -------------- ------------- Balance, beginning of period................... -- 800,500 Granted........................................ 890,500 319,000 Canceled....................................... (90,000) (239,082) -------------- ------------- Balance, end of period......................... 800,500 880,418 ============== ============= Option prices, end of period................... $14.56-$22.875 $4.188-$8.406
Options granted under the 1998 Plan are exercisable to the extent vested. An option vests over the period specified in each stock option grant. Options must be exercised no later than December 31, 2008. As of September 30, 1999, 21.6% of the options outstanding under the 1998 Plan were vested. 1997 EMPLOYEE STOCK PURCHASE PLAN The 1997 Employee Stock Purchase Plan (the "1997 ESPP") covers 600,000 shares of common stock that can be purchased by eligible employees of the Company. The 1997 ESPP offering periods will have a term not less than three months and not more than 12 months. The first offering period under the 1997 ESPP began January 1, 1997 and the last offering period will end on or before December 31, 1999. The option price of each offering period will be the lesser of (i) 85% of the fair value of a share of common stock on the first day of the offering period or (ii) 85% of the fair value of a share of common stock on the last day of the offering period. A summary of the 1997 ESPP is as follows:
OFFERING OPTIONS EXERCISE PERIOD BEGAN ENDED EXERCISED PRICE --------------------- --------------- ----------------- --------- -------- 1 January 2, 1997 June 30, 1997 73,410 $ 19.125 2 August 1, 1997 December 31, 1997 26,774 $ 19.125 3 January 1, 1998 June 30, 1998 43,800 $18.4875 4 July 1, 1998 December 31, 1998 163,234 $ 7.0125 5 January 1, 1999 June 30, 1999 152,570 $ 7.0125 6 July 1, 1999 December 31, 1999 -- --
The number of options granted and the option price for the sixth offering period will be determined on December 31, 1999 when the option price is known. 1992 DIRECTORS' STOCK OPTION PLAN AND DIRECTORS' UNIT AWARD PLAN The 1992 Directors' Stock Option Plan (the "1992 Directors Plan") provides for the grant of options to non-employee members of the Company's Board of Directors to purchase up to 175,000 shares of the Company's common stock, subject to adjustments to reflect certain changes in capitalization. The options have an exercise price which approximates the fair market value of the common stock on the date of grant. During fiscal 1997, 1998 and 1999, no options were granted. As of September 30, 1999, 75,000 options were outstanding at $8.406. No options were exercised during fiscal 1997, 1998 or 1999. F-32 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 6. STOCKHOLDERS' EQUITY (CONTINUED) Options granted can be exercised from the date of vesting until February 1, 2003. No options can be granted after December 31, 1995. Options vest 20% when granted and an additional 20% on each successive February 1 for a period of four years, if the optionee continues to serve as a non-employee director on the applicable February 1. Unvested options vest in full in certain instances of termination. As of September 30, 1999, all of the options outstanding were vested. In addition, during fiscal 1994, the Company approved the Directors' Unit Award Plan (the "Unit Plan") which provides for the award of a maximum of 15,000 units (the "Units") that, upon vesting under the terms of the Unit Plan, would result in the issuance of an aggregate of 15,000 shares of common stock in settlement of Units. The Unit Plan provides for the award to each director who is not an employee of the Company of 2,500 Units. Upon vesting of the Units awarded to a director, the Company will settle the Units by issuing to the director, with no exercise price, a number of shares of the Company's common stock equal to the number of vested Units. 1996 DIRECTORS' STOCK OPTION PLAN The 1996 Directors' Stock Option Plan (the "1996 Directors Plan") provides for the grant of options to non-employee members of the Company's Board of Directors to purchase up to 250,000 shares of the Company's common stock, subject to adjustments to reflect certain changes in capitalization. The options have an exercise price which approximates the fair market value of a share of the common stock on the date of grant. During fiscal 1997, 25,000 options were granted at an exercise price of $30.812. During fiscal 1998, 50,000 options were granted at an exercise prices ranging from $20.25 to $22.4375. During fiscal 1999, no options were granted. As of September 30, 1999, 150,000 options were outstanding at $8.406. No options were exercised during fiscal 1997, 1998 or 1999. Options granted can be exercised from the date of vesting until November 30, 2005. No options can be granted after December 31, 1999. Options vest at the rate of 25% of the shares covered on each of the four anniversary dates of the grant of the option if the optionee continues to serve as a non-employee director on such dates. Options vest in full in certain instances of termination. As of September 30, 1999, 62.5% of the options outstanding were vested. STOCK OPTION REPRICING On November 17, 1998, the Company's Board of Directors approved the repricing of stock options outstanding under the Company's existing stock option plans (the "Stock Option Repricing"). Each holder of 10,000 or more stock options that was eligible to participate in the Stock Option Repricing was required to forfeit a percentage of outstanding stock options as follows: Directors, including the Chief Executive 40% - - Officer......................................... - - Named Executive Officers........................ 30% - - Other holders of 50,000 or more stock options... 25% - - Other holders of 10,000-49,999 stock options.... 15%
F-33 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 6. STOCKHOLDERS' EQUITY (CONTINUED) The Stock Option Repricing was consummated on December 8, 1998 based on the fair value of the Company's common stock on such date. Approximately 2.0 million outstanding stock options were repriced to $8.406 and approximately 0.7 million outstanding stock options were cancelled as a result of the Stock Option Repricing. Each participant in the Stock Option Repricing was precluded from exercising repriced stock options until June 8, 1999. A summary of the Stock Option Repricing by stock option plan is as follows (in thousands):
OPTIONS OPTIONS REPRICED CANCELLED -------- --------- 1994 Plan................................................... 319 65 1996 Plan................................................... 506 176 1997 Plan................................................... 378 54 1998 Plan................................................... 590 211 1992 Directors Plan......................................... 75 50 1996 Directors Plan......................................... 150 100 ----- --- 2,018 656 ===== ===
RIGHTS PLAN The Company adopted a share purchase rights plan in fiscal 1992 (the "Rights Plan"). Pursuant to the Rights Plan, each share of common stock also represents one share purchase right (collectively, the "Rights"). The Rights trade automatically with the underlying shares of common stock. Upon becoming exercisable, but prior to the occurrence of certain events, each Right initially entitles its holder to buy one share of common stock from the Company at an exercise price of $60.00. The Rights will be distributed and become exercisable only if a person or group acquires, or announces its intention to acquire, common stock exceeding certain levels, as specified in the Rights Plan. Upon the occurrence of such events, the exercise price of each Right reduces to one-half of the then current market price. The Rights also give the holder certain rights in an acquiring company's common stock. The Company is entitled to redeem the Rights at a price of $.01 per Right at any time prior to the distribution of the Rights. The Rights have no voting power until exercised. COMMON STOCK WARRANTS The Company issued 114,690 warrants in fiscal 1992 which expire on June 30, 2002 (the "2002 Warrants") to purchase one share each of the Company's common stock. The 2002 Warrants have an exercise price of $5.24 per share. During fiscal 1997 and 1998, 1,397 and 1,553 were issued, respectively, upon the exercise of 2002 Warrants. At September 30, 1999, 18,920 of the 2002 Warrants were outstanding. The Company also has 146,791 warrants outstanding with an exercise price of $38.70 per share which expire on September 1, 2006. Crescent and COI each have the right to purchase 1,283,311 shares of common stock (2,566,622 shares in aggregate; collectively the "Crescent Warrants") at a warrant exercise price of $30.00 per share F-34 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 6. STOCKHOLDERS' EQUITY (CONTINUED) (subject to adjustment pursuant to antidilution provisions). The Crescent Warrants will be exercisable at the following times and in the following amounts:
NUMBER OF SHARES OF DATE FIRST COMMON STOCK END OF EXERCISABLE ISSUABLE UPON EXERCISE EXERCISE PERIOD JUNE 17, OF WARRANTS JUNE 17, - ------------------------ ------------------------ ------------------------ 1998 30,000 2001 1999 62,325 2002 2000 97,114 2003 2001 134,513 2004 2002 174,678 2005 2003 217,770 2006 2004 263,961 2007 2005 313,433 2008 2006 366,376 2009 2007 422,961 2009 2008 483,491 2009
Crescent's and COI's rights with respect to the Crescent Warrants are not contingent on or subject to the satisfaction or completion of any obligation that Crescent or COI may have to CBHS, or that CBHS may have to the Company, or by any subordination of fees otherwise payable to the Company by CBHS. The Crescent Warrants contain provisions relating to adjustments in the number of shares covered by the Crescent Warrants and the warrant exercise price in the event of stock splits, stock dividends, mergers, reorganizations and similar transactions. The Crescent Warrants were recorded at $25.0 million upon issuance, which was their approximate fair value upon execution of the Warrant Purchase Agreement in January 1997. TREASURY STOCK TRANSACTIONS During fiscal 1998, the Company repurchased an aggregate of 696,600 shares of its common stock in the open market for approximately $14.4 million. Those transactions were funded with cash on hand. In January 1998, the Company issued an aggregate of 2,831,516 shares of treasury stock to the then existing minority stockholders of Green Spring to effect the Green Spring Minority Stockholder Conversion. See Note 2, "Acquisitions and Joint Ventures." INCOME (LOSS) PER COMMON SHARE The Company adopted Statement of Financial Accounting Standards No. 128, "Earnings per Share" ("FAS 128"), effective October 1, 1997. Income per common share for fiscal 1997 has been restated to conform to FAS 128 as required. The effect of adopting FAS 128 was not material. F-35 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 6. STOCKHOLDERS' EQUITY (CONTINUED) The following table presents the components of weighted average common shares outstanding--diluted:
YEAR ENDED SEPTEMBER 30, ------------------------------ 1997 1998 1999 ------ ------ ------ Weighted average common shares outstanding--basic........... 28,781 30,784 31,758 Common stock equivalents--stock options..................... -- -- 151 Common stock equivalents--warrants.......................... -- -- 7 ------ ------ ------ Weighted average common shares outstanding--diluted......... 28,781 30,784 31,916 ====== ====== ======
Options to purchase approximately 3,004,650 shares of common stock at $8.19 - -$31.00 per share were outstanding during fiscal 1999 but were not included in the computation of diluted EPS because the options exercise price was greater than the average market price of the common shares. Approximately 2,851,960 of these options, which expire between fiscal 2004 and 2009, were still outstanding at September 30, 1999. Warrants to purchase approximately 4,713,000 shares of common stock at $26.15 to $38.70 per share were outstanding during fiscal 1999 but were not included in the computation of diluted EPS because the warrants exercise price was greater than the average market price of the common shares. The warrants, which expire between fiscal 2000 and 2009, were still outstanding at September 30, 1999. The Company owned a 61% equity interest in Green Spring Health Services, Inc. ("Green Spring") during the periods presented above. The four minority stockholders of Green Spring had the options to exchange their ownership interests in Green Spring for 2,831,516 shares of the Company's common stock or $65.1 million of subordinated notes. The Exchange Option was considered a potentially dilutive security from the point in time the Company acquired Green Spring in December 1995 for the purpose of computing diluted income per common share. The Exchange Option was anti-dilutive for all periods presented and, therefore, was excluded from the respective diluted income per common share calculations. Each of the minority stockholders of Green Spring exercised the Exchange Option in January 1998, which resulted in the issuance of 2,831,516 shares of the Company's common stock. See Note 2--"Acquisitions and Joint Ventures--Green Spring." On December 15, 1999, the Company consummated the TPG investment (as defined). See Note 15, - "Subsequent Event." Common stock equivalents of approximately 693,000 and 414,000 were excluded from the diluted income per common share calculation for the years ended September 30, 1997 and 1998, respectively, due to their anti-dilutive nature as a result of the Company's loss from continuing operations before extraordinary items for such periods. STOCK-BASED COMPENSATION Effective October 1, 1996, the Company adopted the disclosure requirements of FAS 123. FAS 123 requires disclosure of pro forma net income and pro forma net income per share as if the fair value-based method of accounting for stock options had been applied in measuring compensation cost for stock-based F-36 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 6. STOCKHOLDERS' EQUITY (CONTINUED) awards granted in fiscal 1996, 1997, 1998 and 1999. Pro forma amounts are not representative of the effects of stock-based awards on future pro forma net income and pro forma net income per share because those pro forma amounts exclude the pro forma compensation expense related to unvested stock options granted before fiscal 1996. Reported and pro forma net income and net income per share amounts are set forth below (in thousands, except per share data):
FISCAL YEAR ENDED SEPTEMBER 30, ------------------------------ 1997 1998 1999 -------- -------- -------- Reported: Income (loss) from continuing operations before extraordinary items............... $(37,204) $ (6,799) $22,466 Net income (loss)............................ (498) (19,283) 4,688 Income (loss) per common share--basic: Income (loss) from continuing operations before extraordinary items............... (1.29) (0.22) 0.71 Net income (loss)............................ (0.02) (0.63) 0.15 Income (loss) per common share--diluted: Income (loss) from continuing operations before extraordinary items............... (1.29) (0.22) 0.70 Net income (loss)............................ (0.02) (0.63) 0.15 Pro Forma: Income (loss) from continuing operations before extraordinary items............... $(45,680) $(10,744) $15,443 Net loss..................................... (8,974) (23,228) (2,335) Income (loss) per common share--basic: Income (loss) from continuing operations before extraordinary items............... (1.59) (0.35) 0.49 Net loss..................................... (0.31) (0.75) (0.07) Income (loss) per common share--diluted: Income (loss) from continuing operations before extraordinary items............... (1.59) (0.35) 0.48 Net loss..................................... (0.31) (0.75) (0.07)
The fair values of the stock options and ESPP options granted were estimated on the date of their grant using the Black-Scholes option pricing model based on the following weighted average assumptions:
1997 1998 1999 --------- --------- --------- Risk-free interest rate....................... 6.0% 4.5% 5.8% Expected life................................. 5.5 years 4 years 3.8 years Expected volatility........................... 30% 50% 50% Expected dividend yield....................... 0% 0% 0%
F-37 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 6. STOCKHOLDERS' EQUITY (CONTINUED) The weighted average fair value of options granted during fiscal 1997, 1998 and 1999 was $9.67, $9.53 and $2.21, respectively. Stock option activity for all plans for 1997, 1998 and 1999 was as follows:
FISCAL YEAR ENDED SEPTEMBER 30, --------------------------------------------------------------------- 1997 1998 1999 -------------------- --------------------- ---------------------- WEIGHTED WEIGHTED WEIGHTED AVERAGE AVERAGE AVERAGE EXERCISE EXERCISE EXERCISE OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE --------- -------- ---------- -------- ----------- -------- Balance, beginning of period.... 2,916,159 $17.92 4,122,109 $20.13 3,835,912 $ 22.23 Granted......................... 1,665,166 24.24 1,386,500 24.22 1,669,303 5.730 Canceled........................ (183,623) 20.84 (1,082,331) 23.66 (1,050,067) 19.965 Exercised....................... (275,593) 20.26 (590,366) 9.90 (48,266) 7.992 --------- ---------- ----------- Balance, end of period.......... 4,122,109 20.13 3,835,912 22.23 4,406,882 10.149 --------- ---------- ----------- Exercisable, end of period...... 2,419,711 17.65 2,375,919 20.89 2,190,538 13.739 --------- ---------- -----------
Stock options outstanding on September 30, 1999:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE - -------------------------------------------------------------------- -------------------- WEIGHTED AVERAGE WEIGHTED WEIGHTED RANGE OF REMAINING AVERAGE AVERAGE EXERCISE CONTRACTUAL EXERCISE EXERCISE PRICE OPTIONS LIFE (YEARS) PRICE OPTIONS PRICE - ------------------------------ --------- ------------ -------- --------- -------- $4.188 - $8.188 1,576,921 7.37 $ 5.628 52,843 $ 7.313 $8.406 1,863,739 6.89 8.406 1,223,973 8.406 $9.438 - $24.375 966,222 6.09 20.894 913,722 21.255 --------- --------- 4,406,882 6.89 10.149 2,190,538 13.739 ========= =========
7. INCOME TAXES The provision for income taxes consisted of the following (in thousands):
FISCAL YEAR ENDED SEPTEMBER 30, --------------------------------- 1997 1998 1999 -------- ------- ------- Income taxes currently payable: Federal....................................... $ 10,685 $ 3,462 $ 555 State......................................... 2,740 589 2,800 Foreign....................................... -- -- 500 Deferred income taxes: Federal....................................... (27,873) 1,857 22,583 State......................................... (5,784) (364) 938 Foreign....................................... -- -- -- -------- ------- ------- $(20,232) $ 5,544 $27,376 ======== ======= =======
F-38 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 7. INCOME TAXES (CONTINUED) A reconciliation of the Company's income tax provision (benefit) to that computed by applying the statutory federal income tax rate is as follows (in thousands):
FISCAL YEAR ENDED SEPTEMBER 30, --------------------------------- 1997 1998 1999 --------- --------- --------- Income tax provision (benefit) at federal statutory income tax rate.................... $(17,703) $ 993 $17,665 State income taxes, net of federal income tax benefit...................................... (1,979) 147 2,430 Merit goodwill amortization.................... -- 4,410 7,187 Other--net..................................... (550) (6) 94 -------- -------- ------- Income tax provision (benefit)................. $(20,232) $ 5,544 $27,376 ======== ======== =======
As of September 30, 1999, the Company has estimated tax net operating loss ("NOL") carryforwards of approximately $512 million available to reduce future federal taxable income. These NOL carryforwards expire in 2006 through 2018 and are subject to examination by the Internal Revenue Service. In addition, the Company also has estimated tax NOL carryforwards of approximately $125 million available to reduce the federal taxable income of Merit and its subsidiaries. These NOL carryforwards expire in 2009 through 2018 and are subject to examination by the Internal Revenue Service. Further, these NOL carryforwards are subject to limitations on the taxable income of Merit and its subsidiaries. The Company has recorded a valuation allowance against the portion of the total NOL deferred tax asset and certain other deferred tax assets, that in management's opinion, are not likely to be recovered. Components of the net deferred income tax (assets) liabilities at September 30, 1998 and 1999 are as follows (in thousands):
SEPTEMBER 30, --------------------- 1998 1999 --------- --------- Deferred tax liabilities: Property and depreciation........................... $ 8,670 $ 2,060 Long-term debt and interest......................... 20,388 19,735 ESOP................................................ 12,777 12,968 Intangibles......................................... -- 11,332 Other............................................... 9,556 15,209 --------- --------- Total deferred tax liabilities.................... 51,391 61,304 --------- --------- Deferred tax assets: Intangible Assets................................... (8,992) -- Operating loss carryforwards........................ (250,512) (254,696) Self-insurance reserves............................. (9,534) (2,220) Restructuring costs................................. (4,071) (9,552) Other............................................... (40,359) (51,953) --------- --------- Total deferred tax assets........................... (313,468) (318,421) --------- --------- Valuation allowance................................. 163,893 165,460 --------- --------- Deferred tax assets after valuation allowance....... (149,575) (152,961) --------- --------- Net deferred tax assets............................. $ 98,184 $ 91,657 ========= =========
F-39 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 7. INCOME TAXES (CONTINUED) During June 1999, the Company received an assessment from the Internal Revenue Service (the "IRS Assessment") related to its federal income tax returns for the fiscal years ended September 30, 1992 and 1993. The IRS Assessment disallowed approximately $162 million of deductions that relate primarily to interest expense in fiscal 1992. The Company filed an appeal of the IRS Assessment during September 1999. The Company had previously recorded a valuation allowance for the full amount of the $162 million of deductions disallowed in the IRS Assessment. The IRS Assessment is not expected to result in a material cash payment for income taxes related to prior years; however, the Company's federal income tax net operating loss carryforwards would be reduced if the Company's appeal is unsuccessful. The Internal Revenue Service is currently examining Merit and CMG's income tax returns for pre-acquisition periods. In management's opinion, adequate provisions have been made for any adjustments which may result from these examinations, including a potential reduction in the amount of NOL carryforwards. The Company believes the examinations could result in a reduction in NOL carryforwards available to offset future taxable income. 8. ACCRUED LIABILITIES Accrued liabilities consist of the following (in thousands):
SEPTEMBER 30, ------------------- 1998 1999 -------- -------- Salaries, wages and other benefits.......................... $ 23,893 $ 22,318 CHAMPUS Adjustments......................................... 25,484 51,784 Due to Providers............................................ 17,576 35,918 Other....................................................... 126,577 99,776 -------- -------- $193,530 $209,796 ======== ========
9. MANAGED CARE INTEGRATION PLAN AND COSTS AND SPECIAL CHARGES INTEGRATION PLAN The Company integrated three behavioral managed care organizations ("BMCOs"), Green Spring, HAI and Merit, as a result of acquisitions consummated in fiscal 1996 (Green Spring) and fiscal 1998 (HAI and Merit). The Company also integrated two specialty managed care organizations, Allied and Care Management Resources, Inc. ("CMR"). During fiscal 1998, management committed the Company to a plan to combine and integrate the operations of its BMCOs and specialty managed care organizations (the "Integration Plan") that resulted in the elimination of duplicative functions and standardized business practices and information technology platforms. The Integration Plan resulted in the elimination of approximately 1,000 positions during fiscal 1998 and fiscal 1999. Approximately 510 employees were involuntarily terminated pursuant to the Integration Plan. F-40 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 9. MANAGED CARE INTEGRATION PLAN AND COSTS AND SPECIAL CHARGES (CONTINUED) The employee groups of the BMCOs that were primarily affected include executive management, finance, human resources, information systems and legal personnel at the various BMCOs corporate headquarters and regional offices and credentialing, claims processing, contracting and marketing personnel at various operating locations. The Integration Plan has resulted in the closure and identified closure of approximately 20 leased facilities at the BMCOs, Allied and CMR during fiscal 1998 and 1999. The Company initially recorded approximately $21.3 million of liabilities related to the Integration Plan, of which $12.4 million was recorded as part of the Merit purchase price allocation and $8.9 million was recorded in the statement of operations under "Managed care integration costs" in fiscal 1998. During fiscal 1999, the Company recorded adjustments of approximately $(0.3) million, net, to such liabilities, of which $(0.8) million was recorded as part of the Merit purchase price allocation and $0.5 million was recorded in the statement of operations under "Managed care integration costs." The Company may record additional adjustments to such liabilities during the future periods depending on its ability to sublease closed offices and upon determination of the final amount of the Company's severance obligations. The following table provides a rollforward of liabilities resulting from the Integration Plan (in thousands):
BALANCE BALANCE SEPTEMBER 30, SEPTEMBER 30, TYPE OF COST 1997 ADDITIONS PAYMENTS 1998 - ------------ ------------- --------- ---------- ------------- Employee termination benefits......... $ -- $13,009 $(6,819) $ 6,190 Facility closing costs................ -- 8,008 (533) 7,475 Other................................. -- 244 (75) 169 ---------- ------- ------- ------- $ -- $21,261 $(7,427) $13,834 ========== ======= ======= =======
BALANCE BALANCE SEPTEMBER 30, SEPTEMBER 30, TYPE OF COST 1998 ADJUSTMENTS PAYMENTS 1999 - ------------ ------------- ----------- -------- ------------- Employee termination benefits.......... $ 6,190 $ 1,959 $(7,380) $ 769 Facility closing costs................. 7,475 (2,071) (2,310) 3,094 Other.................................. 169 (169) -- -- ------- ------- ------- ------ $13,834 $ (281) $(9,690) $3,863 ======= ======= ======= ======
OTHER INTEGRATION COSTS The Integration Plan resulted in additional incremental costs that were expensed as incurred in accordance with Emerging Issues Task Force Consensus 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)" that are not described above and certain other charges. Other integration costs include, but are not limited to, outside consultants, costs to relocate closed office contents and long-lived asset F-41 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 9. MANAGED CARE INTEGRATION PLAN AND COSTS AND SPECIAL CHARGES (CONTINUED) impairments. Other integration costs are reflected in the statement of operations under "Managed care integration costs". During fiscal 1998, the Company incurred approximately $8.1 million, in other integration costs, including long-lived asset impairments of approximately $2.4 million, and outside consulting costs of approximately $4.1 million. The asset impairments relate primarily to identifiable intangible assets and leasehold improvements that no longer have value and have been written off as a result of the Integration Plan. During fiscal 1999, the Company incurred approximately $5.7 million in other integration costs, primarily for outside consulting costs and employee and office relocation costs. SPECIAL CHARGES. During fiscal 1999, the Company recorded special charges of approximately $4.4 million related primarily to the loss on disposal of an office building, executive severance and relocation of its corporate headquarters from Atlanta, Georgia to Columbia, Maryland. 10. SUPPLEMENTAL CASH FLOW INFORMATION Supplemental cash flow information is as follows (in thousands):
YEAR ENDED SEPTEMBER 30, ------------------------------ 1997 1998 1999 -------- -------- -------- Income taxes paid, net of refunds received.................. $18,406 $11,116 $ 347 Interest paid, net of amounts capitalized................... 54,378 95,153 102,094 Non-cash Transactions: Initial capital contribution to CBHS, primarily property and equipment, less assumed liabilities....................... 5,281 -- -- Common Stock in Treasury issued in connection with the purchase of the remaining 39% interest in Green Spring Health Services, Inc...................................... -- 63,496 --
F-42 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 11. COMMITMENTS AND CONTINGENCIES The Company is self-insured for a portion of its general and professional liability risks. The reserves for self-insured general and professional liability losses, including loss adjustment expenses, were included in reserve for unpaid claims in the Company's balance sheet and were based on actuarial estimates that were discounted at an average rate of 6% to their present value based on the Company's historical claims experience adjusted for current industry trends. These reserves related primarily to the professional liability risks of the Company's healthcare provider segment prior to the Crescent Transactions. The undiscounted amount of the reserve for unpaid claims at September 30, 1998 was approximately $34.6 million. The carrying amount of accrued medical malpractice claims was $26.2 million at September 30, 1998. The reserve for unpaid claims was adjusted periodically as such claims matured, to reflect changes in actuarial estimates based on actual experience. During fiscal 1998, the Company recorded reductions in malpractice claim reserves of approximately $4.1 million, respectively, as a result of updated actuarial estimates which is included in discontinued operations. This reduction resulted primarily from updates to actuarial assumptions regarding the Company's expected losses for more recent policy years. This revision was based on changes in expected values of ultimate losses resulting from the Company's claim experience, and increased reliance on such claim experience. On July 2, 1999, the Company transferred its remaining medical malpractice claims portfolio (the "Loss Portfolio Transfer") to a third-party insurer for approximately $22.3 million. The Loss Portfolio Transfer was funded from assets restricted for settlement of unpaid claims. The insurance limit obtained through the Loss Portfolio Transfer for future medical malpractice claims is $26.3 million. The healthcare industry is subject to numerous laws and regulations. The subjects of such laws and regulations include but are not limited to, matters such as licensure, accreditation, government healthcare program participation requirements, reimbursement for patient services, and Medicare and Medicaid fraud and abuse. Recently, government activity has increased with respect to investigations and/or allegations concerning possible violations of fraud and abuse and false claims statutes and/or regulations by healthcare providers. Entities that are found to have violated these laws and regulations may be excluded from participating in government healthcare programs, subjected to fines or penalties or required to repay amounts received from the government for previously billed patient services. The Office of the Inspector General of the Department of Health and Human Services and the United States Department of Justice ("Department of Justice") and certain other governmental agencies are currently conducting inquiries and/ or investigations regarding the compliance by the Company and certain of its subsidiaries and the compliance by CBHS and certain of its subsidiaries with such laws and regulations. Certain of the inquiries relate to the operations and business practices of the Company's psychiatric provider operations prior to the consummation of the Crescent Transactions in June 1997. The Department of Justice has indicated that its inquiries are based on its belief that the Federal government has certain civil and administrative causes of action under the Civil False Claims Act, the Civil Monetary Penalties Law, other federal statutes and the common law arising from the participation in federal health benefit programs of CBHS psychiatric facilities nationwide. The Department of Justice inquiries relate to the following matters: (i) Medicare cost reports, (ii) Medicaid cost statements, (iii) supplemental applications to CHAMPUS/TRICARE based on Medicare cost reports, (iv) medical necessity of services to patients and admissions, (v) failure to provide medically necessary treatment or admissions and (vi) submission of claims to government payors for inpatient and outpatient psychiatric services. No amounts related to such proposed causes of action have yet been specified. The Company cannot reasonably estimate the settlement amount, if any, associated with the Department of Justice inquiries. Accordingly, no reserve has been recorded related to this matter. F-43 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 11. COMMITMENTS AND CONTINGENCIES (CONTINUED) On August 1, 1996, the United States Department of Justice, Civil Division, filed an Amended Complaint in a civil QUI TAM action initiated in November 1994 against the Company and its Orlando South hospital subsidiary ("Charter Orlando") by two former employees. The First Amended Complaint alleges that Charter Orlando violated the federal False Claims Act (the "Act") in billing for inpatient treatment provided to elderly patients. The Court granted the Company's motion to dismiss the government's First Amended Complaint yet granted the government leave to amend its First Amended Complaint. The government filed a Second Amended Complaint on December 12, 1996 which, similar to the First Amended Complaint, alleges that the Company and its subsidiary violated the Act in billing for the treatment of geriatric patients. Like the First Amended Complaint, the Second Amended Complaint was based on disputed clinical and factual issues which the Company believes do not constitute a violation of the Act. On the Company's motion, the Court ordered the parties to participate in mediation of the matter. As a result of the mediation, the parties reached a settlement. Pursuant to the settlement, the Company paid approximately $4.8 million in August 1998. Furthermore, Charter Orlando (operated by CBHS) did not seek reimbursement for services provided to patients covered under the Medicare program for a period of up to fifteen months. The Company reimbursed CBHS for the resulting loss of revenues through September 30, 1999. On May 26, 1998, a group of eleven plaintiffs purporting to represent an uncertified class of psychiatrists, psychologists and social workers brought an action (the "Holstein Case") under the federal antitrust laws in the United States District Court for the District of New Jersey against nine behavioral health managed care organizations, including Merit, CMG, Green Spring and HAI (collectively, the "Defendants"). The complaint alleges that the Defendants violated Section I of the Sherman Act by engaging in a conspiracy to fix the prices at which the Defendants purchase services from mental healthcare providers such as the plaintiffs. The complaint further alleges that the Defendants engaged in a group boycott to exclude mental healthcare providers from the Defendants' networks in order to further the goals of the alleged conspiracy. The complaint also challenges the propriety of the Defendants' capitation arrangements with their respective customers, although it is unclear from the complaint whether the plaintiffs allege that the Defendants unlawfully conspired to enter into capitation arrangements with their respective customers. The complaint seeks treble damages against the Defendants in an unspecified amount and a permanent injunction prohibiting the Defendants from engaging in the alleged conduct which forms the basis of the complaint, plus costs and attorneys' fees. Upon joint motion by the Defendants, the case was transferred to the United States District Court for the Southern District of New York, the same court where a previous similar case (the "Stephens Case") was dismissed for failure to state a claim upon which relief can be granted. On March 15, 1999, the Defendants filed a joint motion to dismiss the case for substantially the same reasons as in the Stephens Case. On June 16, 1999, the court denied the motion to dismiss. The case currently is in discovery. On October 14, 1999, the Plaintiffs filed a motion seeking class certification for a class of approximately 200,000 providers. The court has not yet heard argument on that motion. The Company does not believe this matter will have a material adverse effect on its financial position or results of operations. The Company is also subject to or party to other litigation, claims, and civil suits, relating to its operations and business practices. Certain of the Company's managed care litigation matters involve class action lawsuits, including the Holstein Case, in which the Company has been named as a defendant. Besides the Holstein Case, the Company has certain other class action lawsuits which allege (i) the Company inappropriately denied and/or failed to authorize benefits for mental health treatment under F-44 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 11. COMMITMENTS AND CONTINGENCIES (CONTINUED) insurance policies with a customer of the Company and (ii) the Company was party to employee malpractice and professional negligence regarding a specific mental health illness. In the opinion of management, the Company has recorded reserves that are adequate to cover litigation, claims or assessments that have been or may be asserted against the Company, and for which the outcome is probable and reasonably estimable, arising out of such other litigation, claims and civil suits. Furthermore, management believes that the resolution of such litigation, claims and civil suits will not have a material adverse effect on the Company's financial position or results of operations; however, there can be no assurance in this regard. The Company provides mental health and substance abuse services, as a subcontractor, to beneficiaries of CHAMPUS. The fixed monthly amounts that the Company receives for medical costs under CHAMPUS contracts are subject to retroactive adjustment ("CHAMPUS Adjustments") based upon actual healthcare utilization during the period known as the "data collection period". The Company has recorded reserves of approximately $25.5 million and $51.8 million as of September 30, 1998 and 1999, respectively for CHAMPUS Adjustments. During the first quarter of fiscal 2000, the Company reached a settlement agreement with a contractor under one of its CHAMPUS contracts whereby the Company agreed to pay approximately $38.1 million to the contractor during the quarter ended December 31, 1999. The Company and the contractor under this CHAMPUS contract are in the process of appealing the department of defense's retroactive adjustment. While management believes that the present reserve for CHAMPUS Adjustments is reasonable, ultimate settlement resulting from the adjustment and available appeal process may vary from the amount provided. 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Gerald L. McManis, a director of the Company, is the President of McManis Associates, Inc. ("MAI"), a healthcare development and management consulting firm. During fiscal 1997, 1998 and 1999, MAI provided consulting services to the Company with respect to the development of strategic plans and a review of the Company's business processes. The Company incurred approximately $865,000 and $85,000 in fees for such services and related expenses during fiscal 1997 and 1998, respectively. G. Fred DiBona, Jr., a director of the Company, is a Director and the President and Chief Executive Officer of Independence Blue Cross ("IBC"), a health insurance company. IBC owned 16.67% of Green Spring prior to December 13, 1995. On December 13, 1995, IBC sold 4.42% of its ownership interest in Green Spring to the Company for $5,376,000 in cash. IBC had a cost basis of $3,288,000 in the 4.42% ownership interest sold to the Company. The Exchange Option described previously gave IBC the right to exchange its ownership interest in Green Spring for a maximum of 889,456 shares of Common Stock or $20,460,000 in subordinated notes through December 13, 1998. IBC exercised its Exchange Option in January 29, 1998 for Magellan Common Stock valued at approximately $17.9 million. IBC and its affiliated entities contract with the Company for provider network, care management and medical review services pursuant to contractual relationships entered into on July 7, 1994 with terms of up to five years. The Company's contract with IBC is in the process of being renegotiated. During fiscal 1997, 1998 and 1999, IBC and its affiliated entities made payments to Green Spring of approximately $48.0 million, $54.7 million and $71.3 million and owed Green Spring approximately $13.5 million and $1.3 million F-45 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (CONTINUED) at September 30, 1998 and 1999, respectively. The Company recorded revenue of approximately $47.4 million, $54.6 million and $59.1 million from IBC during fiscal 1997, 1998 and 1999, respectively. On July 7, 1994, IBC sold a subsidiary to Green Spring in exchange for a $15 million promissory note. As of September 30, 1999, such promissory note had been repaid. Darla D. Moore, a director of the Company since February 1996, is the spouse of Richard E. Rainwater, Chairman of the Board of Crescent and one of the largest stockholders of the Company (13.0% beneficial ownership as of September 30, 1999). Because of her relationship to Mr. Rainwater, Ms. Moore did not participate in any Board action taken with respect to the Crescent Transactions. Daniel S. Messina, a director of the Company, is the Chief Financial Officer of Aetna U.S. Healthcare, a subsidiary of Aetna. Mr. Messina became a director of the Company in December 1997. On December 4, 1997, the Company consummated the purchase of HAI, formerly a unit of Aetna, for approximately $122.1 million plus contingent consideration. The Company may be required to make additional contingent payments of up to $60.0 million annually to Aetna over the five-year period subsequent to closing. The amount and timing of the payments will be contingent upon net increases in the HAI's covered lives in specified products. The Company paid $60.0 million to Aetna for both the full Tranche 1 Payment and the full Tranche 2 Payment for the Contract Year ended December 31, 1998, on March 26, 1999. The consideration paid for HAI was determined through arm's length negotiations that considered, among other factors, the historical and projected income of HAI. The consideration paid by the Company was determined by the Board with the advice of management and the Company's investment bankers. Aetna and its affiliated entities contract with the Company for various behavioral and specialty managed care services pursuant to contractual relationships, the most material of which is the Master Service Agreement, which was entered into on December 4, 1997. During fiscal 1998 and 1999, Aetna and its affiliated entities paid the Company approximately $72.3 million and $296.4 million, respectively for such services. As of September 30, 1998 and 1999, Aetna and its affiliated entities owed the Company approximately $0.8 million and $24.4 million, respectively. The Company recorded revenue of approximately $69.2 million and $293.1 million, respectively from Aetna during fiscal 1998 and 1999. 13. BUSINESS SEGMENT INFORMATION The Company operates through three reportable business segments engaging in (i) the behavioral managed healthcare business, (ii) the human services business and (iii) the specialty managed healthcare business. The behavioral managed healthcare segment provides behavioral managed care services to health plans, insurance companies, corporations, labor unions and various governmental agencies. The human services segment provides therapeutic foster care services and residential and day services to individuals with acquired brain injuries and for individuals with mental retardation and developmental disabilities. The speciality managed healthcare segment provides managed care services to health plans and insurance companies for chronic medical conditions and other specialty services. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance of its segments based on profit or loss from continuing operations before depreciation, amortization, interest, net, stock option expense (credit), F-46 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 13. BUSINESS SEGMENT INFORMATION (CONTINUED) managed care integration costs, special charges, net, income taxes and minority interest ("Segment Profit"). Intersegment sales and transfers are not significant. The Company's reportable segments are strategic business units that offer different services. They are managed separately because each business has (i) different marketing strategies due to differences in types of customers and (ii) different capital resource needs. The following tables summarize, for the periods indicated, operating results and other financial information, by business segment (in thousands):
BEHAVIORAL SPECIALTY CORPORATE MANAGED HUMAN MANAGED OVERHEAD HEALTHCARE SERVICES HEALTHCARE AND OTHER CONSOLIDATED ---------- -------- ---------- --------- ------------ 1997 Net revenue.................................. $ 375,541 $ 88,331 $ -- $ -- $ 463,872 Segment profit (loss)........................ 37,019 10,695 (2,303) (25,578) 19,833 Equity in loss of unconsolidated subsidiaries............................... (5,567) -- -- -- (5,567) Capital expenditures......................... 9,548 1,880 567 21,353 33,348 1998 Net revenue.................................. $1,026,243 $141,032 $143,503 $ -- $1,310,778 Segment profit (loss)........................ 137,192 15,493 3,128 (15,866) 139,947 Equity in earnings of unconsolidated subsidiaries............................... 12,795 -- -- -- 12,795 Investment in unconsolidated subsidiaries.... 10,125 -- -- 941 11,066 Capital expenditures......................... 27,535 8,391 3,937 4,350 44,213 Total assets................................. 1,356,259 119,356 78,062 363,411 1,917,088 1999 Net revenue.................................. $1,483,202 $191,277 $197,157 $ -- $1,871,636 Segment Profit (loss)........................ 218,253 21,728 2,410 (13,939) 228,452 Equity in earnings of unconsolidated subsidiaries............................... 20,442 -- -- -- 20,442 Investment in unconsolidated subsidiaries.... 18,396 -- -- -- 18,396 Capital expenditures......................... 37,487 5,779 4,129 724 48,119 Total assets................................. 1,472,539 127,348 88,535 193,193 1,881,615
The following tables reconcile segment profit to consolidated income from continuing operations before provision for income taxes, minority interest and extraordinary items: 1997 Segment profit.............................................. $ 19,833 Depreciation and amortization............................... (19,683) Interest, net............................................... (46,438) Stock option expense........................................ (4,292) -------- Loss from continuing operations before provision for income taxes, minority interest and extraordinary items................................................... $(50,580) ========
F-47 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 13. BUSINESS SEGMENT INFORMATION (CONTINUED) 1998 Segment profit.............................................. $139,947 Depreciation and amortization............................... (49,264) Interest, net............................................... (76,505) Stock option credit......................................... 5,623 Managed care integration costs.............................. (16,962) -------- Income from continuing operations before provision for income taxes, minority interest and extraordinary items................................................... $ 2,839 ========
1999 Segment Profit.............................................. $228,452 Depreciation and amortization............................... (73,531) Interest, net............................................... (93,752) Stock option (expense) credit............................... (18) Managed care integration costs.............................. (6,238) Special charges............................................. (4,441) -------- Income from continuing operations before provision for income taxes, minority interest and extraordinary item..... $ 50,472 ========
Revenue generated and long-lived assets located in foreign countries are not material. Revenues from one customer of the Company's behavioral managed healthcare segment represented 11.4% of the Company's consolidated revenues for fiscal 1999. Revenues from one customer served by both the Company's behavioral managed healthcare segment and specialty managed healthcare segment represented 15.7% of the Company's consolidated revenues for fiscal 1999. F-48 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 14. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) The following is a summary of the quarterly results of operations for the years ended September 30, 1998 and 1999.
FOR THE QUARTER ENDED --------------------------------------------------- DECEMBER 31, MARCH 31, JUNE 30, SEPTEMBER 30, 1998 1999 1999 1999 ------------ --------- -------- ------------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1999 Net Revenue........................................... $443,331 $479,703 $463,421 $485,181 -------- -------- -------- -------- Cost and expenses: Salaries, cost of care and other operating expenses.......................................... 392,313 429,602 412,315 429,396 Equity in earnings of unconsolidated subsidiaries... (3,783) (6,262) (8,196) (2,201) -------- -------- -------- -------- Segment Profit...................................... 54,801 56,363 59,302 57,986 -------- -------- -------- -------- Depreciation and amortization....................... 17,513 18,129 19,801 18,088 Interest, net....................................... 24,122 24,229 22,662 22,739 Stock option expense................................ 12 6 -- -- Managed care integration costs...................... 1,750 2,119 522 1,847 Special charges, net................................ 1,084 2,252 -- 1,105 -------- -------- -------- -------- 44,481 46,735 42,985 43,779 -------- -------- -------- -------- Income from continuing operations before income taxes and minority interest............................... 10,320 9,628 16,317 14,207 Provision for income taxes............................ 5,915 5,658 8,323 7,480 -------- -------- -------- -------- Income from continuing operations before minority interest............................................ 4,405 3,970 7,994 6,727 Minority interest..................................... 410 (34) 189 65 -------- -------- -------- -------- Income from continuing operations..................... 3,995 4,004 7,805 6,662 Discontinued operations: Income (loss) from discontinued operations.......... 186 (47) 13,694 15,812 Loss on disposal of discontinued operations......... -- -- -- (47,423) -------- -------- -------- -------- 186 (47) 13,694 31,611 -------- -------- -------- -------- Net income (loss)..................................... $ 4,181 $ 3,957 $ 21,499 $(24,949) ======== ======== ======== ======== Income (loss) per common share -- basic: Income from continuing operations................... $ 0.13 $ 0.13 $ 0.25 $ 0.21 ======== ======== ======== ======== Income (loss) from discontinued operations.......... $ 0.01 $ -- $ 0.43 $ (0.99) ======== ======== ======== ======== Net income (loss)..................................... $ 0.13 $ 0.12 $ 0.68 $ (0.78) ======== ======== ======== ======== Income (loss) per common share -- diluted: Income from continuing operations................... $ 0.13 $ 0.13 $ 0.24 $ 0.21 ======== ======== ======== ======== Income (loss) from discontinued operations.......... $ 0.01 $ -- $ 0.43 $ (0.98) ======== ======== ======== ======== Net income (loss)..................................... $ 0.13 $ 0.12 $ 0.67 $ (0.77) ======== ======== ======== ========
F-49 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 14. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (CONTINUED)
FOR THE QUARTER ENDED --------------------------------------------------- DECEMBER 31, MARCH 31, JUNE 30, SEPTEMBER 30, 1997 1998 1998 1998 ------------ --------- -------- ------------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1998 Net Revenue........................................... $159,632 $321,256 $415,863 $414,027 -------- -------- -------- -------- Cost and expenses: Salaries, cost of care and other operating expenses.......................................... 146,078 294,513 375,943 367,092 Equity in (earnings) losses of unconsolidated subsidiaries...................................... 634 (1,200) (6,750) (5,479) -------- -------- -------- -------- Segment Profit...................................... 12,920 27,943 46,670 52,414 -------- -------- -------- -------- Depreciation and amortization....................... 5,568 11,489 16,326 15,881 Interest, net....................................... 7,685 17,799 24,693 26,328 Stock option expense (credit)....................... (3,959) 420 12 (2,096) Managed care integration costs...................... -- 11,074 1,240 4,648 -------- -------- -------- -------- 9,294 40,782 42,271 44,761 -------- -------- -------- -------- Income (loss) from continuing operations before income taxes, minority interest and extraordinary items.... 3,626 (12,839) 4,399 7,653 Provision for (benefit from) income items............. 1,451 (4,278) 3,361 5,010 -------- -------- -------- -------- Income (loss) from continuing operations before minority interest and extraordinary items........... 2,175 (8,561) 1,038 2,643 Minority interest..................................... 2,374 618 1,095 7 -------- -------- -------- -------- Income (loss) from continuing operations before extraordinary items................................. (199) (9,179) (57) 2,636 Discontinued operations: Income (loss) from discontinued operations.......... 7,827 6,887 7,467 (1,650) -------- -------- -------- -------- Income (loss) before extraordinary items.............. 7,628 (2,292) 7,410 986 Extraordinary item -- net loss on early extinguishments of debt............................. -- (33,015) -- -- -------- -------- -------- -------- Net income (loss)..................................... $ 7,628 $(35,307) $ 7,410 $ 986 ======== ======== ======== ======== Income (loss) per common share -- basic: Income (loss) from operations before extraordinary items............................................. $ (0.01) $ (0.30) $ -- $ 0.08 ======== ======== ======== ======== Income (loss) from discontinued operations.......... $ 0.27 $ 0.22 $ 0.24 $ (0.05) ======== ======== ======== ======== Extraordinary losses on early extinguishments of debt.............................................. $ -- $ (1.06) $ -- $ -- ======== ======== ======== ======== Net income (loss)..................................... $ 0.26 $ (1.14) $ 0.24 $ 0.03 ======== ======== ======== ======== Income (loss) per common share -- diluted: Income (loss) from continuing operations before extraordinary items............................... $ (0.01) $ (0.30) $ -- $ 0.08 ======== ======== ======== ======== Income (loss) from discontinued operations.......... $ 0.27 $ 0.22 $ 0.24 $ (0.05) ======== ======== ======== ======== Extraordinary losses on early extinguishments of debt.............................................. $ -- $ (1.06) $ -- $ -- ======== ======== ======== ======== Net income (loss)..................................... $ 0.26 $ (1.14) $ 0.24 $ 0.03 ======== ======== ======== ========
F-50 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1999 15. SUBSEQUENT EVENT On July 19, 1999, the Company entered into a definitive agreement to issue approximately $75.4 million of cumulative convertible preferred stock to TPG Magellan, LLC, an affiliate of the investment firm Texas Pacific Group ("TPG") (the "TPG Investment"). On December 15, 1999, the Company and TPG amended and restated the definitive agreement and consummated the TPG Investment. Pursuant to the amended and restated definitive agreement, TPG purchased approximately $59.1 million of the Company's Series A Cumulative Convertible Preferred Stock (the "Series A Preferred Stock") and an Option (the "Option") to purchase an additional approximately $21.0 million of Series A Preferred Stock. Net proceeds from issuance of Series A Preferred Stock were $54.0 million. Approximately 50% of the net proceeds received from the issuance of the Series A Preferred Stock was used to reduce debt outstanding under the Term Loan Facility with the remaining 50% of the proceeds being used for general corporate purposes. The Series A Preferred Stock carries a dividend of 6.5% per annum, payable in quarterly installments in cash or common stock, subject to certain conditions. Dividends not paid in cash or common stock will accumulate. The Series A Preferred Stock is convertible at any time by the holder into approximately 6.3 million shares of the Company's common stock at a conversion price of $9.375 per share and carries "as converted" voting rights. The Company may, under certain circumstances, require the holders of the Series A Preferred Stock to convert such stock into common stock. The Series A Preferred Stock, plus accrued and unpaid dividends thereon, must be redeemed by the Company on December 15, 2009. The Options will expire unless exercised by June 15, 2002. TPG may exercise the Options in whole or in part. The Company may, under certain circumstances, require TPG to exercise the Options. The terms of the shares of Series A Preferred Stock issuable pursuant to the Options are identical to the terms of the shares of Series A Preferred Stock issued to TPG at the closing of the TPG Investment. TPG has three representatives on the Company's twelve-member Board of Directors. The issuance of common stock in respect of accrued and unpaid dividend obligations on the Series A Preferred Stock and the issuance of common stock underlying the Options are subject to approval by the Company's stockholders. The Company intends to seek such stockholder approval no later than the next annual meeting of its stockholders, which is expected to be held in February 2000. F-51 REPORT OF INDEPENDENT AUDITORS Executive Board Choice Behavioral Health Partnership We have audited the accompanying balance sheets of Choice Behavioral Health Partnership (Choice) as of December 31, 1998 and 1999, and the related statements of income, partners' capital, and cash flows for the years then ended. These financial statements are the responsibility of Choice's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Choice Behavioral Health Partnership at December 31, 1998 and 1999, and the results of its operations, changes in its partners' capital, and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States. Ernst & Young LLP Jacksonville, Florida February 18, 2000 F-52 CHOICE BEHAVIORAL HEALTH PARTNERSHIP BALANCE SHEETS
DECEMBER 31 ------------------------- 1998 1999 ASSETS ----------- ----------- Current assets: Cash and cash equivalents................................. $ 3,995,107 $ 8,498,857 Restricted cash and cash equivalents...................... 11,591,085 6,741,533 Receivable from Humana.................................... 4,883,700 4,917,887 Other current assets...................................... 477,944 291,690 ----------- ----------- Total current assets........................................ 20,947,836 20,449,967 Property and equipment, net................................. 310,225 202,879 ----------- ----------- Total assets................................................ $21,258,061 $20,652,846 =========== =========== LIABILITIES AND PARTNERS' CAPITAL Current liabilities: Claims payable............................................ $11,591,085 $ 6,741,533 Accounts payable and accrued expenses..................... 910,062 909,539 Due to related parties.................................... 61,475 64,003 Contract settlement reserve............................... 1,942,561 5,464,927 ----------- ----------- Total current liabilities................................... 14,505,183 13,180,002 Partners' capital: CMG Health, Inc........................................... 3,376,439 3,736,422 FHC Options, Inc.......................................... 3,376,439 3,736,422 ----------- ----------- Total partners' capital..................................... 6,752,878 7,472,844 ----------- ----------- Total liabilities and partners' capital..................... $21,258,061 $20,652,846 =========== ===========
THE ACCOMPANYING NOTES TO FINANCIAL STATEMENTS ARE AN INTEGRAL PART OF THIS BALANCE SHEET. F-53 CHOICE BEHAVIORAL HEALTH PARTNERSHIP STATEMENTS OF INCOME
YEAR ENDED DECEMBER 31 ------------------------- 1998 1999 ----------- ----------- Provider contract revenue................................... $70,351,009 $54,353,683 Clinical expenses........................................... 29,169,252 24,723,492 ----------- ----------- Gross margin................................................ 41,181,757 29,630,191 Administrative expenses..................................... 5,362,452 5,340,987 ----------- ----------- Income from operations...................................... 35,819,305 24,289,204 Other income: Investment income......................................... 1,037,021 860,762 ----------- ----------- Net income.................................................. $36,856,326 $25,149,966 =========== ===========
THE ACCOMPANYING NOTES TO FINANCIAL STATEMENTS ARE AN INTEGRAL PART OF THIS STATEMENT. F-54 CHOICE BEHAVIORAL HEALTH PARTNERSHIP STATEMENTS OF PARTNERS' CAPITAL
CMG HEALTH, INC. FHC OPTIONS, INC. TOTAL ---------------- ----------------- ----------- Balance at December 31, 1997..................... $ 1,454,361 $ 1,454,361 $ 2,908,722 Partner distributions.......................... (16,506,085) (16,506,085) (33,012,170) Net income..................................... 18,428,163 18,428,163 36,856,326 ----------- ----------- ----------- Balance at December 31, 1998..................... 3,376,439 3,376,439 6,752,878 Partner distributions.......................... (12,215,000) (12,215,000) (24,430,000) Net income..................................... 12,574,983 12,574,983 25,149,966 ----------- ----------- ----------- Balance at December 31, 1999..................... $ 3,736,422 $ 3,736,422 $ 7,472,844 =========== =========== ===========
THE ACCOMPANYING NOTES TO FINANCIAL STATEMENTS ARE AN INTEGRAL PART OF THIS STATEMENT. F-55 CHOICE BEHAVIORAL HEALTH PARTNERSHIP STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31 ------------------------- 1998 1999 ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES Net income.................................................. $36,856,326 $25,149,966 Adjustments to reconcile net income to net cash provided by operating activities Depreciation.............................................. 188,904 183,488 Loss on disposal of equipment............................. 7,460 2,072 Changes in operating assets and liabilities: Decrease in restricted cash and cash equivalents........ 5,134,237 4,849,552 (Increase) decrease in receivable from Humana........... (4,883,700) (34,187) Decrease (increase) in other current assets............. (147,459) 186,254 (Decrease) increase in accounts payable and accrued expenses.............................................. 188,000 (523) Decrease in medical claims payable...................... (5,134,237) (4,849,552) Increase (decrease) in contract settlement reserve...... (4,040,844) 3,522,366 Increase (decrease) in due to related parties........... (88,356) 2,528 ----------- ----------- Net cash provided by operating activities................... 28,080,331 29,011,964 CASH FLOWS FROM INVESTING ACTIVITIES Purchases of property and equipment......................... (91,327) (78,214) ----------- ----------- Net cash used in investing activities....................... (91,327) (78,214) CASH FLOWS FROM FINANCING ACTIVITIES Distributions to partners................................... (33,012,170) (24,430,000) ----------- ----------- Net cash used in financing activities....................... (33,012,170) (24,430,000) ----------- ----------- Increase (decrease) in cash and cash equivalents............ (5,023,166) 4,503,750 Cash and cash equivalents, beginning of year................ 9,018,273 3,995,107 ----------- ----------- Cash and cash equivalents, end of year...................... $ 3,995,107 $ 8,498,857 =========== ===========
THE ACCOMPANYING NOTES TO FINANCIAL STATEMENTS ARE AN INTEGRAL PART OF THIS STATEMENT. F-56 CHOICE BEHAVIORAL HEALTH PARTNERSHIP NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1999 1. BUSINESS AND BASIS OF PRESENTATION Choice Behavioral Health Partnership (Choice) is engaged in the business of managing mental health and substance abuse services under a subcontract (the Subcontract) with Humana Military Healthcare Services (Humana), a subsidiary of Humana, Inc. Humana is the prime contractor awarded the managed care support contract for Civilian Health and Medical Program of the Uniformed Services (CHAMPUS) beneficiaries in the Department of Defense Regions 3 and 4 (the Contract). Under the Subcontract, Choice is responsible for the management of mental health and substance abuse services for these regions which are comprised of Florida, Alabama, Georgia, South Carolina, Mississippi, Tennessee, and portions of Louisiana and Arkansas. Choice receives a fixed fee for the management of mental health and substance abuse services provided under the Subcontract and assumes full risk for both inpatient and outpatient services (subject to certain limitations) for all beneficiaries in the defined service area. Choice was formed as a general partnership on January 1, 1996, organized under the laws of the Commonwealth of Virginia, between CMG Health, Inc. (CMG), a Maryland corporation and FHC Options, Inc. (Options), a Virginia corporation. CMG became a wholly owned subsidiary of Magellan Health Services, Inc. (Magellan), a Delaware corporation, by virtue of Magellan's acquisition of Merit Behavioral Care Corporation, CMG's parent company, on February 12, 1998. The original term of the Contract was for the twelve month option period ended June 30, 1997 with four additional twelve month option periods available for contract extensions at the discretion of CHAMPUS. The fourth option period was extended through June 30, 2000; however, there can be no guarantee that the remaining option periods will be extended. If the Contract is extended for an option period, the Subcontract is automatically extended as well. Choice's management of mental health services under the Subcontract commenced on July 1, 1996. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. CASH AND CASH EQUIVALENTS Cash equivalents are short-term, highly liquid, interest bearing investments with an original maturity of three months or less. RESTRICTED CASH AND CASH EQUIVALENTS The Contract with Humana requires that Choice maintain cash balances sufficient to pay claims payable. CONCENTRATIONS OF CREDIT RISK Choice was formed to provide, and currently exclusively provides, services under the Subcontract. The reliance on Humana, which is Choice's sole customer and the holder of the Contract, and on CHAMPUS, which has sole discretion in extending the Contract under which the Subcontract automatically renews, F-57 CHOICE BEHAVIORAL HEALTH PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1999 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) subjects Choice to a concentration of credit risk with respect to the Subcontract. Receivable from Humana represents amounts owed to Choice for services provided under the Subcontract for the month of December. PROPERTY AND EQUIPMENT Property and equipment is carried at cost and is depreciated over the shorter of estimated useful life of the asset or the maximum remaining life of the Subcontract using the straight-line method. Leasehold improvements are amortized on the straight-line method over the shorter of the useful life or the remaining lease term. Amortization of leasehold improvements is included in depreciation expense. Property and equipment is comprised of the following:
DECEMBER 31 ------------------- 1998 1999 -------- -------- Leasehold improvements.................................. $ 3,986 $ 5,996 Furniture and fixtures.................................. 354,155 355,913 Computer equipment...................................... 372,733 413,055 Computer software....................................... 15,420 41,998 -------- -------- 746,294 816,962 Less accumulated depreciation........................... 436,069 614,083 -------- -------- $310,225 $202,879 ======== ========
Depreciation expense for the years ended December 31, 1998 and 1999 was approximately $189,000 and $183,000, respectively. CLINICAL EXPENSES AND CLAIMS PAYABLE Choice contracts with various mental health providers for the provision of mental health services to its beneficiaries. Licensed psychiatrists, licensed psychologists and licensed masters-level clinicians generally are compensated on a discounted fee for service basis. Institutional providers generally are compensated on a per diem basis for acute, partial hospitalization, and residential treatment center services. Claims payable includes the cost of services for which providers have submitted claims as well as management's estimate of the cost of claims that have been incurred, but not yet reported. The cost of claims that have been incurred but not yet reported has been estimated by management based on relevant industry data and historical trends adjusted for management's estimate of the cost efficiencies to be derived from the management of care. Management believes that methodologies employed to estimate the claim liability are reasonable and the claim liability recorded at December 31, 1999 of approximately $6,742,000 is appropriate. Adjustments to estimates of claims payable to reflect actual experience are reflected in the statements of income in the period in which such adjustments become known to management. During 1998 and 1999, clinical expenses were decreased by approximately $5,576,000 and $5,439,000, respectively, due to revisions to estimated claims payable to reflect more accurate data which became available as a result of several factors, including more timely access to authorization and claims payment information, recovery of overpaid claims, and increased experience in managing care related to F-58 CHOICE BEHAVIORAL HEALTH PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1999 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) the Subcontract. Due to uncertainties inherent in the claims estimation process, it is at least reasonably possible that the claims paid in the near term could differ materially from estimated amounts. PROVIDER CONTRACT REVENUE All revenue recorded by Choice is attributable to the Subcontract. INCOME TAXES As a partnership, Choice's income is included in the income tax returns of its partners. Accordingly, no provision for federal income taxes has been made in the accompanying financial statements. 3. FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amount of current assets and current liabilities in the accompanying balance sheets approximates their fair value. 4. RELATED PARTY TRANSACTIONS CMG, Options and Humana provide certain services to Choice and pay certain expenses on behalf of Choice. Choice is billed for the actual cost of all services provided and expenses paid on its behalf. Choice paid the following amounts to these related parties:
YEAR ENDED DECEMBER 31 ----------------------- 1998 1999 ---------- ---------- SERVICES PROVIDED BY MAGELLAN Employee business expenses.............................. $ 45,617 $ 3,439 Salaries, benefits and payroll taxes of CMG employees providing services to Choice.......................... 24,393 -- Supplies and utilities.................................. 5,658 -- -------- -------- $ 75,668 $ 3,439 ======== ======== SERVICES PROVIDED BY VALUE OPTIONS Computer support........................................ $ -- $ 22,440 Employee business expenses.............................. 36,693 4,311 Supplies and utilities.................................. 5,101 462 Salaries, benefits and payroll taxes of Options employees providing services to Choice................ 24,393 2,036 -------- -------- $ 66,187 $ 29,249 ======== ======== SERVICES PROVIDED BY HUMANA Telephone services...................................... $250,703 $234,590 Field office facility space............................. 44,697 43,884 Miscellaneous........................................... 22,732 10,120 -------- -------- $318,132 $288,594 ======== ========
F-59 CHOICE BEHAVIORAL HEALTH PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1999 4. RELATED PARTY TRANSACTIONS (CONTINUED) The amounts due to related parties is comprised of the following:
DECEMBER 31 ------------------- 1998 1999 -------- -------- CMG....................................................... $ -- $ 4,135 Options................................................... 2,666 1,896 Humana.................................................... 58,809 57,972 ------- ------- $61,475 $64,003 ======= =======
5. EMPLOYEE BENEFIT PLANS Choice has a 401(k) savings plan covering all of its employees who meet certain eligibility requirements. Under this plan, employees are allowed to contribute up to 15% of their pre-tax compensation subject to aggregate maximum limits under current tax law. Choice has the right to make a discretionary contribution as determined by the Board of Directors. Discretionary contributions of approximately $250,000 and $276,000 were made during 1998 and 1999, respectively. Choice paid approximately $4,500 and $1,625 in administration costs for the plan during 1998 and 1999, respectively. 6. COMMITMENTS AND CONTINGENCIES Choice is subject to potential claims arising from the conduct of its business and maintains a general and professional liability insurance policy with a per claim limit of $1,000,000 and aggregate limits of $3,000,000. Choice also maintains umbrella insurance coverage with limits of $10,000,000 per occurrence and aggregate and excess liability coverage of $15,000,000 per occurrence and $15,000,000 in aggregate. Management is unaware of any significant claims which may have been asserted against Choice. In the opinion of management, Choice maintains adequate insurance coverage to contain any claims which may eventually be asserted. Choice receives payments in fixed monthly amounts for the management of mental health and substance abuse care. These amounts are subject to retroactive CHAMPUS adjustments, referred to as bid-price adjustments (BPA). There are seven scheduled BPAs which occur over the course of the five-year contract and which measure a variety of factors, including changes in covered lives; estimates of actual costs for the data collection period (DCP); shifts in workload between military-provided services and contractor-provided services; changes in the acuity of services; and CHAMPUS inflation relative to projections. The DCP is the 12-month period ended June 30, 1996 (12-month period immediately preceding healthcare delivery). BPA2 was finalized in 1998 based on remeasurement of covered lives, estimated DCP utilization and consideration of changes in workload. BPA3 was determined in 1999 based on the same considerations. The BPAs are estimated and reflected as an adjustment to provider contract revenue during the applicable period. Estimated amounts payable to Humana, if any, are included in the contract settlement reserve. During 1998, management increased provider contract revenue by approximately $14,366,000 due to the settlement of BPA2. In late 1999, BPA3 was finalized, but not settled, with results indicating a net overpayment to Choice of approximately $4,240,000 for option period one through the first half of option period four. This amount is included in the contract settlement reserve. The determination of the BPA3 F-60 CHOICE BEHAVIORAL HEALTH PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1999 6. COMMITMENTS AND CONTINGENCIES (CONTINUED) settlement did not include the impact of changes in the acuity of services for which consideration has been postponed to BPA4. Management has estimated the impact of changes in the acuity of services on the BPA3 settlement to be approximately $1,225,000. This amount is included in the contract settlement reserve. While management believes that the contract settlement reserve of approximately $5,465,000 is reasonable, because of the inherent uncertainty surrounding the factors included in the determination of the final BPA for each option period, it is at least reasonably possible that the estimated amounts may differ materially from the amounts that would have been recorded had the actual factors been known. F-61 SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS--MAGELLAN (IN THOUSANDS)
CHARGED TO BALANCE AT CHARGED TO OTHER BALANCE AT BEGINNING COSTS AND ACCOUNTS-- DEDUCTIONS-- END OF CLASSIFICATION OF PERIOD EXPENSES DESCRIBE DESCRIBE PERIOD - -------------- ---------- ---------- ---------- ------------ ---------- Fiscal year ended September 30, 1997: Allowance for doubtful accounts............ $50,548 $46,211 (D) $19,373(A) $ 89,114(B) $40,311 $21,400 (E) 5,164(F) 2,943(G) ------- ------- ------- -------- ------- $50,548 $67,611 $19,373 $ 97,221 $40,311 ======= ======= ======= ======== ======= Fiscal year ended September 30, 1998: Allowance for doubtful accounts............ $40,311 $ 4,977 (D) $15,031(A) $ 24,440(B) $34,867 4,376(C) 5,388(F) ------- ------- ------- -------- ------- $40,311 $ 4,977 $19,407 $ 29,828 $34,867 ======= ======= ======= ======== ======= Fiscal year ended September 30, 1999: Allowance for doubtful accounts............ $34,867 $ 3,277 (D) $ 2,362(A) $ 1,280(B) $28,437 (8,072)(E) 604(C) 672(F) 2,649(H) ------- ------- ------- -------- ------- $34,867 $(4,795) $ 2,966 $ 4,601 $28,437 ======= ======= ======= ======== =======
- ------------------------ (A) Recoveries of accounts receivable previously written off. (B) Accounts written off. (C) Allowance for doubtful accounts (net) assumed or disposed of in acquisitions or dispositions. (D) Bad debt expense. (E) Accounts receivable collection fees included in loss on Crescent Transactions. (F) Accounts receivable collection fees payable to CBHS and outside vendors. (G) Amounts reclassified to contractual allowances. (H) Conversion of Provider JVs from consolidation to equity method. S-1 EX-23.B 2 EXHIBIT 23.B EXHIBIT 23(b) CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statements (Form S-3 Amendment 1 No. 333-53353, Form S-3 Amendment 3 No. 333-01217 and Form S-3 No. 333-50423) of Magellan Health Services, Inc. of our report dated February 18, 2000, with respect to the financial statements of Choice Behavioral Health Partnership included in this Annual Report (Form 10-K/A) for the year ended December 31, 1999. ERNST & YOUNG LLP Jacksonville, Florida March 27, 2000 -----END PRIVACY-ENHANCED MESSAGE-----