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Magellan Health Services 10-Q 2006

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-Q

(MarkOne)

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

For the Quarterly Period Ended September 30, 2006

Or

o                                 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 of other jurisdiction of
incorporation or organization)

(IRS Employer
Identification No.)

55 Nod Road, Avon, Connecticut

06001

(Address of principal executive offices)

(Zip code)

 

(860) 507-1900

(Registrant’s telephone number, including area code)


Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x  No o

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes o  No x

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer x                    Accelerated filer o                    Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No x

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEDING FIVE YEARS:

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 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 x  No o

The number of shares of the registrant’s Ordinary Common Stock outstanding as of September 30, 2006 was 37,759,332.

 




FORM 10-Q

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

INDEX

 

 

 

Page No.

PART I—Financial Information:

 

 

Item 1:

 

Financial Statements

 

3

 

 

Condensed Consolidated Balance Sheets—December 31, 2005 and September 30, 2006

 

3

 

 

Condensed Consolidated Statements of Income—For the Three Months and Nine Months Ended September 30, 2005 (restated) and 2006

 

4

 

 

Condensed Consolidated Statements of Cash Flows—For the Nine Months Ended September 30, 2005 (restated) and 2006

 

5

 

 

Notes to Condensed Consolidated Financial Statements

 

6

Item 2:

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

26

Item 3:

 

Quantitative and Qualitative Disclosures About Market Risk

 

45

Item 4:

 

Controls and Procedures

 

45

PART II—Other Information:

 

 

Item 1:

 

Legal Proceedings

 

46

Item 1A:

 

Risk Factors

 

46

Item 2:

 

Unregistered Sales of Equity Securities and Use of Proceeds

 

50

Item 3:

 

Defaults Upon Senior Securities

 

50

Item 4:

 

Submission of Matters to a Vote of Security Holders

 

50

Item 5:

 

Other Information

 

50

Item 6:

 

Exhibits

 

51

Signatures

 

52

 




PART I—FINANCIAL INFORMATION

Item 1.                        Financial Statements.

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)

 

 

December 31,

 

September 30,

 

 

 

2005

 

2006

 

 

 

 

 

(unaudited)

 

ASSETS

 

 

 

 

 

 

 

 

 

Current Assets:

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

 

$

81,039

 

 

 

$

128,286

 

 

Restricted cash

 

 

149,723

 

 

 

127,732

 

 

Accounts receivable, less allowance for doubtful accounts of $2,442 and $1,567 at December 31, 2005 and September 30, 2006, respectively

 

 

42,428

 

 

 

59,245

 

 

Short-term investments (restricted investments of $42,976 and $28,859 at December 31, 2005 and September 30, 2006, respectively)

 

 

236,153

 

 

 

38,855

 

 

Other current assets (restricted deposits of $16,498 and $19,665 at December 31, 2005 and September 30, 2006, respectively)

 

 

31,434

 

 

 

36,435

 

 

Total Current Assets

 

 

540,777

 

 

 

390,553

 

 

Property and equipment, net

 

 

102,898

 

 

 

96,466

 

 

Long-term investments - restricted

 

 

2,897

 

 

 

2,996

 

 

Investments in unconsolidated subsidiaries

 

 

15,339

 

 

 

 

 

Deferred income taxes

 

 

76,023

 

 

 

79,046

 

 

Other long-term assets

 

 

10,948

 

 

 

4,994

 

 

Goodwill

 

 

290,192

 

 

 

504,683

 

 

Other intangible assets, net

 

 

30,412

 

 

 

76,984

 

 

Total Assets

 

 

$

1,069,486

 

 

 

$

1,155,722

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

Current Liabilities:

 

 

 

 

 

 

 

 

 

Accounts payable

 

 

$

14,834

 

 

 

$

17,256

 

 

Accrued liabilities

 

 

62,327

 

 

 

77,835

 

 

Medical claims payable

 

 

164,013

 

 

 

139,801

 

 

Other medical liabilities

 

 

45,557

 

 

 

30,168

 

 

Current maturities of long-term debt and capital lease obligations

 

 

25,194

 

 

 

25,197

 

 

Total Current Liabilities

 

 

311,925

 

 

 

290,257

 

 

Long-term debt and capital lease obligations

 

 

37,890

 

 

 

18,958

 

 

Deferred credits and other long-term liabilities

 

 

84,832

 

 

 

119,008

 

 

Minority interest

 

 

1,762

 

 

 

174

 

 

Total Liabilities

 

 

436,409

 

 

 

428,397

 

 

Preferred stock, par value $.01 per share

 

 

 

 

 

 

 

 

 

Authorized—10,000 shares—Issued and outstanding—none

 

 

 

 

 

 

 

Ordinary common stock, par value $.01 per share

 

 

 

 

 

 

 

 

 

Authorized—100,000 shares at December 31, 2005 and September 30, 2006—Issued and outstanding—36,584 shares and 37,759 shares at December 31, 2005 and September 30, 2006, respectively

 

 

366

 

 

 

378

 

 

Multi-Vote common stock, par value $.01 per share

 

 

 

 

 

 

 

 

 

Authorized—40,000 shares—Issued and outstanding—none

 

 

 

 

 

 

 

Other Stockholders’ Equity:

 

 

 

 

 

 

 

 

 

Additional paid-in capital

 

 

429,933

 

 

 

462,937

 

 

Retained earnings

 

 

194,904

 

 

 

258,679

 

 

Warrants outstanding

 

 

8,489

 

 

 

5,384

 

 

Accumulated other comprehensive loss

 

 

(615

)

 

 

(53

)

 

Total Stockholders’ Equity

 

 

633,077

 

 

 

727,325

 

 

Total Liabilities and Stockholders’ Equity

 

 

$

1,069,486

 

 

 

$

1,155,722

 

 

 

See accompanying notes to condensed consolidated financial statements.

3




MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

(In thousands, except per share amounts)

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2005

 

2006

 

2005

 

2006

 

 

 

(restated)

 

 

 

(restated)

 

 

 

Net revenue

 

$

454,266

 

$

429,487

 

$

1,371,564

 

$

1,229,016

 

Cost and expenses:

 

 

 

 

 

 

 

 

 

Cost of care

 

299,134

 

271,905

 

920,263

 

804,446

 

Cost of goods sold

 

 

15,212

 

 

15,212

 

Direct service costs and other operating
expenses(1)

 

91,867

 

96,661

 

278,958

 

276,827

 

Equity in earnings of unconsolidated subsidiaries

 

(1,759

)

 

(4,711

)

(390

)

Depreciation and amortization

 

12,161

 

13,096

 

36,952

 

35,086

 

Interest expense

 

8,711

 

1,807

 

25,961

 

5,497

 

Interest income

 

(4,995

)

(4,280

)

(11,927

)

(13,418

)

Gain on sale of assets

 

 

 

 

(5,148

)

Special charges (benefits)

 

(556

)

 

(556

)

 

 

 

404,563

 

394,401

 

1,244,940

 

1,118,112

 

Income from continuing operations before income taxes and minority interest

 

49,703

 

35,086

 

126,624

 

110,904

 

Provision for income taxes

 

16,828

 

13,890

 

49,696

 

47,169

 

Income from continuing operations before minority interest

 

32,875

 

21,196

 

76,928

 

63,735

 

Minority interest, net

 

(25

)

(40

)

47

 

(40

)

Income from continuing operations

 

32,900

 

21,236

 

76,881

 

63,775

 

Income from discontinued operations(2)

 

696

 

 

1,526

 

 

Net income

 

33,596

 

21,236

 

78,407

 

63,775

 

Other comprehensive (loss) income

 

44

 

186

 

(428

)

562

 

Comprehensive income

 

$

33,640

 

$

21,422

 

$

77,979

 

$

64,337

 

Weighted average number of common shares outstanding—basic (See Note D)

 

36,436

 

37,096

 

35,795

 

36,925

 

Weighted average number of common shares outstanding—diluted (See Note D)

 

37,605

 

39,023

 

37,200

 

38,569

 

Income per common share—basic:

 

 

 

 

 

 

 

 

 

Income from continuing operations

 

$

0.90

 

$

0.57

 

$

2.15

 

$

1.73

 

Income from discontinued operations

 

$

0.02

 

$

 

$

0.04

 

$

 

Net income

 

$

0.92

 

$

0.57

 

$

2.19

 

$

1.73

 

Income per common share—diluted:

 

 

 

 

 

 

 

 

 

Income from continuing operations

 

$

0.87

 

$

0.54

 

$

2.07

 

$

1.65

 

Income from discontinued operations

 

$

0.02

 

$

 

$

0.04

 

$

 

Net income

 

$

0.89

 

$

0.54

 

$

2.11

 

$

1.65

 


(1)          Includes stock compensation expense of $3,855, and $8,939 for the three months ended September 30, 2005 and 2006, respectively, and $12,024 and $21,033 for the nine months ended September 30, 2005 and 2006, respectively.

(2)          Net of income tax provision of $28 and $1,073 for the three months and nine months ended September 30, 2005, respectively.

See accompanying notes to condensed consolidated financial statements.

4




MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30,

(Unaudited)

(In thousands)

 

 

2005

 

2006

 

 

 

(restated)

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

78,407

 

$

63,775

 

Adjustments to reconcile net income to net cash from operating activities:

 

 

 

 

 

Gain on sale of assets

 

 

(5,148

)

Depreciation and amortization

 

36,952

 

35,086

 

Equity in earnings of unconsolidated subsidiaries

 

(4,711

)

(390

)

Non-cash interest expense

 

1,042

 

1,042

 

Non-cash stock compensation expense

 

12,024

 

21,033

 

Non-cash income tax expense

 

45,393

 

42,232

 

Cash flows from changes in assets and liabilities, net of effects from
acquisitions of businesses:

 

 

 

 

 

Restricted cash

 

(41,121

)

22,241

 

Accounts receivable, net

 

(2,787

)

11,125

 

Other assets

 

4,604

 

(384

)

Accounts payable and accrued liabilities

 

68

 

(19,013

)

Medical claims payable and other medical liabilities

 

12,804

 

(39,602

)

Other

 

1,767

 

(39

)

Net cash provided by operating activities

 

144,442

 

131,958

 

Cash flows from investing activities:

 

 

 

 

 

Capital expenditures

 

(14,384

)

(14,999

)

Proceeds from sale of assets

 

 

22,200

 

Purchase of investments

 

(462,011

)

(29,589

)

Maturity of investments

 

331,642

 

227,534

 

Acquisitions and investments in businesses, net of cash acquired

 

 

(282,806

)

Proceeds from note receivable

 

7,000

 

3,000

 

Net cash used in investing activities

 

(137,753

)

(74,660

)

Cash flows from financing activities:

 

 

 

 

 

Payments on long-term debt and capital lease obligations

 

(19,266

)

(18,929

)

Proceeds from exercise of stock options and warrants

 

12,787

 

8,878

 

Net cash used in financing activities

 

(6,479

)

(10,051

)

Net increase in cash and cash equivalents

 

210

 

47,247

 

Cash and cash equivalents at beginning of period

 

45,390

 

81,039

 

Cash and cash equivalents at end of period

 

$

45,600

 

$

128,286

 

 

See accompanying notes to condensed consolidated financial statements.

5




MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2006

(Unaudited)

NOTE A—General

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of Magellan Health Services, Inc., a Delaware corporation (“Magellan”), include the accounts of Magellan, its majority owned subsidiaries, and all variable interest entities (“VIEs”) for which Magellan is the primary beneficiary (together with Magellan, the “Company”). The financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the Securities and Exchange Commission’s (the “SEC”) instructions to Form 10-Q. Accordingly, the financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments considered necessary for a fair presentation, have been included. The results of operations for the three months and nine months ended September 30, 2006 are not necessarily indicative of the results to be expected for the full year. All intercompany accounts and transactions have been eliminated in consolidation.

These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements for the year ended December 31, 2005 and the notes thereto, which are included in the Company’s Annual Report on Form 10-K filed with the SEC on March 8, 2006.

Restatements of Previously Issued Unaudited Condensed Consolidated Financial Statements

On March 7, 2006, the Company announced that it was restating previously filed financial statements to correct the Company’s accounting for reversals of valuation allowances pertaining to deferred tax assets (excluding deferred tax assets related to the Company’s net operating loss carryforwards) that existed prior to the Company’s emergence from bankruptcy on January 5, 2004. The Company had recorded the reversals of valuation allowances for such deferred tax assets as reductions to the Company’s income tax provision. In accordance with American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 90-7, “Financial Reporting by Entities in Reorganization Under the Bankruptcy Code” (“SOP 90-7”), and the Financial Accounting Standard Board’s Emerging Issues Task Force (“EITF”) Topic No. D-33, “Timing of Recognition of Tax Benefits for Pre-Reorganization Temporary Differences and Carryforwards” (“EITF D-33”), such reversals of valuation allowances should be recorded as reductions to goodwill. Accordingly, the Company has restated its consolidated financial statements for the fiscal year ended December 31, 2004, and for the quarters ended March 31, 2004, June 30, 2004, September 30, 2004, December 31, 2004, March 31, 2005, June 30, 2005 and September 30, 2005. All applicable financial information contained in this Form 10-Q gives effect to these restatements.

6




The quarterly impacts of the restatement adjustments for the three months and nine months ended September 30, 2005 are reflected below (in thousands, except per share amounts):

 

 

Three months ended

 

Nine months ended

 

 

 

September 30,

 

September 30,

 

 

 

2005

 

2005

 

Net revenue

 

 

$       —

 

 

 

$       —

 

 

Cost and expenses:

 

 

 

 

 

 

 

 

 

Cost of care

 

 

 

 

 

 

 

Direct service costs and other operating expenses

 

 

 

 

 

 

 

Equity in earnings of unconsolidated subsidiaries

 

 

 

 

 

 

 

Depreciation and amortization

 

 

 

 

 

 

 

Interest expense

 

 

 

 

 

 

 

Interest income

 

 

 

 

 

 

 

Gain on sale of assets

 

 

 

 

 

 

 

Special charges (benefits)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income from continuing operations before income taxes and minority interest

 

 

 

 

 

 

 

Provision for income taxes

 

 

595

 

 

 

1,517

 

 

Income (loss) from continuing operations before minority interest

 

 

(595

)

 

 

(1,517

)

 

Minority interest, net

 

 

 

 

 

 

 

Income (loss) from continuing operations

 

 

(595

)

 

 

(1,517

)

 

Income (loss) from discontinued operations, net of income taxes

 

 

(208

)

 

 

(746

)

 

Net income (loss)

 

 

(803

)

 

 

(2,263

)

 

Income (loss) available to common stockholders

 

 

$  (803

)

 

 

$(2,263

)

 

Weighted average number of common shares outstanding—basic

 

 

36,436

 

 

 

35,795

 

 

Weighted average number of common shares outstanding—diluted

 

 

37,605

 

 

 

37,200

 

 

Income per common share—basic:

 

 

 

 

 

 

 

 

 

Income (loss) from continuing operations

 

 

$ (0.02

)

 

 

$ (0.04

)

 

Income (loss) from discontinued operations

 

 

$       —

 

 

 

$ (0.02

)

 

Net income (loss)

 

 

$ (0.02

)

 

 

$ (0.06

)

 

Income per common share—diluted:

 

 

 

 

 

 

 

 

 

Income (loss) from continuing operations

 

 

$ (0.02

)

 

 

$ (0.04

)

 

Income (loss) from discontinued operations

 

 

$       —

 

 

 

$ (0.02

)

 

Net income (loss)

 

 

$ (0.02

)

 

 

$ (0.06

)

 

 

The weighted average number of common shares outstanding, both basic and diluted, are not affected by the restatement.

Summary of Significant Accounting Policies

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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

7




financial statements and the reported amounts of revenue and expenses during the reporting period. Significant estimates of the Company include, among other things, accounts receivable realization, valuation allowances for deferred tax assets, valuation of goodwill and intangible assets, medical claims payable, other medical liabilities, stock compensation assumptions, tax contingencies and legal liabilities. 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. Managed care risk revenues approximated $405.5 million and $1,221.1 million for the three months and nine months ended September 30, 2005, respectively, and $360.9 million and $1,063.4 million for the three months and nine months ended September 30, 2006, respectively.

Performance-based Revenue

The Company has the ability to earn performance-based revenue under certain risk and non-risk contracts included in the managed behavioral healthcare and radiology benefits management lines of business. Performance-based revenue generally is based on either the ability of the Company to manage care for its clients below specified targets, or on other operating metrics. For each such contract, the Company estimates and records performance-based revenue after considering the relevant contractual terms and the data available for the performance-based revenue calculation. Pro-rata performance-based revenue is recognized on an interim basis pursuant to the rights and obligations of each party upon termination of the contracts. Performance-based revenues were $2.9 million and $9.8 million for the three months and nine months ended September 30, 2005, respectively, and $3.9 million and $11.0 million for the three months and nine months ended September 30, 2006, respectively.

Significant Customers

Managed Behavioral Healthcare

The Company’s contracts with the State of Tennessee’s TennCare program (“TennCare”) and with subsidiaries of WellPoint, Inc. (“WellPoint”), each generated revenues that exceeded, in the aggregate, ten percent of managed behavioral healthcare net revenues for each of the three months and nine months ended September 30, 2005 and 2006. The Company also has a significant concentration of business from individual counties which are part of the Pennsylvania Medicaid program.

The Company provides managed behavioral healthcare services for TennCare, through contracts held by the Company’s wholly owned subsidiaries Tennessee Behavioral Health, Inc. (“TBH”) and Premier Behavioral Health Systems of Tennessee, LLC (“Premier”). Prior to April 11, 2006 Premier was a joint venture in which the Company owned a fifty percent interest; however the Company consolidated the results of operations of Premier, the joint venture, in the Company’s consolidated statements of income. On April 11, 2006, the Company purchased the other fifty percent interest in Premier for $1.5 million, so that Premier is now a wholly-owned subsidiary of the Company. TennCare has divided its program into three regions, and the Company’s TennCare contracts, which extend through September 30, 2007, currently encompass all of the TennCare membership for all three regions. The Company recorded revenue of $108.1 million and $334.8 million during the three months and nine months ended September 30, 2005, respectively, and $101.8 million and $312.1 million during the three months and nine months ended September 30, 2006, respectively, from its TennCare contracts.

On April 7, 2006, TennCare issued a Request for Proposals (“RFP”) for the management of the integrated delivery of behavioral and physical medical care to TennCare enrollees in the Middle region by managed care organizations. On July 26, 2006, TennCare announced the two winning bidders to the RFP process, neither of which had partnered with the Company, and a start date of April 1, 2007 at which time the Company’s contracts with TennCare will be amended to remove the Middle region enrollees. For the

8




three months and nine months ended September 30, 2006, revenue derived from TennCare enrollees residing in the Middle region amounted to $36.7 million and $113.9 million, respectively.

Total revenue from the Company’s contracts with WellPoint was $51.3 million and $155.7 million during the three months and nine months ended September 30, 2005, respectively, and $49.9 million and $148.3 million during the three months and nine months ended September 30, 2006, respectively. Included in the revenue amount for the three months and nine months ended September 30, 2006 is revenue of $3.2 million and $9.4 million from contracts that National Imaging Associates, Inc. (“NIA”) has with WellPoint (see Note B for discussion of the Company’s acquisition of NIA).

On September 6, 2006, the Company announced that it was notified by WellPoint of its intent to terminate its contract with the Company for the management of behavioral healthcare services for its commercial members in Indiana, Kentucky and Ohio (the “Midwest contract”), effective March 31, 2007. The Midwest contract had been set to expire on December 31, 2007; however, WellPoint notified the Company of its intent to exercise its right under the Midwest contract to terminate without cause with six months’ notice. For the nine months ended September 30, 2006, the Midwest contract generated revenue of $73.4 million. The Company has two other managed behavioral healthcare contracts with WellPoint that generated revenue of $65.5 million for the nine months ended September 30, 2006. Each of these contracts has a term expiring on December 31, 2007, neither contract has an early termination provision similar to that contained in the Midwest contract and the Company has not received notice of a change in the status of these contracts. The contracts with respect to the management of radiology benefits through the Company’s NIA subsidiary are unrelated to and unaffected by WellPoint’s decision regarding behavioral healthcare management for the Midwest contract.

The Company derives a significant portion of its revenue from contracts with various counties in the State of Pennsylvania (the “Pennsylvania Counties”). Although these are separate contracts with individual counties, they all pertain to the Pennsylvania Medicaid program. Revenues from the Pennsylvania Counties in the aggregate totaled $54.2 million and $159.7 million in the three months and nine months ended September 30, 2005, respectively, and $62.1 million and $186.1 million in the three months and nine months ended September 30, 2006, respectively.

The Company recorded net revenue from Aetna, Inc. (“Aetna”) of $61.8 million and $184.5 million for the three months and nine months ended September 30, 2005, respectively, which represented in excess of ten percent of the managed behavioral healthcare net revenues of the Company for such periods. The Company’s contract with Aetna terminated on December 31, 2005. During the three months and nine months ended September 30, 2006, the Company recognized $0.6 million and $6.0 million of revenue related to the performance of one-time, transitional activities associated with the contract termination.

Radiology Benefits Management and Specialty Pharmaceutical Management

Included in the Company’s Radiology Benefits Management line of business are three customers that each exceeds 10 percent of the net revenues for this line of business. The three customers represent 30.7 percent, 12.0 percent and 11.1 percent, respectively, of the net revenues for Radiology Benefits Management for the year to date period through September 30, 2006. The second customer discussed above has contracts with the Company for three geographical markets, and such customer has informed the Company that the contracts for two of these markets will terminate effective December 31, 2006.

 

Included in the Company’s Specialty Pharmaceutical Management line of business are three customers that each exceeds 10 percent of the net revenues for this line of business. The three customers represent 49.4 percent, 17.2 percent and 14.8 percent, respectively, of the net revenues for Specialty Pharmaceutical Management for the year to date period through September 30, 2006.

9




Cash and Cash Equivalents

Cash equivalents are short-term, highly liquid interest-bearing investments with maturity dates of three months or less when purchased, consisting primarily of money market instruments. Included in cash and cash equivalents are excess capital and undistributed earnings for its regulated subsidiaries, which as of September 30, 2006 was $47.4 million.

Restricted Assets

The Company has certain assets which are considered restricted for: (i) the payment of claims under the terms of certain managed behavioral healthcare contracts; (ii) regulatory purposes related to the payment of claims in certain jurisdictions; and (iii) the maintenance of minimum required tangible net equity levels for certain of the Company’s subsidiaries. Significant restricted assets of the Company as of December 31, 2005 and September 30, 2006 were as follows (in thousands):

 

 

December 31,
2005

 

September 30,
2006

 

Restricted cash

 

 

$ 149,723

 

 

 

$ 127,732

 

 

Restricted short-term investments

 

 

42,976

 

 

 

28,859

 

 

Restricted deposits (included in other current assets)

 

 

16,498

 

 

 

19,665

 

 

Restricted long-term investments

 

 

2,897

 

 

 

2,996

 

 

Total

 

 

$ 212,094

 

 

 

$ 179,252

 

 

 

Investments

The Company accounts for its investments in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”).

As of September 30, 2006, there were no unrealized losses that the Company believed to be other-than-temporary, because the Company believes it is probable that: (i) all contractual terms of each investment will be satisfied, (ii) the decline in fair value is due primarily to changes in interest rates (and not because of increased credit risk), and (iii) the Company intends and has the ability to hold each investment for a period of time sufficient to allow a market recovery. Unrealized losses related to investments greater and less than one year are not material. No realized gains or losses were recorded for the three months and nine months ended September 30, 2005 and 2006. The following is a summary of short-term and long-term investments at December 31, 2005 and September 30, 2006 (in thousands):

 

 

December 31, 2005

 

 

 

 

 

Gross

 

Gross

 

 

 

 

 

Amortized

 

Unrealized

 

Unrealized

 

Estimated

 

 

 

Cost

 

Gains

 

Losses

 

Fair Value

 

U.S. Government and agency securities

 

$ 63,783

 

 

$—

 

 

 

$(158

)

 

$ 63,625

 

Corporate debt securities

 

175,580

 

 

 

 

 

(457

)

 

175,123

 

Certificates of deposit

 

302

 

 

 

 

 

 

 

302

 

Total investments at December 31, 2005

 

$ 239,665

 

 

$—

 

 

 

$(615

)

 

$ 239,050

 

 

 

 

September 30, 2006

 

 

 

 

 

 

Gross

 

Gross

 

 

 

 

 

 

Amortized

 

Unrealized

 

Unrealized

 

Estimated

 

 

 

 

Cost

 

Gains

 

Losses

 

Fair Value

 

 

U.S. Government and agency securities

 

 

$ 24,657

 

 

 

$—

 

 

 

$(12

)

 

 

$24,645

 

 

Corporate debt securities

 

 

17,000

 

 

 

 

 

 

(41

)

 

 

16,959

 

 

Certificates of deposit

 

 

247

 

 

 

 

 

 

 

 

 

247

 

 

Total investments at September 30, 2006

 

 

$ 41,904

 

 

 

$—

 

 

 

$(53

)

 

 

$41,851

 

 

 

10




The maturity dates of the Company’s investments as of September 30, 2006 are summarized below (in thousands):

 

 

Amortized

 

Estimated

 

 

 

Cost

 

Fair Value

 

Due prior to October 1, 2007

 

 

$

38,900

 

 

 

$

38,855

 

 

Due October 1, 2007 to April 30, 2008

 

 

3,004

 

 

 

2,996

 

 

Total investments at September 30, 2006

 

 

$

41,904

 

 

 

$

41,851

 

 

 

Goodwill

Goodwill is accounted for in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). Pursuant to SFAS 142, the Company is required to test its goodwill for impairment on at least an annual basis. The Company has selected October 1 as the date of its annual impairment test. The balance of goodwill has been allocated as follows (in thousands):

 

 

December 31,

 

September 30,

 

 

 

2005

 

2006

 

Health Plan segment (defined below)

 

 

$

290,192

 

 

 

$

254,090

 

 

Radiology Benefits Management segment (defined below)

 

 

 

 

 

105,854

 

 

Specialty Pharmaceutical Management segment (defined below)

 

 

 

 

 

144,739

 

 

Total

 

 

$

290,192

 

 

 

$

504,683

 

 

 

The changes in the carrying amount of Company goodwill for the nine months ended September 30, 2006 are reflected in the table below (in thousands):

Balance as of December 31, 2005

 

$

290,192

 

Adjustment to goodwill as a result of the projected realization of net operating loss carryforwards subsequent to fresh-start reporting(1)

 

(36,102

)

Adjustment to goodwill as a result of the acquisition of National Imaging Associates, Inc. (“NIA”)—See Note B

 

105,854

 

Adjustment to goodwill as a result of the acquisition of ICORE Healthcare LLC (“ICORE”)—See Note B

 

144,739

 

Balance as of September 30, 2006

 

$

504,683

 


(1)          During fiscal 2006, the Company recorded tax benefits from the utilization of deferred tax assets, including net operating loss carryforwards (“NOLs”), that existed prior to the Company’s emergence from bankruptcy on January 5, 2004. These tax benefits have been reflected as reductions of goodwill in accordance with SOP 90-7.

Intangible Assets

At December 31, 2005 and September 30, 2006, the Company had net identifiable intangible assets (primarily customer agreements and lists and provider networks) of approximately $30.4 million and $77.0 million, respectively, net of accumulated amortization of approximately $17.3 million and $25.7 million, respectively. Intangible assets are amortized over their estimated useful lives, which range from approximately three to sixteen years. Amortization expense was $3.4 million and $10.4 million for the three months and nine months ended September 30, 2005, respectively, and $3.5 million and $8.5 million for the three months and nine months ended September 30, 2006, respectively.

11




Cost of Care, Medical Claims Payable and Other Medical Liabilities

Cost of care is recognized in the period in which members received managed healthcare services. In addition to actual benefits paid, cost of care includes the impact of accruals for estimates of medical claims payable. Medical claims payable represents 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 on past claims payment experience for member groups, enrollment data, utilization statistics, authorized healthcare services and other factors. This data is incorporated into contract-specific actuarial reserve models. 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 cost of care caused by changes in actual experience could cause the estimates to change in the near term. The Company believes that the amount of medical claims payable is adequate to cover its ultimate liability for unpaid claims as of September 30, 2006; however, actual claims payments and other items may differ from established estimates.

Other medical liabilities consist primarily of “reinvestment” payables under certain managed behavioral healthcare contracts with Medicaid customers. Under this type of contract, if the cost of care is less than certain minimum amounts specified in the contract (usually as a percentage of revenue), the Company is required to “reinvest” such difference in behavioral healthcare programs when and as specified by the customer or to pay the difference to the customer for their use in funding such programs.

Cost of Goods Sold

Cost of goods sold represents the net purchase cost of specialty pharmaceutical medicines and related medical supplies distributed to customers related to the Company’s Specialty Pharmaceutical Management segment (see Note F). Inventories of $3.7 million at September 30, 2006 consist of pharmaceutical medicines and related medical supplies, stated at lower of cost or market, and are included in other current assets within the accompanying condensed consolidated balance sheet. The Company accounts for such inventory on the first-in, first-out method.

Income Taxes

The Company’s effective income tax rate was 33.9 percent and 39.2 percent for the three months and nine months ended September 30, 2005 (restated), respectively, and 39.6 percent and 42.5 percent for the three months and nine months ended September 30, 2006, respectively. The effective rates for such periods differ from federal statutory income tax rates primarily due to state income taxes and permanent differences between book and tax income.

Stock Compensation

At December 31, 2005 and September 30, 2006, the Company had equity-based employee incentive plans, which are described below.

Stock Option Awards

On January 5, 2004, (the “Effective Date”), the Company established the 2003 Management Incentive Plan (“2003 MIP”) which allows for the issuance of up to 6,373,689 shares of common stock pursuant to stock options or stock grants. During fiscal 2004, the Company granted options for the purchase of 4.4 million shares of common stock at a weighted average grant date fair value of approximately $14.61 per share. These options vest ratably on each anniversary date over the three to four years subsequent to grant, and have a 10 year life. During fiscal 2005, the Company granted options for the purchase of 1.1 million shares of common stock at a weighted average grant date fair value of

12




approximately $10.90 per share. These options vest ratably on each anniversary date over the four years subsequent to grant, and have a 10 year life. Other than the 2004 Options (defined below) and certain options granted under the 2006 MIP (defined below), options granted by the Company have exercise prices equal to the fair market value on the date of grant.

Summarized information relative to the Company’s stock options issued under the 2003 MIP for the years ended December 31, 2004 and 2005 is as follows:

 

 

2004

 

2005

 

 

 

Options

 

Weighted
Average
Exercise
Price

 

Options

 

Weighted
Average
Exercise
Price

 

Balance, beginning of period

 

 

 

$

 

 

4,220,222

 

 

$

13.34

 

 

Granted

 

4,402,522

 

 

13.34

 

 

1,115,185

 

 

34.28

 

 

Cancelled

 

(182,300

)

 

16.10

 

 

(255,947

)

 

27.58

 

 

Exercised

 

 

 

 

 

(1,064,749

)

 

12.48

 

 

Balance, end of period

 

4,220,222

 

 

$

13.34

 

 

4,014,711

 

 

$

18.50

 

 

Exercisable, end of period

 

 

 

$

 

 

30,045

 

 

$

33.05

 

 

 

The fair values of the stock options granted were estimated on the date of their grant using the Black-Scholes-Merton option pricing model based on the following weighted average assumptions for the years ended December 31, 2004 and 2005:

 

 

2004

 

 

 

 

 

Senior Executive
Options

 

Other
Options

 

2005

 

Risk-free interest rate

 

 

3.35

%

 

2.97

%

4.00

%

Expected life

 

 

5 years

 

 

4 years

 

4 years

 

Expected volatility

 

 

39.10

%

 

37.80

%

32.50

%

Expected dividend yield

 

 

0.00

%

 

0.00

%

0.00

%

 

The following table illustrates pro forma net income and pro forma net income per share as if the fair value-based method of accounting for stock options under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) had been applied in measuring stock compensation expense for all awards for the three months and nine months ended September 30, 2005 (in thousands, except per share data):

 

 

Three Months
Ended

 

Nine Months
Ended

 

 

 

September 30, 2005

 

 

 

(restated)

 

Net income, as reported

 

 

$

33,596

 

 

 

$

78,407

 

 

Add: Stock-based employee compensation expense included in reported net income, net of related tax effects

 

 

3,626

 

 

 

10,901

 

 

Deduct: Total stock-based employee compensation expense determined under fair value method, net of related tax effects

 

 

(5,371

)

 

 

(15,622

)

 

Pro forma net income

 

 

$

31,851

 

 

 

$

73,686

 

 

Income per common share:

 

 

 

 

 

 

 

 

 

Basic—as reported

 

 

$

0.92

 

 

 

$

2.19

 

 

Basic—pro forma

 

 

$

0.87

 

 

 

$

2.06

 

 

Diluted—as reported

 

 

$

0.89

 

 

 

$

2.11

 

 

Diluted—pro forma

 

 

$

0.85

 

 

 

$

1.98

 

 

 

13




On February 24, 2006, the board of directors of the Company approved three equity plans and recommended they be submitted for approval by the Company’s shareholders at the 2006 Annual Meeting of Shareholders. The board approved the 2006 Management Incentive Plan (“2006 MIP”), the 2006 Director Equity Compensation Plan (“Director Plan”) and the 2006 Employee Stock Purchase Plan (“ESPP”). All three of these plans were approved by the Company’s shareholders at the 2006 Annual Meeting of Shareholders on May 16, 2006.

The 2006 MIP, which is similar to the Company’s 2003 MIP, authorizes the issuance of equity awards covering a total of 2,750,000 shares of the Company’s common stock, no more than 300,000 shares of which may be restricted stock or restricted stock units. A restricted stock unit is a notional account representing the right to receive a share of Ordinary Common Stock (or, at the Company’s option, cash in lieu thereof) at some future date. Under the 2006 MIP, the exercisability of certain options and the vesting of certain restricted stock units is subject to certain performance targets. The Director Plan covers 120,000 shares of the Company’s common stock, no more than 15,000 of which may be restricted stock or restricted stock units, and provides for the issuance of options and restricted stock or restricted stock units to directors immediately following each annual meeting of shareholders in 2006 and 2007. The ESPP is a noncompensatory plan and covers 100,000 shares of the Company’s common stock and permits employees of the Company to purchase Common Stock at a 5 percent discount. The initial period of activity for the ESPP is August 1, 2006 through December 31, 2006.

Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS 123 (revised 2004) “Share-Based Payment” (“SFAS 123R”), using the modified prospective transition method and therefore has not restated results for prior periods. Under this transition method, stock compensation expense for the three months and nine months ended September 30, 2006 includes stock compensation expense for all awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123. Stock compensation expense for all awards granted after January 1, 2006 is based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. The Company recognizes stock compensation expense on a straight-line basis over the requisite service period, which is generally the option vesting term ranging from three to four years. Prior to the adoption of SFAS 123R, the Company recorded stock compensation expense under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”).

The Company uses the Black-Scholes-Merton formula to estimate the fair value of stock options granted to employees and recorded stock compensation expense of $8.9 million and $21.0 million for the three months and nine months ended September 30, 2006, respectively. As stock compensation expense recognized in the condensed consolidated statements of income for the three months and nine months ended September 30, 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures, currently estimated at four percent, as required by SFAS 123R. In the Company’s pro forma information that was required under SFAS 123 for the periods prior to January 1, 2006, the Company accounted for its forfeitures as they occurred. The impact of adopting SFAS 123R to the condensed consolidated financial statements for the three months and nine months ended September 30, 2006 was a reduction to net income of $1.8 million and $4.1 million, respectively, or a decrease of $0.05 and $0.11, respectively, on both basic and fully-diluted income per common share.

SFAS 123R also requires the benefits of tax deductions in excess of recognized stock compensation expense to be reported as a financing cash flow, rather than as an operating cash flow. In the three months and nine months ended September 30, 2006, the tax deductions related to stock compensation expense were not recognized because of the availability of NOLs, and thus there were no such financing cash flows reported.

14




The weighted average grant date fair value of the stock options granted during the nine months ended September 30, 2006 was $14.20 as estimated using the Black-Scholes-Merton option-pricing model based on the following weighted average assumptions:

Risk-free interest rate

 

4.83

%

Expected life

 

4 years

 

Expected volatility

 

29.90

%

Expected dividend yield

 

0.00

%

 

As part of its SFAS 123R adoption, management determined that volatility based on actively traded equities of companies that are similar to the Company is a better indicator of expected volatility and future stock price trends than the Company’s historical volatility, due to the lack of sufficient history of the Company subsequent to the Company’s emergence from bankruptcy on the Effective Date.

Summarized information related to the Company’s stock options for the nine months ended September 30, 2006 is as follows:

 

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

Weighted

 

Average

 

Aggregate

 

 

 

 

 

Average

 

Remaining

 

Intrinsic

 

 

 

 

 

Exercise

 

Contractual

 

Value

 

 

 

Options

 

Price

 

Term (in years)

 

(in thousands)

 

Outstanding, beginning of period

 

4,014,711

 

 

$

18.50

 

 

 

 

 

 

 

 

 

 

Granted

 

1,620,484

 

 

37.10

 

 

 

 

 

 

 

 

 

 

Cancelled

 

(198,928

)

 

24.57

 

 

 

 

 

 

 

 

 

 

Exercised

 

(481,757

)

 

18.39

 

 

 

 

 

 

 

 

 

 

Outstanding, end of period

 

4,954,510

 

 

$

24.35

 

 

 

6.97

 

 

 

$

91,780

 

 

Vested and expected to vest at end of
period

 

4,778,185

 

 

$

24.11

 

 

 

0.87

 

 

 

$

89,639

 

 

Exercisable, end of period

 

190,979

 

 

$

32.70

 

 

 

8.23

 

 

 

$

1,921

 

 

 

The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (based upon the difference between the Company’s closing stock price on the last trading day of the fiscal 2006 third quarter of $42.60 and the exercise price) for all in-the-money options as of September 30, 2006. This amount changes based on the fair market value of the Company’s stock. The total pre-tax intrinsic value of options exercised (based on the difference between the Company’s closing stock price on the day the option was exercised and the exercise price) during the nine months ended September 30, 2006 was $9.9 million.

As of September 30, 2006, there was $33.0 million of total unrecognized stock compensation expense related to nonvested stock options that is expected to be recognized over a weighted average remaining recognition period of 2.56 years. The total fair value of shares vested during the three months and nine months ended September 30, 2006 was $0 million and $9.4 million, respectively.

During the nine months ended September 30, 2006, the Company granted 956,002 options to members of management at a weighted average grant date fair value of approximately $13.35 and at an exercise price of $38.52, which was equal to the price of the Company’s stock on February 24, 2006, the date that the option grants were approved by the board of directors of the Company.

The Company granted an additional 199,463 options pursuant to the January 31, 2006 acquisition of NIA (see Note B below), including 99,463 Incentive Stock Options (“ISOs”). The weighted average grant date fair value of the 100,000 options, other than ISOs, granted to NIA employees was approximately $11.01. The 99,463 ISOs were granted to three employees previously employed by NIA in exchange for

15




outstanding NIA incentive stock options held by such individuals and were granted at exercise prices that ranged from $4.44 to $7.66 per share, which prices were determined based on the exercise price of the NIA options exchanged times the exchange ratio equal to the price of the Company’s stock at closing to the purchase price per share of NIA paid by the Company in the acquisition. The options had a weighted average grant date fair value of approximately $32.24. Stock compensation expense related to the ISOs for the three months and nine months ended September 30, 2006 was approximately $0.3 million and $0.7 million, respectively. The remaining 465,019 options granted to management in the nine months ended September 30, 2006 were granted at exercise prices which equaled the fair market value of the Company’s Ordinary Common Stock on the respective grant dates, which included options to purchase 222,319 shares granted upon exercise of 2004 Options (defined below) pursuant to the amendments as described below.

Substantially all of the Company’s options granted during the nine months ended September 30, 2006 vest ratably on each anniversary date over the three years subsequent to grant, and all have a ten year life.

At September 30, 2006, 2,508,691 shares of the Company’s common stock remain available for future grant under the Company’s 2003 MIP and the 2006 MIP.  At September 30, 2006, 73,758 shares of the Company’s common stock remain available for future grant under the 2006 Director Plan.

Restricted Stock Awards

During the year ended December 31, 2005, the Company granted 140,636 shares of restricted stock pursuant to the 2003 MIP, 14,507 of which were vested and 126,129 of which vest ratably on each anniversary date over the four years subsequent to grant. Of these grants, 10,872 shares were cancelled pursuant to terminations of employment, resulting in a total of 115,257 outstanding unvested shares of restricted stock at December 31, 2005.

Summarized information related to the Company’s nonvested restricted stock awards for the nine months ended September 30, 2006 is as follows:

 

 

 

 

Weighted Average

 

 

 

 

 

Grant Date

 

 

 

Shares

 

Fair Value

 

Outstanding, beginning of period

 

115,257

 

 

$

34.06

 

 

Awarded

 

550,629

 

 

$

44.06

 

 

Vested

 

(25,493

)

 

$

34.57

 

 

Forfeited

 

(8,243

)

 

$

34.57

 

 

Outstanding, end of period

 

632,150

 

 

$

42.74

 

 

 

On July 31, 2006, pursuant to the Company’s purchase of ICORE, the Company granted to the unitholders of ICORE, 543,879 shares of restricted stock of the Company valued at $24.0 million, which stock will vest over three years, provided that the unitholders do not earlier terminate their employment with the Company or any subsidiary of the Company. The remaining 6,750 restricted stock awards granted in the nine months ended September 30, 2006 vest ratably on each anniversary date over the three years subsequent to grant. As of September 30, 2006, there was $23.1 million of unrecognized stock compensation expense related to nonvested restricted stock awards. This cost is expected to be recognized over a weighted-average period of 2.78 years

Restricted Stock Units

During the nine months ended September 30, 2006, the Company granted 121,080 restricted stock units pursuant to the 2006 MIP which vest ratably on each anniversary date over the three years subsequent to grant. As of September 30, 2006, there was $4.1 million of unrecognized stock compensation expense related to nonvested restricted stock units. This cost is expected to be recognized over a weighted-average period of 2.42 years.

16




Option Modification

On January 3, 2006, the Company amended certain stock options outstanding under the 2003 MIP. The amendments, as further described below, were intended primarily to bring the features of such options into compliance with certain requirements established by Section 409A of the Internal Revenue Code of 1986, as amended (the “Code”), which was added to the Code by the American Jobs Creation Act of 2004 and governs as a general matter the federal income tax treatment of deferred compensation. The amended options were originally issued in connection with the consummation of the Plan, which occurred on the Effective Date (the “2004 Options”). Because the exercise price of such 2004 Options may be considered to have been less than the fair market value of the shares that may be acquired upon exercise of such options as determined by the market trading in such shares following the consummation of the Plan, such options might be subject to the provisions of Section 409A, including certain penalty tax provisions on the option holders.

The amendments in each case reduced the period in which the 2004 Options, once vested, could be exercised from the tenth anniversary of the date of grant to the end of the calendar year in which each option first becomes exercisable. The vesting schedule of the options was not changed and no change was made in the exercise price or other material terms.

In addition, the 2004 Options issued to the Company’s Chief Executive Officer, Chief Operating Officer and Chief Financial Officer (the “Senior Executives”) were also amended to defer until January 5, 2007 the exercisability of all but 137,398 of their options that vest in January 2006. This deferral was agreed upon in connection with the waiver by the Company of the restriction on sale before January 5, 2007 of 413,003 shares held by the Senior Executives, that they had previously acquired upon exercise of a portion of their 2004 Options that vested in January 2005.

In connection with these amendments, the Company agreed to grant new options to option holders, other than the Senior Executives, upon exercise of their 2004 Options. The new options will be in an amount equal to the number of options exercised, will have exercise prices equal to the market price on the date of grant and will vest ratably on each anniversary date over the three years subsequent to grant. In the nine months ended September 30, 2006, options to purchase 222,319 shares were granted pursuant to these amendments upon exercise of 2004 Options during this period.

Common Stock Warrants

On the Effective Date, Magellan and 88 of its subsidiaries consummated their Third Joint Amended Plan of Reorganization, as modified and confirmed (the “Plan”). Under the Plan, the Company issued 570,825 warrants to purchase common stock of the Company at a purchase price of $30.46 per share at anytime until January 5, 2011. As of September 30, 2006, 570,381 of these warrants remain outstanding. Also on the Effective Date and pursuant to the Plan, the Company entered into a warrant agreement with Aetna whereby Aetna had the option to purchase, between January 1, 2006 and January 5, 2009, 230,000 shares of Ordinary Common Stock at a purchase price of $10.48 per share. On January 30, 2006, Aetna effected a cashless exercise for all of their warrants, which resulted in 150,815 shares being issued to Aetna.

Recent Accounting Pronouncements

In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109” (“FIN 48”), which prescribes a minimum recognition threshold and measurement methodology for tax positions taken or expected to be taken in a tax return. FIN 48 will be effective beginning January 1, 2007. The Company has not yet evaluated the impact of implementation of FIN 48 on its consolidated financial statements.

17




Reclassifications

Certain amounts previously reported for the three months and nine months ended September 30, 2005 have been reclassified to conform to the presentation of amounts reported for the three months and nine months ended September 30, 2006.

NOTE B—Acquisitions

Acquisition of National Imaging Associates

On January 31, 2006, the Company acquired all of the outstanding stock of NIA, a privately held radiology benefits management (“RBM”) firm headquartered in Hackensack, New Jersey, for approximately $121 million in cash, after giving effect to cash acquired in the transaction, and NIA became a wholly owned subsidiary of Magellan.

NIA manages diagnostic imaging services on a non-risk basis for its health plans to ensure that such services are clinically appropriate and cost effective. NIA has approximately 17.3 million covered lives under contract as of September 30, 2006. The Company reports the results of operations of NIA as a separate segment entitled Magellan Radiology Benefits Management (“Radiology Benefits Management”). See Note F—Business Segment Information.

The estimated fair values of NIA assets acquired and liabilities assumed at the date of the acquisition are summarized as follows (in thousands):

Assets acquired:

 

 

 

Current assets

 

$

9,927

 

Property and equipment, net

 

5,998

 

Other assets

 

85

 

Goodwill

 

105,854

 

Other identified intangible assets

 

13,530

 

Total assets acquired

 

135,394

 

Liabilities assumed:

 

 

 

Current liabilities

 

5,626

 

Total liabilities assumed

 

5,626

 

Net assets acquired

 

$

129,768

 

 

The purchase price has been allocated based upon the estimated fair value of net assets acquired at the date of acquisition. A portion of the excess purchase price over tangible net assets acquired has been allocated to identified intangible assets totaling $13.5 million, consisting of customer contracts in the amount of $12.6 million, which is being amortized over 10 years, and developed software in the amount of $0.9 million, which is being amortized over 5 years. In addition, the excess of purchase price over tangible net assets and identified intangible assets acquired resulted in $105.9 million of non-tax deductible goodwill.

18




As a result of the acquisition of NIA, the Company approved an exit plan for certain NIA operations and activities. The Company’s plan to exit certain facilities of NIA resulted in assumed liabilities of $0.7 million to terminate an initial estimate of 25 employees and $0.4 million to close excess facilities, which were recorded based on EITF No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination.” Such assumed liabilities are reflected in accrued liabilities in the condensed consolidated financial statements. Additional liabilities may be recognized in future periods as the Company completes its analysis of this acquisition. A rollforward of exit plan liabilities assumed is as follows (in thousands):

 

 

Balance

 

 

 

 

 

Balance

 

 

 

January 31, 2006

 

Additions

 

Payments

 

September 30, 2006

 

Type of Cost

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Employee severance and termination benefits

 

 

$

654

 

 

 

$

 

 

 

$

(311

)

 

 

$

343

 

 

Lease termination and other costs

 

 

362

 

 

 

 

 

 

(60

)

 

 

302

 

 

 

 

 

$

1,016

 

 

 

$

 

 

 

$

(371

)

 

 

$

645

 

 

 

Acquisition of ICORE Healthcare, LLC

On July 31, 2006, pursuant to the Agreement and Plan of Merger (the “Merger Agreement”), dated as of June 27, 2006, among Magellan Health Services, Inc. (“Magellan”), Green Spring Health Services Inc. (a wholly-owned subsidiary of Magellan) (“Green Spring”), Magellan Sub Co. II, Inc. (a wholly-owned subsidiary of Green Spring), ICORE Healthcare LLC (“ICORE”), a Delaware limited liability company, and Raju Mantena as representative of the unitholders of ICORE, Magellan Sub Co. II, Inc. merged with and into ICORE (the “Merger”). As a result of the Merger, Magellan became the owner of all outstanding units of membership interest of ICORE, which will now operate as an indirect wholly-owned subsidiary of Magellan.

As consideration for the Merger, the Company paid or agreed to pay to the previous unitholders of ICORE, all of whom are members of ICORE’s management team, (i) $161 million of cash at closing; (ii) $24 million of restricted stock of Magellan with such restricted stock vesting over three years, provided the unitholders do not earlier terminate their employment with Magellan; (iii) $25 million plus accrued interest (the “Deferred Payment”) on the third anniversary of the Closing, subject to any indemnity claims Magellan may have under the agreement; (iv) the amount of positive working capital that existed at ICORE on the closing date (the “Working Capital Payments”), which is currently estimated to be $19.7 million and which is payable in installments ending 30 days after the final reconciliation of working capital is determined on the first anniversary of the closing; and (v) a potential earn-out of up to $75 million (the “Earn-Out”). The $161 million of cash paid at closing, the $25 million Deferred Payment and $19.7 of estimated Working Capital Payments were recorded as purchase price. The $24 million of restricted stock is being recognized as stock compensation expense over the three year vesting period. The Deferred Payment and the remaining estimated Working Capital Payments are included in Deferred Credits and Other Long-Term Liabilities and in Accrued liabilities, respectively, on the Company’s accompanying condensed consolidated balance sheet as of September 30, 2006. The earn-out has two parts: (i) up to $25 million based on earnings for the 18 month period ending December 31, 2007 and (ii) up to $50 million based on earnings in 2008. The earn-out, if earned, is payable 33 percent in cash and 67 percent in restricted stock of Magellan that vests over two years after issuance. Any earn-out earned will be recognized as compensation expense over the applicable reporting period.

ICORE is engaged in providing specialty pharmaceutical services to managed care organizations. Specialty pharmaceutical drugs represent high-cost injectible, infused, oral, or inhaled drugs which traditional retail pharmacies typically do not supply due to their high cost, sensitive handling, and storage needs. ICORE’s specialty pharmaceutical services include (i) the distribution of specialty pharmaceutical drugs on behalf of health plans, (ii) administering on behalf of health plans rebate agreements between health plans and pharmaceutical manufacturers, and (iii) providing consulting services to health plans and pharmaceutical manufacturers. ICORE holds contracts with approximately 29 health plans, after

19




consolidating health plans under common control, and 9 pharmaceutical manufacturers as of September 30, 2006.

The Company reports the results of operations of ICORE as a separate segment entitled Magellan Specialty Pharmaceutical Management (“Specialty Pharmaceutical Management”). See Note F—Business Segment Information.

The estimated fair values of ICORE assets acquired and liabilities assumed at the date of the acquisition are summarized as follows (in thousands):

Assets acquired:

 

 

 

Current assets

 

$

31,920

 

Property and equipment, net

 

752

 

Other assets

 

31

 

Goodwill

 

144,739

 

Other identified intangible assets

 

41,500

 

Total assets acquired

 

218,942

 

Liabilities assumed:

 

 

 

Current liabilities

 

12,238

 

Total liabilities assumed

 

12,238

 

Net assets acquired

 

$

206,704

 

 

The purchase price has been allocated based upon the estimated fair value of net assets acquired at the date of acquisition. A portion of the excess purchase price over tangible net assets acquired has been allocated to identified intangible assets totaling $41.5 million, consisting of customer contracts which are being amortized over 3 to 10 years. In addition, the excess of purchase price over tangible net assets and identified intangible assets acquired resulted in $144.7 million of tax deductible goodwill. The Company’s tax provision will not be impacted by the tax deductible goodwill from the ICORE transaction.

Pro Forma Financial Information

The following unaudited supplemental pro forma information represents the Company’s consolidated results of operations for the three and nine months ended September 30, 2005 as if the acquisitions of NIA and ICORE had occurred on January 1, 2005 and for the three and nine months ended September 30, 2006 as if the acquisition of ICORE had occurred on January 1, 2006, in all cases after giving effect to certain adjustments including interest income, depreciation and amortization, and stock compensation expense. The results of NIA have been included in the Company’s consolidated financial statements since January 31, 2006, the date of acquisition. Had NIA’s results of operations been included in the Company’s results of operations since January 1, 2006, there would have been no material effect on the Company’s consolidated results of operations.

Such pro forma information does not purport to be indicative of operating results that would have been reported had the acquisitions of NIA and ICORE occurred on January 1, 2005 and 2006 (in thousands):

 

 

Pro Forma

 

 

 

(unaudited)

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2005

 

2006

 

2005

 

2006

 

Net revenue

 

$

479,202

 

$

438,936

 

$

1,440,103

 

$

1,296,053

 

Net income

 

33,221

 

21,097

 

77,294

 

63,721

 

Income per common share—basic:

 

$

0.91

 

$

0.57

 

$

2.16

 

$

1.72

 

Income per common share—diluted:

 

$

0.88

 

$

0.54

 

$

2.08

 

$

1.64

 

 

20




NOTE C—Long Term Debt and Capital Lease Obligations

Information with regard to the Company’s long-term debt and capital lease obligations at December 31, 2005 and September 30, 2006 is as follows (in thousands):

 

 

December 31,

 

September 30,

 

 

 

2005

 

2006

 

Credit Agreement:

 

 

 

 

 

 

 

 

 

Revolving Loan Facility due through 2008

 

 

$

 

 

 

$

 

 

Term Loan Facility (7.17% at September 30, 2006) due through 2008

 

 

62,500

 

 

 

43,750

 

 

4.36% to 6.00% capital lease obligations due through 2008

 

 

584

 

 

 

405

 

 

 

 

 

63,084

 

 

 

44,155

 

 

Less current maturities of long-term debt and capital lease obligations

 

 

(25,194

)

 

 

(25,197

)

 

 

 

 

$

37,890

 

 

 

$

18,958

 

 

 

NOTE D—Income per Common Share

The following tables reconcile income (numerator) and shares (denominator) used in the computations of income from continuing operations per common share (in thousands, except per share data):

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2005

 

2006

 

2005

 

2006

 

 

 

(restated)

 

 

 

(restated)

 

 

 

Numerator:

 

 

 

 

 

 

 

 

 

 

 

 

 

Income from continuing operations—basic and diluted